The financial system

ARIEMBA JARED MOGAKASOUTH EASTERN UNIVERSITY COLLEGE

(A CONSTITUENT COLLEGE OF THE UNIVERSITY OF NAIROBI)

ARIEMBA J. MOGAKA, South Eastern University College

THE FINANCIAL SYSTEM AND ITS ROLE IN THE ECONOMY

BACHELOR OF COMMERCE LECTURE I


The Financial System

A financial system is the connected universe of financial instruments, financial institutions, and financial markets operating in a given place at a given time, that is, it is the financial superstructure of the economy.


The financial system consists of all financial intermediaries and financial markets and their relations with respect to the flow of funds to and from households, governments, business firms, and foreigners, as well as the financial infrastructure.


The financial system is the totality of the players that facilitate the flow of funds from and to different players in the economy.

Therefore, those with excess funds are able to find a mechanism within the financial system to channel their funds to those in deficit.


Therefore, the financial system allocates funds from surplus economic units to deficient economic units within the economy.

In playing the above allocation function, the financial sector is able to reduce information and transaction costs, and facilitate the trading, diversification, and management of risk.


Constituents of the financial system

A financial system consists of banks, insurance companies, mutual funds and other institutions such as, non-bank financial institutions, which promote and mobilise savings and make the same available to actual investors.


The financial institutions are the intermediaries between the surplus economic units and the deficit economic units: they mobilize savings from surplus units and provide credit to the deficit units.

The financial instituions generate financial instruments which are then traded in the financial markets. The financial markets therefore provide a platform for the trading of the instruments.


The markets can be classified as either money markets or capital markets.

The money markets deal with instruments of a short-term maturity period while capital markets mobilize savings into instruments of a long term maturity period.


The markets can also be either primary or secondary. Primary markets provide an avenue for listing of new securities hence mobilizing more savings while secondary markets provide a forum for the trading of the already listed securities hence promoting the liquidity of the securities.


The financial securities are traded within the financial markets.

Primary securities are issued to the ultimate savers by the ultimate investors for example ordinary shares and debentures. Secondary securities are issued to the ultimate savers as bank deposits, unit trusts, insurance policies etc.


The actual investors can be individual investors, industrial and trading companies and the government.

It also includes other institutions, which actually act as alternative channels for investment of savings rather than promoters of savings. For instance, the new issue market and the stock exchanges which facilitate the buying and selling of shares and debentures of various companies.


The various regulatory agencies are a critical component of the financial system. They help promote financial stability and protect interests of consumers of financial services.

The regulators also give direction to the financial sector by ensuring it is aligned to the needs of the economy.


Role of the Financial System

Financial systems play an important role in allocating scarce resources.

They channel individual or household savings to the corporate sector, and allocate investment funds among companies.

When companies make profits, the systems also help funnel some of the returns back to the individual savers.


Such a process will be very complex, highly inefficient, very expensive or practically impossible without a well developed financial system.

Therefore, the main task of the financial system is to channel funds from sectors that have a surplus to sectors that have a shortage of funds.


In doing so, the financial institutions performs two main functions, namely, reducing information and transaction costs, and facilitating the trading, diversification, and management of risk.

Financial markets release information to aid the price-discovery process. They also provide a platform to trade and the relevant infrastructure to settle trades.


Individual entrepreneurs rarely have enough of their own capital to undertake investments themselves.

Individual savers, without pooling their money, would not be able to take advantage of the potential increasing returns to scale of their investments, and would face a large degree of risk with little liquidity.


The financial system – including banks and other financial intermediaries, equity markets, and debt markets – solves these problems by agglomerating capital from many smaller savers, allocating capital to the most important uses, and monitoring to ensure that it is being used well.


Therefore, the financial system matches savers and investors.

Although many people save, such as for retirement, and many have investment projects, such as building a factory or expanding the inventory carried by a family micro enterprise, it would be only by the wildest of coincidences that each investor saved exactly as much as needed to finance a given project.


Therefore, it is important that savers and investors somehow meet and agree on terms for loans or other forms of finance.

This can occur without financial institutions; even in highly developed markets, many new entrepreneurs obtain a significant fraction of their initial funds from family and friends.


However, the presence of banks, and later venture capitalists or stock markets, can greatly facilitate matching in an efficient manner.

Small savers simply deposit their savings and let the bank decide where to invest them.


Financial systems increase the liquidity of assets. Some investments are very long-lived; in some cases - a hydroelectric plant, for example - such investments may last a century or more.

Sooner or later, investors in such plants are likely to want to sell them.

In some cases, it can be quite difficult to find a buyer at the time one wishes to sell - at retirement, for instance. Financial development increases liquidity by making it easier to sell, for example, on the stock market or to a syndicate of banks or insurance companies.


The financial systems help in allocating credit efficiently. Channeling investment funds to uses yielding the highest rate of return.

Well-functioning financial systems do a very good job of selecting the most productive recipients for these resources and ensuring that they are using them in high return activities.

In contrast, poorly functioning financial systems often allocate capital in low-productivity investments. The differences in terms of growth and total factor productivity can be enormous.


One of the most important functions of the financial system is to share risk and it is often argued that financial markets are well suited to achieve this aim.This is two-pronged:

Insurance markets provide protection against risk; infact, this is the core mandate of the insurance industrty.

Also, the financial markest allow for diversification possible in stock markets or in banks' loan syndications. All these help in risk management.


Another seemingly obvious but very important role is that financial systems generate and distribue alot of information. The acquisition and use of information to allocate resources efficiently is one of the most important functions of a financial system.


In market-based systems, the large number of publicly listed firms, together with extensive disclosure requirements, means that a great deal of information about firms’ activities is released.


Financial Intermediation

Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.

Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.

As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).


Documents

The financial system