Introduction
The financial system deals with financial transactions and money exchange between Savers, Investors, Lenders, and Borrowers. The system is made of different intricate and complex models that link financial institutions and markets to provide financial services for various stakeholders operating in the financial system.
The primary job of the financial system is to make a relationship between the different stakeholders in this particular system. The stakeholders could be depositors, lenders, borrowers, the government, and others. Moreover, the financial system tries to integrate these stakeholders for the transaction purpose and exchange the money between them.
Let us consider an example to understand the entire flow of money from the depositor point of view:
- A depositor deposits money to the financial institutes (banks) to get some percentage of returns or interests.
- Commercial borrowers or the corporate sector try to take a loan and use it for some specific investments. It means now money is in the market and being invested for the growth and development of the resources. The outcome could be the growth activities in the economy at large.
In short, a financial system facilitates all the stakeholders who are trying to participate in the market with certain objectives like maximizing the return or getting certain kinds of benefits from this particular system.
Understanding of Important terms used in the Financial System
- Savers are those people who want to save their money for specific reasons. Savers mainly belong to the household sector.
- Investors are those people who want to use those special savings to generate sure profits primarily; the corporate sectors are responsible for that.
- Lenders are the financial institutions or banks which lend the money for specific reasons to the borrowers. For example, the reasons could be buying the house, investing the money in the market, or buying other consumable products. Lenders provide the loan to the different stakeholders.
- Borrowers are the individuals or financial institutions who want to borrow money from the financial system.
- Money refers to the current medium of exchange or means of payment. We can also define it as money, a particular medium of exchange or means of payments whenever we transact in the financial system or any other market in this specific economy.
- Credit or loan is a sum of money to be returned, usually with interest; it refers to debt of economical unit. For example, commercial banks provide credit to different companies, corporate sectors, or individuals expecting particular interest.
- If a company takes a loan, it is considered as debt for them.
- If an individual has taken a loan, then it is a liability for them.
- Suppose financial institutions provide a loan to the individual or company. It is considered an asset for them because, in return, it receives interest or income.
- Finance is monetary resources comprising debt and ownership funds of the State, company, or person.
For example, a company wants to do business by selling the products or producing certain products, selling them in the goods market, and generating a certain kind of income. Here, profit refers to the difference between overall money invested in developing and selling a product and income generated after selling a product.
To start a new business, either company uses the money already they have, borrows the money from the commercial banks or other financial institutions, or raises the money from the market in terms of equity or stock from the public. An ownership fund is money a particular company has generated in terms of debt and equity.
Functions of Financial System
- It provides a payment system for the exchange of goods and services in the economy.
- It provides the mechanism to pull the funds in terms of household savings for corporate investments. For example, most salaried people have surplus money or savings after all the household expenditures, and keeping this money at home will not give any benefits. So the financial system, such as banks, provides the option to deposit money to their bank accounts, and banks pay interest in returns. This way, money can be utilized in the market or individual or corporates, etc.
- It provides the financial capital for long-term capital formation for the government and business organizations. It can be understood in the following way once the money is pulled out from household saving to the corporate section. This accumulated money can be invested or lent to the borrowers, such as the government or the business organizations. This money can be utilized to generate certain assets and infrastructure, which can be further utilized to generate profit and revenue for the business unit. Thus, which indirectly helps the individuals or economy to maximize or increase the growth rate in a larger way.
- It facilitates the investors and other market participants to liquidate their investment alternatives like stocks and bonds etc. For example, these kinds of assets or instruments (stock, bonds, etc.) can be brought and sold through the financial system. It has lots of implications for the generation of the resources as well as provides the services in terms of the different instruments, and finally, these services or instruments can be liquidated to generate the cash at the time of requirements. Thus, we can say it helps to provide very larger financial services to the system, which can help the participants to liquidate whatever financial alternatives they are holding.
- It provides avenues for managing the risks faced by the market participants. As there is enough financial alternative available, the market participants can minimize the risk rather than investing the entire surplus into a particular market. The best example to minimize risk is to hold more types of assets in our portfolio. If one asset is losing, then possibly it may be that the other is gaining. Thus, we can say it provides avenues for managing the risk.
- It takes care of both the short-term and long-term needs of the market participants. So the financial system is the only system that is able to cater to the demand for all types of stakeholders of different maturity.
- It provides price information, which helps to coordinate the decentralized decision-making process in the various sectors.
- It helps reduce the asymmetric information and moral hazard problems, which in turn facilitates reducing the transaction costs.
- It creates different investment opportunities for the investors to maximize their returns.
- It helps in the efficient allocation of financial resources.
- It plays a significant role in economic growth as it helps to create the demand and supply of the funds through which the interest rates are determined in various markets. Changes in interest rates affect the money supply, inflation rate, and the possibility of foreign investments.
Structure of the Financial System
Financial System is divided into two parts, Financial Institutions, and Financial Markets. When we focus on Financial Institutions, there are many institutions; some act as regulatory, others act as intermediaries and non-Intermediaries.
In India, there are four significant regulatory, which include the Reserve Bank of India (RBI), Security and Exchange Board of India (SEBI), Pension Fund Regulatory Development Authority (PFRDA), and Insurance Regulated Development Authority (IRDA). These regulatory regulate as follows:
- RBI regulates banks,
- SEBI regulates the stock market
- PFRDA regulates pension funds
- IRDA regulates insurance.
Intermediaries are the banks, and non-intermediaries are venture capitalists, etc.
On the other side, when we look at Financial Markets, there are two types of markets, organised and unorganised. The organised market consists of Money Market, Capital Market, and Foreign Exchange Market.
Classification of Financial Institutions
Banking Vs. Non-Banking
The financial institutions are classified into Banking and Non-banking institutions. The banking institutions provide transaction services which include the creation of deposits or credit. However, they need to maintain certain reserves based on the RBI guidelines. In the case of non-banking institutions, we have Life Insurance Corporation (LIC), Mutual Fund Institutions (MFIs), and other Non-banking Financial Companies (NBFCs).
One significant difference is that Banking institutions are the creators of credit, and non-banking institutions are purveyors of credit.
Intermediaries Vs. Non-Intermediaries
Intermediaries intermediate between savers and investors. They lend money as well as mobilize savings, and their liabilities are towards the ultimate savers, while their assets are from the investors or borrowers. All the banking institutions, LIC, GIC, and some other non-banking financial intermediaries (NBFI) are intermediaries.
Non-intermediaries institutions do the loan business, but their resources are not directly obtained from the savers. For example, IFC and NABARD.
One significant difference is that intermediaries take money from the savers, whereas non-intermediaries do not obtain money from the savers.
Classification of Financial Markets
Money Vs. Capital Market
Almost all financial market provides specific services. However, the significant difference is the period of maturity of financial assets issued in these markets. The money market deal in the short-term claims with a period of maturity of one year or less. Whereas the capital market does so in the long-term maturity period above one-year claims.
The most popular examples of money market are call money market, reserve money market, certificate of deposits market, commercial papers market, etc. In comparison, the examples of capital markets are the stock market, corporate bond market, etc.
Primary Vs. Secondary Market
Primary market deal in the new financial claims or new securities such as IPO. Whereas secondary market deals in securities already issued or existing or outstanding, such as existing listed companies in the stock exchange.
References
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