Five Basic Functions of a Financial System
IndraStra Open Journal Systems
IndraStra Global

Five Basic Functions of a Financial System

By Rose McReid
Associate Editor, IndraStra Global

B&E | Five Basic Functions of a Financial System

Image Attribute: Wall Street (2011), Alex Proimos. Creative Commons Attribution 2.0 Generic

The Financial system is one of the most important inventories of modern society. The phenomenon of imbalance in the distribution of capital or funds exists in every economic system. There are areas or people with surplus funds, while other areas or people are facing a deficit. A financial system functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. It is a composition of various institutions, markets, regulations and laws, practices, money managers, analysts, transactions, and claims & liabilities. 

The financial system helps determine both the cost and the volume of credit. This system can affect a rise in the cost of funds, thus adversely affecting the consumption, production, employment, and growth of the economy. Vice-versa, lowering the cost of credit can have a positive effect and enhance all the above factors. Clearly, a financial system has an impact on the basic existence of an economy and its citizens. 

1. The Savings Function:

As already stated, public savings find their way into the hands of those in production through the financial system. Financial claims are issued in the money and capital markets, which promise future income flows. The funds, in the hands of the producers, resulting in the production of better goods and services and an increase in society's living standards. When savings flow decline, however, the growth of investment and living standards begins to fall. 

2. Liquidity Function:

Money in the form of deposits offers the least risk of all financial instruments. But its value mostly eroded by inflation. That is why one always prefers to store funds in financial instruments like stocks, bonds, debentures, etc. However, in such investments (i) a greater level of risk is involved, (ii) and the degree of liquidity (i.e., conversion of the claims into money) is less. The financial markets provide the investor with the opportunity to liquidate the investments. 

3. Payment Function:

The financial systems offer a very convenient mode of payment for goods and services. The check system, credit card systems et al are the easiest methods of payment in the economy; they also drastically reduce the cost and rime of transactions.

4. Risk Function:

The financial markets provide protection against life, health, and income risks. These are accomplished through the sale of life, health, and property insurance policies. Overall, they provide immense opportunities for the investor to hedge himself/herself against or reduce the possible risk involved in various instruments. 

5. Policy Function:

Most governments intervene in the financial system to influence macroeconomic variables like interest rates or inflation. For example, the federal bank or a central bank does indulge in several cuts in CRR and try to force the interest rates down and increase the availability of credit-at cheaper rates to the corporates. 


Modern-day economies require huge sums of money for investment in capital assets (land, types of equipment, factory, etc.), which are then used for providing goods and services. The funds required are so huge that it's not possible for a single government/firm to meet the requirement. By selling financial claims like stocks, bonds, etc., the required funds can be quickly raised from a variety of investors. The business firm/government issuing such a financial claim then hopes to return the borrowed funds from expected future inflows. Indeed, we see that the financial markets within the financial system have made possible the exchange of current income for future income and transformation of savings into investments so that production and income keep growing.