Functions and importance of Financial System

The financial system helps production, capital accumulation and growth by 

  1. Encouraging savings
  2. Mobilising them
  3. Allocating them among alternative uses and users.

Each of these functions is important and the efficiency of a given financial system depends on how well it performs each of these functions.

Inducement to save : the financial system promotes savings by providing a wide array of financial assets as a store of value accompanied by the services of financial markets and intermediaries of various kind. For wealth holders, all this offers ample choice of portfolios with attractive combinations of income, safety and yield. Saving – income ratio is directly related both financial assets and financial institutions, i.e. financial progress generally induce larger savings out of the same level of real income.

As a store of value, financial assets have advantages over tangible assets (physical capital, inventories of goods etc.). They are convenient to hold or easily storable, more liquid, more easily divisible and less risky.

Savers are the household sector, domestic private corporate sector and the public sector. Household sector comprises; individuals, non-government, non-corporate entities in agriculture, trade and industry and non-profit making organisations like trusts and charitable institutions.

Public sector comprises; central and state government, departmental and non-departmental undertakings, RBI etc.

Domestic Private corporate sector comprises non-governmental public and private limited companies, corporate institutions.

Of all these, the dominant saver is the household followed by the domestic private corporate sector.

Mobilisation of Savings : a financial system is a highly efficient mechanism for mobilising savings. The public holds its savings in the form of money. However, this is not the only way of instantaneous mobilisation of saving. Other financial methods used are deductions at source of the contributions to provident fund and other saving schemes. More generally, mobilisation of savings take place when savers move into financial assets. Whether currency, bank deposits, post office saving deposits, life insurance policies, bill, bonds, equity shares, etc.

Allocation of funds : Another function of financial system is to arrange smooth, efficient and socially equitable allocation of credit. by granting easy and chap credit to particular firms, they can shift outward the resource constraint of these firms and make them grow faster. On the other hand, by denying adequate credit on reasonable terms to the firms, financial institutions can restrict the growth or ever normal working of these other firms substantially. Thus, the power of credit can be used highly discriminately to favour some and to hinder others.

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