Financial System
Complete and complex ever changing set of rules, regulations, procedures, practices policies,
conducts; role of institutions (financial institution), Governments, Policy makers and central
bank taken together may be called financial system.
The financial system does have its impacts on individuals, businesses, corporations and
governments alike. At times in your life, you will be a saver and at other times, you may be a
borrower. The financial system channels funds from savers to borrowers and makes it possible
for both to achieve their objectives. When the financial system works efficiently, it leads to
better health of the economy.
Purpose of the financial system
Most of us at one time or another may need more funds than you have on hand for one purpose
or another. At the same time, others spend Jess than their incomes. Those who have surplus
funds may be willing to let someone else use their savings if they are compensated for doing so.
The mismatch of income and spending for individuals and organizations / creates an opportunity
to trade. The investor can use the funds saved by different classes of people. The investor would
be better off by earning a profit from investing funds in a new venture and savers who have lent
their money would be better off 'by receiving the return that the investor pays them for lending
their funds.
Now we can easily understand the functions provided by the financial system in an economy. It
moves funds from those who want to spend less than they have available to those who have a
desire to purchase durable goods or those who have productive investment opportunities. This
matching process increases the economy's ability to produce goods and services. In addition, it
makes house- holds and businesses better off by allowing them to time purchases according to
their needs and desires. A smoothly functioning financial system thus improves the economy's
efficiency and people's economic welfare.
The financial system provides channels to transfer funds from individuals and groups who have
saved money to individuals and groups who want to borrow money. Savers (or lenders) are
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suppliers of funds, providing funds to borrowers in return for promises of repayment of even
more funds in the future.
The financial system brings together savers and borrowers in following two ways.
Direct Finance In direct finance, individual savers through financial markets hold the claims
issued by individual borrowers.
Indirect Finance In indirect finance individual savers through financial intermediaries hold
claims over the portfolio of assets of the borrowers.
Financial markets provide play field to the financial instruments. Financial instruments are
traded by household, business firms, government and foreigners in wide variety of financial
markets or markets for financial instruments.
Financial market can at preliminary stage be termed as market for bonds and stock markets.
Functions of Financial Markets and Financial Intermediaries
The function is explained through the following figure:
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Indirect Finance
 Households.
 Business Firms.
 Government.
 Foreigners.
Borrower Spenders:
Direct Finance
Business Firms.
Those who have saved and lending funds, the Lender Savers are at the left side & those who
must borrow funds to finance their spending, the Borrower-Spenders are at the right. The arrows
show that Funds flow from lender savers to Borrower – spenders via two routes i.e.; through
financial markets (Direct Finance) and through Financial intermediaries i.e. Banks etc. (Indirect
In direct finance borrowers borrow funds directly from lenders in financial markets by selling
them securities or bonds which are claim on borrowers’ future income or assets.
Types of Financial Markets
Financial markets are divided as under:
Foreign exchange market.
Stock market.
Bond market.
Financial markets are one arena in which savers’ surpluses are transferred to borrowers. Savers
can buy stocks and Bonds and Business borrowers can obtain funds by issuing stocks and Bonds
Financial Institutions: (Global Perspective)
Financial institutions are also called Financial Intermediaries, these include the following:
Commercial Banks
Credit Unions
Savings and Loan Associations
Mutual Saving Banks
Mutual Funds
Finance Companies
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Pension Funds etc.
The role of Financial Institution is to act as Financial Intermediary or to provide function of
Financial Intermediation, role of go-between for savers and borrowers.
Banks are the largest financial intermediaries. Banks lend to many sectors of the economy.
However, banks and other financial institutions compete with one another and this competition
has advantage for savers, borrowers and system as a whole.
Key Services Provided by Financial Institutions
In addition to matching individuals who have excess funds with chose who need them, the
financial system provides three key services for savers and borrowers. These services are risk
sharing, liquidity, and information. Financial markets and financial intermediaries provide these
services in different ways, making various financial assets and financial liabilities more attractive
to individual savers and borrowers. Many financial decisions made by savers and borrowers are
shaped by the availability of these services.
Risk Sharing
One advantage of using the financial system to match individual savers and borrowers is that it
allows the sharing of risks. Risk is the chance that the value of financial assets will change
relative to what you expect. Most individual savers are not gamblers and would like to seek a
steady return on their assets rather than erratic swings between high and low earnings. Indeed,
individuals prefer stable returns on the collection of assets they hold. A collection of assets is
called a portfolio. For example, you might hold some government treasury securities, some
shares of stock, and some shares in a mutual fund. Although one asset or set of assets may
perform well and another may not perform as well, but overall returns tend to average out. This
splitting of wealth into many assets is known as diversification. As long as the individual returns
do not vary in the same way, the risk of severe fluctuations in a portfolio's value will be reduced.
The financial system provides risk sharing by allowing savers to hold many assets.
The second service, the financial system offers to savers and borrowers is liquidity, which is the
ease with which an asset can be exchanged for money to purchase other assets or exchanged for
goods and services. Savers view the liquidity of financial assets as a benefit. When they need
their assets for their own consumption or investment, they can exchange them easily. In general,
the more liquid an asset, the easier it is to exchange the asset for something else. You can easily
exchange the currency notes for purchasing a book or anything else because it is highly liquid.
You can also cash a check within a short period of time to buy clothes. However, selling a car
would take more time because personal property is not very liquid. By holding financial claims
(such as stock or bonds) on a factory, individual investors have more liquid savings than they
would if they owned the machines in the factory. The reason is that the investor can more easily
sell the claim than a specific machine in order to buy other assets or goods. Liquid assets allow
an individual or firm to respond quickly to new opportunities or unexpected events. Financial
assets created by the financial system, such as stocks, bonds, or checking accounts, are more
liquid than cars, machinery, or real estate.
Financial markets and intermediaries provide trading systems for making financial assets more
liquid. In addition to creating financial assets, the financial system provides mechanism for
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increasing the liquidity of financial assets. Investors can readily sell their holdings in government securities and stocks and bonds of large corporations, making those assets very liquid.
During the past two decades, the financial system has made many other assets liquid besides
stocks and bonds. One measure of the efficiency of the financial system is the extent to which it
can transform illiquid assets into the liquid claims that savers want.
A third service of the financial system is the collection and communication of information, or
facts about borrowers and expectations about returns on financial assets. The first informational
role the financial system plays is to gather information. That includes finding put about
prospective borrowers and what they will do with borrowed funds. Obtaining such information
would be costly and time-consuming for savers, who of course want all the facts before lending
their money. Working through the financial system, a prospective investor is likely to learn more
about the borrower than he would if he tried to make the investment on his own.
Another problem that exists in most transactions is asymmetric information. This means that
borrowers possess information about their opportunities or activities that they don't disclose to
lenders or creditors and can take advantage of this information. Sometimes, financial
arrangements have to be structured so that borrowers do not take advantage of asymmetric
information at the expense of lenders.
The financial system specializes in information gathering and monitoring, and arrangements
exist for solving problems of asymmetric information."
The second informational role the financial system plays is communication of information.
Savers and borrowers receive the benefits of information from the financial system by looking at
asset returns. As long as financial market participants are informed, the information works its
way into asset returns and prices. Information is communicated to borrowers as well as to savers.
The incorporation of available information in asset returns is the distinguishing feature of wellfunctioning financial markets.
Structure of Financial Market
Financial markets are categorized as under:
- Debt and equity markets.
- Primary Markets and secondary markets.
- Exchange markets and over-the-counter market. (OTC)
- Forward contracts and future markets.
Debt and Equity Markets
Debt instruments such as issuing bonds. These may be short term (Maturity less than one year),
long-term (maturity ten year or longer) and intermediate term (maturity between one and ten
years). Second method of raising funds is by issuing equities
Primary Market and Secondary Markets
Primary Market is a financial market in which new issues of a security such as Bonds or stocks
are sold to initial buyers whereas in secondary Markets there is further sale of already issued
Exchange and Over-the-Counter Markets
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Secondary Markets can be organized in the following ways:
Through organizing/establishing Stock Exchange through Over-the-Counter (OTC) markets,
(Dealers in these markets are in computer contact and know the prices set by one another, OTC
markets are very competitive.
Money Market and Capital Market
Money Market is a financial market which deals in short term debt instruments. Capital market
deals in long term debt instruments
Forward Contracts and Futures Market
Under Forward Contract, buyers and/sellers agree to trade certain quantity of commodity for a
specific price at a specified date in future, contracts are formally made in commodities exchange
Financial Regulations
Respective Governments regulate financial markets and financial institutions around the world,
which is necessary for the maintenance of financial stability, build confidence of all stake holders
in the system.
There are also international norms, practices and protocols which are required to be observed by
all participants, trading across the borders such as Uniform customs and practices for
documentary credits (UCP 600)
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