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The financial system is a complex network of financial markets, financial institutions who operate in
that market, financial instruments and financial services that are bought and sold in the markets to
facilitate transfer of funds and regulators who are responsible for regulating the system.
It plays a vital role in the economic growth of a country, intermediating the flow of funds between those
who save a part of their income and those who invest in productive assets.
Financial systems of most countries are characterized by financial dualism or dichotomy i.e. it comprises a
formal (organized) and informal (unorganized) sector.
The informal financial sector is an unorganized, non-institutional and non-regulated system dealing
with the traditional and rural spheres of the economy.
The formal financial sector comprises:
1. Financial Markets are mechanisms enabling participants to deal in financial claims. It comprises the
Money Market, Capital Market and Derivatives Market in addition to the Foreign Exchange Market.
2. Financial Institutions are intermediaries that mobilize savings and facilitate the allocation of funds
in an efficient manner. They are classified into Banking, Non-banking and Specialized Institutions.
3. Financial Instruments represent a financial claim on an asset. They comprise primary and secondary
4. Financial Services help with borrowing, funding, lending and investing services. The major
categories of financial Services include fund intermediation, payment mechanisms, provision of
liquidity, risk management and financial engineering.
5. Regulators namely the Central Bank, SEBI, IRDA, Ministry of Finance, etc. regulate the financial
The key elements of a well-functioning financial system are:
1. Strong legal and regulatory system that produces and enforces laws.
2. Strong and stable currency. Large fluctuations in value of currency leads to financial crises.
3. Sound public finances and public debt management.
4. Strong and autonomous Central Bank that supervises and regulates the activities of the banking
5. Sound banking system with both domestic and international operations and ability to withstand adverse
6. Easy availability of information, proper disclosure practices and networking of information systems.
7. Efficient and well functioning financial market.