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What are the Components of Financial System?

Last updated date: 17th Jul 2024
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The financial system is all about taking money from someone who has ample of it and making it to reach those who have the best opportunities to utilise it. This way the economic resources are allocated most efficiently and best returns are ensured.  Economic transactions are done by various organisations like banks, pension funds, organised exchanges and insurance companies and many more. They are the financial institutions who use various financial instruments such as bonds, stocks, interests derived on deposits, credit to the borrowers etc. 

Objectives of the financial system 

The main objectives of this system are:

  • To create a structured payment system

  • To give money the time value as it deserves

  • To reduce risks and compensate for the same through offering products and services

  • To enable the most efficient economic resource allocation 

  • To maintain market stability in the economic sector

Components of the system

1. Financial Institutions

Here is where the borrowers meet the investors. The latter’s investment is utilised in various sectors via financial instruments and investing in the financial market. There are myriad service providers in this same field also who get involved in the process. They can be of any type, Regulatory, Intermediaries, non-intermediaries and Others. There are organisations which seek the assistance of these service providers every now and then and strategic ideas regarding the diversification or restructuring of the unit are provided. In this way, financial assets like loans, securities and other deposits are taken care of along with raising funds from the market. All sorts of services are thus reached to the service-users. 

2. Financial Markets

In financial markets, the exchange of financial assets is involved in terms of both the creation and transfer of the same. The difference here with a real transaction is that there is no direct money involved in the exchange process and instead of products or services, deposits, loans and other such financial assets are used for the transaction process. There are financial instruments involved in this. Here a claim of payment of money in the future is made and interest or dividend is paid on a periodic basis. The financial market again is composed of four units. 

a. Money Market

This refers to a wholesale market of debts involving financial instruments that are low-risk, short-term and highly-liquid. One can get funds for a day’s span up to a year’s. Banks, the government and other financial institutions regulate such a market. 

b. Capital Market

This is for investments of long-term nature, such as more than a year. 

c. Foreign Exchange Market

Exchange of currencies in a multicurrency facet is what foreign exchange markets are for. There is a particular exchange rate fixed depending on which the funds are transferred within the market. This particular market is the most developed one in the world. 

d. Credit Market 

In this market loans of medium or long-term tenure are given to the individuals or corporate companies by financial institutions, banks, Non-Bank Financial Institutions or NBFCs etc. 

3. Financial Instrument 

All securities and financial assets fall under the broad category of financial instruments. Various investors and credit seekers have the demand for various types of loans and deposits. Thus the securities are of various types too. A principal is settled which will be repaid by regular dividends or interests. Bonds, debentures and equity shares are a few financial instruments. 

4. Financial Services

These are derived from the Liability Management and Asset Management companies. These help in both acquiring and investing the money appropriately. Their assistance is sought for determining the financing combination. From borrowing to selling, purchasing to the lending of securities, making payments to regulating risk exposures- all are looked after by these service providers. The clients are myriad starting from mutual fund houses, acceptance houses, leasing companies to merchant bankers and portfolio managers. The services offered here are credit rating, book building, merchant banking, capital financing, depository services and mutual funds. 

5. Money 

This may be mentioned at the last but it is undoubtedly one of the most important components of the financial system. Money refers to anything that is used to pay for the products bought or services used and accepted by the seller too. Money acts as an exchange medium for repayment and a complete transaction process. Money holds the value of the product or service. The exchange process is eased out when money is utilised. 

Thus, the financial system is the common meeting place of the borrowers and lenders from where both can reap mutual benefits. Situations where capital crunch is higher (as in India), the proper action of financial institute can result in capital accumulation. At the end, the country finds economic development which is much desired.