Most of us don’t really understand about the financial system (including me). So, let’s we learn to give a clear picture of the financial system.
A financial system is a densely interconnected network of financial intermediaries, facilitators and markets that serves three major purposes : allocating capital, sharing risks and facillitationg intertemporal trade.
Do you understand? Maybe it is a bit hard to understand.
The main function of the financial system is when it includes borrowers. Borrowers also include inventors, entrepreneurs and other economic agents, like domestic households, governments, established businesses, and foreigners with potentially profitable business ideas but limited financial resources.
Lenders or savers include domestic households, businesses, governments and foreigners with excess funds. The financial system also helps to link risk-averse entities called hedgers to risk-loving ones known as speculators. The financial system illustrates you are probably already deeply embedded in the financial system as both a borrower and as a saver.
Occasionally, people and companies, especially small businesses or ones that sell into rapidly growing markets, have enough wealth (a stock) and income (a flow) to implement their ideas without outside help by plowing back profits (aka internal finance). Most of the time, however, people and firms with good ideas do not have the savings or cash needed to draw up blueprints, create prototypes, lease office or production space, pay employees, obtain permits and licenses, or suffer the myriad risks of bringing a new or improved good to market.
Why do we need a financial system? Why can’t individuals and companies simply borrow from other individuals and companies when they need to? Lending, like supplying many other types of goods, is most efficiently and cheaply conducted by specialists, companies that do only one thing (or a couple of related activities) very well because they have much practice doing it and because they tap economies of scale. The fixed costs of making loans are fairly substantial. To recoup those fixed costs, to drive them toward insignificance, lenders have to do quite a volume of business.
Little guys usually just can’t be profitable. This is not to say, however, that bigger is always better, only that to be efficient financial companies must exceed the minimum efficient scale.
