DIFFERENT COMPONENTS OF A FINANCIAL SYSTEM:
The main components of financial system are market participants, financial instruments, financial institutions, financial markets and regulatory authorities. As mentioned above financial system is defined as arrangements facilitating the flow of funds from non financial economic units and the intermediation by financial institutions to transfer the funds when additional money is required. The five components of the financial market are identified as participants (government and investors), instruments (equity, debt and derivatives), markets (credit, stock market, and money market), institutions (banks, financial institutions) and regulation.
This identifies five elements of financial system
1. Participants.
2. Financial institutions.
3. Financial instruments.
4. Financial markets.
5. Regulating Authorities
Participants:
The participants of the financial system are surplus units and deficit units i.e. lenders and the borrowers. Deficit units are borrowers of funds for capital investment and consumption and surplus units are the savers of funds which are then available for lending. In an economy, there are always bodies having extra finance or money after fulfilling their needs. This extra money is termed as “savings” and could be used by a saver for investing and purchase of real assets after being fully insured about the risk involved in the flow of funds. A saver expects to earn positive rate of return with minimization of risk involved and maximizing the liquidity. Financial system facilitates flow of funds from savers to borrowers and funding needs of market participants. Therefore the main participants identified in a financial system are savers & the borrowers and the parties that facilitate the flow of these accumulated funds like banks, other financial institutions.
Financial Institutions:
In a financial system there is always a baffling collection of financial institutions. These financial institutions include banking & non-banking institutions and are vital in facilitating financial transactions and the flow of funds between the savers and the borrowers. These institutions produce diverse range of loans and are also assumed to be profit maximizers. These financial firms are large and so maximize the profit for shareholders rather then who manages the firms (Howells & Bain, 1990).
These different types of financial institutions and intermediaries adopt relatively different approaches for attracting funds from the surplus units and then advancing of these funds to the deficit units. These institutions can be classified into
- depository financial institutions (credit unions),
- investment banks and merchant banks,
- contractual savings institutions (life & general insurers and superannuation funds),
- finance companies and
- Unit trusts.
All these financial institutions engage in acquiring assets, incurring liabilities, by taking deposits, borrowing and lending, providing superannuation funds, supplying all type of insurance, leasing and investing in financial assets. The largest share of total assets of financial intuitions is accounted by banks. Banks manage their deposit and offer a wide variety of products with different returns, liquidity and cash flows. The second most dominant financial institution after banks is insurance companies and superannuation funds (Viney, 2003).
Financial Instruments:
In a financial system when a financial transaction takes place between lenders and borrowers i.e. when funds flow from the surplus units to the deficit units a financial instrument is created. Thus a financial instrument is a commitment between the two parties for a future cash flow. There are several kind of financial instruments traded on in financial markets, and the savers are dubbed as the buyers of these instruments where as the receiver of funds are the sellers of these instruments. These numerous types of instruments can be differentiated on the basis of rate of return, risk involved, liquidity and the time-pattern of cash flows and are broadly categorized into three different categories equity, debt and derivatives.
- Equity can be defined as the sum of financial interest on investor has in an asset. (Viney, 2003) In other words it gives the holder an ownership in an asset. Business corporations issue equity in the form of ordinary shares. This entitles the shareholder a share in the business profits and in case of business failure a share in the residual value of the assets.
- Debt represents a contractual claim against an issuer to make specified payments over a given period of time. A debt is a loan that a borrower is bound to repay. The debt instruments can be classified in to two categories known as secured debt and unsecured debt on the basis of nature of loan and on the basis of transferability of ownership into negotiable and non-negotiable debt instruments. The lender of the debt is entitled to hold the possession of the asset in case the borrower defaults on loan repayments.
- The financial instruments that have gained significant importance in recent years are the derivatives. They are used to manage exposure to price risk. Derivatives are synthetic security that are derived from the other two types of physical market instruments equity and debt and are classified into four basic types i.e. futures, forwards, options and swaps.
Financial markets:
In a layman’s language a market is a place where things are bought and sold. So a financial market can be referred to as a physical or virtual environment where different types of financial institutions inhabit and where flow of funds take place in the form of buying and selling or exchange of financial instruments. The financial markets can be classified into two basic kinds i.e. the primary market & the secondary market The financial instruments are not traded in a single market, there is a range of markets depending on the type, maturity, value and location of the financial instrument. The Australian financial system can be classified into three main markets .They are share markets, bonds markets and money markets.
Regulations:
It is often argued that individuals or the lenders who advance their money into a financial system needs some level of protection for their savings to encourage them to save more and invest more in an economy. Therefore governments and other regulating authorities influence the activities of the banks and other financial institutions. Governments supports competition in the financial sector because of their benefits to the economy. They facilitate improved access to capital for business and cheaper credits and housing loans to consumers. The fraud or unfair market practices by the market participant is regulated by the market integrity regulation to promote efficiency and fairness of the markets.
In the Australian financial system there are three main regulating authorities. These are the Reserve Bank of Australia(RBA), the Australian Prudential Regulation Authority(APRA) and the Australian Securities and Investments Commission (ASIC).
The RBA has an important role in regulatory system and is responsible for monetary policy, soundness of the payments system and responsibility for the stability of the financial system as a whole.
APRA is the prudential supervisor for authorized deposit taking institutions such as banks, life and general insurers and superannuation funds. Prudential supervision is a process for the imposition and monitoring of standards designed to ensure the soundness and stability of the banking sector.(Viney,2003)
The ASIC assumes responsibility for ensuring market integrity and consumer protection in the financial system.
The Australian Financial System Before and After Reforms:
http://www.apra.gov.au/RePEc/RePEcDocs/Archive/working_papers/wp0003.pdf