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 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.
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 Finance)
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:
1.
Foreign exchange market.
2.
Stock market.
3.
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
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.
Liquidity
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 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.
Information
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 well-functioning 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 securities.
Exchange and
Over-the-Counter Markets
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 markets.
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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