Financial System and its stages, components and Functions.

Finance & Economy

Financial System

“Financial System” is a set of inter-related activities working together to achieve some pre-determined goal. It includes-

  • Markets
  • Financial institutions
  • Financial Instruments
  • Financial services and
  • The Mechanism that influences the generation of savings for investment, capital formation and growth.

An efficient financial system plays the key role for an economy to operate efficiently and is the key contributor for economic growth and development.  The well-functioning financial system help in technological innovation by offering funding to entrepreneurs who have innovative abilities.

Some economics has viewed that economic growth creates demand for financial institutions. It means that first economic development takes place then development of financial sector follows. Hence, we can say that there is double-sided relation between financial system and economic growth.

The financial system transfers financial resources from savers to investors in the following two ways:-

  1. By mobilising savings of many small investors to make it available for productive purpose.
  2. By mobilising fund between savers and investors (financial intermediaries), then between investor and borrowers.

The fund borrowed by borrowers are invested in various productive activities, which in turn, increase the GDP, national income and supports other sectors of economy to increase overall development of the economy besides generating employment.

Financial Intermediaries

Financial Intermediaries are the institutions, which issues their own liabilities, and hold the liabilities of ultimate borrowers as assets that is investors in physical assets or of other intermediaries. Financial intermediaries fall into following three categories:-

  1. Commercial Banks, Co-operative banks and NBFCs (Non-banking financial companies.)
  2. Long terms investing institutions like IDBI (Industrial development bank of India) and LIC etc.
  3. Special credit institutions set up by Government to provide long-term finance for particular purposes like NABARD (National Bank for agriculture and rural development.)

Stages of Financial System

The current financial system has evolved through three stages as explained below-

  1. First Stage Financial System- The first stage financial system was evolved in Europe and North America up to the middle of nineteenth century. During this period- (1) Financial institutions accounted for low share of outstanding assets. (2) Financial institutions were limited. (3) Commercial banks are the leading institutions. (4) Financial system did not own risk capital.
  2. Second Stage Financial System- The structure of Second stage financial system were similar to first stage but the role of government became prominent to promote financial transactions.
  3. Third Stage Financial System-In the third stage, the system diversified its structure, instruments and borrowing lending activity.

Components of Financial System

There are four main components of financial system, which are explained below:-

  • Financial Institutions- Financial Institutions are the business organisation that act as mobilisers of savings and suppliers of fund. They also provide various financial services to the community. These financial business organisations deal in financial assets such as deposits, loans, securities etc. Financial institutions can be classified into various categories, two important categories of financial institutions are explained below-

  1. Banking Financial institutions AND  Non-Banking  Financial Institutions- Banking Financial institutions are those institution which participate in the economy’s payment system and which provides transaction services like commercial banks. Their deposits liabilities constitute a major part of the national money supply.  On the other hand non-banking financial institutions are those institutions which act as mere supplier of credit and they will not create credit like LIC, UTI and IDBI (Industrial development bank of India).
  2. Financial Intermediaries AND Non-Financial Intermediaries- Financial intermediaries are those institutions, which intermediate between savers and investors. These institutions lend money as well as mobilise savings. Their liabilities are towards the ultimate savers; while their assets are from the borrowers. On the other hand, Non-financial Intermediaries are those institutions, which do provide the loans to borrowers, but their resources are not directly obtained from the savers. All banking financial institutions are intermediaries but many non-banking institutions also act as intermediaries and they are known as non-banking financial intermediaries Like LIC, GIC, IDBI, IFC and NABARD etc.

  • Financial Markets- Financial markets are arrangement that provide facilities for buying and selling of financial products i.e. financial claims and services. The participants in the financial markets are corporations, financial institutions, individuals and the government. These participants trade in financial products in these financial markets. They trade either directly or through brokers and dealers. In short, financial markets are the markets in which financial instruments (Like stocks, bonds, insurance policies, government securities and debentures etc.) are traded. Financial market is said to be the brain of entire economic system. The savings are channelled to investments through financial market. Financial markets can be classified into various categories. Two important categories of financial markets are-

  1. Primary market and Secondary market- Primary markets are also known as new issue markets (NIM) as they deal in the new financial claims or new securities. Primary market (or new issue market) is a market for raising fresh capital in the form of securities (shares and debentures.) issued directly by the company. Secondary markets  are those markets which deal in securities already issued (existing or outstanding securities). The secondary market do not contribute directly to the supply of additional capital but they do so indirectly by rendering securities liquid which were issued on the primary markets.
  2. Money market and Capital Market- Money market is a market where short-term funds are borrowed and lent like treasury bill market, call money market, commercial bill market etc. Money markets deal with short-term assets, which are near substitutes for money. Short –terms assets are those assets which are having a period of maturity of one year or less, these are also called as money market instruments like treasury bills, commercial bills, commercial paper, certificate of deposits, repurchase options (REPO), Inter-bank participation certificates (IBPC), securitised debt, options, future contract, forward rate agreement and swaps etc. On the other hand, Capital market deal in the long term claims, securities and stocks with a maturity period of more than one year like stock market, government bond market and derivative market.

  • Financial Instruments : Financial instruments are those instruments which are used for raising resources for corporate entities. The Financial instrument may be money market instrument or capital market instruments. The financial instruments that are used for raising capital through capital market are known as capital market instruments like preference shares, equity shares, warrants, debentures and bonds etc. On the other hand, the financial instruments which are used in money market for raising and supplying money for short period (upto one year) are called money market instruments like Treasury bills, gilt edged securities, commercial papers, certificate of deposits etc.
  • Financial Services: Financial services are an important component of a financial system. Financial institutions provides various financial services to individuals and institutional investors. They require a number of financial services in order to fulfil the tasks assigned. The efficient functioning of financial system depends upon the range of financial services provided. Some examples of financial services are banking, professional advisory, wealth management, mutual fund, Insurance and tax consulting services.

Functions of Financial system

Some important functions of financial system are as follows-

  1. Economic Development- Financial system plays an important role in economic development. A well-functioning financial system can contribute significantly to the acceleration of economic development through following three ways-

  1. Technical progress is vital for economic development and Capital is an important source for technical progress. Increase in capital requires higher savings and investments, which can be achieved through an efficient financial system.
  2. Economic development depends on rate of capital formation. Capital formation depends on whether finance is made available in time, in adequate quantity and on favourable terms, which can be achieved through an efficient financial system.
  3. Financial system enhances the efficiency of exchanges and it also enlarges the markets, thereby it helps in economic development.

2. Other Functions

  1. Financial system is effective for optimum allocation of financial resources in an economy.
  2. Financial system helps in establishing a link between savers and investors and thereby helps in mobilising and allocating the savings efficiently and effectively.
  3. Financial system allows assets-liability transformation.
  4. Financial system ensures the efficient functioning of the payment mechanism in an economy.
  5. Financial system helps in risk transformation by diversification like  in case of mutual funds.
  6. Financial system enhances liquidity of financial claims.
  7. Financial system helps in reducing the cost of transactions.
  8. Financial system helps in price discovery of financial assets resulting from the interaction of buyers and sellers.

Hence, the primary function of any financial system is to facilitate the allocation and deployment of economic resources in an efficient manner to make it available for productive purpose.