Written by A financial system may be defined as consisting of the institutional units, and markets that interact, typically in a complex way for the purpose of mobilizing funds for investments and development purposes.
It consists of the group of institutions in the economy that help to match one person’s savings with another person’s investment in the economy.
That is, the financial system is the network of institutions, markets, and regulations that facilitate the exchange of funds between borrowers and lenders.
It moves scarce resources from the savers to the borrowers in the economy.
The financial system is anchored on the belief that economic agents are categorized into surplus and deficit spending units.
The surplus spending units are individuals, groups, or organizations operating within the economy that have excess funds above their immediate needs.
They have more income than they spend on current consumption and therefore have money left over to save or invest.
Surplus spending units constitute suppliers of surplus funds to the financial system.
These units typically save or invest their surplus money, seeking a return or interest in exchange for entrusting their funds to the financial system.
The deficit spending units, on the other hand, are those that have a shortage of funds and, thus, require borrowing to fund their operations.
They have less income than they spend on current consumption and, therefore, have a shortage of money to meet their needs or wants.
The deficit spending units constitute the users of the excess funds supplied by the surplus spending units in the financial system.
The mechanism facilitating this transfer of funds is called financial intermediation.
Surplus spending units lend their funds to financial intermediaries, who, in turn, lend these funds to deficit spending units—primarily consisting of firms and other investors.
This role of financial intermediation is pivotal in ensuring a smooth and efficient flow of funds in the financial system.
Functions of a Financial System
1. Mobilization of savings: The financial system allows savers to pool their resources and make them available to borrowers.
The financial system allows for a smooth and efficient transfer of funds from surplus to deficit units.
The transfer of funds summarized in the fundamental flow of funds’ equation occurs directly through money and capital markets and indirectly through the intermediation market(financial institutions).
For example, banks collect deposits from savers and lend them to businesses and individuals who need funds for investment or productive purposes.
This process ensures that savings are not idle but are used to finance productive investments.
2. Allocating resources: One of the key functions of the financial system is to allocate resources to the most productive uses.
This is done by directing capital to businesses and projects that are most likely to generate a return.
For example, when investors buy securities in the financial market, they provide finance and capital for businesses, allowing the financial system to allocate resources to entities capable of providing the necessary return and creating significant value.
3. Providing liquidity: Money, in its basic form, is the most liquid asset that anyone can hold.
But the problem is that the value of money is easily eroded by inflation. This is why many people prefer to invest in financial instruments.
The financial system plays an important role in providing liquidity to the economy. When an investor who has bought security is in need of cash, he can easily sell his securities in the financial market and become liquid.
Moreover, Banks and other mutual funds provide liquidity by allowing depositors and investors to withdraw their funds at any time.
4. Effective payment system: The payment system is the infrastructure and mechanisms that enable the transfer of money between individuals, businesses, and financial institutions.
It includes various payment methods such as cash, checks, electronic funds transfers, and digital payments.
The financial system provides a suitable and effective payment system without which specialization in production would to a great extent be obstructed.
Banks and other institutions in the financial system allow businesses to focus on one task or product and trade with each other people using an efficient payment system.
Conclusion
The financial system is essential for the functioning of a modern economy. From mobilizing savings to allocating resources efficiently, enhancing liquidity, and providing an effective payment system, the financial system plays a vital role in facilitating economic activities, promoting growth, and ensuring the optimal use of financial resources.
