Chapter 1
OVERVIEW OF THE
FINANCIAL SYSTEM
AN OVERVIEW OF THE FINANCIAL SYSTEM
Financial system structure and functions
The financial system plays the key role in the
economy by stimulating economic growth,
influencing economic performance of the actors,
affecting economic welfare. This is achieved by
financial infrastructure, in which entities with
funds allocate those funds to those who have
potentially more productive ways to invest those
funds.
2.2
AN OVERVIEW OF THE FINANCIAL SYSTEM
A financial system makes it possible a more
efficient transfer of funds. As one party of the
transaction may possess superior information than
the other party, it can lead to the information
asymmetry problem and inefficient allocation of
financial resources. By overcoming the information
asymmetry problem the financial system facilitates
balance between those with funds to invest and
those needing funds.
2.3
According to the structural approach, the
financial system of an economy consists of
three main components:
1) financial markets;
2) financial intermediaries (institutions);
3) financial regulators.
Each of the components plays a specific role in the
economy.
2.4
According to the functional approach,
Financial Markets facilitate the flow of funds in
order to finance investments by corporations,
governments and individuals.
Financial Institutions are the key players in the
financial markets as they perform the function of
intermediation and thus determine the flow of
funds.
The Financial Regulators perform the
role of monitoring and regulating the participants in
the financial system.
2.5
AN OVERVIEW OF THE FINANCIAL
SYSTEM
Primary Function of the Financial System is
Financial Intermediation
2.6
FUNCTION OF FINANCIAL MARKETS
Channels funds from person or business
without investment opportunities (i.e.,
“Lender-Savers”) to one who has them
(i.e., “Borrower-Spenders”)
Improves economic efficiency
Critical for producing an efficient
allocation of capital, which contributes
to higher production and efficiency of
overall economy
FUNCTION OF FINANCIAL MARKETS
Well-functioningmarkets improve
the well being of consumers by
allowing them to time their
purchases better
FINANCIAL MARKETS FUNDS
TRANSFEREES
Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners
METHODS OF FUNDS TRANSFER
1. Direct financing
2. Indirect financing
DIRECT FINANCING
Borrowers borrow directly from
lenders in financial markets by
selling financial instruments which
are claims on the borrower’s future
income or assets
DIRECT FINANCE
Securities
are assets for the person
who buys them
They are liabilities for the individual
or firm that issues them
INDIRECT FINANCE
• Borrowers borrow indirectly from
lenders via financial intermediaries
(established to source both loanable
funds and loan opportunities) by
issuing financial instruments which
are claims on the borrower’s future
income or assets
FUNCTION OF FINANCIAL MARKETS
IMPORTANCE OF FINANCIAL MARKETS
This is important. For example, if you
save $1,000, but there are no financial
markets, then you can earn no return on
this—might as well put the money under
your mattress.
However, if a carpenter could use that
money to buy a new saw (increasing her
productivity), then she’d be willing to
pay you some interest for the use of the
funds.
IMPORTANCE OF FINANCIAL MARKETS
▪ Financial markets are critical for
producing an efficient allocation of
capital, allowing funds to move from
people who lack productive investment
opportunities to people who have them.
▪ Financial markets also improve the
well-being of consumers, allowing them
to time their purchases better.
CLASSIFICATIONS OF FINANCIAL MARKETS
Debt Markets
Short-term (maturity < 1 year) – the
Money Market
Long-term (maturity > 10 year) – the
Capital Market
Medium-term (maturity >1 and < 10
years)
2.1 © 2008 Pearson Education Canada
DEBT INSTRUMENT
A contractual agreement by the
borrower to pay the holder of the
instrument fixed dollar amounts at
regular intervals until a specified
date (the maturity date) when a final
payment is made.
COMMON STOCK
Claims to share in the net income
and the assets of the business
Often make periodic payments called
dividends
Long-term as no maturity date
Residual claimant
CLASSIFICATION OF FINANCIAL MARKETS
1. Primary market
2. Secondary market
PRIMARY MARKET
New security, bond or stock, issues
sold to initial buyers by the
corporation or government agency
borrowing funds
Financial institution that facilitates is
investment bank
Does underwriting securities
Guarantees a price for the
corporation’s securities and then sells
them to the public
2.2 © 2008 Pearson Education Canada
SECONDARY MARKETS
Securities previously issued are bought
and sold
Even though firms don’t get any money,
from the secondary market, it serves two
important functions:
Provide liquidity, making it easy to buy
and sell the securities of the companies
Establish a price for the securities
SECONDARY MARKETS –
ORGANIZATION OF EXCHANGES
1. Organize exchanges where buyers and
sellers of securities (or their brokers or
agents) meet in one central location to
conduct trades
2. Over the counter market: Dealers at
different locations who have an
inventory of securities stand ready to
buy and sell securities over the counter
2.2 © 2008 Pearson Education Canada
SECONDARY MARKETS
Security brokers and dealers are crucial
to well functioning secondary markets
Brokers
are agents of investors who
match buyers with sellers of securities
Dealerslink buyers and sellers by
buying and selling securities at stated
prices
MONEY AND CAPITAL MARKETS
Another way of distinction:
Money market: financial market in
which only short-term debt instruments
with maturity of one year or less are
traded
Capital market: market in which debt
instruments with a maturity of more
than one year and equity instruments
are traded
FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT FINANCE
Instead of savers lending/investing
directly with borrowers, a financial
intermediary (such as a bank) plays as
the middleman:
▪ the intermediary obtains funds from
savers
▪ the intermediary then makes
loans/investments with borrowers
▪ This process, called financial
intermediation, is actually the primary
means of moving funds from lenders to
borrowers.
▪ More important source of finance than
securities markets (such as stocks)
▪ Needed because of transactions costs,
risk sharing, and asymmetric
information
TRANSACTION COSTS
1. Financial intermediaries make
profits by reducing transactions costs
2. Reduce transactions costs by
developing expertise and taking
advantage of economies of scale
3. Provide liquidity services
TRANSACTION COSTS
A financial
intermediary’s low
transaction costs mean that it can provide
its customers with liquidity services
1. Banks provide depositors with
checking accounts that enable them to
pay their bills easily
2. Depositors can earn interest on
checking and savings accounts and yet
still convert them into goods and
services whenever necessary
RISK SHARING
FI’slow transaction costs allow them to
reduce the exposure of investors to risk,
through a process known as risk sharing
FIs create and sell assets with lesser
risk to one
party in order to buy assets with
greater risk from another party
This process is referred to as asset
transformation, because in a sense
risky assets are turned into safer assets
for investors
RISK SHARING
▪ Financial intermediaries also help by
providing the means for individuals and
businesses to diversify their asset
holdings.
▪ Low transaction costs allow them to
buy a range of assets, pool them, and
then sell rights to the diversified pool to
individuals.
FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT FINANCE
▪ Another reason FIs exist is to reduce the
impact of asymmetric information.
▪ One party lacks crucial information
about another party, impacting decision-
making.
▪ We usually discuss this problem along
two fronts: adverse selection and moral
hazard.
FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT FINANCE
▪ Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to
produce adverse outcome are ones
most likely to seek a loan
3. Similar problems occur with
insurance where unhealthy people
want their known medical problems
covered
ASYMMETRIC INFORMATION:
ADVERSE SELECTION AND MORAL HAZARD
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to
engage in undesirable (immoral)
activities making it more likely that
won’t pay loan back
3. Again, with insurance, people may
engage in risky activities only after
being insured
4. Another view is a conflict of interest
ASYMMETRIC INFORMATION:
ADVERSE SELECTION AND MORAL HAZARD
▪ Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits.
▪ Because of their expertise in screening
and monitoring, they minimize their
losses, earning a higher return on
lending and paying higher yields to
savers.
TYPES OF FINANCIAL INTERMEDIARIES
