Meaning of Financial System

Meaning of Financial System

The economic expansion of any country depends upon the existence of a well-ordered financial system. It helps in the creation of wealth by linking savings with investment. The financial system is an organized and regulated structure where an exchange of funds takes place between the lender and the borrower. It supplies the necessary financial inputs for the production of goods and services, in turn, promotes the well-being and standard of living of people in the country.

Definition of the Financial System:

According to Prasanna Chandra: the financial system consisting of a variety of institution, markets, and the instruments which are related in a systematic manner and provide the principal means by which savings are transformed into instruments.

Significance of the Financial System:

1.    To attain economic development, financial systems are important since they induce people to save by offering attractive interest rates. These savings are then channelized by lending to various business concerns which are involved in production and distribution.

2.    It helps in monitor corporate performance

3.    It links savers and investors. This process is known as capital formation

4.    It helps in lowering the transaction cost and increase returns which will motivate people to save more

5.    It helps the government in deciding monetary policy

Constituents of the Financial System:

1.    Financial institutions:  

It is a corporation affianced in the business of dealing with financial and monetary matters such as deposits, loans, investments, and currency exchange. They are providing various services to economic development with the help of issuing financial instruments. They are further divided into banking institutions and non-banking institutions.

a)    Banking Institutions: They are the key part of economic development. They play a vital role in the field of savings and investment of money from the public and lending to business concerns. 

b)    Non-banking Institutions: They are the entities and the institutions that provide certain bank-like and financial services but do not have a banking license. E.g. IFCI, IDBI, LIC.

2.    Financial market:

It is a market which deals with various financial instruments such as shares, debentures, bonds, etc., and financial services such as merchant banking, underwriting, etc. They are further divided into 

a)    Capital market: Institutional arrangement for borrowing medium and long-term funds and which provides facility for marketing and trading of securities. E.g. shares, debentures, bonds, etc. They are then divided into:

  •  Primary market: Where securities are offered for the first time for receiving the public subscription.
  •  Secondary market: where pre-issued securities dealt between the investors.

b)    Money market: It is for short-term funds, which deals in financial assets whose period of maturity is up to 1 year. They are highly liquid and easily marketable. Eg treasury bill, commercial paper, etc

3.    Financial services:

These services are provided by the finance industry. They are usually customer-focused. They study the needs of the customer in detail before deciding their financial strategy, giving due regard to cost, liquidity, and maturity. Eg insurance company, credit rating facility, etc

4.    Financial instruments:

it is any contract that gives rise to a financial asset of one entity and financial liabilities or equity instruments to another entity. The various instruments are shares, debentures, bonds in the capital market and Treasury bill, commercial paper, certificate of deposit, repurchase agreement in the money market.

Capital marketMoney market
1.It is a market where lending and Borrowing take place for the medium and long term.1. It is a market where lending and borrowing take place for a short term up to 1 year.
2. They deal in equity, shares, debentures, bonds, preference shares2. They deal in treasury bills,  commercial bills, deposits, etc.
3. Capital markets are formal3. The money market is informal
4. Due to its less liquid nature and long Maturity, the risk is comparatively high4. Due to more liquid nature and maturity is less than 1 year, the risk Involved is low
5. The capital market fulfills the long term Credit needs of the business5.The money market fulfills short term credit needs of the business
6. It stabilizes the economy due to long  term savings6. It increases the liquidity of funds in the market
7. The returns are high because of higher Duration7. The returns are usually low


The money market is usually accessed alongside the capital market. This money market is termed as a good place to park funds that are needed in a shorter period. They provide a variety of functions for individuals, corporates, or government entities such as high liquidity. The company may want to invest funds overnight and look to the money market to accomplish or to cover operating expenses or working capital of any. Those individuals living on a fixed income often use the money market because of the safety associated with these types of investment.

The capital market is a widely followed market. Their daily movements are analyzed for the general economic conditions of the world markets. The institutions operating in the capital market access them to raise capital for long-term purposes such as for merger and acquisition or to expand the business or capital projects.

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