The functioning of an economy depends on the financial system of a country. The financial system includes banks as a central entity along with other financial services providers. The financial system of a country is deeply entrenched in the society and provides employment to a large population. According to Baily and Elliott, there are three major functions of the financial system:
Credit Provision – Credit supports economic activity. Governments can invest in infrastructure projects by reducing the cycles of tax revenues and correcting spends, businesses can invest more than the cash they have and individuals can purchase homes and other utilities without having to save the entire amount in advance. Banks and other financial service providers give this credit facility to all stakeholders.
Liquidity provision – Banks and other financial providers protect businesses and individuals against sudden cash needs. Banks provide the facility of demand deposits which the business or individual can withdraw at any time. Similarly, they provide credit and overdraft facility to businesses. Moreover, banks and financial institutions offer to buy or sell securities as per need and often in large volumes to fulfil sudden cash requirements of the stakeholders.
Risk management services – Finance provides risk management from the risks of financial markets and commodity prices by pooling risks. Derivative transactions enable banks to provide this risk management. These services are extremely valuable even though they receive a lot of flak due to excesses during financial crisis.
The above three major functions are important for the running and development activities of any economy. Apart from these functions, an economy’s growth is boosted by the savings-investment relationship. When there are sufficient savings, only then can there be sizeable investment and production activity. This savings facility is provided by financial institutions through attractive interest schemes. The money saved by the public is used by the financial institutions for lending to businesses at substantial interest rates. These funds allow businesses to increase their production and distribution activities.
Growth of capital markets
Another important work of finance is to boost growth of capital markets. Businesses need two types of capital – fixed and working. Fixed capital refers to the money needed to invest in infrastructure such as building, plant and machinery. Working capital refers to the money needed to run the business on a day-to-day basis. This may refer to the ongoing purchase of raw materials, cost of finishing goods and transport of finished goods to stores or customers. The financial system helps in raising capital in the following ways:
Fixed capital – Businesses issue shares and debentures to raise fixed capital. Financial service providers, both public and private, invest in these shares and debentures to make profits with minimal risk.
Working capital – Businesses issue bills, promissory notes etc. to raise short term loans. These credit instruments are valid in the money markets that exist for this purpose.
Foreign exchange markets
In order to support the export and import businessmen, there are foreign exchange markets whereby businesses can receive and transmit funds to other countries and in other currencies. These foreign exchange markets also enable banks and other financial institutions to borrow or lend sums in other currencies. Moreover, financial institutions can invest and reap profits from their short term idle money by investing in foreign exchange markets. Governments also meet their foreign exchange requirements through these markets. Hence, foreign exchange markets impact the growth and goodwill of an economy in the international markets.
Governments use the financial system to raise funds for both short term and long term fund requirements. Governments issue bonds and bills at attractive interest rates and also provide tax concessions. Budget gaps are taken care of by government securities. Thus, capital markets, foreign exchange markets and government securities markets are essential for helping businesses, industries and governments to carry out development and growth activities of the economy.
Infrastructure and growth
The economic growth depends on the growth of infrastructural facilities of the country. Key industries such as power, coal, oil determine the growth of other industries. These infrastructure industries are funded by the finance system of the country. The capital requirement for infrastructure industries is huge. Raising such a huge amount is difficult for private players and hence, traditionally, governments have taken care of infrastructure projects solely. However, the economic liberalization policy led to the private sector participation in infrastructure industries. Development and Merchant banks such as IDBI in India help fund these activities for the private sector.
Trade is the most important economic activity. Both, domestic and international trade are supported by the financial system. Traders need finance which is provided by the financial institutions. Financial markets on the other hand help discount financial instruments such as promissory notes and bills. Commercial banks finance international trade through pre and post-shipment funding. Letters of credit are issued for importers, thereby helping the country to earn important foreign exchange.
Financial system plays a key role in employment growth in an economy. Businesses and industries are financed by the financial systems which lead to growth in employment and in turn increases economic activity and domestic trade. Increase in trade leads to increase in competition which leads to activities such as sales and marketing which further increases employment in these sectors.
Increase in venture capital or investment in ventures will boost growth in economy. Currently, the extent of venture capital in India is less. It is difficult for individual companies to invest in ventures directly due to the risk involved. It is mostly the financial institutions that fund ventures. An increase in the number of financial institutions supporting ventures will boost this segment.
Balances economic growth
The growth of different sectors of an economy is balanced through the financial system. There are primary, secondary and tertiary sector industries and all need sufficient funds for growth. The financial system of the country funds these sectors and provides sufficient funds for each sector – industrial, agricultural and services.
Thus, finance plays a key role in the development of any economy and no economy can run successfully without a sound financial system.