Lesson 3. Financial system and financial institutions

[Brother]

We often watch or read news stories about the World Bank or centralized finance. Even if you manage to grasp the main point, a person cannot understand how the world economy works and how this has to do with him personally. He barely manages his finances and rarely cares about the financial system as such. However, a financially literate person should know such things - for himself or for a serious discussion.
If you learn to understand the financial system, you can defend your point of view and understand many economic issues. We will not only consider each subsystem separately, but also touch on such a delicate topic as corruption.
Every person probably often thinks about what happens to his money after he spent it or why taxes are needed. Unfortunately, the matter does not go beyond interest and he continues to live as before. We will try to partially cover these issues and consider what the financial system of the state and the entire planet consists of.

Content:

The structure of the financial system​

The financial system is a form of organization of monetary relations between all subjects of the reproduction process for the distribution and redistribution of the aggregate social product.
Simply put, the financial system is the accumulation of cash income and its subsequent distribution. This can be done by the bank, the state and even you, because you are also part of the financial system.
You must understand that some things in economics are very easy to explain. Any financial system deals with income and expenses. Always remember these two simple words - it will help you understand many difficult things. Just as the financial system deals with income and expenses, in the same way, finance itself can be spent or acquired (or temporarily acquired).
The financial system is divided into two types: centralized and decentralized finance.

Centralized finance​

Centralized finances are funds of funds intended to support the activities of state and municipal authorities. Accordingly, they are divided into municipal and state finances.
Municipal finance - form the basis of the economic viability of municipalities. Moreover, each such municipality has its own budget, which is called local.
The local budget is money intended for the financial provision of the functions and tasks of local self-government.
Let's take any town. It is ruled by local government bodies (mayor's office and city council), which need municipal finances to form the local budget. Any city requires a large amount of expenses, which becomes possible only when there is the same amount of income.

Let's see what methods of income for the local budget exist:

• Revenues from local taxes and fees. The City Hall passes local laws in the same way as the state, and collects taxes.
• Deductions on certain federal taxes and fees. This means that the state can additionally help the local budget if it cannot cope on its own.
• Deductions from some regional taxes and fees. As we can see, the city budget can be helped not only by the state, but also by the regions.
• Subsidies. We are talking about transferring money from the state budget on a free basis.
• Income from municipal property. This can be, for example, renting out a city object.
• Penalties. For example, for incorrect parking.
• Other receipts.

The municipal authorities form the local budget expenditures from the available revenues.

Local budget expenditures can be as follows:

• Maintenance of local government bodies.
• Landscaping and landscaping.
• Maintenance of educational institutions, culture, physical culture and sports.
• Organization of public transport. Buses, trolleybuses and trams require a lot of money for repairs and maintenance.
• Organization and maintenance of housing and communal services.
• Disposal and recycling of waste.
• Maintenance of local roads, as well as their construction.
• Conducting local elections and referendums.
• Other expenses.

The column "Other expenses" includes dozens of other types of expenses of the local budget. Sometimes they can vary greatly depending on the requirements of the voters and the budgetary possibilities. There can also be big differences from country to country.
The second type of centralized finance is public finance.
Public finance is a form of organization of financial relations, where the state is a participant in one form or another. Any state requires the required amount of money for the functioning and fulfillment of its obligations to the society that established it.

Public finance has three main functions:

• Control.
• Distribution.
• Regulatory.

Public finances form the state budget. The state budget is a document that indicates the income and expenses of a particular state for a certain period of time. As a rule, for one year - from January 1 to December 31. Significant cash flows pass through the budget and it directly affects such economic indicators as the unemployment rate, money supply, exchange rate, inflation, government debt, investments, production volumes, etc.
Let's take a look at what government revenues and expenditures can be.

State budget revenues:

• Duties and Nontax Fees.
• Income taxes for legal entities and individuals.
• Regional and local taxes.
• Revenues from the real sector (income tax).
• Indirect tax and excise receipts.

As you can see, the main source of income for the state budget is taxes. Therefore, it will be so tempting for a state leader to focus on this type of replenishment of the state treasury. In countries with a social bias, taxes are very high, there is a redistribution of resources from the rich to the poor. Which can lead to sad consequences: emigration of rich people to countries with low tax rates.
For example, the city-state of Singapore has one of the most sophisticated and fair tax systems in the world. This does not make Singapore a great tourist destination because prices are high, but it is an investor's paradise. Perhaps in the very near future, Singapore will overtake Switzerland, the world leader in this area, in terms of the size of the placed assets. This city-state is just a dream for any investor, besides, many of them can get permanent resident status if they invest enough money in the economy. Whereas France, for example, is going in the opposite direction.

State budget expenditures:

• Industry.
• Agriculture.
• The science.
• Defense.
• Public administration.
• Healthcare.
• Social politics.
• International activity.
• Law enforcement activity.

If the ratio of income and expenditure in the state budget is equal, then it is spoken of as balanced. When expenditures exceed revenues, this is called a budget deficit and the government often issues new money, which causes inflation. If incomes exceed expenses, we are talking about a budget surplus. We touched on this topic in the last lesson, but now we see how this happens in practice, since we understand what specific income and expenses can be.
However, there are other ways to replenish the state treasury in the event of a serious deficit. The state can decide to issue and sell securities (bonds and bills). In this case, a rich entrepreneur can become a bank for such a state and it will owe it. Central bank funds can be used, but this should be the last thing. Some countries apply for loans from other countries or banks. This all helps to temporarily patch the hole in the budget and show the population that everything is under control.

Corruption​

It is impossible not to ignore the theft of finance in the field of public finance management. It is here that the level of corruption in any country is simply amazing. Why? Because, in fact, the state money has no owner, besides, very few people are interested in building a state facility and a lot of people want to get big profits from this.
A very revealing story happened in the 19th century after the creation of the Pacific Railroad in the USA. It was a state-owned company and it was declared bankrupt several times, despite the fact that the state invested huge amounts of money in its development. Workers and managers were paid for every mile they ran, so they were motivated to build it in a wobbling rather than a straight line. In addition, the structure was constantly being altered, because it was as if it was deliberately built incorrectly. The workers were interested in increasing the length of the railway and long-term construction, and the managers only supported the former in this. In addition, money was constantly disappearing somewhere.
At the same time, James Hill built his own railway, called the Great Northern Railway, with his own money. He found investors, invested his money, and very quickly built an incredibly efficient railroad. To make a profit, Hill knew a simple truth: the road must be straight and steady. When a physical object is built with the private money of specific people, you can be sure that the level of corruption in it will be minimal.
If you heard in the news about the monstrous level of corruption, then you can also be sure that it is about public money and most likely there are many who are interested in this under the government. Even if we assume that the person who is in charge of the construction with state money will be very decent, this object will still be built for more money than if he built it for his own. This is how human psychology works.

Decentralized finance​

Decentralized finance is a form of organization of monetary relations formed by enterprises, organizations, other business entities, as well as individual households and citizens. They belong to commercial and legal entities. Part of the income from such a business goes to the state and local budgets, with their help budgetary organizations are financed, as well as subsidies, pensions, and scholarships are paid.
Decentralized finance moves the economy of any country forward, because the overwhelming majority of such organizations are commercial and tax collections from their revenues allow them to replenish the budget. If we imagine for a second that such organizations will leave the country en masse, very difficult times will await it, because there will be nothing to collect taxes from. In this case, the state will switch to its population, raise taxes and all this will end very badly, perhaps even with default.
Also, it is these financial institutions that attract new investments to the country, which allows building and producing more. In addition, they take loans for their business from banks, which allows the country's banking system to function.
Consider the types of entities that contain decentralized finance. There are three main ones - household, organizational and international finance.

Household finances​

This is a set of relationships regarding the creation and use of funds of cash and financial assets necessary for the life of members of the household. This is understood as a group of people, most often related by family relations, jointly making monetary decisions and forming a household budget. Although a household may also consist of one person, who independently and independently forms its own budget. So whether you like it or not, you are a member of the household.

In the system of market relations, the household acts as:

• The taxpayer forming the budget.
• Buyer and consumer of goods and services.
• Lender or borrower.
• The accumulator of funds by saving part of the income received (we will talk about this in the next lesson).
• Supplier of factors of production: labor, capital, and so on.

Household members develop internal and external financial relationships. Internal ones arise among members of the household. External relationships are:

• with the state;
• with enterprises and organizations;
• with employers;
• with commercial banks about loans and deposits;
• with insurance companies;
• with other households.

Household budget​

This is the balance of income and expenses of the farm for a certain period of time (month, quarter, year).
Household income is:

• Wage.
• Pensions, scholarships, allowances and other social benefits.
• Income from real estate and cash transactions on the stock exchange and financial market.
• Business income.

We will talk about ways to generate income in the next lesson. Now it is worth adding that a financially literate person always keeps his income above his expenses. Although there are a large number of them.
Household expenses are:

Taxes and fees:

• Income tax.
• Land tax.
• Property tax.
• National tax.
• Vehicle owner tax.
• Resort tax.
• Cleaning fee for settlements.
• Etc.

Utility and other monthly payments:

• Payment of utility services.
• Payment for cold water.
• Payment for hot water.
• Payment for electricity.
• Garbage collection fee.
• Payment for heating.
• Payment for a radio point.
• Etc.

Current consumption costs:

• Clothing and footwear expenses.
• Food and beverage expenses.
• Recurring expenses: hairdresser, laundry, dentist, other medical services, personal insurance, and so on.
• Expenses for tourism, recreation, travel.
• Etc.

Capital expenditure on consumption of non-food items:

• Purchase of housing.
• Purchase of a car.
• Purchase of furniture.
• Etc.

Capital expenditures for earning profits in the future:

• Education expenses.
• Business expenses.
• Etc.

Also, expenses include the accumulation of money capital or an insurance reserve for a rainy day.

Financial institutions​

These are monetary relations that are associated with the formation and distribution of monetary income and their use for various purposes. A financial institution uses money from the sale of products - the sale of goods, services and works. If such an organization does not have funds, then usually loans are used to obtain them for a short-term period. If for a long-term, then stocks and bonds can be issued. And the ratio of loans to issue of shares forms the capital structure.
These organizations can decide to invest, that is, to receive additional income. They assess risks by analyzing economic factors.

There are three types of financial institutions:

Commercial Bank​

They are divided into three more types:

• Commercial bank. This is a lending institution that carries out banking operations for individuals and legal entities.
• Investment bank. This type of bank organizes the attraction of capital in the global financial markets for large companies and governments. He is also an intermediary in the trading of stocks and bonds, and can provide consulting services when buying and selling a business.
• Mortgage bank. Provides mortgage loans and resells mortgage-backed securities.

This division is very arbitrary, because some banks work in all three directions.

Non-bank credit institution​

Its types:

• Lombard. Such an organization provides short-term loans secured by property.
• Insurance company. She concludes insurance contracts and their maintenance.
• Non-state pension fund. He accumulates pension savings and can even invest them with the consent of the person.
• Credit cooperative. Specializes in providing financial assistance to members of this organization.

Investment Institutions​

Its types:

• Investment company. The members of such an organization give it the right to manage their investments. The so-called investment portfolios are created, where the shares of different companies are collected. This allows you to minimize the risk in the event that a company goes bankrupt - then the member of the organization will lose only the minimum amount of money, and in the best case will receive less income.
• Investment fund. Looks like an investment company. There are several types of such a fund, among which hedge funds and mutual funds stand out.
• Stock exchange. Ensures the regular functioning of the securities market. We will talk about it separately in the fifth lesson when we study financial analysis.
• Investment dealers and brokers. The broker performs intermediary functions on the stock exchange - only he is licensed to carry out such transactions. The dealer, on the other hand, conducts business on his own behalf and can be an investment or commercial bank.

International finance​

This is a concept that characterizes the totality of international financial resources in their movement. Globalization has led to the development and growth of international finance and the emergence of world financial markets.
The main participants in the global system are banks, portfolio investors, transnational corporations and many others.
The very existence of international finance has led to the fact that a big financial crisis in one single country eventually spreads to the whole world. This is, for example, the 2008 global crisis. Today, international financial flows are so intertwined in the world that financially literate people pay attention to the global economy and try to predict the future situation in their home country.
Thus, an international financial institution appeared. This is a financial institution in which states and non-state institutions are participants, therefore they are all subjects of international law. International financial organizations emerged after the world crisis of 1929-1933.
An IFI is created so that the participating countries come together to solve problems in the field of the development of the world economy. The goals can be the development of cooperation, smoothing out contradictions and ensuring the integrity of the world economy. Also, such organizations analyze trends in the economy, conduct operations in the stock market, fund scientific research and are engaged in charitable activities.

Examples of international financial institutions:

• World Bank. Created with the aim of organizing financial and technical assistance to developing countries. The headquarters is located in Washington DC.
• International Monetary Fund. A specialized UN agency that provides short- and medium-term loans in case of a deficit in the balance of payments of the state. Currently, the IMF unites 188 countries, each of which can apply for a loan if certain conditions are met. The headquarters is located in Washington DC.
• International Bank for Reconstruction and Development. Member of the World Bank Group. Objectives: to assist in the reconstruction and development of the economies of the member states and to promote private foreign investment. The headquarters is also located in Washington.
• European Investment Bank. Created to finance the development of backward European countries in the form of long-term loans. The headquarters is located in Luxembourg.
• European Central Bank. This organization issues the euro and also manages the official reserves of the Eurosystem. She is completely independent. The headquarters is located in the German city of Frankfurt am Main.

In this lesson, we have covered the world's financial system, moving from household finance to the World Bank. Of course, in fact, everything is much more complicated, however, in order to understand financial news or analyze some important points, you have a weapon. In order to understand any structure, you need to look at it from two points of view - a close-up and a general plan, which we did.
In the next lesson, we will deal with one of the most important aspects of financial well-being - the study of the sources of passive income. We will also understand the importance of accumulation, which will allow us to invest in the future.

Test your knowledge​

If you want to test your knowledge of the topic of this lesson, you can take a short test consisting of several questions. In each question, there can be only one correct answer. After you have selected one of the options, the system automatically proceeds to the next question. The points you receive are influenced by the correctness of your answers and the time spent on passing. Please note that the questions are different each time, and the options are mixed.