12 Advantages and Disadvantages of Financial System

Meaning of Financial System

The financial system is a system that facilitates the movement of funds among people in an economy. It is simply a means through which funds are exchanged between investors, lenders, and borrowers. A financial system is composed of various elements like financial institutions, financial intermediaries, financial markets, and financial instruments which altogether facilitate the smooth transfer of funds.

This system exists at the regional, national, and international levels. It is an efficient tool that helps in the economic development of a country by linking savings and investments thereby leading to wealth creation. The financial system acquires money from people who are keeping it idle and distributes it among those who use it for yielding income and generates wealth in the country.

Financial system aims at the efficient allocation of financial resources by channelizing funds between net savers and net spenders. The financial system has an efficient role in minimizing the risk through diversification of funds among a large number of people. 

Advantages and Disadvantages of Financial System
Advantages and Disadvantages of Financial System

Advantages of Financial system

  1. Provides Payment System: The financial system provides a payment mechanism for the smooth flow of funds among peoples in an economy. Buyers and sellers of goods or services are able to perform transactions with each other due to the presence of a financial system.
  2. Links Savers and Investors: The financial system serves as a means of bridging the gap between savings and investment. It acquires money from those with whom it is lying idle and transfers it to those who need it for investing in productive ventures.
  3. Minimizes Risk: It aims at reducing the risk by diversifying it among a large number of individuals. The financial system distributes funds among a large number of peoples due to which risk is shared by many peoples.
  4. Helps in Capital Formation: The financial system has an efficient role in capital formation of the country. It enables big corporates and industries to acquire the required funds for performing or expanding their operations thereby leading to capital formation in the nation.
  5. Raises Standard of living: It raises the standard of living of peoples by promoting regional and rural development of the country. The financial system promotes the development of weaker sections of society through cooperative societies and rural development banks.
  6. Enhance liquidity: Maintaining optimum liquidity in an economy is another important role played by the financial system. It facilities free movement of funds from households (savers) to corporates (investors) which ensures sufficient availability of funds in the economy.
  7. Promotes Economic Development: The financial system influence the pace of economic growth or development of an economy. It aims at optimum utilization of all financial resources by investing all idle lying resources into useful means which leads to the creation of wealth.

Disadvantages of Financial system

  1. Lack of Co-ordination among financial institutions: The financial system faces a lack of coordination among various financial institutions. The presence of a large number of financial institutions and government roles in controlling authorities of these institutions leads to a lack of coordination.
  2. Monopolistic Market Structure: Many institutions in the Indian financial system occupy a monopolistic position in the market. LIC and UTI are two institutions that have grabbed a large part of the life insurance business and the mutual fund industry. These large structures could lead to mismanagement or inefficiency of funds.
  3. High Rate of Interest: There is a possibility of the high-interest rate charged by several financial institutions in the financial system of our country. Various institutions due to their monopolistic structure in the market may charge high or unfair interest rates.  
  4. Inactive Capital Market: Our country’s financial system faces the problem of the inactive capital market. All corporates in India are mostly able to acquire funds through development banks and do not need to go to the capital market.
  5. Imprudent Financial Practice: The financial system of India has developed imprudent financial practices due to the dominance of development banks. Development banks provide funds to corporates in the form of term loans which makes the capital structure of borrowed concerns uneven. These banks even permit the use of unwarranted debts which is against the sound capital structure.