What’s it: A financial system is a set of institutions and other elements involved in the exchange of funds. The system includes financial institutions such as banks, pension funds, and insurance companies. Financial markets are also included. In addition, the system also involves financial assets and financial services by which funds are transferred from savers to users. The system also requires regulation and related organizations such as central banks and self-regulatory organizations (SROs).
Financial systems vary between countries. And indicators such as financial depth, access, efficiency, and stability characterize their differences. The four components become benchmarks to assess how advanced the financial system in a country is.
Why is the financial system important?
The financial system has a vital role in the economy. First, it allows financial resources to be allocated efficiently. The financial system facilitates the transfer of funds between savers and users.
On the one hand, savers have excess funds and expect their funds to generate returns by investing in financial assets. On the other hand, users need funds for several purposes, such as spending on infrastructure by the government or buying durable goods by households. Finally, these efforts allow funds in the economy to be allocated to their best use.
Second, the financial system promotes economic growth and development. An efficient system minimizes transaction costs and provides a low cost of funds. And stakeholders benefit from it. For example, companies can raise funds at a low cost to support their capital investments, increasing the accumulated capital in the economy. Likewise, the government can do so to support infrastructure development.
In addition, through the financial system, savers get a return on their investment. For example, households can accumulate wealth by buying stocks or bonds. It ultimately supports their consumption more sustainably, both now and in the future.
Third, it is vital to support effective monetary policy. Monetary policy transmits to the economy through the financial system to influence inflation and economic growth. For example, commercial banks will adjust their lending rates upwards when the central bank raises its policy rate. Ultimately, it dampens loan-financed household consumption – as well as investment. In addition to bank lending rates, policies transmit to the economy through their effects on asset prices and exchange rates.
Fourth, economic shocks are transmitted through the financial system. Crises in other countries can spread to the domestic economy through financial markets, besides through international trade. For example, the 1998–99 Asian foreign currency crisis began with the Thai baht crisis. And it then spread to other countries, including Indonesia. It led to an economic crisis – even social turmoil in Indonesia.
Fifth, rescuing troubled financial institutions requires significant funds. As a result, authorities in several countries have issued significant bailouts to avoid systemic risks, which could destroy the financial system and create instability in the economy. For example, the financial crisis in the United States in 2008-2009 cost a bailout of $700 billion for the Troubled Assets Assistance Program (TARP).
What is the function of the financial system?
The financial system serves to connect savers and users of funds. The goal is to distribute economic resources efficiently, which in turn, supports economic development and prosperity.
The financial system plays three critical functions. First, it facilitates us to achieve goals. On the one hand, savers have funds and are trying to find a return on their money. On the other hand, users of funds need funds to finance their needs, such as investment in capital goods by companies or infrastructure development by the government.
Second, it determines the equilibrium interest rate in the economy. The financial system serves to achieve an equilibrium where the aggregate demand for funds equals the aggregate supply for funds. Savers act on the supply side. Meanwhile, the user acts on the demand side.
Third, the financial system functions to allocate financial resources efficiently. On the one hand, savers try to minimize losses, so they are careful to make the right decisions about where to invest. On the other hand, the user seeks to utilize the raised funds for its highest use. For example, the company uses funds from issuing bonds for the most profitable projects. Thus, they can generate maximum profits and are higher than the cost of issuing bonds.
Characteristics of well-functioning financial markets
First, the supporting infrastructure has been well-established, including those related to financial institutions, financial instruments, and regulatory systems. Thus, the system exists to overcome financial problems in the economy.
Second, liquidity is available. It ensures trades can be executed appropriately. Thus, fund users can quickly raise funds, for example, by selling securities such as stocks and bonds. Likewise, savers can easily invest their funds in the instruments they are most interested in.
Third, trading costs are low. It is also closely related to liquidity. Liquid financial markets make it possible to reduce trading costs.
Fourth, market information is available correctly and promptly. This is important to produce fair market prices and low information costs. Transparency and liquidity ultimately encourage more parties to participate.
What are the parts of the financial system?
The financial system includes three main parts:
- Financial intermediary
- Fund users
Both savers and fund users can come from companies, governments, or even individuals (households). Take the household as an example. They act as savers when, for example, buying corporate bonds. But on the other hand, they also act as users, for example, when they borrow money to purchase durable goods.
Then, the exchange in the financial system involves financial intermediaries. They include financial institutions such as banks, insurance, and pension funds and financial markets such as capital markets (stock and bond markets) and money markets. They offer various financial services for specific purposes, whether directly involved in mobilizing funds or indirectly.
Savers have funds to invest in several financial assets. For example, we invest by buying company shares or debt securities. Or we can also put our money in time deposits.
Meanwhile, fund users need money for various purposes. For example, companies need money to buy capital equipment, build factories, or as working capital. Meanwhile, the government needs funds to finance infrastructure projects. And individuals borrow money from banks to buy houses or cars.
Say we invest in stocks. In this case, we need financial intermediaries such as stock exchanges and brokers to do this. Without them, we may incur high transaction costs for negotiating and trading company stock. Then, once we buy shares, the money goes from our pockets to the company, which can be used to invest in capital goods or other purposes.
What are the components of the financial system?
The financial system includes four main components. They are:
- Financial market
- Financial assets
- Financial institutions
- Financial services
Financial markets represent places where savers and fund users interact with each other and trade financial assets such as stocks and bonds. They include:
- Money market
- Capital market
- Forex market
- Derivatives market
The capital market trades long-term securities such as bonds and stocks. Meanwhile, the money market transacts short-term instruments such as commercial paper and certificates of deposit. The forex market trades international currencies, while the derivatives market trades derivative instruments.
Financial assets refer to non-physical assets by which funds move from savers to users. Examples are stocks, bonds, time deposits, and commercial paper. They are the means by which savers get a return on their funds. For example, we buy shares to get dividends or capital gains. Or, we buy bonds to get regular coupons and principal at maturity.
On the other hand, financial assets become the means by which fund users raise money. For example, a company issues shares or bonds and sells them publicly through the capital market.
There are various financial institutions with various financial services. For example, as banks and stock exchanges do, they may provide services to mobilize funds from savers to users. Alternatively, they offer other financial services to support the financial system’s operation without being directly involved in mobilizing funds.
Examples of financial institutions include:
- Finance company
- Brokerage company
- Trust company
- Insurance company
- Investment dealer
- Pension fund
- Investment banks
- Mortgage loan company
- Credit unions
Financial services are non-physical products provided by financial institutions, including services provided by exchanges. For example, such services may be related to savings and loans like those performed by banks. Or they provide contract services such as those offered by insurance companies and pension funds. Cash and wealth management, clearing, depository, and underwriting, payment systems are other examples.