Introduction to Finance and Financial System - Study Guide
This domain tests how savings move from surplus units to deficit units and how the financial system supports that flow. Expect questions on the components and functions of the financial system, direct versus indirect finance, money versus capital markets, financial instruments, and the roles of RBI, SEBI, IRDAI and PFRDA.
Core ideas
- Finance is the allocation of funds over time under uncertainty; it is not the same as accounting, which records past transactions.
- A financial system has savers, borrowers, intermediaries, markets, instruments and regulators.
- Direct finance: firms sell securities to savers. Indirect finance: banks and other intermediaries issue claims to savers and acquire claims on borrowers.
- Money market deals in short-term instruments (T-bills, commercial paper, certificates of deposit); capital market deals in long-term equity and debt.
- Primary markets raise new funds; secondary markets provide liquidity and price discovery.
- Regulators: RBI for banking and monetary stability, SEBI for securities markets, IRDAI for insurance, PFRDA for pensions.
Worked example
A household deposits ₹1,00,000 in a bank at 6% for one year. The bank lends ₹90,000 at 9% and keeps ₹10,000 as reserves. Interest paid to the depositor is ₹6,000. Interest earned from the borrower is ₹8,100. Gross intermediation margin is ₹2,100 before operating costs, loan losses and reserve requirements. The example shows indirect finance: the household does not lend directly to the borrower; the bank transforms deposits into loans and bears credit risk.
Traps
Do not call the whole financial system a bank. Do not confuse primary market with secondary market. Do not assign SEBI to insurance. The bank's spread is not net profit, because costs and defaults must be deducted.