Financial system

The financial system puts borrowers in touch with lenders and allocates risks to those who wish to take them. It is a complex interactive system, events in one component of which can have significant repercussions elsewhere. International linkages often add to its complexity by enabling developments in one country to generate consequences elsewhere. Under normal circumstances, national and international financial systems contribute to the economic efficiency of their users, but their malfunction can cause widespread economic damage.

Overview

The functioning of financial systems

A basic function of a financial system is the transfer of productive resources from those who own them but do not wish to use them, to those who wish to use them but do not own them. In the absence of that function, only a small proportion of the country's current output could be produced. A secondary function is the transfer of risk from those who wish to limit their exposure to it, to those willing to accept it for a fee. That function, also, can make a major contribution to a community's productive capacity. Various instruments are used to make those transfers - each of them a promise to do something in return. There are promises to make fixed payments (bonds); to pay dividends (equity); to provide retirement income (pensions); to bear some of the costs of accidents (insurance) - and there are also promises to deliver other promises (derivatives).
Without the confidence that such promises will be kept, no sensible person would be willing to take part in such a transfer. Such willingness commonly survives the knowledge that promises are occasionally broken by people who are unwilling or unable to keep them. But fear of default can be contagious, and a general loss of confidence can prevent the operation of a financial system. The consequences of such breakdowns are so damaging that governments are expected to take effective action to avoid them - and that turns out to be a difficult undertaking.

The principal components of the system

Financial instruments

Bonds

In the terminology of this article, the term "bond" normally refers to an instrument, issued by a company or by local or central government, that represents a loan that is repayable after an interval of not less than a year (but in economics terminology it refers to any of the entire category of fixed-interest loan instruments). The term is also applied in some contexts to investments that do not conform to that definition - such as "investment bonds" (collections of investment funds) and "premium bonds" (a type of lottery). Unlike most other loan instruments, a bond can be bought or sold without reference to its issuer - normally on the bond market (see below). Bonds issued by the government are termed "Treasury bonds" (or "T-bonds") in the United States and "Gilt-edged securities" (or "gilts") in the United Kingdom.

The simplest form of bond is the "straight" (or "plain vanilla") bond, that makes a regular (often 6-monthly) fixed interest payment and is repaid (or "redeemed") on predetermined date. The sum of money for which the bond is to be redeemed, is called its "par value", the annual interest rate that is paid is called its "coupon", and its date of repayment is called its "maturity date". A bond's coupon divided by its market price is called its "current yield" and its internal rate of return taking account of the eventual repayment is termed its "yield to maturity".

Other forms of bond can be categorised as particular adaptations of the above payment conditions. Strictly speaking an "irredeemable bond" (or "perpetual bond" or "consol") is not a loan, but only an undertaking to make stipulated and indefinitely continuing fixed interest payments. A "zero-coupon bond", on the other hand, pays no interest, is issued at a price that is below its par value, and is held in order to obtain a capital gain. A "callable bond" has a redemption date that is at the discretion of the issuer. Convertible bonds include an option, under stated conditions, to exchange them for an equivalent amount of the issuer's equity.

Bonds can also be categorised according to the degree of security provided to their purchasers. A "covered bond" is a bond that is secured by other assets so that the investor can lay claim to those assets should the issuer of the bond become insolvent. In the UK the term "debenture" refers to a company loan secured by a claim on the company's assets, but in the US the term is applied to unsecured loans (and debentures are sometimes referred to as bonds). In the UK a "fixed-charge debenture" specifies the assets against which it is secured, whereas a "floating-charge debenture" is secured on the issuer's assets as a whole. Repayment of a "guaranteed bond" is guaranteed by a body other than the issuer - such as its parent company or its government.

Finally, bonds can be categorised according to their currency of denomination. The term "eurobond" (or "global bond") refers to a bond that is traded outside the country in whose currency it is denominated - so called because it is often applied to a bond issued by a non-European company for sale in Europe.

Theoretical developments

Financial economics

There is evidence that suggests that a well-functioning financial system contributes to economic growth .

Proposals for reform

In preparation for a meeting of the world leaders in November 2008, an ebook was published by an international group of twenty leading financial economists. They agreed on the need to augment IMF resources and to strengthen existing arrangements for global governance. Several of them also argued for new approaches to the regulation of large cross-border financial institutions.