The Financial Sector
The financial sector can be defined as the interaction of lenders and borrowers in financial markets within a regulatory framework. Key in this interaction is lending and borrowing of financial capital or money. This lending and borrowing is usually achieved through financial intermediaries such as commercial banks, brokers and other financial institutions.
Functions of Financial Intermediaries
- Mobilization of savings – financial intermediaries allow individuals to save money in a secured place, which can then be lent to firms and individuals in society.
- Providing loans (risk management) – financial institutions manage risk by lending to a large number of borrowers. This means that the risk is spread among a large section of the system.
- Expert advice – many investors may lack knowledge about investing and so financial intermediaries perform the role of providing advice to investors regarding the most suitable investment instruments to invest in.
- Facilitating the exchange of goods and services – this exchange of goods and services is usually facilitated by these financial intermediaries performing the role of middlemen. For example, when a consumer wants to purchase a pair of shoes, they can do so with their bank’s debit card.
Financial Institutions
The financial institutions of most economies include: the Central Bank, commercial banks, stock exchange, insurance companies, credit unions, mutual funds, development banks, building societies and investment trust companies.
Role of a Central Bank
The main functions of a central bank include:
- Issuer of notes and coins – the Central Bank is the only issuer of notes and coins in a country. No other entity performs this role. The reason why the Central Bank is usually the sole issuer of notes and coins is for there to be confidence in the notes and coins;
- Banker’s bank – the Central Bank is the facilitator of loans to commercial banks;
- Government’s bank – the Central Bank acts on behalf of the government for all financial transactions. Additionally, if the government needs loans the Central Bank facilitates this;
- Management of the economy – the Central Bank usually assists the central government in managing the economy through monetary policy;
- Lender of last resort – if commercial banks get into liquidity shortages meaning that they cannot honour their financial obligations, then the Central Bank is able to lend the commercial banks sufficient funds to avoid the bank running short of money.
Commercial Banks
The main functions of commercial banks are:
- Mobilizing Saving for Capital Formation – commercial banks help in mobilizing savings through network of branch banking. They allow citizens to deposit their monies into the commercial banks and commercial banks pay these depositors a rate of interest. These commercial banks then use these deposits to lend to businesses and individuals in society. By lending these monies, the commercial banks charge borrowers a higher rate of interest than the rate of interest that they pay to depositors. The difference between the interest rate that commercial banks charge borrowers and the interest rate they pay to depositors for the use of their money is the profit to the commercial banks. Therefore, by taking deposits from individuals, commercial banks are mobilizing savings which they lend to others which contribute to capital formation. Besides lending the deposited money, commercial banks also invest a portion of these deposits.
- Financing Industry – the commercial banks finance the industrial sector through granting loans.
- Financing Trade – commercial banks finance both exports and imports of goods and services of countries by providing foreign exchange facilities to importers and exporters of goods.
- Financing Consumer Activities – people in less developed countries being poor and having low incomes do not possess sufficient financial resources to buy durable consumer goods. The commercial banks advance loans to these consumers for the purchase of such items.
Stock Exchange
Some of the important functions of stock exchange are as follows:
- Mobilization of capital – by allowing investors to be able to buy shares of listed companies and being able to allow sellers of shares to sell their shares on the secondary market, a stock exchange assists in the mobilization of capital and the efficient allocation of such capital.
- Economic indicator – changes in economic conditions are reflected in the share prices of companies listed on the stock exchange.
- Pricing of securities – the stock market helps to determine the value of securities. This is accomplished through the forces of demand and supply.
Insurance Companies
Insurance is a method of transferring risk or pooling risk where people pay a fee (premium) to insure life and property. Insurance involves pooling funds from many insured entities to pay for the losses that some may incur.
Insurers make money in two ways:
- Underwriting – underwriting is the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks,
- Investing – insurance companies invest portions of the premiums they collect from insured parties.
Credit Unions
A credit union is a member-owned financial cooperative, democratically controlled by its members.
The role and function of credit unions include:
- Providing loans – members are given loans at competitive rates based on the number of shares they own in the credit union.
- Supporting community development – credit unions assist in sponsoring local community events as well as enhancing the physical appearance of communities.
Mutual Funds
A mutual fund is a professionally-managed trust that pools the savings of many investors and invests them in securities like stocks, bonds and short-term money market instruments. Investors in a mutual fund have a common financial goal and their money is invested in different asset classes in accordance with the fund’s investment objective. Investments in mutual funds entail comparatively small amounts, giving retail investors the advantage of having financial professionals control their money.