When Elon Musk started Tesla, he needed financing to begin the production of EVs. Elon had to go to a bank and take a loan to do so. The bank's loan was made possible because individuals like you decided to deposit money in the bank. The same money that the bank decided to loan to Elon to bring electric vehicles to life. Is it right to say that we helped Elon create Tesla? Or is it better to say that the financial system enabled Tesla to happen?
Why don't you read on and find out the answer to that question? You'll learn all there is about the financial system and how it helps companies use your funds to expand while both of you profit from it.
Fig. 1 - Tesla Supercharger
Financial System Meaning
The financial system's meaning is based on the idea that sets of financial institutions make it possible for borrowers, lenders, and investors to exchange money with one another. The financial system provides borrowers with the funds necessary to finance initiatives, and it also provides investors with a return on their investments.
The financial system is a set of markets and financial institutions that enable funds to flow from lenders to borrowers.
Examples of financial institutions and markets that are part of the financial system include commercial banks, stock exchanges, investment banks, insurance companies, etc.
The financial markets are comprised of several participants, including borrowers, lenders, and investors who arrange loans to make investments.
Financial markets are markets where borrowers and lenders meet and exchange funds.
Money is often exchanged between borrowers and lenders for the promise of a return on the investment at some point in the future.
Additionally, derivative instruments, contracts whose outcomes are decided according to the performance of an underlying asset, are traded on the financial markets.
The financial system enables investors, lenders, and borrowers to exchange these funds and have a return on their investment in a secure matter.
The financial system has a unique regulated framework that allows funds to flow across financial institutions. The government makes the regulation of the financial system, and other relevant parties involved.
Financial System Functions
Financial system functions serve as an intermediary in allowing funds to be transferred from savers to borrowers. It is financial system functions that enable the surplus and deficit of funds to be allocated efficiently in the economy.
It is a well-functioning financial system that enabled Elon Musk to raise the necessary funds to create EV vehicles and contribute to reducing carbon emissions. All the bonds, stocks, and credit that are an instrumental part of the financial system provided Elon with the necessary means to produce EVs.
Financial system function includes stimulating higher savings and higher investment by providing an efficient environment where funds can be channeled from savers to borrowers. Financial system ensures that there is incentive from savers to save via providing a return on their savings. Additionally, the financial system allows borrowers to access funds they can borrow for investment.
Investment is crucial to economic growth and development as it provides more output and lowers the unemployment rate. Therefore, a well-functioning financial system is crucial in attaining sustained economic development over the long term.
Objectives of Financial System
The objectives of the financial system are to lower transaction costs, reduce risk, and provide liquidity as seen in Figure 2 below.
These are the three main problems that are faced by borrowers and lenders, which the financial system aims to regulate.
Transaction costs
Lowering the transaction cost is one of the main objectives of the financial system.
Transaction cost is the cost that is associated with carrying out a financial transaction.
An example of a transaction cost would be when a bank spends money and resources on a credit check for a business seeking a loan extension.
The objective of the financial system is to ensure that these transaction costs are reduced.
For example, the financial system sets up credit scores that different financial institutions accept. That way, banks do not need to spend a massive amount of resources and time checking a borrower's ability to pay, as it is reflected in the borrower's credit score.
Similarly, when a corporation wants to raise public money and use it to expand, borrowing money from each individual would be very costly. Think about the time and resources spent preparing a deal between the corporate and all investors who want to invest. Instead, the financial system enables the corporate to raise money by either borrowing from the bank or issuing bonds.
Reducing financial risk
Reducing financial risk is another objective of the financial system.
Financial risk is the future outcome associated with economic loss or benefit.
The future outcome of financial transactions in the financial system is not always certain. The uncertainty of the future, which includes the possibility of both losses and profits, gives rise to an issue known as financial risk, which is simply referred to as risk.
For instance, you might buy shares in a company for your future retirement plans. However, you didn't know that the company you invested in didn't disclose all the financial information. At some point, the company files for bankruptcy which causes you to lose your life savings.
To prevent such situations, the financial system ensures that each company discloses all information about its financial health. This reduces risks and provides a more sound financial system.
Another way the financial system reduces risk is by enabling individuals to diversify their portfolio of investments.
Diversification is an investment strategy that includes investing in several assets with uncorrelated risks.
An example of diversification would be buying stocks and, at the same time, buying gold. Stocks decrease in value when there is an economic recession. On the other hand, gold increases in value when there is an economic recession. This way, one would mitigate the risk of financial loss.
Providing liquidity
Providing liquidity is perhaps one of the most important objectives of the financial system.
Liquidity is the ability of an asset to be converted into cash.
When an asset is liquid, it can be turned into cash quickly. On the other hand, when an asset is illiquid, it is harder to turn it into cash. The financial system ensures that investors are provided with liquidity.
Imagine you put your savings with a bank that uses your savings to make a loan to an individual who wants to buy a house. However, you are unaware that the bank makes loans to individuals with a small likelihood of paying back the loan. As a result, the bank isn't capable of delivering your savings back.
The financial system makes sure that banks always keep a certain amount of deposits in their reserve to provide liquidity to depositors.
Financial System Components
The main financial system components include financial institutions, financial services, financial markets, and financial instruments.
- Financial institutions. Financial institutions play a significant role in bringing together lenders and borrowers. This is done by using various financial instruments and services, all of which contribute to an efficient financial system. The financial institution is one of the main components which ensure liquidity in the financial system through the development of credit and other liquid assets.
- Financial services. Financial services include credit rating agencies, mutual funds, pension funds, venture capital, and other institutions that are part of the financial system. Financial services are an important component of the financial system due to their specific tasks.
- Financial markets. A financial market is where both the creation of new financial assets and the trading of existing ones occur. Financial markets move funds from savers to borrowers much more efficiently and ensure that there is always liquidity.
- Financial instruments. Financial instruments are another main component of the financial system. Financial instruments are papers that entitle the buyer to future income from the seller. That's because there are different needs between investors and those looking for credit.
Financial System Importance
Financial system importance comes from its role in stimulating higher savings and investment expenditure, leading to higher economic growth. A well-functioning financial system is crucial in attaining sustained economic development over the long term. Additionally, it guarantees that expenditures on investments and savings are carried out effectively.
Financial systems contribute to the local and international economies' overall economic and financial stability. They serve as the foundation upon which economic transactions may occur and upon which monetary policy can be based.
Due to financial regulations, economic and financial institutions between parties involved in the financial system are safe and secure. The financial system ensures that companies disclose all relevant information about their current financial situation, which helps investors make better decisions.
The financial systems also guarantee that monetary policies can successfully assist in managing and mitigating risk and avert various issues, such as an economic slowdown or a rise in fiscal expenses.
This is becoming increasingly important as there are more financial technology businesses, more ways to connect, and stronger economic and commercial ties between countries. Financial systems help prevent problems by ensuring rules are followed across many industries and borders.
Financial System - Key takeaways
- The financial system is a set of markets and financial institutions that enable funds to flow from lenders to borrowers.
- Examples of financial institutions and markets that are part of the financial system include commercial banks, stock exchanges, investment banks, insurance companies, etc.
- The objectives of the financial system are to lower transaction costs, reduce risk, and provide liquidity.
- The main financial system components include financial institutions, financial services, financial markets, and financial instruments.
