Functions of Financial System – Intermediation & Liquidity

Introduction

Why do we need a financial system? Can't I just lend money to my neighbor directly? A formal system provides Scale, Safety, and Speed.

1. Intermediation (The Bridge)

The most critical function is to act as a Financial Intermediary.

• Why? A saver (Households) and an Investor (Business) usually don't know each other.
• How? The system connects them via Banks/Markets.

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1. Primary Functions

1. Savings Function (Mobilization)

• It encourages people to save by offering attractive instruments (FDs, Mutual Funds).
• Instead of keeping cash idle at home, savings enter the economy.

2. Credit Function (Allocation)

• It channels these savings to productive sectors (Industry, Agriculture, Infrastructure).
• Ensures capital goes to the most efficient users.

3. Payment Function (Liquidity)

• Provides a mechanism for making payments (Cheques, UPI, NEFT, RTGS).
• Makes exchange of goods and services easy without barter.

4. Risk Function (Protection)

• Provides protection against life and business risks (Insurance).
• Diversifies investment risk (Mutual Funds).

2. Liquidity Function

Liquidity means how easily an asset can be converted into cash without loss of value.

• The financial market (Stock Market) allows investors to sell their securities and get cash whenever needed.
• Without this, people would hesitate to invest in long-term projects.

3. Information Function

• Financial markets (like Stock Exchange) provide price information.
• This helps in valuation of assets and decision making.

Summary

• Link: Connects Savers and Investors.
• Payments: Facilitates trade via banking channels.
• Liquidity: Allows easy entry and exit for investors.
• Risk: Manages uncertainty via Insurance/Derivatives.

Quiz Time! 🎯

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