Question

a) What are the basic functions of a financial system?

Why is financial system important for improving economic welfare and promoting economic growth?

Answer 1

Functions of Financial System

1. Mobilization of Savings: Savings are done by millions of people. But the amount saved is of no use unless they are deposited into financial assets, whether currency, bank deposits, life insurance policies, mutual funds, bonds or equity shares

2. Allocation of Savings: The amount of savings mobilized through millions of people will then be allocated among the needy sector. Direct lending by the general public has been made possible through corporate bonds and equities. Besides, there are banks, insurance companies, and other financial institutions.

3. Provide payment and settlement mechanism: Banks provide this mechanism by means of payment facility based upon cheques, promissory notes, credit and debit cards. The clearing and settlement mechanism of the stock market is done through depositories and clearing corporations.

4. Monitor Corporate Performance: A financial system not only helps in selecting the projects to be funded but also motivates various stakeholders of the financial system to monitor the performance of the investment. Financial markets and institutions help to monitor corporate performance and exert pressure on the corporates to continuously improve their performance.

5. Provide price-related information: Financial markets provide information which enables the investor to make informed decisions whether to buy, sell or hold a financial asset. This information dissemination facilitates the valuation of financial assets. Further, this process of valuation influences the market price of equity and debt instruments and guides the management as to whether their actions are consistent with the objective of wealth maximization of the shareholders.

6. A financial system provides a mechanism for the pooling of funds to invest in large scale enterprises.

Importance of Financial System for improving economic welfare and promoting economic growth:

1. The financial system is possibly the most important institutional and functional vehicle for economic transformation. Further, for mobilization of savings and their efficient, effective and equitable allocation for investment, it is the success with which the financial system performs its functions that sets the pace for achievement of economic growth and development of the nation.
2. Financial System enables Investment by business organizations to commence the production of goods and services.
3. The financial system leads to capital formation and savings.