Meaning and Functions of the Financial System

Meaning and Functions of the Financial System

A financial system is an essential part of any economy, facilitating the smooth flow of funds between individuals, businesses, and governments. In this article, we will discuss about Meaning and Functions of the Financial System.

The financial system plays an important role in economic growth by providing a platform for investments, credit creation, and financial stability.

A financial system functions as a bridge between savers and investors. It helps transfer funds from where they are surplus to where they are needed.

It is concerned with money, credit, and finance. These three parts are very closely interrelated and depend on each other.

The financial system deals with money, credit, and finance, which are closely connected and depend on each other.

A financial system may be defined as a set of institutions instruments and markets which promote savings and channel them to their most efficient use. It includes individuals (savers), intermediaries, markets and users of savings (Investors).

“Financial system allocates savings efficiently in an economy to ultimate users either for investment in real assets or for consumption.

Van Horne

A financial system is a network of financial institutions, financial markets, financial instruments and services which help to transfer funds.

Financial institutions collect funds from suppliers and provide these funds to those who need them.

Similarly, financial markets help transfer funds from savers to intermediaries and then to investors.

In short, the financial system is an instrument by which savings are transformed into investments.

Functions of the Financial System

The following are the Functions of the Financial system :

Payment System

An efficient financial system should ensure a payment system, enabling easy and speedy exchange of goods and services.

Commercial banks and other financial intermediaries are the major agencies which provide the payment system. The operating efficiency of these agencies saves the economic system from any breakdown.

Pooling of funds

The modern business needs large volumes of finance for expansion, diversification and undertaking new projects. At the same time, there are corporate as well as individual entities that have surplus funds.

The financial system should provide a proper link between domestic and corporate savers, and those in need of funds, to pool the surplus funds and channel them to productive lines. Financial intermediaries ensure pooling of funds and providing such funds to the borrowers.

In other words, the financial system should provide an opportunity for small savers to participate in the larger investment portfolios by pooling their savings and ensuring them a reasonable return.

Transfer of resources

 An efficient financial system ensures the transfer of economic resources across time and space. The financial system provides mechanisms to transfer surplus resources from the savers to other segments of the markets across time.

It also accelerates the capital formation process by providing appropriate investment opportunities in corporate and government securities.

The capital market segment in the financial system helps corporate bodies to mobilise equity as well as debt from the market at competitive costs. Capital markets also provide an opportunity for small investors to become owners of large companies.

While the primary market helps corporate bodies to expand their capital base, secondary markets help them to maximize the shareholder’s wealth.

Risk Management

Multinational business operations have brought in various risk exposures, along with multifarious business opportunities. Besides, the domestic side of business is also open to various risks.

These business risks can be broadly classified as counter-party risk, credit risk, documentation risk, legal risk, accounting risk and operating risk.

Financial markets across the world provide different types of hedging instruments to cover such exposures.

Modern finance functions call for the effective use of these instruments to minimize risks as also to maximize profits by taking full advantage of cross-border diversification.

 Price information for decentralized decision-making

Financial markets provide valuable information to help coordinate and decentralize decision-making. The investors, who are spread across the country, may not get all the financial information.

Financial markets, therefore, provide the required information through various publications, so that all the investors have equal access to such information.

Price discovery process

Buyers and sellers interact with each other in a financial market like in any other. This interaction enables the counterparties to know at what price a financial asset can be brought or sold at a mutually agreed price.

They decide the required return, which becomes the benchmark return for the firms that need funds. The process enables the firms to estimate the demand for funds and plan their resource mobilization process accordingly.

The financial markets thus signal how the funds in an economy should be allocated among financial assets. This is known as the price discovery process.

Liquidity

An efficient financial market should ensure easy liquidity. One of the important investment considerations is the ability to convert investment into cash in case of exigencies.

Financial markets provide a platform for buyers and sellers to meet together and buy and sell securities. This process enables an investor to get back his investment as and when he requires it.

Fungibility

The financial market converts cash into securities and back to cash without any hurdles. Intermediaries operating in the market pool funds from savers and issue different forms of securities which are offered for investment in the market. Therefore, the form of funds is changed and this can be brought back to the original form as and when required.

So, these were the Meaning and Functions of the Financial System, If you have any suggestions to improve this post, please share them in the comments.

Leave a Reply

Your email address will not be published. Required fields are marked *