The financial system includes money, financial markets, and financial institutions.
The financial system is the plumbing of the economy. It allocates funds by connecting savers and borrowers. People need access to finance to manage expenses over time. Businesses need access to funds to launch and grow. Therefore, the financial system provides an essential service to the economy.
Financial assets and liabilities are the contracts that make up the financial system. A financial asset is a claim on someone else to pay you money. A financial liability is the obligation to pay.
Financial markets connect the supply and demand of funding. Securities are financial assets that trade in a financial market. Firms issue securities (supply) and investors buy securities (demand). There are many types of financial markets for trading different types of securities. Some categories of financial markets are the following: stocks (equity), bonds (fixed income), securitized loans (ABS), money (money market), foreign exchange (currencies) and commodities.
Financial institutions provide financial services. Examples of financial services are risk sharing, liquidity, and information.
The financial system matches savers and borrowers through two channels of funding:
- Direct finance
- Indirect finance
Direct finance is the channel of funding associated with financial markets. Stock exchanges are an example of direct finance.
Indirect finance is the channel of funding associated with financial institutions. Banks are an example of indirect finance.
The key difference between direct and indirect finance is that banks function as financial intermediaries in the indirect channel of funding.
There is a wide range of financial institutions. One of the main distinctions is commercial banks versus non-commercial banks. The non-bank financial intermediaries include investment banks, insurance companies, pension funds, mutual funds, and hedge funds.
Primary market is the market in which a financial asset is created.
Secondary market is the market in which a financial asset is traded.
An exchange is a market where buyers and sellers meet to trade goods or services.
A bull market is a market with a price index that has risen by more than 20% from a recent low and a bear market is a market with a price index that has fallen by more than 20% from a recent high. An easy way to remember these terms is that a bull swings up with its horns and a bear swings down with its claws. We often associate the terms bull market and bear market with the stock market, but these terms can be applied to any financial market. For instance, the bond market can be a bull market or bear market as well. A market correction is a decline in a market price index of more than 10%.
Financial regulation is an important part of defining the rules of conduct and enforcing those rules. The financial sector is one of the most heavily regulated sectors in the economy. The primary regulators of financial markets are the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The primary federal regulators for banks are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Federal Reserve.
Central banks also play an important role in the financial system. The Federal Reserve (the “Fed”) is the central bank of the United States. Central banks set monetary policy, which controls the supply of money in an economy.
The financial system is being disrupted by technology. The newest generation of technology in finance is called “fintech.”
Glossary
Bear market. A market with a price index that has fallen by more than 20% from a recent high
Bull market. A market with a price index that has risen by more than 20% from a recent low
Direct finance. The channel of funding associated with financial markets
Exchange. A market where buyers and sellers meet to trade goods or services
Indirect finance. The channel of funding associated with financial institutions
Market correction. A decline in a market price index of more than 10%
Primary market. The market in which a financial asset is created
Secondary market. The market in which a financial asset is traded