What is the financial system?

The financial system refers to a set of components and mechanisms, such as monetary policies, insurance and banks, that allow economic transactions to take place. There are many types of financial systems that exist at different levels of society, from those used to operate transactions within a company to those that facilitate international financial transactions. Without these systems, many normal activities would become difficult, if not impossible, such as trading and investing.

The International Monetary Fund (IMF) says: “Resilient and well-regulated financial systems are essential for economic and financial stability in a world of increasing capital flows.” Cash, credit cards and checks are examples of the types of components that can exist in a financial system. An accounting method, an audit service and funding procedures are examples of mechanisms that facilitate the functioning of these systems. The absence of a financial system would produce drastic changes because people might not have access to credit, there would be no monetary products to exchange for goods, and there would be no policies to regulate complex transactions.

Companies generally exist to make money. A company therefore generally needs to have its own internal financial system. This can determine how transactions are approved, accounted for, and how plans are made for current assets. A company's system may mirror the workings of a larger system, but it is much less complex.

A national financial system is one that will affect not only the individuals of one nation, but other nations as well. As each country tends to interact with other countries, it is necessary to have a functioning global financial system. This establishes a medium for acts such as converting and transferring money. It also provides for a procedure for requesting and granting credit between foreign entities. For these types of cross-border transactions to take place, there must be an established method that allows financial institutions to interact.

While every nation generally has a financial system, not all of them operate in the same way. In some nations, for example, the use of credit cards is common. This part of the system allows people to make cashless purchases if they agree to pay the funds in small amounts and add interest. In other less developed nations, credit cards cannot be used.

Some financial systems are weak and inadequate. This can create a lot of problems like inflation and excessive debt. Systems like these are also commonly susceptible to criminals with corrupt and fraudulent intent. A major problem with precarious domestic financial systems is that they often create problems that have far-reaching effects, potentially leading to a global financial crisis of the kind seen in the early 21st century.