Business e-Bulletin

Vol. 1, Issue 1, 2009, 1-5

FINANCIAL SYSTEM’S ROLE IN THE

ECONOMIC DEVELOPMENT
AMINA ZAHRA SHEIKH OMAR MOHAMUD

Without financial system it is quite difficult and expensive to allocate

resource and shift risks to its lowest level (low economic development).
Financial system plays an important role in the economic development and it
is divided into financial markets and institutions. The role of the financial
system is to gather or pool money from people and businesses that have
more than they need currently and transmit those funds to those who can
use them for either consumption or investment. The larger the flow of funds
and the more efficient their allocation is, the better the economic output and
welfare of the economy and society.
A healthy economy is dependent on efficient transfers of resources
from people who are net savers (surplus) to firms and individuals who need
capital. Without efficient transfers, the economy simply could not function.
Obviously, the level of employment and productivity, hence our standard of
living, would be much lower. Therefore, it is absolutely essential that our
financial market functions efficiently, not only quickly, but also at a minimal
cost. So this paper is written to describe the importance of financial system
to the economic development of a nation. It will also seek to highlight the
techniques used to allocate funds or resource and also risk minimization.
Lastly, it attempts to identify the financial intermediation players and the
instruments used in doing so.

ASSET ALLOCATION BETWEEN SAVERS (SURPLUS)

AND BORROWERS (DEFICIT) PARTS

The financial system consists of financial markets and institutions. Financial

markets are where people buy and sell, win and lose, bargain and argue
about the price and the product/services. The only difference between
financial markets and normal market that we know is that in the financial
markets people buy and sell financial instruments like stocks, mortgage
contracts, and bonds and so on. Financial institutions, as part of financial
system, they also play an important role in economic development by
facilitating the flow of funds from surplus unit (savers) to the deficit unit
(borrowers). They are firms such as credit unions, commercial banks, finance
institutions, insurance companies and etc.
Economic elements or parties that are involved can be divided into
households, business organizations, and government. Business often needs
capital to implement growth plans; government requires funds to finance
building projects; and households frequently want loans for example to
purchase homes, cars and so on. Fortunately, there are other individuals or
households and firms with incomes greater than their expenditures (surplus
budget position). Therefore financial markets bring together people and

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organizations needing money with those having surplus funds. In other
words, the purpose of the financial system is to transfer funds from savers to
the borrowers in the most effective and efficient possible manner. And that
job can be done by direct financing or by indirect financing. Despite the
method of transferring the resources the objective is to bring the involving
parties together at the lowest possible cost.

a. Direct Financing: In direct financing borrowers and savers exchange

money and financial instruments directly. Borrowers or deficit units issue
financial claims (they are claims against someone else’s money at a future
date) on themselves and sell directly to savers or surplus units for money.
The savers hold the financial claims as interest bearing instruments and
they can sell it in financial markets. Upon agreed time or maturity date
borrowers have to give back the savers principle plus the agreed interest
rate.

b. Indirect financing: A problem that arises from direct financing brought the
usage of indirect financing. Sometimes the savers or surplus units can’t
wait to hold financial claims till maturity date therefore they sell the
financial claims to the financial intermediation and take their funds from
them to do whatever they please.

BENEFITS OF FINANCIAL INTERMEDIATION (INSTITUTIONS)

Financial intermediaries have three main sources of proportional advantage

compare to others. First, financial institutions can achieve economies of
balance through specialization of what they offer and do, because they
handle large numbers of transactions, they are able minimize the fixed cost
through spreading between them. Second, financial institutions’ searching
and transaction cost for credit information can be minimized. Lastly, financial
institutions have the ability to get important information concerning the
borrowers’ financial position because they have a history of exercising
discretion with this type of information, and they also can reduce unreliable
information concerning about the borrower.

SERVICES OF FINANCIAL INSTITUTIONS

In transferring resource allocation from direct financing to indirect financing,

financial institutions provide the following five basic services:

a. Currency alteration: Buying financial claims denominated in one currency

and selling financial claims denominated in another currencies.

b. Quantity Divisibility: Financial institutions are capable in producing a

broad range of quantity from one dollar to many millions, by gathering
from different people.

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Vol. 1, Issue 1, 2009, 1-5

c. Liquidity: Easy to liquidate the instruments by buying direct financial

claims with low liquidity and issuing indirect financial claims with more
liquidity.

d. Maturity Flexibility: Creating financial claims with wide range of maturities

so as to balance the maturity of different instruments so as to reduce the
gap between assets and liabilities.

e. Credit Risk Diversification (portfolio investment): By purchasing a broad

range of instruments, financial institutions are able to diversify the risk.

TYPES OF FINANCIAL INSTITUTIONS

Different financial institutions exist in our economy and they serve to

accomplish one function i.e. to purchase financial claims from borrowers
(deficit unit) and sell it with different characteristics to the savers (surplus
unit). Here are the major types of intermediaries:

1. Commercial banks are the major institutions that lend money, handle
checking accounts, and also provide an ever-widening range of services,
including stock brokerage services and insurance. Commercial banks are
the largest and most diversified institutions on the basis of range of
assets held and liabilities issued.

2. Thrift Institutions - Mutual savings and savings and loan associations are
commonly called thrift institutions. They serve individual savers and
residential and commercial mortgage borrowers, take the funds of many
small savers and then lend this money to home buyers and other types of
borrowers.

3. Credit unions are cooperative associations whose members are supposed

to have common bond. Credit unions are often the cheapest source of
funds available to individual borrowers.

4. Mutual funds sell equity shares to investors and use these resources to
purchase stocks or bonds. These organizations pool resources and thus
minimize risks through diversification. They also achieve economies of
scale in analyzing securities, managing portfolios, and buying and selling
securities.

5. Life insurance companies take savings in the form of premiums and then
invest these funds in bonds, stocks, mortgages, real estate and so on,
and then make payments to beneficiaries.

6. Pension funds are retirement plans obtain their funds from employers and
employees and administered generally by the trust departments of
commercial banks, or by life insurance companies. Pension funds invest

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 their money primarily in stocks, bonds real estate and mortgages like
insurance companies.

TYPES OF FINANCIAL MARKETS

There are many different types of financial markets. Each market exists to
serve a different region or deals with a different type of security. Here are
some of the major types of markets:

1. Physical asset markets also called tangible or real asset markets are those
market that are traded for such products as wheat, autos and real estate.

2. Financial asset markets deal with stocks, bonds, notes, mortgages, and
other claims on real assets.

3. Spot markets and futures markets are terms that refer to whether the
assets are bought or sold for “on-the-spot” delivery or for transfer at
some upcoming date.

4. Money markets are the markets for debt securities with maturities of less
than one year.
5. Capital markets are the markets for long-term debt (more than a year)
and corporate stocks.

6. Primary markets are markets in which corporation raise new capital such
as initial public offering (IPO).

7. Secondary markets are markets in which existing or already outstanding,

securities are traded among investors.

CONCLUSION

Financial system plays a significant role in the economic development of a

country. Financial markets present three major efficiencies for the sake of
development and they are allocation, information, and operational efficiency.
Financial institutions are profit maximizing businesses that earn profits by
acquiring funds at interest rates lower than they earn on their assets.

BIBLIOGRAPHIES

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Diamond, D. (1984). Financial intermediation and delegated monitoring.
Review of Economic Studies, 51, 393-414.

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Franklin, A., & Douglas, G. (2004). Financial intermediaries and markets.

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AMINA ZAHRA SHEIKH OMAR MOHAMUD

PhD Student (Islamic Finance and Banking)
College of Business
Universiti Utara Malaysia
06010 Sintok, Kedah
e-mail: aminafurso@gmail.com