Key Roles Performed by Financial System in the Economy - Essay Example

?Key Roles Performed by Financial System in the Economy Introduction In simple terms, financial system can be called as the system that keeps the flow of money between people and institutions. It is the mechanism through which money flow from the individual investors to the borrowers in the system. Financial system is an inevitable factor for the very existence of the economy itself. The term financial system is an all-encompassing term consisting of various types and components within it. “A financial system can be defined at the global, regional or firm specific level.” (Investopedia, 2011) A firm level financial system refers to the financial system followed by companies in order to track their financial performance. Most companies will have similar kind of financial system. Regional level refers to the system where money is exchanged between lenders and borrowers. It is not necessarily between lenders and borrowers but also between lenders and investors or investors and borrowers. The third one is global level. It refers to the exchange or movement of finance between big corporate and government institutions at the global level. Though each of these levels is important in the economy, global level is the most important level. Before looking into the each level of the financial system and their importance, it is important to have a detailed look into the various components of financial system. The components of financial system will include all the three levels which are mentioned in the previous paragraph. The main components of a financial system are as follows: 1. Financial Intermediaries 2. Financial Markets 3. Regulators 4. Financial Instruments Components of Financial System & their Roles Financial Intermediaries Financial intermediaries are the first component of financial system. As the name signifies, financial intermediaries act as an intermediary or channel between two parties. The two parties are namely investors and the firms that are raising fund or savers and borrowers. “The difficulty that lenders (savers) and borrowers (spenders) encounter when confronted with finding and dealing directly with each other has provoked the appearance of financial intermediaries” (Morawski, 2007) All kinds of financial institutions fall under the category of financial intermediaries. Some of the most common financial intermediaries are banks, insurance companies, investment brokers, mutual fund houses, wealth management companies, pension funds, etc. Financial intermediaries are the component that facilitates the flow of money in the economy. It helps to convert one form of fund the other. As such it becomes an inevitable factor for the development of an economy. The major roles played by financial intermediaries in the economy are as follows: 1. Channel of Transfer 2. Avoid the difficulties in direct dealing 3. Safe keeping of assets 4. Mobilisation of funds 5. Creation of financial instruments 6. Investment Services 7. Quicker development Channel of transfer: The basic function of a financial intermediary is to act as a channel. Financial intermediaries channelize funds from one person to the other based on each other’s need. This can simply be explained with the case of commercial banks. Commercial bank’s take deposits from the investors and distribute is as loans to other parties. Thus, a link is established between investors and borrowers. Such an efficient system of exchange is not possible without the existence of financial intermediaries. Avoid the difficulties in direct dealing: If there were no financial intermediaries at all, it would have resulted in several unorganised lending and receiving activities in the market. It would be difficult for the investors to find borrowers and vice versa. Such a situation would also cause chaos in the whole system. But financial intermediaries help to identify the investors and borrowers and provide them the required services. Safe keeping of assets: Financial intermediaries help the people with surplus funds by aiding them to keep it safe. Due to various threats, it is difficult for people to keep surplus money or assets like gold at their houses. But financial intermediaries provide facility for safe keeping of such assets. Mobilisation of funds: Mobilisation of fund is extremely important for economic development. If money is concentrated only in the hands of certain people and there is not much investments being made by them, the economy will be adversely affected. Financial intermediaries help to avoid such situation. Money collected from investors is invested into other asset classes by financial institutions. Thus more money is generated in the market through economic activities. Creation of financial instruments: Financial market presently has many investment products compared to a few decades ago. All these new financial instruments are created by financial intermediaries. Though many of such innovations had led to a global economic trouble, the benefits always surpassed the disadvantages. Small retail investors are now able to park their surplus money in various investment products. Therefore, financial intermediaries help to improve the surplus income and standard of living of the people. Investment Services: A person or institution with surplus money may not have the required expertise in selecting right investment products. But financial institutions provide them the required advice to select the right kind of investment products. Quicker development: Most big ticket investments in an economy are carried on with a significant share of bank loans or other kinds of fund raising facility. If government or a business waits for accumulation of enough surplus money to make investments, infrastructure and allied development would have been very slow in the economy. But loans and other fund raising facilities helps to gain quicker development. Financial Markets Financial market is the second major component of the financial system. Financial market is the arena where all the financial intermediaries perform. It can be defined as the market where various types of financial products are traded. It is one of the most happening industry segments in the world. The nature of its risk and return are the main reasons for such huge happening. Financial market is a collective term for bond market, stock market, derivative market, foreign exchange market, commodity market, OTC market and other similar markets in an economy. Each of these classifications is very wide consisting of sub classifications within themselves. Some of the most important roles performed by financial markets are as follows: 1. International trade 2. Risk mitigation 3. Fund raising 4. Wealth creation and protection 5. Price determination International Trade: The main role of financial market is that it facilitates the easy exchange of products between different countries. International trades are mostly done in Dollars and other major currencies. Foreign exchange markets facilitates buying and selling of foreign currencies in order to make or receive payment for international trades. Due to the increased activity in foreign exchange market, cross border transactions are made easier at present. Risk Mitigation: One of the major risks faced by investors and businesses are an unexpected price movement in currencies or commodities. Currency movements mainly affect the profitability of exporters and importers than that of the domestic businesses. But commodity price movements affect all those companies that have the commodity as a component in their product. But derivative instruments in the financial market help the companies to mitigate such risks to an extent. Fund (Capital) Raising: Traditionally, loans were the only form of fund raising in the market. But the tremendous growth of financial market has helped companies with various options to raise capital. Stock market is one of the most popular among them. “Financing through stock markets is optimal for industries where there are continuous technological advances and where there are little consensus on how firms should be managed.” (ECB, 2001) Wealth Creation and Protection: An individual cannot generate wealth until surplus funds are invested in potential assets or portfolio of assets. Most of the high return assets come from the financial markets. Equities, bonds etc are some of the investments that help investors to protect and create wealth. Price Determination: Financial market helps in price determination of various assets. The volume of transactions in various assets helps to increase or decrease the price of related assets. Thus a market determined pricing mechanism is carried on in the financial market. Regulators Every financial system is incomplete without the existence of proper regulatory authorities. As the name states, the need for regulator is to monitor and exercise control on the market in order to avoid any possible irregularities. Regulators are different for different financial intermediaries. For banks, it is the central banks. In the case of stock market it is Securities and Exchange Commission (in US). Each country has their own regulatory bodies for their financial system. Regulatory bodies are established mainly for the banking sector, stock market, insurance industry, commodity market, and credit rating. The regulatory bodies for each of these segments function to assure that everything goes well in the concerned domain. The major roles of a regulatory body are as follows. 1. Investor protection 2. Financial innovation Investor Protection: Investor protection is the major role played by a regulatory body. Financial market is the industry where investors face the most vulnerability to losses. Therefore, a system has to make sure that the investors are given basic protection and are not left to be exploited by the companies. Financial Innovation: Financial innovation is an inevitable factor for the quick development of an economy. But if unregulated, financial innovations can lead to mass destruction of the economy. Financial institutions will develop instruments that reap maximum profits for them. A clearly formulated regulatory measure will help to avoid such happenings in the sector. Financial Instruments Financial Instruments is the next component of the financial system. Financial instruments refer to the investment products that are backed by the market or any other underlying assets. Most financial instruments are tradable assets. Financial instruments are either real or virtual. All the financial instruments are based on any or in combination of debt, equity, foreign exchange market, commodity markets, etc. Some of the most popular financial instruments available for the investors are Mutual Fund, Unit Linked Insurance Plan, Corporate and Treasury Bonds, Gold ETF’s, etc. If financial intermediaries are the component that helps mobilise money in the economy, financial instruments are the tools they use to mobilise money. The major roles played by financial instruments in an economy can be enumerated as follows. 1. Explore investment avenues 2. Fund collection 3. Disposable income 4. Flexibility Explore Investment Avenues: Financial instruments help the economy by pooling capital into a certain asset class. For instance, in the case of an equity mutual fund, money is collected from the investors and they are invested in the equity market. This instrument helps to channelize funds to stock market thereby generating more trade volumes and investments. More trades and investments will help to boost the stock market indexes and thereby the economy. It is a chain process in which one activity leads to the other. Similarly, there are many other financial instruments that help to increase investments in a particular asset class based on the nature of such instruments. Fund Collection: Fund requirement is an important factor for any activity in an economy. If the government wants to make huge investments in development projects, it can raise funds by issuing government or treasury bonds. By issuing bonds, government collects fund from investors for which the investors are paid a fixed rate of interest until the end of the instrument’s maturity period. It is as good as taking loan from a financial institution. But the norms and obligations are different from that of a loan. Therefore, different kinds of financial instruments help governments and businesses to raise funds through issuing financial instruments. Disposable Income: Disposable income in the hands of people is an important determinant of economic development. Traditionally, the investors had only very limited options to invest the money. The returns were comparatively limited. But later, with the advent of newer financial instruments, investors had ample investment opportunities to choose from. Most of these were instruments with fast growth rate and lower maturity periods. This fostered a fast growth of disposable income in the hands of people. More disposable income in the hands of investors will boost the economy due to spending by the consumers. Flexibility: With the introduction of more financial instruments, investments have become a risk free concept. This does not imply that an investment is zero percent riskier. This concept is taking advantage of the uneven risk distribution. For instance, if there is a huge fall in the stock market, investors can take out their investments from stock market and park it with debt instruments. This will help them to protect their investment until the stock market recovers. Similarly, when there is an uncertainty in the overall economy, investors mostly chase Gold which is considered as a safe heaven. Investing in gold is possible by purchasing paper instruments of which the value is based on underlying gold stocks. Such a flexibility of investment will help to continue investment activity in the economy. Global Financial System We have now seen the various components of financial system. It is now important to look at Global Financial System. Global financial system does not form a part of the normal financial system. But it is extremely important for the benefit of global economy. This system represents the financial institutions and regulators that operate on a global level. It consists of both government and private parties. From the government front, it is mostly the law making bodies. A nation or a group of nations formulate laws for general governance in the financial system. This is to ensure that the financial activities are carried on with the best interest of all the stakeholders. We also have International Monetary Fund (IMF), World Bank, Asian Development Bank (ADB), World Trade Organization, Institute of International Finance, etc. Each of these components have separate role they are entrusted with. All these components frame policies at a global perspective though there are debates on whether they favour particular nations. Any global dispute or transactions come under the purview of any of these organizations. Therefore, global financial system has a major role to play in the global economic front. Impact of a bad Financial System A bad financial system will result in total havoc in the whole economy. Not much explanation is required in this statement as the havoc is evident from the current market itself. Many developed nations are struggling hard to come out of the worst ever crisis. As it is a globalised world a crisis situation in one nation will definitely have their rippling effects on other countries that have direct or indirect financial and trade relations with them. European Union countries and United States are the most struggling nations in terms of financial crisis. Growth and sustainability has gone to an area of unpredictable level to those countries. At the same time it can be seen that countries that were cautious while developing their financial system are insulated to an extent from such crisis. India, China, Brazil and other developing nations are an example for this. They were conservative to a certain level while implementing financial policies. Moreover, they were having strict regulatory policies to govern any irregularities in the market. This helped them to record good growth even when the global economy was in uncertainty. “The sweeping credit crunch of 2008 triggered several high-profile financial failures and prompted widespread debate about how the U.S. government regulates financial markets.” (Teslik, 2008) US were more liberal in their regulatory policies when it came to stock markets, financial instruments or other investment avenues. Even the rating agencies functioned against their general principles. Such liberal policies lead to the growth of destructive financial instruments that pretended to be profitable at the first glance. Financial institutions piled up huge stocks of such instruments. When there were defaults in the underlying assets of such instruments, financial institutions faced their biggest losses ever. Some were allowed to fall and some others were rescued by the government. All these events prove that, if not well managed, there is no other system that can cause such a huge economic impact than that of the financial system. Conclusion It is seen that financial system is a chain process that keeps the money flow happening in the economy. There is no activity in an economy that is untouched by the financial system. As such, it is a very crucial element in the economic development and needs to be maintained with utmost care. The absence of that utmost care has resulted in what is called as the economic crisis that is happening globally. As mentioned earlier in the essay, every component of the financial system is extremely important. But the present crisis which happened mainly due to the unregulated financial innovations has proved that Regulators form the most important role in the overall system. It is always good to be more on the conservative side when it comes to financial innovation. Some countries practiced otherwise and were proved wrong by the economy. References Investopedia, 2011. Financial System. [Online] Available at: [Accessed 27 November 2011] Morawski, A, 2007. The Role of Financial Intermediaries and the Increased Need for Regulation of Financial Markets. [Online] University of Essex. Available at: [Accessed 27 November 2011] ECB, 2011. The role of financial markets for economic growth. [Online] Available at: [Accessed 28 November 2011] Jalloh, M, 2009. The role of financial markets in economic growth. [Online] Available at: [Accessed 29 November 2011] Teslik, L, H., 2008. The U.S. Financial Regulatory System.[Online] Available at: [Accessed 3 November] Bain, A.D., 1992. The Economics of the Financial System.2nd Ed. NJ: Blackwell. Schmid, V., 2004. Financial Innovation – With a particular view on the role of banks. Norderstedt: GRIN Verlag. Read More