Components of Financial System
Components of Financial System: An economy’s financial system provides a mechanism for taking money from those who possess it and giving it to people who can use it most effectively. Therefore, a financial system that distributes money to those people and for those causes that will provide the best returns achieves the optimal allocation of economic resources.
The financial system is made up of the goods and services offered by financial institutions, such as banks, insurance firms, pension funds, structured exchanges, and the numerous other businesses that help to make transactions between people and businesses easier. A financial institution or several of them handle almost all economic transactions. They provide financial products like stocks and bonds, pay interest on bank deposits, make loans to reputable borrowers, and develop and operate the payment systems that are used in contemporary economies.
The following core goals of any contemporary financial system serve as the foundation for these financial products and services:
- Establishing a payment mechanism
- To make time worth money
- To provide goods and services that reduce financial risk or reward taking risks in order to achieve desired goals
- To gather and spread knowledge that enables for the most effective use of economic resources
- To establish and maintain financial markets that offer prices that reflect the performance of investments, determine how resources are allocated moving forward, and uphold market-based economic stability
Parts of the Financial System
A system that allows money to be transferred between investors and borrowers is referred to as a financial system. An international, regional, or organisational level definition of a financial system is possible. The word “system” in “Financial System” refers to a collection of intricately intertwined economic institutions, agents, processes, markets, transactions, claims, and liabilities. The financial system is made up of five parts, which are described below:
Financial Institutions: By bringing borrowers and investors together, it ensures that the financial system runs smoothly. Through the employment of various financial instruments and the assistance of several financial service providers, they directly or indirectly mobilise investor savings through financial markets. They can be divided into four groups: intermediates, non-intermediaries, regulators, and others. They provide services to businesses looking for guidance on a variety of issues, from restructuring to diversification plans. They provide a full range of services to businesses looking to raise capital from the market and manage their financial assets, such as deposits, securities, loans, etc.
Financial Markets: The market where financial assets are created or moved is referred to as a financial market. A financial transaction entails the creation or transfer of a financial asset as opposed to a real transaction, which involves exchanging money for actual products or services. A claim to the payment of an amount of money in the future and/or a recurring payment in the form of interest or dividend is represented by financial assets or financial instruments. Below are the four elements of the financial market:
Money Market: The money market is a wholesale debt market for short-term, low-risk instruments that are also quite liquid. In this market, funds are offered for terms ranging from one day to one year. Generally speaking, the government, banks, and financial organisations control this market.
Capital Market: To finance long-term investments, the capital market is set up. The duration of the transactions in this market will be longer than a year.
Foreign Exchange Market: The Foreign Exchange market handles the multicurrency needs that are satisfied via currency exchange. The transfer of funds occurs in this market based on the applicable exchange rate. One of the most advanced and integrated markets on the planet is this one.
Credit Market: Short-, medium-, and long-term loans to businesses and individuals are distributed in this market through banks, financial institutions (FIs), and non-bank financial institutions (NBFCs).
Financial instruments are a crucial part of the financial system. Financial assets, securities, and other kinds of financial instruments are the goods that are traded on a financial market. Since the needs of investors and those looking for credit varied, there are many different securities available on the market. They represent a claim on the future repayment of principal or the regular payment of an amount, such as interest or dividends. Examples include equity shares, bonds, and debentures.
Financial Services: These include products and services offered by asset and liability management firms. They assist in obtaining the necessary cash and ensure that they are invested effectively. They offer their expertise up to the stage of servicing lenders and help to decide the financing combination. They support lending and investing, making and authorising payments and settlements, buying and selling assets, managing risk exposures in financial markets, and borrowing.
Leasing firms, mutual fund companies, merchant bankers, portfolio managers, bill discounting and acceptance businesses are a few examples. Numerous expert services are provided by the financial services industry, including credit rating, venture capital funding, mutual funds, merchant banking, depository services, book building, etc. Through the use of financial instruments, financial markets and institutions contribute to the operation of the financial system. They require a number of financial services in order to perform the tasks assigned to them. As a result, financial services are ranked as the financial system’s fourth most important element.
Money is defined as anything that is accepted as payment for goods and services or as a means of repaying debt. It serves as a store of value and a means of exchange. It makes it simpler to swap various commodities and services for cash.
Therefore, it can be claimed that a financial institution gives lenders and borrowers a forum to communicate with one another for their mutual benefits. The main benefits of this interaction are capital accumulation (which is essential for emerging nations like India, which has a capital shortage problem) and national economic growth.