When we talk about the financial system, we refer to the institutions and other elements involved in circulating funds in the economy. The system includes financial institutions such as banks, pension funds, and insurance companies. Meanwhile, other elements include financial markets, financial assets, and financial services.
Financial markets include capital markets – such as the stock and bond markets – money and derivatives markets. The financial system involves financial assets and services through which funds are transferred from savers to users. It also requires regulation and related organizations such as central banks and self-regulatory organizations (SROs).
How advanced the financial system is varies between countries. Financial depth, access, efficiency, and stability indicate their differences. The four indicators are commonly used in benchmarking to assess how advanced a country’s financial system is.
Why is the financial system vital?
The financial system has a vital role in the economy. It is through which money and funds circulate in the economy. Several reasons explain why the financial system is critical.
First, the financial system allows financial resources to be allocated efficiently. It facilitates the transfer of funds between savers and users. On the one hand, savers get returns to optimize their money/funds. On the other hand, users – such as companies – can raise funds for their best interests, such as working capital and investment.
Second, the financial system promotes economic growth and development. An efficient system minimizes transaction costs and therefore provides a low cost of funds.
Third, effective monetary policy requires a financial system to work. Monetary policy is transmitted to the economy through the financial system to influence inflation and economic growth. For example, an increase in interest rates by the central bank affects the economy by reducing aggregate demand through its impact on borrowing costs, prices of financial assets, and exchange rates.
Fourth, economic shocks spread through the financial system. Crises in other countries can spread to the domestic economy through financial markets.
Fifth, rescuing troubled financial institutions requires significant bailouts. For example, the 2008 crisis in the US forced Congress to initially pass a $700 billion Troubled Asset Relief Program (TARP).
What are the roles and functions of the financial system?
The financial system functions as a link between savers and users of funds. If working effectively, the system distributes economic resources efficiently, supporting economic development and prosperity.
The financial system plays three critical functions:
- Facilitate us to reach the goal
- Determines the equilibrium interest rate in the economy
- Allocate financial resources efficiently
Facilitate us to reach the goal
The financial system is through which funds are transferred from savers to users of funds. You are a saver if you are an investor in the stock or bond market. In addition to individuals, savers may refer to organizations such as insurance and pension funds.
Savers have excess money to optimize. They are trying to find a return on the money they hold. For example, you buy a bond for a fixed return.
Meanwhile, fund users need money to finance their needs. They may be individuals, companies, or governments.
For example, you apply for a mortgage to buy a house. Or, you borrow to buy a car. Or, you borrow to start a new business.
Meanwhile, companies need funds for working capital or investing in capital goods. They then raise funds through bank loans, issuing bonds, or selling their shares to the public.
Then, the government borrows to cover the deficit. Tax revenues are insufficient to cover expenditures. Thus, the government must borrow, for example, by issuing bonds.
Determine the equilibrium interest rate
The financial system is essential for determining the equilibrium interest rate in the economy. Through it, the aggregate demand for funds equal to the aggregate supply for funds converges to form the equilibrium interest rate
Savers supply funds. Meanwhile, the user acts on the demand side. Their funds meet in the financial system. Thus, an effective system allows the economy to determine the equilibrium point for the interest rate.
Allocate financial resources efficiently
The financial system functions to allocate financial resources efficiently. The equilibrium reached represents the best interests of savers and users of funds.
On the one hand, savers are trying to maximize the return on their money. They are scrupulous in making the right decisions about where to invest. So they can increase their money.
On the other hand, users collect funds for their highest usage. For example, the company uses the funds from issuing bonds for the most profitable projects. Thus, they can generate maximum profits and are higher than the cost of funds.
Characteristics of a well-functioning financial system
First, the supporting infrastructure is well established, including those related to financial institutions, financial instruments, and regulatory systems. Thus, the system exists to solve financial problems in the economy.
Second, liquidity is available. It ensures trades can be executed quickly and inexpensively. Thus, fund users can easily collect 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 fees are low. It is also closely related to liquidity. Liquid financial markets make it possible to reduce trading costs.
Fourth, market information is available in a correct and timely manner. This is essential 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 user
Both savers and users can come from individuals (households), companies, or the government. Take household as an example. They act as savers when, for example, buying corporate bonds. On the other hand, they can also act as users, for example, when they borrow money from a bank to purchase durable goods.
Then, exchanges within the financial system involve financial intermediaries. They include financial institutions such as banks, insurance, and pension funds, and financial markets such as capital and money markets. They offer financial services for a specific purpose, whether they are directly involved in mobilizing funds – as banks do – or indirectly.
Savers have funds to invest in several financial assets. For example, we invest by buying company shares or buying company bonds. Or we put money in a time deposit.
Meanwhile, users of funds 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. We may incur high transaction costs to negotiate and trade company stock without them. Then, once we buy stock, money moves from our pockets to the company, which can be used to invest in capital goods or other purposes.
- How the Financial System Plays a Vital Role in the Economy
- How Many Parts Are There in the Financial System and How They Work