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What comes to mind when you think of a financial system? Stock trading apps like SoFi or the infamous Robinhood the app at the heart of the GameStop brouhaha a couple of years ago? Maybe you think of all those interlinked bank machines that honour practically every payment network, starting with Visa and Mastercard. All of those may be components of a financial system but they are not systems in and of themselves.
Financial systems comprise four parts:
- financial institutions connect investors and borrowers
- financial markets are where asset trading takes place.
- financial services take on the day-to-day work of trading and investing on behalf of their clients
- financial assets are the products that underpin financial systems
Obviously, this is a very broad overview of financial systems. It does nothing to explain what financial instruments are - the assets that get bought and sold at financial markets. Nor does it detail any particular financial institution. Are we talking banks or strictly investment houses like Charles Schwab and Goldman Sachs? And who does all the buying and selling of assets? Read on for the answer to all those questions and more.
Explaining Financial Systems
From this article's introduction, we know that financial systems are not any of the components we know and use daily. Such systems include all of the people and 'places' where financial activity takes place. We know that the finance managers take on the bulk of asset movement. Sometimes, they take orders from clients to buy or sell a certain stock or other asset. Often, they buy or sell assets without any client specifically telling them to do so, depending on market activity.
Fundamentally, a financial system allows the exchange of funds between market participants (more on them in the next segment). You might think of such a system as the exchange and use of assets for the benefit and profit of the parties involved. Money plays a huge part in keeping financial systems running, as you might imagine. That's 'money' as in 'anything of value', not the way we commonly (mis)use the term - synonymous with cash. Credit also plays a huge role in finance.
Managing finance at this level is a complex undertaking. Finance managers must keep a constant eye on the markets and scrutinize for any potential risk. They may choose to avert risk altogether, maybe by selling a client's more risky stock ahead of a potential downturn. This aspect of investment management alone keeps financial systems operating more or less smoothly.
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Who Uses Financial Systems?
This is a trick question. Anyone who uses currency - the correct 'cash' synonym uses some part of a financial system. If you have a bank account, you're plugged into a financial system. Your mortgage, car note or student loan, if you have any such, also derive from a financial system. However, when pondering the question from a finance perspective, financial systems only cater to three users.
Lenders
In the general sense, lenders have cash to lend. If the amount requested is particularly high or the individual requesting the loan - the borrower, doesn't have a proven record of creditworthiness, lenders may ask for some sort of collateral. It may be another asset the borrower owns or it could simply be an employment contract that (more or less) guarantees the loan will be repaid, plus interest. We all know that type of lender. Lenders in financial systems operate on a far broader scope.
Let's say the government needs to borrow money. Before appealing to the World Bank or the International Monetary Fund (IMF) for a loan, they might try to raise the needed funds by selling government bonds. The public is invited to purchase such bonds, with the promise that they will receive the full value of their purchase plus a bit of interest once the bond matures. The purchase of such bonds, in effect, makes the buying public a lender to the government.
Borrowers
Bond-selling governments aside, borrowers are the ones petitioning for the temporary use of funds from other parties. Again, this is self-explanatory but we need to make one point clear. Generally, all business-related debts must be made in writing for them to be enforceable. Should a borrower fall into default due to their inability to pay back a loan, the consequences depend on the 'level' of the borrower.
Consumers - ordinary members of the public who default on their debts, often suffer harsher penalties than, say, a country that defaults. Indeed, a non-paying nation may not see any punishment at all but they may have to renegotiate their debt. All of this is quite apart from strategic default, a tactic borrowers use when they have the means to make their loan payments but have a particular reason not to. For example, in the US, at the height of the 2008 financial meltdown, many people stopped paying their mortgages, choosing instead to use their available funds to find other housing.
Investors
As those homebuyers strategically defaulted on their mortgages, investors swooped in to buy thousands of properties for pennies on the dollar. Those agents embodied the very definition of 'investor': a person who allocates capital to gain financial profit in the future. Investors fall into two categories: retail and institutional. It was the latter type of investor that snapped up all those properties.
Most of us fall into the retail investor category. It's populated with individuals or groups that generally make small inroads into the financial system. They're on the 'personal' branch of the three dimensions of finance, the other two being public and corporate. By contrast, institutional investors encompass everybody from finance managers that buy mutual funds for their clients to sovereign governments.
Banks and Non-Bank Financial Institutions
Banks may be the most visible components of a financial system but they are far from the only ones. Among non-bank financial institutions or NBFIs, we count insurance companies, brokerage firms, asset management firms and even microloan firms and pawn shops. In essence, any financial institution that exchanges assets but does not have a full banking license is considered a non-bank financial institution. The 'unbanked', people who do not have a bank account, may resort to a cheque-cashing outlet to get their wages; such outlets are also NBFIs.
The word 'bank' has come to mean any financial institution with a full banking license but the term is deceptive. Banks may be commercial or state-run. Postal bank systems are generally considered public banks as they are funded, at least in part, by taxpayer money. Cooperatives banks like credit unions, mutual savings banks and building societies tend to be more resilient in the face of economic turmoil.
Reserve banks, also called central banks, are a country's monetary authority. They use financial theory to make crucial economic decisions that underpin a nation's economic health. Raising interest rates to combat inflation is a recent example of the type of financial decisions they're called to make.
Financial Services
In these day-trade, penny-stock times, more people than ever access financial markets. Financial services, however, remain the purview of bona fide investors. The finance industry provides economic services through such outlets - the banks, credit unions, insurance agencies, brokerage firms and others. Even your payment (debit or credit) card comes from a financial services company.
These and entities like them offer a long list of services. Foreign exchange outlets let you send money abroad or, if you come back from holiday on the continent, you can exchange any leftover European currency. Did you buy insurance before you travelled? You did so from a financial services outlet. Insurance underwriters may draft short-term policies such as travel insurance or they may specialise in annuities, a type of insurance that pays out while the insured person is still alive.
If you're in over your head financially - in these times, that's very easy to do, you might consult with a debt settlement agent. Agents specialising in this financial service negotiate with their clients' lenders to forgive a portion of the owed debt, guaranteeing that their client will pay off the remaining balance. This is the perfect financial solution for debtors who do not wish to file for bankruptcy or lose their assets.
More and more, financial services are moving online. The trading apps mentioned at the start of this article are just the tip of the iceberg; the ones accessible to anyone with an internet connection and the money (and smarts!) to use them. You can also find currency exchange websites, broker services for everything from insurance to financial instruments and, of course, financial market utilities.
Online banking is now a free component of any bank account, as is bank machine access. Those point-of-sale (POS) card readers in shops and restaurants are also a component of financial services. Your card issuer is paid a small fee every time you swipe or tap your card. Even cryptocurrency exchanges provide financial services, though some may debate that. In short, any financial transaction that involves the exchange of assets from one party to another defines what finance is.
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