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 mobilizes 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 financial system provides channels to transfer funds from individual and groups who have saved money to individuals and group who want to borrow money. Saver (refer to the lender) are suppliers of funds to borrowers in return with promises of repayment of even more funds in the future. Borrowers are demanders of funds for consumer durables, house, or business plant and equipment, promising to repay borrower funds based on their expectation of having higher incomes in the future. These promises are financial liabilities for the borrower-that is, both a source of funds and a claim against the borrower’s future income.
Main Functions of Financial System
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.
As discussed above, financial markets play a significant role in economic growth through their role of allocation capital, monitoring managers, mobilizing of savings and promoting technological changes among others. Economists had held the view that the development of the financial sector is a crucial element for stimulating economic growth. Financial development can be defined as the ability of a financial sector acquire effectively information, enforce contracts, facilitate transactions and create incentives for the emergence of particular types of financial contracts, markets and intermediaries, and all should be at a low cost. Financial development occurs when financial instruments, markets and intermediaries ameliorate through the basis of information, enforcement and transaction costs, and therefore better provide financial services. The financial functions or services may influence saving and investment decisions of an economy through capital accumulation and technological innovation and hence economic growth. Capital accumulation can either be modeled through capital externalities or capital goods produced using constant returns to scale but without the use of any reproducible factors to generate steady-state per capita growth. Through capital accumulation, the functions performed by the financial system affect the steady growth rate thereby influencing the rate of capital formation. The financial system affects capital accumulation either by altering the savings rate or by reallocating savings among different capital producing levels. Through technological innovation, the focus is on the invention of new production processes and goods.
As market frictions and laws, regulations and policies differs to a greater extent across economies and over time, the impact of financial development on growth may have different implications for resource allocation and welfare in the economy.
Services Provided by the Financial System
- Risk Sharing: Financial system provides risk sharing by allowing savers to hold many assets. It also means financial system enables individuals to transfer risk. Financial markets can create instruments to transfer risk from savers to borrowers who do not like uncertainty in returns or payments to savers or investors who are willing to bear risk. The ability of the financial system to provide risk sharing makes savers more willing to buy borrowers’ IOUs. This willingness, in turn, increases borrowers’ ability to raise funds in the financial system.
- Liquidity: The second service that financial system provides for savers and borrowers is liquidity, which is the ease with which an asset can be exchanges for money to purchase other assets or exchanges for goods and services. Most of the savers view the liquidity as a benefit. If an individual need their assets for their own consumption and investment, they can just exchange it. Liquid assets allow an individual or firm to respond quickly to new opportunities or unexpected events. Bonds, stocks, or checking accounts are created by financial assets, which have more liquid than cars, machinery and real estate.
- Information: The third service of financial system is collection and communication of information or we can say that it is the facts about borrowers an expectations about returns on financial assets. The first informational role the financial system plays is to gather information. That includes finding out about prospective borrowers and what they will do with borrowed funds. Another problem that exists in most transactions is asymmetric information. This means that borrowers posses information about their opportunities or activities that they don’t disclose to lenders pr creditors and can take advantage of this information. The second informational role that financial system plays is communication of information. Financial markets do that job by incorporating information into the prices of stocks, bonds, and other financial assets. 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.