IFS UNIT I_Financial System and The Economy.pptx

IFS UNIT I_Financial System and The Economy.pptx

1. Financial System and the Economy UNIT I: Role of Financial System in Economic Development, Economic Growth and Capital Formation – Financial Deepening and Financial Widening – Real Assets VS Financial Assets – Bank based VS Market Based Financial System - Structure of Indian Financial System – Reforms (Banking/Stock Market/Financial Sector) in Indian Financial Sector.

2. UNIT-1 STRUCTURE OF FINANCIAL SYSTEM FINANCIAL SYSTEM: System: System is a set of inter-related components working together to achieve some purpose. Def : Financial system: “A system that aims at establishing and provide a regular, smooth, efficient and cost effective linkage between depositors (savers) and Investors ( borrowers) “

3. A Financial System is a network of institutions, markets, instruments, and services that enables the efficient movement of funds from surplus economic units (savers) to deficit units (borrowers). FINANCIAL SYSTEM

4. The financial system is essential for economic development—it mobilizes savings, allocates resources, manages risks, and ensures liquidity. Built upon robust institutions and regulations, it supports growth, stability, and inclusive progress. Role of Financial System in Economic Development

5. ROLE OF FINANCIAL SYSTEM IN ECONOMIC DEVELOPMENT

6. Role of Financial System in Economic Development, Economic Growth and Capital Formation The Capital Allocation Process In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it. Suppliers of capital – individuals and institutions with “excess funds”. These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital – individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

7. Role of Financial System in Economic Development

8. ROLE OF FINANCIAL SYSTEM IN ECONOMI DEVELOPMENT Financial system increases the volume of investment ( by creating return and Liquidity) It promotes efficient allocation of financial resources for socially desirable and Economically productive purpose. It influence both the quality and the pace of economic development The production function is link between Finance and Economic Development. ( i.e., men material and money are crucial inputs in production activities)

9. Capital Formation & Economic Growth Households: Bank deposits Provident funds Insurance schemes Mutual funds Capital markets Savings → Investments → Capital Formation → Growth Productive Investment: Infrastructure (roads, ports, power) Industries and manufacturing Agriculture and services Entrepreneurship and innovation More physical assets Creation of employment Improved productivity Rise in income levels Capital Formation = Increase in Real Capital Stock Efficient capital formation leads to: GDP growth Industrial expansion Increase in national income Infrastructure development Technological advancement Financial intermediaries “The financial system is the engine that drives capital formation in any modern economy.” — Basu, Indian Financial System

10. Institution Role Commercial Banks Accept deposits, provide loans Development Banks Long-term finance for infrastructure Capital Market Equity, bonds, IPOs for corporate funding NBFCs Fill credit gaps in semi-formal sector Insurance Cos. Channel premiums to long-term investments Strong financial systems are maintained: Low inflation Balanced liquidity Investor confidence Regulatory bodies (RBI, SEBI, IRDAI) ensure trust and system resilience.

11. Role of Financial System in Economic Development, Economic Growth and Capital Formation Theoretical Perspective 1.Harrod-Domar Model: The Harrod-Domar model is a classical economic growth theory that highlights the importance of investment and savings in promoting economic growth. Higher Savings (S) → More funds available for investment → Higher growth. Lower Capital-Output Ratio (v) → More efficient use of capital → Higher growth. “Harrod-Domar stresses the importance of both quantity (savings) and quality (efficiency of investment) in driving economic development.” 2.Solow Model: 3.Finance-Growth Nexus Theory:

12. Role of Financial System in Economic Development, Economic Growth and Capital Formation Theoretical Perspective 1.Harrod-Domar Model: 2.Solow Model: Developed by Robert Solow (1956), this model explains long-term economic growth based on capital accumulation, labor growth , and technological progress . Sustained growth requires investment in capital and advancement in technology . Solow Model emphasizes that capital accumulation is important for growth, but long-term development also depends on technological innovation —something a mature financial system can facilitate by supporting R&D, human capital, and infrastructure. 3.Finance-Growth Nexus Theory:

13. Role of Financial System in Economic Development, Economic Growth and Capital Formation Theoretical Perspective 1.Harrod-Domar Model: 2.Solow Model: 3.Finance-Growth Nexus Theory: Studies (like those by King & Levine, 1993) found a positive correlation between financial development (like size and efficiency of banks and markets) and long-term economic growth.

14. Financial Deepening and Financial Widening Financial systems play a crucial role in mobilizing savings, allocating resources, and promoting growth. Two important aspects of financial development are: Financial Deepening: An increase in the availability, diversity, and efficiency of financial services and instruments in an economy. Financial Widening: The expansion of access to financial services across a broader section of the population, especially the underserved.

15. Financial Deepening and Financial Widening Financial Deepening Financial deepening leads to a higher financial asset-to-GDP ratio and greater monetization of the economy. The M2/GDP ratio compares the total money supply (M2) to the size of the economy (GDP) .

16. Financial Deepening and Financial Widening Financial Deepening It is a key M2/GDP ratio indicator of financial deepening. A higher ratio means the financial sector is well-developed, with more financial assets and services available to the public. A lower ratio suggests a shallow financial system , where people may rely more on cash and informal financial methods.

17. Financial Deepening and Financial Widening Features: Growth of financial institutions and markets Increased availability of credit and savings instruments Improved intermediation between savers and investors Expansion of financial products: loans, insurance, mutual funds, etc.

18. Financial Deepening and Financial Widening Benefits of Financial Deepening Enhances resource mobilization Supports capital accumulation Facilitates technological innovation Improves monetary policy effectiveness Stimulates economic growth

19. Financial Deepening and Financial Widening Financial Widening The expansion of access to financial services across a broader section of the population, especially the underserved. Financial widening promotes financial inclusion , especially in rural and informal sectors. Features of Financial Widening Focus on outreach: unbanked, rural, poor, and informal workers Introduction of microfinance, SHGs, Jan Dhan Yojana, etc. Use of technology: digital payments, mobile banking Measured by: % of population with bank accounts Credit access among small borrowers Benefits of Financial Widening Promotes inclusive growth Reduces poverty and income inequality Encourages saving and productive investment Builds a more resilient and formal economy

20. Aspect Financial Deepening Financial Widening Focus Volume & complexity Coverage & access Goal Efficiency & innovation Inclusion & equity Target Formal sector participants Underserved populations Example Indicator M2/GDP, Credit/GDP Bank account penetration

21. Real Assets VS Financial Assets Real Assets Assets that have a physical form and are used to produce goods and services. Examples : Land, buildings, machinery, gold, etc. Financial Assets Assets that represent a claim on real assets or income , but have no physical form . Examples : Bank deposits, stocks, bonds, mutual funds, insurance policies.

22. Financial Deepening: Shift from Real to Financial Assets Indicates trust in the formal financial system Improves capital allocation in the economy Enhances monetary control and liquidity Example : A household shifting its savings from gold to fixed deposits, or investing in mutual funds.

23. Financial Widening: Broader Access to Financial Assets Financial widening focuses on bringing more people into the financial system , helping them move from informal saving (real assets or cash at home) to formal financial instruments. Implications: Promotes financial inclusion Targets unbanked populations Reduces reliance on informal channels like moneylenders Example : A rural laborer opening a bank account and starting to save money regularly instead of keeping cash or livestock.

24. Financial Widening: Broader Access to Financial Assets Financial widening focuses on bringing more people into the financial system , helping them move from informal saving (real assets or cash at home) to formal financial instruments. Implications: Promotes financial inclusion Targets unbanked populations Reduces reliance on informal channels like moneylenders Example : A rural laborer opening a bank account and starting to save money regularly instead of keeping cash or livestock.

25. Criteria Real Assets Financial Assets Tangibility Physical (e.g., land, gold) Paper/electronic claims Liquidity Less liquid Highly liquid (bank deposits) Economic Efficiency Limited use for investment Used in productive sectors Policy Control Outside formal economy Aids in monetary regulation Inclusion Indicator Not tracked by banks Reflected in formal stats

26. Bank-Based Financial System 1. Bank-Based Financial System Primary Focus : In a bank-based system, banks play the dominant role in the financial sector. They act as intermediaries between savers and borrowers, channeling funds through loans and deposits. Real Assets vs. Financial Assets : Bank-based systems typically emphasize financial assets (such as loans and deposits) and the intermediation process of banks. Real assets are often financed indirectly through credit from banks, as financial institutions offer loans for purchasing real assets like property or machinery. Financial Deepening : As banks offer more financial products (loans, deposits, investment accounts), financial deepening occurs, expanding access to financial assets . Financial Widening : Financial widening focuses on broadening access to banking services for individuals and businesses, often targeting the unbanked or those without access to formal financial services.

27. Bank-Based Financial System 2. Market-Based Financial System Primary Focus : In a market-based system, the primary role of financial markets is to mobilize savings and allocate capital directly. Investment takes place through stocks, bonds, and other market instruments. Real Assets vs. Financial Assets : Market-based systems deal more with financial assets , as individuals and businesses purchase stocks or bonds, often bypassing banks. Real assets are financed directly through equity or debt issued in capital markets. Financial Deepening : Financial markets deepen when there is a greater volume of securities being traded, such as stocks and bonds. This results in a more liquid, diverse financial market that provides companies with the means to raise capital and invest in real assets. Financial Widening : Financial widening in this context refers to expanding the access to financial markets , allowing smaller businesses or individuals to participate in investment opportunities previously limited to larger institutions or wealthy individuals.

28. Bank-Based Financial System Feature Bank-Based Financial System Market-Based Financial System Primary Intermediary Banks (Loans, Deposits) Financial Markets (Stocks, Bonds) Role of Banks Dominant in credit allocation Less dominant, focus on capital markets Real vs. Financial Assets More reliance on financial assets (loans, deposits) Direct investment in financial assets like stocks and bonds Financial Deepening Increased lending & deposits Increased trading of securities Financial Widening Bank branch expansion & inclusion Expanding access to financial markets (e.g., mutual funds, ETFs)

29. Bank-based systems are more focused on credit intermediation , supporting financial deepening and widening through improved access to banking services. Market-based systems facilitate financial deepening and widening by enabling direct access to financial markets, empowering individuals and businesses to participate in capital markets.

30. Structure of Indian Financial System

31. Reforms in Banking - Indian Financial Sector. Reform Area Details 100% FDI in Insurance Budget 2025 raises FDI cap from 74% to 100%, provided premiums collected are invested domestically ( smefutures.com , marketinsiders.in ). India Post Payment Bank Expansion Rural outreach enhanced via new branches, financial literacy, microfinance partnerships . Grameen Credit Score for Rural Lending Introduces standardized, AI‑enabled risk scoring for farmers and MSMEs . CGTMSE + MSME Credit Card AI-based claim processing and ₹10 lakh revolving credit facility launched . Centralised KYC Registry Faster re‑KYC, single-point identification system enhances onboarding . Pension & Pension Product Reforms Regulatory forum created for flexible pension products .

32. Reform Area Details PSU Special Delisting Route SEBI now enables delisting of PSUs with ≥90% govt share ( economictimes.indiatimes.com ). IPO & QIP Ease Streamlined disclosures, finesse in SME IPO criteria, founder-friendly ESOP, QIP reforms . Derivatives Risk Controls Caps on open interest; expiry days standardised; position limit linked to cash market . Algo Trading & Finfluencer Rules Mandatory algo registration, audits; banning unregistered influencer partnerships . Equity Derivatives Oversight New open‑interest norms, more robust position tracking . SME IPO Enhancements Higher EBITDA bar; restricted use of funds; extended lock-ins and lock-up posts IPO . REIT/ InvIT & AIF Rationalisation Simplified norms, lower investment thresholds, improved disclosures . Reforms in Stock Market - Indian Financial Sector.

33. Reforms in Financial Sector - Indian Financial Sector. Reform Area Details Strengthened Exchange Oversight SEBI mandates MIIs to appoint independent heads for trading, risk & compliance, reporting directly to Boards & SEBI ( reuters.com ). ESG & LODR Updates New corporate governance norms for debt issuers; phased ESG value chain disclosures . IFSC – GIFT City Push Incentives aimed at transforming GIFT City into a global financial hub . Digital Rupee (CBDC) RBI advances token- and account-based pilots, offline capability & cross-border utility .

34. References: M.Y. Khan – Indian Financial System L.M. Bhole & J. Mahakud – Financial Institutions and Markets E. Gordon & K. Natarajan – Financial Markets and Services

35. Thank You