1. What is a financial system and what are its constituents? One way of knowing the economic development of a nation is by examining the financial system of the country. The more matured the financial system, the more developed is the economy. Such is the importance of the financial system, as it acts as a bridge between the surplus owners of funds and the people who are in need of funds. A financial system facilitates the movement of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various financial institutions (such as banks), markets (such as stock markets), regulatory bodies (such as RBI) and depositors (majorly common public). Financial Markets
Financial markets are the places where financial assets are created and/or transferred. Financial transactions involve creation of a financial asset, commonly known as financial instruments, and also transfer of the financial asset. Financial instrument is a claim to the payment of a sum of money in the future and /or periodic payment in the form of interest or dividend. Money Market- The money market is where low-risk, highly liquid, short-term instruments are created and traded. Funds are available in these markets for a single day up to a year. Main participants of this market are mostly government, banks and large financial institutions. Capital Market - The capital markets finance long-term investments. The instruments created here are high risk and high return instruments. The transactions taking place in this market will be for longer durations, typically more than 2 years. Forex Market - The Forex market deals with exchange of currencies, at a price (called as exchange rate) determined by the demand and supply of a particular currency. Depending on exchange rate, the transfer of funds takes place in this market. This is one of the most developed and integrated markets across the globe. Credit Market- In credit markets, all the participants of the financial system – banks, other financial institutions and non-banking financial companies – provide short, medium and long-term loans to corporate and individuals.
Constituents of a Financial System
2. What is the importance of financial system in an economy? The importance of the financial system in development of an economy is well documented. Banks along with other financial institutions play a key role in resource allocation, by transferring surplus funds from one section of the economy to the other. The transfer of funds will fuel the growth of the economy and in turn economic growth will result in availability of more funds, resulting in complex credit allocation in all sectors — primary, manufacturing and services. To meet the complexities, banks and financial institutions diversify and expand to meet the demands placed on them. Therefore, as economies grow, the financial sector gets more sophisticated and will become broader and deeper, reducing reliance on banks as other financial institutions develop to fulfill specific needs. Like every other sector, the financial sector also needs competition to drive down costs, increase efficiency and function to the best interests of the economy. As an efficient and competitive financial system lowers spread between deposit and lending rates, cost of capital reduces, the prerequisite for higher investments. Competition will also lead to better risk assessment (as efficiencies call for lower NPAs) and with that resources will reach the deserving, thus improving capital productivity of the economy. In addition, on one hand, competition reduces borrowing costs and on the other hand, a broad financial system diversifies financial risk within the economy. The central role played by the financial sector in the growth and stability of an economy calls for proper, effective and fool-proof regulation. Regulation of the banking system needs to be capitalised, so that the economy as a whole can avoid undue risk. All...
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