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FINANCIAL SYSTEMS ROLE IN THE ECONOMIC DEVELOPMENT Without financial system it is quite difficult and expensive to allocate resource

and shift risks to its lowest level (low economic development). Financial system plays an important role in the economic development and it is divided into financial markets and institutions. The role of the financial system is to gather or pool money from people and businesses that have more than they need currently and transmit those funds to those who can use them for either consumption or investment. The larger the flow of funds and the more efficient their allocation is, the better the economic output and welfare of the economy and society. A healthy economy is dependent on efficient transfers of resources from people who are net savers (surplus) to firms and individuals who need capital. Without efficient transfers, the economy simply could not function. Obviously, the level of employment and productivity, hence our standard of living, would be much lower. Therefore, it is absolutely essential that our financial market functions efficiently, not only quickly, but also at a minimal

cost. So this paper is written to describe the importance of financial system to the economic development of a nation. It will also seek to highlight the techniques used to allocate funds or resource and also risk minimization. Lastly, it attempts to identify the financial intermediation players and the instruments used in doing so. ASSET ALLOCATION BETWEEN SAVERS (SURPLUS) AND BORROWERS (DEFICIT) PARTS The financial system consists of financial markets and institutions. Financial markets are where people buy and sell, win and lose, bargain and argue about the price and the product/services. The only difference between financial markets and normal market that we know is that in the financial markets people buy and sell financial instruments like stocks, mortgage contracts, and bonds and so on. Financial institutions, as part of financial system, they also play an important role in economic development by facilitating the flow of funds from surplus unit (savers) to the deficit unit (borrowers). They are firms such as credit unions, commercial banks, finance institutions, insurance companies and etc.

Economic elements or parties that are involved can be divided into households, business organizations, and government. Business often needs capital to implement growth plans; government requires funds to finance building projects; and households frequently want loans for example to purchase homes, cars and so on. Fortunately, there are other individuals or households and firms with incomes greater than their expenditures (surplus budget position). Therefore financial markets bring together people and 2 organizations needing money with those having surplus funds. In other words, the purpose of the financial system is to transfer funds from savers to the borrowers in the most effective and efficient possible manner. And that job can be done by direct financing or by indirect financing. Despite the method of transferring the resources the objective is to bring the involving parties together at the lowest possible cost. a. Direct Financing: In direct financing borrowers and savers exchange money and financial instruments directly. Borrowers or deficit units issue

financial claims (they are claims against someone elses money at a future date) on themselves and sell directly to savers or surplus units for money. The savers hold the financial claims as interest bearing instruments and they can sell it in financial markets. Upon agreed time or maturity date borrowers have to give back the savers principle plus the agreed interest rate. b. Indirect financing: A problem that arises from direct financing brought the usage of indirect financing. Sometimes the savers or surplus units cant wait to hold financial claims till maturity date therefore they sell the financial claims to the financial intermediation and take their funds from them to do whatever they please. BENEFITS OF FINANCIAL INTERMEDIATION (INSTITUTIONS) Financial intermediaries have three main sources of proportional advantage compare to others. First, financial institutions can achieve economies of balance through specialization of what they offer and do, because they handle large numbers of transactions, they are able minimize the fixed cost

through spreading between them. Second, financial institutions searching and transaction cost for credit information can be minimized. Lastly, financial institutions have the ability to get important information concerning the borrowers financial position because they have a history of exercising discretion with this type of information, and they also can reduce unreliable information concerning about the borrower. SERVICES OF FINANCIAL INSTITUTIONS In transferring resource allocation from direct financing to indirect financing, financial institutions provide the following five basic services: a. Currency alteration: Buying financial claims denominated in one currency and selling financial claims denominated in another currencies. b. Quantity Divisibility: Financial institutions are capable in producing a broad range of quantity from one dollar to many millions, by gathering from different people. Business e-Bulletin Vol. 1, Issue 1, 2009, 1-5 3 c. Liquidity: Easy to liquidate the instruments by buying direct financial claims with low liquidity and issuing indirect financial claims with more liquidity.

d. Maturity Flexibility: Creating financial claims with wide range of maturities so as to balance the maturity of different instruments so as to reduce the gap between assets and liabilities. e. Credit Risk Diversification (portfolio investment): By purchasing a broad range of instruments, financial institutions are able to diversify the risk. TYPES OF FINANCIAL INSTITUTIONS Different financial institutions exist in our economy and they serve to accomplish one function i.e. to purchase financial claims from borrowers (deficit unit) and sell it with different characteristics to the savers (surplus unit). Here are the major types of intermediaries: 1. Commercial banks are the major institutions that lend money, handle checking accounts, and also provide an ever-widening range of services, including stock brokerage services and insurance. Commercial banks are the largest and most diversified institutions on the basis of range of assets held and liabilities issued. 2. Thrift Institutions - Mutual savings and savings and loan associations are commonly called thrift institutions. They serve individual savers and

residential and commercial mortgage borrowers, take the funds of many small savers and then lend this money to home buyers and other types of borrowers. 3. Credit unions are cooperative associations whose members are supposed to have common bond. Credit unions are often the cheapest source of funds available to individual borrowers. 4. Mutual funds sell equity shares to investors and use these resources to purchase stocks or bonds. These organizations pool resources and thus minimize risks through diversification. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. 5. Life insurance companies take savings in the form of premiums and then invest these funds in bonds, stocks, mortgages, real estate and so on, and then make payments to beneficiaries. 6. Pension funds are retirement plans obtain their funds from employers and employees and administered generally by the trust departments of commercial banks, or by life insurance companies. Pension funds invest 4

their money primarily in stocks, bonds real estate and mortgages like insurance companies. TYPES OF FINANCIAL MARKETS There are many different types of financial markets. Each market exists to serve a different region or deals with a different type of security. Here are some of the major types of markets: 1. Physical asset markets also called tangible or real asset markets are those market that are traded for such products as wheat, autos and real estate. 2. Financial asset markets deal with stocks, bonds, notes, mortgages, and other claims on real assets. 3. Spot markets and futures markets are terms that refer to whether the assets are bought or sold for on-the-spot delivery or for transfer at some upcoming date. 4. Money markets are the markets for debt securities with maturities of less than one year. 5. Capital markets are the markets for long-term debt (more than a year) and corporate stocks. 6. Primary markets are markets in which corporation raise new capital such as initial public offering (IPO).

7. Secondary markets are markets in which existing or already outstanding, securities are traded among investors. CONCLUSION Financial system plays a significant role in the economic development of a country. Financial markets present three major efficiencies for the sake of development and they are allocation, information, and operational efficiency. Financial institutions are profit maximizing businesses that earn profits by acquiring funds at interest rates lower than they earn on their assets. BIBLIOGRAPHIES Bradford, C., & Shapiro, A. C. (1987). Corporate stakeholders and corporate finance. Financial Management Journal, 16(1), 5-14. Brennan, M. J. (1995). Corporate finance over the past 25 years. Financial Management. Financial Management Journal, 24(2), 9-22. Diamond, D. (1984). Financial intermediation and delegated monitoring. Review of Economic Studies, 51, 393-414. Business e-Bulletin Vol. 1, Issue 1, 2009, 1-5 5 Franklin, A., & Douglas, G. (2004). Financial intermediaries and markets. Econometric, 72(4), 1023-1061.

Jensen, M. C. (2001). Value maximization, stakeholders theory, and the corporate objective function. Journal of Applied Corporate Finance, 14(3), 8-21. Johnson, H. (1993). Financial institutions and markets: A global perspective. New York: McGraw-Hill. Jung, W. S. (1986). Financial development and economic growth: International evidence. Economic Development and Cultural Change, 34(2), 333-346. King, R. G., & Levine, R. (1993). Financial intermediation and economic development. In C. Mayer & X. Vives (Eds.), Capital markets and financial intermediation (pp. 156-189) London: Centre for Economic Policy Research. Merton, R. C. (1993). Operation and regulation in financial intermediation: A functional perspective. In P. England (Ed.), Operation and regulation of financial markets (pp. 1767). Stockholm: The Economic Council. AMINA ZAHRA SHEIKH OMAR MOHAMUD PhD Student (Islamic Finance and Banking) College of Business Universiti Utara Malaysia 06010 Sintok, Kedah