Functions of the Financial System | CFA Level I Equity Investments
Before we dive into equities, let’s first gain an understanding of the organization and structure of the financial market. In this first part, we’ll explore the functions of the financial system.
Participants in the Financial System
The participants in the financial system are primarily individuals, firms, and governments.
The three main functions of the financial system are to:
- Help these participants achieve their purposes in using the financial system.
- Determine the returns that equate the total supply of savings with the total demand for borrowing.
- Allocate capital to its most efficient uses.
Let’s examine each of these functions.
1. Helping Participants Achieve Their Purposes
Some of the purposes of using the financial system are to save, borrow, issue equity capital, manage risks, exchange assets, and utilize information. The financial system is best at fulfilling these roles when the markets are liquid, transactions costs are low, information is readily available, and when regulation ensures the execution of contracts.
Here’s a brief look at some of these purposes:
Individuals typically save for retirement and expect a return that compensates them for risk and the use of their money. Firms save a portion of their sales to fund future expenditures. Instruments used for saving include stocks, bonds, certificates of deposit, or real assets such as real estate.
Individuals often borrow to buy a house, fund a college education, or for other purposes. Governments may borrow by issuing debt to fund their expenditures. Firms may borrow to finance capital expenditures and for other activities.
Issuing Equity Capital
Firms can raise capital by issuing equity, where the capital providers become shareholders of the company and share in any future profits. The financial system facilitates raising equity capital. Investment banks help with issuance, analysts value the equity, and reporting requirements and accounting standards ensure the production of meaningful financial disclosures.
Many individuals, firms, and governments face financial risks, such as changing interest rates, currency values, commodities values, and defaults on debt. These risks can often be managed by trading contracts that serve as hedges for the risks.
A wheat farmer and a flour producer both face risks related to the price of wheat. The farmer’s risk is that prices will be lower than expected when his crop is ready for sale. The flour producer fears that prices will be higher than expected when it has to buy wheat in the future. They can both reduce their risks if they enter into a forward contract for the farmer to sell to the flour producer at a future date at a fixed price. As such, both parties are not subject to the market price of wheat for this batch. This removes uncertainty about future prices for both parties.
The financial system helps participants exchange assets, both for immediate delivery (spot market trading) and for future delivery. Organized markets governed by the financial system make these exchanges more convenient and efficient.
Not all market participants have an operational need to trade in the financial market. Some participants primarily aim to profit from trading in the markets based on information they believe allows them to predict future prices. Investors who can identify assets that are currently undervalued or overvalued in the market can earn extra returns from investing based on their information.
These six aspects illustrate how the financial system helps participants achieve their purposes.
2. Determining Rates of Return or Interest Rates
It’s interesting to view the financial system as two distinct activities: borrowing and lending.
When a saver places money in a bank deposit, they are lending money to the bank, which becomes the borrower. When an investor purchases debt or equity securities issued by a government or company, the investor is the lender, and the issuing entity collects the capital and becomes the borrower.
Similarly, when a bank issues a loan to a borrower, the bank becomes the lender.
This borrowing and lending can be viewed as demand and supply of money in the financial system. The demand and supply are highly affected by the rate of return, or interest rates.
When interest rates are high, lenders will want to lend more as the returns are higher, and borrowers want to borrow less as the interest cost is high. This causes the supply of money to be high and the demand for money in the system to be low. Lenders may be driven to lower their rates of lending, enticing more borrowers to borrow more.
This drives the money supply down and the money demand up, until an equilibrium level where supply equals demand is reached. This is known as the equilibrium interest rate – the rate at which the amount borrowers desire is equal to the amount lenders desire. In many countries, the central bank plays an important role in guiding this equilibrium rate through monetary policy. This topic is covered under the Economics section of the CFA curriculum.
3. Allocating Capital Efficiently
As capital is limited, the financial system should be structured to allocate funds to the most productive uses. In market-based economies, lenders determine, directly or indirectly, which borrower obtains capital. Borrowers with better credit ratings are perceived as being less risky, so lenders with a lower risk appetite will be fine with lending even though the rate of return is lower. Conversely, borrowers with poorer credit ratings will have to offer higher returns to convince investors to lend to them. This process is efficient only if market information is accurate. Regulators and standards-setting bodies have the responsibility to ensure that financial information is accurately reported in the most useful manner.
And there you have it! The three key functions of the financial system. In the next lesson, we’ll learn about the classifications of financial assets and markets. See you again!