economic development of a nation is reflected by the progress of the various
economic units, broadly classified into corporate sector, government and
household sector. There are areas or people with surplus funds and there are
those with a deficit. A financial system or financial sector functions as an
intermediary and facilitates the flow of funds from the areas of surplus to the
areas of deficit. A Financial System is a composition of various institutions,
markets, regulations and laws, practices, money manager, analysts, transactions
and claims and liabilities. Financial system comprises of set of subsystems of
financial institutions, financial markets, financial instruments and services
which helps in the formation of capital. It provides a mechanism by which
savings are transformed to investment. Financial System; The word
“system”, in the term “financial system”, implies a set of
complex and closely connected or interlinked institutions, agents, practices,
markets, transactions, claims, and liabilities in the economy. The financial
system is concerned about money, credit and finance -the three terms are
intimately related yet are somewhat different from each other. Indian financial
system consists of financial market, financial instruments and financial
intermediation. Meaning of Financial System A financial system functions as an
intermediary between savers and investors. It facilitates the flow of funds
from the areas of surplus to the areas of deficit. It is concerned about the
money, credit and finance. These three parts are very closely interrelated with
each other and depend on each other. A financial system may be defined as a set
of institutions, instruments and markets which promotes savings and channels
them to their most efficient use. It consists of individuals (savers),
intermediaries, markets and users of savings (investors). In the worlds of Van
Horne, “financial system allocates savings efficiently in an economy to ultimate
users either for investment in real assets or for consumption”. According to
Prasanna Chandra, “financial system consists of a variety of institutions,
markets and instruments related in a systematic manner and provide the
principal means by which savings are transformed into investments”. Thus
financial system is a set of complex and closely interlinked financial
institutions, financial markets, financial instruments and services which
facilitate the transfer of funds. Financial institutions mobilize funds from
suppliers and provide these funds to those who demand them. Similarly, the
financial markets are also required for movement of funds from savers to
intermediaries and from intermediaries to investors. In short, financial system
is a mechanism by which savings are transformed into investments. Functions of
Financial System The financial system of a country performs certain valuable
functions for the economic growth of that country. The main functions of a
financial system may be briefly discussed as below:
Saving function: An important function of a financial system is to mobilize
savings and channelize them into productive activities. It is through financial
system the savings are transformed into investments.
Liquidity function: The most important function of a financial system is to
provide money and monetary assets for the production of goods and services.
Monetary assets are those assets which can be converted into cash or money
easily without loss of value. All activities in a financial system are related
to liquidity-either provision of liquidity or trading in liquidity.
Payment function: The financial system offers a very convenient mode of payment
for goods and services. The cheque system and credit card system are the
easiest methods of payment in the economy. The cost and time of transactions
are considerably reduced.
Risk function: The financial markets provide protection against life, health
and income risks. These guarantees are accomplished through the sale of life,
health insurance and property insurance policies.
Information function: A financial system makes available price-related
information. This is a valuable help to those who need to take economic and
financial decisions. Financial markets disseminate information for enabling
participants to develop an informed opinion about investment, disinvestment,
reinvestment or holding a particular asset.
Transfer function: A financial system provides a mechanism for the transfer of
the resources across geographic boundaries.
Reformatory functions: A financial system undertaking the functions of
developing, introducing innovative financial assets/instruments services and
practices and restructuring the existing assets, services etc., to cater the
emerging needs of borrowers and investors (financial engineering and re-engineering).
Other functions: It assists in the selection of projects to be financed and
also reviews performance of such projects periodically. It also promotes the
process of capital formation by bringing together the supply of savings and the
demand for investible funds.
and Importance of Financial System in Economic Development
It links the savers and investors. It helps in mobilizing and allocating the
savings efficiently and effectively. It plays a crucial role in economic
development through saving-investment process. This savings – investment
process is called capital formation.
It helps to monitor corporate performance.
It provides a mechanism for managing uncertainty and controlling risk.
It provides a mechanism for the transfer of resources across geographical
It offers portfolio adjustment facilities (provided by financial markets and
It helps in lowering the transaction costs and increase returns. This will
motivate people to save more.
7. It promotes the process of capital
8. It helps in
promoting the process of financial deepening and broadening. Financial
deepening means increasing financial assets as a percentage of GDP and financial
broadening means building an increasing number and variety of participants and
instruments. In short, a financial system contributes to the acceleration of
economic development. It contributes to growth through technical progress. The
Indian financial system can be broadly classified into formal (organized)
financial system and the informal (unorganized) financial system. The formal
financial system comprises of Ministry of Finance, RBI, SEBI and other
regulatory bodies. The informal financial system consists of individual money
lenders, groups of persons operating as funds or associations, partnership
firms consisting of local brokers, pawn brokers, and non-banking financial
intermediaries such as finance, investment and chit fund companies.