An Overview of the Financial System

FINANCIAL SYSTEM DEFINITION

Inez the Inventor has created a low-priced machine that can clean the house, washes vehicles, and mows the grass, but  due to lack of cash, she was unable to put her brilliant robot into production. Walter the Widower has a sizable savings account that he and his wife have built up over the years. 

Inez's robot would see the light of day if Inez and Walter could work together to offer finances to Inez, and the economy would be better off, thus, we'd have cleaner houses, brighter vehicles, and more neat lawns. The basic function of financial markets, such as bond and stock markets, and financial intermediaries, such as banks, insurance companies, and pension funds, is to bring people together like Inez and Walter by moving funds from those who have a surplus of funds like Walter to those who have a shortage of funds, like our robot inventor Inez.

As any complicated system, The framework of the financial system comprises of divisions and markets that collaborate in a complicated way in order to generate scarce resource for investment and provide facilities, such as payment systems, for commercial activity funding. Deposit takers play a crucial role in the financial system. They represent the source of liquidity to the rest of the economy since they provide a convenient site for the placement and borrowing of required funds. They also provide payment services that are invested by all other businesses to run their operations. Deposit taker failures can thus negatively affect the activities of all other financial and nonfinancial firms, as well as on public trust in and functioning of the financial system as a whole.

Financial System Definition: There are hundreds of definitions of financial markets that can be found in literatures, in 2019, Prasanna Chandra defined the financial system as an entity comprising different institutions called financial markets handling instruments systematically related to provide different ways for transferring funds into instruments. Others defined it as a group of practices performed via the financial intermediaries to facilitate the exchange of funds between borrowers, investors and lenders. These financial intermediaries can take the form of banks, insurance companies, stock exchange corporations, and insurance companies. Hence, we can derive a general definition of Financial System, it is a global network comprising different intermediaries who work together to make good use of available funds not needed by one part to be invested by other part who are in need of it, in exchange for some interest agreed upon by both parties.

WHAT ARE THE COMPONENTS OF A FINANCIAL SYSTEM?

Among other intermediaries commercial banks and currency exchange firms are the most common financial institutions in the financial system. They all work upon certain terms specified by central bank and the regulatory laws set by the government. Hence, despite the common features, each financial system will sound unique at its own. They all share the same rules and practices applicable for both borrowers and lenders that help in determining the required financing project and the party who will provide the funds in the form of financing capital. In the following few lines we illustrate some of the commonly known components of a financial system:

•    Money: it is the cornerstone of all monetary systems. Money's consistency varies depending on changes in technology and financial institutions, but it most frequently refers to electronic funds. It can take the form of commodity money, coins, paper money, banknotes, and banking checks.
•     Financial Markets: are virtual markets where buyers and sellers engage to trade, buy, and sell assets such as shares and bonds. The New York Stock Exchange is one example of these markets. There are four types of financial markets, money market, derivative market, equity market and bonds market.
•      Financial Institutions: are financial organizations, such as banks, they offer a variety of products and services while also serving as a conduit between borrowers and investors. Mortgages, brokerage access, and insurance are among the services they provide. They assist in the direct or indirect mobilization of savings and the raising of capital for financial assets such as loans, securities, and deposits. They are largely involved in financial intermediation activities closely related to financial intermediation.
•    Financial instruments: Securities, stocks, bonds, insurance, and mortgages are common examples of financial instruments or assets that are exchanged on financial markets. Each credit seeker may have different needs, and trading stocks or securities may include mutual funds or pooling investors' savings.
•     Financial services: they include investment, insurance, and banking services, which are supplied by liability and asset management businesses. These solutions enable in the acquisition and efficient investment of funds.
•      Regulatory agencies: they take the form of regulatory authorities that monitor all market and institutional operations, and they frequently rely on government review processes to assure best practices. They are in charge of reviewing and enforcing system practices rules. To protect the public's funds and assets, they also supervise certain members of the system.
•     Central banks: they play a crucial role in government operations. These banks exist to assist in the financing, but not the control, of a country's available money and credit. The Federal Reserve of the United States is an example of a central bank.

IMPORTANCE OF FINANCIAL SYSTEMS

The main function of financial systems is to help to maintain economic and financial stability on a national and worldwide level. They set the stage for economic activities and the implementation of monetary policy. These regulations aid in the proper facilitation of investments and exchanges, allowing savings to be channeled into growth-oriented ventures. They also ensure that monetary policies are effective in managing and preventing a variety of issues, such as an economic slowdown or higher fiscal costs. With the rise of FinTech (Finance Technology) companies and increased communication, financial and trade linkages across countries, this is becoming increasingly vital. Financial systems aid in the prevention of problems by enacting policies that apply across industries and borders. In general, financial systems are important in different aspects:

·        Provisioning physical infrastructure, such as real-time gross settlement (RTGS) systems

·        Minimizing systemic risk by supplying the liquidity required to keep the financial system lubricated

·        Monitoring infrastructures such as the national pension system and financial markets to guarantee that they operate smoothly and efficiently

Understanding Money, Banking, and Financial Markets

 

WHY WE NEED TO UNDERSTAND BANKING, AND FINANCIAL MARKETS?

In August 2007, the United States witnessed a subprime financial crisis as a result of asset-price bubble following the housing market crisis. At the beginning, Financial institutions' holdings in mortgage-backed securities dropped. Eventually, the crisis raised the unemployment rates above predictions level, not just in the Unites States but encompassed Europe and the rest of world. A global recession occurred as a result of fraudulent activity of mortgage-backed securities brokers and the lack of transparency in most financial institutions. All over the world, governments were working on multibillion-dollar banks bailouts to rescue their economies. This brief introduction about one of the world historic financial crisis can give us a good beginning to understand why everyone, business student or layman, needs to understand money, banking and financial market nature.

According to the nightly news, we hear that The Bank of Brooklyn is hiking the bank rate by one third a percentage point, so a layman may wonder if this slight rise can affect the interest rate charged by a real-estate loan, and if this means a condominium price, for instance, can fluctuate or not. The answer expected by most people who do not belong to financial markets will be “definitely no”, how can a one third of a percentage point lead to prices rise, but in most scenarios, the answer can be “definitely YES”. Credit unions, chartered banks, insurance firms, trust and mortgage lending companies, mutual fund firms, and other institutions constitute what is known as Financial Market. To understand financial markets you need to figure out how these institutions work and under which protocols they operate their everyday tasks.

Financial markets institutions are financial foundations where funds are transferred from people who have excess, in the form of savings for instance, available to other people or entities who need these funds. These funds are transferred in different forms:

•    Bank deposits
•    Derivatives
•    Debt securities
•    Stocks
•    Hybrid securities

Using these types of securities, along with bank deposits, money can generate additional income to savers and solve solvency problems to investors. Money market institutions work as intermediaries between them. But you may wonder, what is security? What’s its job? And how it works?

WHAT ARE THE TYPES OF SECURITIES?

Known as financial instrument, a security is a claim on the borrower, known as the asset issuer, to the lender, known as underwriter. Both parties make benefit from securities based on the face value and the interest rate it bears. The issuer is supposed to pay the security face value in addition to interest rate at the maturity date. Maturity date refers to the date of repaying the full value of a certain security or financial instrument.

There are four commonly known types of securities;

•  Debt Securities: know as fixed-income securities, this type of money that has been borrowed and must be repaid based on determined terms that specify the amount borrowed, the interest rate, and the maturity date, debt securities are financial instruments that can be traded between parties, such as bonds or Certificates of Deposit “CDs”. Debt Securities implies that the holder makes regular interest payments in addition to return of the principle amount, as well as any other contractual rights that may be stipulated.
•  Equity Securities: through equity securities, shareholders' ownership interests in a corporation are represented, it's an investment in an organization's equity shares that allows you to become a shareholder. If a company files for bankruptcy, equity investors can only share the interest that remains after all debt security holders have been paid. Dividends are frequently distributed to shareholders, who share the produced earnings from fundamental business operations, however this is not the case for debt holders.
• Derivative Securities: are the type of financial instruments whose value is determined by a set of fundamental variables, such as assets, bonds, stocks, interest rates, market indices, currencies, and goods. Previously, derivatives main job was to ensure that goods sold abroad had balanced exchange rates. International traders by then required an accounting system that would allow them to lock in a set exchange rate for their various national currencies. Futures, forwards, options and swaps are the four common types of derivative securities.
• Hybrid Securities: As the name suggests, hybrid means a tool that combines characteristics of both equity and debt securities. They usually offer to pay a higher interest rate, either fixed or floating, for a set period of time, same scenario applied with bonds. Unlike a bond, however, the volume and timing of interest payments are not guaranteed.

WHY WE STUDY FINANCIAL INSTITUTIONS AND BANKING?

With various types of securities, financial institutions and terms used to govern both, financial system seem more complex, comprising many types of interest bearing equations, banking accounts and investing scenarios, in both private and public sectors. Regulated by governmental agencies, financial intermediaries extend available credit to one party using detailed legal documents. All mentioned elements of financial system comprise a coherent framework that analyzes the financial structure of financial markets all over the world.