Financial System

The Financial System is a set or aggregation of institutions, instruments, markets and services.

Intermediaries

Intermediaries are the financial institutions that accept deposits from the savers and channelize the same as lending/investment to the users. In other words, financial intermediaries function as a bridge between the savers and the users in any economy. The financial intermediaries by their smooth ‘conduit function’ make the economy infinitely more efficient in the usage of money.

Examples of financial intermediaries are:

• Banks
• Investment Companies
• Non-Banking Finance Companies [NBFCs],
• Insurance companies,
• Mutual funds,
• Stock Brokerages
• Credit Card Companies

Non-Intermediaries

These are popularly known as Development Banks. These institutions fund the users of money, but, as a matter of policy, do not accept deposits from ordinary savers. They get funds from their owners or members as capital contribution/subscription & not from depositors.

Classic examples of such institutions in the international context are

• Asian Development Bank
• World Bank
• International Monetary Fund (IMF).
• State Financial Corporations(In the Indian context)

Regulatory Agencies

These are agencies whose sole function is to monitor and regulate the functioning of the intermediaries and non-intermediaries and are referred to as ‘Regulatory Authorities’. They are like the traffic cops that lay down the “Do’s and Don’ts” for the players in the market. To make their regulations enforceable, these agencies are generally armed with punitive powers, which can be exercised in case of non-compliance by any of the players.

Examples:

Banking Sector: In the Indian context, Reserve Bank of India [RBI], is the regulatory agency vis-à-vis the banking system. In US it is called the Federal Reserve Bank. In UK till eight years ago, Bank of England was the regulator of the banking system; today that role is being performed by the Financial Supervision Authority [FSA].

Capital Market:  Financial regulators, such as the U.S. Securities and Exchange Commission, Financial Services Authority in the UK, Financial Supervision Authority in Finland, and Securities & Exchange Board of India [SEBI] are responsible for regulating the capital market segment to ensure that investors are protected against wrong selling.

Financial Services

The term “Financial Services” is generally used to refer to the services provided by the finance industry. It is also a term used to represent organizations that deal with the management of money & provide a variety of money and investment related services.

Important Financial Services offered include:

• Banking Services
• Investment Planning
• Insurance Planning
• Wealth Management & Estate Planning
• Share Broking
• Credit Cards Services

Financial Instruments

As is the case with financial markets, financial instruments are dime a dozen. Some of the most well known ones are:

• Simple Check
• Demand draft drawn in one’s favor
• Shares
• Trade Bills
• Debentures
• Bonds
• Government Securities
• Treasury Bills and Commercial Papers
• National Saving Certificates
• Fixed Deposit Receipts

Financial Markets

The financial markets can be divided into different subtypes:

• Capital markets: Capital Market (securities markets) is the market for securities, where companies and the government can raise long-term funds. The capital market includes the stock market and the bond market. The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.
  • Bond markets: The bond market, also known as the debt, credit, or fixed income market, is a financial market where participants buy and sell debt securities usually in the form of bonds. Bond Markets provide financing through the issuance of Bonds, and enable the subsequent trading thereof.
  • Stock market: A stock market is a market for the trading of company stock, and derivatives. Both of these include securities listed on a stock exchange as well as those only traded privately. It provides financing through the issuance of shares or common stock, and enables subsequent trading.
• Commodity markets: Commodity Markets facilitate the trading of commodities & are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized Contracts. Items traded include: Food stuffs, Livestock, Precious metals (Gold, Silver), and Industrial metals, Fuel etc
• Money markets: Money Market is a financial market for short-term borrowing and lending, typically up to thirteen months. In the money markets, banks lend to and borrow from each other, short-term financial instruments such as certificates of deposit (CDs) or enter into agreements such as repurchase agreements (repos). It provides short to medium term liquidity in the global financial system. Money market derivatives include forward rate agreements (FRAs) and short-term interest rate futures.
• Derivatives markets: The Derivatives Markets are the financial markets for derivatives, which provide instruments for the management of financial risk. The market can be divided into two, one for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both
• Futures markets: Future Markets provide standardized forward contracts for trading products at some future date. A futures exchange is a corporation or organization which provides a marketplace in which to trade derivatives such as futures contracts and options
• Foreign Exchange markets: Foreign Exchange (Currency or Forex or FX) Market is where one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The trade happening in the Forex markets across the globe currently exceeds $1.9 trillion/day (on average). Retail traders (individuals) are currently a very small part of this market and may only participate indirectly through brokers or banks and may be targets of Forex scams
• Insurance markets

Central / Apex Bank – Its Functions

In most countries, the Central bank is the pivot of the financial system. It is called the ‘Regulatory Bank’. In India, Reserve Bank of lndia is the central bank & in US it is the Federal Reserve Bank that is responsible for maintaining the stability of the financial system. Similarly each country has an Apex/Central Bank to regulate & control its Financial System

Functions of the Central bank vary from country to country. The following could be listed as generic ones:

• Issue currencies and coins. Put into circulation currency notes of all denominations
• Monitor and regulate the functioning of intermediaries and non-intermediaries
• Make regulations ( Compliance Norms ) and exercise powers to monitor compliance/ non Compliance
• Act as bankers to commercial banks, i.e.: Banks are entitled to maintain their accounts with the Central bank. In fact, in most other countries, it is mandatory that banks, which participate in the clearing system, maintain their accounts with the central bank or one of its agent institutions.
• Function as banker to the Government
• Act as the lender of last resort to banks during times of crisis
• Manage the country’s foreign exchange, gold reserves, and Government’s stock register & control their use
• Setting the official interest rate to manage both inflation and the country’s exchange rate

Banking Systems – UK

In the UK, banks that deal with the public are called ‘high Street banks’. They take care of the transactional requirements of the general public. Besides, there is a unique institution by name ‘Discount House’ operating in the UK. A ‘discount house’ does not deal with the general public. Instead, it is primarily focused on dealing with banks and other financial institutions. On the regulatory front, while till eight years ago Bank of England was the regulator of the banking system, today that role is being performed by the Financial Supervision Authority [FSA].

Banking Systems – US

The US banking system is possibly the most fragmented system one can find anywhere in the world. In the first place, there are a number of types of banks in the US: International banks, national banks, state banks and unit banks. The number of banking entities is phenomenally large in the US (around 9000). On the regulatory front, these banks/ banking entities are governed by various regulators.

Within the US itself, banking regulations differ from state to state. Till a few years back, the US banking laws were totally anti-competitive, but some of the new regulations put in place during and after 1999 has triggered consolidation of banks in the country.

Banking in United States began in 1781 with the establishment of the Bank of North America in Philadelphia. During the American Revolutionary War, the Bank was given a monopoly on currency prior to which private banks printed their own bank notes, backed by deposits of gold and/or silver.

Definition of a Bank

The term bank is generally understood as an institution that holds a banking license granted by the Bank regulatory authority and is provided rights to conduct the most fundamental banking services. All Banks come under the Intermediaries categories functioning as a bridge between the savers and the users.

A Bank is a commercial institution licensed as a receiver of deposits. It is a financial institution that accepts deposits and channels the money into lending activities. It provides banking services for profit. The essential function of a bank is to provide services related to the storing of deposits and extending of credit. A bank generates profits from transaction fees on financial services and on the interest it charges for lending.

Banking Services

Although the nature of services offered by a bank depends upon the type of the bank and the country, the primary services provided include

• Taking deposits from the general public and issuing checking and savings accounts, keeping money safe while also allowing withdrawals when needed
• Providing loans to individuals, businesses & Corporate
• Encashing cheques
• Facilitating money transactions such as wire transfers and cashiers checks (Inter Bank, Intra Bank, Inter/Intra country etc…)
• Issuing credit cards, ATM, and debit cards
• Storing valuables, particularly in a safe deposit box
• Facilitation of standing orders and direct debits, so that payments for bills can be made automatically

Types of Banks

Banking activities can be characterized as Retail banking and Investment banking. Most banks are profit-making, private enterprises. Some are owned by government, or are non-profit making. In some jurisdictions retail and investment activities have been, separated by law.

The Types of Retail banks & their primary activities in operation today can be broadly classified as follows:

Retail Banks or Commercial Banks

Commercial banks provide products & activities dealing directly with individuals, small businesses & Corporate. It is the term used for a normal Bank to distinguish it from an Investment Bank & is what people normally call a “Bank”.

In some English-speaking countries outside North America, the term “Trading Bank” is used to denote a commercial bank

A Commercial Bank undertakes the following functional roles:

• Raises funds by collecting deposits from businesses and consumers via checkable deposits, savings deposits, and time (or term) deposits
• Makes loans to businesses and consumers
• Trades in Corporate bonds and Government bonds
• Its primary liabilities are deposits and primary assets are loans and bonds

It can be further subdivided into

• A Retail Banking Division-that deals directly with individual consumers and small  businesses
• Commercial Divisions that deal with Corporations or large businesses.

Commercial banking can also refer to a bank or a division of a bank that mostly deals with deposits and loans from Corporations or large businesses, as opposed to normal individual members of the public (retail banking).

Retail banking is typical mass-market banking where individual customers use local branches of larger commercial banks. Services offered include: Savings and Checking accounts, Mortgages, Personal/Auto/ Student loans, Debit/credit cards, and so forth.

Transactions under Retail banking would include

• Accepting deposits from individuals,
• Maintaining their accounts
• Extending loans and advances under different schemes.
• On the Services front,

• Issuance of demand drafts,
• Execution of money transfer requests from individual customers
• Carrying out their standing orders
• Issuing various types of cards—credit, debit
• Collection of Checks

Some Examples are: ABN AMRO, ANZ Bank, Bank of America, Bank of New York, Bank of Nova Scotia BNP Paribas, Canadian Imperial Bank of Commerce (CIBC), Citibank, Credicorp Ltd, SBI, Punjab National Bank, ICICI bank, and HDFC Bank etc.

Community Development Banks (CDBs)

Community Development Banks are special Banks designed to serve the residents of low to moderate income (LMI) areas to spur economic development in those areas.

• They are Regulated banks that provide financial services to underserved markets/ populations
• Like any national bank, all federally chartered CDBs are regulated primarily by the Office of the Comptroller of the Currency
• CDBs are required  to accept deposits, lend, invest, and provide services primarily to LMI individuals or communities in which it is chartered to conduct business

E.g. : Shore Bank in Chicago, Albina Community Bank in Portland, Carver Federal Savings Bank in New York, Central Bank of Kansas City,  City First Bank of D.C. Dryads Savings Bank in New Orleans, Liberty Bank & Trust in New Orleans, Louisville Commune, Regional Rural Banks or Village Cooperative Banks in India

Postal Savings Banks

Postal Savings Banks are Associated with National Postal Systems. They were offered by Post Offices of many Nations to provide Banking facilities to depositors who did not have access to banks. This was a safe and convenient method to save money and promote the habit of savings among the poor. The first Nation to offer such an arrangement was Great Britain in 1861.

Savings Bank

A Savings Bank is a financial institution whose primary activity is accepting savings deposits. It may also perform some other functions. Presently Savings Banks focus on retail banking services like payments, savings products, credits and insurances for individuals or small and medium-sized enterprises. They differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach and by their socially responsible approach to business and society.

Private Banks

Private Banks are banks that are owned by either an individual or with limited partners. These banks normally have two distinct divisions – private banking, and corporate banking. Private banking has been viewed as very exclusive, only catering to high net worth individuals with liquidity of over $1 million, although it is now possible to open accounts in some private bank with around $50,000.

An institution’s private banking division provides various services such as Asset/Wealth management, Savings, Inheritance, and Tax planning etc for their clients.

E.g.: JP Morgan Chase, Goldman Sachs, Merrill lynch, Citigroup Private Bank, Credit Suisse Private Banking are some examples of Institutions that provide Private Banking services.

Investment Banks

Investment Banks are those that provide investment related services. They do not provide direct credit as done by Commercial Banks.

The main activities rendered by an Investment Bank include:

• Help companies, governments and their agencies to raise money by issuing and selling securities in the primary market
• Assist public and private corporations in raising funds in the capital markets (both equity and debt) and the division handling this is called the “Investment Banking Division” (IBD)
• Provide financial services such as the trading of fixed income, foreign exchange, commodity, and equity securities and act as intermediaries in trading for clients.
• “Underwrite” stock and bond issues and other types of financial transactions
• Offer assistance in the purchase and sale of stocks, bonds, and mutual funds
• Operate as both brokerages and investment banks
• Advice on mergers and acquisitions

Some examples are: Goldman Sachs of the USA, Nomura Group of Japan, Lehman Brothers, Morgan Stanley, Bears Stearns, and Merrill Lynch etc.

Credit Unions

A Credit Union is a cooperative financial institution that is owned and controlled by its members. Credit unions differ from other financial institutions (banks, savings and loan, etc.) in that the members who have accounts in the Credit Union are the owners of the Credit Union.

Policies of the Credit union governing interest rates and other matters are set by a voluntary Board of Directors elected by and from the membership itself. Only a member of a Credit Union may deposit money or borrow money from it. As such, Credit Unions have historically marketed themselves as providing superior member service and being committed to helping members improve their financial health.

Credit unions typically pay higher dividend (interest) rates on shares (deposits) and charge lower interest on loans than banks. Credit union revenues (from loans and investments) do, however, need to exceed operating expenses and dividends (interest paid on deposits) in order to maintain capital and solvency.

Due to their status as not-for-profit financial institutions, Credit Unions in the United States are exempt from Federal and State income taxes. Credit unions exist in a wide range of sizes, ranging from volunteer operations with a handful of members, to institutions with several billion dollars in assets and hundreds of thousands of members.

NBFCs

Non-Bank Financial Companies (NBFCs) also known as Non-Banks are financial institutions that provide banking services without meeting the legal definition of a Bank, i.e. one that does not hold a banking license. Regardless of this, its operations are still exercised under the Banking regulation. However this depends on the jurisdiction, as in some jurisdictions, such as New Zealand, any company can do the business of banking, and there are no banking licenses issued.

Non-Bank institutions frequently acts as suppliers of loans and credit facilities, supporting investments in property, providing services such as funding private education, wealth management and retirement planning. However they are typically not allowed to take deposits from the general public and have to find other means of funding their operations such as issuing debt instruments.

Deposits

A Deposit Account is an account through which a banking institution is allowed to hold money on behalf of the account holder. Some banks charge a fee for this service, while others may pay the Customer interest on the funds deposited. The account holders retain rights to their deposits, although restrictions placed on access depend upon the terms and conditions of the account and the provider.

Demand Deposits/Liabilities

Demand Deposits (Payable on Demand) are those accounts held at a Financial Institution from which the deposited funds can be withdrawn at any time through a variety of Channels. These are accounts from which a depositor may withdraw funds immediately without prior notice. Since funds may be withdrawn on demand in person or by presentation of a check, the account has many of the liquid characteristics of circulating currency. These accounts allow the customer to “demand” money at any time, unlike a term deposit, which has been made for a predetermined period. Savings Accounts, Checking Accounts, Interest/Non – Interest bearing Accounts are some types of Demand Deposits.

A demand account allows the account holder to make or receive payments by:

• Cash money (banknotes)
• Cheque and money order (paper promise to pay)
• Giro (funds transfer, direct deposit)
• Direct debit (pre-authorized debit)
• Standing order (automatic funds transfer)
• Debit card or ATM card
• EFTPOS (cashless direct payment at a store or merchant)