INTRODUCTION TO FINANCIAL SYSTEMS
The Financial System
A financial system no matter how rudimentary is a complex system. It is complex in its operation such that neither the system itself nor its operation can be measured accurately. Because of this complexity a simple definition cannot adequately capture what a financial system is. A financial system comprises financial institutions, financial markets, financial instruments, rules, conventions, and norms that facilitate the flow of funds and other financial services within and outside the national economy.
The financial system can be described as a whole system of all institutions, individuals, markets and regulatory authorities that exist and interact in a given economy. The institutions, government and individuals form the participants in various markets; money markets (including foreign exchange) and capital markets (including security) markets. The participant buy (borrow) and sell (lend) money to different parties at a price (interest or dividend) within the market, which is determined by the forces of demand and supply.
In a broader aspect a financial system can also be defined as a system that allows the transfer of money between savers (and investors) and borrowers operating on a global, regional or firm specific level. According to Gurusam, it is a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and
transactions.
Financial systems are crucial to the allocation of resources in a modern economy. They channel household sav ings to the corporate sector and allocate investment funds among firms; they allow inter-temporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. Since these functions take place in a market oriented environment, there is a need for an independent party to enforce rules and contracts and this is the regulator. The main regulatory authorities of the financial institutions that constitute the financial system of a given economy are the Central Bank and Capital Market Authority.
THE ROLE OF FINANCIAL SYSTEM IN THE ECONOMY
The financial sector provides six major functions that are crucial for the survival and efficient operation of any given economy. These functions are outlined below:
1. Providing payment services.
It is inconvenient, inefficient, and risky to carry around enough cash to pay for purchased goods and services. Financial institutions provide an efficient alternative. The most obvious examples are personal and commercial checking and check-clearing and credit and debit card services; each are growing in importance, in the modern sectors at least, of even low-income countries.
2. Matching 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.
3. Generating and distributing information.
One of the most important functions of the financial system is to generate and distribute information. Stock and bond prices in the daily newspapers of developing countries are a familiar example; these prices represent the average judgment of thousands, if not millions, of investors, based on the information they have available about these and all other investments. Banks also collect information about the firms that borrow from them; the resulting information is one of the most important components of the capital of a bank although it is often unrecognized as such. In these regards, it has been said that financial markets represent the brain of the economic system.
4. Allocating credit efficiently .
Channeling investment funds to uses yielding the highest rate of return allows increases in specialization and the division of labor, which have been recognized since the time of Adam Smith as a key to the wealth of nations.
5. Pricing, pooling, and trading risks Insurance markets provide protection against risk, but so does the diversification possible in stock markets or in banks’ loan syndications.
6. Increasing asset liquidity.
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.
7. Financial systems and economic growth:
Both technological and financial innovations have driven modern economic growth. Both were necessary conditions for the Industrial Revolution as steam and water power required large investments facilitated by innovations in banking, finance, and insurance. Both are necessary for developing countries as they continue their struggle for economic development. But the effective functioning of the financial system requires, in turn, the precondition of macroeconomic stability.
The Five Parts of the Financial System
1.Money : A Good which is used as a means of payment for exchanging goods. This has not always been the case, we once used gold and silver coins as a means of paper.
2. Financial Instruments : A written legal obligations of one party to transfer something of value to another party at some future date under certain conditions. These obligations usually transfer resources from savers to investors. Examples: Stocks, bonds, insurance policies.
3. Financial Markets : Markets where financial instruments are traded. Examples: New York Stock Exchange, Chicago Board of Trade and Nairobi Stock exchange.
4. Financial Institutions : These entities prov ide services and allow agents access to financial instruments and markets. Examples: Banks, securities firms and insurance companies.
5. Regulators : Government entity which monitors the state of the economy and conducts monetary policy. Example: central Bank of Kenya.
