Financial System & its Components

Financial System

The financial system of an economy provides a way to collect money from the people who have it and distribute it to those who can use it best. So, the efficient allocation of economic resources is achieved by a financial system that distributes money to those people and for those purposes that will yield the best returns.

The financial system is composed of the products and services provided by financial institutions, which includes banks, insurance companies, pension funds, organized exchanges, and the many other companies that serve to facilitate economic transactions. Virtually all economic transactions are effected by one or more of these financial institutions. They create financial instruments, such as stocks and bonds, pay interest on deposits, lend money to creditworthy borrowers, and create and maintain the payment systems of modern economies.

These financial products and services are based on the following fundamental objectives of any modern financial system:

I. To provide a payment system

II. To give time value to money

III. To offer products and services to reduce financial risk or to compensate risk-taking for desirable objectives

IV. To collect and disperse information that allows the most efficient allocation of economic resources

V. To create and maintain financial markets that provide prices, which indicates how well investments are performing, determines the subsequent allocation of resources, and to maintain economic stability in the markets

Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and borrowers. A financial system could be defined at an international, regional or organizational level. The term “system” in “Financial System” indicates a group of complex and closely linked institutions, agents, procedures, markets, transactions, claims and liabilities within an economy. There are five components of Financial System which is discussed below:

1. Financial Institutions: It ensures the smooth working of the financial system by making investors and borrowers meet. They mobilize the savings of investors either directly or indirectly via financial markets by making use of different financial instruments as well as in the process using the services of numerous financial services providers. They offer a complete series of services to the organizations who want to raise funds from the markets and take care of financial assets, for example, deposits, securities, loans, etc.

2. Financial Markets: A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves the exchange of money for real goods or services, a financial transaction involves the creation or transfer of a financial asset.

• Money Market: The money market is a wholesale debt market for low-risk, highly-liquid, short-term instrument. 

• Capital Market: The capital market is designed to finance long-term investments.  The transactions taking place in this market will be for periods over a year.

• Foreign Exchange Market: The Foreign Exchange market deals with the multicurrency requirements which are met by the exchange of currencies. This is one of the most developed and integrated markets across the globe.

• Credit Market- Credit market is a place where banks, Financial Institutions (FIs) and Non-Bank Financial Institutions (NBFCs) purvey short, medium and long-term loans to corporate and individuals.

3. Financial Instruments: This is an important component of the financial system. The products which are traded in a financial market are financial assets, securities or other types of financial instruments. Equity shares, debentures, bonds, etc. are some examples.

4. Financial Services: It consists of services provided by Asset Management and Liability Management Companies. They help to get the required funds and also make sure that they are efficiently invested. The financial services sector offers several professional services like credit rating, venture capital financing, mutual funds, merchant banking, depository services, book building, etc.

5. Money:  It is understood to be anything that is accepted for payment of products and services or for the repayment of debt. It is a medium of exchange and acts as a store of value. It eases the exchange of different goods and services for money.

Functions of Financial Components

1.  Transferring Resources Across Time and Space
2. Clearing & Settling payments
3. Pooling Resources
4. Risk Management
5. Providing Price Infomation

Conclusion: Hence it can be said that a financial provides a platform to the lenders and borrowers to interact with each other for their mutual benefits. The ultimate profits of this interaction come in the form of capital accumulation (which is very crucial for the developing countries like India, who faces the problem of capital crunch) and economic development of the country.