Unit 1:

FINANCIAL
SYSTEM
Whelllhyne Kiara Gayle C. Paculan, MBA
Instructor
 After studying this chapter, you will be able to:

1. Explain the functions of

financial system.

2. Describe the components

of financial system.
Financial System
 functions as an intermediary between
savers and investors. It facilitates the
flow of funds from the areas of
surplus to the areas of deficit. It is
concerned about the money, credit and finance.

 may be defined as a set of institutions, instruments and markets

which promotes savings and channels them to their most efficient use.
It consists of individuals (savers), intermediaries, markets and users
of savings (investors).
Financial System

 In the words of Van Horne, “financial system allocates savings

efficiently in an economy to ultimate users either for investment in
real assets or for consumption”.
 Functions of Financial System
The functions of a good financial system are manifold. They are as follows:

(1) REGULATION OF CURRENCY: As a part of the financial system,

central banks generally control the supply of a currency and interest
rates, while currency traders control exchange rates.

(2) Banking functions

(a)to assemble capital and make it effective;
(b)to receive deposits and make collections;
(c)to check out and transfer funds;
(d)to discount or lend;
(e)to exercise fiduciary or trust powers;
(f)to issue circulating notes.
 Functions of Financial System

(3) Performance of agency services and custody of cash reserves:

Different constituents of the financial system act as the agents for their
clients. They buy and sell shares and bonds, receive and pay utility bills,
premiums, dividends, rents and interest for their clients.

(4) Management of national reserves of international currency: Various

parts of financial system help the economy in particular and polity in general
to manage international reserve.
 Functions of Financial System

(5). Credit control: Financial system controls credit by serving the dual
purpose of:
(a) increasing sales revenue by extending credit to customers who
are deemed a good credit risk, and
(b) minimizing risk of loss from bad debts by restricting or
denying credit to customers who are not a good credit risk

(6). Ensure stability of the economy: Financial system performs the

function of administering national, fiscal, and monetary policy to ensure the
stability of the economy.
 Functions of Financial System

(7). Supply and deployment of funds for productive use: Financial markets
permit the transfer of funds (purchasing power) from one agent to another
for either investment or consumption purposes.

(8). Maintaining liquidity: Financial markets provide the holders of financial

assets with a chance to resell or liquidate these assets.

(9). Price determination: Financial markets provide vehicles by which

prices are set both for newly issued financial assets and for the existing
stock of financial assets.
 Functions of Financial System

(10). Information aggregation and coordination: Financial markets act as

collectors and aggregators of information about financial asset values and
the flow of funds from lenders to borrowers.

(11). Risk sharing: Financial markets allow a transfer of risk from those who
undertake investments to those who provide funds for those investments.

(12). Improve efficiency: Financial markets reduce transaction costs and

information costs.
 Functions of Financial System

(13). Ensure long term growth to itself: Long-term growth of financial

markets is ensured through:
(a) Giving autonomy to Financial Institutions to become efficient
under competition
(b) Education of investors
(c) Consolidation through mergers
(d) Facilitating entry of new institutions to add depth the market
(e) Minimizing regulatory measures and market segmentation.
Components of Financial System
 Components of Financial System
 The financial system consists of the Central Bank, as the apex financial
institution, other regulatory authorities, financial institutions, markets,
instruments, a payment and settlement system, a legal framework and
regulations. The financial system carries out the vital financial
intermediation function of borrowing from surplus units and lending to
deficit units. The legal framework and regulators are needed to monitor
and regulate the financial system. The payment and settlement system is
the mechanism through which transactions in the financial system are
cleared and settled.
1. REGULATORY AUTHORITIES
2. FINANCIAL INSTITUTIONS
3. FINANCIAL MARKETS
4. FINANCIAL INSTRUMENTS
5. PAYMENT AND SETTLEMENT INFRASTRUCTURE.
 Financial Institutions
 The financial system consists of many financial institutions. While most
of them are regulated by the Central Bank, there are some which it
manages just indirectly.

 Institutions regulated by the Bangko Sentral ng Pilipinas

The institutions regulated by the RBI are:
i. Nationalized Commercial Banks (PNB)
ii. Specialized Banks (DBP, LBP)
iii. Registered Finance Companies (SME)
iv. Registered Finance Leasing Establishments
v. Micro-finance Institutions.
 Financial Market
 The Financial Market, which is the market for credit and capital, can be
divided into the Money Market and the Capital Market. The Money
Market is the market for short-term interest-bearing assets.
Examples:
1.TREASURY BILLS
2.COMMERCIAL PAPER
3.CERTIFICATES OF DEPOSITS

 The major task of the Money Market is to facilitate the liquidity

management in the economy. The Capital Market is the market for
trading in medium-long-term assets.
Examples:
1.Treasury bonds
2.Private debt securities (bonds and debentures)
3.Equities (shares)
 Financial Market
 The main purpose of the Capital Market is to facilitate the raising of
long-term funds.

The main issuers in the

1. Money Market are the Government, banks and private companies, while
the main investors are banks, insurance companies and pension and provident
funds.

2. Capital Market are the Government, banks and private companies, while
the main investors are pension and provident funds and insurance companies.
 Financial Instruments
 The main financial instruments can be categorized as under:

Deposits
 Deposits are sums of money placed with a financial institution, for credit
to a customer's account. There are three types of deposits — demand
deposits, savings deposits and fixed or time deposits.
Demand deposits are mainly used for transaction purposes and for the
safekeeping of funds.
 Funds can be withdrawn on demand.
 Demand deposits do not earn interest, but banks provide a number
of services to demand deposit- holders like cheque facilities,
standing orders,
 Automated Teller Machine (ATM) cards and debit cards to facilitate
withdrawals and payments.
 Financial Instruments

Savings deposits earn interest, which may be calculated on a daily, weekly,

monthly or annual basis.
 Funds may be withdrawn from savings accounts at any time.
 However, if the number of withdrawals exceeds four in any month,
interest will not be paid for that particular month.
 Financial institutions issue passbooks or statements detailing
transactions to savings deposit holders and also provide services
such as ATM and debit cards.
 Financial Instruments

Fixed or time deposits are funds placed at financial institutions for a

specified period or term.
 Fixed/time deposits earn a higher rate of interest than savings
deposits.
 Fixed/time deposits can be for short, medium or long term.
 Funds can only be withdrawn before the maturity date with prior
notice and a penalty may be imposed.
 A fixed/time deposit holder has a facility to borrow funds from the
financial institution using the deposit as collateral.
 Financial Instruments

Loans
A loan is a specified sum of money provided by a lender, usually a
financial institution, to a borrower on condition that it is repaid, either in
installments or all at once, on agreed dates and at an agreed rate of
interest. In most cases, financial institutions require some form of security
for loans.
 Financial Instruments

Treasury Bills and Bonds

 Treasury bills are government securities that have a maturity period of
up to one year.
 Treasury bills are issued by the central monetary authority, on behalf of
the Government of Philippines. T
 reasury bills are issued in maturities of 91 days, 182 days and 364 days.
 Treasury bills are zero coupon securities and are sold at a discount to
face value, which is paid at maturity.
 The difference between the purchase price and the face value is the
interest income to the owner.
 Financial Instruments

Treasury Bills and Bonds

 Treasury bills are considered liquid assets as they can be easily sold
in the secondary market and converted to cash.
 Treasury bonds are medium and long-term government securities
and are issued in maturities ranging from 2 years to 20 years.
 Treasury bills and bonds are guaranteed by the Government and are
the safest of all investments, as they are default risk free.
 Treasury bills and bonds are tradable securities which are sold by
auction to Primary Dealers, who in turn market the securities to the
public.
 Financial Instruments

Repurchase Agreements
 Repurchase agreements (Repo) are arrangements involving
transaction between two parties that agree to sell and repurchase
the same security.
 Under repurchase agreement, the seller sells the specified
securities to the buyer with an agreement to repurchase the same
at a mutually decided future date and price.
 Such kind of transaction between parties approved by BSP and in
securities (Treasury Bills, Central/State Govt. securities) as
approved by BSP.
Task 1
1. Find out the differences between the sale
price and the repurchase price from the
financial system of the Philippines.
 Financial Instruments

Commercial Paper
 Commercial Papers (CPs) are short-term, non-collateralized
(unsecured) debt securities issued by private sector companies to
raise funds for their own use, by banks and other financial
intermediaries.
 CPs are generally issued by creditworthy (high-rated) institutions in
large denominations and have additional bank guarantees of payment.
 CPs are usually sold at a discount, although some are interest
bearing.
 Financial Instruments
1. Promissory notes:
 A promissory note is a
written promise to pay a
certain sum of money to a
specified person or entity on
a specific date or on demand,
and is the most common form
of commercial paper.

 Promissory notes are often

used in commercial
transactions as a way for one
party to borrow money from
another party.
 Financial Instruments
2. Drafts:
 A draft is a written order
directing a bank to pay a
specified sum of money to a
designated person or entity.

 There are two types of drafts:

sight drafts, which are payable
when presented to the bank,
and time drafts, which are
payable at a later date.
 Financial Instruments
3. Checks:
 A check is a written order
directing a bank to pay a
specified sum of money to a
designated person or entity.

 Checks can be either personal

checks, which are issued by
individuals, or cashier's
checks, which are issued by
banks.
 Financial Instruments
4. Certificates of deposit (CDs):
 A certificate of deposit is a type
of time deposit offered by banks
and other financial institutions.

 It is a promise to pay the

depositor a fixed sum of money
on a specific date in the future.

 CDs typically have fixed

maturities and fixed interest
rates.
 Financial Instruments
Corporate Bonds and Debentures

Corporate bonds
 are medium or long-term
securities of private sector
companies which obligate the
issuer to pay interest and redeem
the principal at maturity.

 Corporate bonds that are not

backed by a specific asset are
called debentures.
 Financial Instruments
Corporate Bonds and Debentures

Debentures
 are medium or long term, interest-bearing
bonds issued by private sector companies,
banks and other financial institutions that
are backed only by the general credit of
the issuer.
 Debentures are usually issued by large,
well-established institutions.
 The holders of debentures are considered
creditors and are entitled to payment
before shareholders in the event of the
liquidation of the issuing company.
 Financial Instruments
Corporate Bonds and Debentures

1.Convertible Debentures are debentures issued with an option to debenture

holders to convert them into shares after a fixed period.
 A convertible debenture is a type of debenture or commercial loan that
gives the choice to the lender to take stock or shares in the company, as an
alternative to taking the repayment of a loan.
 It is any form of debenture which can be converted into some other kind
of security like shares or Common Stocks.
 Convertible are either partially or fully convertible.
 In case of partially convertible debentures, part of the instrument is
redeemed and part of it is converted into shares and in case of fully
convertible debentures, the full value of the debenture is converted into
equity.
 Financial Instruments
Corporate Bonds and Debentures

1.Convertible Debentures
 Convertible debentures are generally issued to prevent sudden outflow of
the capital at the time of maturity of the instrument, which may cause
liquidity problems.
 The conversion ratio, which is the number of equity shares exchanged per
unit of the convertible debenture is clearly stated when the instrument is
issued.
 Usually, Convertible Debentures offer more safety to the investor
compared to Common Shares or Preference Shares.
 They are suitable for investors who look for potential increases in asset
value (appreciation) compared to that yielded by Bonds, and more earnings
than Common Stocks provide.
 Financial Instruments
Corporate Bonds and Debentures

2.Non-convertible Debentures are debentures issued without conversion option.

 The total amount of the debenture will be redeemed by the issuing company at
the end of the specific period.
a. Asset-backed Securities (Secured Debentures)
 Asset-backed Securities (ABS) are bonds collateralized (secured) by
mortgages, loans, or other receivables.
 Typically, the issuing institution sells mortgages, loans, instalment credit,
credit card or other receivables to a trust or a Special Purpose Vehicle
(SPV) that in turn sells ABSs to the public.
 ABSs are interest- bearing instruments and are often enhanced through
the use of guarantees or insurance.
 Financial Instruments
Corporate Bonds and Debentures

b. Warrants can be described as a derivative security that gives the holder the
right to purchase securities (usually equity) from the issuer at a specific price
within a certain time frame.
 Warrants are frequently attached to bonds or preferred stock as a sweetener,
allowing the issuer to pay lower interest rates or dividends.
 They can be used to enhance the yield of the bond, and make them more
attractive to potential buyers. Warrants can also be used in private equity deals.
 Warrants are often confused with call options. But the main difference between
the two is that warrants are issued and guaranteed by the company, whereas
options are exchange instruments and are not issued by the company.
 Also, the lifetime of a warrant is often measured in years, while the lifetime of a
typical option is measured in months.
 Financial Instruments
Corporate Bonds and Debentures

c. Shares are securities representing a portion of the ownership of a company that

are a claim on the company's earnings and assets.

 Shareholders are paid dividends which are a percentage of the profits of the
company.

 Shares in the company may be similar i.e. they may carry the same rights and
liabilities and confer on their holders the same rights, liabilities and duties.
 Financial Instruments
Corporate Bonds and Debentures

There are two types of shares under Indian Company Law:

1. Equity shares:
 Equity shares are shares which do not enjoy any preferential right in the matter
of payment of dividend or repayment of capital.
 The equity shareholder gets dividend only after the payment of dividends to the
preference shares.
 There is no fixed rate of dividend for equity shareholders. The rate of dividend
depends upon the surplus profits.
 In case of winding up of a company, the equity share capital is refunded only
after refunding the preference share capital. Equity shareholders have the
right to take part in the management of the company. However, equity shares
also carry more risk.
 Financial Instruments
Corporate Bonds and Debentures

There are two types of shares under Indian Company Law:

2.Preference shares: Preference shares are the shares which carry preferential
rights over the Notes equity shares. These rights are:

a.receiving dividends at a fixed rate,

b.getting back the capital in case the company is wound-up. Investment in these
shares are safe, and a preference shareholder also gets dividend regularly.
Preference Shares may be of following types:
 Financial Instruments
Corporate Bonds and Debentures

a. Cumulative or non-cumulative:
 A non-cumulative or simple preference share gives right to fixed percentage
dividend of profit of each year. In case no dividend thereon is declared in any
year because of absence of profit, the holders of preference shares get nothing
nor can they claim unpaid dividend in the subsequent year or years in respect of
that year.

 Cumulative preference shares however give the right to the preference

shareholders to demand the unpaid dividend in any year during the subsequent
year or years when the profits are available for distribution. In this case
dividends which are not paid in any year are accumulated and are paid out when
the profits are available.
 Financial Instruments
Corporate Bonds and Debentures

b. Redeemable and non-redeemable:

 Redeemable Preference shares are preference shares which have to be repaid
by the company after the term for which the preference shares have been
issued.

 Irredeemable Preference shares are those preference shares that need not be
repaid by the company except on winding up of the organization.
 Financial Instruments
Corporate Bonds and Debentures

c. Participating preference share or non-participating preference shares:

 Participating preference shares are entitled to a preferential dividend at a
fixed rate with the right to participate further in the profits either along
with or after payment of certain rate of dividend on equity shares.

 A non- participating share is one which does not have any such right to
participate in the profits of the company after the dividend and the capital
have been paid to the preference shareholder.
 Financial Instruments
Financial Derivatives

 A financial derivative is a financial instrument that is linked to another specific

financial instrument, indicator or commodity and through which specific financial
risks (such as interest rate risk, foreign exchange risk, equity and commodity
price risk) can in their own right, be traded in financial markets.

 The value of a financial derivative comes from the price of an underlying item
such as an asset or index. Financial derivatives can be used for risk management,
hedging (protecting) against financial losses on commercial transactions and
financial instruments and arbitrage between markets and speculation.
 Financial Instruments
Financial Derivatives

 There are two distinct classes of financial derivatives — forwards and related
instruments, and options.

 The most common forward instruments are forward contracts, futures

contracts, Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRS).

 Financial derivatives are traded over-the-counter, in which case they are

customized and can be purchased from financial institutions or are standardized
products which are traded on organized exchanges.
 Financial Instruments
Payment and Settlement Infrastructure

 One of the most important functions of the financial system is to ensure safety
and efficiency in payments and securities transactions.

 Financial infrastructure refers to the different systems that provide for the
execution of both large-value and small- value payments.

 Payment and settlement systems enable the transfer of money in the accounts
of financial institutions to settle financial obligations between individuals and
institutions.
Thanks!
Do you have any questions?
[email protected]
Kiara Gayle Paculan

_kiaragayle

@krgylpcln

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