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ADEGITE GABRIEL

P20DLBA80209

INTRODUCTION

A ‘Financial system’ is a system that allows the exchange of funds between financial market participants such as

lenders, investors, and borrowers. Financial systems operate at national and global levels. Financial Institutions

consist of complex, closely related services, markets, and institutions intended to provide an efficient and

regular linkage between investors and depositors. In other words, financial systems can be known wherever

there exists the exchange of a financial medium (money) while there is a reallocation of funds into needy areas

(financial markets, business firms, banks) to utilize the potential of ideal money and place it in use to get

benefits out of it.

The financial system performs the essential economic function of channeling funds from those who are net

savers (i.e. who spend less than their income) to those who are net spenders (i.e. who wish to spend or invest

more than their income). In other words, the financial system allows net savers to lend funds to net spenders.

Funds are intermediated by banks and other credit institutions, and directly via financial markets through the

issuance of securities. An efficient allocation of funds, together with financial stability, contribute to economic

growth and prosperity. The most important lenders are normally households, but firms, public entities and non-

residents may also lend out excess funds. The principal borrowers are typically non-financial corporations and

government, but households and non-residents also sometimes borrow to finance their purchases.

Funds flow from lenders to borrowers via two routes. In direct or market-based finance, debtors borrow funds

directly from investors operating on the financial markets by selling them financial instruments, also called

securities (such as debt securities and shares), which are claims on the borrower’s future income or assets. If

financial intermediaries play an additional role in the channeling of funds, one refers to indirect finance.

Financial intermediaries can be classified into credit institutions, other monetary financial institutions and other

financial intermediaries, and they are part of the financial system. One of the key features of a well-functioning

financial system is that it fosters an allocation of capital that is most beneficial to economic growth. Well-
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functioning financial systems do not easily drift into financial crises and can perform their basic tasks even

under difficult financial conditions.

The infrastructure of the financial system refers to payment and settlement systems, through which financial

market operations are concretely carried out. A smooth and reliable functioning of payment and settlement

systems promotes effective capital movements in the economy and thereby supports financial stability. A

financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit

the exchange of funds. Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and

investors exchange current funds to finance projects, either for consumption or productive investments, and to

pursue a return on their financial assets. The financial system also includes sets of rules and practices that

borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial

deals.

Financial markets :- Financial markets involve borrowers, lenders, and investors negotiating loans and other

transactions. In these markets, the economic good traded on both sides is usually some form of money: current

money (cash), claims on future money (credit), or claims on the future income potential or value of real assets

(equity). These also include derivative instruments. Derivative instruments, such as commodity futures or stock

options, are financial instruments that are dependent on an underlying real or financial asset's performance. In

financial markets, these are all traded among borrowers, lenders, and investors according to the normal laws of

supply and demand.

Central Planning :- In a centrally planned financial system (e.g., a single firm or a command economy), the

financing of consumption and investment plans is not decided by counterparties in a transaction but directly by

a manager or central planner. Which projects receive funds, whose projects receive funds, and who funds them

is determined by the planner, whether that means a business manager or a party boss.

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Mix Of Both :- Most financial systems contain elements of both give-and-take markets and top-down central

planning. For example, a business firm is a centrally planned financial system with respect to its internal

financial decisions; however, it typically operates within a broader market interacting with external lenders

and investors to carry out its long term plan

At the same time, all modern financial markets operate within some kind of government regulatory framework

that sets limits on what types of transactions are allowed. Financial systems are often strictly regulated because

they directly influence decisions over real assets, economic performance, and consumer protection.

Multiple components make up the financial system at different levels. The firm's financial system is the set of

implemented procedures that track the financial activities of the company. Within a firm, the financial system

encompasses all aspects of finances, including accounting measures, revenue and expense schedules, wages,

and balance sheet verification. On a regional scale, the financial system is the system that enables lenders and

borrowers to exchange funds. Regional financial systems include banks and other institutions, such as securities

exchanges and financial clearinghouses. The global financial system is basically a broader regional system that

encompasses all financial institutions, borrowers, and lenders within the global economy. In a global view,

financial systems include the International Monetary Fund, central banks, government treasuries and monetary

authorities, the World Bank, and major private international banks.

SURPLUS AND DEFICIT UNITS

Surplus units are those units who receive more money than they spend. They can be termed as investors. They

provide their net savings to the financial markets while deficit units are those units who spend more money than

they received. They are also termed as borrowers. They access funds from the financial markets. Financial

markets match surplus and deficit units for lending and borrowing. Monetary institutions lend to deficit units

and borrow from surplus units by issuing money to the surplus units. This process is known as monetizing debt,

whereby the debt of deficit units is converted to money that is then used within the economy. Monetary

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institutions supply money in the form of paper bills, coins, and checkable deposits. A nonmonetary institution

also borrows from surplus units and lends to deficit units. However, the securities provided by the nonmonetary

institution to the surplus units do not act as money but rather are indirect securities issued as a liability of the

financial institution. These securities meet specialized needs of the surplus units by providing insurance,

pensions, mutual funds, trust accounts, etc. These indirect securities also help provide a rich and diverse set of

investments to the surplus units to encourage them to participate in the flow of funds by lending to deficit units.

The flow of funds has to attract all of the savers and dissavers to participate in order to maintain the current

level of production . Using credit money provides savers with a diverse menu of securities ranging from no-

return, low-risk, high-liquidity (money) to high-return, high-risk, low-liquidity (equity). It is crucial that the

flow of funds system maintains the confidence of all of the economic units within an economy. If confidence

erodes, people will leave the system and drops in the production of goods and services will ensue (recession and

depression). Surplus units transfer their claims to goods and services to the deficit units and in return, they

receive debt and equity instruments from the deficit units. These instruments can be acquired through the

financial markets or they may be transformed into money through monetary institutions and indirect securities

through the nonmonetary institutions. In Table 4, we see an overview of the financial institution system with a

summary of their balance sheets that result from lending to deficit units while borrowing from surplus units.

CONCLUSION

Financial markets help to efficiently direct the flow of savings and investment in the economy in ways that

facilitate the accumulation of capital and the production of goods and services. The combination of well-

developed financial markets and institutions, as well as a diverse array of financial products and instruments,

suits the needs of borrowers and lenders and therefore the overall economy.

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REFERENCE

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