The financial system is an aggregation of markets and financial intermediates that allow the transfer of assets and risks between investors. We can “transfer” various instruments such as stocks, bonds, currencies, and derivatives.
Main Functions of a Financial System
A financial system has three main functions.
First, it facilitates six activities: save and borrow money, raise equity capital, manage risks, exchange assets, and trade on information.
Second, it determines the rate of return that equates to the amount of borrowing and saving in an economy.
Third, it allocates capital to its most efficient use.
Function #1: The Six Purposes
The first function of a financial system is to help the involved parties achieve six main purposes:
When we save money, we often choose to postpone our current consumption to have more cash in the future. The most common example is retirement planning. We save now and spend later. So, we do that by buying stocks, certificates of deposit, or bonds.
Obviously, these instruments provide a better return than simply keeping money under the mattress. In countries when the financial system works properly, such instruments can earn a fair rate of return. It compensates them for locking in their cash and risking their finances.
The second purpose of the financial structure is to facilitate borrowing. We borrow money when we need to spend more than we currently have. A good financial apparatus promotes borrowing and allows people and companies to quickly access capital at a low cost. What makes lenders willing to provide us with money? A reasonable interest rate that is consistent with the risk of the investment one takes.
Another method for acquiring capital is to issue equity, which happens to be the third function of a financial system. Unlike borrowing money, capital lenders receive company stocks rather than an interest rate on the capital. This process is facilitated by investment banks, such as Goldman Sachs and Deutsche Bank. Analysts determine the appropriate price of the equity, whereas regulators help with information dissemination.
When the financial system works properly, markets are liquid, and companies raise capital easily. Moreover, information about equity prices is accessible, and individuals can invest and divest their holdings effortlessly.
Governing financial risks is the fourth role of the financial system. By right, risk can be a multitude of things ― the default risk on a debt obligation, the risk of interest rate changes, or the unpredictability of commodities’ prices.
In a well-functioning financial system, companies could hedge their risks by buying different derivatives. This option makes it easier for firms to do business and eliminate most of the risks they face.
Moreover, the financial system allows us to exchange assets. For instance, Daimler makes up a large portion of its sales in the US, but its parts are mainly produced in Europe. The company can sell the earned US dollars on the cash market and cover its costs in Europe.
Lastly, the financial system enables trading based on information. Suppose that John is a trader who needs to monitor the market at all times. He has gathered enough data to assume that Tesla is currently overpriced, so he can sell the stock on the financial markets and earn an extra return if his prediction turns out to be true. This exemplifies the importance of Information-based trading. Besides, it allows market prices to remain somewhat close to their fair values.
Function #2: Determining the Rate of Return
Borrowing, saving, and issuing equity are all different ways to move money from one point in time to another. Sadly, time machines do not exist, so money can only travel forward in time if an equal amount flows from the present.
For example, the bond sold by a company that needs to move money from the future to the present is the same bond previously bought by a saver who needs to move money from the present to the future.
These transactions take place within the invisible borders of a financial system. As such, its function is to determine the return rate that makes the amount of savings equal to that of borrowing. A low rate identifies that borrowing is higher than saving. On the contrary, if the rate is too high, saving is higher than borrowing.
In practice, the interest rate at which the amount of money demanded is equal to the quantity of money supplied is known as the equilibrium interest rate. Historically, it is the price for moving money through time. This is one of the most important functions of the financial system!
The equilibrium interest rate is different for each security type and depends on its risk characteristics, terms, and liquidity. For example, equity is considered riskier than debt, that’s why investors require a higher rate of return.
Function #3: Capital Allocation
What we know from economics is that we need to allocate capital to its most productive use. This is the third main function of a financial structure.
Overall, companies might be willing to invest in many opportunities, but not all of them are worth funding. The main goal is to allocate the investor funds to the most efficient projects only. As long as financiers are well aware of the risk and return characteristics associated with each investment, money is in good hands and capital will be allocated in the best possible way.
The Bottom Line
The three main functions of a financial system are the brass tacks of each nation’s economic welfare. When the financial system works properly, transaction costs are low, analysts can easily value investments, and the limited amount of capital is put to its best use. Ultimately, the economy becomes more prosperous and its people wealthier.
So, which assets, and how much of each, should you include in your investment portfolio? Before becoming an active part of a financial system, you must study asset classifications and financial assets in more detail.