The stock market is just one piece of something much bigger: the financial system. To understand the financial system, you need to picture two different groups.
# It All Sums Up to 2 Groups
First, you have “lenders”. Sometimes these are corporations with a bunch of cash, but lenders can also be ordinary households, people like you and me. Us regular folks are gonna need money in the future to retire, or send our kids to college, or go on a vacation to Yap Island. So we need a way to turn the money we have now into more money in the future.
The second group is “borrowers”. There are several different kinds of borrowers.
First, you have other households who want to borrow money to buy stuff like a car or a house.
You also have businesses that have a great idea for a new product, but that have a problem. They need money to make the product, and they’ll have money when the finished products are sold. But for now, they need to borrow money to invest in capital – things like machinery, tools, and factories. And they’ll pay it back once they make some sales. Basically, they need to buy stuff to produce other stuff.
Third, you have governments who need to borrow money because they’re spending more than they’re bringing in.
So, you have lenders who have money now and want to turn it into more money in the future. And you have borrowers who need money now and will repay it in the future.
The financial system is a network of institutions, markets, and contracts that brings these two groups together. Lenders put money into the financial system, which loans it out to borrowers. These borrowers pay back those loans with interest, which makes it worth the lender’s time.
# The 3 Ways This Exchange Works
There are three ways this exchange takes place. The first is the banks.
A lender deposits money in a bank, and then the bank turns around and loans that money – to a family who wants to buy a house or a business that wants to expand. As those borrowers pay the interest on their loans, the bank takes part of that money to cover their costs and passes the rest along to the depositor.
The second way lenders and borrowers link up is through the “bond market”.
A government or large corporation that needs to borrow money will sell bonds to lenders. A bond is basically an “IOU” (I Owe You), in which the borrower agrees to pay regular interest payments and promises to repay all of the money back at a set date in the future. If that lender decides they’d rather have cash now, they’re free to sell that bond to another party.
The third way lenders and borrowers link up is through – you guessed it – the stock market.
Say you want to expand your business, but you don’t have the money to do it; You could sell stocks, which is basically slices of ownership in the company. Households get the stock, and you get the cash. If your company profits in the future, you’ll share some of those profits with the shareholders, or the shareholders can sell the stock at a higher price.
Either way, they make money if the company’s profitable.
So, banks and bonds have something in common. They’re dealing in something called “debt”. If you get a loan from a bank, or if you’re a government that sells a bond, the amount you must repay is set.
In almost all cases, you’re obligated to pay back the amount you borrowed with a set amount of interest.
Stocks, on the other hand, are known as equity.
If a company enjoys high profits, shareholders get more money.
If a company goes bankrupt, shareholders may get nothing.
In the news, you might hear about changes in the Dow Jones Industrial Average. But fluctuations in stock markets are not always reliable indicators of how the economy’s doing. Changes in the stock market can be reactions to real, but often to just perceived, changes in economic fundamentals like consumer confidence, the unemployment rate, and GDP growth.
# Why Do We Need This Financial System?
Bonds and stocks also have something in common. They’re traded on markets for financial instruments. Bonds are debt instruments, and stocks are equity instruments, but they’re both pieces of paper that are traded on markets with many buyers and sellers.
Banks, on the other hand, are financial institutions. With the help of the FDIC, they safeguard our money while making loans to individual households and businesses.
So why do we even need this complicated financial system? Why don’t households take their savings and lend them out directly?
Well, if you want to loan out your life savings to your neighbor so he can launch his artisanal smartphone business, go for it!
But that’s a pretty risky bet, so you’re more likely to use a financial system.
Financial markets, with instruments like stocks and bonds, allow borrowers to crowdsource the money they need to borrow.
They raise their capital from lots of investors and spread the risk around. Banks do the same thing.
They accumulate small deposits from thousands of people and use that to make loans. It’s like Kickstarter except better because you get money as opposed to an earnest thank you email.
From the lender’s point of view, a financial system allows you to spread your savings over dozens or hundreds of different loans.
A few companies might go bankrupt and a few people might not pay back their car loans, but those losses will be offset by borrowers who do pay back their loans. You don’t have to put all your eggs in one basket.
The thing to remember here is that this stuff is not just an abstraction or someone else’s concern. Almost all of us are lenders and borrowers at some point in our lives, and understanding lending and borrowing is a big deal.Our disclaimer: https://www.iam-unchained.com/disclaimer/