An Introduction to Financial System

A financial system is a network of markets where various institutions participate and trade of various instruments occurs. From this perspective, the financial system serves a crucial role by providing fuel for the real economy in producing goods and services.

1. Efficient allocation of resources through financial intermediation: One of the primary functions of the financial system is intermediation, which involves channeling funds from those who have surplus funds to those who need funds. 

2. Enabling Risk Management: The financial system provides a range of instruments and tools that facilitate individuals, businesses, and governments to manage various types of financial risks.  

3. Price Determination: A financial system enables the correct prices of goods and services to be determined in an economy. 

4. Promoting Capital Accumulation: A healthy and stable financial system fosters the accumulation of capital, which is essential for increasing the productive capacity of economies. It encourages individuals and businesses to sav and invest, increasing the stock of physical capital, such as factories, machinery and equipment, and human capital, through investments in education and skills development. 

5. Encouraging Innovation and Entrepreneurship: Access to financial resources and capital is essential for innovation and entrepreneurship. 

The spot market is a financial market where financial instruments, such as stocks or bonds, are bought and sold for immediate delivery and settlement. In the spot market, transactions are executed “on the spot,” meaning that the exchange of the asset and payment occur immediately or within a very short period. The prices quoted in the spot market represent the current market price for the exchanged asset.

The futures market, sometimes also called the futures exchange, is a financial market where participants buy and sell standardized contracts called futures contracts.

Exchanges are organized financial markets where buyers and sellers come together to trade standardized financial instruments, such as stocks, bonds, and commodities. These markets characteristically operate in centralized physical or electronic platforms that adhere to strict regulatory guidelines. The exchange acts as an intermediary, facilitating the trading process and ensuring transparency and fair execution of transactions. New York Stock Exchange (NYSE), NASDAQ, Borsa Istanbul (BIST), and London Stock  Exchange are examples of traditional exchanges.

An over-the-counter (OTC) market is a financial market where financial instruments are traded directly between two parties without a centralized exchange. Unlike exchanges, OTC markets do not have a physical location and do not operate under a formalized system of rules and regulations. Instead, OTC markets rely on a network of brokers and dealers to facilitate trades and provide liquidity.

The stock market, also referred to as the equity market or share market, provides a platform for individuals an institutions to purchase and sell shares (equity) of publicly listed companies.

The bond market, governments, municipalities, and corporations issue debt securities to raise funds from investors.

The money market is where short-term and more liquid securities are traded.

The capital market is where long-term securities are traded.

A primary market is where newly issued securities are sold to the initial buyers by the issuer, a corporation or a government agency. Primary markets are not well known as the exchange usually occurs behind closed doors; investment banks usually assist initial securities sales in the primary markets. The secondary market is where previously issued (thus second-hand) securities are resold. Secondary markets are very well known; most of the news we hear and read comes from secondary markets.

Cash instruments are financial assets that represent direct ownership of money or cash equivalents. They are easily convertible into cash; therefore, they are highly liquid instruments. Some examples are cash, bank deposits, and money market funds.

Debt instruments are contractual agreements between the borrower and the holder of the instrument in which the borrower promises to make fixed payments at regular intervals (interest and principal payments) until a specified date. 

Debt instruments are categorized as shortterm, medium-term and long-term according to their maturities. There are no exact definitions, but short-term is less than 1 year of maturity, mediumterm is between 1 to 5 years, and long-term is more than 5 years in general. However, these also depend on the state of the market and the economy.

Equity-based instruments represent ownership in a company and entitle the holder to a share of the company’s assets and earnings after taxes and expenses. Investors in equity instruments are referred to as shareholders or stockholders. Some examples are common or preferred stocks.

Foreign exchange (Forex) instruments are financial products that facilitate
the exchange of one currency for another. These instruments are mainly used for international trade and investment. Fluctuation in the price of these instruments also provides speculation opportunities for financial investors. Examples are spot foreign exchange, forward foreign exchange, and currency swaps.

Cryptocurrencies are a form of digital or virtual currency that uses cryptography for secure financial transactions. These systems function without reliance on traditional banks and operate in a decentralized manner. Cryptocurrency is digital money that does not require a bank or financial institution to verify transactions and can be used for purchases or as an investment.

There are various reasons why indirect financing is more prevalent in the financial system compared to direct financing:

1. Financial institutions can reduce transaction costs. Due to their expertise in the financial sector, experts of these institutions could follow the developments in the market, track improvements in relative returns of financial assets and so on. Additionally, they can handle larger transactions, giving them an advantage of economies of scale. Financial intermediaries use their advantage of larger transaction volumes to decrease the cost per dollar of transactions.

2. Financial institutions help investors to reduce the risks involved in the financial system. In a sense, financial institutions share their customers’ risk sharing. This is promoted through two channels: asset transformation and portfolio diversification. 

3. Financial institutions could solve information asymmetries. Asymmetric information is the inherent characteristic of the financial system. In the financial system, a borrower has better information about the potential returns and risks associated with the investment project for which funds are supposed to be used than the lender.

Asset transformation is where riskier assets are purchased by financial institutions, and less risky assets are sold to the customers. That is how these institutions make profits, through the spread between what they buy and sell.

Portfolio diversification is the common principle of not putting all your eggs in the same basket. Financial institutions enable individuals to diversify by investing in assets whose returns move in different directions so that overall risk is lowered for the individual. Financial intermediaries can pool a group of assets together and create a new asset, like a mutual fund, which they can then sell to individuals, thanks to low transaction costs.

Information asymmetry refers to a situation where one party involved in a financial transaction possesses more information than the other party, leading to a potential disadvantage for the party with less information.

The most well-known type of bank to the general public is a commercial bank. Commercial banks are financial intermediaries that offer a wide range of services to individuals, businesses, and governments. Their primary functions include accepting deposits from customers, providing loans and credit facilities, and facilitating various financial transactions.

Participation banks, also known as Islamic banks, are financial institutions that operate by Islamic principles and laws. Participation banks do not charge or pay interest on loans and deposits. Instead, they use profit-sharing arrangements or other noninterest-based mechanisms for financial transactions.

Insurance companies are financial institutions that offer protection against various risks. They provide policies to individuals and businesses whereby policyholders pay premiums in exchange for financial compensation in case of specified events, such as accidents, illnesses, property damage, or death.

Pension and retirement funds are financial intermediaries that help individuals plan for their retirement by managing and investing their funds. These funds are typically set up by employers or governments to provide a steady stream of income for retirees.

Credit unions are financial institutions that operate cooperatively, with ownership held by their members. These members often share a common bond, such as membership in the same community, workplace, or organization. Credit unions provide comparable services to banks, such as savings accounts, loans, and other financial products.

Investment intermediaries are financial institutions that facilitate the investment of funds on behalf of individuals and institutions. They act as go-betweens for investors and the financial markets by providing investment products and services. Some examples are brokerage firms, asset management companies, and investment
banks.

1. Richer economies have larger financial sectors: As countries become wealthier and their incomes increase, their financial systems become more developed. The development of the financial system can be measured in terms of size, activity, and effectiveness of financial institutions. When the size of the financial system is compared with the per capita GDP as an economic development criterion, higherincome countries tend to have relatively larger and more efficient financial systems. This phenomenon can be observed when making country comparisons, as well as historical comparisons. Historically, a country’s financial system grows along with its increasing income. 

2. Globally, indirect finance is more common than direct finance: Direct finance refers to investors directly purchasing financial assets from the market without the involvement of intermediaries. On the other hand, indirect finance involves the flow of funds through financial institutions like banks. 

3. In developed economies, banks, along with other financial intermediaries and equities markets, are larger and more effective: We can interpret this fact as a consequence of the first fact we discussed earlier. The financial system is more developed in advanced high-income countries, so we expect their institutions and markets to be more advanced. 

4. Banks are the most important financial intermediaries worldwide: In the second fact, we mentioned the importance of indirect financing; in addition, the fact that indirect financing is primarily carried out through banks is one of the characteristics of the financial sector. In short, banks are the most significant financial institutions globally.

From 2021 to 2022, financial sector assets shrank to 19,657.5 Billion TL. This rapid growth in the financial sector has been faster than the growth in economic activity. 

Similar to examples worldwide, the weight in the financial sector in Türkiye also lies in institutions that collect deposits, namely commercial banks.

We can observe that the depth of the financial system is rapidly increasing in Türkiye. Considering the positive connections between the financial sector and economic activity and the risks brought about by rapid financialization, the development of the financial sector’s depth in the Turkish economy should be carefully observed. 

In conclusion, the banking sector plays the most crucial role in Türkiye’s financial system. Over the years, the share of the banking sector has been significant in the increasing depth of the financial sector. In this context, there is a need for further development in the non bank segment of the sector.