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– By Darshana Rajendran, IFMR Finance Foundation Recent Comments


santosh dash
In a stylised sense, there are two fundamentally different perspectives for analysis of financial systems. Hi, the topic is very important and
The institutional perspective takes the institutional structure of the financial system as given, and looks to It's a nice post. It is good to get
define what can be done to make those institutions perform their particular financial functions more first-hand info from the...
efficiently. In contrast to the institutional perspective, a functional approach to designing and managing Why Do Small Firms Stay
Small? · 2 weeks ago
financial system, as proposed by Professor Robert Merton (Harvard Business School) and Professor Zvi
Bodie (Boston University) in various papers over the last two decades, takes the functions performed by Asmita
financial systems to be given, and studies the institutional structure that would best perform these I agree that an advice of merely
increasing savings for a low
functions.
income household (LIH), may not...
Financial Markets and intermediaries have been rapidly evolving due to technological advances and The Nature of Financial Advice for
Low-income Households · 3
integration of financial markets and intermediaries around the world. Financial innovation ensures that
months ago
the structure of the financial system changes over time, but the functions per se of the financial system
remain stable. The basic functions of the financial system are essentially the same in all economies and Malavika Raghavan
do not change over time. These functions ultimately set the benchmarks for innovation in financial Thank you for reading, Dr. Mor -
very glad the post was useful.
systems. This is why a functional perspective is more reliable and long-term than an institutional one,
The Right to Privacy Judgment:
especially in times of a rapidly changing financial environment. This functional perspective rests on these
Initial Reflections on Implications
two basic premises: ‘Financial functions are more stable than financial institutions’ and ‘Institution form for Digital Financial Services · 4
follows function.’ months ago

The primary function of any financial system is to facilitate the allocation and deployment of economic Nachiket Mor
This is an excellent exposition.
resources, both spatially and temporally, in an uncertain environment. Professor Merton and Professor
Thank you for sharing it.
Bodie further distinguish six core functions performed by the financial system:
The Right to Privacy Judgment:
Initial Reflections on Implications
Function 1: Transferring resources across time and space.
for Digital Financial Services · 4
A well developed financial system provides a way to transfer economic resources through time and
months ago
across geographic regions and industries. Loans help move resources from the future to today, and
savings products help do the opposite, but the underlying function for these two seemingly different Nachiket Mor
This is a very powerful post and
products is the same. Student loans, borrowing to buy a house and saving for retirement are all actions
brings an entirely fresh insight to
that shift resources from one point in time to another. The financial system also provides mechanisms to
the issue of privacy. Its...
shift resources from one place to another. So, when a person sends money to a family member in a
Big Data, Financial Inclusion and
different location, the basic function the movement of resources to him to the recipient. Privacy for the Poor · 4 months ago

Function 2: Managing Risk


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The financial system provides a way to manage uncertainty and control risk. Through financial securities Top 5 Game changers for the
and through private sector and government intermediaries, the financial system provides risk pooling and Indian Financial System in 2017
risk sharing opportunities, for both households and business firms. For example, suppose you want The Privacy Judgment and
$100,000 to start a business. You get $70,000 from a private investor in equity capital in exchange for Financial Inclusion in India
75% share of the profits of the business, and you get a $30,000 dollar loan from the bank at 6% interest Why Do Small Firms Stay Small?
rate per year. Suppose the bank requires that you get other members of your family to guarantee the Policy Directions for a Modularised
loan, thereby transferring the risk of default from the bank to your relatives. Thus the bank is now and Well-Functioning Financial
providing you with the money with minimal risk to itself and the risk of the loan is transferred to your System
relatives. Just as funds are transferred through the financial system, so are risks. For example, Customer Centricity Challenge
Insurance companies are financial intermediaries that offer to transfer the risk from the customers to the

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1/2/2018 Functional Perspective of Financial Systems – An Introduction « IFMR Blog
investors in exchange for some premium. Many financial contracts transfer risk without transferring the Blogroll

funds, as in the case with most insurance contracts and derivatives. Ajay Shah's blog
All About Finance – World Bank
Function 3: Clearing and settling payments blog
The financial system provides a payments system for the exchange of goods and services. Suppose you Center for Financial Inclusion
live in a country whose government sets a limit on the foreign currency that is accessible. In your country
CGAP Blog
you will be able to pay for your goods and services with the local currency. But if you wish to travel, you
Financial Access Blog
will need to use other means of payment. One way of making payments is to barter, exchange goods
without making payments, but this would be inconvenient. An important function of the financial system is Financial Markets Blog

to provide an efficient way for people and businesses to make payments for the goods and services they Stanford Center for International
Development
wish to buy. Depository financial intermediaries serve this function with wire transfers, checking
accounts, and credit/cash cards. Other intermediaries such as money market mutual funds offer Vox
transaction-draft accounts and firms whose principal business is not financial, such as General Electric,
offer general credit cards. The key elements for managing the costs and risks associated with the Tag Cloud
Advocacy Agriculture Australia
process of clearing and settling payments include netting arrangements, efficient use of collateral,
delivery-versus payment, immobilization of securities, and extension of credit. Bindu Ananth Capital
CCFS CFS CMF Conference
Function 4: Pooling resources and Subdividing shares
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The financial system provides a mechanism for the pooling of funds to undertake large-scale indivisible Dvara Research economic growth
enterprise or for the subdividing of shares in enterprises to facilitate diversification. Finance Matters Financial Depth
Suppose you wish to invest in a business that costs $100,000, but you only have $10,000 to invest.
financial inclusion
Forbes FSLRC Future of Finance
Since you cannot possibly divide the business to buy a part of it, you will not be able to make this
Housing Finance IFMR Capital
investment. A financial system corrects this problem by bringing together a bunch of investors and
distributing shares to them, thereby dividing the $100,000 investment into smaller economic pieces. Any IFMR Finance
money the business earns from the race will then be distributed among the shareholders.
Foundation IFMR
Function 5: Providing information Holdings Ignacio Interview
The financial system provides price information that helps coordinate decentralized decision-making in KGFS LTDM Malegam MFI
various sectors of the economy. The clear function of financial markets is to allow individuals and microfinance Mosec
businesses to trade financial assets. An additional function of the capital market is to provide information Municipal Finance Nachiket Mor
that assists in decision-making. For example Interest rates and security prices are information that Pension RBI Regulation rural
households use in making their consumption-saving decisions. channels rural finance
Securitisation
Function 6: Dealing with incentive problems Securitization South Africa
The financial system provides a way to deal with the asymmetric-information and incentive problems Suitability Systems Design
when one party to a financial transaction has information that the other party does not. An efficient Conference Technology
financial system reduces these incentive problems. Incentive problems take a variety of forms – moral Urbanisation Workshop
hazard, adverse selection and principal-agent problems. The financial institutions develop mechanisms Archives Archives
to help overcome these problems. For example, they develop ways to take and manage collaterals to Select Month
address the moral hazard and adverse selection problems.

Applicability of this perspective is useful in different levels of analysis. It offers a useful frame of reference
for analysing the country’s entire financial system, by helping assess how well the system is doing vis-a-
vis its essential objectives – as understood in terms of these functions. It is also useful in the study of a
particular institutional form, which can be understood in terms of the functions it is supposed to fulfil is
management of risk. The functional perspective may also be applicable at an activity level. For example
– Lending is a homogeneous financial activity in the private and public sector decision making. But from
a functional perspective, lending falls under the two basic functional categories of ‘intertemporal transfer
of resources’ and ‘risk management’. The functional perspective can also be applied at the level of an
individual financial product.

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