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 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
Definition of financial system
Financial system may be defined as “a set of markets and Institution
to facilitate the exchange of assets and risks.”
Features of financial system
Financial system provides an ideal linkage between depositors and
investors, thus encouraging both savings and investments.
Financial system facilitates expansion of financial markets over
space and time.
Financial system promotes efficient allocation of financial resources
for socially desirable and economically productive purposes.
Financial system influences both the quality and the pace of
Functions of financial system
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
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
Financial system helps reducing the cost of transactions.
Importance of financial system
The following benefits suggest the importance of financial system :
Facilitate economic / industrial activity and growth.
Helps accelerate the volume and rate of savings.
Monitors the management of companies (corporate sector).
Facilitates execution of monetary policy by the Central Bank.
Facilitates evaluation of assets.
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 organization level.
Following are the Key Components of Financial
Financial Instruments (Assets or Securities)
Financial institutions are those organizations that are involved
in providing various types of financial services to their
customers. The financial institutions are controlled and
supervised by the rules and regulations delineated by
These are the various Financial Institutions:
Stock brokerage firms
Insurance companies etc.
Financial institutions deal with various financial activities
associated with bonds, debentures, stocks, loans, risk
diversification, insurance, hedging, retirement planning,
investment, portfolio management, and many other types of
related functions. With the help of their functions, the financial
institutions transfer money or funds to various tiers of economy
and thus play a significant role in acting upon the domestic and
the international economic.
For carrying out their business operations, financial institutions
implement different types of economic models. They assist their
clients and investors to maximize their profits by rendering
appropriate guidance. Financial institutions also impart a wide
range of educational programs to educate the investors on the
fundamentals of investment and also regarding the valuation of
stock, bonds, assets, foreign exchanges, and commodities.
Financial institutions can be both private and public in nature.
Financial institution is that type of an institution, which performs the
collection of funds from private investors and public investors and
utilizes those funds in financial assets. The functions of financial
institutions are not limited to a particular country, instead they have
also become popular in abroad due to the growing impact of
Financial Market, in very crude terms, is a place where the savings
from various sources like households, government, firms and
corporate are mobilized towards those who need it. Alternatively
put, financial market is an intermediary which directs funds from the
savers (lenders) to the borrowers.
In other words, financial market is the place where assets like
equities, Bonds, currencies, derivatives and stocks are traded.
Some of the salient features of financial market are
Basic regulations on trading
Low transaction costs
Market determined prices of traded securities
Major Players in Financial Market:
The main participants in the financial market are as follows:
BANKS : Largest provider of funds to business houses and
corporate through accepting deposits.
INSURANCE COMPANIES : Issue contracts to individuals or firms
with a promise to refund them in future in case of any event and
thereby invest these funds in debt, equities, properties, etc.
FINANCE COMPANIES : Engages in short to medium term
financing for businesses by collecting funds by issuing debentures
and borrowing from general public.
MERCHANT BANKS : Funded by short term borrowings; lend
mainly to corporations for foreign currency and commercial bills
COMPANIES : The surplus funds generated from business
operations are majorly invested in money market instruments,
commercial bills and stocks of other companies.
MUTUAL FUNDS : Acquire funds mainly from the general public
and invest them in money market, commercial bills and shares.
GOVERNMENT : Authorized dealers basically look after the
demand-supply operations in financial market. Also works to fill in
the gap between the demand and supply of funds.
The finance industry provides a number of services to the clients.
There are different types of financial services company to provide
these services to different commercial sectors as well as to the
There are different types of financial services like lending money for
different purposes, insurances, depository services, mortgage
services, investment services, credit rating services and many
The different types of financial services company jointly create one
of the largest industries of the world. There are a number of
financial services Companies in the world.
Some of these companies are the following:
Investment services company
It is one of the biggest financial services companies of the
world. There are different types of banks in the world. Some of
these are commercial banks, private banks and many more. There
are some banks that work for the capital markets only. Banks
provide a number of financial services to the clients. These services
include depository services, lending services, credit card facilities
and many more. These services are provided for both the
individuals and the commercial sector.
The insurance companies provide the clients
with risk coverage services. These services are designed to cover a
number of risks that are related to an individual's life, property and
many more. These services are not only designed to provide
security but at the same time there are a number of insurance plans
that are designed to provide regular income to the clients. The
insurance policies can be divided in several types like general
insurance, life insurance, commercial insurances and a lot more.
Credit Rating Agencies
The credit rating agencies are those firms that
evaluate different types of financial services companies. These
ratings are based on a number of factors like the kind of services,
risk factor involved with the services, customer facilitation and many
A Financial Instrument is a legal document identified by cheques,
drafts, bonds, shares, bills of exchange, futures or options contracts
etc., which has a monetary value. The agreement is signed
between two parties
regarding payment of money with specified conditions.
Categories of Financial Instruments:
The financial instruments can be broadly classified under 3
Equity based: characterized by ownership of assets.
Debt based: loans from an investor to the owner of assets.
Foreign exchange instruments: unique instrument dealing with
Types of Financial Instruments:
MUTUAL FUNDS: It is an investment scheme in which a group of
people collectively invests funds with a predetermined objective.
The pooled money is again invested in stocks, bonds, short term
money market instruments and other securities by the mutual fund
complexes. The major advantage in such an investment plan lies in
its cost effectiveness, risk diversification, professional management
and sound regulation.
BONDS: Bonds are debt based financial instruments, bearing
interest on maturity. The organizations or companies generate
funds by issuing bonds with fixed interest rate for a definite period of
time (maturity period). Bonds have a maturity period of one year
which distinguishes them from other debt securities like commercial
papers, treasury bills and money market instruments. Bonds are
issued by both private companies and government organizations.
Usually, government bonds are a safe area for investment due to
their lower risk level and fair returns.
CASH EQUIVALENTS: The name itself suggests that this is the
most liquid investment option. These are the assets that can be
readily converted into cash. Money market holdings, short-term
government bonds or treasury bills, commercial papers, etc. are few
examples of cash equivalents.
DEPOSITS: These are investment avenues where surplus funds
are invested in banks or post-offices. The risks associated are the
lowest in this case but so are the returns on such deposits.