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Financial System

What is a 'Financial System'

A financial system is the system that covers financial transactions and the exchange of money between investors, lender and borrowers. A financial system can be defined at the global, regional or firm specific level. Financial systems are made of intricate and complex models that portray financial services, institutions and markets that link depositors with investors.

BREAKING DOWN 'Financial System'

The firm's financial system is the set of implemented procedures that track the financial activities of the company. On a regional scale, the financial system is the system that enables lenders and borrowers to Exchange funds.The global financial system is basically a broader regional system that encompasses all Financial instirtutions, borrowers and lenders within the global economy.

There are multiple components making up the financial system of different levels: Within a firm, the financial system encompasses all aspects of finances. For example, it would include accounting measures, revenue and expense schedules, wages and balance sheet verification. Regional financial systems would include banks and other financial institutions,  financial markets, financial services In a global view, financial systems would include the international monetary fund, central banks, World Bank and major banks that practice overseas lending.

Financial Market Components

Financial systems are strictly regulated because they directly influence financial markets. The stability of the financial markets plays a crucial role in the monetary protection of consumers. These financial systems are mostly handled by financial institutions which include commercial banks, central banks, public banks and cooperative banks. Cooperative banks and development banks managed by states are also listed under financial institutions that have heavily regulated financial systems.

Financial systems are not only evident in bank financial institutions. Some institutions have market brokring, investment and risk pooling services. However, these institutions are non-bank financial institutions that are not regulated by a bank regulation firm or agency. Examples of non-bank financial institutions are companies that offer mutual funds, insurance, and financial loans. Companies with commodity traders are also considered to be non-bank financial institutions that have financial systems.

Another component of financial systems are financial markets that trade commodities, securities and other items that are traded according to general supply and demand. Financial markets include the primary markets and secondary markets. Primary markets provide avenues for buyers and sellers to buy and sell stocks and bonds. Secondary markets provide a venue for investors and traders to purchase instruments that have been previously bought.

Aside from financial institutions and markets, financial systems are also evident in financial instruments. These financial instruments include cash instruments and derivative instruments. Cash instruments include loans, deposits and securities. Derivative instruments are financial instruments that are dependent on an underlying asset's performance.

Financial Institution - FI

A financial institution (FI) is a company engaged in the business of dealing with monetary transactions, such as deposits, loans, investments and currency exchange. Financial institutions encompass a broad range of business operations within the financial services sector, including banks,   trust companies, insurence comapnies and brokerage firms or investment  dealers. Virtually everyone living in a developed economy has an ongoing or at least periodic need for the services of financial institutions.

BREAKING DOWN 'Financial Institution - FI'

Because financial operations are a critical part of any economy, and because essentially all of a country's citizenry depends on financial institutions for transactions, savings and investment needs, governments consider it imperative to oversee and regulate banks and other financial service companies. Historically, the bankruptcy of financial institutions creates panic within an economy. In the United States, the Federal Deposit Insurance Corporation (FDIC) insures regular deposit accounts to reassure individuals and businesses regarding the safety of their finaces on deposit with financial institutions. The health of a nation's banking system is a linchpin of economic stability. Loss of confidence in financial institutions can easily lead to additional negative  extermalities in the economy.

 Types of Financial Institutions

Financial institutions offer a wide range of products and services for individual and commercial clients. The specific services offered vary widely between different types of financial institutions.

Shadow Banking System

A shadow banking system refers to the fanancial intermediaries involved in facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions. Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swapts

BREAKING DOWN 'Shadow Banking System'

The shadow banking system has escaped regulation primarily because it does not accept traditional bank deposits . As a result, many of the institutions and instruments have been able to employ higher market, credit and  liquidity risks, and do not have capital requirments commensurate with those risks. Subsequent to the subprime  meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.

Financial Instrument

Financial instruments are assets that can be traded. They can also be seen as packages of capital that may be traded. Most types of financial instruments provide an efficient flow and transfer of capital all throughout the world's investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one's ownership of an entity.

BREAKING DOWN 'Financial Instrument'

Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt-based financial instruments represent a loan made by an investor to the owner of the asset. foreign exchange instruments comprise a third, unique type of financial instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity. international accounting standards defines financial instruments as "any contract that gives rise to a financail  assets of one entity and a financial liability or equity instrument of another entity."

Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and derivative instruments.

The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.

The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates or indices. These can be over - the - counter (OTC)derivatives or exchange-traded derivatives.

Asset Classes

Financial instruments may also be divided according to assets class, which depends on whether they are debt-based or equity-based.

Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T- bills and commercail paper. Cash of this kind can be deposits and  certificates of deposits (CSs).Exchange-traded derivatives under short-term debt-based financial instruments can be short-term interest rate futures OTC derivatives are forward rate agareements. 

Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds.  Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors,  interest rate options, and exotic derivatives.

Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives.

There are no securities under foreign exchange Cash equivalents come in spot foreign exchange. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options,  outright forwards and foreign exchange swaps.