Question

Answer the question below Please in 150 - 200 words atleast

1. Describe the main components of a Financial system?

Answer 1

What Is a Financial System?

• A financial system is the set of global, regional, or firm-specific institutions and practices used to facilitate the exchange of funds.
• Financial systems can be organized using market principles, central planning, or a hybrid of both.
• Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets.
• The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals.
• The global financial system is basically a broader regional system that encompasses all financial institutions, borrowers, and lenders within the global economy.
• The global financial system includes the International Monetary Fund, central banks, government treasuries and monetary authorities, the World Bank, and major private international banks.
• Financial systems are strictly regulated because they directly influence decisions over real assets, economic performance, and consumer protection.

Five Basic Components of Financial System

• Money
• Financial Instruments (Assets or Securities)
• Financial Markets
• Financial Services
• Financial Institutions

The Securities and Exchange Commission (SEC) in the United States financial system is a regulatory body that monitors the financial system, exchange, and securities market.

1) Money

Money is the start of the financial system and the means for making purchases. Money is used as a medium to buy goods & services. It also is a standard unit of measurement and acts as a store of value.  However, money may not be a good store of value since it loses value with inflation. As technology evolves, money is being defined by electronic transactions i.e. by swiping debit/credit cards, online account transfer.

2) Financial Instruments

Financial instruments are also known as securities. The products which are traded in a financial market are financial assets, securities or other type of financial instruments. There is a wide range of securities in the markets since the needs of investors and credit seekers are different.  Equity shares, debentures, bonds, etc are some examples.

Mutual funds pool the savings of a broad number of investors. By leveraging a high volume of buyers, more investors can purchase, trade and accumulate portfolios.

The financial instruments indicate a claim on the settlement of principal on maturity or payment of a regular amount by means of interest or dividend.

3) Financial Markets

Financial markets are trading houses that are dedicated to the purchase and sale of stocks and bonds, such as the New York Stock Exchange or the NASDAQ. Buyers and sellers gather at the market to determine buying and selling prices for securities, typically with assistance from a stockbroker. Markets continually fluctuate, resulting in inherent risks in the process. It can be broadly categorized into money markets and capital markets.

Money market handles short-term financial assets (less than a year) whereas capital markets consist of those financial assets that have maturity period of more than a year. The key functions are:

1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.

Most large corporations participate in the money markets, especially when they have more cash on hand than needed to run their businesses. By investing in money market securities, the company earned interest rather than leaving its funds in non -interest -bearing commercial bank checking accounts.

Corporations enter the capital markets to obtain long-term funds, either debt or equity. Many corporations are unable to generate enough funds internally to satisfy their needs, so they raise additional funds externally in the capital markets.

Capital market is again classified into primary & secondary markets. Primary markets handles new issue of securities in contrast secondary markets consist of securities that are presently available in the stock market.

An investor who purchases new securities is participating in a primary financial market. Net proceeds from the sale of new securities go directly to the issuing company.

An investor who resells existing securities is participating in a secondary financial market.

Secondary markets are well established in the United States, where stocks can be traded on the “floor” of a security exchange, such as the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE or AMEX) or in the over-the-counter market (OTC).

4) Financial Services

Financial services consist of services provided by Asset Management and Liability Management Companies. They help organizations to get the necessary funds and also make sure that they are efficiently deployed. They assist to determine the financing combination and extend their professional services upto the stage of servicing of lenders. They help with borrowing, selling and purchasing securities, lending and investing, making and allowing payments and settlements and taking care of risk exposures in financial markets. Examples of these type of companies are leasing companies, mutual fund houses, merchant bankers, portfolio managers, bill discounting and acceptance houses.

The financial services sector offers a number of professional services like credit rating, venture capital financing, mutual funds, merchant banking, depository services, etc. Financial institutions and financial markets help in the working of the financial system by means of financial instruments. To be able to carry out the jobs given, they need several services of financial nature. Therefore, Financial services are considered as the 4th major component of the financial system.

5) Financial Institutions

A variety of different financial intermediaries exists to facilitate the flow of funds between surplus spending units and deficit spending units. They mobilize the savings of investors either directly or indirectly via financial markets, by making use of different financial instruments as well as in the process using the services of numerous financial services providers.

They could be categorized into Regulatory, Intermediaries, Non-intermediaries and Others.

• Regulatory Agencies

Regulatory agencies were introduced by the governments to monitor the activities of financial institutions and markets. Through examination and enforcement of strict guidelines, regulatory agencies supervise members of the financial system to ensure the safety of the public's money and investments.

• Central Banks

Almost every country in the world has a central bank that is integral to each country's government. Central banks control the availability of money and credit. They are integral to the stability of the country's financial system as they oversee national currency and its value. The U.S. Federal Reserve is one of the most important central banks in the modern world.

• Commercial Banks

  Commercial banks accept both demand deposits (in the form of checking accounts) and time deposits (in the form of savings accounts and certificates of deposit). These funds are loaned to individuals, businesses, and governments. Commercial banks are an important source of short -term loans. Seasonal businesses, such as retailers, certain manufacturers, some food processors, and builders often require short-term financing to help them through peak periods.

  Many other types of businesses have a more or less continuing need for short -term financing and make prior arrangements with their banks to borrow on short notice. Banks are also a major source of term loans, which have initial maturities between 1 and 10 years and are usually repaid in installments over the life of the loan.

  The proceeds from term loans can be used to finance current assets, such as inventory or accounts receivable, and to finance the purchase of fixed plant facilities and equipment, as well as to repay other debts.

• Thrift Institutions

  They include savings and loan associations, mutual savings banks, and credit unions. These institutions accept both demand and time deposits. Savings and loan associations and mutual savings banks invest most of their funds in home mortgages, whereas credit unions are engaged primarily in consumer loans.

• Investment Companies

  Investment companies, such as mutual funds and real estate investment trusts (REITs), pool the funds of many savers and invest these funds in various types of assets. Mutual funds invest in specific financial assets such as debt and equity securities of corporations or money market instruments. Mutual funds attempt to achieve superior performance through diversificationof risk and professional investment management. REITs typically invest their pool of funds in real estate.

• Pension Funds

  Private pension funds pool the contributions of employees (and/or employers) and invest these funds in various types of financial assets, such as corporate securities, or real assets, such as real estate. Pension funds are often managed by bank trust departments and life insurance companies.

• Insurance Companies

  Insurance companies receive periodic or lump -sum premium payments from individuals or organizations in exchange for agreeing to make certain future contractual payments. Life insurance companies make payments to a beneficiary based on certain events, such as the death or disability of the insured party. Property and casualty insurance companies make payments when a financial loss occurs due to events such as fire, theft, accident, and illness. The premiums received are used to build reserves to pay future claims. These reserves are invested in various types of assets, such as corporate securities.

• Finance Companies

  Finance companies obtain funds by issuing their own debt securities and through loans from commercial banks. These funds are used to make loans to individuals and businesses. Some finance companies are formed to finance the sale of the parent company’s products. Some examples include General Motors Acceptance Corporation (GMAC) and Ford Motor Credit.