Financial system and it’s functions

Introduction to financial system:

A financial system is a network of financial institutions, financial markets, financial instruments and financial services to facilitate the transfer of funds. The system consists of savers, intermediaries, instruments and the ultimate user of funds. The level of economic growth largely depends upon and is facilitated by the state of financial system prevailing in the economy. Efficient financial system and sustainable economic growth are corollary. The financial system mobilises the savings and channelizes them into the productive activity and thus influences the pace of economic development. Economic growth is hampered for want of effective financial system. Broadly speaking, financial system deals with three inter-related and interdependent variables, i.e., money, credit and finance.

The functions of financial system can be enumerated as follows:

  • Financial system works as an effective conduit for optimum allocation of financial resources in an economy.
  • It helps in establishing a link between the savers and the investors.
  • Financial system allows ‘asset-liability transformation’. Banks create claims (liabilities) against themselves when they accept deposits from customers but also create assets when they provide loans to clients.
  • Economic resources (i.e., funds) are transferred from one party to another through financial system.
  • The financial system ensures the efficient functioning of the payment mechanism in an economy. All transactions between the buyers and sellers of goods and services are effected smoothly because of financial system.
  • Financial system helps in risk transformation by diversification, as in case of mutual funds.
  • Financial system enhances liquidity of financial claims.
  • Financial system helps price discovery of financial assets resulting from the interaction of buyers and sellers. For example, the prices of securities are determined by demand and supply forces in the capital market.
  • Financial system helps reducing the cost of transactions.