You deal with the financial system when you borrow from a bank or invest in stocks or bonds. The system facilitates you, the saver, with the users of the funds.
Fund users – or fund spenders – may be individuals. For example, your friend applied for a mortgage with the bank. He needs funds to buy a house.
The fund spenders can also be a company. They need funds for working capital and investment needs. Because there is insufficient internal capital, they raise funds by selling their shares to the public through an initial public offering or issuing debt securities. Or they borrow from the bank.
The financial system has a vital contribution to the economy. Through it, savers maximize the return on their money, and users of funds pool funds for their highest use.
I will explain why the financial system is vital to the economy on both positive and negative sides. Positive means the system is working effectively. And negative means when the system fails to work effectively, or shock occurs.
Allows financial resources to be allocated efficiently
As previously explained, the financial system facilitates funds transfer between savers and users. On the one hand, savers have excess funds and expect their funds to generate returns by saving or investing in financial assets. On the other hand, users need funds for several purposes, such as spending on infrastructure by the government or purchasing durable goods by households.
Intermediation may be through banks or other institutions, such as the stock and bond markets. This intermediation allows funds in the economy to be allocated to their best use.
For example, you save money in the bank. You earn interest on your savings. The bank then lends your money to another party, an individual, or an organization.
Likewise, money changes hands from you to the bond issuer, such as a corporation, when you buy a bond. The company then uses the funds for investment. And you get a coupon as a return.
When you buy stock, you own the company. You are entitled to dividends distributed. If its price goes up, you can get capital gains.
Helps in managing risk
An advanced financial system enables us to manage risks using certain financial services or assets. For example, when you invest in financial markets, you can reduce your risk by purchasing contracts in the derivatives market.
Say, you buy a futures contract and take a short position if you believe the underlying asset will decrease in price. Or, you buy a credit default swap (CDS) to protect yourself from credit risk when purchasing bonds.
In addition, we can also use financial services such as bank guarantees to cover losses if business transactions do not go according to plan. The lending institution promises to provide compensation if one of the transacting parties does not fulfill the contractual obligations.
Facilitate liquid transactions and exchanges
For example, you want to gain exposure in the commodity market to make a profit. Say, you see that gold will rise in price as uncertainty in the economy increases in the next few months.
The financial system makes it easy for you to make transactions. You don’t have to physically buy gold. However, you can gain exposure by buying commodity ETFs such as the SPDR Gold Trust or iShares Gold Trust.
Alternatively, you buy shares of gold miners. You expect their stock to go up following the gold price trend.
Promote economic growth and development
An efficient system minimizes transaction costs and therefore provides a low cost of funds. And fund users benefit from it.
For example, low costs encourage firms to invest capital, increasing capital accumulated in the economy. Likewise, the government can do it to support infrastructure development.
In addition, through the financial system, savers get a return on their funds. Through it, households can accumulate wealth by purchasing stocks or bonds.
Increasing wealth supports household consumption, both now and in the future. So, the consumption is sustainably maintained, which supports resilient aggregate demand. Thus, when times are tough, they still maintain their consumption levels.
Determine the equilibrium interest rate
The financial system brings together the supply and demand for money. The point where the two intersect determines the equilibrium interest rate in the economy.
If interest rates are high, savers will move money from the present to the future. More savers will forget current consumption and save more because it promises more returns. Thus, the aggregate supply of funds increases.
Conversely, high-interest rates force borrowers to postpone loans due to high fees. As a result, the aggregate demand for funds decreases.
The aggregate supply for funds and the aggregate demand for funds will meet at the equilibrium point. And the equilibrium point determines the interest rate in the economy.
Supports effective monetary policy
Monetary policy influences the economy through its transmission to the financial system. Effective monetary policy is transmitted to the financial system influencing the behavior of savers and users, affecting aggregate demand, inflation rates, and economic growth.
For example, the central bank raises interest rates. Rising interest rates will encourage commercial banks to upward adjust their lending rates. As a result, households reduce consumption financed by loans, and businesses reduce investment due to high costs.
In addition to bank lending rates, policies transmit to the economy through their effects on asset prices and exchange rates. For example, an increase in interest rates lowers bond prices because the two are inversely related. This situation affects household consumption behavior because their wealth decreases.
Contagion effects and their impact on the economy
Economic shocks between countries spread through the financial system. Crises in other countries can spread to the domestic economy through financial markets, apart from international trade.
For example, the foreign currency crisis in Asia in 1998–1999 started with the Thai baht crisis. However, the problem then spread to other countries, including Indonesia. It gave rise to an economic crisis – even social turmoil in Indonesia.
Likewise, the subprime mortgage crisis in the US created panic in global financial markets. Investors become risk averse and avoid risks. They then attract investments in risky assets, such as those belonging to developing countries, and use them to safe-haven assets, such as gold. It also caused regions such as Central and Eastern Europe to experience negative economic growth after previously seeing strong growth.
Cost significant to save the economy
Maintaining financial system stability is expensive. Likewise, saving it from destruction could be significantly more costly.
Authorities in several countries have issued significant bailouts to avoid systemic risk. They are trying to save troubled financial institutions to avoid more severe effects. The bailout is expected to prevent the financial and economic system from becoming unstable and collapsing.
For example, the financial crisis in the United States in 2008-2009 cost a bailout of up to $700 billion for the Troubled Asset Assistance Program (TARP). Likewise, the debt crisis in the Eurozone also cost the bailout more than 400 billion euros.