Income Tax Filing for AY 2024-25 is now open. File early for quicker refunds. Start Now eFile now

Financial System

What is a financial system?

A financial system comprises various institutions, insurance companies, banks, and stock exchanges, that enable money transfers. Financial systems operate at different levels, such as firm, regional, and global. Borrowers, lenders, and investors use current funds to support projects for consumption or productive investments and to seek a return on their financial assets. The financial system also involves sets of rules and practices that borrowers and lenders follow to determine which projects get funded, who funds projects, and the terms of financial deals.

Explanation of Financial System

Economic resources are not enough to satisfy people's infinite needs. This is the problem of scarcity, which drives the economy to find a way out. How to allocate resources efficiently and fairly is a big challenge for any economy. To deal with this challenge, a financial system was developed to help the economy grow and benefit its participants. The financial system does this by:

  • Enabling payments (banks)

  • Rewarding savers with interest (investment institutions)

  • Protecting against financial risks (insurance)

  • Providing financial information (credit agencies)

  • Regulating the system to keep it stable (central banks and governments)

  • Ensuring liquidity and cash conversion (banks and financial institutions)

Financial institutions are the key players in the financial system, allowing people to save and invest their money as they wish. They take money from savers and give them interest, lending money to borrowers who use it to produce goods and services or fund other projects. This creates more economic activity, increasing jobs, profits, and economic contributions.

The funds can flow from the saver to the borrower in two ways:

  • Market-Based

  • Centrally Planned

In a market-based economy, savers, borrowers, and investors can exchange securities, such as stocks and bonds, in the financial markets. The price of these securities is determined by supply and demand. In a centrally planned economy, a central authority or planner decides how to invest the funds. Most economies have a mix of both types of systems.