Overview of Financial System

Overview of Financial System

Objectives

  • Define a financial system

  • Identify the components of the financial system

  • Understand the functions of a financial system in an economy

Definition of Financial System

Simple Definition

  • A financial system is a framework of institutions, markets, instruments, and regulations facilitating the flow of funds from surplus units (savers) to deficit units (borrowers).

Academic Definition

  • A financial system is a network of financial institutions, markets, instruments, payment mechanisms, and regulatory bodies that enables the mobilization of savings, capital allocation, risk management, and payment facilitation in an economy.

  • It supports real economic activity and connects:

    • Households

    • Businesses

    • Government

    • The economy at large

Surplus Units

Definition

  • A surplus unit is an economic agent whose income exceeds expenditure, resulting in excess funds for saving or investment.

Who Are Surplus Units?

  • Households with savings after meeting expenses

  • Pension funds collecting contributions over current payouts

  • Insurance companies retaining premiums before claims

  • Firms with retained earnings

  • Government when running a budget surplus

Usage of Excess Funds

  • Actions taken by surplus units:

    • Depositing money in banks

    • Purchasing financial instruments (bonds, shares)

    • Investing through mutual funds or pensions

Importance of Surplus Units

  • They provide crucial funds for lending and investment

  • Enable financing of:

    • Businesses

    • Government projects

    • Economic growth

Deficit Units

Definition

  • A deficit unit is an economic agent whose expenditure exceeds income and thus needs external financing.

Who Are Deficit Units?

  • Businesses needing finance for expansion and operations

  • Governments financing infrastructure and public services

  • Households borrowing for housing, education, or durable goods

Purpose of Borrowing

  • Deficit units borrow to:

    • Invest before earning revenue

    • Smooth consumption over time

    • Finance long-term projects

Accessing Funds

  • Methods of obtaining funds by deficit units:

    • Bank loans

    • Issuing bonds

    • Issuing shares (for firms)

    • Government securities

Role in Financial System

  • Create demand for funds; their borrowing drives:

    • Investment

    • Production

    • Economic growth

  • Without them, savings would remain idle and economic activity would decelerate.

Components of the Financial System

  • The financial system comprises several core components working together to drive capital movement:

    • Financial Institutions: Mediate between savers and borrowers (e.g., banks, pension funds).

    • Financial Markets: Platforms for issuing and trading financial instruments.

    • Regulation Bodies: Ensure stability, transparency, and investor protection.

    • Payment Systems: Facilitate safe, efficient money transfer for economic activities.

Financial Institutions

Definition

  • Organizations that mediate between surplus and deficit units, mobilizing savings to channel funds as loans and investments.

Examples

  • Commercial banks

  • Development banks

  • Insurance companies

  • Pension funds

  • Microfinance institutions

Functions

  1. Intermediation: Stand between surplus and deficit units—collect funds and distribute them efficiently.

  2. Mobilization of Savings: Offer savings products that encourage saving rather than hoarding cash.

  3. Risk Management: Pool funds to manage risk, providing liquidity and reducing information asymmetry between parties.

  4. Economic Growth Contribution: Allocate savings to productive uses, supporting growth, employment, and income generation.

  5. Preventing Systemic Crises: Stable institutions promote confidence and prevent financial crises.

Financial Markets

Definition

  • A financial market is where financial assets are created or transferred, connecting borrowers and lenders to facilitate fund movement in the economy.

Characteristics

  • Not limited to physical locations; can exist as platforms for buying/selling financial assets.

  • Supports investment by connecting surplus with deficit units to finance economic activities.

Types of Financial Markets

  1. Money Market:

    • Deals with short-term financial instruments (maturity < 1 year)

    • Ensures liquidity and short-term funding.

    • Common instruments: Treasury Bills, Commercial Paper, Certificates of Deposit, Interbank Loans.

  2. Capital Markets:

    • Deals with long-term financial instruments (maturity > 1 year)

    • Focuses on long-term investment and growth.

    • Instruments include Shares (Equity), Bonds/Debentures, Preference Shares, and Government Long-term Securities.

Financial Instruments

Importance

  • Financial instruments facilitate the transfer of funds from surplus to deficit units, linking investors with borrowers.

Nature

  • Represent financial claims on future payments, providing rights to future cash flows for investors.

Types

  • Debt Instruments: Loan agreements with principal repayment and interest.

    • Features: Defined maturity, predictable returns, lower risk.

    • Examples: Bonds, Treasury Bills.

  • Equity Instruments: Ownership representation in a company, involving dividends and capital gains without fixed maturities.

    • Features: Higher risk, but potential for higher returns.

    • Examples: Ordinary shares, Preference shares.

Financial Services

Definition

  • Services from financial institutions assisting in managing financial resources effectively.

Functions

  1. Mobilisation of Funds: Assists raising capital from savings/investments.

  2. Resource Allocation: Ensures efficient fund allocation to productive activities.

  3. Investment Support: Aids in choosing financing combinations and investment options.

  4. Payments Facilitation: Ensures secure transactions and smooth fund transfers.

  5. Risk Management: Offers solutions like insurance and diversification to manage financial risks.

Functions of the Financial System

Saving

  • Individuals and companies save funds for future use, through various investment vehicles from low-risk treasury bills to higher-risk corporate stocks.

Borrowing

  • Involves receiving funds now, repaid later, via secured or unsecured loans.

Raising Equity Capital

  • Investment banks assist in trading cash for equity shares, expecting future dividends or capital gains.

Managing Risks

  • Investors use contracts and insurance to hedge against adverse price movements.

Information-Motivated Trading

  • Traders leverage information for excess returns, hoping to buy undervalued stocks and sell overvalued ones.

Rate of Return Determination

  • The equilibrium interest rate balances supply and demand for funds between savers and borrowers.

Questions for Discussion

  • What role do financial services play in the financial system?

  • Critically evaluate the statement: “Financial services are the backbone of modern financial systems.”

  • Illustrate how financial services support financial markets with examples of providers.

  • Assess the importance of financial services in facilitating investment and economic development.

  • Analyze how financial services contribute to smooth market functioning.

Questions

  • Any questions?