Financial System

Saving and Investment Occuring in the Financial System

The process of economic growth Opens in new window depends on the ability of firms to expand their operations, buy additional equipment, train workers and adopt new technologies.

Firms can finance some of these activities from retained earnings, which are profits that are reinvested in the firm rather than taken out of the firm and paid to the firm’s owners.

For many firms, retained earnings are not sufficient to finance the rapid expansion required in economies experiencing high rates of economic growth.

Firms acquire funds from households, either directly through financial markets—such as the share and bond markets—or indirectly through financial intermediaries—such as banks.

Financial markets and financial intermediaries together comprise the financial system.

Financial system is the system of financial markets and financial intermediaries through which firms acquire funds from households.

Without a well-functioning financial system, economic growth Opens in new window is impossible because firms will be unable to expand and adopt new technologies.

This was made very clear with the collapse of a number of financial institutions in the United States and Europe, in 2007 and 2008, and the near collapse of many others, which led to the GFC Opens in new window.

Accessing credit became difficult and costly, and many businesses could no longer borrow sufficient funds. Australia was much less affected than many other countries, but still faced an increased difficulty in accessing funds overseas.

As we noted earlier, no country without a well-developed financial system has been able to sustain high levels of economic growth.

An Overview of the Financial System

The financial system channels funds from savers to borrowers and channels returns on the borrowed funds back to savers.

In financial markets, such as the share market or the bond market, firms raise funds by selling financial securities directly to savers.

When a firm sells a bond the firm promises to pay the purchaser of the bond an interest payment each year for the term of the bond, as well as a final payment of the amount of the loan.

Financial intermediaries are firms such as banks and non-bank financial intermediaries (NBFIs) which include credit unions, building societies, managed funds, superannuation funds and insurance companies), that borrow funds from savers and lend them to borrowers.

Financial intermediaries and non-bank financial intermediaries (NBFIs) act as go-betweens for borrowers and lenders.

When you deposit funds in your bank account the bank may lend the funds (together with the funds of other savers) to an entrepreneur who wants to start a business.

Suppose Lisa wants to open a Laundromat. Rather than you lending money directly to Lisa’s Laundromat, the bank acts as a go-between for you and Lisa.

Intermediaries pool the funds of many small savers to lend to many individual borrowers.

The intermediaries pay interest to savers in exchange for the use of savers’ funds and earn a profit by lending money to borrowers and charging borrowers a higher rate of interest on the loans.

For example, a bank might pay you as a depositor a 5 percent rate of interest, while it lends the money to Lisa’s Laundromat at a 10 percent rate of interest. Financial institutions also make profits from charging fees for carrying out borrowing and lending transactions.

Banks and NBFIs also make investments in shares and bonds on behalf of savers.

For example, unit trusts sell shares to savers and then use the funds to buy a portfolio of shares, bonds, mortgages and other financial securities.

Some NBFIs hold a wide range of shares or bonds; others specialize in securities issued by a particular industry or sector, such as technology; and others invest as an index fund in a fixed market basket of securities such as shares of the Australian Securities Exchange’s top 100 firms.

Over the past 30 years the role of NBFIs in the financial system has increased dramatically. Today, competition between numerous NBFIs gives investors a number of funds from which to choose.

In addition to matching households that have excess funds with firms that want to borrow funds, the financial system provides three key services for savers and borrowers:

  1. risk sharing,
  2. liquidity and
  3. information.
Risk is the chance that the value of a financial security will change relative to what you expect.

For example, you may buy a Qantas share at a price of $2.50, only to have the price fall to $2.00.

Most individual savers are not gamblers and seek a steady return on their savings rather than erratic swings between high and low earnings.

The financial system provides risk sharing by allowing savers to spread their money over many financial investments.

For example, you can divide your money between a bank certificate of deposit, individual bonds, shares and a managed fund.

Liquidity is the ease with which a financial security can be exchanged for cash.

The financial system provides the service of liquidity by providing savers with markets in which they can sell their holdings of financial securities.

For example, savers can easily sell their holdings of the shares and bonds issued by large corporations on the major share and bond markets.

A third service that the financial system provides savers is the collection and communication of information, or facts about borrowers and expectations about returns on financial securities.

For example, Lisa’s Laundromat may want to borrow $10 000 from you. Finding out what Lisa intends to do with the funds and how likely she is to pay you back may be costly and time consuming. By depositing $10 000 in the bank, you are, in effect, allowing the bank to gather this information for you.

Because banks specialize in gathering information on borrowers they are able to do it faster and at a lower cost than can individual savers.

The financial system plays an important role in communicating information. If you read a news story announcing that a car firm has invented a car with an engine that runs on water, how would you determine the effect of that discovery on the firm’s profits?

Financial markets do the job for you by incorporating information into the prices of shares, bonds and other financial securities.

In this example, the expectation of higher future profits would boost the price of the car firm’s shares.