Elements of a Financial System
The elements of a financial system make up several key parts of an economy. A financial system involves all of the businesses, regulations and systems that handle money in that economy. These businesses work together, along with people, as a system to keep money flowing through an economy. While financial systems may seem complicated, the elements of financial systems are regular parts of everyday life that, when working well, combine to create and facilitate large-scale economic impacts.
What Is a Financial System?
Financial systems are made up of different financial institutions working together or within the same economy. Any type of business that’s involved in financial transactions is a financial institution. Stock exchanges are one type of financial institution and play a major role in most financial systems. Banks, mortgage lenders and insurance companies are also common financial institutions.
A financial system also includes the markets through which financial institutions move money. A third component of a financial system is the regulations, either set by the government or by the financial organizations, that control how money can move from one institution to the next. The financial system is responsible for handling all of the financial service needs of people and businesses that exist and operate within an economy.
What Are the Elements of a Financial System?
The six elements of a financial system are lenders and borrowers, financial intermediaries, financial instruments, financial markets, money creation and price discovery. These financial-system components keep money flowing between people and businesses in an organized manner. Here’s what each is and how it functions.
Lenders and Borrowers
Lenders loan money to borrowers. Although people can be lenders on a private basis, lenders in a financial system are typically financial institutions. Mortgage lenders, banks and credit unions are some of the most common types of lenders. Credit cards are also forms of loans, making credit card companies a type of lender.
A borrower is any person or entity that takes out a loan. A homebuyer often finances the purchase of their home through a mortgage loan, making them a borrower. Businesses also take out loans from financial institutions. The processes of lending and borrowing help keep money flowing through a financial system because they allow people and entities to make purchases that they could not afford otherwise.
One characteristic of a good financial system is regulation surrounding lending. Loans have interest rates and other additional fees that require a borrower to pay back more than the original amount, called the principal, that they borrowed. If borrowers get loans without understanding the full cost, they may not be able to pay the money back. Financial institutions could run out of money if a large number of borrowers were unable to pay back their loans. That’s why there are regulations surrounding criteria for getting loans and the amount of interest and other fees a lender can charge a borrower. These regulations protect both the borrower and lender, and they keep money moving throughout the financial system.
Financial intermediaries act in between two financial institutions to make the entire financial system more stable. Think of a financial intermediary as a "middle man." Financial intermediaries rarely own the money they hold. Rather, these businesses and organizations move funds from one part of the financial system to the next.
Financial intermediaries balance out financial systems because they move money from areas that have too much to areas that don’t have enough. Banks are one example of a financial intermediary. Suppose a business needs a $1 million loan. The bank can offer that loan by combining the funds of 10,000 people who have $100 deposited in their bank accounts. Those 10,000 people won’t be missing their $100 because the bank has more money, from other depositors, available.
A financial instrument is a contract for trading a financial asset. Financial instruments are an important part of a financial system because they allow wealth to keep moving throughout the system. Checks, bonds, certificates of deposit, stock trades and stock options contracts are all examples of financial instruments.
A financial market is any marketplace, physical or virtual, where financial instruments can be traded between people and financial institutions. The stock market is a financial market. Other examples of financial markets include the real estate market, the bonds market, the commodities market and the foreign exchanges market.
Financial systems rely on money circulating throughout them. A government may introduce new money to the market by printing it. In the United States, the Federal Reserve makes decisions regarding the creation of money. Sometimes, money is given to banks virtually rather than being physically printed.
Different financial systems may have different forms of money creation, but there must be an adequate amount of money circulating to keep the system going. In regards to cryptocurrency, money creation happens when a new type of currency is created. In terms of the stock market, money creation happens when a company makes more shares available for the public to purchase.
Price discovery is the process of setting a price for goods, services or even financial instruments. Price discovery is based on a variety of factors, such as supply and demand. If more people want something, its price rises. If there’s a limited supply of a certain good, its price rises. Items that are unwanted or plentiful often have cheaper prices.
Although it may not always seem this way to consumers, price discovery is a collaborative effort between buyers and sellers. Sellers must price their goods in order to make a profit, and buyers must be willing to pay that price.
Characteristics of a Good Financial System
Good financial systems have financial markets that are large enough to support as many investors as are willing to take part in the market. Financial instruments in a good financial system have liquidity. In other words, professionals can sell good financial instruments for their cash value without taking too much time and effort. The financial system needs internal components that make the process of turning financial instruments into cash easy without adding on excessive fees.
Good financial systems have adequate financial institutions, markets and intermediaries in place to handle all of the transactions the people and businesses who use the system desire. Price discovery should happen in such a way that it encourages all parties to remain part of the financial system rather than pricing large portions of the population out.