What is Financial System? Components, Objectives, Importance, Types of Financial Markets

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What is Financial System?

A financial system is a collection of entities that allow money to be exchanged such as banks, insurance firms and stock exchanges. On a business, regional and global scale, financial systems exist.

Borrowers, lenders and investors all trade current monies to fund projects for consumption or productive investment, as well as to earn a profit on their financial holdings. The financial system also contains a set of rules and procedures that borrowers and lenders use to determine which projects are funded, who funds initiatives and the conditions of financial transactions.

Lenders and borrowers can trade funds through the financial system. In the areas of insurance, banking, capital markets and numerous services, India’s financial system is governed by independent authorities. As a result, a financial system can be known to play a substantial part in a country’s economic growth by mobilising extra funds and putting them to productive use. It is critical to a country’s economic development. It motivates saving as well as investment, connects investors and savers and aids in the formation of capital. Moreover, it aids in risk allocation and makes it easier for financial markets to expand.

In a centrally planned financial system (e.g., a single business or a command economy), the financing of consumption and investment plans is set directly by a management or central planner, rather than by counterparties in a transaction. The planner, whether a company manager or a party leader, determines which initiatives receive funding, which projects receive cash and who funds them.

Both give-and-take marketplaces and top-down central planning are present in most financial systems. In terms of internal financial decisions, a business firm is a centrally organised financial system, yet, it often functions within a larger market, interacting with external lenders and investors to carry out its long-term ambitions.

At the same time, all contemporary financial markets are governed by some form of government regulation that limits the types of transactions that are permitted. Because financial systems have such a direct impact on decisions about actual assets, economic performance and consumer protection, they are frequently heavily regulated.

In this article, you will study the financial system and its constituents, nature of financial system, objectives of financial system, importance of financial system, meaning of financial markets, types of financial markets, etc., in detail.

Components of Indian Financial System

The term ‘financial system’ refers to a structure through which lenders and borrowers exchange funds. A financial system plays a crucial role in boosting the economic growth of a country through the mobilisation of surplus funds and their effective utilisation for productive purposes. India’s financial system is controlled by independent regulators dealing in insurance, banking, capital markets and various services sectors. There are four major components of the Indian financial system, are:

Let us discuss these four components of the Indian financial system.

Financial institutions

Financial institutions serve as mediators between investors and borrowers, allowing the financial system to run smoothly. They mobilise surplus unit savings and invest them in productive resources with a higher rate of return. Financial institutions also offer assistance to individuals, businesses and governments on diverse matters from restructuring to diversification strategies. They offer services to companies looking to generate money through markets or otherwise.

Financial institutions are also known as financial intermediaries because they serve as a link between savers and borrowers by accumulating funds and lending them out. It also serves as an intermediary by accepting deposits from a group of consumers. Financial institution can be of two types, namely banking institutions and non-banking institutions.

Financial markets: The financial system of an economy operates through financial markets and institutions. Financial markets are the institutional system for trading in various sorts of financial assets and credit instruments such as currency, checks, bank deposits, bills, bonds and so on. Financial markets serve the following purposes:

  • To enable the generation and allocation of loans and liquidity
  • To act as a conduit for the mobilisation of savings
  • To aid in the process of achieving growth in the economy in a more balanced manner
  • To make things easier financially
  • To meet the diverse credit requirements of businesses

Financial markets are further divided into two categories, namely capital market and money market. You will study about financial markets in detail in upcoming chapters of the book.

Financial instruments

A financial instrument is the claim of a particular sum of money when the sum has to be repaid, plus interest or dividend, at the conclusion of a given term. In other words, documents that represent financial claims on assets are referred to as financial instruments, which are also called financial securities or financial assets. Bills of exchange, promissory notes and treasury bills are some examples of financial instruments.

Financial securities are divided into two categories, namely primary or direct securities and secondary or indirect securities. Primary securities are the ones that are issued directly to ultimate savers by final investors. For example, direct-to-the-public shares and debentures. On the other hand, securities that have been resold to eventual savers by a group of intermediaries are called secondary securities.

Financial services

The quality and diversity of financial services supplied by financial intermediaries has a significant impact on the efficiency of the evolving financial system. Financial services are described as ‘activities, rewards and satisfactions related to the selling of money that provide financial related value to users and clients.’

Banks, financial institutions and non-banking financial enterprises are the primary sectors in the financial services industry. There are two types of financial services supplied by distinct financial institutions, commercial banks and merchant bankers namely asset-based/fund-based services and fee-based/advisory services.

Nature of Financial System

A financial system facilitates the movement of financial assets from one individual to another. It aids in the distribution of optimal lying resources among people into productive sources. The financial system collects funds from savers and distributes them to those in need for various development reasons. Apart from that, risk diversification is an important characteristic of a financial system. Because the financial system invests people’s money in a variety of places, risk is spread out.

A financial system encourages people to participate in various investment channels. People can invest their resources in a variety of income-generating investment opportunities. The financial system contributes to an economy’s optimal liquidity. It allows for free transfer of cash from individuals (savers) to businesses (investors), ensuring enough liquidity.

Objectives of Financial System

The main objective of a financial system is to make possible trade and transfer of funds in a secure manner. Apart from that, the following are some other objectives of a financial system:

  • To provide a structured system of payment

  • To give money the time value it deserves

  • To eliminate risks and compensate for them through the provision of goods and services

  • To enable the most efficient economic resource allocation

  • To ensure market stability in the economy

Importance of Financial System

A well-functioning financial arrangement aids in the creation of more job possibilities in the economy. The financial system assists in the provision of cash to expanding businesses and industries, resulting in an increase in output.

It serves as a marketplace for buyers and sellers of financial assets. The market force, which is the demand and supply process, determines the pricing of the same. The investors’ savings are mobilised so that they can be put to profitable use.

The importance of a financial system is explained in the following points:

  • A financial system provides financial instruments to assist investors in managing their capital over various time zones.

  • A financial system provides a source of finance for enterprises based on short-term or long-term financing needs for both the commercial and public sectors.

  • Risks are mitigated through techniques such as hedging or diversification and acting as a mirror reflecting the country’s/states’ economic realities.

  • A financial system boosts economic growth by attracting capital through overseas inflows or investments.

  • It provides market participants with access to information, allowing them to take preventive steps.

Meaning of Financial Markets

A financial market is a marketplace where securities are traded. It plays a significant role in allocating the scarce resources available in any country’s economy. These markets are found in from major markets with daily transactions of over a trillion dollars in securities to minor markets with a limited number of operations.

Financial markets serve as a conduit for the transfer of funds between savers and investors. They are one of the most popular venues for buyers and sellers to trade various assets based on market conditions.

Financial markets provide liquidity to firms, allowing them to expand and raise funds for their endeavours. These markets decrease risk by making information easily available to traders and investors and they also aid in the stabilisation of the economy by fostering investor confidence. This, in turn, aids in economic stabilisation.

A financial market is a term that refers to a trading floor where bonds, stocks, securities and currencies are transacted. Few financial markets deal with trillions of dollars of securities on a daily basis and some are small-scale with less activity. These are marketplaces where businesses increase their cash flow, firms reduce their risks and investors profit.

A financial market is defined as a location where financial assets and securities are sold and bought. It distributes limited resources throughout the economy of the country. It acts as a middleman between investors and collectors, facilitating the transfer of funds.

The stock market is a type of financial market that allows investors to buy and sell publicly traded company shares. The main stock market is where new stocks are originally launched, while the secondary stock market is where stock securities are traded.

Any location or mechanism that allows buyers and sellers to exchange financial assets such as bonds, shares, international currencies and derivatives is referred to as a financial market. Financial markets make it easier for individuals who need money to get it and those who want to invest it. Financial markets allow players to transfer risk (usually through derivatives) and stimulate trade in addition to raising funds.

Types of Financial Markets

Financial markets rely heavily on informational transparency to ensure that the markets set prices that are efficient and appropriate.

The following are the types of financial markets:

Stock Markets

Stock markets are no doubt the most common type of financial market. These are places where corporations list their stock and where traders and investors can buy and sell it. Companies utilise stock markets, also known as equities markets, to obtain cash through an Initial Public Offering (IPO), with shares then exchanged among numerous buyers and sellers in a secondary market.

It is a stock exchange where you may buy and sell shares in publicly listed companies. Businesses gain money on the secondary market by selling stock to the general public in an IPO.

The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) are the two stock exchanges in India that handle the majority of the stock market’s transactions (NSE). Since 1875, the BSE has been around.

The National Stock Exchange, on the other hand, was established in 1992 and began trading in 1994. Both exchanges, however, use identical trading system, trading hours and settlement procedure.

The BSE has 5,565 listed companies as of November 2021, whereas the competitor NSE had 1,920 as of March 31, 2021. Almost all of India’s major corporations are listed on both the markets.

Although the BSE is the elder stock exchange, the NSE is the largest in terms of trading volume. Both exchanges compete for order flow, which leads to lower costs, improved market efficiency and new product development. Due to the existence of arbitrageurs, the prices on the two stock markets are kept fairly close together.

Over-the-Counter Markets

An Over-the-Counter (OTC) market is a dispersed place in which market participants sell securities directly amongst two parties without the need of a broker. It has no physical locations and conducts all of its business online. Some markets which deal in derivatives, on the other hand, are entirely OTC and hence represent a significant portion of the financial markets. OTC markets and the transactions that take place on them are, in general, significantly less regulated, liquid and transparent.

Bond Markets

A bond is a financial instrument in which an investor lends money for a set length of time at a fixed interest rate. A bond can be thought of as an agreement between the lender and the borrower that describes the loan and its instalments. Bonds are issued to fund projects and operations by firms, municipalities, states and sovereign governments.

Money Markets

Money markets are known to trade in highly liquid short-term maturities (less than one year) and are featured by a high level of safety and a low rate of interest return. Money markets feature large-volume trading between institutions and traders at the wholesale level. Money market refers to a segment of the financial market that trades financial securities with high liquidity and short maturities.

The money market has evolved into a segment of the financial market for the purchase and sale of short-term securities, such as Treasury bills and commercial papers, with maturities of one year or less. OTC trading is a wholesale operation that takes place in the money market. Participants utilise it to borrow and lend money for a brief period of time.

Derivatives Markets

A derivative is defined as a contract between two or more parties in which the value of the contract is dependent by a settled-upon underlying financial asset (such as a securities) or collection of assets (such as an index). Derivatives are secondary securities that derive their value solely from the value of the original security to which they are tied.

A derivative is having no value in and of itself. A derivatives market, rather than trading stocks directly, trades futures and options contracts, as well as other advanced financial instruments that are based on financial instruments such as bonds, commodities, currencies, interest rates, market indexes and stocks.

Forex Market

The forex (foreign exchange) market is a market where people can buy, trade, hedge and speculate on currency pairs’ exchange rates. Because cash is considered the most liquid of assets, the FX market is the most liquid in the world. Banks, commercial companies, central banks, investment management firms, hedge funds and retail forex brokers and investors make up the forex market.

Commodities Markets

Commodities markets are gathering places for producers and consumers to trade physical commodities such as maize, livestock and soybeans, as well as energy goods (oil, gas and carbon credits) precious metals (gold, silver and platinum) and “soft” commodities (such as cotton, coffee and sugar).

Spot commodities markets are those where tangible things are exchanged for money. However, the majority of these commodities are traded in derivatives markets, which use spot commodities as the underlying assets. Commodity forwards, futures and options are traded both OTC and on regulated exchanges such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

Crypto-currency Markets

Crypto-currencies such as Bitcoin and Ethereum, which are decentralised digital assets based on block chain technology, have been introduced and have grown in popularity over the last few years. Hundreds of crypto-currency tokens are now accessible and traded on a patchwork of independent online crypto exchanges throughout the world. These exchanges provide traders with digital wallets via which they can exchange one cryptocurrency for another or fiat currencies such as dollars or euros.

Users are vulnerable to hackers or fraud because the bulk of crypto exchanges are centralised systems. There are also decentralised exchanges that function without a central power. These exchanges enable direct peer-to-peer (P2P) digital currency trading without the requirement for a central exchange to handle the transactions. On major crypto-currencies, futures and options trading are also available.

Stock Markets and IPOs

When a business is starting off, it will require capital from investors. As a business grows, it frequently requires access to considerably bigger sums of capital than it can obtain from continuous operations or a regular bank loan. Corporations can raise this amount of money by exiting from the shares to the general public in an IPO. This alters the company’s status from a “private” corporation with a few shareholders to a publicly traded company with shares held by a large number of people.

The IPO also gives first time investors in the firm the option to cash out a portion of their interest, generally for a large profit. Initially, the underwriters established the price of the IPO through their pre-marketing procedures.

When a company’s shares are listed on a stock market and trading begins, the price of those shares tends to fluctuate as investors and traders evaluate and reassess their intrinsic value, as well as the supply and demand for those shares at any given time.

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