How does the Financial System operate?

What is financial system? At times in your life, you will be a saver, as when you put aside money for your children’s education or your retirement. At other times, you will be a borrower. You may borrow to buy a home or car or to build a factory to produce your great invention. The financial system channels funds from savers to borrowers and make it possible for both to achieve their objectives. When the financial system works efficiently, it increases the health of the economy: borrowers obtain funds for consumption and investment, and savers are rewarded with interest rate.

Financial MarketsThe financial system provides channels to transfer funds from individual and groups who have saved money to individuals and group who want to borrow money. Saver (refer to the lender) are suppliers of funds to borrowers in return with promises of repayment of even more funds in the future. Borrowers are demanders of funds for consumer durables, house, or business plant and equipment, promising to repay borrower funds based on their expectation of having higher incomes in the future. These promises are financial liabilities for the borrower-that is, both a source of funds and a claim against the borrower’s future income.

Funds

Funds

The figure above show that the financial system channels funds from savers to borrowers and channels returns back to savers, both directly and indirectly. The borrowers and the savers can be household, firms and government. Financial markets (stock market or bond market) issue claims on individual borrowers directly to savers. Financial institutions or intermediaries (banks, mutual funds, insurance company) acts as go-between by holding a portfolio of assets and issuing claims based on that portfolio to savers.

Key service provided by the financial system

-Risk Sharing

Financial system provides risk sharing by allowing savers to hold many assets. It also means financial system enables individuals to transfer risk. Financial markets can create instruments to transfer risk from savers to borrowers who do not like uncertainty in returns or payments to savers or investors who are willing to bear risk. The ability of the financial system to provide risk sharing makes savers more willing to buy borrowers’ IOUs. This willingness, in turn, increases borrowers’ ability to raise funds in the financial system.

-Liquidity

The second service that financial system provides for savers and borrowers is liquidity, which is the ease with which an asset can be exchanges for money to purchase other assets or exchanges for goods and services. Most of the savers view the liquidity as a benefit. If an individual need their assets for their own consumption and investment, they can just exchange it. Liquid assets allow an individual or firm to respond quickly to new opportunities or unexpected events. Bonds, stocks, or checking accounts are created by financial assets, which have more liquid than cars, machinery and real estate.

-Information

The third service of financial system is collection and communication of information .Or we can say that it is the facts about borrowers an expectations about returns on financial assets. The first informational role the financial system plays is to gather information. That includes finding out about prospective borrowers and what they will do with borrowed funds .Another problem that exists in most transactions is asymmetric information. This means that borrowers posses information about their opportunities or activities that they don’t disclose to lenders pr creditors and can take advantage of this information. The second informational role that financial system plays is communication of information. Financial markets do that job by incorporating information into the prices of stocks, bonds, and other financial assets. Savers and borrowers receive the benefits of information from the financial system by looking at asset returns. As long as financial market participants are informed, the information works its way into asset returns and prices.

Financial Market in the financial system

Financial markets bring savers and borrowers together directly. When an individual wan to buy the bond from Boomco stock for $100, the individual are investing $100 directly to the Boomco to finance its growth. In the financial world, this is call direct finance; an individual saver holds financial claims issued directly by an individual borrower. These direct finance arrangements take place through financial markets, markets allow the investor lend their savings directly to the borrowers.

The roles play by financial markets:

Matching Saver and Borrowers: Debt and Equity

Primary markets are those in which newly issued claims are sold to initial buyers by the borrower. Business use primary markets to raise funds for new ventures, and governments use them to finance budget deficits. Borrowers can raise funds in a primary financial market in two ways:

– By borrowing shares

– By selling shares

This will result in different types of claims on the borrower’s future income.

The most common claim is debt, which requires the borrower to repay the amount borrowed, the principal, plus a rental fee, or interest. The other type of claim is equity, which is an ownership claim to a share in the profits and assets of a firm.

Providing risk-sharing ,liquidity, and information services

Risk-sharing, liquidity, and information service are provided in secondary markets, markets in which claims that have already been issued are sold by one investor to another. Most of the news about events in financial markets concerns secondary markets rather than primary ones. Most primary markets transactions are sales of new debt or equity instruments to initial buyers and are conducted behind closed doors. Smoothly functioning secondary markets make it easier for investor to reduce their exposure to risk by holding a diversified portfolio of stocks, bonds, and other assets. Secondary markets also promote liquidity for stocks, bonds, foreign exchange, and other financial instruments so that it is easier for investor to sell the instruments for cash. This liquidity makes investors more willing to hold financial instruments, thereby making it easier for the issuing firm or government agency to sell the securities in the first place. At the end, secondary markets convey information to both savers and borrowers by determining the price of financial instruments.

Financial intermediaries in the financial system

The financial system also channels funds from savers to borrowers indirectly through intermediaries. These institutions facilitate trade by raising funds from savers and investing in the debt or equity claims of borrowers. This indirect form of finance is known as financial intermediation. Like financial markets, financial intermediaries have two tasks:

matching savers and borrowers

When an individual deposit his/her funds in checking account, the bank may lend the funds to the Mr.J to open a shop. In this intermediated transaction, the checking account is an asset and liabilities for the bank. The loan becomes Mr.J’s liabilities and the bank’s asset. Rather than holding a loan to Mr.J’s shop as an asset directly, the bank acts as a go-between. Financial intermediaries, such as banks, insurance companies, pension funds, and mutual funds, also make investments in stock and bonds on behalf of savers. Intermediaries pool the funds of many small savers to lend to many individual borrowers. The intermediaries pay interest to savers in exchange for the use of savers’ funds and earn a profit by lending money to borrowers and charging borrowers a higher rate of interest on the loans.

providing risk-sharing, liquidity, and information services

Intermediation adds an extra layer of complexity and cost to financial trade. The savers who want to have risk-sharing can choose financial intermediaries. Because banks have a large quantity of deposits and access to numerous borrowers and investment, they can diversify and provide risk-sharing service to everyone at a lower cost .Next, bank deposits and other intermediary claims are liquid. It means an individual can easily withdraw funds from the bank account. The third is financial intermediaries provide information services that are important to savers who may not have the time or resources to research investments on their own. Financial intermediaries are the largest group in the financial system. They move more funds between savers and borrowers than financial markets in U.S and most other countries. From the survey, most of the economists believe that intermediaries’ advantage in reducing information costs accounts for this pattern globally as well as nationally.

Competition and change in the financial system

-Financial Innovation

Which financial markets or institutions should savers or borrowers choose among the various? Of course they will base on the liquidity, risk-sharing, and information characteristics that are best suit for their needs. A saver who has a lower degree of risk might turn to financial markets that match savers with the low-risk borrowers. For example, the U.S. government or well-known corporations. A saver who does not want to do research on their diversified, he/she can choose turn to intermediaries like banks. Banks will specialize in reducing information costs and have an accumulated stock of information about borrowers. But this types of services offered by markets and intermediaries change over time.

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Financial innovation means that the changes in costs of providing risk-sharing, liquidity or information service or changes in demand for these services encourage financial markets and intermediaries to alter their operations and to offer new types of financial assets and liabilities. Financial innovation can benefit to everyone. Financial markets and institutions that have survived and thrived are those that combine low operation costs with high demand. The competitive balance among markets and institutions in the financial system can be altering by the shift in the cost of and demand for financial service.

-Changes in Financial Integration

Financial integration is the measurement for the system’s efficiency. We also can say it is the way in which financial markets are tied together geographically. Because of the high costs of gathering and communicating information, eastern capital to a large extent was used in the East; similarly, western or southern capital was used in the West or South. So, the interest been charged is different from each of the country, making the financing of a high-quality investment project more costly in the West the East. The increasing ease of communicating information has enabled U.S. financial markets to become much more integrated. Now borrowers who raise funds through securities have access to national markets.

-Changes in Globalization

A major development during recent decades has been the global integration of financial markets. Just as capital became more mobile among regions in the United States, moving capital between countries has become increasingly important since year 1970.The globalization of financial markets has two effects:

The easy flow of capital across national boundaries helps countries with productive opportunities to grow, even if their current resources are insufficient.

Increasing financial integration around the world reduces the cost of allocating savers ‘funds to the highest-valued uses, wherever they maybe. This is what the financial system supposed to do.