There are three main constituents of the financial system: (a) the financial assets, (b) the financial market and (c) the financial institutions.

1. Financial Assets:

The financial assets or near-money assets are the claims to money and perform some functions of money. They have high degree of liquidity but are not as liquid as money is. Financial assets are of two types: (a) primary or direct assets, and (b) secondary or indirect assets.

Primary assets are the financial claims against real-sector units created by real-sector units as ultimate borrowers for raising funds to finance their deficit spending; they are the obligations of ultimate borrowers.

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The examples of Primary assets are bills, bonds, equities, book debits, etc. Secondary assets are financial claims issued by financial institutions against themselves to raise funds from the public; these assets are the obligations of the financial institu­tions.

The examples of secondary assets are bank deposits, life insurance policies, Unit Trust of India units, etc.

2. Financial Markets:

The financial system of a country works through the financial markets and the financial institutions. The financial markets deal with the financial assets of different types, currency deposits, cheques, bills, bonds, etc.

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Financial markets perform the following functions: (a) They create and allocate credit, (b) They serve as intermediaries in the process of mobilisation of saving, (c) They provide convenience and benefits to the lender and borrowers, (d) They promote economic development through a balanced regional and sectoral allocation of investible funds.

Financial markets are credit markets which cater the credit needs of individuals, firms and institutions. Since credit is required and supplied for short period and long period, the financial markets are broadly divided into two types: (a) money market and (b) capital market.

Money market deals with the short-period borrowing and lending of funds; in the money market, the short term securities are exchanged. Capital market deals with the long period borrowing and lending of funds; in the capital market, long-term securities are exchanged.

Financial market may also be categorized into: (a) primary market, and (b) secondary market. Primary market is a market in which newly issued credit instruments are sold and purchased. Secondary market, on the other hand, is market in which previously issued credit instruments are bought and sold.

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3. Financial Institutions:

Financial institutions or financial inter-mediaries act as half- way houses between the primary lenders and the final borrowers.

They borrow funds (or accept deposits) from those who are willing to give up their current purchasing power and lend to (or buy securities from) those who require the funds for meeting the current expenditures.

Financial institutions are generally divided into two categories (a) banks, and (b) non-bank financial intermediaries. The main difference between banks and non bank financial intermediaries is that the former possess, while the latter do not possess the demand deposits or credit-creating power.