The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations.
While the corporates will have a surplus arising from the retained earnings, their need for funds will be for investment in new projects, for expansion/ diversification/modernization, etc. On the other hand, the government which is always in a deficit budgetary situation will be in need of funds for public expenditure, to finance its developmental projects and other Public Sector Undertakings (PSUs), etc. Apart from these two economic units, even the household sector will require funds for varied purposes for example, for acquiring assets. However, the surplus funds of the households will normally be more when compared to the other units.
Hence, it can be observed that, at any given point of time there would be some units having idle funds and a few others which would be in need of funds. The volume of funds required for the investment activity of the corporates and for the public expenditure of the government is very large when compared to the household requirements. And if funds are not provided for these activities, it will hinder economic progress. On the other hand, there are surplus budget units which have excess funds in the form of savings.
Mere act of saving will, however, not guarantee economic progress. This is due to the fact that savings and investments will usually be carried out by different groups, savings come from the household sector and the investments are being made by the corporate sector. Hence, there should be a mechanism to ensure that savings flow from those who save to those who wish to invest. This process would enable the utilization of excess idle funds, thereby enhancing their value.
Enabling such a transfer of funds from the savers to the borrowers is the Financial System. The financial system represents a channel through which savings are mobilized from the surplus units and routed to the deficit units. The role of the financial system can be broadly classified into the following:
Savings Function: Mobilize savings in a way to provide a potentially profitable and low risk outlet.
Policy Function: Through the policy function, the government ensures a smooth flow of funds from savings into investments in order to stabilize the economy.
Credit Function: After mobilizing, the savings and laying down the necessary policies for the transfer of these funds, the credit function of the financial system, will then ensure that these savings will transform into the necessary credit for investment and spending purposes.
Complexities may arise while performing these functions, especially when the requirements of the savers and those of the borrowers do not match. The main considerations of the savers will be with regard to the safety of funds, returns and liquidity. On the other hand, the needs of the investors will be relatively diversified. Their concerns will relate to the term for which the funds are available and the cost of funds.