NATURE AND IMPORTANCE OF FINANCIAL SYSTEM

Financial system is a set of arrangements or conventions embracing the lending and borrowing of funds
by non-financial economic units and the intermediation of this function by financial intermediaries in
order to facilitate the transfer of funds, to create additional money when required, and to create markets in
debt and equity instruments so that the price and allocation of funds are determined efficiently.

It permits an efficient method to move funds between entities that have funds and entities that needs
funds. Financial system serves as a regular, time-efficient, and cost-effective link between fund providers
and fund demanders. It also encourages fund savings from its stakeholders and transforms these savings
efficiently into investment vehicles that help the economy grow faster.

At times, the financial system seizes up and produces financial crises, major disruptions in financial
markets that are characterized by sharp declines in asset prices and the failures of many financial and non-
financial firms. In the channeling of funds, if capital goes to the wrong uses and does not flow at all, the
economy will operate inefficiently or go into an economic downturn.

The natures of financial system are:

 Transfer Funds

Financial system helps in transferring of financial resources from one person to another
person. This system includes financial markets, financial intermediaries, financial assets and
services which facilitates fund movements in an economy.

 Mobilize Savings

It helps in allocating ideal lying resources with peoples into productive means. Financial
system is the one which obtains funds from savers and provide it to those who are in need of it for
various development purposes.

 Risk Allocation

Diversification of risk in an economy is important feature of financial system. Financial

system allocates people’s funds in various sources due to which risk is diversified.

 Facilitate Investments
 Financial system encourages investment by peoples into different investment avenues. It
provides various income-generating investment options to peoples for investing their savings.

 Enhances Liquidity

Financial system helps in maintaining optimum liquidity in an economy. It facilities free

movement of funds from households (savers) to corporates (investors) which ensures sufficient
availability of funds.

Importance of Financial System

1. To attain economic development, financial systems are important since they induce people to
save by offering attractive interest rate. These savings are then channelized by lending to various
business concerns which are involved in production and distribution.
2. It helps in monitor corporate performance.
3. It links savers and investors. This process is known as capital formation.
4. It helps in lowering the transaction cost and increase returns which will motivate people to save
more.
5. It helps government in deciding monetary policy.

ELEMENTS OF FINANCIAL SYSTEM

1. Lenders and borrowers (Who are the players?)

Lenders and borrowers are also known as fund provider and fund demanders,
respectively. These are the most essential stakeholders that make up the foundation of a
transaction in the financial system. Without these two parties, the financial system will not
exist.

Lenders are parties that have excess funds that they can lend out to other entities for a
required return. Borrowers are parties who are willing to pay the required return to obtain
additional funds to finance their investment initiatives.

2. Financial intermediaries (How will the exchange occur?)

 Financial intermediaries are special type of financial entity that acts as a third party to
facilitate the borrowing activity between lenders and borrowers. They gather funds from
lenders and redistribute it to borrowers through an investment vehicle like loans. Potential
lenders and borrowers then just need to visit a financial intermediary to participate in the
financial transaction. The individual or firm who provided or demanded for the funds is not
disclosed. They only need to have access to the financial intermediary to enjoy the benefits of
the financial transaction. Financial intermediation is the primary route in the process of
indirect finance using financial intermediaries for moving funds from lenders to borrowers.

3. Financial instruments (What will be used?)

Financial instruments are medium of exchange of contractual obligation of a party,
where such contract can be traded. These can be tangible or intangible. There are two types of
financial instruments; it could be cash or derivative financial instruments. International
Financial Reporting Standards (IFRS) defined financial instruments as a contract where a party
recognizes it as an asset and another is a liability. Other examples are receivables, loans, and
other debt and equity instruments.

4. Financial markets (Where will it be traded?)

Financial Markets is same with the other economic markets where suppliers and buyers
of financial instruments meet. There are two types of financial markets depending on the
instrument that were being traded. For cash financial instruments, these are exchanged in the
money market. For derivative financial instrument, it will be traded in the capital markets.

5. Regulatory environment (How it is controlled?)

Risk is inherent in every business operation. Moreover, for financial systems since it
involves different business and financial risks, government should intervene in the system.
Regulatory environment is the governance body to ensure that the transactions that occur within
the financial systems complies with the laws and regulations imposed to the actors as well as the
elements that plays within the system. Financial systems are normally regulated by Central banks.

6. Money creation (What is the value it creates?)

With the flow of financial instruments, money is created. Money is used to either be
reinvested or earned out from the system flows. In economics, the money as it was given value
out of the financial transactions because of the exchange that occurred in the system may be
converted into another form.
 7. Price discovery (How much is created?)
As the financial system continuously flows and operates, the financial instruments create
value. Price discovery is the process of determining or valuing the financial instrument in the
market. The price is normally driven by the level of risk on how the issuer of the financial
instruments.

NATURE AND IMPORTANCE OF FINANCIAL MARKET

Financial market refers to channels or places where funds and financial instruments such as stocks,
bonds, and other securities are exchanged between willing individuals and/or entities. Its main economic
function is to serve as a channel to transfer excess funds from fund providers to fund demanders.

Its nature is that of a forum where buyers and sellers can meet to facilitate transactions. It provides
options to the lenders and borrowers on the form of the transaction they want to enter.

Importance of Financial Market

Financial markets are common to each country, and they play a major role in the economic growth of the
country. Such markets act as an intermediary between savers and investors, or they help savers to become
investors. On the other hand, they also help businesses to raise money to expand their business. Investors
and businesses access the financial markets to raise money and also to make more money. Moreover, they
also help in lowering unemployment as these markets create massive job opportunities.

MONEY MARKET VS. CAPITAL MARKET

Money market is the sector of the financial system where financial instruments that will mature or be
redeemed in one year or less from issuance date are traded. Specifically, money markets cater to fund
demanders who need short-term funds from fund providers who have excess short-term funds. Short-
term is defined as one year or less. Money market securities are usually more widely traded than longer-
term securities, and so tend to be more liquid. Once money market securities are issued, they are traded in
the secondary market. Money markets are not exclusive for short-term investors. Long-term investors
need the money market as they tend to invest this market to meet their short-term liquidity needs.
Money market is very important for fund demanders since immediate cash requirements of individuals,
government, and corporations do not necessarily coincide on the timing of their cash receipts. Money
market instruments offer an investment opportunity that yields a higher return than just mere holding of
cash.

Capital market is the sector of the financial markets where financial instruments issued by governments
and corporations that will mature beyond one year from issuance date (long-term) are traded. Long-term
financial instruments encompass financial instruments that have maturity dates longer than one year and
perpetual securities (with no maturity). The foundation of the capital markets is made up by the dealers
and brokers market which creates a venue for bond and stock transactions.

Capital markets are expected to be a liquid market where fund demanders can interact with potential
investors to acquire external financing resources. Investors believe that capital market should be an
efficient market to ensure that available funds are allocated to its most productive use.

Capital market securities are classified into two: equity and debt. Equity securities are financial assets
representing ownership interest, while debt securities are financial assets that define the terms of a loan
between an issuer (the borrower) and an investor (the lender).

PRIMARY MARKET VS. SECONDARY MARKET

Primary market is a type of financial market wherein fund demanders such as corporation or a
government agency rise funds through new issuances of financial instruments e.g. bonds and stocks.
Normally, when internally generated funds (e.g. retained earnings) are not enough, demanders need to
raise additional funds in primary markets to fully finance new projects or production expansion
requirements.

New issuances of financial instruments are sold to original fund providers in exchange for money that the
fund demander needs. Usually, primary markets’ transactions are coursed through investment banks
which are financial institutions that act as intermediaries between issuing companies (fund demanders)
and potential investors (fund providers). Investment banks provide advice to issuers on matters related to
prices of securities, transaction costs, and number of securities to be issued based on their fund needs.
They also provide advice on how to present information to attract potential investors to the securities
issuance.
There are four types of issuance methods that can be done in the primary markets:

 Public offering. This occurs when securities are offered for sale to the general public.
Offering to the general public is done through issuing a prospectus or placing a document which
contains an offer to the general public to subscribe or purchase securities at a stated price. Private
companies, who will sell shares to the general public for the very first time, is said to undergo an
initial public offering, or IPO. IPOs are usually done through the help of investment banks.

Public offerings can either be an offer for subscription or an offer for sale. In an offer
subscription, the general public is invited to subscribe to unissued shares of the company.
Proceeds received from this offer are enjoyed by the company and can be used to finance their
investment objectives. In an offer for sale, existing shareholders invites potential subscribers to
buy portion of the shares they own. Proceeds from this offer are enjoyed by the existing
shareholders, not by the company.

Most of the time, an underwriter is appointed for public offerings. An underwriter provides an
undertaking to purchase the remaining securities if the offer will not be fully subscribed by the
public. In exchange of the undertaking, a fee is paid by the issuing company to the underwriters.
Securities coursed through underwriters gives comfort to potential investors since underwriters
are willing to take the risk of guaranteeing these securities.

 Private placement (also called as limited public offer). This occurs when the issuer
looks for a single investor, an institutional buyer or group of buyers to purchase the whole
securities issuance instead of offering it to the general public. Traditionally, securities sold
through private placements lend to be illiquid and are not easily converted into cash because of
the very limited parties it was sold to. As a result, it is a common that only established financial
institutions or firms are able to buy and hold on to them.

One variation of a private placement is that an underwriter subscribes to all securities at a certain
price and consequently, sells these same securities to a group of investors at a higher price. The difference
between these two prices is termed as underwriting spread.

 Auction. Another way to offer securities to the general public is through an auction
process. Auction is usually used for issuance of treasury bills, bonds and other securities issued
 by the government and are commonly executed exclusively with market markers. Auction can be
done in three methods:

1. Dutch Auction
A type of auction where the seller begins the sale at a high price. From that point,
the price of securities is continuously lowered down at specific intervals until the
potential buyer agrees to purchase at that price.

2. English Auction
A type of auction where the prospective buyers commence the auction by
submitting an initial bid price. Other buyers interested to purchase the securities submit a
new bid to top the previous one. The process is continuous as price of the securities
increases as more interested buyers bid on it. The bidding stops when no other bidders
want to top the last bid. The last, highest bid price becomes the price of the securities that
the higher bidder should pay.

3. Descending price sealed auction (or first-price sealed auction)

A type of auction where bidders submit sealed bids to the sellers,. The sealed
bids are ranked from highest to lowest price. The number of securities is allocated first to
highest priced bid and follows a descending order. Highest priced bids receive full
allocation while lower bods receive allocations distributed pro rata.

 Tap issue. This method occurs when issuers are open to receive bids for their securities
at all times. Issuers maintain the right to accept or reject bid prices based on their how much fund
they need, when they need the fund and what is their outlook of the market.

Secondary market refers to the market wherein the securities issued in primary market are subsequently
traded i.e. resold and repurchased (secondhand). Buyers in the secondary market include households,
businesses and governments who have excess funds while the sellers are the household, business and
governments who are need funds. Secondary markets become a centralized marketplace wherein buyers
and sellers can quickly and efficiently transact with each other. As a result, the secondary market allows
the buyers and sellers to save on search and information costs as they do not need look for transactions on
their own.
There are two classifications of primary and secondary markets based on where financial instruments are
traded:

4. Exchanges – organizing an exchange involves buyers and sellers of securities to meet in one
central location to conduct trades.
5. Over-the-Counter Market – dealers at different locations who have an inventory of securities
stand ready to buy and sell securities “over the counter” to anyone who comes to them and is
willing to accept their prices.
Textbook Sources:

Lascano, M. V., Baron H. C., & Cachero A. T. L. (2019). Fundamentals of Financial Markets. Metro
Manila

Mishkin, F. S. & Eakins S. G. (2012). Financial Markets & Institutions (Seventh Ed.). United States.
Pearson Education Inc.

Internet Sources:

Borad, S. B. (2019, February 12). Financial Markets – Functions, Importance And Types. Retrieved from
https://efinancemanagement.com/financial-management/financial-markets-functions-importance-and-
types?fbclid=IwAR09x26kr_tAsWsm6thBE8ege8aIDnSCPyRfHU5Hx0PUoUpDj2pFiKYa-9M

Commerce Mates. (n.d.). Nature and Role of Financial System. Retrieved from
https://commercemates.com/nature-and-role-of-financial-system/?
fbclid=IwAR09x26kr_tAsWsm6thBE8ege8aIDnSCPyRfHU5Hx0PUoUpDj2pFiKYa-9M

Fairbourn, M. (2018, October 02). What Are Equity Securities and Debt Securities? Retrieved from
https://tickertape.tdameritrade.com/investing/equity-securities-debt-securities-16959

Rahut, S. (n.d.). Meaning of Financial System. Retrieved from https://www.estartindia.com/knowledge-

hub/blog/meaning-of-financial-system?
fbclid=IwAR1VGrloX3ZRSVdd6qMXr_xPG1D7tfKUQ1uWcyfn0NT9daxZrnjtaJ-fIo4
Questions:

1. Which of the following is NOT true about financial system?

a. Financial system encourages fund savings from its stakeholders and transforms these savings
efficiently into investment vehicles that help the economy grow faster.
b. Financial system aids borrowers in acquiring long-term securities with the lowest cost
possible.
c. Financial system permits an efficient method to move funds between entities that have funds
and entities that needs funds.
d. Financial system serves as a regular, time-efficient, and cost-effective link between fund
providers and fund demanders.

2.  A major disruptions in financial markets that are characterized by sharp declines in asset prices and the
failures of many financial and nonfinancial firms. 
a. Financial Fluctuations 
b. Financial Disruptions 
c. Financial Risks 
d. Financial Crises 

3. Which of the following is NOT a financial instrument?

a. Equity Instruments
b. Loans
c. Computer
d. Receivables

4. What is the process of indirect finance using financial intermediaries for moving funds from lenders to
borrowers?
a. Financial Processing
b. Financial Transaction
c. Financial Intermediation
d. Financial Allocation

5. Which of the following is NOT a function of a financial market?

a. It serves as a channel to transfer excess funds from fund providers to fund demanders.
b. Establish a consistent, efficient, and cost-effective bridge between fund providers and
intermediaries.
c. Serves as a forum where buyers and sellers can meet to facilitate transactions.
d. Provides options to the lenders and borrowers on the form of the transaction they want to enter.

6. Which of the following statements is true?

a. Financial Markets’ existence is beneficial only to those who have the capacity to lend funds.
b. Financial Market’s function is to channel funds from households, firms, and governments
that have saved surplus funds to those that have a shortage of funds.
c. Financial Market is only concerned with the process of lending funds indirectly to borrowers.
d. Financial Markets’ function is to monitor the account of the saved surplus funds of the lender.

7. Which of the following statements is TRUE?

a. Money market securities tend to be more liquid due to being widely traded than longer-
term securities.
b. Capital market securities tend to be more liquid due to being widely traded than short-term
securities.
 c. Money markets are concerned with the trading of long-term debts and equity instruments
d. Capital market is preferred by firms and banks because of the safer investments due to smaller
fluctuations in prices of short-term securities.

8. Financial assets that define the terms of a loan between an issuer and an investor. 
a. Market Securities 
b. Debt Securities 
c. Equity Securities 
d. None of the above 

9. Which of the following is not a part of the three methods in conducting an auction?
a. Dutch Auction
b. English Auction
c. Ascending Price Sealed Auction
d. Descending Price Sealed Auction

10. Which of the following are the classifications of primary and secondary market based on where
financial instruments are traded?
I. Exchanges III. Over-the-counter Market
II. Bond Markets IV. Equity Market
a. I only
b. I, II, and III
c. II and III
d. I and III