The Financial System — and everything that makes it
Understanding the financial system should be your first step in navigating any finance — corporate finance, business, or personal. In this article, we will gain a workable knowledge of how our financial system works.
History of the Financial System
Before the human population explosion, the exchange system in place was the trade by barter system. If Kunle, the community butcher, wanted to buy yams, he would have to find a yam seller like Ada and offer meat in exchange for the yams. It was as simple as that.
But the barter system came with its problems. Most notably was the double coincidence of wants. If Ada did not want what Kunle was offering, the trade would not occur. Determining the exact value of a good was also tricky in the barter system, and when it came to serving many customers, the barter system failed spectacularly. Thus, the credit system replaced the barter system as communities grew and our society became more complex.
Under the credit system, a buyer could have a good or service delivered while incurring a debt to the seller. The credit system ensured that Kunle could get yams at any time if he owed Ada a favour after the trade. However, credit comes with risk, and debts could remain unpaid due to death or disablement.
The introduction of cash, which we all know and love, minimised the risk of unpaid credit by allowing the immediate settlement of any transaction without the risk of debt. It also allowed goods and services to be valued fairly.
Equipped with cash, the system of exchanging goods and services blossomed into the financial system in place today.
What is the financial system like?
A financial system is a dense network of intermediaries, facilitators, and markets that efficiently distributes economic resources to promote economic growth and generate a return on investment (ROI) for the market participants.
A financial system effectively manages the transfer of funds between lenders and borrowers. Lenders in the financial system are the entities that have the funds to give out to the Borrowers that would use the money to launch businesses and drive the economy or do whatever they like. When a system is in place, the transfer and receipt of funds between these two entities are better handled, documented and regulated.
Our current financial system also comprises financial institutions, financial markets (where the exchange of financial instruments between individuals and other entities happens), and money as the medium of exchange.
The material progress and technological breakthroughs of the last two centuries would not have been possible without the financial system.
For instance, Stella wants to supply food to the offices in her estate, but she does not have the funds to deploy her idea. She goes to a company that gives loans to SMEs and receives one to start a food business. Stella begins to supply food, makes a profit, and pays back her loan. The result is that some happy workers have lunch delivered to them by an entrepreneur with a thriving business. The financial system eases the creation of value.
This is the magic of a booming economy supported by an effective financial system. It facilitates economic growth, supports entrepreneurship, and improves the lives of everyone participating.
Benefits of a Financial System
A financial system does so much more than fund the dreams of entrepreneurs. More benefits include;
- Ensures the smooth flow of funds among people in an economy — the free movement of funds from savers to investors to borrowers.
- Ensures sufficient availability of funds in the economy by improving liquidity (amount of spendable cash) in the hands of members of the system.
- It bridges the gap between savings and investment by acquiring money from those sitting on it and transferring it to entrepreneurs who need it for their productive ventures.
- Reduces risk by distributing funds to a large number of people.
- Aids in capital formation by enabling large corporations and industries to acquire the funds needed to carry out or expand their operations (think of Stella’s business but bigger).
Our financial system is not perfect. It requires constant regulation, tight rules, and monopolies need to be squashed down. Nevertheless, the system continues to evolve and serve people who understand it.
We will be back with more in Part 2…
