What is a Financial System?
A financial system is a network of financial institutions – such as insurance companies, stock exchanges, and investment banks – that work together to exchange and transfer capital from one place to another. Through the financial system, investors receive capital to fund projects and receive a return on their investments.
- A financial system can be perceived on a company, regional, or global scale, which facilitates the practice of exchanging funds between one entity to another.
- It involves various players such as insurance companies, stock exchanges, investment banks, and more.
- Financial systems are regulated, as their processes influence and contribute to the growth of many assets.
Understanding Financial Systems
Financial markets involve various players, including borrowers, lenders, and investors that negotiate loans for investment purposes. The borrowers and lenders tend to trade money in exchange for a return on the investment at some future date. Derivative instruments are also traded in the financial markets as well, which are contracts that are determined based on an underlying asset’s performance.
When determining the guidelines of raising capital within a financial system, the project being funded and who funds them are decided upon by the planner, who can be a business manager. Thus, the financial system is typically organized through central planning, a market economy, or a combination of both.
A centrally planned economy is structured around a central authority, such as a government, which makes economic decisions regarding the manufacturing and distribution of products for a specific country. A market economy is when the pricing of goods and services is dictated by the aggregated decision of citizens and business owners, often resulting in the effects of supply and demand.
Financial markets operate within a government regulatory framework that filters the sort of transactions that can be conducted. Financial systems are heavily regulated due to their influence and facilitation capabilities to contribute to the growth of real assets.
Financial System Components
The financial system is composed of many components depending on the level. From a company’s perspective, its financial system includes procedures that follow its financial activities. It would include aspects such as finances, accounting, revenue, expenses, wages, and more.
From a regional standpoint, the financial system, as mentioned above, facilitates the exchange of funds between borrowers and lenders. Players on a regional level would include banks and other financial institutions such as clearinghouses.
On a global scale, the financial system includes the interactions between financial institutions, investors, central banks, government authorities, the World Bank, and more.
An example of one player within the financial system is the Bank of Canada (BoC). The BoC promotes economic and financial welfare for Canadians by cultivating a financial system whereby banks, credit unions, financial markets, and other factors interact to ensure the economic landscape continues to operate effectively for its citizens. The BoC achieves its objectives through the following:
- Providing central bank services such as liquidity and credit facilities: The Bank of Canada sources liquid funds to the financial system and is often known as the lender of last resort.
- Developing and implementing national policy: The federal government introduces legislation to implement a new retail payments framework. The BoC would oversee the service with operational and financial requirements, ensuring regulations are maintained.
- Oversees financial market infrastructures: The Canadian central bank conducts regulatory oversight and acts as the resolution authority for financial market infrastructures. They include payments systems and clearing and settlement systems.
List of Financial System Banks
- Public banks
- Commercial banks
- Central banks
- Cooperative banks
- State-managed cooperative banks
- State-managed land development banks
Non-Bank Financial Institutions
- Finance and loan companies
- Insurance companies
- Mutual funds
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: