Introduction to Financial Markets and Institutions

There are certain types of financial markets and financial institutions that are found in almost every country in the world. For instance, most countries where economic activities take place have an established stock exchange and a banking system. Each of these institutions is different and hence perform different functions. However, together, these financial markets and institutions make up a financial system.

Financial systems all over the world are similar to some extent since all of them tend to have some common features. However, financial systems also tend to have unique features based on political, economic, and even cultural factors.

In this article, we will have a basic look at the fundamental features of the financial system.

What is a Financial System?

A financial system is a complex, interrelated arrangement of financial institutions and markets. In order to understand the system as a whole, we first need to understand its component parts. The financial systems across the world are generally known to have three components. These components are as follows:

  • Private financial institutions (banks, insurance companies, mutual funds, etc.)

  • Government regulatory agencies which overlook these institutions

  • The Central bank which decides the monetary policy and thereby impacts all institutions in the financial market

How the Financial System Works?

A wide variety of motives are at play in the financial system of any country. The three types of institutions mentioned above have very different incentives.

  • For instance, private financial institutions are driven purely by financial motives.

    Private Banks, insurance companies, and mutual funds collect money from people who have surplus money to invest. At the same time, they lend this money to industrialists who need money upfront in order to make investments.

    The profit motive makes banks and other financial institutions compete with each other in order to find a mechanism in which savings can be transferred to investors with the minimum transaction costs.

  • The financial system is the best example of Adam Smith’s invisible hand at work. In the pursuit of their individual profits, these financial institutions lead the entire economy towards growth and development. This transfer of funds from the idle to the industrious forms the backbone of any economy.

    Empirical data clearly indicates that countries with more advanced financial systems record better economic growth. Therefore, having a well-developed financial system is an indicator of a developed economy.

  • The regulatory agencies have a very different function as compared to private bodies. Their task is to ensure that private companies compete with each other in a fair and equitable manner.

    For instance, the regulatory body monitoring the stock market needs to ensure that it prevents insider trading. It is the job of the regulatory body to ensure that the information related to the company must become available to everyone at the same time. This ensures that no party has an information advantage over the other.

    If the regulatory agency fails to do so, the stock market will cease to function. For some time, a handful of people will make money at the expense of everybody else. Over a period of time, investors will simply lose faith in the market and stop investing.

    The job of regulatory agencies is to ensure fair play in the markets. Almost every major financial institution viz. banks, insurance companies, mutual funds, etc. require their own regulatory agency.

    However, it needs to be understood that excessive regulation is not always good. Excessive regulation means that a lot of rules have to be followed. As a result, compliance costs increase for companies. This makes them less competitive in the international market.

    Also, excessive regulation limits the flexibility of investors to run their company in the manner they want. Therefore, the amount of regulation has to be just right. It should only prevent unfair trades from happening.

    Once again, the empirical data is quite clear on the fact that any country which has been able to set up an effective regulatory mechanism has reaped dividends in the form of rapid economic growth.

  • Lastly, a special mention needs to be given to central banks. This is because, on the one hand, they perform the regulatory function, but on the other hand, they also decide the money supply of any country. This money supply is one of the factors which leads to economic cycles.

    Also, economic cycles like recession, depression, and boom phase affect the entire financial industry and even other industries. It is for this reason that the central bank is considered to be the most powerful monetary authority in any country.

    There is considerable debate about how this institution should be structured. Some countries prefer to keep this institution in private hands whereas there are other nations who have nationalized it. We have covered the structural design of the central bank in a separate article.

Therefore, it can be said that a financial system is formed with many different types of parties. These different types of parties have different needs. These different needs, as well as the contribution of the different parties to the overall financial system, have been summarized above.

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