The Functions of a Financial System

Financial resources are scattered across the economy. This is the reason that there is a need for a financial system that can enable the timely deployment of these resources across different parts of the economy at the right time. A well-functioning financial system is supposed to perform several functions. Some of these functions have been mentioned in this article.

Function #1: Facilitating Payments

The transfer of goods and services can take place smoothly only if there is a mechanism in place to ensure that the payments reach in time. This function is carried out by the payments system. The payment system can be viewed as a subset of the financial system. It is composed of several institutions, such as banks, depository institutions, and private companies.

These institutions pool in their services to provide convenience to users. As a result, users can use different mechanisms like a check, credit cards, and even wire transfers to pay for goods and services.

The slow movement of money had been an impediment to trade and commerce for many years. However, now, with the advancement in technology, money can be transferred instantaneously to almost any part of the world.

From the consumer’s point of view, these services appear to be seamless. However, the reality is that for every swipe or check that is issued, a complex settlement process needs to be undertaken. This is why there are special institutions called clearing houses that undertake this process.

Function #2: Transfer of Resources

The cash flow which individuals and companies have sometimes may not match with the cash flow that they desire. For instance, a retired person may have a lump sum of money. However, they may be more interested in a periodic sum of money.

On the other hand, a company may want a significant sum of money upfront so that they can invest it in a project. In return, they may be willing to make a series of payments.

Both of these tasks are accomplished through the financial system. The financial system allows investors to transform their resources and access it during a point of time that is convenient for them.

Function #3: Risk Management

The derivatives market and the insurance market are an important part of the financial system. These markets have been created with the sole purpose of rationalizing the risk, which is an inevitable part of the life of individuals as well as businesses.

Using the financial system, individuals are able to pool in their resources and cover themselves in case any unforeseen event happens in their lives. In many countries, the government has created a social welfare system. This can also be seen as a system of insurance, which is a part of the larger financial system.

Function #4: Managing Information

The financial system provides important information, which is important for the well-being of the economy as a whole. One of the most important information provided by the markets is about prices. The price information is the basis on which all of the economic theory has been developed. It is the basis on which all economic decisions are made.

For instance, the law of demand as well as supply, both have a price as an important parameter. Hence, traders and other individuals use this information in order to decide the amount they will produce or buy. This means that the economy as a whole also rations its resources based on the price information. This mechanism is extremely important for the economy since it is this mechanism that enables maximum utilization of underlying resources and, therefore, maximum economic growth.

Other prices like interest rates, foreign exchange rates, and even stock prices are important indicators. Individuals can cater to their investment plan based on the information received from the financial system.

Function #5: Efficient Middleman

The financial system plays the role of an efficient middleman. This is because the financial system allows the savings to be diverted towards productive activities with the least amount of transaction costs.

The financial system consists of various systems that have been created, keeping in mind the needs of the specific markets.

For instance, banks and debt holders based system has been created to fund infrastructure projects which continue over the long term. At the same time, equity-based securities have been created for investors who want to participate directly in the business by taking the associated risks.

Function #6: Pooling of Resources

The financial system makes it possible for a group of investors to achieve what they could not have done individually. For instance, individual investors are limited by their knowledge when they start investing in stocks. However, when a group of investors gets together, the pool of funds becomes so large that they can afford to hire a team of specialists. This enables them to compete with the bigger funds on an equal footing.

The ability to pool resources and deploy them safely is the hallmark of any financial system. All major financial systems and services like banking, insurance, and even mutual funds are the result of the proper discharge of this function.

Therefore, it would be appropriate to say that financial systems perform a lot of functions that can be considered fundamental. If these functions are not discharged, the markets, as we know today would not exist.