Introduction to Financial Institutions and Markets Financial System- implies a set of Complex and closely connected institutions, markets, transactions, agents, practices, claims and liabilities in a economy

What is the financial system concerned with? Money Credit Services finance

Functions of Financial system Financial Institutions- act as mobilisers and depositories of saving and as the custodian of finance. Provides various financial services to the society.

Financial institution A financial institution is an institution whose primary source of profits is through financial asset transactions

Functions of Financial Institutions The principal function of financial institutions is to collect funds from the investors and direct the funds to various financial services providers in search for those funds.

Financial Markets A financial market is a market in which financial assets are traded. In addition to enabling exchange of previously issued financial assets

Six basic functions of financial markets Borrowing and Lending Price Determination Information Aggregation and Coordination Risk Sharing Liquidity Efficiency

Financial Instruments Financial instruments are cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver, cash or another financial instrument.

Equilibrium in financial Markets When the expected demand for funds matches with the planned supply of funds generated out of saving and credit creation or when the total desired borrowing is equal to the total desired lending.

Determinants of supply of funds Aggregate savings by the household sector Aggregate savings by the business sector Aggregate savings by the government

Determinants of demand for funds Investment in fixed and circulating capital (working capital) Demand for consumer durables Investment for housing

Theories on savings and investment Prior Savings Theory- Samuelson Credit Creation Theory- Kalecki and Schumpeter Theory of forced Savings- Keynes and Tobin Financial Regulation theory- Stiglitz Financial Liberalisation Theory- Mckinnon and Shaw

Prior Savings Theory- Samuelson This theory is of the view that savings are a must for investment in any economy. All savings find some investment outlets. The theory stressed the need for mobilising savings which is possible if monetary policy support high and real interest rate to be offered to public for saving, which if invested will lead to economic growth. A well developed financial system helps in mobilising money from surplus spending units to deficit spending units and helps in increasing volume investments and output.

…Continued Thereby, transforming a given amount of investment into more productive forms. Thus efficient financial system increases resource and locational efficiency among different investment avenues and reduces cost of finance and risk by providing various insurance and hedging opportunities.

Credit Creation Theory- This theory of the view that credit is created in expectation of savings and this insures some level of independent investment which generates appropriate level of income which in turn leads to an amount of savings which is equal to the investment already done. Therefore investment generates income and this is facilitated by credit creation which takes place in an efficient and sound financial system.

…Continued In a nutshell, the financial system facilitates generation of credit and its appropriate investment which leads to economic development

Theory of Forced Savings This theories main focus is on monetary expansion that is increasing in money supply which is the catalyst of growth in any economy. As per this theory monetary expansion leads to increase in aggregate demand output and will induce savings. If the resources are fully employed this monetary expansion increases inflation which in turn will shift investment into physical assets rather than financial assets due to low return.

…Continued This shift in portfolio will increase output and therefore savings this is known as Tobins or Portfolio shift effect of monetary expansion. The theory also holds that inflation reduces the purchasing power of money which is a kind of tax on the money which redistributes money in favour of the government.

…Continued Therefore this Theory is of the view that low rate of interest is the key to economic growth as it increases investment in physical assets and thus force savings by a increase in output.

Financial Regulation theory- Financial repression or regulation the proponents of this theory are of the view that allocative efficiency of the capital is improved only when interest rates are kept low by the government. Competition does not ensure efficient resource allocation specially in the underdeveloped and in perfect markets.

…Continued Financial regulation protects the less-developed financial market from market failures. Competition does not ensure protection of stable payment system and it increases the possibility of bank failures and loss of public confidence. therefore administered interest rates in finance through government interventions supports financial market.

Financial Regulation theory- Financial markets are prone to market failures Government interventions makes them function better Lowering interest rates and credit programmes

Financial Liberalisation Theory- The proponents of financial liberalisation are of the view that financial repression leads to fixation of low interest rates which does not ensure allocative efficiency of capital and generally investment takes place in low productive areas with no compensating returns leading to fragile financial system.

Directed credit programs by the financial institutions do not ensure optimal utilization of scarce finance thus adds to a burden on society with proportionate output. Financial liberalisation helps the financial system of an economy to strengthen it also puts the system and economy on the growth path. Economy starts growing at a much faster pace than ever before in terms of GDP. It increases the foreign exchange reserves it increases in the standard of living of people and so on.

Financial Liberalisation offers the following Advantages It allows the market forces to operate freely and let the equilibrium level of interest rates to be determined through it It increases the allocative efficiency of capital into the investment projects yielding high returns It increases the average productivity of capital and results in increased output

It increases savings and reduces the holding of real assets It helps in expansion of real credit supply It leads to a sound and effective financial system thereby increasing the level of economic growth and development

Financial Development Financial development of any economy depends upon its financial structure. Financial structure of any economy in turns depends upon the economic progress of the country. If the economy has a strong and sound stock market, debt market, insurance companies, pension funds, mutual funds etc. an effective non-banking financial sector, this shows a high level of financial development.

Financial development of any economy can be judged by the presence or absence of the Indicators such as Finance Ratio that is the ratio of total issue of primary and secondary claims to national income Financial inter relation ratio that is the ratio of financial to physical assets in the economy New issue ratio that is the issue of primary issues to the physical capital formation

…Continued Intermediation ratio that is the ratio of secondary issues to primary issues The ratio of money to national income The promotion of current account deficit financed by market flows The level of integration of domestic and international financial system The level of government intervention in credit allocation