Financial System

A financial system is a system that allows the exchange of funds between financial market
participants such as lenders, investors, and borrowers. Financial systems operate at national and global
levels. Financial institutions consist of complex, closely related services, markets, and institutions
intended to provide an efficient and regular linkage between investors and depositors.

In other words, financial systems can be known wherever there exists the exchange of a financial
medium (money) while there is a reallocation of funds into needy areas (financial markets, business
firms, banks) to utilize the potential of ideal money and place it in use to get benefits out of it. This
whole mechanism is known as a financial system.

Money, credit, and finance are used as media of exchange in financial systems. They serve as a medium
of known value for which goods and services can be exchanged as an alternative to bartering. A modern
financial system may include banks (public sector or private sector), financial markets, financial
instruments, and financial services. Financial systems allow funds to be allocated, invested, or moved
between economic sectors, and they enable individuals and companies to share the associated risks.

According to Prasanna Chandra,

“financial system consists of a variety of institutions, markets, and instruments related in a systematic
manner and provide the principal means by which savings are transformed into
investments”.

According to Van Horne,

“financial system allocates savings efficiently in an economy to ultimate users either for investment in
real assets or for consumption”.

Features of Financial System:

 It plays a vital role in economic development of a country.

 It encourages both savings and investment.

 It links savers and investors.

 It helps in capital formation.

 It helps in allocation of risk.

 It facilitates expansion of financial markets.

 It aids in Financial Deepening and Broadening.

Functions of financial system in India:

Liquidity Function

The most important function of a financial system is to provide money and monetary assets for
the production of goods and services. Monetary assets are those assets that can be converted
into cash or money easily without loss of value. All activities in a financial system are related
to the liquidity-either provision of liquidity or trading in liquidity.

Payment Function

The financial system offers a very convenient mode of payment for goods and services. The
cheque system and credit card system are the easiest methods of payment in the economy. The
cost and time of transactions are considerably reduced.
Saving Function

An important function of a financial system is to mobilize savings and channelize them into
productive activities. It is through the financial system the savings are transformed into
investments.

Risk Function

The financial markets provide protection against life, health, and income risks. These guarantees
are accomplished through the sale of life, health insurance, and property insurance policies.

Transfer Function

A financial system provides a mechanism for the transfer of resources across geographic
boundaries.

Reformatory Functions

A financial system undertaking the functions of developing, introducing innovative financial

assets/instruments services and practices and restructuring the existing assets, services, etc, to
cater to the emerging needs of borrowers and investors.

Objectives of financial system

Facilitate Payment

The financial system facilitates payment through banks and any other financial institution.
Anything we buy or sale requires the transection of money. That is done by the financial system

It Link Between Saver And Investor

The financial system provides a place where saver and investor meets. Saver saves money and
investors invest it in different types of stocks to get profit on it.

Helps In Capital Formation

For capital formation, there should be a good financial system that provides the finance timely
and in an appropriate amount.

To Ensure Safety On Investment

The financial system has different institutions for the proper supervision of the financial market
that controls the market. So, the safety of the investment can be done.

Helps In The Growth Of The Economy

Proper mobilization of funds and proper control in the financial market helps the business to
grow and motivate investors to invest. That helps in the growth of the economy.
Structure of Indian financial system
The Indian Financial System is one of the most important aspects of the economic development of our
country. This system manages the flow of funds between the people (household savings) of the country
and the ones who may invest it wisely (investors/businessmen) for the betterment of both the parties.

This is an important topic with respect to the various Government exams conducted in the country, and
aspirants must carefully consider going through this article and prepare themselves accordingly.

In this article, you shall know about what the Indian Financial system is, its components and how it helps
in the economic growth of a country.

Components of Indian Financial System

There are four main components of the Indian Financial System. This includes:

1. Financial Institutions

2. Financial Assets

3. Financial Services

4. Financial Markets

Let’s discuss each component of the system in detail.

1. Financial Institutions
The Financial Institutions act as a mediator between the investor and the borrower. The investor’s
savings are mobilized either directly or indirectly via the Financial Markets.

The main functions of the Financial Institutions are as follows:

 A short term liability can be converted into a long term investment

 It helps in conversion of a risky investment into a risk-free investment

 Also acts as a medium of convenience denomination, which means, it can match a small deposit
with large loans and a large deposit with small loans

The best example of a Financial Institution is a Bank. People with surplus amounts of money make
savings in their accounts, and people in dire need of money take loans. The bank acts as an intermediate
between the two.

The financial institutions can further be divided into two types:

 Banking Institutions or Depository Institutions – This includes banks and other credit unions
which collect money from the public against interest provided on the deposits made and lend
that money to the ones in need

 Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds and

brokerage companies fall under this category. They cannot ask for monetary deposits but sell
financial products to their customers.

Further, Financial Institutions can be classified into three categories:

 Regulatory – Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc.

 Intermediates – Commercial banks which provide loans and other financial assistance such as
SBI, BOB, PNB, etc.

 Non Intermediates – Institutions that provide financial aid to corporate customers. It includes
NABARD, SIBDI, etc.

2. Financial Assets

The products which are traded in the Financial Markets are called Financial Assets. Based on the
different requirements and needs of the credit seeker, the securities in the market also differ from each
other.

Some important Financial Assets have been discussed briefly below:

 Call Money – When a loan is granted for one day and is repaid on the second day, it is called call
money. No collateral securities are required for this kind of transaction.
  Notice Money – When a loan is granted for more than a day and for less than 14 days, it is called
notice money. No collateral securities are required for this kind of transaction.

 Term Money – When the maturity period of a deposit is beyond 14 days, it is called term
money.

 Treasury Bills – Also known as T-Bills, these are Government bonds or debt securities with
maturity of less than a year. Buying a T-Bill means lending money to the Government.

 Certificate of Deposits – It is a dematerialised form (Electronically generated) for funds

deposited in the bank for a specific period of time.

 Commercial Paper – It is an unsecured short-term debt instrument issued by corporations.

3. Financial Services

Services provided by Asset Management and Liability Management Companies. They help to get the
required funds and also make sure that they are efficiently invested.

The financial services in India include:

 Banking Services – Any small or big service provided by banks like granting a loan, depositing
money, issuing debit/credit cards, opening accounts, etc.

 Insurance Services – Services like issuing of insurance, selling policies, insurance undertaking
and brokerages, etc. are all a part of the Insurance services

 Investment Services – It mostly includes asset management

 Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part of the
Foreign exchange services

The main aim of the financial services is to assist a person with selling, borrowing or purchasing
securities, allowing payments and settlements and lending and investing.

4. Financial Markets

The marketplace where buyers and sellers interact with each other and participate in the trading of
money, bonds, shares and other assets is called a financial market.

The financial market can be further divided into four types:

 Capital Market – Designed to finance the long term investment, the Capital market deals with
transactions which are taking place in the market for over a year. The capital market can further
be divided into three types:

(a)Corporate Securities Market

 (b)Government Securities Market

(c)Long Term Loan Market

 Money Market – Mostly dominated by Government, Banks and other Large Institutions, the
type of market is authorised for small-term investments only. It is a wholesale debt market
which works on low-risk and highly liquid instruments. The money market can further be divided
into two types:

(a) Organized Money Market

(b) Unorganized Money Market

 Foreign exchange Market – One of the most developed markets across the world, the Foreign
exchange market, deals with the requirements related to multi-currency. The transfer of funds
in this market takes place based on the foreign currency rate.

 Credit Market – A market where short-term and long-term loans are granted to individuals or
Organizations by various banks and Financial and Non-Financial Institutions is called Credit
Market

5. Money

It is an important medium of exchange that can be used to purchase goods and services. It can also act
as a store of value. It is uniformly accepted everywhere.

It eases transactions especially impromptu daily purchases. It makes the goods and services easily
exchangeable. It acts as a verifiable record in the socio-economic context.

Comparison between Money Market and Capital Market

Money Market Capital Market

 Involves dealing with short-term funds.  Involves dealing with long-term funds.

 Associates with assets like treasury bills,  Associates with assets such as shares,
commercial paper, bills of exchange, certificate debentures, bonds and government securities.
of deposits, etc.
 Its participants include Stockbrokers,
 Its participants include commercial banks, underwriters, mutual funds, individual investors,
NBFS, chit funds, etc. financial institutions etc.

 The RBI is responsible for its working.  The SEBI is responsible for its working.
Nature of Financial System

Transfer Funds

Financial system helps in transferring of financial resources from one person to another person. This
system includes financial markets, financial intermediaries, financial assets and services which facilitates
fund movements in an economy.

Mobilizes Saving

It helps in allocating ideal lying resources with peoples into productive means. Financial system is the
one which obtains funds from savers and provide it to those who are in need of it for various
development purposes.

Risk Allocation

Diversification of risk in an economy is important feature of financial system. Financial system allocates
people’s funds in various sources due to which risk is diversified.

Facilitates Investment

Financial system encourages investment by peoples into different investment avenues. It provides
various income-generating investment options to peoples for investing their savings.

Enhances Liquidity

Financial system helps in maintaining optimum liquidity in an economy. It facilities free movement of
funds from households (savers) to corporates (investors) which ensures sufficient availability of funds.

Role of Financial System

Facilitates Payment Mechanism

Financial system provides a payment mechanisms for the smooth flow of funds among peoples in an
economy. Buyers and sellers of goods or services are able to perform transactions with each other due
to the presence of a financial system.

Reduces Risk

It aims at reducing the risk by diversifying it among a large number of individuals. Financial system
distributes funds among a large number of peoples due to which risk is shared by many peoples.
Brings Savers And Investors Together

Financial system serves as a means of bridging the gap between savings and investment. It acquires
money from those with whom it is lying idle and transfers it to those who need it for investing in
productive ventures.

Assist In Capital Formation

Financial system has an efficient role in the capital formation of the country. It enables big corporates
and industries to acquire the required funds for performing or expanding their operations thereby
leading to capital formation in the nation.

Improves Standard Of Living

It raises the standard of living of peoples by promoting regional and rural development of the country.
The financial system promotes the development of weaker sections of society through cooperative
societies and rural development banks.

Facilitates Economic Development

Financial system influences the pace of economic growth or development of an economy. It aims at
optimum utilization of all financial resources by investing all idle lying resources into useful means which
leads to the creation of wealth.

Role of financial Intermediaries

Meaning of financial Intermediaries

A financial intermediary is an entity that facilitates a financial transaction

between two parties. Such an intermediary or a middleman could be a firm or an
institution. Some examples of financial intermediaries are banks, insurance
companies, pension funds, investment banks, and more. One can also say that
the primary objective of the financial intermediaries is to channel savings into
investments. These intermediaries charge a fee for their services.

Financial intermediaries have emerged as a useful tool for the efficient market
system as they help channelize savings into investment. However, they can also
be a cause of concern, as the sub-prime crisis shows. Often, there is a need to
regulate the activities of these intermediaries.
Examples of Financial Intermediaries

Bank

These intermediaries are licensed to accept deposits, give loans and offer many
other financial services to the public. They play a major role in the economic
stability of a country, and thus, face heavy regulations.

Mutual Funds

Mutual funds help pool savings of individual investors into financial markets. A
fund manager oversees a mutual fund and allocates the funds to different
investment products.

Financial Advisors

Such intermediaries may or may not offer a financial product, but advises
investors to help them achieve their financial objectives. These financial
advisors usually undergo special training.
Credit Union

It is also a type of bank but works to serve its members and not the public. They
may or may not operate for profit purposes.

Other financial intermediaries are pension funds, insurance companies,

investment banks, and more.

Functions of Financial Intermediaries

A financial intermediary performs the following functions:

 As said before, the biggest function of these intermediaries is to convert

savings into investments.

 Intermediaries like commercial banks provide storage facilities for cash and
other liquid assets, like precious metals.

 Giving short and long term loans is a primary function of the financial
intermediaries. These intermediaries accept deposits from the entities with
surplus cash and then loan them to entities in need of funds. Intermediaries
give the loan at interest, part of which is given to the depositors, while the
balance is retained as profits.

 Another major function of these intermediaries is to assist clients to grow

their money via investment. Intermediaries like mutual funds and
investment banks use their experience to offer investment products to help
their clients maximize returns and reduce risks.

Advantages of Financial Intermediaries

 They help in lowering the risk of an individual with surplus cash by

spreading the risk via lending to several people. Also, they thoroughly
screen the borrower, thus, lowering the default risk.

 They help in saving time and cost. Since these intermediaries deal with a
large number of customers, they enjoy economies of scale.
  Since they offer a large number of services, it helps them customize
services for their client. For instance, banks can customize the loans for
small and long term borrowers or as per their specific needs. Similarly,
insurance companies customize plans for all age groups.

 They accumulate and process information, thus lowering the problem of

asymmetric information.

Let us consider a simple example that will help us understand these advantages
better. Suppose you need a loan, but you don’t know who has enough money to
give you. So, you contact a middleman, who in turn is in contact with those with
surplus money.

Financial Market

A financial market is a word that describes a marketplace where bonds, equity,

securities, currencies are traded. Few financial markets do a security business of
trillions of dollars daily, and some are small-scale with less activity. These are
markets where businesses grow their cash, companies decrease risks, and
investors make more cash.

Meaning of Financial Markets

A Financial Market is referred to space, where selling and buying of financial

assets and securities take place. It allocates limited resources in the nation’s
economy. It serves as an agent between the investors and collector by mobilising
capital between them.

In a financial market, the stock market allows investors to purchase and trade
publicly companies share. The issue of new stocks are first offered in the primary
stock market, and stock securities trading happens in the secondary market.

Types of Financial Markets

 Over the Counter (OTC) Market – They manage public stock exchange,
which is not listed on the NASDAQ, American Stock Exchange, and New
 York Stock Exchange. The OTC market dealing with companies are usually
small companies that can be traded in cheap and has less regulation.

 Bond Market – A financial market is a place where investors loan money on

bond as security for a set if time at a predefined rate of interest. Bonds are
issued by corporations, states, municipalities, and federal governments
across the world.

 Money Markets – They trade high liquid and short maturities, and lending
of securities that matures in less than a year.

 Derivatives Market –They trades securities that determine its value from
its primary asset. The derivative contract value is regulated by the market
price of the primary item — the derivatives market securities, including
futures, options, contracts-for-difference, forward contracts, and swaps.

 Forex Market – It is a financial market where investors trade in currencies.

In the entire world, this is the most liquid financial market.

Functions of Financial Market

Mentioned below are the important functions of the financial market.

 It mobilises savings by trading it in the most productive methods.

 It assists in deciding the securities price by interaction with the investors

and depending on the demand and supply in the market.

 It gives liquidity to bartered assets.

 Less time-consuming and cost-effective as parties don’t have to spend extra

time and money to find potential clients to deal with securities. It also
decreases cost by giving valuable information about the securities traded in
the financial market.

Classification of Financial Market

The financial market can be classified into three different forms.

1. By Nature of Claim

1. Debt Market – It is a market where fixed bonds and debentures or bonds

are exchanged between investors.

2. Equity Market – It is a place for investors to deal with equity.

2. By Maturity of Claim

1. Money Market – It deals with monetary assets and short-term funds such
as a certificate of deposits, treasury bills, and commercial paper, etc. which
mature within twelve months.

2. Capital Market – It trades medium and long term financial assets.

3. By Timing of Delivery

1. Cash Market – It is a market place where trade is completed in real-time.

2. Futures Market – Here, the delivery or compensation of products are

taken in the future specified date.

4. By Organizational Structure

 Exchange-Traded Market – It has a centralised system with a patterned

procedure.

 Over-the-Counter Market – It has a decentralised organisation with

customised procedures

What are Financial Markets and Institutions?

Financial markets dispense efficiently flow of investments and savings in the economy and facilitate
the growth of funds for producing goods and services. The right blend of financial products and
instruments and financial markets and institutions fuels the demands of investors, receiver and the
overall economy of a country.
Financial markets (bonds and stocks), instruments (derivatives, bank CDs, and futures), and
institutions (banks, pension funds, insurance companies, and mutual funds) give the investors the
opportunities to specialize in specific services and markets. As quoted by Demirgcc-Kunt and Levine
“Financial markets and financial institutions together contribute to economic growth and not the
relative mix of these two factors”.
The Key Players in Financial Markets

Key Players in Financial Markets: Roles

There are various kinds of participants in financial markets who assume different
kinds of roles. They may be issuers, investors or other intermediaries. Some of the
prominent ones have been provided below.

Issuer

Markets bring together buyers and sellers: either directly or through

intermediaries. In this context, the seller is called the issuer and the price of what
is sold is called the Issue price. There are two broad categories of issuers in
financial markets; government (including municipal bodies and governmental
agencies) and corporates.

Governments and municipal bodies need money to spend on public goods : roads,
defense, health, social security and so on : and they generally face a fund deficit.
They can not issue equity- you can not take an ownership interest in a
government and so apart from taxation and selling public assets (privatization) ,
borrowing money is one of the options. Governments generally cannot borrow
directly from consumers.

So, central government securities (primarily debt securities like bonds) are issued
and traded in a wholesale market through financial intermediaries.

Corporates are legal entities (such as an association, turn, government,

government agency, institution) identified by a particular name. They sell three
categories of investment propositions in the primary market:

 Short-term debt (less than one year)

 Long-term debt (more than one year)

 Equity

Investors
Investors are the lenders in any market. Investors can be of two kinds:

Retail Investors

Retail investors: Retail investors are those individuals who participate in markets
for their personal account and not for another company or organization.

Institutional Investors

Institutional investors: An institutional investor is an entity, company, mutual

fund, insurance corporations, brokerage, or other such group that has a large
amount of money or assets to invest. These firms typically represent investors
who might be retail or other firms.

Financial Intermediaries

These are institutions or individuals which facilitate to channel funds between

surplus and deficit agents and thus often act as middlemen.

Bank

A Bank is a financial institution which:

 Accepts demand and time deposits

 Provides loans to individuals and organizations, and

 Provides services such as documentary collections, international banking,

trade financing.

Brokers

A broker is a commissioned agent of a buyer (or seller) who facilitates trade by

locating a seller (or buyer) to complete the desired transaction. A broker does not
take a position in the assets he or she trades in – that is, the broker does not
maintain inventories in these assets. The profits of brokers are determined by the
commissions they charge to the users of their services (the buyers, the sellers, or
both).

Dealers

The Dealer Like brokers, dealers facilitate trade by matching buyers with sellers of
assets. Unlike brokers, however, a dealer can and does take positions (i.e.,
maintain inventories) in the assets he trades. This permits the dealer to sell out of
inventory rather than always having to locate sellers to match every offer to buy.
Unlike brokers, dealers do not receive sales commissions. Dealers make profits by
buying assets at a price which is lower than the price at which they are sold.

The price at which a dealer offers to sell an asset is called as the offer price or ask
price. The price at which a dealer offers to buy an asset is called as the bid price.
The difference between the bid price and ask price is called the bid-ask or the bid-
offer spread and represents the dealer profit margin.

Mutual Funds

You can think of a mutual fund as an organization that brings together a group of
people and invests their money in stocks, bonds, and other securities. Each
investor owns units, which represent a portion of the holdings of the fund. In a
mutual fund, the financial risk of the investment belongs to the investor. The fund
charges a small fee for managing the fund.

Provides advice to clients: Advising corporations on various aspects during

mergers & acquisitions as well as capital structures. Advising on capital structures
includes advice on whether they should raise capital by issue of bonds or stock, or
any other mezzanine structures. They charge the client fees for their advisory
role.

Helps clients raise money: It assists in the initial sale of newly issued securities by
engaging in different activities:

Assistance in legal and procedural formalities: Before securities are issued, there
are a lot of legal formalities which need to be carried out. These include preparing
the prospectus, submitting the same to the regulator, book running, etc.
Advice on pricing: Investment bankers help the issuer get an optimum price for
the security which is being issued.

Underwriting: Guaranteeing corporations that the securities on offer will be fully

subscribed to. This is in return for what is called as underwriting fees. For
example, if company A wants to go public, it can directly go to the end investors
with their shares. However there is no guarantee that it will be able to find
investors who are willing to buy their shares (especially if the company is not well
known or new). Here the investment bank steps in and agrees to buy all the
shares at an agreed price if people do not subscribe to the same. They will then
sell these shares in the market (using their distribution chain) for a higher price
making a profit on the margin.

Market Makers

A market maker is an intermediary who is willing and ready to buy and sell
securities. The market maker provides a two way quote in the market, thus
creating a market for the securities.

Let us imagine a hypothetical situation where there is only one buyer and one
seller for security X on any given day. If this security is traded on the exchange,
and the exchange is open for 6 hours, then for the trade to happen, the buyer and
seller need to meet at a common time on the exchange If the timing does not
match, then the trade will not take place, even though a buyer and a seller exist
for the security.

It is in these cases that a market maker is useful. By providing a two way quote,
he buys from the seller and later during the day, he sells the securities to the
buyer, thus creating a market. The market maker earns from the Bid-Ask spread.
The more liquid the security, the narrower is the Bid-Ask spread. Thus market
makers help to create liquidity and efficiency in the market.
Stock Exchanges

Stock is a share in the ownership of a company. Stock represents a claim on the

company assets and earnings. Whether you say shares, equity or stock, it all
means the same thing.

Most stocks are traded on exchanges. Exchanges are places where buyers and
sellers meet and decide on a price. Retail Investors get access to the exchanges
through brokers, who are members of the exchange. Some of the major
exchanges in the world are the New York Stock Exchange, NASDAQ, Bombay Stock
Exchange, etc.

Some exchanges are physical locations where transactions are carried out on a
trading floor. The other type of exchange is a virtual kind; composed of a network
of computers where trades are made electronically. The purpose of a stock
market is to facilitate the exchange of securities between buyers and sellers.
Actual trades are based on an auction market model where a potential buyer bids
a specific price for a stock and a potential seller asks a specific price for the stock.
(Buying or selling at market means you will accept any ask price or bid price for
the stock, respectively.) When the bid and ask prices match, a sale takes place.

Depositories

A bank or company which holds securities deposited by others, and where

exchanges of these securities take place is defined as a depository. It can also be
defined as an organization where the securities of an investor are held in
electronic form, at the request of the investor through the medium of a
Depository Participant.

A depository can be compared to a bank for shares. Just as a bank holds cash in
your account and provides all services related to the transaction of cash, a
depository holds securities in electronic form and provides all services related to
transaction of shares / debt instruments. A depository interacts with clients
through a Depository Participant (DP) with whom he client has to maintain a
Demat Account. When a transaction happens in the security exchange, the
depository is instructed to transfer the shares from the sellers account to the
buyers account (this is similar to the payment process in a bank where the
payment is transferred from the buyers account to the sellers account).

Clearing House

A clearing house takes responsibility for settling the obligations for the respective
counter-parties on maturity of the trades as well as during their tenure. This
ensures that trades done through exchanges have a very low settlement risk.

Information Providers

Information providers provide live and historical quotes for all exchanges,
newsroom information, technical charts, financial analyses, etc. Reuters and
Bloomberg are major information providers across the world for financial data.
Live information on prices and market movements helps to make the markets
more transparent by providing reliable information to investors, on the basis of
which they can take decisions.

Regulators

A regulator is an official or body that monitors the behavior of companies and the
level of competition in particular markets. Financial regulations are a form of
regulation or supervision, which subjects market participants to certain
requirements, restrictions and guidelines, aiming to maintain the integrity of the
financial system.

Securities & Exchange Commission (SEC)

The US Securities and Exchange Commission (commonly referred to as SEC is an

independent agency which holds primary responsibility for enforcing the federal
securities law/and regulating the securities industry, the nations stock and
options exchanges, and other electronic securities markets in the United States.
Similarly, regulators are present m different countries like the Financial Services
Authority (FSA) in UK and the Securities Exchange Board of India (SEBI) in India.

The SEC oversees the key participants in the securities world, including securities
exchanges, securities brokers and dealers, investment advisors, and mutual funds.
Here the SEC is concerned primarily with promoting the disclosure of important
market related information, maintaining fair dealing, and protecting against fraud.

The Federal Reserve

The Federal Reserve System (also known as the Federal Reserve, and informally as
the Fed) is the central banking system of the United States. Other central banks
around the world include the Reserve Bank of India in India, Bank of England in
England. Its functions fall under four major areas:

Formulating and implementing the nations monetary policy

Supervising and regulating banking institutions to ensure the safety and

soundness of the nations banking and financial system, and protecting the credit
rights of consumers.

Maintaining stability of the financial system and containing systemic risk that may
arise in financial markets.

Providing financial services to depository institutions, the US government, and

foreign official institutions including playing a major role in operating the nations
payments system.

Rating Agencies
A credit rating agency is an organization that rates the ability of a person or
company to pay back a loan. These are independent professional firms that
conduct in depth research on companies and securities issued by them. The rating
given by a credit rating agency is important because it affects the perceived risk
element incorporated into interest rates that are applied to loans. For example, if
the bonds of company A have a low rating then the company will have to give a
higher interest payout on these bonds in order to compensate for the risk an
investor takes by investing in a bond with low rating (indicating higher risk of
default by issuer).

Ratings are done at three levels:

 Firm level rating: Rating of the entity itself

 Rating of it long-term debt

 Rating of its short-term debt

Regulations of Financial Market

Indian Capital Markets are regulated and monitored by the Ministry of

Finance, The Securities and Exchange Board of India and The Reserve Bank
of India.

The Ministry of Finance regulates through the Department of Economic

Affairs - Capital Markets Division. The division is responsible for formulating
the policies related to the orderly growth and development of the
securities markets (i.e. share, debt and derivatives) as well as protecting the
interest of the investors. In particular, it is responsible for

 institutional reforms in the securities markets,

 building regulatory and market institutions,

 strengthening investor protection mechanism, and

 providing efficient legislative framework for securities markets.

 The Division administers legislations and rules made under the

 Depositories Act, 1996,

 Securities Contracts (Regulation) Act, 1956 and

 Securities and Exchange Board of India Act, 1992.

The Regulators

Securities & Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) is the regulatory

authority established under the SEBI Act 1992 and is the principal regulator
for Stock Exchanges in India. SEBI’s primary functions include protecting
investor interests, promoting and regulating the Indian securities markets.
All financial intermediaries permitted by their respective regulators to
participate in the Indian securities markets are governed by SEBI
regulations, whether domestic or foreign. Foreign Portfolio Investors are
required to register with DDPs in order to participate in the Indian
securities markets.

Reserve Bank of India (RBI)

The Reserve Bank of India (RBI) is governed by the Reserve Bank of India
Act, 1934. The RBI is responsible for implementing monetary and credit
policies, issuing currency notes, being banker to the government, regulator
of the banking system, manager of foreign exchange, and regulator of
payment & settlement systems while continuously working towards the
development of Indian financial markets. The RBI regulates financial
markets and systems through different legislations. It regulates the foreign
exchange markets through the Foreign Exchange Management Act, 1999.

National Stock Exchange (NSE) – Rules and Regulations

In the role of a securities market participant, NSE is required to set out and
implement rules and regulations to govern the securities market. These
rules and regulations extend to member registration, securities listing,
transaction monitoring, compliance by members to SEBI / RBI regulations,
investor protection etc. NSE has a set of Rules and Regulations specifically
applicable to each of its trading segments. NSE as an entity regulated by
SEBI undergoes regular inspections by them to ensure compliance.

Money Market Instruments

The money market is referred to as dealing in debt instruments with less

than a year to maturity bearing fixed income. In this article, we will cover
the meaning of money market instruments along with its types and
objectives.

What is Money Market?

Money Market is a financial market where short-term financial assets

having liquidity of one year or less are traded on stock exchanges. The
securities or trading bills are highly liquid. Also, these facilitate the
participant’s short-term borrowing needs through trading bills. The
participants in this financial market are usually banks, large institutional
investors, and individual investors.

There are a variety of instruments traded in the money market in both the
stock exchanges, NSE and BSE. These include treasury bills, certificates of
deposit, commercial paper, repurchase agreements, etc. Since the
securities being traded are highly liquid in nature, the money market is
considered as a safe place for investment.

The Reserve Bank controls the interest rate of various instruments in the
money market. The degree of risk is smaller in the money market. This is
because most of the instruments have a maturity of one year or less.
 Hence, this gives minimal time for any default to occur. The money market
thus can be defined as a market for financial assets that are near
substitutes for money.

Objectives of Money Market

Below are the main objectives of the money market:

1. Providing borrowers such as individual investors, government, etc. with

short-term funds at a reasonable price. Lenders will also have the
advantage of liquidity as the securities in the money market are short-term.

2. It also enables lenders to turn their idle funds into an effective investment.
In this way, both the lender and borrower are at a benefit.

3. RBI regulates the money market. Therefore, in turn, helps to regulate the
level of liquidity in the economy.

4. Since most organizations are short on their working capital requirements.

The money market helps such organizations to have the necessary funds to
meet their working capital requirements.

5. It is an important source of finance for the government sector for both

national and international trade. And hence, provides an opportunity for
the banks to park their surplus funds.

Types of Money Market Instruments in India

1. Treasury Bills

Treasury Bills are one of the most popular money market instruments. They
have varying short-term maturities. The Government of India issues it at a
discount for 14 days to 364 days.

These instruments are issued at a discount and repaid at par at the time of
maturity. Also, a company, firm, or person can purchase TB’s. And are
issued in lots of Rs. 25,000 for 14 days & 91 days and Rs. 1,00,000 for 364
days.
2. Commercial Bills

Commercial bills, also a money market instrument, works more like the bill
of exchange. Businesses issue them to meet their short-term money
requirements.

These instruments provide much better liquidity. As the same can be

transferred from one person to another in case of immediate cash
requirements.

3. Certificate of Deposit

Certificate of Deposit (CD’s) is a negotiable term deposit accepted by

commercial banks. It is usually issued through a promissory note.

CD’s can be issued to individuals, corporations, trusts, etc. Also, the CD’s
can be issued by scheduled commercial banks at a discount. And the
duration of these varies between 3 months to 1 year. The same, when
issued by a financial institution, is issued for a minimum of 1 year and a
maximum of 3 years.

4. Commercial Paper

Corporates issue CP’s to meet their short-term working capital

requirements. Hence serves as an alternative to borrowing from a bank.
Also, the period of commercial paper ranges from 15 days to 1 year.

The Reserve Bank of India lays down the policies related to the issue of
CP’s. As a result, a company requires RBI‘s prior approval to issue a CP in
the market. Also, CP has to be issued at a discount to face value. And the
market decides the discount rate.

Denomination and the size of CP:

Minimum size – Rs. 25 lakhs

Maximum size – 100% of the issuer’s working capital

5. Call Money
 It is a segment of the market where scheduled commercial banks lend or
borrow on short notice (say a period of 14 days). In order to manage day-
to-day cash flows.

The interest rates in the market are market-driven and hence highly
sensitive to demand and supply. Also, the interest rates have been known
to fluctuate by a large % at certain times.

Features of Money Market

 It can be called as a collection of the market. Its main feature is liquidity. All
the submarkets, such as call money, notice money, etc. have close
interrelation with each other. This helps in the movement of funds from
one sub-market to another.

 The volume of traded assets is generally very high.

 It enables the short-term financial needs of the borrowers. Also, it deals

with investments that have a maturity period of 1 year or less.

 It is still evolving. There is always a possibility of adding new instrument.

Money Market vs Stock Market

Particulars Money Market Stock Market

Maturity of The money market However tradable in the

the instruments carry a short term, stocks create
instruments maturity period of less wealth creation when
than a year. invested for a number of
years.

Financing These instruments are Used for long-term fund

needs used to fund the short- requirements.
term needs of the
borrower.

Types of It has instruments like T- It’s a stock of an

 instruments bills, certificate of independently listed
deposits, inter-bank call company
money, etc.

Degree of risk Risk is comparatively Risk is higher.

lower due to the short-
term maturity period

What are Money Market Funds?

Money Market Mutual Funds, MMMFs are highly liquid open-ended dent
funds generally used for short term cash needs. The money market
fund deal only in cash and cash equivalents with an average maturity of an
year with fixed income.

The fund manager invests in money market instruments like treasury bills,
commercial paper, certificate of deposits, bills of exchange etc.

Factors to determine Interest Rates of Money Market Instruments

Currently, the interest rate is dependent on the market forces of demand

for; and supply of short term money.

Fiscal deficit, for example, occurs when the government expenditure is

more than government revenue. To fund this deficit, the government
requires money which in turn leads to borrowing by the government and
hence influencing the interest rates.

In other words, the higher the fiscal deficit more will be the money
required by the government. Hence, it will lead to an increase in interest
rates.

Purpose of the Money Market

1. Money market maintains liquidity in the market. RBI uses money market
instruments to control liquidity.
2. It finances short term needs of the government and economy. Any business
or organisation can borrow money at short notice for a short term.

3. Helps in utilising surplus funds in the market for a short term to earn an
additional return. It channelises savings to investments.

4. Assists in mobilising funds from one sector to another with the utmost
transparency

5. Guides in devising monetary policies. The current money market conditions

are the result of previous monetary policies. Hence it acts as a guide for
devising new policies regarding short term money supply.

Characteristics of Money Market Instruments

 It is a financial market and has no fixed geographical location.

 It is a market for short term financial needs, for example, working capital
needs.

 It’s primary players are the Reserve Bank of India (RBI), commercial banks
and financial institutions like LIC, etc.,

 The main money market instruments are Treasury bills, commercial papers,
certificate of deposits, and call money.

 It is highly liquid as it has instruments that have a maturity below one year.

 Most of the money market instruments provide fixed returns.

Importance of the Money Market

 The money market is a market for short term transactions. Hence it is
responsible for the liquidity in the market. Following are the reasons why
the money market is essential:

 It maintains a balance between the supply of and demand for the monetary
transactions done in the market within a period of 6 months to one year..

 It enables funds for businesses to grow and hence is responsible for the
growth and development of the economy.

 It aids in the implementation of monetary policies.

 It helps develop trade and industry in the country. Through various money
market instruments, it finances working capital requirements. It helps
develop the trade in and out of the country.

 The short term interest rates influence long term interest rates. The money
market mobilises the resources to the capital markets by way of interest
rate control.

 It helps in the functioning of the banks. It sets the cash reserve ratio
and statutory liquid ratio for the banks. It also engages their surplus funds
towards short term assets to maintain money supply in the market.

 The current money market conditions are the result of previous monetary
policies. Hence it acts as a guide for devising new policies regarding short
term money supply.

 Instruments like T-bills, help the government raise short term funds.
Otherwise, to fund projects, the government will have to print more
currency or take loans leading to inflation in the economy. Hence the it is
also responsible for controlling inflation.

What is the credit market?

 The credit market is a financial market where the government and
companies issue debt to investors to raise money. Here, the investors buy
and sell securities, mostly in the form of bonds. Also, in a developing
market like India, these markets are an important source of funds.
Moreover, the market size of the Indian credit market is one of the largest
in Asia. Furthermore, like other countries, the credit market in India is also
a substitute for banking channels for finance. Hence, the Credit market is
also known as the Debt Market.

The debt issued in the credit market can be in the form of junk bonds,
government bonds, investment-grade bonds and commercial paper. Also, it
includes debt offerings such as notes and securitized obligations,
collateralized debt obligations (CDOs), credit default swaps (CDS) and
mortgage-backed securities.

The status of the credit markets depicts the collective health of the
economy. Comparatively, the credit market is larger than the equity
market. Hence, traders look for strength or weakness in the credit market.
Thus, this acts as a signal to understand the same effect on the economy.

This market plays a vital role in the Indian economy to meet the financial
needs in the various segments. The following are the financial regulatory
bodies in India –

 Reserve Bank of India (RBI)

 Securities and Exchange Board of India (SEBI)

 The Securities Contracts Regulation Act (SCRA)

 Department of Company Affairs (DCA)

Factors that affect the credit market

The following are the factors that affect the credit market internally and
externally.

Internal factors
  RBI economic policies

 Liquidity in the market

 Interest rate movement

 Inflation rate

 Demand for money

 Supply of money

 Government borrowings to tide over its fiscal deficit

 The credit quality of the issuer

External Factors

 Global economic conditions and their impact

 Foreign exchange

 Fed rates

 Crude oil prices

 Economic indicators

Types
The credit market can be classified into two categories –
Government Securities Market
This is one of the significant sources of borrowing funds by the central and
state governments. The government issues short term and long term
securities to raise funds from the general public. However, these securities do
not carry any risk. The reason being, the government promises the payment
of interest and repayment of the principal amount. These securities are also
known as gilt-edged securities. Thus, the government securities market is the
major market in any economic system.
Corporate Bond Market
The corporate bond market is a similar financial market where the private and
public corporations issue bonds and debt securities. Likewise, the companies
issue bonds to raise money for a variety of purposes. For instance, building a
plant, purchasing equipment or business expansion. When these bonds are
sold to the investors, the company gets its capital required. In return, the
company pays a pre-established number of interest payments at either a fixed
or variable interest rate. Lastly, on the maturity of the bond, the issuer pays
the principal and interest to the investor.

the market participants in the credit market?

The following are the market participants in credit market.

 Banks

 Financial institutions

 Primary dealers

 Insurance companies

 Provident funds

 Mutual fund houses

 Corporate

 Foreign institutional investors (FIIs)

 Trusts