Introduction
The financial system is a set of institutions, instruments and markets that provide a means to transfer budgetary resources from the saving sector to the spending sector the basic objective of the financial system is to ensure an efficient intermediation process between economic agents that want to borrow and those that are ready to lend, and to accomplish this, the system has to serve three main functions. The first one is to transfer funds from savers to borrowers whereas the second is to diversify financial risks and the third one is to facilitate exchange of financial assets as well as to promote financial stability.
Functions of Financial System
The financial system encompasses the process of providing available funds to households, corporations, and governments through intermediation activities. During the process, financial intermediaries and markets allocate available funds to their desired use. Financial intermediaries are legal entities that pool funds from savers and lend funds to borrowers with the help of financial instruments. The role of financial markets is to determine asset prices so that lenders and borrowers can adequately compare the return of their respective positions. This allows efficient allocation of resources and promotes sound economic decisions.
The primary goal of the financial system is to facilitate the efficient allocation of resources and this is done mainly by ensuring that: 1) funds flow from saving sectors to investment sectors; 2) financial risks are adequately diversified through the use of diverse financial instruments; and 3) financial assets are traded efficiently and at low cost. In order to achieve this goal, the financial system is typically composed of formal institutions such as banks, insurance companies, investment banks, and stock exchanges, as well as informal intermediaries such as mutual funds, hedge funds, and private equity funds.
The main function of the financial system is to connect the savers and the borrowers in the market. The savers, normally households and firms, provide the lenders with funds in return for a predetermined rate of return. On the other hand, the borrowers are owed to acquire funds they need to build plants, buy machines, or purchase other items. The borrower and the saver are connected through some intermediaries. The intermediaries offer the services and assistance to connect the two parties, and in turn, the intermediaries receive commissions for their services.
These intermediaries have evolved to serve various roles in the financial system. To start with, they are involved in the transfer of funds from the savers to the borrowers. They also facilitate the diversification of financial risks by pooling funds from different investors and directing them towards different investments. They also facilitate the trading of financial assets in order to promote a more efficient allocation of resources.
Role of Central Bank
Along with the financial markets and institutions, the central bank is a major component of the financial system. The role of the central bank is to provide monetary policy support to the central government in order to promote macroeconomic stability. It controls the supply of money in the economy through its ability to set the interest rate, control the level of reserve requirements, and engage in open market operations. The central bank can also act as a lender of last resort if a particular financial institution experiences liquidity problems. Finally, the central bank can act as an overseer of the financial system to ensure that the activities of the various financial markets and institutions comply with regulations and promote stability.
Conclusion
To sum up, the financial system is an organized set of financial markets and institutions that are aimed at promoting efficient and sound economic decisions by facilitating the transfer of funds from savers to borrowers and by reducing financial risk. The main components of the financial system include the financial markets and institutions, the central bank, and informal intermediaries such as mutual funds and hedge funds. The role of the central bank, in particular, is to provide monetary policy support to the government and promote a stable macroeconomic environment. By doing so, the financial system is fundamental to promote economic stability and efficiency.
