Functions and Components of a Financial System
A financial system is central to a country’s economic growth because it channels savings into productive investment. By acting as an intermediary between those who save a portion of their income and those who require funds to build assets, it mobilizes savings, directs them to the most productive uses, and helps allocate the country’s scarce resources efficiently.
More broadly, a financial system comprises a network of institutions, markets, instruments and services that work together to facilitate the transfer and allocation of funds across the economy. When well integrated, these elements lower the cost of transactions, manage risks, and ensure that funds flow smoothly from savers to borrowers, thereby supporting sustained economic activity.
Financial Dualism and Integration
Most developing countries exhibit a dual structure in their financial systems, where an organized, regulated formal sector exists alongside an unregulated, informal sector. This coexistence is often described as “financial dualism.” The formal sector—comprising banks, non‑bank financial institutions and other regulated intermediaries—serves the needs of the modern, urban economy through standardized products, supervision and legal protection. In contrast, the informal sector operates outside formal regulation, serving traditional, rural and small‑scale economic activities through personal networks and customary practices.
The informal financial system has grown out of deeper economic and social dualities in developing societies and from episodes of financial repression that restrict access to credit for disadvantaged groups. It is marked by operational flexibility and close, often personal, relationships between lenders and borrowers. These features tend to reduce transaction frictions: procedures are simple, monitoring can be direct, and default risk is managed through social enforcement mechanisms. At the same time, the informal sector shows wide variation in lending rates and, in many cases, higher rates than those in the formal market.
Despite their differences, the formal and informal sectors are not isolated: they interpenetrate through shared participants, overlapping activities and complementary services. This interaction has reinforced their coexistence, but it also highlights a policy priority. Strengthening an efficient formal financial system is important because, when well‑developed and accessible, it can lower intermediation costs and extend reliable services to a broader base of savers and entrepreneurs, thereby enhancing financial inclusion and supporting sustained economic development.
Formal and Informal Financial Systems
The Indian financial system is broadly divided into two parts: the formal (organized) financial system and the informal (unorganized) financial system. The formal system operates under the oversight of central institutions such as the Ministry of Finance, the Reserve Bank of India and the Securities and Exchange Board of India, together with other statutory regulators that set rules for banking, capital markets and other financial services.
The informal system, by contrast, operates largely outside this regulatory framework and includes several types of providers. At the individual level there are moneylenders — neighbours, relatives, landlords, traders and shop‑owners — who extend credit on personal terms. There are also self‑governing groups that pool savings and lend among members under locally agreed rules, frequently known by names such as “fixed fund,” “association” or “saving club.” Finally, small partnership firms and local intermediaries — brokers, pawnbrokers and certain non‑bank finance entities including chit‑funds and other finance or investment firms — supply credit and services in ways tailored to local needs.
The gradual spread of banking into rural areas has helped bring more people and transactions into the organized financial system, thereby expanding its reach and reducing reliance on informal sources in many parts of the country.
Elements of the Formal Financial System
The formal financial system comprises four interrelated components: financial institutions, financial markets, financial instruments, and financial services. Financial institutions — including banks, non‑bank intermediaries and other entities — mobilise savings and channel funds between savers and borrowers. Financial markets are the venues and mechanisms where money and capital are traded, enabling price discovery and liquidity. Financial instruments are the contracts and claims (such as deposits, loans, bonds and equity) used to transfer funds and share risk. Financial services encompass the range of activities — payments, insurance, investment management, advisory and related services — that support the functioning and efficiency of the entire system.
Financial institutions are intermediaries that mobilize savings and channel funds into productive uses, thereby improving the efficiency of capital allocation in the economy. Broadly, they fall into two functional groups: banking institutions, which both accept deposits and create credit, and non‑banking financial institutions, which primarily extend credit without creating the same type of monetary liabilities. Because banks take deposits, their liabilities form part of the money supply; liabilities of non‑bank institutions generally do not.
In India, the non‑bank sector comprises several important categories. Development financial institutions (DFIs), non‑banking financial companies (NBFCs) and housing finance companies (HFCs) are major purveyors of credit outside the banking system. Term‑finance institutions — such as IDBI, ICICI, IFCI, SIDBI and IIBI — specialize in providing medium‑ to long‑term finance for industrial and infrastructure projects. There are also specialized finance entities like EXIM Bank, the Tourism Finance Corporation of India, ICICI Venture and IDFC, alongside sectoral institutions focused on particular needs, for example NABARD for agriculture and rural development and the National Housing Bank for the housing sector.
Investment and insurance institutions form another strand of the financial system. Mutual fund organisations, led historically by the Unit Trust of India and now including various public and private mutual funds, pool household savings into capital markets. Insurance activity is concentrated in bodies such as the Life Insurance Corporation and the General Insurance Corporation with its subsidiaries, which provide risk protection and mobilise long‑term resources.
At the state level, State Financial Corporations and State Industrial Development Corporations, owned and managed by state governments, support regional industrialisation. Since the economic reforms, the boundaries between these categories have grown fluid: banks have moved into non‑bank activities, financial institutions have adopted banking‑type functions, and most institutions increasingly tap financial markets rather than relying solely on administered sources of funds.
Financial markets are the organised venues where buyers and sellers exchange financial instruments and where the interaction of demand and supply determines the price of those instruments. Beyond simply facilitating transactions, these markets perform the essential economic function of price discovery and help channel savings into productive uses.
In India the principal organised markets are the money market and the capital market. The money market deals in short‑term instruments with maturities of less than one year, while the capital market handles long‑term securities with maturities of one year or more. These distinctions reflect differences in purpose, instruments and participants, with the money market focused on liquidity management and the capital market oriented towards long‑term financing.
Financial markets are also classified by the stage at which securities are traded. The primary market is where new securities are issued and sold for the first time; the secondary market provides liquidity by enabling trading in existing or outstanding securities. The secondary market comprises over‑the‑counter (OTC) trading and exchange‑traded activity. In OTC markets—such as the market for many government securities—transactions are negotiated directly between counterparties and are often settled on a spot basis for immediate delivery and payment. In exchange‑traded markets, trades occur through organised exchanges over a trading cycle. More recently, a formal exchange‑traded derivatives market has developed alongside these traditional segments.
A financial instrument is a contractual claim on a person or institution that promises payment of a sum of money at a future date and/or periodic payments such as interest or dividends. The phrase “and/or” indicates that an instrument may promise just a repayment, just periodic payments, or both. Common forms of financial instruments include shares, debentures, bonds and notes—paper claims that represent financial wealth. Many of these instruments are issued in small denominations and traded on organized markets, which makes them marketable and allows investors to hold diversified portfolios; diversification in turn helps reduce individual risk.
The term “securities” covers a broad set of financial instruments used to link savings and investments. Under the Securities Contracts (Regulation) Act, 1956, securities include shares, stocks, bonds, debentures, government securities, derivatives of securities, units of collective investment schemes, security receipts, and other instruments the central government may declare as securities. This legal definition captures instruments that are tradable and widely used to mobilize and allocate capital.
Securities can be classified as primary (direct) or secondary (indirect). Primary securities are issued directly by ultimate borrowers to ultimate savers—for example, equity shares and debentures issued by corporations. Secondary securities are issued by financial intermediaries to savers; typical examples are bank deposits, mutual fund units and insurance policies. The distinction reflects whether funds flow directly from savers to end‑users or through intermediaries.
Financial instruments differ in marketability, liquidity, transferability, embedded options, expected return, risk profile and transaction costs. These differences enable financial markets and intermediaries to channel funds efficiently from lenders to borrowers and to offer products tailored to diverse risk–return preferences. A wide variety of instruments also helps intermediaries manage and diversify their own risks while meeting the financing and saving needs of different classes of investors.
Core Functions and Regulation of Financial Services
Financial services are the activities that enable borrowing and funding, lending and investing, buying and selling of securities, the making and settling of payments, and the management of financial risks. Broadly, these services fall into five categories: funds intermediation, payment mechanisms, provision of liquidity, risk management, and financial engineering.
Funds intermediation links savers with borrowers and thereby supports capital formation. Advances in information technology have created new channels for intermediation, widening access to finance and lowering transaction costs. Payment services complement intermediation by allowing fast, secure and convenient transfers of funds and timely settlement of transactions.
Liquidity is a crucial ingredient for well-functioning markets. Trading in securities enhances the liquidity of financial claims, and liquidity is supplied by market participants such as brokers and market makers who facilitate buy and sell transactions and continuously quote prices. Without adequate liquidity, trading becomes costly and markets can seize up.
Risk management is another core function of financial services. Risk—understood as the chance of loss—can be shared, transferred or transformed through financial contracts. Markets and intermediaries enable participants to move unwanted risks to those willing to accept them; speculators and other market actors use trading platforms to assume and redistribute risk, while insurance and derivative instruments protect firms and investors against interest-rate, exchange-rate and other exposures.
Competitive pressures and technological change have also given rise to financial engineering: the design, development and implementation of innovative solutions for financing, investing and risk control. Financial engineering includes restructuring assets or liabilities, creating off-balance-sheet arrangements, developing synthetic securities and repackaging claims to meet specific needs of issuers and investors.
These services are provided by financial intermediaries—banks, insurance companies, mutual funds, stock exchanges and others—that offer merchant banking, leasing, hire-purchase finance, credit-rating and related activities. By bridging the information gap between sophisticated instruments and ordinary investors, intermediaries support the creation of firms, industrial expansion and broader economic growth.
Regulation underpins confidence in the system. Before lending or investing, participants need assurance that markets operate fairly and that intermediaries and issuers are properly supervised. Regulators protect investor interests, promote orderly conduct, and thereby foster market development. In India, the Reserve Bank of India (RBI) supervises the money market while the Securities and Exchange Board of India (SEBI) is the principal regulator of the capital market; the broader securities market is also overseen by the Department of Economic Affairs and the Company Affairs ministry. A high-level committee on capital and financial markets coordinates the activities of these agencies to ensure coherent supervision and policy.
Interplay of Financial Markets and Intermediaries
The components of a financial system do not operate separately; they are closely interwoven and continuously interact. These interactions—between institutions, instruments, markets and the supporting infrastructure—are what produce a smoothly functioning system capable of allocating capital, sharing risk and supporting economic activity.
Financial intermediaries play a central role in this process. By mobilizing savings through the issuance and distribution of various financial instruments, they channel funds to productive uses. To perform this role effectively they develop specializations and provide tailored financial services that ease the credit-allocation process. At the same time, intermediaries acquire, hold and trade securities, a practice that not only supports their lending and investment functions but also makes markets deeper, more liquid, more diversified and generally more stable.
The relationship between intermediaries and markets is reciprocal. As financial markets expand and become more sophisticated, they generate complex securities and portfolio strategies whose valuation and risk management demand professional expertise—expertise supplied by intermediaries. Conversely, intermediaries depend on these markets to raise funds quickly when needed, a dynamic that intensifies competition between markets and intermediaries for investors and borrowers. This mutual influence has reshaped many banks and institutions, where a growing share of income now comes from service fees and non‑interest activities tied to market operations.
Finally, broad and liquid markets themselves encourage saving by making financial instruments more attractive. When financial services improve the efficiency of intermediation and enhance net returns to investors, they further stimulate saving and investment, reinforcing the cyclical development of the financial system.
Core Functions of the Financial System
A core function of any financial system is to connect savers with investors, thereby mobilising savings and allocating them efficiently. By acting as a reliable conduit for resources, the financial system facilitates continuous technological upgradation and supports sustained economic growth.
Beyond simply allocating funds, the system helps select projects to finance and creates incentives for ongoing monitoring of those investments. Financial markets and institutions play a direct role in supervising corporate performance and enforcing discipline: market scrutiny, disclosure requirements and the threat of hostile takeovers act as checks on underperforming firms and align managers’ actions with investor interests.
Payment and settlement mechanisms are another fundamental service. They enable the exchange of goods and services and the transfer of economic value across time, space and sectors. Efficient payment systems ensure that funds move safely, quickly and predictably; this operational reliability supports the broader allocation efficiency of the financial sector and, in turn, economic growth. Banks historically provide these facilities through instruments such as cheques, promissory notes and cards, and increasingly through electronic platforms. Market clearing and settlement in securities trading are handled by depositories and specialised clearing corporations that minimise settlement risk.
A well-designed financial system also optimises the allocation of risk. By pooling, limiting and enabling trading of risks, it contains exposure within acceptable limits. Risk is reduced through governance rules, borrower screening and portfolio diversification; participants can further protect themselves by buying financial insurance services. Market instruments allow risk to be transferred to those more willing or able to bear it—most notably through derivatives, which are risk‑shifting devices that move exposure from risk-averse to risk-tolerant parties.
Price discovery and information dissemination are additional, indispensable functions. Financial markets generate and circulate price-related information that helps investors and managers form reasoned judgements about buying, selling or holding assets. Rapid valuation of financial instruments guides corporate managers on whether their actions serve shareholder wealth maximisation. At the same time, market mechanisms and institutional practices work to reduce information asymmetry and lower the costs of gathering and analysing information, thereby improving decision quality across the economy.
Financial markets and intermediaries also provide portfolio adjustment facilities—fast, low-cost and reliable means to buy and sell a wide range of assets. Banks, mutual funds and other intermediaries help investors rebalance holdings, diversify risk and access different maturities and instruments as needs change.
By lowering transaction costs, the financial system raises the net return to savers and reduces the cost of borrowing. These efficiency gains encourage higher savings and more productive investment, reinforcing the system’s role in fostering economic activity.
Finally, a functioning financial system promotes both depth and breadth. Financial deepening refers to an increase in financial assets relative to GDP and is a key indicator of development; it is commonly measured by the liquid liabilities of the financial system (currency plus demand and interest-bearing liabilities of banks and non‑bank intermediaries) as a percentage of GDP. Financial broadening denotes a wider range of participants and instruments, expanding access and choice across the economy. Together, deepening and broadening strengthen the resilience and inclusiveness of the financial sector.
Pillars of the Financial System
A well‑functioning financial system rests on several interlinked pillars: a robust legal and regulatory framework, stable money, prudent public finances and debt management, an effective central bank, a resilient banking system, reliable information flows, and efficient securities markets. These elements reinforce one another; weakness in any one can weaken the entire system.
Because financial activity is built on contracts, the single most fundamental requirement is a strong legal and regulatory environment that clearly defines and enforces rights and obligations. Effective laws, impartial courts and credible regulators reduce uncertainty, protect investors and creditors, and make contracts enforceable — all of which lower transaction costs and foster greater participation in financial markets.
Stable money underpins everyday economic activity. Money’s functions—as a medium of exchange, a store of value and a unit of account—make predictable purchasing power essential for saving, investment and long‑term planning. Large swings in the value of money or persistent depreciation distort prices, undermine confidence and can precipitate financial crises that impede growth.
Sound public finances and disciplined public debt management are equally important. Governments must set clear expenditure priorities and raise adequate revenues to meet them without creating unsustainable debt burdens. Historically, the borrowing and payment needs of governments were a key driver in the emergence of modern financial systems; jurisdictions that manage public finances well typically have deeper, more stable financial markets.
The central bank plays multiple, critical roles: it supervises and regulates the banking system, acts as banker to the government and to other banks, manages public debt and foreign exchange operations, and serves as lender of last resort. Its monetary policy influences inflation and aggregate demand, so operational independence and credible policy frameworks help anchor expectations and support a sound financial environment.
Banks remain the core intermediaries in most economies. A healthy banking system comprises a range of institutions—domestic and international—that can absorb shocks without failing. Banks operate payment and clearing systems, participate in foreign exchange markets, assess credit risks, and transmit monetary policy through lending. The overall financial soundness of the system depends on how well banks perform these functions and manage risks.
Reliable information is a foundational input for all market participants. Transparent disclosure, timely reporting and the networking of information systems allow lenders, investors and regulators to assess risks and make informed decisions. Strong information practices reduce asymmetric information, limit moral hazard and support market discipline.
Finally, securities markets facilitate the issuance and trading of equity and debt, channeling savings into productive investment. Efficient securities markets lower firms’ cost of capital, enhance liquidity, attract foreign investment and improve corporate governance by subjecting firms to market scrutiny and potential takeover pressures. Together, these elements create a resilient financial architecture capable of supporting sustainable economic growth.
Bank- and Market-Based Financial Systems
A financial system is the network of markets and institutions that channels savings into investment — a vertical, well-integrated chain of financial intermediation. Its precise design varies across countries and reflects each economy’s structure, stage of development and evolution, and political, technical and cultural context.
At one pole of this variation is the bank-dominated model, exemplified by Germany, where a few large banks play a dominant role and equity markets are relatively unimportant. At the other pole is the market-dominated model, exemplified by the United States, where securities markets are central and banking is less concentrated; most other advanced economies lie between these extremes. Demirguc-Kunt and Levine (1999) characterise these contrasts by noting that in a bank-based system banks mobilise savings, allocate capital, monitor corporate managers and offer risk-management services, whereas in a market-based system securities markets share these functions with banks and exert significant influence over corporate control and risk distribution.
India historically developed as a bank-based system. Policies such as bank nationalisation, administered interest rates and a general government preference for bank intermediation entrenched banks as the primary channel of finance. Using a dataset covering 150 countries, Demirguc-Kunt and Levine classify national financial systems and find broad patterns: wealthier countries tend to have more developed financial systems and, as incomes rise, systems generally become more market-oriented. Legal and institutional features also matter — countries with a common-law tradition, stronger protection of shareholder rights and lower corruption are more likely to be market-based and better developed financially.
Arnold and Walz (2000) emphasise a path‑dependent element: if banks begin competent and improve with experience, they are likely to come to dominate the system; if they start out weak and fail to learn, market mechanisms are more likely to emerge and expand. This helps explain why different countries evolve distinct systems even under similar economic pressures.
Which system is superior depends on the services judged most important. Advocates of market-based systems stress that competitive securities markets tend to deliver efficiency: they offer attractive terms to investors and borrowers, facilitate diversification and risk‑sharing, and create incentives to gather information that is reflected in prices — prices that in turn signal where investment should flow. Markets can also be better at financing new or high‑risk technologies, where a diversity of opinion and flexible funding are valuable. But markets can be volatile, expose investors to direct market risk, and suffer from a free‑rider problem: where ownership is separated from control, individual shareholders may refrain from costly monitoring, expecting others to do the work, which weakens incentives to acquire information.
Bank-based systems are often viewed as more stable because banks develop close, long-term relationships with firms and can offer customised contracts and intertemporal risk‑sharing. By smoothing asset returns over time, banks can provide insurance that prevents forced liquidation at unfavourable prices. Banks also mitigate information problems by investing in screening and monitoring on behalf of depositors and creditors — activities that would be costlier for dispersed market investors. The downside is that bank dominance can dampen innovation and growth: banks often prefer lower‑risk, lower‑return projects, and powerful banks may collude with firm managers in ways that weaken competition, corporate governance and the entry of new firms.
Since the late twentieth century there has been a clear global tilt toward market-based features. France and Japan have reformed their financial systems to increase competitiveness, the European Union has moved toward a unified market, and India has progressively strengthened its capital markets. The share of market financing in India has risen: market capitalisation relative to scheduled commercial bank assets grew from 28.4 per cent in March 1991 to 79.3 per cent in March 2000. Over the same broad period, the relative share of banks in total financial assets fell from nearly three‑quarters in the early 1980s to around two‑thirds since the 1990s, indicating substantial room for further market financing.
Allen and Gale (2000) offer two reasons for the worldwide rise of markets: a scepticism toward government intervention — and the recognition that government failures can be as damaging as market failures — and economic theory that highlights the effectiveness of markets in allocating resources. Empirical research, however, does not decisively favour one system over the other. In practice, well‑functioning financial systems rely on both intermediaries and markets. Their coexistence promotes competition, lowers transaction costs and improves the allocation of resources, supporting a balanced and resilient financial structure.
Financial Intermediaries and Markets
Financial institutions act as the bridge between savers and investors, channeling dispersed savings into productive uses and thereby guiding the economy’s credit allocation. If finance is the circulatory system of an economy, financial institutions are its decision-making centre: they decide where scarce capital should flow and how to use it most efficiently. Empirical research confirms that countries with well-developed financial institutions grow faster, while those with weak institutions are more vulnerable to financial crises.
Those who lend and those who borrow differ in preferences about risk, return and maturity. Financial institutions resolve these differences by issuing claims to savers while taking claims on borrowers. The claims issued to savers—indirect or secondary securities—stand against the intermediaries themselves, whereas the claims that intermediaries hold on borrowers are the direct or primary securities.
Intermediaries perform three key transformation services that make this intermediation possible. First, liability, asset and size transformation: they mobilize many small deposits and pool them into large loans suitable for businesses and projects. Second, maturity transformation: they provide savers with short-term, liquid claims while extending longer‑term loans to borrowers, matching the timing of investment cash flows. Third, risk transformation: by holding diversified portfolios rather than lending directly to a single counterparty, they spread and reduce the risks of lending.
These services allow financial institutions to tap savings that would otherwise be unavailable for investment. By facilitating the flow of finance, they enable consumers to spend in anticipation of future income and entrepreneurs to acquire physical capital for production.
Since the 1990s, the role of many financial institutions has broadened beyond traditional lending. They have diversified into a range of financial services such as merchant banking, underwriting and providing guarantees, expanding the ways in which they support economic activity.
Financial markets are a core component of the financial system, providing the institutional framework and trading mechanisms through which financial products are issued, bought and sold under prevailing policy rules. The main participants are borrowers (issuers of securities), lenders (buyers of securities) and financial intermediaries that connect them. Broadly, financial markets divide into two segments: the money market and the capital market.
The money market deals in short‑term debt instruments with maturities typically under one year. It is characterised by high liquidity and large denominations, which help reduce transaction costs. Key instruments include the call money market, certificates of deposit, commercial paper and treasury bills. Functionally, the money market redistributes cash balances to meet the changing liquidity needs of participants; it serves as the primary arena through which monetary authorities manage liquidity and implement monetary policy; and it provides borrowers and lenders reasonable access to short‑term funds at market‑determined prices. Because it underpins liquidity management and the transmission of policy, the money market is a vital segment of the financial system.
The capital market, by contrast, handles long‑term securities — both equity and debt — and channels savings into investment. Its purposes are to mobilise long‑term savings for productive use; supply risk capital (equity or quasi‑equity) to entrepreneurs; broaden ownership of productive assets; and provide liquidity by enabling investors to sell financial assets. By lowering transaction and information costs and allowing prices to be set competitively, the capital market also improves the efficiency of capital allocation across the economy.
The money market and the capital market are closely interconnected. Many financial institutions that participate actively in the capital market also operate in the money market, moving funds between the two to manage liquidity, short-term funding needs and investment opportunities. Short-term resources raised in the money market are often used to provide working liquidity for longer-term investments and to meet redemption obligations arising from capital-market instruments. In the evolution of financial systems, a functioning money market typically precedes and supports the emergence of a deeper capital market.
A capital market can be divided into the primary market and the secondary market. The primary market is where new securities are issued and capital is raised directly by borrowers from investors; it is the mechanism that creates long‑term instruments for borrowing. The secondary market, commonly referred to as the stock market, is where existing or outstanding securities are bought and sold, providing marketability and liquidity. This liquidity in the secondary market is essential because it helps determine prices, encourages investor participation and thereby facilitates new issuances in the primary market.
Primary and Secondary Market Dynamics
Although the secondary market is many times larger than the primary market, the two are closely interdependent. Activity and returns in the secondary market shape the timing, volume and pricing of new issues in the primary market, while the supply of fresh securities from the primary market affects the depth and liquidity of the secondary market.
Returns in the secondary market reflect broader macroeconomic conditions; when the economy is favorable and listed firms earn higher returns, investor sentiment improves and stock prices rise. Those higher returns create a conducive environment for companies to raise fresh capital for new projects, expansion or modernization, because investors are more willing to subscribe to new issues. Conversely, a buoyant secondary market gives underwriters and issuers confidence about pricing and demand, influencing when and at what price new securities are launched.
The secondary market also provides a reference for valuing new issues: prevailing market prices help determine the offer price of fresh listings. Likewise, the breadth of the secondary market depends on primary market activity—the more firms that enter through initial public offerings, the greater the range of instruments available for trading. For example, the surge in secondary market volumes in 2007–08 was partly driven by an active primary market, since newly listed stocks often exhibit high turnover.
Large new issues or the clustering of several big offerings can pull funds out of the secondary market and into the primary market, temporarily reducing trading demand and putting downward pressure on stock prices. Thus, the health of the capital market rests on a continuous, dynamic interaction between primary issuance and secondary trading.
Structure and Vulnerabilities of Financial Markets
Financial markets are marked by a high volume of transactions and the rapid movement of funds across different market segments. These segments include stock markets and bond markets, each with primary and secondary components—the primary market where new securities are issued and the secondary market where existing securities are traded—allowing savers to choose when and where to invest. The coexistence of many instruments and venues also creates opportunities for near-instant arbitrage, as traders exploit small price differences across markets.
At the same time, financial markets are inherently volatile and prone to episodes of panic or distress selling, because the actions of a relatively small group of operators can quickly influence broader market behaviour. Much of market activity is intermediated: financial institutions make investment decisions and assume risks on behalf of depositors, concentrating decision-making power and exposures. This structure, coupled with tight linkages among segments, gives rise to negative externalities—failures or stresses in one part of the system can spill over into other financial segments and even into the real economy.
Domestic markets are increasingly integrated with global finance, so vulnerabilities in a single national market can produce international repercussions, and shocks abroad can transmit back home. For these reasons—high speed and volume, volatility, intermediation, fragility and global interconnection—financial markets require vigilant monitoring and robust supervision to preserve stability and protect the wider economy.
Core Functions of Financial Markets
Financial markets and institutions emerge because acquiring information and executing transactions are costly. These costs create incentives for intermediaries and contracts that reduce frictions; different combinations of information and transaction costs give rise to distinct financial instruments, institutions and arrangements suited to particular needs.
At their core, financial markets perform several interrelated functions. They allow economic agents to adjust their time preferences by transferring purchasing power across time—savers can defer consumption and borrowers can advance it. Markets also allocate and manage risk: through separation, distribution, diversification and reduction of exposures, they let participants share or offload risks according to their preferences. As a mechanism for payments and settlements, financial markets support smooth exchange of value, lowering transaction frictions and enabling trade. They provide information about firms and securities—through price formation, trading activity and disclosure practices—which encourages investor inquiry and disciplined corporate behaviour and helps in efficient trading decisions.
Financial markets further transform financial claims to match the needs of savers and borrowers. This transformation can involve changing maturities, denominations or risk profiles so that the preferences of both sides are better satisfied. By facilitating trading, markets enhance the liquidity of claims, making assets easier to buy and sell without large price concessions. Finally, markets support professional portfolio management and related services that help investors construct and maintain portfolios aligned with their objectives.
Because these functions affect how funds are allocated, risks are managed and information is conveyed, the quality and efficiency of financial market services can materially influence the pace and pattern of economic growth.