Financial system

An economy's financial system exists to organise the settlement of payments, to raise and allocate finance, and to manage the risks associated with financing and exchange.

A developed financial system is one that has a secure and efficient payment system, security markets and financial intermediaries that arrange financing, and derivative markets and financial institutions that provide access to risk management instruments.

Payment system

The payment system operates to settle transactions. A transaction is settled when the seller has supplied the specific item and received the agreed amount of value. The main features of payments systems are payment instruments and a centralised process for the providers of payment services to exchange the funds involved. Deposit-taking institutions play the dominant role in providing payment services. In many countries these institutions have to be authorised as authorised deposit-taking institutions (ADIs).

Separate systems have been developed to settled retail transactions and wholesale transactions. Retail systems have to handle a large volume of mostly small transactions. There will be a range of processing systems because of the range of retail payment instruments. A large number of retail transactions is made with cash, predominantly in the form of legal tender (banknotes and coins), but also increasingly electronic money. However, payment instructions are used to settle most retail transactions in value terms.

A payment instruction settles a transaction by authorising the transfer of funds that are held in an account with an ADI. Such instructions may be in the form of a paper-based instrument like a cheque or an electronic funds transfer. Electronic payment instructions debit the payer's account and credit the payee's account at the time of transaction, after which there is an inter-ADI transfer of exchange settlement funds held with the central bank. Paper-based instruments may also require the additional step of signature verification.

In comparison with retail payments, wholesale payments account for a much larger share of the aggregate amount paid. These payments are mainly through financial market transactions, such as the foreign exchange and bond markets. The wholesale system has very few participants, most of which are banks and securities companies that have exchange settlement accounts with the central bank.

Because the payment system provides a platform for the conduct of business and commercial exchange within the economy, its efficiency and stability is an important precondition for the economy's performance. An efficient system encourages competition in the supply of payment services so as to provide a range of convenient and low-cost payment methods. A stable system provides a safe haven for the funds held for transaction purposes and secure methods for settling transactions. Stability is maintained through prudent management of operating risks in the use of depositors' funds.

Financing system

The financing system has two general roles - to mobilise surplus funds from people and organisations, and to allocate them among deficit people and organisations. An investor is an example of a surplus unit, whereas a borrower is an example of a deficit unit. Mobilising funds generates returns for surplus units, which generally enhances their wealth and economic well-being. It also allows deficit units to enhance their productive and purchasing capacities, and thus improves an economy's production and consumption potential.

Funds are mobilised either as debt or equity. Debt funds are supplied as a loan and generally the repayments are scheduled, whereas equity funds acquire part ownership of a business and their returns depend on the future profitability of the business.

The financing process allows prospective users of funds to compete for them and creates the incentive for funds to be supplied. In essence, the financial system should ensure the supply of funds when their use has a net present value. That is, the user of the funds expects to earn a return that exceeds the returns paid to the supplier of the funds.

There are at least two fundamental problems that must be solved by the financing system. First, deficit units seek funds for terms that, on average, are longer than the periods for which funds are supplied by surplus units, posing the problem of a maturity mismatch between the supply and demand for funds. This means that financing processes have to be able to transform the maturity of funds - a process referred to as maturity transformation. Second, financing processes have to develop means for coping with the risks faced by the suppliers of funds.

The financing process requires the comprehensive disclosure of relevant information to allow investors and other suppliers of funds to assess the risks and expected returns associated with the proposed use of funds.

Indirect financing

In the indirect process, known also as financial intermediation, funds are raised by deposit-taking institutions and then lent to borrowers. The funds raised are generally in the form of deposits. To attract current deposits, ADIs mainly provide payment services, which are part of the payment system discussed above. To attract savings deposits, ADIs mainly provide a secure place for funds and a reasonable rate of interest. Savings accounts impose almost no transaction costs for depositors and this partly justifies their modest interest rates. Wholesale deposits mainly take the form of certificates of deposit, which are large-value deposits that have a fixed term and are paid a fixed rate of interest.

ADIs provide depositors with liquidity and borrowers with loans for specified terms. Typically, the average term of deposits with ADIs is much shorter than the average term of their loans. Hence, ADIs have to cope with the maturity mismatch between their assets and liabilities. Maturity transformation exposes ADIs to liquidity risk.

ADIs, as a group, make loans that range from a few thousand dollars to hundreds of millions of dollars. Because their charges are generally related to the scale of borrowing, they are the main providers of small-value loans. Large loans generally can be arranged more cheaply in percentage terms by the banks that issue securities than by ADIs. Aside from their loans, ADIs invest a small proportion of their deposits in securities that can be readily sold should funds be required. In some countries, the central bank holds a percentage of ADI funds to ensure that they are able to raise cash in an emergency.

The ADI's income from indirect financing is earned from its interest rate spread (the difference between their lending and borrowing rates). This spread compensates the ADI for the risks it accepts, one of which is the credit risk posed by its borrowers. ADIs transform the risks faced by depositors (risk transformation) by accepting the credit risk posed by borrowers. Typically, an ADI sets its base rate (called its prime or reference rate) and charges each borrower a premium over this rate, depending on the borrower's risk. Non-performing loans result in a reduction in the ADI's net-interest income.

Direct financing

The development of security markets has created an alternative financing process. In the direct process, funds are raised directly from investors through the issue of securities. The issue of securities by financial institutions is a specialised activity known as underwriting that is most economically undertaken in wholesale amounts. Financial institutions that issue securities may also manage funds on behalf of investors and thus have a ready market for the securities.

The main approach to deal with risk within direct financing is to compensate investors for accepting risk. Given that the suppliers of funds are risk averse, the mobilisation and allocation of funds will reflect a risk-return relationship. The greater the risk, the greater the required return.

Risk management

Since the early 1980s, a system has evolved in developed financial systems that is composed of products and instruments that can be used to manage the risks posed by financing.

The main instruments that are used for removing risk (hedging) are forward contracts and derivatives. The use of these instruments is not restricted to hedging; they are used also for investment and speculation. A risk is hedged when another transaction serves to cover the exposure to an unexpected movement. Speculation occurs when a trader takes an unhedged position in a market.

Financial institutions

In developed financial systems, ADIs commonly undertake activities in addition to those associated with indirect financing. Consequently, ADIs are usually part of financial institutions or "conglomerates" that provide a range of financial services. Economies of scope encourage all ADIs to sell other financial services to their customers.

Financial markets

The foreign exchange market serves to link the payment systems in each country.