Overview of Financial System

Money is an integral part of our life. Does Money mean Finance? No, finance means facilitating various sources of money. In our daily life, we come across various finance related terms like interest rates, avenues of investment, inflation, deficit and so on. How does this world of finance actually operate? What is the ecosystem of this financial world? Let us get ourselves apprised with basics on this system of Financial world.

What is financial system?

Financial system is basically the system within which the financial parameters are managed. They are the processes and procedures used by a firm’s management to exercise financial control and accountability. Thus analysing accounts, budgeting and planning,  managing project financing, monitoring funds, planning investments form the financial system of  an organisation. Companies maintain software applications that collate, process, transmit and report the data about the financial events and support financial planning within the organisation. Having a robust financial system in place enables the organisation in efficient decision making and effective management

At national level, financial system consists of financial markets, financial intermediation and financial instruments or financial products.

Role of financial System

The primary role of the financial system is to enable contact of economic agents having excess financial resources with those needing financial resources. This contact can be in direct mode ( Direct Finance) or via intermediaries ( Indirect Finance)

Financial markets are very important in financial system as they facilitate people to buy and sell financial securities, commodities, and other items of value at low transaction costs.

Financial Markets facilitate:-

  • Raising of capital (in the capital markets)
  • Transfer of risk (in the derivatives market)
  • Transfer of liquidity (in the money market)
  • International trade (in the currency markets)


Types of financial markets

The financial markets can be divided into different subtypes:

  • Capital markets which consist of
    • Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.
    • Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.
  • Commodity markets, which facilitate the trading of commodities.
  • Money markets, which provide short term debt financing and investment – The money market is a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions.
  • Derivatives markets, which provide instruments for the management of financial risk.  Futures markets, which provide standardized forward contracts for trading products at some future date.
  • Insurance markets, which facilitate the redistribution of various risks.
  • Foreign exchange markets, which facilitate the trading of foreign exchange – The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.

Capital market basically can be categorised into two markets- primary market and secondary market.   Newly issued securities are bought and sold in Primary markets via IPO. Secondary market provides easy platform for the existing shareholders to trade with their stocks.

Relationship between Lenders and Borrowers

Financial markets play an active role in arranging funds / capital for the borrowers as depicted below

Relationship between lenders and borrowers
Lenders Financial Intermediaries Financial Markets Borrowers
Individuals Companies Banks Insurance Companies Pension Funds Mutual Funds Interbank Stock Exchange Money Market Bond Market Foreign Exchange Individuals Companies Central Government Municipalities Public Corporations

Lenders represent the group who wants to lend their funds for any activity with an intention to earn further income on the same. It can be in the form of a deposit in bank, purchase of stock and other such avenues.

Financial intermediaries provide the investing avenues to the lenders and pay interest / dividend and such other income to the lender.Financial intermediation in the organized sector is conducted by a wide range of institutions functioning under the overall surveillance of the Reserve Bank of India, SEBI, IRDA. Some of the important intermediaries operating in the financial markets include; investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite dealers, self regulatory organizations, etc. Financial intermediaries provide advisory financial services on chargeable basis namely issue management, underwriting, merger and acquisition, capital restructuring, corporate counselling, stock broking and others.

Using the financial markets as a platform to contact the borrowers, the Financial intermediaries manage to channelize the funds collated from lenders.

Borrowers thus get an access to funds and can use the same for their needs. Examples of this are:

  • Individuals borrow money via bankers’ loans for short term needs or longer term mortgages to help finance a house purchase.
  • Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernisation or future business expansion.
  • Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalised industries, municipalities, local authorities and other public sector bodies.
  • Governments borrow by issuing bonds.
  • Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.
  • Borrower’s having same need can form them into a group of borrowers. It can also take an organizational form just like Mutual Fund. They can provide mortgage on weight basis. The main advantage is that it lowers their cost of borrowings.

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