Financial System: Definition, Types, and Market Components

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Investopedia / Katie Kerpel

What Is a Financial System?

A financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals.

Key Takeaways

  • A financial system is the set of global, regional, or firm-specific institutions and practices used to facilitate the exchange of funds.
  • Financial systems can be organized using market principles, central planning, or a hybrid of both.
  • Institutions within a financial system include everything from banks to stock exchanges and government treasuries.

Understanding the Financial System

Like any other industry, the financial system can be organized using markets, central planning, or some mix of both.

Financial markets involve borrowers, lenders, and investors negotiating loans and other transactions. In these markets, the economic good traded on both sides is usually some form of money: current money (cash), claims on future money (credit), or claims on the future income potential or value of real assets (equity). These also include derivative instruments. Derivative instruments, such as commodity futures or stock options, are financial instruments that are dependent on an underlying real or financial asset's performance. In financial markets, these are all traded among borrowers, lenders, and investors according to the normal laws of supply and demand.

In a centrally planned financial system (e.g., a single firm or a command economy), the financing of consumption and investment plans is not decided by counterparties in a transaction but directly by a manager or central planner. Which projects receive funds, whose projects receive funds, and who funds them is determined by the planner, whether that means a business manager or a party boss.

Most financial systems contain elements of both give-and-take markets and top-down central planning. For example, a business firm is a centrally planned financial system with respect to its internal financial decisions; however, it typically operates within a broader market interacting with external lenders and investors to carry out its long term plans.
At the same time, all modern financial markets operate within some kind of government regulatory framework that sets limits on what types of transactions are allowed. Financial systems are often strictly regulated because they directly influence decisions over real assets, economic performance, and consumer protection.

Financial Market Components

Multiple components make up the financial system at different levels. The firm's financial system is the set of implemented procedures that track the financial activities of the company. Within a firm, the financial system encompasses all aspects of finances, including accounting measures, revenue and expense schedules, wages, and balance sheet verification.

On a regional scale, the financial system is the system that enables lenders and borrowers to exchange funds. Regional financial systems include banks and other institutions, such as securities exchanges and financial clearinghouses.

The global financial system is basically a broader regional system that encompasses all financial institutions, borrowers, and lenders within the global economy. In a global view, financial systems include the International Monetary Fund, central banks, government treasuries and monetary authorities, the World Bank, and major private international banks.

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