People have virtually unlimited wants, but the economic resources to produce those wants are limited. Therefore, the greatest benefit of an economy is to provide the most desirable consumer goods and services in the most desirable amounts—what is known as the efficient allocation of economic resources. To produce these consumer goods and services requires capital in the form of labor, land, capital goods used to produce a desired product or service, and entrepreneurial ability to use these resources together to the greatest efficiency in producing what consumers want most. Real capital consists of the land, labor, tools and machinery, and entrepreneurial ability to produce consumer goods and services, and to acquire real capital costs money.
The financial system of an economy provides the means to collect money from the people who have it and distribute it to those who can use it best. Hence, the efficient allocation of economic resources is achieved by a financial system that allocates money to those people and for those purposes that will yield the greatest return.
The financial system is composed of the products and services provided by financial institutions, which includes banks, insurance companies, pension funds, organized exchanges, and the many other companies that serve to facilitate economic transactions. Virtually all economic transactions are effected by one or more of these financial institutions. They create financial instruments, such as stocks and bonds, pay interest on deposits, lend money to creditworthy borrowers, and create and maintain the payment systems of modern economies.
These financial products and services are based on the following fundamental objectives of any modern financial system:
- to provide a payment system,
- to give money time value,
- to offer products and services to reduce financial risk or to compensate risk-taking for desirable objectives,
- to collect and disperse information that allows the most efficient allocation of economic resources,
- to create and maintain financial markets that provide prices, which indicates how well investments are performing, which also determines the subsequent allocation of resources, and to maintain economic stability.
While money as currency is a convenient means of payment between individuals, it is not so convenient for banks, businesses, and other organizations, such as governments, that require and pay out large amounts of money and to have records of their transactions for accounting and tax purposes. Hence, payment systems have evolved to increase the efficiency of money flow and recordkeeping.
Checks were the 1st major financial innovation that simplified payments. The use of checks, which is not money but rather part of the payment system, is a legal document in which the payer of the check promises to pay the payee of the check. Checks greatly simplify payments by eliminating the need to have large amounts of coin and currency, which also makes them more secure. They also generate records of who was paid, how much, and on what date.
However, checks had disadvantages. They could be forged, the payee often had to wait several business days to know if the check was good, and it was expensive to process checks, since paper checks, as physical items, had to be transported, sometimes over great distances, to different banks for clearing and settlement, and the information on the checks had to be transferred to an accounting system.
Since checks were just paper with information on them, there was really no need for the paper since only the information mattered. Hence, various electronic networks have been developed that can quickly and securely transfer money flow information as electronic records—what is often referred to as electronic money.
Increasingly, financial transactions are being conducted electronically because it eliminates the need to transport physical checks, and greatly increases the speed in which money can be transferred for payment. And since most accounting systems are in computer databases, it is much easier to transfer the information in these electronic records to accounting systems automatically.
Hence, a primary objective of the financial system is to provide an efficient payment system that can quickly and securely transfer money and record the transactions.
Interest and Capital Gains
Some people have more money than their immediate needs require. Some people have needs or want to do things that require more money than they have. The economy can grow by having people in the 1st group lend money to the 2nd group. But lenders won't lend money for nothing; to entice people to lend the money, the borrowers pay the lenders interest. This is what gives money time value. However, it isn't easy for lenders to find borrowers, or vice versa, nor could lenders easily determine who would pay the most interest at the least risk. Hence, another major objective of a financial system is to facilitate the location and interaction of lenders and borrowers and to minimize the opportunity cost to both, where lenders can lend money at the highest possible rate for a given amount of risk and borrowers can borrow money at the lowest rate.
Another means of profiting from money is through capital gains—buying low and selling high. When investors pay money to a company in exchange for an ownership interest, usually represented by stock, the investors hope that the stock will increase in value so that they can sell it later for a higher price. Hence, a modern financial system provides various means of earning capital gains, by providing marketplaces for buying or selling financial instruments, such as stocks or bonds, or by providing a marketplace for buying and selling valuable assets, such as real estate.
There is always financial risk whenever a person pays out money in the hope of gaining more back at some future date. This can occur when a lender lends to a borrower by buying a bond, when a person buys stock in a company in the hope that it will increase in value, or when a person saves money at a bank to earn interest. Hence, another goal of a financial system is to allow people to reduce risk by offering to act as an intermediary or to offer products that offset the potential risk. So banks take on much of the risk of lending out savers' money by acting as the intermediary between lender and borrower, and financial markets offer many products that can offset risk, such as buying a put to protect against the decline of a stock, or entering into a futures contract that can protect both the buyer and the seller of a commodity from adverse price moves.
Risk requires compensation, so the greater the risk, the greater the potential compensation must be for lenders or investors to invest their money. For instance, since the bonds of a company are safer than its stock, investors will not buy the stock unless they think the potential profits are greater; otherwise, they would just buy the bonds for a safer return. So a financial system must provide accurate risk assessments to induce lenders or investors to invest their money.
There is also financial risk from accidents or other destructive events. Insurance companies help to protect against this risk by pooling the money of all of the insured to pay out the few claims that will arise in the pool. There are also financial instruments that can protect against calamities, such as weather derivatives that pay off if bad weather occurs.
Financial transactions not only entail risk, but investors will also want to know what the expected returns are, so that they can evaluate whether the expected returns justifies the risk. Financial transactions also have set procedures and legal requirements that must be followed, which can be a barrier to investments.
Hence, a major objective of a financial system is to institutionalize and standardize many common financial transactions, such as the buying and selling of stocks, and to provide common financial instruments with similar characteristics, such as options and futures. Financial institutions also provide the necessary information about companies, contracts, and financial instruments so that investors can make an intelligent choice, and provide current market information so that investors can assess the performance of their investments.
For instance, credit rating agencies rate the credit of companies and other organizations that issue bonds. If a company has a poor credit rating, then it must pay a higher yield on its bonds in order to sell them. Banks assess the creditworthiness of borrowers to determine if they should lend them money and at what price, or interest rate. Organized exchanges provide current prices on stocks and other assets and financial news organizations publish news about companies, the economy, and anything else that can affect the financial markets.
Financial markets consists of all products and services that are offered for sale in exchange for interest, potential capital gains, or for the protection of financial risk, which includes the products and services offered by banks, insurance companies, and other financial institutions, and by marketplaces, such as organized exchanges or the over-the-counter (OTC) market.
Financial markets provide pricing information, which determines how money, and therefore, economic resources, will be allocated. For instance, a company that produces a desirable product will grow faster than a company offering a less desirable product, since more people will buy the more desirable product. Hence, investors will invest money in the company producing the more desirable product, since it will probably grow faster. So the company with the more desirable product expands, creating more of the desirable product, and so its stock price climbs higher and faster than the one with the less desirable product, so it attracts more money.
Financial markets provide liquidity, which allows investors to quickly convert their financial assets to cash at relatively low cost.
Financial markets must also be fair; otherwise, people would be less willing to lend or invest. So the financial system must create fair markets and maintain their fairness through the enforcement of rules, regulations, and laws that help to level the playing field. In fact, the structure of all financial markets and the way that they conduct business is largely determined by the financial regulatory agencies that enforce security and fairness. This is why there are laws against insider trading, for instance.
Economies work best when they are stable. When the financial system falters, so does the economy. There is no better illustration of this than the current credit crisis brought on by excessive speculation and excessive risk-taking by banks, hedge funds, and other major financial institutions. Governments around the world were forced to inject trillions of dollars into their banking systems so that they would not collapse, and to get credit flowing again.
For without credit, businesses stop hiring and start laying off people. People stop spending to conserve money, which causes businesses to contract further, with more layoffs, and more consumer tightening, and so on. A contracting economy also reduces tax receipts for governments and causes them to cut spending, especially if they do not have the power to print money as the central governments do. Raising taxes in a contracting economy only hurts the people more, and forces them to spend even less.
Hence, a major goal of financial systems is to provide economic stability. Central banks have the major role of keeping the economy stable or stabilizing it if it falters. Central banks accomplish this by effecting monetary policies, such as adjusting the cost of money through key interest rates or by controlling the quantity of money in the economy.
The financial system can be viewed simply as a means of managing the flow of financial information. Modern technology is greatly increasing its efficiency, and will continue to do so well into the future. Traditional services will become faster and more secure, and new products and services will be developed to better serve the needs of the people.