The financial system is all about taking money from someone who has ample of it and

making it to reach those who have the best opportunities to utilize it. This way the
economic resources are allocated most efficiently and best returns are
ensured. Economic transactions are done by various organizations like banks, pension
funds, organized exchanges and insurance companies and many more. They are the
financial institutions who use various financial instruments such as bonds, stocks,
interests derived on deposits, credit to the borrowers etc.
Objectives of the financial system
The main objectives of this system are:
 To create a structured payment system
 To give money the time value as it deserves
 To reduce risks and compensate for the same through offering products and
services
 To enable the most efficient economic resource allocation
 To maintain market stability in the economic sector
Components of the system
1. Financial Institutions
Here is where the borrowers meet the investors. The latter’s investment is utilized in
various sectors via financial instruments and investing in the financial market. There are
myriad service providers in this same field also who get involved in the process. They can
be of any type, Regulatory, Intermediaries, non-intermediaries and others. There are
organizations which seek the assistance of these service providers every now and then
and strategic ideas regarding the diversification or restructuring of the unit are provided.
In this way, financial assets like loans, securities and other deposits are taken care of
along with raising funds from the market. All sorts of services are thus reached to the
service-users.
2. Financial Markets
In financial markets, the exchange of financial assets is involved in terms of both the
creation and transfer of the same. The difference here with a real transaction is that there
is no direct money involved in the exchange process and instead of products or services,
deposits, loans and other such financial assets are used for the transaction process.
There are financial instruments involved in this. Here a claim of payment of money in the
future is made and interest or dividend is paid on a periodic basis. The financial market
again is composed of four units.
a. Money Market
This refers to a wholesale market of debts involving financial instruments that are low-
risk, short-term and highly-liquid. One can get funds for a day’s span up to a year’s.
Banks, the government and other financial institutions regulate such a market.
b. Capital Market
This is for investments of long-term nature, such as more than a year.
c. Foreign Exchange Market
Exchange of currencies in a multicurrency facet is what foreign exchange markets are
for. There is a particular exchange rate fixed depending on which the funds are transferred
within the market. This particular market is the most developed one in the world.
d. Credit Market

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In this market loans of medium or long-term tenure are given to the individuals or
corporate companies by financial institutions, banks, Non-Bank Financial Institutions or
NBFCs etc.
3. Financial Instrument
All securities and financial assets fall under the broad category of financial instruments.
Various investors and credit seekers have the demand for various types of loans and
deposits. Thus the securities are of various types too. A principal is settled which will be
repaid by regular dividends or interests. Bonds, debentures and equity shares are a few
financial instruments.
4. Financial Services
These are derived from the Liability Management and Asset Management companies.
These help in both acquiring and investing the money appropriately. Their assistance is
sought for determining the financing combination. From borrowing to selling, purchasing
to the lending of securities, making payments to regulating risk exposures- all are looked
after by these service providers. The clients are myriad starting from mutual fund houses,
acceptance houses, leasing companies to merchant bankers and portfolio managers. The
services offered here are credit rating, book building, merchant banking, capital financing,
depository services and mutual funds.
5. Money
This may be mentioned at the last but it is undoubtedly one of the most important
components of the financial system. Money refers to anything that is used to pay for the
products bought or services used and accepted by the seller too. Money acts as an
exchange medium for repayment and a complete transaction process. Money holds the
value of the product or service. The exchange process is eased out when money is
utilized.
Thus, the financial system is the common meeting place of the borrowers and lenders
from where both can reap mutual benefits. Situations where capital crunch is higher (as
in India), the proper action of financial institute can result in capital accumulation. At the
end, the country finds economic development which is much desired.

A financial system is an economic arrangement wherein financial institutions facilitate

the transfer of funds and assets between borrowers, lenders, and investors. Its goal is
to efficiently distribute economic resources to promote economic growth and generate
a return on investment (ROI) for market participants.
The market participants may include investment banks, stock exchanges, insurance
companies, individual investors, and other institutions. It functions at corporate, national,
and international levels and is governed by various rules dictating the eligibility of
participants and the use of funds for different purposes. Aside from financial
institutions, financial markets, financial assets, and financial services are the
components of the financial system.
• A financial system consists of individuals like borrowers and lenders and
institutions like banks, stock exchanges, and insurance companies actively involved in
the funds and assets transfer.

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 • It gives investors the ability to grow their wealth and assets, thus contributing to
economic development.

• It serves different purposes in an economy, such as working as payment

systems, providing savings options, bringing liquidity to financial markets, and protecting
investors from unexpected financial risks.

A specific set of rules drafted under different government policies is required for a stable
financial system operating at corporate, national, and international levels.

In any functional economy, economic resources are limited, with individuals having
unlimited wants and desires. This problem, referred to as scarcity, is one of the
significant drivers of an economy. However, it challenges an economy in determining
when, where, to whom to distribute its resources. Consequently, it resulted in a financial
system structure capable of efficiently allocating economic resources to stimulate
growth. Also, it allows participants to benefit by:

 Providing a way of making payments (banks)

 Giving participants a way of earning interest in the form of time value (investment
institutions)
 Protecting them against financial risks (insurance)
 Collecting and distributing financial information (credit agencies)
 Governing regulations to maintain stability (central banks and governments)
 Maintaining liquidity and converting investments into cash (banks and financial
institutions)

Financial institutions are at the core of the financial system, giving individuals the
ability to save and invest whenever and wherever they want. Investors put their money
in these institutions, which offer them a reward for saving and use it to lend to
borrowers. The borrowers can use these funds to build goods and services or fund
other projects. All this activity helps promote economic growth – either by creating
additional jobs or generating a profit and contributing back to the economy.
The money or funds flow from the lender to the borrower in one of two ways:

1. Market-Based
2. Centrally Planned

In a market-based economy, borrowers, lenders, and investors can obtain funds by

trading securities, such as stocks and bonds in the financial markets. The law of
supply and demand will determine the price of these securities. With a centrally
planned economy, governing authority or central planner makes the investment
decisions. In most instances, there will be a mix of both types of economies.
Components of Financial Systems

There are several financial system components to ensure a smooth transition of funds
between lenders, borrowers, and investors.
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 Financial Institutions
 Financial Markets
 Tradable or Financial Instruments
 Financial Services
 Currency (Money)

#1 – Financial Institutions

Financial institutions act as intermediaries between the lender and the borrower when
providing financial services. These include:

 Banks (Central, Retail, and Commercial)

 Insurance Companies
 Investment Companies
 Brokerage Firms

#2 – Financial Markets

These are places where the exchange of assets occurs with borrowers and lenders,
such as stocks, bonds, derivatives, and commodities.
Financial markets help businesses to grow and expand by allowing investors to
contribute capital. Investors invest in company stock with the expectation of it producing
a return in the future. As the business makes a profit, it can then pass on the surplus to
the investors.

#3 – Financial Instruments

Tradable or financial instruments enable individuals to trade within the financial markets.
These can include cash, shares of stock (representing ownership), bonds, options, and
futures.

#4 – Financial Services

Financial services provide investors a way of managing assets and offer protection
against systemic risk. These also ensure individuals have the appropriate amount of
capital in the most efficient investments to promote growth. Banks, insurance
companies, and investment services would be considered financial services.

#5 – Currency (Money)

A currency is a form of payment to exchange products, services, and investments and

holds value to society.

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 Examples

Financial systems are an essential part of an economy, and without them, the flow of
funds would cease to exist. It keeps evolving considering the regional or global
economic situations.

An example of this is the G20’s virtual summit held in March 2020, discussing the role
and significance of the global approach to the financial crisis caused by the coronavirus
pandemic. The center of discussion was the ability of the global financial system to
operate effectively and efficiently. Financial markets have mitigated systemic risk due to
the improved financial market infrastructures, systemically important financial market
utilities, risk management standards, and centralized clearing houses.
Here is another example to understand its importance in everyday life.

Business Loans

 When a business requires capital to fund new projects or develop new technology, it
applies for a business loan. There are several options to get it done, such as getting a
line of credit or an installment loan.
 To qualify for the loan, the lender looks at several business components like its credit
score or balance sheet to determine the systemic risk of giving out the loan.
 The financial institution (bank) then allocates the necessary funds to the business. The
business can use the money to fund a future project to generate additional income.
 The bank then requires the business to make payments towards the loan, including
interests for its time value.

Functions of Financial Systems

A financial system allows its participants to prosper and reap the benefits. It also helps
in borrowing and lending when needed. In simpler words, it will circulate the funds to
different parts of an economy. Here are some of the financial system functions:

1. Payment System – An efficient payment system allows businesses and merchants to

collect money in exchange for their products or services. Payments can be made with
cash, checks, credit cards, and even cryptocurrency in certain instances.
2. Savings – Public savings allow individuals and businesses to invest in a range of
investments and see them grow over time. Borrowers can use them to fund new
projects and increase future cash flow, and investors get a return on investment in
return.
3. Liquidity – The financial markets give investors the ability to reduce the systemic risk
by providing liquidity. It thus allows for easy buying and selling of assets when needed.
4. Risk Management – It protects investors from various financial risks through
insurances and other types of contracts.

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5. Government Policy – Governments attempt to stabilize or regulate an economy by
implementing specific policies to deal with inflation, unemployment, and interest rates.

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