Role of the Financial Institutions and Financial Markets in Economy

We have always read that financial stability helps in positive economic growth. The importance of this statement can never be justified. There is absolutely no way for the economy to grow and benefit the country if the financial sector doesn’t support it. 

If the financial sectors constantly promote or encourage the commercial activities of a country, only then the economy of the said country will progress effectively. Financial institutions and financial markets play a vital role in the progress of a nation and act as a critical driving force for economic lift. 

We have already established the fact that financial institutes and financial markets play a role in the economy, but how do they work? Let’s dive deep into what roles they play and how they affect the economy.

What are Financial Institutions? 

All the institutions that specialize in performing financial transactions such as deposits, loans, investments, insurance, etc., are known as financial institutions. There are mainly five types of financial institutions regulated by the central government. 

1. Commercial Banks
2. Investment Companies
3. Brokerage Firms 
4. Investment Banks 
5. Insurance Companies 

These institutions ensure that people make the right use of interest rates and make profits that benefit them and the whole economy.

Role of Financial Institutions in Economy

• Financial institutions have significant importance in maintaining economic stability and controlling inflation. They regulate the money supply for a country’s economy. When the central bank modifies reserve requirements by lowering them, banks can more excessively loan out money. This increase the money supply in the economy. 
• Another role played by financial institutions is capital formation. Anything from land to machinery is considered capital, and financial institutions make sure to increase the capital stock. This is done when the unused money from individuals is invested in different businesses. This is mainly conducted through savings accounts in banks and investment opportunities provided by investment firms. 
• Financial institutions help in the growth of the business sector. Financial institutions assist small, new on the market and medium-sized businesses in their early stages of operation. They supply these businesses with both long-term and short-term funding. The long-term investment assists companies in capital development, while the short-term funding programs help the companies meet their requirements for everyday capital.
• Financial institutions are constantly under government regulation, and it is a country-wide phenomenon. They work according to the government standards and help the economy in its growth. The best way to describe it is to notice how banks come out with loans at lower interest rates for a particular sector. Governments issue guidelines for the banks to lower the interest rates for the industry facing developmental issues. This helps the businesses of the said sector to get the money required to initiate the growth. When the business sector grows, the economy also uplifts itself. 

Financial institutions are the foundation of a country’s economy. If all these institutions collapse, the economy will collapse with them and will be unable to recover. 

What are Financial Markets? 

Financial markets offer a channel for the acquisition and selling of stocks and bonds for potential profits. People invest their money or savings in the form of equities to gain more financial profit in the future. 

Financial markets contribute to the uninterrupted delivery of savings and productive investment in a country’s economy, facilitating economic growth, capital formation, and the development of products and services. 

Following are the types of financial markets existing in today’s economic world: 

1. Capital Markets 
2. Foreign-Exchange Markets (Forex) 
3. Stock Market 
4. Money Market
5. Commodities Market
6. Bond Market
7. Derivatives Market 

The confluence of financial markets and institutions of a country, and a diversified range of financial assets and mechanisms, meets the demands of borrowers and investors and hence benefits the economy as a whole.

Role of Financial Markets in Economy

• Members of the financial markets get indications from the cost of borrowing and the rate of return on their investment. These signals assist in directing finances to individuals, corporations, government organizations, and investors who want to get money by linking them with interested lending institutions or lenders.
• Different securities such as bonds or public and private shares are sold in the capital market to generate financing for multiple enterprises and government institutions in short to long-term ranges.
• The foreign exchange market ensures efficient transactions and smooth transitions of currencies. Without the foreign exchange market, the trading and monetary transactions would not be possible, thus resulting in an economic collapse. 
• Financial markets generate liquidity, helping firms to expand and businessmen to fund their enterprises.
• Capital markets help to stabilize economies by instilling investor interest and confidence. More investments in the business sector contribute to the development and growth of economies.

You may have noticed that the countries with poor economies often have minimum to no growth in their financial markets. Their economies are not developing because their financial markets are not working smoothly. 

It is evident that the economy won’t be able to stand on its feet without the smooth and uninterrupted functioning of financial markets and financial institutions. There are many factors that contribute to stable economic growth, and financial markets and institutions are one of them. 

To have a developing economy and a better country’s financial stability, each factor has to play its part. If any of the elements are not working efficiently, the economy will face a downfall.