Key Services of the Financial System
In this article, we will consider the key services provided by the banks, insurance companies, mutual funds, stockbrokers, and the other financial services firms that make up the financial system. The firms in this sector, which make different financial assets and financial liabilities more or less attractive to individual investors and borrowers, offer different services.
We can look briefly at each of these key services:
Effective Payment System:
One of the biggest services provided by the financial system is an effective payment system. Financial systems make is possible in any economy the usage and availability of money for its various purposes. The efficiency of any financial system is the ability of its institutions (banks, trust companies, credit unions, and so on) helping billions of exchanges to happen amongst millions of people participating in the financial system. The financial system helps the process of exchange by making it easier to exchange goods and services by enabling consumers to purchase goods and services using money that the system helps to provide and circulate.
Secondly, an effective payment system enables the usage of negotiable instruments like cheques or promissory notes. In an economy with only cash, all transactions have to be made in cash, which is not only burdensome but also risky. Financial institutions and a financial system overcome the problems and risks of dealing in cash. Cheques can be used to make many transactions, particularly larger ones, easier and safer.
Intermediary to Investors and Borrowers:
In addition to providing an effective payment system, the financial system acts as an intermediary, linking savers and borrowers and enabling purchasing power to be transferred from one group to another. Financial intermediaries facilitate this process by raising funds from depositors and lending the same funds to borrowers. Commercial banks play a key role in the financial system by taking in deposits from households and firms and investing most of those deposits, either by making loans to households and firms or by buying securities, such as government bonds or securitized loans.
Sharing of Economic & Financial Risk:
We know that the value of financial assets changes over a period based on a number of factors. Some factors could be interest earned or expanded, inflation, growth of the economy, price in the share market, demand and supply ratio, etc. Risk is the chance that the value of financial assets will change relative to your expectation or your current value. The financial system makes it possible for individual depositors and borrowers to share the risk.
Diversification:
Most individual investors want to have a steady return on their assets rather than erratic swings between high and low earnings. One way to improve the chances of a steady return is by holding a portfolio of assets. This helps in distributing the risk. For example, during any particular period one asset or set of assets may perform well and another not so well, and having a diversified portfolio, tends to average out the earnings. This splitting of wealth into many assets is known as diversification. The financial system provides risk-sharing by allowing investors to simultaneously invest in and hold many assets.
Liquidity:
The ability of the financial system to provide risk-sharing added with the capability to make investments repayable on demand makes investors more willing to buy stocks, bonds, and other financial assets. This willingness, in turn, increases the ability of borrowers to raise funds in the financial system. This generates liquidity on the systems. Liquidity is the ease with which an asset can be exchanged for money. Liquid assets can be quickly and easily exchanged for money, while less liquid or illiquid assets can be exchanged for money only after a delay or by incurring costs. During the past two decades, the financial system has increased the liquidity of many other assets besides stocks and bonds. The process of securitization has made it possible to buy and sell securities based on loans. As a result, mortgages and other loans have also become liquid assets that investors are holding today.
Financial Information:
The financial system also facilitates the collection and communication of information, or facts about borrowers and expectations of returns on financial assets. Financial intermediaries collect information on borrowers and perform their research to gain the ability to forecast the likelihood of borrowers repaying the loans advanced to them. Because these financial intermarries specializes in collecting and processing information, the costs for information gathering are lower and available to a pool of information users as many financial systems share the information with each other. Further, the financial markets convey information to both savers and borrowers by determining the prices of stocks, bonds, and other securities. The incorporation of available information into asset prices is an important feature of well-functioning financial markets.
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