Characteristics of a Well-Functioning Financial System | CFA Level I Equity Investments

Functions of the Financial System

First things first, let’s have a quick recap of the financial system’s primary functions:

1. Help participants achieve their purposes in using the financial system.
2. Determine the returns that equate the total supply of savings with the total demand for borrowing.
3. Allocate capital to its most efficient uses.

Participants in the financial system include individuals, firms, and governments. Some of their purposes are to:

• Save for the future
• Borrow for operational needs
• Issue equity to raise capital for expansion
• Manage and hedge financial risks
• Exchange assets such as currencies and commodities
• Profit through information advantage

Complete Markets and Efficiency

A well-functioning financial system allows participants to achieve their purposes. More specifically, complete markets:

• Allow investors to save for the future at fair rates of return
• Enable creditworthy borrowers to obtain funds through debt or equity issuance
• Allow hedgers to easily trade away or offset the risks that concern them
• Allow traders to easily exchange currencies, commodities, and other assets they need

If a market can perform these functions at low trading costs, it is said to be operationally efficient. If security prices reflect all the information associated with fundamental value in a timely fashion, then the financial system is informationally efficient.

Financial Intermediaries in a Well-Functioning Financial System

Key players in a well-functioning financial system include:

• Exchanges, brokerages, and alternative trading systems that match buyers to sellers
• Dealers that provide liquidity on demand to traders
• Securitisers that securitise assets to produce investment instruments attractive to investors, lowering interest costs for borrowers
• Banks that match investors to borrowers by taking deposits and making loans
• Insurance companies that pool uncorrelated risks
• Financial advisors that help investors manage and grow their assets
• Clearinghouses that ensure everyone settles their trades and contracts
• Depositories that ensure nobody loses their assets

Benefits of a Well-Functioning Financial System

With a well-functioning financial system:

• Savers and investors can directly or indirectly fund companies that need capital for expansion or projects
• Risk can be transferred to those better equipped to bear it
• Transactions can occur among strangers, widening opportunities for capital formation and risk-sharing in the economy
• Capital is allocated to its most productive use, leading to allocationally efficient markets

Allocation Efficiency and Informational Efficiency

In well-functioning financial systems, markets are allocationally efficient. This means:

• Reporting requirements and accounting standards produce meaningful and timely financial disclosures
• Analysts can form more accurate estimates of fundamental values
• Well-informed traders make prices informationally efficient

If markets are operationally efficient, prices will also be more informationally efficient because low trading costs encourage trading based on new information.