Characteristics of a Well-functioning Financial System

A well-functioning financial system has complete markets with effective financial intermediaries and financial instruments allowing:

• Investors to move money from the present to the future at a fair rate of return;
• Borrowers to easily obtain capital;
• Hedgers to offset risks; and
• Traders to easily exchange currencies and commodities.

The characteristics of a good financial systems include:

• Complete markets. The presence of robust markets for trading financial products that assist individuals in resolving their financial issues.
• Markets with operational efficiency. Markets with low trading costs, including commissions, and bid-ask spreads.
• Support markets with information efficiency. Governments and businesses make timely financial disclosures that enable the estimate of fundamental values.
• Markets with a high degree of information efficiency. prices that are true to their fundamental values and that mostly fluctuate in reaction to fundamental value changes.

Financial intermediaries create effective markets by:

• Setting up alternative trading platforms, brokerages, and exchanges that connect buyers and sellers.
• Providing liquidity.
• Asset securitizing to create investor-friendly investment instruments.
• Managing banks that accept deposits and provide loans, connecting investors and borrowers.
• Operating insurance businesses that combine unrelated risks.
• Setting up clearinghouses to guarantee that trades are settled for all parties.
• Offering services for investment advising.

A sound financial system has the following advantages:

• Entrepreneurs in need of funding can readily connect with investors.
• Producers who might shy away from projects due to their high level of risk might shift those risks to those who can bear them.
• Generate information-efficient prices

Ineffective financial systems face significant challenges when allocating funds.

Question

Which of the following is least likely a characteristic of a well-functioning financial system?

1. Instruments that solve financial problems.
2. Market prices that always equal fundamental value.
3. Markets where assets can be easily traded at low cost.

Solution

The correct answer is B.

Informational efficiency in well-functioning financial systems should allow investors to estimate fundamental values and cause price changes to correlate with changes in fundamental value. However, fundamental value estimates in well-functioning financial systems will not necessarily always match actual fundamental value.

A is incorrect. This option is actually a positive characteristic of a well-functioning financial system. A system that provides financial instruments designed to address various financial needs—such as hedging, liquidity management, and investment opportunities—demonstrates its ability to meet the needs of different market participants. Therefore, this is not the least likely characteristic.

C is incorrect. This characteristic is also a positive feature of a well-functioning financial system. High liquidity and low transaction costs are crucial for the efficient functioning of financial markets. They ensure that assets can be bought and sold quickly and at a reasonable price, which supports market efficiency and accessibility.