The financial system

THE FINANCIAL SYSTEM AND ITS ROLE IN THE ECONOMY

BACHELOR OF COMMERCE LECTURE I

ARIEMBA JARED MOGAKA
SOUTH EASTERN UNIVERSITY COLLEGE
(A CONSTITUENT COLLEGE OF THE
UNIVERSITY OF NAIROBI)

jared.ariemba@gmail.com

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).


The financial system

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