Six elements of the financial system
The financial system is primarily concerned with borrowing (issuing of debt and share securities) and lending and may be depicted simply as in Figure 1.
Figure 1: financial system (simplified)
The financial system has six essential elements:
- First: the ultimate lenders (= surplus economic units) and borrowers (= deficit economic units), i.e. the non-financial economic units that undertake the lending and borrowing process. The ultimate lenders lend to borrowers either directly or indirectly via financial intermediaries, by buying the securities they issue.
- Second: the financial intermediaries which intermediate the lending and borrowing process. They interpose themselves between the lenders and borrowers, and earn a margin for the benefits of intermediation (including lower risk for the lender). They buy the securities of the borrowers and issue their own to fund these (and thereby become intermediaries).
- Third: financial instruments (or assets), which are created/issued by the ultimate borrowers and financial intermediaries to satisfy the financial requirements of the various participants. These instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. retirement annuities).
- Fourth: the creation of money (= bank deposits) by banks when they satisfy the demand for new bank credit. This is a unique feature of banks. Central banks have the tools to curb money growth.
- Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.
- Sixth: price discovery, i.e. the establishment in the financial markets of the price of money, i.e. the rates of interest on debt (and deposit) instruments and the prices of share instruments.
Each of these is given attention below.
Element 1: lenders and borrowers
Figure 2: sectors of lenders & borrowers
The ultimate borrowers comprise the four broad sectors of the economy (see Figure 2):
- Household sector.
- Corporate (or business) sector.
- Government sector.
- Foreign sector.
The same non-financial economic sectors appear on the other side of the financial system as ultimate lenders. The members of the four sectors are either lenders or borrowers or both at the same time. An example of the latter is government: the governments of most countries are permanent borrowers (usually long-term), while at the same time having short-term funds in their accounts at the central bank (and the private banks in some cases), pending spending. As noted before, borrowing and lending takes place either directly or indirectly via the financial intermediaries.
Element 2: financial intermediaries
Financial intermediaries exist because there is a conflict between lenders and borrowers in terms of their financial requirements (term, risk, volume, etc.). For example, members of the household sector as lenders generally have a need for current account deposits (i.e. essentially 1-day deposits), while government's borrowing needs range from 3 months to 30 years. Another example: a surplus company may wish to lend for 3 months, while a deficit company may wish to borrow for 2 years.
The financial intermediaries solve these divergent requirements by (for example) investing in the instruments of debt of government with the short-term funds of the household sector invested with them. They also perform many other functions such as lessening of risk for lenders, creating a payments system, the efficacy of monetary policy, and so on.
Table 1: Financial intermediaries
Financial intermediaries may be classified in many ways. A list of the financial intermediaries that are found in most countries, according to our categorization preference, is as shown in Table 1. There are two broad categories: mainstream financial intermediaries and quasi-financial intermediaries. The former are straightforward: they have financial liabilities and assets (with the exception of PUTs), while the latter border on being financial intermediaries. A good example is the SPV (special purpose vehicle); it generally is created for a specific purpose (usually a specific activity such as securitizing mortgages), and after this transaction is completed it is closed to further business.
Figure 3: financial intermediaries
The main financial intermediaries (or categories) and their relationship to one another may be depicted as in Figure 3.