Financial System and its Components

Introduction to Financial System

A financial system (within the scope of finance) is a system that allows the exchange of funds
between lenders, investors, and borrowers. Financial systems operate at national, global, and
firm-specific levels. They consist of complex, closely-related services, markets, and institutions
used to provide an efficient and regular linkage between investors and depositors. Money, credit,
and finance are used as media of exchange in financial systems. They serve as a medium of known
value for which goods and services can be exchanged as an alternative to bartering.

The Financial System primarily consists of:

I. Money
II. Financial Markets
III. Financial Institutions
IV. Regulators
V. Financial Instruments/ Services/ Assets/ Claims

Money
Money is any item or verifiable record that is generally accepted as payment for goods and
services and repayment of debts in a particular country or socio-economic context, or is easily
converted to such a form. The main functions of money are distinguished as: a medium of
exchange; a unit of account; a store of value; and, sometimes, a standard of deferred payment. Any
item or verifiable record that fulfils these functions can be considered money.

The word "money" is believed to originate from a temple of Juno, on Capitoline, one of Rome's
seven hills. In the ancient world Juno was often associated with money. The temple of Juno
Moneta at Rome was the place where the mint of Ancient Rome was located. The name "Juno"
may derive from the Etruscan goddess Uni (which means "the one", "unique", "unit", "union",
"united") and "Moneta" either from the Latin word "monere" (remind, warn, or instruct) or the
Greek word "moneres" (alone, unique).

In the Western world, a prevalent term for coin-money has been specie, stemming from Latin in
specie, meaning 'in kind'.

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Financial System and its Components

Functions of Money

Money's a matter of functions four,

A Medium, a Measure, a Standard, a Store
Medium of exchange
When money is used to intermediate the exchange of goods and services, it is performing a
function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as
the "coincidence of wants" problem. Money's most important usage is as a method for comparing
the values of dissimilar objects.

Measure of value
A unit of account (in economics) is a standard numerical monetary unit of measurement of the
market value of goods, services, and other transactions. Also known as a "measure" or "standard"
of relative worth and deferred payment, a unit of account is a necessary prerequisite for the
formulation of commercial agreements that involve debt.

Money acts as a standard measure and common denomination of trade. It is thus a basis for
quoting and bargaining of prices. It is necessary for developing efficient accounting systems.

Standard of Deferred Payment

A "standard of deferred payment" is an accepted way to settle a debt – a unit in which debts are
denominated, and the status of money as legal tender, in those jurisdictions which have this
concept, states that it may function for the discharge of debts. When debts are denominated in
money, the real value of debts may change due to inflation and deflation, and for sovereign and
international debts via debasement and devaluation.

Store of value
To act as a store of value, a money must be able to be reliably saved, stored, and retrieved – and
be predictably usable as a medium of exchange when it is retrieved. The value of the money must
also remain stable over time. Some have argued that inflation, by reducing the value of money,
diminishes the ability of the money to function as a store of value.

Money and Money Supply

In economics, money is a broad term that refers to any financial instrument that can fulfill the
functions of money (detailed above). These financial instruments together are collectively
referred to as the money supply of an economy. In other words, the money supply is the amount
of financial instruments within a specific economy available for purchasing goods or services.
Since the money supply consists of various financial instruments (usually currency, demand

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Financial System and its Components

deposits and various other types of deposits), the amount of money in an economy is measured
by adding together these financial instruments creating a monetary aggregate.

Monetary Policy
When gold and silver are used as money, the money supply can grow only if the supply of these
metals is increased by mining. This rate of increase will accelerate during periods of gold
rushes and discoveries, such as when Columbus discovered the New World and brought back
gold and silver to Spain, or when gold was discovered. This causes inflation, as the value of gold
goes down. However, if the rate of gold mining cannot keep up with the growth of the economy,
gold becomes relatively more valuable, and prices (denominated in gold) will drop, causing
deflation. Deflation was the more typical situation for over a century when gold and paper money
backed by gold were used as money in the 18th and 19th centuries.

Modern day monetary systems are based on fiat money and are no longer tied to the value of gold.
The control of the amount of money in the economy is known as monetary policy. Monetary policy
is the process by which a government, central bank, or monetary authority manages the money
supply to achieve specific goals. Usually the goal of monetary policy is to accommodate economic
growth in an environment of stable prices.

For the sake of monetary purposes SBP classifies Money into four categories:

M0 (Base Money): includes (Currency Notes issued by SBP + Reserve Deposits of commercial
banks with SBP)

M1 (Narrow Money): includes M0 + Currency in Circulation + Demand Deposits of commercial

banks + Other Deposits of commercial banks with SBP

M2 (Broad Money): includes M1 + Time Deposits of commercial banks + Resident Foreign

Currency Deposits of commercial banks

SBP set Monetary targets on quarterly basis and try to achieve those targets by means of various
Monetary Policy Tools (Qualitative and Quantitative) to stabilize certain Economic Indicators like
Inflation, Interest Rates, and Employment Level etc. to achieve its ultimate objective of Macro
Economic Stability and Development.

Types of Money
Currently, most modern monetary systems are based on fiat money. However, for most of history,
almost all money was commodity money, such as gold and silver coins. As economies developed,
commodity money was eventually replaced by representative money, such as the gold standard,

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Financial System and its Components

as traders found the physical transportation of gold and silver burdensome. Fiat currencies
gradually took over in the last hundred years, especially since the breakup of the Bretton Woods
system in the early 1970s.

Commodity
Many items have been used as commodity money such as naturally scarce precious metals, conch
shells, barley, beads etc., as well as many other things that are thought of as having value.
Commodity money value comes from the commodity out of which it is made. The commodity itself
constitutes the money, and the money is the commodity. Examples of commodities that have been
used as mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones,
decorated belts, shells, alcohol, cigarettes, cannabis, candy, etc. These items were sometimes used
in a metric of perceived value in conjunction to one another, in various commodity valuation
or price system economies. Use of commodity money is similar to barter, but a commodity money
provides a simple and automatic unit of account for the commodity which is being used as money.
Although some gold coins such as the Krugerrand are considered legal tender, there is no record
of their face value on either side of the coin. The rationale for this is that emphasis is laid on their
direct link to the prevailing value of their fine gold content.

Representative
In 1875, the British economist William Stanley Jevons described the money used at the time as
"representative money". Representative money is money that consists of token coins, paper
money or other physical tokens such as certificates that can be reliably exchanged for a fixed
quantity of a commodity such as gold or silver. The value of representative money stands in direct
and fixed relation to the commodity that backs it, while not itself being composed of that
commodity.

Fiat
Fiat money or fiat currency is money whose value is not derived from any intrinsic value or
guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value
only by government order (fiat). Usually, the government declares the fiat currency (typically
notes and coins from a central bank, such as the Federal Reserve System in the U.S.) to be legal
tender, making it unlawful not to accept the fiat currency as a means of repayment for all debts,
public and private.

Some bullion coins such as the Australian Gold Nugget and American Eagle are legal tender,
however, they trade based on the market price of the metal content as a commodity, rather than
their legal tender face value (which is usually only a small fraction of their bullion value).

Fiat money, if physically represented in the form of currency (paper or coins) can be accidentally
damaged or destroyed. However, fiat money has an advantage over representative or commodity

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Financial System and its Components

money, in that the same laws that created the money can also define rules for its replacement in
case of damage or destruction. For example, SBP will replace mutilated Pak Rupees notes if at
least half of the physical note can be reconstructed, or if it can be otherwise proven to have been
destroyed. By contrast, commodity money which has been lost or destroyed cannot be recovered.

Financial Markets
A Financial Market can be defined as the situation in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods or
services, a financial transaction involves the creation or transfer of a financial asset. Financial
Assets or Financial Instruments represent claims to the payment of a sum of money sometime in
the future and /or periodic payment in the form of interest or dividend.

Role of Financial Markets

One of the important sustainability requisite for the accelerated development of an economy is
the existence of a dynamic financial market. A financial market helps the economy in the following
manner.

 Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments
etc. is an important role played by financial markets.

 Investment: Financial markets play a crucial role in arranging to invest funds thus
collected in those units which are in need of the same.

 National Growth: An important role played by financial market is that, they contribute
to a nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of
funds for productive purposes is also made possible.

 Entrepreneurship growth: Financial market contribute to the development of the

entrepreneurial claw by making available the necessary financial resources.

 Industrial development: The different components of financial markets help an

accelerated growth of industrial and economic development of a country, thus
contributing to raising the standard of living and the society of well-being.

Functions of Financial Markets

 Intermediary Functions: The intermediary functions of a financial markets include the
following:

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Financial System and its Components

 Transfer of Resources: Financial markets facilitate the transfer of real economic

resources from lenders to ultimate borrowers.

 Enhancing income: Financial markets allow lenders to earn interest or dividend

on their surplus invisible funds, thus contributing to the enhancement of the
individual and the national income.

 Productive usage: Financial markets allow for the productive use of the funds
borrowed. The enhancing the income and the gross national production.

 Capital Formation: Financial markets provide a channel through which new

savings flow to aid capital formation of a country.

 Price determination: Financial markets allow for the determination of price of

the traded financial assets through the interaction of buyers and sellers. They
provide a sign for the allocation of funds in the economy based on the demand and
to the supply through the mechanism called price discovery process.

 Sale Mechanism: Financial markets provide a mechanism for selling of a financial

asset by an investor so as to offer the benefit of marketability and liquidity of such
assets.

 Information: The activities of the participants in the financial market result in the
generation and the consequent dissemination of information to the various
segments of the market. So as to reduce the cost of transaction of financial assets.

 Financial Functions

 Providing the borrower with funds so as to enable them to carry out their
investment plans.

 Providing the lenders with earning assets so as to enable them to earn wealth by
deploying the assets in production debentures.

 Providing liquidity in the market so as to facilitate trading of funds.

 Providing liquidity to commercial bank

 Facilitating credit creation

 Promoting savings

 Promoting investment

 Facilitating balanced economic growth

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Financial System and its Components

 Improving trading floors

Constituents of Financial Market

Based On Market Levels

 Primary market: Primary market is a market for new issues or new financial claims.
Hence it’s also called new issue market. The primary market deals with those securities
which are issued to the public for the first time.

 Secondary market: It’s a market for secondary sale of securities. In other words,
securities which have already passed through the new issue market are traded in this
market. Generally, such securities are quoted in the stock exchange and it provides a
continuous and regular market for buying and selling of securities.

Simply put, primary market is the market where the newly started company issued shares to the
public for the first time through IPO (initial public offering). Secondary market is the market
where the second hand securities are sold (security /Commodity Markets).

Based On Security Types

 Money market: Money market is a market for dealing with financial assets and securities
which have a maturity period of up to one year. In other words, it’s a market for purely
short term funds.

 Capital market: A capital market is a market for financial assets which have a long or
indefinite maturity. Generally it deals with long term securities which have a maturity
period of above one year. Capital market may be further divided into: (a) industrial
securities market (b) Govt. securities market and (c) long term loans market.

 Equity markets: A market where ownership of securities are issued and

subscribed is known as equity market. An example of a secondary equity market
for shares is the Bombay stock exchange.

 Debt market: The market where funds are borrowed and lent is known as debt
market. Arrangements are made in such a way that the borrowers agree to pay
the lender the original amount of the loan plus some specified amount of interest.

 Derivative markets: A market where financial instruments are derived and traded based
on an underlying asset such as commodities or stocks.

 Financial service market: A market that comprises participants such as commercial

banks that provide various financial services like ATM. Credit cards. Credit rating, stock

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Financial System and its Components

broking etc. is known as financial service market. Individuals and firms use financial
services markets, to purchase services that enhance the working of debt and equity
markets.

 Depository markets: A depository market consist of depository institutions that accept

deposit from individuals and firms and uses these funds to participate in the debt market,
by giving loans or purchasing other debt instruments such as treasure bills.

 Non-Depository market: Non-depository market carry out various functions in financial

markets ranging from financial intermediary to selling, insurance etc. The various
constituency in non-depositary markets are mutual funds, insurance companies, pension
funds, brokerage firms etc.

Participants of Financial Markets

The participants of financial markets means and includes those individuals or institutions who
perform transactions in financial markets and as such can be categorized in three broad
categories as:

 Supply side participants

 Demand side participants
 Intermediaries
Supply Side Participants
Supply side participants are those who are Surplus Spending Units (SSUs), those who have more
income than spending and hence have some savings. These savings form the basis of investments
for further capital generation. Thus, these SSUs emerge as Investors, Lenders or Creditors in the
Markets. These SSUs may very well be individual or institutional.
Demand Side Participants
Demand side participants are collectively termed as Deficit Spending Units (DSUs), those who
have more spending than income or those who are in need of funds. They emerge as Borrowers
and Entrepreneurs in the Financial Markets. Just like their coutnerparts, DSUs may also vary from
Individual to Institutional Borrower. Usually largest DSU in any economy is Govt. itself.
Intermediaries
Financial Intermediaries are those who act as a bridge between SSUs and DSUs and as such are
trivial for smooth working of financial markets. They includes Financial Institutions (Banks,
Insurance Companies, Mutual Funds, Leasing Companies etc.); Brokers & Dealers; Govt. Bodies
(Chambers of Commerce, National Savings Instutions etc.); Credit Rating Agencies (PACRA,
Moddy’s, JCRA etc.); and Depositories like CDC etc.
Together these three participants of financial markets form the blood life of financial markets.
While financial markets only provide mechanisim and tools of performing financial transactions,
these participants actually perform those transactions.

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Financial System and its Components

Financial Institutions
Financial institutions are the intermediaries who facilitate smooth functioning of the financial
system by creating a link between savers and borrowers. They mobilize savings of the surplus
units and allocate them in productive investments promising a better rate of return. Financial
institutions also provide services to entities seeking advice on various issues ranging from
restructuring to diversification of investments. They provide a whole range of services to the
entities who want to raise funds from the markets and elsewhere. Financial institutions act as
financial intermediaries, because they act as middlemen between savers and borrowers. These
financial institutions may be of Banking or Non-Banking institutions.

Categorization of Financial Institutions

Broadly speaking, there are three major types of financial institutions:

1. Depositary institutions – deposit-taking institutions that accept and manage deposits

and make loans, including banks, building societies, unions, trust, and mortgage
loan companies;

2. Contractual institutions – insurance companies and pension funds; and

3. Investment institutions – investment banks, underwriters, brokerage firms.

Regulators
Every Financial system is regulated by some supervisory institutions such as Central Banks and
Exchange Commission in order to keep harmony and resolve any issues within the financial
system. The Financial System of Pakistan is governed by majorly three Regulators

a) State Bank of Pakistan (SBP)

b) Securities and Exchange Commission of Pakistan (SECP)
c) Ministry of Finance (MoF)

State Bank of Pakistan

As the central bank of the country, the State Bank of Pakistan has a number of policies, regulatory
and fiduciary responsibilities designed to strengthen the financial system of the country and
provide a workable framework for the financial industry that will help in economic growth.

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Financial System and its Components

These responsibilities include regulation of the domestic monetary and credit system through an
efficient monetary policy, securing monetary and exchange rate stability and ensuring financial
stability through effective regulation and supervision of the banking sector in particular and the
financial industry in general.

Role of SBP in Regulating the Activities of Pakistan's Financial System

In addition to performing various functions mandated under relevant legislation, the State Bank
performs a number of developmental roles as a responsible member of the economic
management team of the country. These vary from undertaking ground-breaking research to
introducing innovative products such as Islamic Export Refinance Schemes, Housing Finance
Windows and promotion of microfinance, as well as provision of an enabling environment by
facilitating and opening of Internet Merchant Accounts and developing a Real Time Gross
Settlement System (RTGS) for the banking industry. The State Bank of Pakistan has been
entrusted with the responsibility of formulating and conducting monetary and credit policy in a
manner consistent with the Government’s targets for growth and inflation and the
recommendations of the Monetary and Fiscal Policies. For that purpose SBP performs the
following functions:

1. Regulation of Liquidity

As regulator of the financial system of Pakistan, SBP is continuously taking steps to improve the
financial system. During the period of Mr Ishrat Hussain as governor of SBP, the SBP initiated five

years of reforms in the financial sector of Pakistan in early 2005，which have been successfully

completed, and now SBP has started a second phase of reforms to be implemented in the next five
years. These reforms must be reviewed continuously to adjust them according to changing
circumstances, both locally and internationally. The main objective of the second phase of
reforms is to further strengthen the financial sector and to integrate it according to the needs of
the global economy.

2. Ensuring Soundness of Financial System

One of the fundamental responsibilities of the State Bank is regulation and supervision of the
financial system and to ensure its soundness and stability as well as to protect the interests of
depositors. For this purpose SBP has established a Customer Protection Department. Banking
activities are now being monitored through a system of ’off-site’ surveillance and on-site
inspection and supervision. Off-site surveillance is conducted by the State Bank through rigorous
checking of various returns regularly received from the different banks, while on-site inspection
is undertaken by the State Bank, when required, in the premises of the banks concerned.

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Financial System and its Components

3. Inspection

As mentioned above，banking activities are monitored through a system of off-site surveillance

and ’on-site，inspection and supervision.

4. Prudential Regulations

In order to safeguard the interest of ultimate users of the financial services, and to ensure the
viability of institutions providing these services, the State Bank has issued a comprehensive set
of Prudential Regulations (for commercial banks) and Rules of Business (for NBFIs).

The "Prudential Regulations" for banks, besides providing for credit and risk exposure limits,
prescribe guidelines relating to classification of short-term and long-term loan facilities, set
criteria for management, and prohibit criminal use of banking channels for the purpose of money
laundering and other unlawful activities.

5. Exchange rate management

One of the major responsibilities of the State Bank is the maintenance of the external value of the
currency. In this regard, the State Bank is required, among other measures, to regulate the
country’s foreign exchange reserves in line with the stipulations of the Foreign Exchange Act
1947. As an agent of the Government of Pakistan, the State Bank is authorized to purchase and
sell gold, silver or approved foreign exchange and transactions of Special Drawing Rights with the
International Monetary Fund under sub-sections 13(a) and 13(f) of Section 17 of the State Bank
of Pakistan Act, 1956.

6. Development Role

Besides discharging its traditional functions of regulating money and credit, the State Bank of
Pakistan plays an active developmental role in promoting the realization of macroeconomic goals.
Accordingly, conventional central banking functions are combined with a well- recognized
developmental role. The Bank’s participation in the development process is in the form of
rehabilitation of the banking system in Pakistan, development of new financial institutions and
debt instruments in order to promote financial intermediation, establishment of Development
Financial Institutions (DFIs), directing the use of credit according to selected development
priorities, providing subsidized credit, and development of the capital market.

Reforms can be successfully implemented only if there is consultation, involvement and

consensus among all the stakeholders throughout the process. Application of technology,
thorough use of human resource competencies and managerial skills are the key tools for

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Financial System and its Components

achieving results. In the first phase of the reforms, financial markets in Pakistan have been
liberalized and have become competitive and relatively efficient, although they are still capable
of farther development.

The range of financial instruments available for various types of transactions in the market has
widened but the evolution of new instruments has to remain on track.

Financial infrastructure has been strengthened but the legal system is still too time consuming
and costly for ordinary market participants. The regulatory environment has improved and the
capacity of regulators to oversee and monitor is much better today, but the enforcement
procedures and prompt corrective action capabilities need to be further enhanced.

Financial soundness indicators of the system show an upward moving trend in almost all
dimensions but there are weaknesses that require to be addressed.

Corporate governance rules have been clarified and aligned with best international practices, but
their consistent application and voluntary adoption by the industry as a whole remain uneven.

The financial sector is opening up to the middle and lower income groups, but the commitment
and mind-set of the providers still need to be improved in line with the new realities.

4.2. Securities and Exchange Commission of Pakistan (SECP)

Since its inception in 1997 SECP has been concerned with the regulation of corporate sector and
capital market. Over time, its mandate has expanded to include supervision and regulation of
insurance companies, non-banking finance companies and private pensions. The SECP has also
been entrusted with oversight of various external service providers to the corporate and financial
sectors, including chartered accountants, credit rating agencies, corporate secretaries, brokers,
surveyors etc. The challenge for the SECP has amplified manifold with its increased mandate.

SECP is responsible for registration and supervision of all companies (forming under Companies
Ordinance, 1984) and partnership firms (forming under Partnership Act 1920). Moreover it is
also liable to formulate rules and regulation for corporate good governance and oversighting the
listing of public limited companies in stock exchange market and their subsequent working
within.

4.3. Ministry of Finance

Ministry of Finance, technically is not a direct participant of Financial System as suggested under
the Capitalistic Economic Theory that markets should operate free of govt. interventions. Since
Pakistan is a developing country which requires certain push from its govt. in specific areas so
Govt. of Pakistan do participate from time to time in the affairs of open market by either direct
intervention or by laws and legislation related to working of markets. MoF being direct

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Financial System and its Components

controlling body of both SBP and SECP concerning selection of its Executive committees, effect
the Financial System indirectly.

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