it or not, we all are a part of an ecosystem where finance plays a major role.
Have you ever thought about how the economy works? Why do the banks pay
interest to their depositors? Why is the goods and services price keeps on increasing
every year… The questions are unending, yet the answers are connected with
each other at some or the other way. Finance is a very broad term and hence
this blog is focused on breaking these norms in the easiest possible manner.….
However, in this article, we will be having a look at the backbone of the
economy i.e. The Financial Services Industry from a broader perspective. (If
you need more details on any specific finance terminology than do have a look
at the “Glossary Section” of TheFinanceMagic.com)
Income, Expenditure and Savings are some terms which everyone would be familiar with. Basically, we are saving if we spend less than we earn. There’s a difference between savings and investment. If we are willing to earn returns from our savings than it is called as an investment, in short instead of keeping the money idle in our lockers, we are looking for opportunities where we could generate returns with the help of our savings and thus increasing our investment value. The aim is to generate sufficient returns that could surpass the inflation rate of the economy (or even more).
Let’s take an example: Suppose there was Mr Tom, who wanted to start his own business but due to shortage of capital he was not able to do so. He had a very detailed plan and probably one of the most successful business ideas. Now in order to accumulate the required capital, he started searching for investors who could take some sort of risk and provide him with the funds to execute his business idea. After hunting for a period of 11 months, he was able to successfully raise the required funds and in exchange promised investors to provide some returns or share in the profits of the business. (Here investors provided the fund with the belief that they would be able to get back more money than they have invested.)
We won’t go further from this point as we are not concerned with whether the business was able to generate profits or not. (that is something dependent on the business model and the investor’s faith in the promoter’s vision). I would like to bring your focus on just one thing that is “raising of funds” (which is the core need for running any company/business).
Did you notice? The time taken by the company to raise funds was very long, what if it could be quicker and easier if there was a system that could easily connect the lenders to the borrowers.
Well there is such a system, where the providers of capital (i.e. investors) meet the user of capital (i.e. spenders) and it is known as “the financial system”
Where can an Individual invest his savings?
Savings can be invested in two forms: Real assets or Financial assets
Real assets are physical assets such as land, building, machinery, cattle, gold whereas financial assets are basically claims on real assets or other financial assets. For example, Shares/ Stocks, which gives its holders some claim on the companies assets and earning.
(FYI: The investors total holding of financial assets is called an investment portfolio)
Financial assets that can be traded are called “securities” and the two most common securities in the market are Debt securities and Equity securities.
Debt securities are basically loans provided by the investors to the spenders. In return, investors expect a fixed periodical interest payment on the outstanding loans until it is completely repaid. Debt securities are issued by both corporate as well as governments to raise capital. The securities issued by corporates are known as corporate bonds and if issued by the government, it is known as government bonds. Corporate bond posses higher risk as compared to government bonds and thus provide higher returns. If the investor has a high risk-taking capacity than they should opt for Corporate bonds.
Equity securities are also called as stocks and shares. The person who invests into this securities are known as shareholders and as discussed earlier they have some claim on the companies assets and earnings. However, the company has no obligation to either repay back their invested capital or provide any form of dividends. The Equity investors are able to earn a return on their invested capital when the shares are being sold at a price higher than their buying price. (even dividends paid by the companies is an income for shareholders). Hence an investor opting for equity securities should do complete research on the company before investing. In simple words, buying shares of any company simply denotes the investor’s belief in the companies growth prospect. Equity securities are more riskier as
compared to debt securities and thus it has the potential to give returns
beyond investors expectations and vice versa.
For more details on the Different Investment Asset Class, you can check this amazing article: Different Types of Investment Asset Class | Building Your Dream Portfolio
(FYI: A place where buyers and sellers trade securities are known as Financial market or securities market.)
financial services industry work?
The financial services industry helps to channel funds between the investors and the spenders either via direct finance method or indirect finance method.
Under Direct Finance, the investor can directly interact with the spenders via financial markets and thus the investor has a direct claim on the user of capital (i.e. the spenders). For Example,
as discussed earlier if the investor owns shares of the X company than he has some claim on its earnings and asset.
Under Indirect Finance, the financial intermediaries act as a middleman to channel the funds between the investors and spenders, they might also create a new financial asset where the investor might invest and on the other hands, the spenders could use it for their capital requirements. Unlike direct finance, the former does not have any direct claims on the latter.
Financial Institution is a type of financial intermediaries. where the role is to collect money from the investors and lend to or invest in the companies or businesses. They have better knowledge on monitoring the financial health of companies and picking the suitable one for investments.
The two largest financial institutions are banks and insurance companies.
Banks: Banks collect deposits from the individuals, on which they provide a specific rate of return and further lend it to borrowers at higher rates. The difference in rates is what a bank earns. It is the bank’s responsibility to manage its borrowers and generate a continuous flow of income. In this case, the investors do not have any direct claims on the borrowers rather they have a claim on the banks and further the banks has claims on their lenders. The banks are further classified as retail banks which provide services to individuals and small companies and commercial banks which provides services to companies and other financial institutions. Even though if a borrower defaults the bank is still liable to pay interest to its investors.
Insurance companies: These companies provide insurance contracts (also known as policies) to individuals and companies who have a certain risk associated with the business. Insurance contract protects the buyer from any potential loss. A non-refundable premium is required to be paid by the insurance buyer upfront at a regular interval in order to claim the insured sum at times of uncertainties. If the risk actually materialises, the insurance company pays the insurance amount to the insurance buyer and makes the settlement. There are two types of insurance companies i.e. “Property and casualty insurers” which covers asset used in the business or in personal life and “Life Insurers” that pays money if the person insured dies or faces any accidental injuries.
This was a short overview on “The Financial System”. I hope it helped you to get a basic understanding of the economy and the investment industry. Will see you soon in the next blog post, till then do check our other popular post (mentioned below) and if you want to invest in the equity securities than download the below app and start investing. The sooner you begin the higher will be the returns
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