What is the financial sector?
The financial sector is made of firms and markets that deal with money: saving it, lending it, insuring against risk and moving it from one person to another.
Its key job is to be a bridge between:
- savers: households and firms with money they do not need right now, and
- borrowers: people who want to buy a house or study, firms that want to invest, and governments.
Firms that stand in the middle like this are called financial intermediaries.
Banks, insurers, markets
Commercial banks (and building societies, credit unions)
- Accept deposits and keep them safe; pay interest to savers.
- Give loans, mortgages and overdrafts; charge a higher interest rate to borrowers. The gap pays the bank's costs and profit.
- Provide payment services: cards, online transfers, cheques, UPI.
Insurance companies
- Collect a small premium from many customers.
- Pay out to the few who suffer a loss (fire, theft, illness, accident). This is risk pooling.
- Invest the premiums meanwhile, so they also provide money for firms.
Financial markets
- Stock (share) market: firms sell shares (small pieces of ownership) to raise money; investors can later sell them to others.
- Bond market: firms and governments borrow by selling bonds, promising to pay interest and repay later.
- Foreign exchange market: one currency is swapped for another, needed for trade and travel.
- Money market and commodity markets: short-term borrowing, and trading in goods like oil, wheat and gold, including deals for future delivery.
The central bank
Each country's central bank (for example the Reserve Bank of India, the Bank of England, the European Central Bank) is the banks' bank. It sets the main interest rate, issues notes and watches over banks to keep the system safe.
Why the sector matters
- Saving becomes investment: money sitting in accounts is lent to firms to build factories and buy machines, which raises output and jobs.
- Easy payments: without cards and transfers, trade would be slow and risky.
- Spreading big costs: loans and mortgages let people buy a home or pay for study now and repay over years.
- Sharing risk: insurance means one bad event does not ruin a family or a firm.
- Helping trade: currency exchange and trade finance let firms buy and sell abroad.
When it goes wrong
If banks lend too much to people who cannot repay, they can make big losses. In 2008 such losses spread around the world, banks stopped lending, firms closed and unemployment rose in many countries. That is why central banks and regulators watch banks closely and why deposits are often protected by a guarantee scheme.
Try it: follow 10,000 through the sector
A saver deposits 10,000 at 4% a year. The bank lends it at 7%.
- Saver earns 10,000 × 4 ÷ 100 = 400.
- Borrower pays 10,000 × 7 ÷ 100 = 700.
- The bank keeps 700 − 400 = 300 to pay staff, cover bad loans and make profit.
Change the numbers in the 3D free play and check your answers.
Key formulas and definitions
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Worked examples
1. Riya deposits 20,000 at 5% a year. How much interest does she earn after one year?
Interest = 20,000 × 5 ÷ 100 = 1,000.
2. A bank pays savers 3% and charges borrowers 8%. It lends out 1,000,000 of deposits. What is its margin for a year?
Borrowers pay 1,000,000 × 8 ÷ 100 = 80,000. Savers get 1,000,000 × 3 ÷ 100 = 30,000. Margin = 80,000 − 30,000 = 50,000.
3. 1,000 people each pay a premium of 500 for home insurance. Three homes have fires costing 120,000 each. Can the insurer pay?
Pool = 1,000 × 500 = 500,000. Claims = 3 × 120,000 = 360,000. Yes, 500,000 > 360,000, leaving 140,000 for costs and profit. Each family paid only 500 to be protected against a 120,000 loss.
4. Why would a firm sell shares instead of taking a bank loan?
Shares do not have to be repaid and no interest is due; investors share in profits through dividends. The cost is that the original owners give up part of the ownership and control.
Common mistakes
- Thinking banks keep all deposits in a vault. Most deposits are lent out; only a part is kept as reserves.
- Mixing up shares and bonds: a share is part ownership; a bond is a loan that must be repaid with interest.
- Thinking insurance stops the loss from happening. It only shares the cost of the loss.
- Confusing a commercial bank with the central bank. Commercial banks serve the public; the central bank serves banks and the government.