Five Basic Functions of a Financial System

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.

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 imbalance in capital distribution or funds exists in every economic system. There are areas or people with surplus funds, while other places 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. Consequently, this system can affect a rise in the price of funds, thus adversely affecting the consumption, production, employment, and growth of the economy. Vice-versa, lowering the cost of credit can positively affect and enhance all the above factors. Clearly, a financial system impacts the bare 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, result in better goods and services and an increase in society's living standards. When savings flow declines, 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 is mainly 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 moreover, The financial markets provide the investor with the opportunity to liquidate their 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 charge in the economy; they also drastically reduce the cost and time 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. So, for example, the federal or 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. 

Conclusion:

Modern-day economies require vast sums of money to invest in capital assets (land, equipment, factory, etc.), which are then used to provide goods and services. The funds required are so huge that a single government/firm can't meet the requirement. However, by selling financial claims like stocks, bonds, etc., various investors can quickly raise the required funds. The business firm/government issuing such a monetary claim 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 the transformation of savings into investments so that production and revenue keep growing. 

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IndraStra Global: Five Basic Functions of a Financial System
Five Basic Functions of a Financial System
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.
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