Financial System

A collection of entities that allow money to be exchanged.

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Last Updated:September 22, 2023

What Is A Financial System?

A financial system is a collection of entities that allow money to be exchanged, such as banks, insurance firms, and stock exchanges. It exists on firm, regional, and global scale.

Borrowers, lenders, and investors exchange current monies to fund projects for consumption or productive investment and earn a profit on their financial holdings. 

The FIN SYS also contains a set of rules and practices that borrowers and lenders use to determine which projects are funded, who finances initiatives, and the terms of financial transactions.

Borrowers, lenders, and investors participate in financial markets, negotiating loans for investment reasons. Borrowers and lenders frequently exchange money for a future return on investment

Derivative instruments, contracts dependent on an underlying asset's performance, are traded in the financial markets.

  • A Fin Sys is a collection of global, regional, or firm-specific institutions and practices that help people trade money.
  • Market principles, central planning, or a combination of both can be used to organize Fin Sys.
  • Banks, stock exchanges, and government treasuries are all part of a financial system's institutions.

Understanding financial system

Like any other industry, it can be organized via markets, central planning, or a combination of both. Borrowers, lenders, and investors negotiate loans and other transactions in financial markets. 

The economic goods sold on both sides in these marketplaces are usually money in some form:

  • Present money (cash)
  • Claims on future money (credit)
  • Claims on the future earning potential or value of tangible assets (equity) 

Derivative instruments are also included. Financial instruments based on the performance of an underlying real or financial asset, such as commodities futures or stock options, are known as derivatives. 

According to supply and demand laws, these are all traded in financial markets between borrowers, lenders, and investors.

In a centrally planned Fin Sys (e.g., a single firm or a command economy), the financing of consumption and investment plans is set directly by management or a central planner rather than by counterparties in a transaction. 

The planner, whether a company manager or a party leader, determines which initiatives receive funding, which projects receive cash, and who funds them.

Both give-and-take marketplaces and top-down central planning are present in most Fin Sys. In terms of internal financial decisions, a business firm is a centrally organized Fin Sys.

However, it often functions within a broader market, interacting with external lenders and investors to carry out its long-term ambitions.

At the same time, all modern financial markets are governed by some form of government regulation that limits the types of permitted transactions.

Because they directly impact decisions about tangible assets, economic performance, and consumer protection, they are frequently heavily regulated.

Why Are Financial Systems Important?

It's purpose is to act as a middleman between savings and investors, providing transparent and accurate information on risks and expected returns so that risk-adjusted returns can be maximized and the economy and savers can thrive.

Banks, non-bank lenders, securities markets, pension, mutual, and other investment funds, insurers, and market infrastructures, including central clearing counterparty, payment providers, and central banks, as well as regulatory and supervisory authorities, make up a country's Fin Sys. 

These organizations and markets provide a framework for conducting economic transactions and implementing monetary policy, as well as assisting in channeling savings into investment, thus promoting economic growth.

These faults disrupt financial intermediation and can stifle monetary policy effectiveness, amplify economic downturns, create capital flight and exchange rate pressures, and result in significant government spending on bailing out bankrupt financial firms.

Furthermore, as financial institutions become more connected, fintech companies arise, and economic and trade linkages between countries get tighter, financial shocks in one jurisdiction can quickly spread across financial sectors and national borders. 

As a result, local and international economic and financial stability requires solid financial institutions that are adequately regulated and controlled. 

In addition, recent IMF research has found essential connections between financial stability, financial depth, financial inclusion, and the importance of gender and racial equality.

Financial Market Components

At various levels, it is made up of multiple components.

1. Financial Institutions

Financial institutions help the Fin Sys run smoothly by bringing investors and borrowers together. 

They use financial markets to mobilize investors' savings, either directly or indirectly, by employing various financial instruments and utilizing the services of a variety of financial service providers.

Regulatory, Intermediaries, Non-intermediaries, and Others are the several types of intermediaries. 

They provide consulting services to businesses seeking advice on various issues, from restructuring to diversification initiatives. 

They provide a comprehensive range of services to companies seeking to raise cash from the markets and manage financial assets such as deposits, securities, and loans.

2. Financial Markets

The place where financial assets are created or transferred is the financial market. It can be divided into two types: money markets and capital markets. 

Money markets handle short-term financial assets (less than a year). In contrast, long-term financial assets (more than a year) are governed by capital markets.

3. Financial Instruments (Assets or Securities)

This is a crucial part of the Fin Sys. Financial assets, securities, and other types of financial instruments are among the things exchanged in a financial market. 

Because the needs of investors and credit seekers vary, the markets offer a diverse choice of securities. 

They denote a claim on future principal repayment or payment of a regular sum in the form of interest or dividends. Examples include equity shares, debentures, bonds, and other financial instruments.

4. Financial Services

Asset Management and Liability Management Companies are two types of financial services providers. They assist in obtaining actual money and ensuring that they are used effectively. 

They aid in determining the financing combination and provide expert services up to the point of lender servicing. 

They assist with financial market borrowing, selling and purchasing securities, lending and investing, making and permitting payments and settlements, and managing risk exposures. 

Leasing firms, mutual fund houses, merchant bankers, portfolio managers, bill discounting, and acceptance houses are a few examples.

Credit rating, venture capital funding, mutual funds, merchant banking, depository services, book building, and other professional services are available in the financial services sector. 

Financial institutions and financial markets use financial instruments to assist in the operation of the Fin Sys. 

They require various financial services to do the tasks assigned to them. As a result, financial services are regarded as the financial system's fourth major component.

5. Money

Money is anything accepted as payment for goods and services or as a means of debt repayment. It functions as a medium of exchange and a store of value.

The Fin Sys of a corporation is a set of procedures that track the organization's financial activity. The Fin Sys comprises all areas of financial management inside a company, including accounting measures, revenue and spending plans, wages, and balance sheet verification.

It is the framework that allows lenders and borrowers to trade funds on a regional scale. Banks and other financial institutions, such as securities exchanges and financial clearinghouses, are part of the regional fin sys.

The global financial system is a more extensive geographical system that includes all financial institutions, borrowers, and lenders worldwide. 

Fin Sys encompasses the International Monetary Fund, central banks, government treasuries, and monetary authority on a worldwide scale.

The IMF's Contribution to Financial System Stability

Through ongoing bilateral and multilateral surveillance, the design of its lending programs, and the provision of technical support, the IMF promotes financial system soundness in member nations.

The IMF must give regular communication and policy guidance to all its members under bilateral surveillance. This is referred to as an Article IV consultation, which includes macroeconomic and financial events and policies in many countries. 

There are continuous efforts to improve the coverage of macro-financial concerns in Article IV consultations, such as spillovers to and from the financial sector and other sectors of the economy and systemic risk in the financial industry.

Another vehicle is the Financial Sector Assessment Program (FSAP), established in 1999. It provides member nations with a comprehensive assessment of their Fin sys.

The FSAP was first implemented voluntarily. Still, it became a requirement for 25 countries with systemically important financial sectors as part of the Article IV consultation. In 2013, the list was enlarged to include 29 countries. 

The FSAP's in-depth study complements the Article IV consultations' frequent macro-financial oversight. 

FSAPs increasingly provide a systematic study of cross-border risks and spillovers, encouraging more consistency in regulatory change and macroprudential policy implementation.

A multi-country or global perspective is introduced via multilateral surveillance. Many pertinent concerns straddle numerous jurisdictions as economies and financial systems become more linked, and spillovers from one country or fin sys to another are common.

The Fund aims to uncover underlying risks connected to such links and promote policies that maintain orderly global financial conditions through its multilateral activities.

The IMF's Global Financial Stability Report examines significant financial market developments and risks to detect systemic weaknesses from a multilateral viewpoint. 

The IMF's Spillover Notes contain thorough IMF studies on these effects and serve as the foundation for the World Economic Outlook's particular chapter on spillovers. 

The IMF's semiannual Early Warning Exercise was conducted in collaboration with the Financial Stability Board. 

And regional financial sector surveillance projects covering Central America, the West African Economic and Monetary Union, the Central African Economic and Monetary Community, the Eastern Caribbean Currency Union, and the European Union are other examples of multilateral surveillance.

The IMF has made effective financial surveillance at the bilateral and multilateral levels a top strategic goal.

Following the 2014 Triennial Surveillance Review, IMF staff made a concerted effort to mainstream macro-financial surveillance, integrate and deepen risk and spillover analyses, and improve the coverage and integration of macro-financial problems in Article IV consultations.

The IMF-supported projects frequently include measures to enhance member nations' financial systems. 

The IMF assists members in identifying and diagnosing financial system problems, developing strategies for systemic reforms and bank restructuring, and ensuring that these initiatives are consistent with and supported by appropriate macroeconomic and other structural policies.

  • Technical support assists member nations in implementing specific reforms that help them develop and strengthen their Fin Sys. 
  • Training and advice on monetary and macroprudential policy frameworks, debt management, foreign exchange and capital market development, payment system design, and deposit insurance arrangements;
  • Regulatory and supervisory frameworks governing financial institution activities and crisis preparedness, crisis management, bank resolution, and central bank governance and transparency are examples of such assistance.

The IMF has also defined and promoted a set of critical Financial Soundness Indicators, which are crucial in analyzing financial system strengths and weaknesses. 

The IMF backs countries' efforts to collect and disseminate such data. Through its Financial Access Survey, the Fund also contributes to a more significant effort to collect data on financial inclusion.

Financial System Example

The Bank of Canada is one example of a financial system player (BoC). 

The Bank of Canada promotes economic and financial well-being for Canadians by cultivating a fin sys in which banks, credit unions, financial markets, and other factors interact to ensure the economy continues to function effectively for its citizens.

The BoC achieves its goals by doing the following:

  • The Bank of Canada provides central bank services such as liquidity and credit facilities to the fin sys. It is often referred to as the lender of last resort.
  • National policy development and implementation: The federal government introduces legislation to implement a new retail payments framework. 

The Board of Directors would oversee the service's operational and financial requirements, ensuring that regulations are followed.

  • Oversees financial market infrastructures: The Canadian central bank acts as the resolution authority for financial market infrastructures and conducts regulatory oversight. They consist of payment systems as well as clearing and settlement systems.

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Researched and authored by Ruxue Bai | LinkedIn

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