Role and Functions of Financial Markets

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Role and Functions of Financial Markets


Financial Markets facilitate the institutions accept deposits as liability and transform them into assets such as loans. This is known as liability asset transformation function.

Financial institutions can bring about scale economies in lending and borrowing by providing large loans on the basis of numerous small deposits. This is known as size transformation function.

Financial Market facilitates savers assets with varying degree of yield, liquidity and risks and provide borrowers with loans of desired maturities. This is called maturity transformation function.

Financial markets shift risk to those who are willing to bear it. This they do by pooling, pricing and diversifying risk. This is called risk transformation function.

Financial institutions as intermediaries of Financial Market are better placed than individuals to evaluate alternative investment proposals and monitor the activities of the borrowers to improve the efficiency of resource use. This is called efficiency augmenting function.

The process of financial intermediaries raises the aggregate volume of savings and investment above the level that would have occurred in the absence of institutional borrowing and lending. The benefits to the real sector of the economy from financial intermediation depend on the efficiency with which the financial sector performs its functions.

The term ‘efficiency’ has two aspects:

  • Operational efficiency and
  • Allocative efficiency.

While operation efficiency is concerned with the minimization of transaction costs, allocative efficiency deals with the distribution of given funds among competing ends.

The efficiency of the financial sector is greatly influenced by the market structure and the regulatory instruments. The central bank of a country has an important role to shape the market and create the regulatory framework. Financial institutions can hardly perform the functions assigned to them in the absence of a strong and transparent central banking system.

The role of the financial system in the process of capital accumulation is judged by certain financial deepening ratios.

  1. Finance ratio: It refers to the total of financial assets in a year to national income.
  2. Financial inter-relation ratio: It is defined as the ratio of the increase in the stock of financial claims to net capital formation.
  3. Internal ratio: The relative importance of the financial institutions in financial transactions is indicated by the intermediation ratio, which is usually measured by the ratio of secondary market issues total issues (primary plus secondary market issues).
  4. New issue ratio: It measures the proportions of primary claims issued by non-financial firms to net capital formation.

The above trends are indicative of the financial depending of the Indian economy in the post-independence period.

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