Financial system
Also written Indian financial system
The whole set of institutional arrangements that move funds from surplus units (households) to deficit units (companies and governments) — made up of financial markets, instruments and intermediaries.
In plain language
Some people and businesses have more money than they need right now. Others need more than they have — to build a factory, fund a road, run a government. A financial system is everything that connects the two.
The workbook's definition is precise: the entire set of institutionalised arrangements by which funds are transferred from surplus units to deficit units at terms acceptable to both sides. Households are the surplus sector. Corporations and governments together are the deficit units.
The system does two jobs. It pools money from those who have more than they currently need, and it allocates that money to those who can use it for investment. The larger the flow and the better the allocation, the better the economic output and welfare of society — provided the markets involved also work efficiently and at minimal cost.
How it works
The workbook breaks the financial system into financial markets, financial instruments and financial intermediaries, and adds the market infrastructure institutions that let them work.
Markets — where financial assets such as equities, bonds, currencies and derivatives are created or transferred:
| Market | What it does |
|---|---|
| Money market | Short-term funds, instruments of one year or less — T-bills, CPs, negotiable CDs, repos, call/notice money, bankers' acceptances |
| Capital market | Long-term funds, longer than a year — stock market and bond market |
| Forex market | Exchange of currencies at the applicable exchange rate |
| Credit market | Banks, FIs and NBFCs lending short, medium and long term to corporates and individuals |
| Insurance market | Transfer of risks to insurance companies |
Market infrastructure institutions — depositories (with DPs as their agents), stock exchanges, clearing corporations, and SEBI's Social Stock Exchange, a separate segment of a recognised exchange for Not for Profit Organisations.
Intermediaries — merchant bankers, bankers to issues, registrars and share transfer agents, stock brokers, portfolio managers, mutual funds, custodians, credit rating agencies, debenture trustees and vault managers.
Instruments — the SCRA's list of securities: shares, bonds and debentures; derivatives; units of collective investment schemes and mutual funds; security receipts; securitised instruments; government securities; rights or interest in securities; zero coupon zero principal instruments; and anything else the Central Government declares.
Over all of it sit the regulators of Chapter 2 — SEBI, RBI, IRDAI, PFRDA, IFSCA — with the Ministry of Finance and the Ministry of Corporate Affairs.
A worked example
Illustrative figures. Follow one household's savings through the system.
Kavita, a teacher in Nagpur, saves Rs 25,000 a month. She is a surplus unit. A cement company that wants to add a kiln needs Rs 400 crore. It is a deficit unit. They will never meet.
Kavita's SIP Rs 25,000 a month → Rs 3,00,000 a year
Mutual fund (intermediary) pools her money with lakhs of others
Primary market (capital market) buys Rs 400 crore of the company's 5-year bonds
Depository + clearing corporation settle and hold the securities
Cement company (deficit unit) builds the kiln
If Kavita needs her money back in three years, she redeems her units; the fund may sell some bonds in the secondary market to another investor. The company is not asked to repay early. That continuous exit, the workbook notes, is precisely what makes investors willing to fund the primary market in the first place.
Now change one piece. Suppose the company only needs Rs 150 crore for 90 days to pay suppliers. The same household money reaches it through a very different door — a commercial paper bought by a liquid fund in the money market. Same system; different market, different instrument.
Why NISM asks about it
Chapter 1 (Introduction to the Financial System) opens the paper with this definition and its components; Chapter 2 layers the regulators on top. The chapter's first review question is a direct one: "Financial systems consist of banks, non-banks and ______" — the answer is financial markets. Expect also questions matching intermediaries to their functions (who does safekeeping — custodians; who collates subscription data — registrars).
Common exam traps
- Households are the surplus unit; corporations and governments are the deficit units. Reversing them is the easy mistake.
- The three components are markets, instruments and intermediaries — MIIs such as depositories and exchanges are the infrastructure those components run on.
- Money market is one year or less; capital market is longer than one year. Both have a primary and a secondary segment.
- Bullion is not a security under the SCRA — a Chapter 1 review question lists it as the odd one out.
- A depository can transfer beneficial ownership; a custodian cannot. The workbook draws that distinction explicitly.
- "NCDs" in the money market list are negotiable certificates of deposit, not non-convertible debentures.
Where this is taught
Free preparation for NISM Series III-ARelated terms
- CustodianThe SEBI-registered entity that holds a fund's securities in accounts of its own and settles its trades, so the assets sit somewhere other than with the manager who decides what to buy.
- Market Infrastructure InstitutionsThe institutions that form the plumbing of the securities market — stock exchanges, depositories and clearing corporations, and under SEBI's cyber framework also KRAs and QRTAs.
- DepositoryAn institution that holds investors' securities in electronic form and provides the services needed to transact in them — the securities equivalent of a bank holding money rather than cash.
- Primary marketThe market where an issuer sells securities to investors for the first time and receives the money itself — the "new issue market", as against the secondary market where investors trade among themselves.
- Secondary marketThe market where securities already issued are traded between investors — the money goes to the selling investor, not to the company, and the issuer's capital is unchanged.
- Money Market InstrumentsDebt instruments with maturity of one year or less. Under the PM Regulations they include commercial paper, trade bills, treasury bills, certificates of deposit and usance bills.
- Capital marketThe market in which companies and governments raise long-term funds — for periods longer than a year — through shares and bonds, together with the secondary market where those securities later trade.
- Board for Financial SupervisionThe committee of RBI's Central Board, constituted in 1994, that directs RBI's consolidated supervision of commercial banks, financial institutions and NBFCs.
- Financial marketThe market in which financial assets such as equities, bonds, currencies and derivatives are created or transferred — a mechanism for dealing in financial securities and commodities at low cost.
- Financial disintermediationThe shift of borrowing away from banks and towards the securities markets, where a company raises money directly from investors by issuing paper instead of taking a bank loan.