a) The following is a discussion on assertion that “A central function of the financial
system is to facilitate an efficient allocation of resources in the economy”
Financial system can be defined as a network of financial markets and Financial Institutions
including regulations and practices, through which fund is transferred between lenders, borrowers
and investors. The well-functioning financial system is crucial in allocating economic resources
efficiently to promote economic growth at the long term.
Fund flows between the surplus spending units (those with excess funds) and deficit spending units
(those who needs funds) in the economy, through the exchange of short term and long-term
financial securities like stocks, corporate bonds, bank loans, mortgages, financial derivatives,
government bonds and bills.
These units include households, businesses and government agencies who are the ultimate
borrowers, lenders and investors. The suppliers of fund to the financial system earns a return on
their investments.
The importance of financial system comes from its role of effective stimulation of high savings
and investment expenditure, leading to higher economic growth. Its contribution to the economic
growth is achieved by lowering information costs, transaction costs, financial risk and mostly
provision of liquidity to the players of financial system.
Through financial system;

Information and Transaction cost is reduced.
Despite the fact that financial system has established systems for collecting and analyzing enough
and reliable financial information for decision-making processes to satisfy financial needs of the
surplus spending units and deficit spending units in the economy, also carries larger financial
transactions, which exploits the economies of scale to reduce cost per transaction. Without
financial system, borrowers, lenders and investors could incur higher cost to transact directly.

Financial risk is reduced.
All information about financial health of all companies is disclosed in the financial system, which
is vital for savers and investor to make right financial decisions regarding their funds, which results
into reduced risk of loss for their investment.
Also, through financial system, small amount of funds are collected from depositors and investors,
then the fund is used by the financial institutions to invest in various assets with uncorrelated
financial risks. The diversification of portfolio investment would mitigate the risk of potential loss.

Provision of liquidity
Financial system has established financial infrastructure which enables investors holding financial
assets to convert them into cash easily, depositors to easily obtain cash out of their deposits and
businesses to easily acquire new funds to finance their profitable investments.
Liquidity can be the most important function of the financial system as far as the efficient
allocation of resources in the economy is concerned.
b) The following is the difference between the role of Banks and Financial markets
regarding the channeling funds from the ultimate lender to the ultimate borrowers
Banks are among of the financial institutions which are key players in the financial system. Banks
act as intermediaries in bringing borrowers and lenders together by using different financial
instruments and services. Banks offers various deposit account to the lenders in which the lender
makes deposits, the deposits are used by the banks to issue loans to the households, businesses and
government agencies to meet their financial needs. The borrowers in return makes periodic
payments to the bank which cover interest payments and principal amount. The lenders receive
their deposits and interest income from their deposits if any depending on the nature of the deposit
accounts they operate.
Financial Market is a medium in which financial securities such as Debt, Equities, currencies and
derivatives are newly issued or the existing ones are traded. Through rules and practices within
financial markets, they facilitate transactions between those who needs Capital and those with
capital to invest through the intermediation of Financial Institutions. Financial market makes
possible to move funds from Surplus spending units to Deficit spending units more efficiently to
ensure liquidity in the economy.
References:
David S. Kidwell, David W. Blackwell, David A. Whidbee, Richard W. Sias: The Financial
Institutions, Markets, & Money, 11TH Edition.
Peter Johnson: Financial system
(https://www.wallstreetmojo.com/financial-system/)
Imf.org: The overview of the financial system
(https://www.imf.org/external/pubs/ft/fsi/guide/2006/pdf/chp2.pdf)
Studymaster.co.uk: Financial system
(https://www.studysmarter.co.uk/explanations/macroeconomics/financial-sector/financialsystem/)