A financial system refers to a set of public and private institutions, like banks, insurance providers, and stock markets, that are set up to facilitate the exchange of money in an economy. They have defined rules that govern the operations of businesses and individuals. A given financial system could be designed for operability within a company, a specified region, or even the global economy. Funds in a financial system are exchanged through an interaction between lenders, borrowers, and exchanges. This system enables investors to earn returns on their investments through financial planning.
What do you mean by a financial system
Financial systems determine how borrowers, investors, and lenders interact with each other to determine where and how funds are allocated to fund projects and generate returns. A financial system combines the free market and a centrally organised structure.
A free market includes actors like lenders, borrowers, and investors who trade under market regulations. The core feature here is that the decisions are left to the market forces of demand and supply. On the other hand, the rules and regulations under a centrally planned financial system are different. Here, the decisions regarding trade and the economy are solely overseen by the central planner.
Typically, a solid financial system picks up elements from both systems to build a robust framework. For instance, if you start a business, one of the factors dictating the pricing of your goods or services would be the competition in the market. You will research what your direct competitors are charging for similar services and then fix your prices. This is determined by market forces. All of this would also be taking place in a centrally planned framework where you will have to consider government regulations surrounding your operations, taxes, customer protection, etc.
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Components of a financial system
As mentioned earlier, every financial system will have components from the markets and central planning. Depending on the level that it exists at, a financial system may comprise:
- Financial establishment: Financial institutions in a financial system are the regulators of money exchange. They facilitate transactions like deposits and loans. Banks and insurance companies are prominent examples of financial institutions.
- Financial instruments: Instruments can be thought of as assets that investors trade in the market. These include securities, stocks, futures, and loans, among others. They are an important part of the system as they are the instruments that are exchanged in the market.
- Financial markets: As the name suggests, a financial market is the place where the actual exchange of financial instruments takes place, facilitated by financial institutions. Markets provide a platform for investors to earn returns and encourage economic growth.
- Financial services: Last but not least, financial services form a key part of a financial system. Everyone requires help from time to time, and financial service providers assist various actors in the market. Financial institutions also often provide these services for the benefit of consumers and investors.
Functions of a financial system
Now that the financial system’s meaning has been discussed, let us understand its role. A broad-level financial system may cover the global economy and serve to develop living standards across the globe. However, here, we will try to understand some core functions of a financial system that are applicable at all levels.
- Liquidity: Every exchange of funds necessitates liquidity. And financial systems, with their diverse institutions and instruments, enable trade. A financial system maintains a steady flow of capital so that investors can easily trade assets. Easy access and liquidity also ensure that the financial system is robust, further reducing the susceptibility to market volatility.
- Payment systems: A financial system establishes a standardised payment system and regulations which govern and facilitate money exchanges. With fluid payment systems in place, investors can save valuable time. A sound financial system has multiple payment systems in place, including digital payments, credit cards, and cash.
- Risk management: Financial institutions often play a significant role in managing risk in investments in an economy by providing protection to investors’ assets. They are also well-equipped to analyse macroeconomic conditions and indicators to hedge their investments and collaborate with regulatory authorities to avoid crises. With financial services and insurance providers to secure their wealth, investors can explore diverse investment options in a financial system according to their risk tolerance.
- Access to financing: A primary function of a financial system is to provide access to financing for individuals and organisations that need it. This financing can be invaluable for you if you are starting your own business or want to purchase a house or car. Financial institutions like banks can give out loans through accumulated deposits collected from individuals.
- Policy implementation: Financial systems also play a pivotal role in influencing economic policy. Governments derive insights from the functioning of the system and often make changes to manage economic markers like employment, prevalent interest rates, etc., in the interest of the broader population in a region.
- Maximising savings and returns: While we have discussed several macro-level functions of a financial system, maximising individual savings is one of its major functions. If a financial system does not enable people to earn from profitable investments and save more, their participation in the market will decrease. Thus, by promoting savings schemes, attractive returns on investments, and ways to make you financially independent, a financial system also incentivises its own growth.
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Conclusion
A financial system serves as a vital framework facilitating the exchange of capital and funds within an economy. It comprises various institutions, instruments, markets, and services and facilitates interactions between borrowers, investors, and lenders to allocate funds efficiently. Drawing elements from market-driven and centrally planned systems, a solid financial system balances competition and regulation to foster economic growth and stability. Through functions such as providing liquidity, managing risks, ensuring access to financing, implementing policies, and maximising savings and returns, a financial system not only supports individual and organisational financial goals but also contributes to the overall economic prosperity of people.
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