What's the Definition of a Financial System?

By Indeed Editorial Team

Published April 20, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Exchanging and investing funds requires rules, regulations and systems to protect everyone involved. This may create complex systems to provide a framework for all types of financial interactions. In this article, we discuss the definition of a financial system, how they work, why they matter and the components of a financial system.

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What is a financial system?

A financial system is a set of institutions and practices that facilitate and allow for the exchange of funds between borrowers, lenders and investors. Financial systems exist on firm-specific, regional and global levels. They include institutions like:

  • Banks

  • Government treasuries

  • Insurance companies

  • Loan companies

  • Mutual funds

  • Stock exchanges

Related: Brokerage vs. Investment Bank: What's the Difference?

What are the components of a financial system?

Each financial system is unique. However, each system includes a set of practices and rules for borrowers and lenders use. These rules help determine things like which projects receive financing, who will finance the project and the specific terms of financial deals.

Here some components of a financial system:

  • Money: Money provides the basis of financial systems. While the consistency of money may vary based on changes in technology and financial systems themselves, money most often relates to electronic funds.

  • Financial markets: Financial markets are the environments where buyers and sellers interact with one another to purchase, trade and sell assets like bonds and shares. These markets include trading houses, such as the New York Stock Exchange and NASDAQ.

  • Financial institutions: Financial institutions, such as banks, provide a range of products and services and act as a mediator between borrowers and investors. They offer services like mortgages, brokerage accessibility and insurance. They help mobilize savings directly or indirectly and raise funds for financial assets like loans, securities and deposits.

  • Financial instruments or financial assets: Financial instruments or assets are the products traded in financial markets, such as securities, stocks, bonds, insurance and mortgages. There may be different requirements for each credit seeker, and trading stocks or securities may involve mutual funds or pooling the savings of investors.

  • Financial services: Financial services are the services provided by liability and asset management companies, such as investment, insurance and banking services. These services help acquire and efficiently invest funds.

  • Regulatory agencies: Regulatory agencies oversee all activities of markets and institutions, and they often rely on government review systems to help ensure best practices. They review and enforce guidelines related to the practices of systems. They also supervise specific members of the system to protect the public's money and investments.

  • Central banks: Central banks are integral to government functions. Countries have these banks to help finance, but not control, the country's available money and credit. An example of a central bank is the United States Federal Reserve.

How does a financial system work?

Financial systems allow investors, lenders and borrowers to exchange funds and pursue a return on their financial assets. These parties may use these funds to finance projects or productive investments. Each system has a unique framework regulated by the government or similar organizations. This helps to regulate each institution's influence over assets and economic performance and to protect consumers.

How a financial system works depends on its organization. Here are some of the common organizational structures:

Central planning

Central planning may occur in a single firm or a command economy. With this organizational structure, a manager or central planner makes decisions related to funds, such as whose and which projects receive funds and who will fund projects. The central planner is often a business manager or party boss within the institution.

Read more: Economic Systems: Definitions and Types

Markets

Markets allow institutions to trade economic goods based on laws of supply and demand. They trade goods based on:

  • Cash: Current money

  • Credit: Claims on future money

  • Equity: Claims on future income potential or value of real assets

Markets also involve derivative instruments. These are financial instruments that depend on the performance of an underlying real or financial asset. Examples of derivative instruments include stock options and commodity futures.

Combination

Most financial systems have a combination of markets and central planning organizational structures. For example, an individual business firm may use central planning for their internal business decisions. However, the same firm may work in a large market and interact with external leaders and potential investors to seek funds for long-term plans.

Importance of financial systems

Financial systems promote the overall domestic and international economic and financial stability. They provide the framework for allowing economic transactions and implementing monetary policies. These policies help properly facilitate investments and exchanges, channeling savings into investments to support growth.

Systems also ensure monetary policies are effective to help manage and rude risk and prevent a range of problems, such as economic downturn or increased fiscal costs. This is increasingly important with the growth of fintech companies and increased connectivity and financial and trade links between different countries. Financial systems help prevent issues through policies that apply for multiple sectors and borders.

Related: The Benefits of a Career in Fintech (Plus Jobs List)

Examples of financial systems

Financial systems exist on an individual firm, regional and global scale. Each of these systems has unique components and purposes. These systems include:

  • Firm scale: The financial system includes procedures to track a company's financial activities. The system encompasses all aspects of finance, such as accounting measures, balance sheet verification, revenue and expense schedules and wages.

  • Regional scale: Regional scale financial systems enable borrowers and lenders to exchange funds. These systems include banks and other institutions, such as financial clearinghouses and securities exchanges.

  • Global scale: A global scale financial system is broader than a regional scale. It encompasses all financial institutions, lenders and borrowers within a global economy. This system may include central banks, government treasuries, international monetary funds, major private international banks, money authorities and world banks.

Here is an example of a financial system:

State of Florida Bank is a central bank established to promote and protect the financial and economic well-being of Floridians. It oversees financial markets, credit unions, banks and other factors to develop a healthy, functioning economic landscape. The bank develops and implements policies to establish payment frameworks and oversees infrastructures for settlement systems.

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