What Is Financial System?
Financial system is an arrangement through which there is transfer or flow of money from the lenders and investors to the borrowers. Financial system facilitates the flow of money from the areas of surplus to the areas of deficit. It helps in the effective mobilization and allocation of financial resources for productive uses in an economy. A sound financial system is important for the smooth functioning of a country’s economy. A financial system consists of various components.
Indian Financial System Consists Of The Following Components:-
Money market deals with short-term funding. In money market, funds are made available for a short period. The funds are borrowed or lent for a period of less than one year. The maturity period of instruments in money market range from one day to one year. In India, the money market is regulated and controlled by the Reserve bank of India (RBI). Government is the biggest borrower in the money market in most countries including India.
Capital market deals with long-term funding. In capital market, funds are made available for a long period. The funds are borrowed or lent for a period of more than one year. In India, the capital market is regulated and controlled by the Securities and Exchange board of India (SEBI). The capital market is divided into two types:-
(1) Primary capital market:-
Primary capital market provides the channel for sale of new securities. In primary market, private unlisted companies issue shares to the public for the first time which is called Initial public offer (IPO) which leads to the listing of the company on the stock exchange for trading of the issued shares. In primary market, existing listed companies issue further shares to the public to raise capital which is called as Follow on public offer (FPO). The companies also raise capital by issuing debentures to the public in the primary market. Primary market is also called as new issues market.
(2) Secondary capital market:-
In secondary capital market, buying and selling of the securities issued in primary market is done. Securities issued in primary market are traded in the secondary market. The trading of securities in the secondary market is done through the platform of the stock exchanges and the investors can trade in the stock exchanges only through the brokers.
Difference Between Money market And Capital Market:-
|Money market||Capital market|
|Money market deals with short-term funding.||Capital market deals with long-term funding.|
|In India, the money market is regulated and controlled by Reserve bank of India.||In India, the capital market is regulated and controlled by Securities and Exchange board of India.|
|Money market is a highly liquid market.||Capital market is a illiquid market.|
|Money market is a wholesale debt market.||Capital market is a retail debt and equity market.|
|Money market instruments are less risky than the capital market instruments and the returns on them are lower than capital market.||Capital market instruments are more risky than money market instruments and the returns on them are higher than money market.|
Financial instruments can be divided into money market instruments and capital market instruments.
Money Market Instruments:-
Following are some of the important instruments which are issued in the money market:-
Treasury bills ( T-bill):-
Treasury bills are issued by the Government to fulfill its short-term borrowing needs. The maturity periods of treasury bills range from 14 days to 364 days. Currently only 91-day and 364-day treasury bills are issued by the Indian government. Treasury bills are issued at a discount to the face value and on maturity the face value is paid to the holder of treasury bill. The issue price and discount rate are determined by the bidding process through auctions. 91-day treasury bills are auctioned on the basis of uniform price auction method which is also called as dutch auction method and the 364-day treasury bills are auctioned on the basis of multiple price auction method which is also called as french auction method.
Commercial papers (CP):-
Commercial paper is a short-term unsecured promissory note issued by the corporates and financial institutions at a discount to the face value. The maturity period of commercial papers range from 1 day to 270 days. Commercial papers can be issued in both physical and dematerialized form. Commercial papers are generally issued by companies that are financially strong and have a high credit rating.
Certificates of deposit (CD):-
Certificates of deposit are issued in the form of a usance promissory note by banks in the form of a certificate entitling the holder of certificate to receive interest at a fixed rate. The maturity period of certificates of deposit range from 15 days to 365 days. Certificates of deposit can be issued in both physical and dematerialized form. They are like bank term deposits but are freely negotiable instruments unlike bank term deposits.
Call and Notice money:-
When money is borrowed or lent for one day, it is called as call money and when money is borrowed or lent for more than one day but up to fourteen days only, it is called as notice money. Mostly the banks are borrowers and non-banking financial institutions are the lenders.
Capital Market Instruments:-
Following are some of the important instruments which are issued in the capital market:-
A share is one of the units into which the capital of the company is divided. Share is the share in the share capital of a company. A person having the shares of a company is called as shareholder of that company and is regarded as the part owner of the company. Shares are of two types:-
(1) Equity shares:-
Equity shares are also called as ordinary shares and they represent part or fractional ownership in the company for the equity shareholder and gives right to the equity shareholder of a share in the profits of the company in the form of dividend as and when declared by the company and also voting rights. Equity shareholders are the members of the company.
(2) Preference shares:-
Preference shares are the shares which give the preference shareholders two preferential rights- first, the right to receive dividend at a fixed rate or fixed amount before any dividend is paid to the equity shareholders and second, the right to receive re-payment of their capital on winding up of the company before the capital of equity shareholders is returned. Because of these two preferential rights they are called as preference shares. Preference shareholders do not have any voting rights and they are not the members of the company. There are various kinds of preference shares which a company can issue:-
– Cumulative and non-cumulative preference shares:- If a company does not have adequate profit for a year and so is not able to pay preference dividend then such unpaid dividend gets accumulated and is carried forward to future years and is paid out of the profits earned by the company in those years before paying equity dividend. In case of non-cumulative preference shares, the unpaid dividend does not get accumulated and is not carried forward to future years. So if the company has inadequate profit for a year, then the preference shareholders do not get any dividend for that year.
– Redeemable and irredeemable preference shares:- Redeemable preference shares have to be redeemed or repaid by the company after the expiry of a fixed period from the date of issue while irredeemable preference shares cannot be redeemed or repaid by the company except at the time of winding up of the company.
– Participating and non-participating preference shares:- Participating preference shareholders have a right to participate in the surplus profits of the company left after payment of dividend to equity shareholders and other preference shareholders in addition to the fixed rate of dividend payable to them. Non-participating preference shareholders do not have any such right to participate in the surplus profits of the company.
– Convertible and non-convertible preference shares:- Those preference shares which can be converted into equity shares at the end of a specified period are called as convertible preference shares. The terms of issue must include a right for conversion into equity shares and in absence of any such right for conversion in the terms of issue, the preference shares cannot be converted into equity shares and are called as non-convertible preference shares.
Difference Between Equity Shares And Preference Shares:-
|Equity shares||Preference shares|
|Equity shares are the owned capital of the company.||Preference shares are the borrowed capital of the company.|
|Equity shareholders are the members and part owners of the company.||Preference shareholders are not members or part owners of the company. They are just like other lenders to the company.|
|The rate of dividend on equity shares is not fixed. It depends on the profits made by the company.||The rate of dividend on preference shares is fixed.|
|Equity shareholders are paid dividend after preference shareholders.||Preference shareholders are paid dividend before equity shareholders.|
|Equity shareholders are repaid their capital after preference shareholders in case of winding up of the company.||Preference shareholders are repaid their capital before equity shareholders in case of winding up of the company.|
|Equity shareholders have voting rights in the company.||Preference shareholders do not have any voting rights in the company.|
Debentures are the long-term borrowed funds of the company. Debentures have a fixed maturity period and have a fixed rate of interest. Debentures are usually in the form of a certificate issued under the common seal of the company . The certificate is an acknowledgement by the company of its indebtedness to the holder of the debentures. There are various kinds of debentures which are issued by a company:-
– Secured and unsecured debentures:- Debentures that are secured by a charge on some of the assets or property of the company are called as secured or mortgage debentures. So the holders of such debentures have a right to sell off those assets or property of the company on which the charge is created in case the company defaults in re-payment of the principal amount of debentures or interest. Debentures that do not carry any such charge on the assets or property of the company are called as unsecured debentures.
– Registered and bearer debentures:- Registered debentures are registered with the company. The name of every debenture holder is recorded on the debenture certificate and in the company’s register of debenture holders. Registered debentures are non-negotiable instruments and interest on such debentures is payable only to the registered holders of debentures. Bearer debentures are not registered with the company. The names of debenture holders are not registered in the books of the company but the holders are entitled to claim principal amount and interest as and when due. Bearer debentures are negotiable instruments and interest on such debentures is payable to the bearer. Bearer debentures are transferable by mere delivery.
– Redeemable and irredeemable debentures:- Redeemable debentures are the debentures that have to be redeemed or repaid by the company after the expiry of a fixed period from the date of their issue whereas irredeemable debentures cannot be redeemed or repaid by the company except at the time of winding up of the company. They are also called as perpetual debentures.
– Fully convertible, partly convertible and non-convertible debentures:- Those debentures which can be converted into equity shares at the end of a specified period are called as fully convertible debentures. The terms of issue must include a right for conversion into equity shares. Partly convertible debentures have two portions- one is the convertible portion and the other is the non-convertible portion. The convertible portion is converted into equity shares at the end of the specified period and the non-convertible portion is redeemed or repaid by the company after the expiry of the stipulated period. Non-convertible debentures do not have the option of conversion into equity shares and are redeemed or repaid after the expiry of fixed period.
Bonds are long-term borrowed funds of the government and also companies. Bonds have a fixed maturity period and have a fixed rate of interest which is called as coupon rate. There are various kinds of bonds which are issued. Some of them are:-
– Fixed rate bonds:- The coupon rate remains the same throughout the lifetime of such bonds.
– Floating rate bonds:- The coupon rate is not fixed and keeps changing according to the changes in market rates in case of such bonds.
– High yield bonds:- These bonds are also called as junk bonds. They are rated below the investment grade and have a higher risk of default as they are issued by companies rated lower by the credit rating agencies. But they pay higher returns to the investors as compared to other bonds because of the higher risk.
– Inflation indexed bonds:- These bonds act as a hedge against inflation. they have a fixed coupon rate and the principal amount is adjusted against inflation rate in the country for which an index such as consumer price index (CPI) is used. The coupon on these bonds is paid periodically on the adjusted principal amount. On maturity, the adjusted principal amount or original principal amount, whichever is higher, is paid.
– Zero coupon bonds:- These bonds are also called as deep discount bonds. These bonds do not pay any coupon during the lifetime of the bonds. They are issued at a price lower than its face value and the face value is repaid to the investor at the time of maturity of the bond.
Difference Between Debentures And Bonds:-
|Debentures are issued mostly by the companies.||Bonds are issued mostly by the government.|
|The rate of interest on debentures is generally higher than bonds.||The rate of interest on bonds is generally lower than debentures.|
|Debentures carry a higher risk than bonds.||Bonds carry a lower risk than debentures.|
|The return on debentures is called as interest and the rate of return is called as interest rate.||The return on bonds is called as coupon and the rate of return is called as coupon rate.|
Reserve bank of India (RBI):-
Reserve bank of India is India’s central bank. It was established on 1st April, 1935 in accordance with the provisions of the Reserve bank of India Act, 1934. The central office of RBI was initially established in Kolkata but was later moved to Mumbai in 1937. The RBI is fully owned by the government of India. Following are the main functions of RBI:-
– RBI formulates, implements and monitors the monetary policy with a view to maintain price stability and financial stability and to ensure adequate flow of credit to the productive sectors of the economy.
– RBI issues and destroys currency notes and coins not fit for circulation to give the public adequate quantity of currency notes and coins in good quality.
– RBI acts as a banker to the central government and to those state governments that have entered into an agreement with RBI.
– RBI acts as a banker to all the banks operating in India.
– RBI plays a key role in the regulation and development of the foreign exchange market in India.
– RBI regulates and supervises the banking system in India to ensure orderly development and conduct of banking operations.
For more information about RBI you can visit the site http://www.rbi.org.in
Securities and Exchange board of India (SEBI):-
Securities and Exchange board of India is the regulator of the securities market in India. It was established on 12th April, 1992 in accordance with the provisions of the Securities and Exchange board of India Act, 1992. The head office of SEBI is located in Mumbai. Following are the main functions of SEBI:-
– Protecting the interests of investors in securities.
– Promoting the development of and regulating the securities market.
– Regulating the business in stock exchanges and any other securities market.
– Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities market in any manner.
– Registering and regulating the working of depositories and depository participants, custodian of securities, foreign institutional investors, credit rating agencies and any other intermediaries as the board may specify.
– Registering and regulating the working of venture capital funds and collective investment schemes including mutual funds.
– Promoting and regulating self-regulatory organizations.
– Prohibiting fraudulent and unfair trade practices relating to securities market.
– Promoting investors education and training of intermediaries of securities market.
– Prohibiting insider trading in securities.
– Regulating substantial acquisition of shares and takeover of companies.
For more information about SEBI you can visit the site http://www.sebi.gov.in
Intermediaries in the financial markets are a important link between the issuers of securities and the investors in securities. They act as a middleman between the borrowers of money who are companies and government and lenders of money who are retail and institutional investors. Following are the main intermediaries in the capital market:-
Merchant bankers are the intermediaries who provide various services such as managing the public issue of securities like shares, debentures and other securities of companies and providing advisory services regarding such issue management, underwriting of such public issue of securities, advisory services for mergers and acquisitions, advisory services for projects, financial advisory services, etc. All public issue of securities are managed by at least one merchant banker who functions as the lead merchant banker. Merchant banking services are offered by commercial banks and investment banks.
Underwriters are the intermediaries who assure the issuing company to take up shares, debentures and other securities to a specified extent in case the public does not fully subscribe to the issue of securities by the company. For this purpose, an agreement is entered between the issuing company and the underwriter. The underwriters help the companies to raise the required capital by assuring to take up the unsubscribed portion of securities issue to a specified extent in case the public response to the issue is not satisfactory. Underwriting service is provided mostly by investment banks.
Registrars and Share transfer agents:-
Registrars to an issue and share transfer agents play an important role in the capital market. Registrars to an issue provide various services such as collecting applications from investors in respect of an issue of shares by the company, keeping a proper record of applications and application money received from investors, assisting in determining the basis of allotment of shares, finalizing the list of investors who are entitled to allotment of shares, processing and dispatching allotment letters and refund orders, etc.
Share transfer agents maintain the records of holders of shares issued by the company and also undertake the work of transfer of shares from one investor to other. Share transfer agents transfer those shares which are in the form of physical share certificates. With the introduction of depository system in India, almost all the shares are now in dematerialized form but still there are few companies whose shares are in the form of physical share certificates. Registrar and share transfer services are provided by investment banks.
Bankers to an issue:-
Bankers to an issue collect applications and application money from investors in respect of an issue of shares by the company and refund the application money to those investors who are not allotted shares by the company. Scheduled commercial banks generally act as bankers to an issue.
Debenture trustees are intermediaries between the companies issuing debentures or bonds and the holders of debentures or bonds. Debenture trustees are appointed by the companies issuing debentures to represent and protect the interest of debenture holders. It is compulsory for the issuing companies to appoint debenture trustees if the maturity period of debentures or bonds is beyond eighteen months irrespective of whether the debentures or bonds are secured or not. The issuing companies pay the fee to debenture trustees. The companies have to appoint one or more debenture trustees by creating a trust deed before giving a letter of offer to the public for subscription to its debentures. Debenture trustees can be scheduled commercial banks, public financial institutions, insurance companies.
Stock brokers and sub brokers:-
Stock brokers and sub brokers play a very important part especially in the secondary capital market. Stock brokers are the members of the stock exchange and help the buyers and sellers of securities to enter into a transaction. If a buyer or seller wants to buy or sell securities in stock exchange, he can only do it through the stock brokers and not directly. The stock brokers execute the buy and sell orders of securities of the investors on their behalf in the stock exchange and charge commission for this service which is called as brokerage. The stock broker issues a contract note to the investors i.e his clients indicating all the details of the trades i.e buy and sell transactions which he has done on their behalf.
Sub brokers are the ones who work along with the main stock broker and are not directly registered with the stock exchange as members. They act on behalf of the stock brokers as agents for assisting the investors in buying and selling of securities through the stock brokers. Stock broking service is provided by investment banks and specialized stock broking companies.
Portfolio managers advise and undertake the management of various securities of the investors i.e clients or funds of clients pursuant to a contract made with them. Portfolio managers can be discretionary or non-discretionary. Discretionary portfolio managers individually and independently manage the securities and funds of each client according to the needs of the client. They take investment decisions by themselves without consulting the clients but according to the investment objective of the clients. Non-discretionary portfolio managers on the other hand manage the securities and funds according to the directions given by the clients. They do not take any investment decisions themselves. Portfolio management service is provided by investment banks.
Custodian of securities:-
Custodian of securities are responsible for safekeeping of various securities of the investors i.e clients , collecting corporate benefits accruing to the clients like dividend, interest, etc, and keeping the clients informed about the corporate actions. Custodian of securities keep only those securities of clients which are in the form of physical certificates. With the introduction of depository service in India, majority of the securities are now in dematerialized form but there are still few investors whose securities are in physical form. Many institutional investors also use services of custodian for safekeeping of their securities. Custodian service is provided by commercial banks and financial institutions.
Depository and Depository Participants:-
Depository is an organization which holds the securities of investors in electronic form at the request of the investors through a registered depository participant. It is just like a bank account but holds securities, facilitates transfer of ownership of securities without handling them and also facilitates sake keeping of securities of investors. There are two depositories in India which are registered with SEBI. (i) National securities depository Ltd (NSDL) and (ii) Central depository services (India) Ltd (CDSL). Following are the main services provided by the depository:-
– De-materialization:- De-materialization is the process by which physical certificates of an investor are converted into an equivalent number of securities in electronic form and credited into his demat account with his depository participant.
– Re-materialization:- Re-materialization is the process of converting the dematerialized securities i.e securities in electronic form into physical certificates.
– Maintaining record of securities held by beneficial owners:- In the depository system, the depository is the registered owner of securities in the books of the issuing company as against the physical system where the names of actual investors are recorded as registered owners. But all the benefits of the securities are given to the actual investors. So the investors are the beneficial owners of the securities. The depository maintains a record of all securities held by the beneficial owners.
– Settlement of trades of beneficial owners:- Depository settles the trades of beneficial owners by giving delivery of securities from beneficial owners accounts in case of sale of securities by beneficial owners and taking delivery of securities in the beneficial owners accounts in case of purchase of securities by them.
– Receiving non-cash corporate benefits:- Depository receives non-cash corporate benefits such as bonus shares and rights shares or any other non-cash corporate benefits given by the issuing company in electronic form on behalf of the beneficial owners.
– Receiving electronic credit of securities:- Depository receives electronic credit in respect of securities allotted by the issuing company in IPO or FPO on behalf of the beneficial owners.
Benefits of depository services:-
* Elimination of risks associated with physical certificates such as bad delivery, delays, theft, etc.
* Safe and convenient way to hold the securities.
* Reduction of paperwork involved in transfer of securities.
* Less stamp duty on transfer of securities.
* Immediate transfer of securities.
* Transmission of securities without contacting the issuing company.
* Nomination facility.
Depository cannot provide services to investors directly. It provides services to the investors through depository participants. Depository participants are the agents of the depository. They are the intermediaries between depository and investors and provide depository services to the investors. The investors have to open a demat account with a depository participant in order to avail the depository services. Depository participants are mostly scheduled commercial banks and stock brokers.
Difference Between Custodian Of Securities And Depository:-
|Custodian Of Securities||Depository|
|Custodian is responsible for safekeeping of securities of investors in physical form.||Depository is responsible for safekeeping of securities of investors in electronic form.|
|Custodian cannot legally transfer beneficial ownership of securities.||Depository can legally transfer beneficial ownership of securities.|
Credit rating agencies:-
Credit rating agency is a company that provides the investors with assessments of risk of debt instruments issued by a company by giving a rating to indicate the ability and willingness of the issuer company for timely payment of interest and principal amount. The companies issuing debt securities pay the credit rating agencies to provide rating to the debt securities issued by them. The rating is denoted by an alphanumeric symbol such as AA+, BB, AAA, P-1, DA2, etc. Each credit rating agency used different symbols. The rating given is monitored throughout the lifetime of the debt securities and rating given may be upgraded or downgraded if the risk of default becomes lower or higher respectively. Credit rating agencies only indicate the probability of default in payment of principal and interest on debt instruments and do not recommend to buy, sell or hold a debt instrument. In addition to rating of debt instruments, credit rating agencies also provide grades to the initial public offers (IPO) of equity shares of companies by providing assessments of the fundamentals of the issues. It is called as IPO grading and helps the investors who are looking to invest in companies that are unknown in equity market. Currently there are five credit rating agencies in India which are registered with SEBI:-
(1) CRISIL Ltd (2) ICRA Ltd (3) Credit analysis and research Ltd (4) Fitch ratings India Pvt Ltd and (5) Brickwork ratings India Pvt Ltd.
The banking sector in India is regulated by the Reserve bank of India which is India’s central bank. Banks in India are divided into three main categories:-
(1) Commercial banks:-
Commercial banks provide services such as accepting deposits from public, giving loans to businesses and individuals, offering savings and current accounts, providing credit cards, etc. Now-a-days the commercial banks have also started to offer merchant banking services. They offer all these services to earn profit. So the main aim of commercial banks is earning maximum profit. Commercial banks can be further subdivided into four categories:-
(a) Public sector banks:-
Public sector banks, which are also called as nationalized banks, are the banks in which majority of the stake or shareholding is of government of India. Some examples of public sector banks are State bank of India, Corporation bank, Dena bank, bank of Baroda, etc.
(b) Private sector banks:-
Private sector banks are the banks in which majority of the stake or shareholding is of private individuals and not government of India. Some examples of private sector banks are HDFC bank, Yes bank, ING vysya bank, etc.
(c) Foreign banks:-
Foreign banks are the banks which are established and have their head office in a country outside India but operate their branches in India. Some of the examples of foreign banks are Citibank, HSBC, Standard chartered, etc.
(d) Regional rural banks:-
Regional rural banks were started in 1975 to develop the rural economy and to provide the rural areas of country with banking and financial services. These banks mostly provide finance to the agricultural sector and other rural sectors. Some of the examples of regional rural banks are Maharashtra gramin bank, Himachal gramin bank, Pragathi gramin bank, etc.
(2) Co-operative banks:-
Co-operative banks in India are registered under the co-operative societies Act. They are often formed by persons who share a common interest. The main aim of co-operative banks is not profit maximization but to provide service to its members and the society. They provide basic banking services like loans, deposits, banking accounts, etc unlike the commercial banks who provide many other services in addition to the basic banking services. Co-operative banks mostly provide finance to the small businesses, salaried people, self-employed professionals, farmers, etc. The co-operative banks have a three-tier structure:-
(i) Primary urban co-operative banks
(ii) District central co-operative banks
(iii) State co-operative banks
Some of the examples of co-operative banks are shamrao vithal co-operative bank Ltd, Rupee co-operative bank Ltd, The Maharashtra state co-operative bank Ltd, The Gujarat state co-operative bank Ltd, Pune district central co-operative bank Ltd, Bhopal district central co-operative bank Ltd, etc.
(3) Development banks:-
Development banks are financial institutions that provide finance to the important sectors of the economy such as agriculture, housing, etc at a lower rate. Some of the examples of development banks are National bank for agriculture and rural development (NABARD), Industrial finance corporation of India (IFCI), Industrial development bank of India (IDBI), National housing bank (NHB), etc.