Chapter one

An Overview Of The Financial System

The financial system is complex, comprising many different types of private-sector financial
institutions, including banks, insurance companies, mutual funds, finance companies, and
investment banks all of which are heavily regulated by the government. If you wanted to make a
loan to IBM or General Motors, for example, you would not go directly to the president of the
company and offer a loan. Instead, you would lend to such companies indirectly through
financial intermediaries, institutions such as commercial banks, savings and loan associations,
mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and
finance companies that borrow funds from people who have saved and in turn make loans to
others.
A financial system can be defined at the global, regional or firm specific level. The firm's
financial system is the set of implemented procedures that track the financial activities of the
company. On a regional scale, the financial system is the system that enables lenders and
borrowers to exchange funds. The global financial system is basically a broader regional system
that encompasses all financial institutions, borrowers and lenders within the global economy. A
financial system also implies that a set of complex and closely connected or interlined
institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The
financial system is concerned about money, credit and finance-the three terms are intimately
related yet are somewhat different from each other.

1.1 The Role of financial system in the economy

The financial system performs the essential economic function of channeling funds from those
who are net savers (i.e. who spend less than their income) to those who are net spenders (i.e. who
wish to spend or invest more than their income).This section discusses the main functions of
financial intermediaries and financial markets, and their comparative roles. Financial systems,
i.e. financial intermediaries and financial markets, channel funds from those who have savings to
those who have more productive uses for them. They perform two main types of financial service
that reduce the costs of moving funds between borrowers and lenders, leading to a more efficient
allocation of resources and faster economic growth. These are the provision of liquidity and the
transformation of the risk characteristics of assets.
  Provision of liquidity

The link between liquidity and economic performance arises because many high return
investment projects require long-term commitments of capital, but risk adverse lenders (savers)
are generally unwilling to delegate control over their savings to borrowers (investors) for long
periods. Financial systems mobilize savings by agglomerating and pooling funds from disparate
sources and creating small denomination instruments. These instruments provide opportunities
for individuals to hold diversified portfolios. Without pooling individuals and households would
have to buy and sell entire firms.

Financial markets can also transform illiquid assets (long-term capital investments in illiquid
production processes) into liquid liabilities (financial instrument). With liquid financial markets
savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted
into purchasing power, if they need to access their savings. For lenders, the services performed
by financial markets and intermediaries are substitutable around the desired risk, return and
liquidity provided by particular investments. Financial intermediaries and markets make longer-
term investments more attractive and facilitate investment in higher return, longer gestation
investment and technologies. They provide different forms of finance to borrowers. Financial
markets provide arm’s length debt or equity finance (to those firms able to access markets), often
at a lower cost than finance from financial intermediaries.

 Transformation of the risk characteristics of assets

Financial systems facilitate risk-sharing by reducing information and transactions costs. If there
are costs associated with the channeling of funds between borrowers and lenders, financial
systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform
this role by taking advantage of economies of scale; markets do so by facilitating the broad offer
and trade of assets comprising investors’ portfolios.

Financial systems can reduce information and transaction costs that arise from an information
asymmetry between borrowers and lenders. In credit markets an information asymmetry arises
because borrowers generally know more about their investment projects than lenders. A
borrower may have an entrepreneurial “gut feeling” that cannot be communicated to lenders, or
more simply, may have information about a looming financial risk to their firm that they may not
wish to share with past or potential lenders. The second main service financial intermediaries and
markets provide is the transformation of the risk characteristics of assets. Financial systems
perform this function in at least two ways. First, they can enhance risk diversification and
second, they resolve an information asymmetry problem that may otherwise prevent the
exchange of goods and services, in this case the provision of capital.An information asymmetry
can occur ex ante or ex post. An ex ante information asymmetry arises when lenders can not
differentiate between borrowers with different credit risks before providing a loan and leads to an
adverse selection problem. Adverse selection problems arise when lenders are more likely to
make a loan to high-risk borrowers, because those who are willing to pay high interest rates will,
on average, be worse risks. The information asymmetry problem occurs ex post when only
borrowers, but not lenders, can observe actual returns after project completion. This leads to a
moral hazard problem. Moral hazard problems arise when borrowers engage in activities that
reduce the likelihood of their loan being repaid. They also arise when borrowers take excessive
risk because the costs may fall more on lenders compared to the benefits, which can be captured
by borrowers.

1.1 Financial Assets: Role and Properties

Financial Assets

Financial assets, also referred to as financial instruments or securities, are intangible assets. They
are often used to finance the ownership of tangible assets as equipments and real estate. In
general, financial assets serve two main economic functions: the first is to transfer funds from
those who have surplus funds to invest to those who need a source of financing tangible assets.
The second is to redistribute the risk associated to the investment in tangible assets between
different counterparties according to their preferences and risk aversion.

Financial assets represent legal claims to future cash expected often at a defined maturity. The
counterparties involved in the agreement are the institution or entity that will pay the future cash
(issuer) and the investors. Some examples of financial assets are: stocks, bonds, bank
deposits, loans. All these instruments can be classified in different categories according to the
features of the cash flow associated with them. They can be classified as debt instruments or
equity instruments. Debt instruments as bonds or loans require a fixed amount payment; equity
instruments have an uncertain cash flow, based on the issuer’s earnings. Equity instruments are
also referred to as residual claims because the issuer can satisfy these claims only after holders
of debt instruments have been paid. There are also fixed income instruments that can be paid
only after claims on debt instruments have been satisfied. This is the case of preferred stocks and
convertible bonds. In general, all financial assets present some typical properties.

An asset is any possession that has value in an exchange ( any resource that is expected to provide
future benefits and, hence, has economic value ). Assets can be classified as tangible or in tangible.
The value of a tangible asset depends on particular physical properties- examples include
buildings, land, or machinery. Tangible assets may be classified in to reproducible assets such as
machinery, or non reproducible assets land, a mine or a work of art. Are recorded

Intangible assets, by contrast, represent legal claims to some future benefit. There value bears
no relation to the form, physical or otherwise, in which the claims are recorded. Financial
assets, financial instruments, or securities are intangible assets.
Some financial assets fall in to both categories, preferred stock, represents for example an equity
claim that entities the investor to receive a fixed amount. This payment is, however, due only
after payments to debt instrument holders are made. Another instrument is convertible bond,
which allows the investor to convert a debit in to equity under certain circumstances. Both debt
and preferred that pays a fixed dollar amount are called fixed income instruments.

Properties of financial assets

Financial assets posses certain properties that determine or influence their attractiveness to
different classes of investors. The 10 properties of financial assets are
Moneyness: some financial assets can be used as a medium of exchange or can be
converted into money at little cost or risk. This attractive property for investors is
called moneyless. They act as a medium of exchange or in settlement of transactions.
These assets are called money. In the United States they consist of currency and all
forms of deposits that permit the check writing. Other financial assets, even though
not money, closely approximate money in that they can be transformed in to money
at little cost, delay, or risk. They are referred as near money. In the United States near
money instruments include time and saving deposits and securities issued by U.S.A
government with a maturity of three months called a three month treasury bills.
monyness offers clearly desirable property for investors
Divisibility and denomination: refers to the minimum amount or size in which
assets can be traded i.e. the minimum size at which the financial asset can be
liquidated and exchanged for money. For instance, US bonds are generally sold in
$1,000 denominations, commercial paper in $25,000 units and deposits are infinitely
divisible. The smaller the size, the more the financial asset is divisible. In other ward,
financial asset a deposit at a bank is typically infinitely divisible(down to the penny),
but other financial assets set varying degrees of divisibility depending on their
denomination which is the dollar value of the amount that each unit of the asset will
pay at maturity.
Reversibility: refers to the cost of investing in financial asset and then getting out of
it and back in to cash again. As result, reversibility is also referred to as turnaround
cost or round-trip cost. It indicates the cost of buying an asset and then re-selling it.
A financial asset a deposit at a bank is highly reversible because usually the investor
incurs no charge for adding to or withdrawing from it. for financial assets traded in
organize markets or with “market makers” (discussed in ch-7), the most relevant cost
of round trip cost is the so called bid-ask spread, to which might be added
commissions and the time and the cost, if any of delivering the asset. The bid ask
spread consists of the difference between the price at which a market maker is
willing to sell a financial asset (i.e., the price it is asking) and at which a market
maker is willing to buy the financial asset (i.e., the price it is bidding). For example,
if a market maker is willing to sell some financial asset for $70.50 (the ask price) and
buy it for $$70.00 (the bid price), the bid ask spread is $0.50. The bid ask spread is
referred to as offer spread.
Term to maturity: is the length of interval until the date when the instrument is
scheduled to make its final payment or the owner is entitled to demand liquidation. It
is the length of the period until the final repayment date or the date at which the
owner can demand the asset liquidation. In different cases the financial assets may
terminate before the stated maturity (in presence of call provisions, bankruptcy of the
issuer...) or can be also increased or extended on demand of both counterparties.
Convertibility relates to the possibility to convert the financial assets into another
type of asset. This is the case of convertible bonds and preferred stocks.
Instruments for which the creditor can ask for repayment at any time, such as
checking accounts and many saving accounts, are called demand instruments.
Maturity is an important characteristic of financial assets such as debt instruments
and in the United States can range one day to 100 years.
Liquidity: serve as an important and widely used function; even though no
uniformly accepted definition of liquidity is presently available. A useful way to
think of liquidity and illiquidity is in terms of how much sellers to lose if they wish to
sell immediately against engaging in costly and time consuming search. An example
of the most illiquid financial asset is the stock of the small corporation or a bond
issued by small school district for which the market is extremely thin, and one must
search out of the few suitable buyers. For many other financial assets, liquidity is
determined by contractual arrangements. Ordinary deposits at a bank, for example
are perfectly liquid because the bank operates under contractual obligation to convert
them at par on demand.
Convertibility: an important property of some financial asset is their convertibility in
to other financial assets. In some cases, conversion takes place with one class of
financial assets, as when a bond converted in to another bond. For example, with
corporate convertible bond the bond holder can change in to equity shares. Some
preferred stock may be convertible in to common stock.
Currency: most financial assets are denominated in one currency such as US dollars
or Yen or Euros, and investors may choose them in that feature in mind.
Cash flow and return predictability: the return that an investor will realize by
holding financial asset depends on the cash expected to be received, which includes
dividend payments on stock and interest payments on debt instruments, as well as the
repayment of principal for a debt instrument and the expected sale price of stock.
Complexity: some financial assets are complex in the sense that they combine two or
more complex assets.
Tax status: an important feature of any financial asset is its tax status. Governmental
codes for taxing the income from ownership or sale of financial assets vary widely.
Tax rates differ from year to year, country to country, or from financial to financial
 asset, depending on the type of the issuer, the length of time the asset is held, the
nature of the owner and so on.

1.3 Financial markets: role, classfications and participants

 Role of financial markets

A financial market is a market in which financial assets (securities) such as stocks and bonds can
be purchased or sold. Funds are transferred in financial markets when one party purchases
financial assets previously held by another party. Financial markets facilitate the flow of funds
and thereby allow financing and investing by households, firms, and government agencies.
Financial markets transfer funds from those who have excess funds to those who need funds.
They enable college students to obtain student loans, families to obtain mortgages, businesses to
finance their growth, and governments to finance many of their expenditures. Many households
and businesses with excess funds are willing to supply funds to financial markets because they
earn a return on their investment. If funds were not supplied, the financial markets would not be
able to transfer funds to those who need them.
Those participants who receive more money than they spend are referred to as surplus units (or
investors). They provide their net savings to the financial markets. Those participants who spend
more money than they receive are referred to as deficit units. They access funds from financial
markets so that they can spend more money than they receive. Many individuals provide funds to
financial markets in some periods and access funds in other periods.
Many deficit units such as firms and government agencies access funds from financial markets
by issuing securities, which represent a claim on the issuer. Debt securities represent debt (also
called credit, or borrowed funds) incurred by the issuer. Deficit units that issue the debt securities
are borrowers. The surplus units that purchase debt securities are creditors, and they receive
interest on a periodic basis (such as every six months). Debt securities have a maturity date, at
which time the surplus units can redeem the securities in order to receive the principal (face
value) from the deficit units that issued them. Equity securities (also called stocks) represent
equity or ownership in the firm. Some businesses prefer to issue equity securities rather than debt
securities when they need funds but might not be financially capable of making the periodic
interest payments required for debt securities.
Basic Functions of Financial Market:

Financial market has emerged as one of the biggest markets in the world. It is engaged in a wide
range of activities that cater to a large group of people with diverse needs.
Six key functions of Financial Market are -

1. Borrowing & Lending: Financial market transfers fund from one economic agent
(saver/lender) to another (borrower) for the purpose of either consumption or investment.
2. Determination of Prices: Prices of the new assets as well as the existing stocks of
financial assets are set in financial markets.
 3. Assimilation and Co-ordination of Information: It gathers and co-ordinates information
regarding the value of financial assets and flow of funds in the economy.
4. Liquidity: The asset holders can sell or liquidate their assets in financial market.
5. Risk Sharing: It distributes the risk associated in any transaction among several
participants in an enterprise.
6. Efficiency: It reduces the cost of transaction and acquiring information.

 Classifications of financial markets

Primary markets facilitate the issuance of new securities. Secondary markets facilitate the trading
of existing securities, which allows for a change in the ownership of the securities. Primary
market transactions provide funds to the initial issuer of securities; secondary market transactions
do not. An important characteristic of securities that are traded in secondary markets is liquidity,
which is the degree to which securities can easily be liquidated (sold) without a loss of value.
Some securities have an active secondary market, meaning that there are many willing buyers
and sellers of the security at a given moment in time. Investors prefer liquid securities so that
they can easily sell the securities whenever they want (without a loss in value). If a security is
illiquid, investors may not be able to find a willing buyer for it in the secondary market and may
have to sell the security at a large discount just to attract a buyer.
Securities traded in the financial market
Securities can be classified as money market securities, capital market securities, or derivative
securities.
Money Market Securities
Money markets facilitate the sale of short-term debt securities by deficit units to surplus units.
The securities traded in this market are referred to as money market securities, which are debt
securities that have a maturity of one year or less. These generally have a relatively high degree
of liquidity, not only because of their short-term maturity but also because they commonly have
an active secondary market. Money market securities tend to have a low expected return but also
a low degree of risk. Common types of money market securities include Treasury bills (issued by
the U.S. Treasury), commercial paper (issued by corporations), and negotiable certificates of
deposit (issued by depository institutions).
Capital Market Securities
Capital markets facilitate the sale of long-term securities by deficit units to surplus units.
The securities traded in this market are referred to as capital market securities. Capital market
securities are commonly issued to finance the purchase of capital assets, such as buildings,
equipment, or machinery. Three common types of capital market securities are bonds,
mortgages, and stocks, which will be described in ch-4.
Derivative Securities
In addition to money market and capital market securities, derivative securities are also traded in
financial markets. Derivative securities are financial contracts whose values are derived from the
values of underlying assets (such as debt securities or equity securities). Many derivative
securities enable investors to engage in speculation and risk management.
Foreign Exchange Market
International financial transactions normally require the exchange of currencies. The foreign
exchange market facilitates this exchange. Many commercial banks and other financial
institutions serve as intermediaries in the foreign exchange market by matching up participants
who want to exchange one currency for another. Some of these financial institutions also serve as
dealers by taking positions in currencies to accommodate foreign exchange requests. Like
securities, most currencies have a market-determined price (exchange rate) that changes in
response to supply and demand. If there is a sudden shift in the aggregate demand by
corporations, government agencies, and individuals for a given currency, or a shift in the
aggregate supply of that currency for sale (to be exchanged for another currency), the price of the
currency (exchange rate) will change.
 financial market participants
BANKS: Largest provider of funds to business houses and corporate through
accepting deposits.
INSURANCE COMPANIES: Issue contracts to individuals or firms with a promise to
refund them in future in case of any event and thereby invest these funds in debt,
equities, properties, etc.
FINANCE COMPANIES: Engages in short to medium term financing for businesses
by collecting funds by issuing debentures and borrowing from general public.
MERCHANT BANKS: Funded by short term borrowings; lend mainly to
corporations for foreign currency and commercial bills financing.
COMPANIES: The surplus funds generated from business operations are majorly
invested in money market instruments, commercial bills and stocks of other
companies.
MUTUAL FUNDS: Acquire funds mainly from the general public and invest them in
money market, commercial bills and shares.
GOVERNMENT: Authorized dealers basically look after the demand-supply
operations in financial market. Also works to fill in the gap between the demand
and supply of funds.

Who are the Major Players in Financial Markets?

By definition, financial institutions are institutions that participate in financial markets, i.e., in
the creation and/or exchange of financial assets. At present in the United States, financial
institutions can be roughly classified into the following four categories: "brokers;" "dealers;"
"investment bankers;" and "financial intermediaries."

Brokers:

A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller
(or buyer) to complete the desired transaction. A broker does not take a position in the assets he
or she trades -- that is, the broker does not maintain inventories in these assets. The profits of
brokers are determined by the commissions they charge to the users of their services (either the
buyers, or sellers, or both). Examples of brokers include real estate brokers and stock brokers.

Diagrammatic Illustration of a Stock Broker:

Payment ----------------- Payment
------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares

Dealers:

Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions"
(i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of
inventory rather than always having to locate sellers to match every offer to buy. Also, unlike
brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets
at relatively low prices and reselling them at relatively high prices (buy low - sell high). The
price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer
offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's
profit margin on the asset exchange. Real-world examples of dealers include car dealers, dealers
in U.S. government bonds, and NASDAQ stock dealers.

Diagrammatic Illustration of a Bond Dealer:

Payment ----------------- Payment
------------>| |------------->
Bond | Dealer | Bond
Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------
Investment Banks:

An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial
Public Offerings) by engaging in a number of different activities:

 Advice: Advising corporations on whether they should issue bonds or stock, and, for bond
issues, on the particular types of payment schedules these securities should offer;
 Underwriting: Guaranteeing corporations a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
 Sales Assistance: Assisting in the sale of these securities to the public.
Some of the best-known U.S. investments banking firms are Morgan Stanley, Merrill Lynch,
Salomon Brothers, First Boston Corporation, and Goldman Sachs.

Financial Intermediaries:

Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions
that engage in financial asset transformation. That is, financial intermediaries purchase one kind
of financial asset from borrowers -- generally some kind of long-term loan contract whose terms
are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different
kind of financial asset to savers, generally some kind of relatively liquid claim against the
financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial
intermediaries typically hold financial assets as part of an investment portfolio rather than as an
inventory for resale. In addition to making profits on their investment portfolios, financial
intermediaries make profits by charging relatively high interest rates to borrowers and paying
relatively low interest rates to savers.

Types of financial intermediaries include: Depository Institutions (commercial banks, savings

and loan associations, mutual savings banks, credit unions); Contractual Savings Institutions
(life insurance companies, fire and casualty insurance companies, pension funds, government
retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual
funds, money market mutual funds).

Diagrammatic Example of a Financial Intermediary: A Commercial Bank

Lending by B Borrowing by B

deposited
------- Funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- Loan ------- deposit -------
Contracts accounts

Loan contracts Deposit accounts

issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households

1.4 Lending and borrowing in the financialsystem

The main task of the financial system: to channel financing from savers to investors. The
financial system performs the essential economic function of channeling funds from those who
are net savers (i.e. who spend less than their income) to those who are net spenders (i.e. who
wish to spend or invest more than their income). In other words, the financial system allows net
savers to lend funds to net spenders. The most important lenders are normally households, but
firms, the government and non-residents may also lend out excess funds. The principal
borrowers are typically non-financial corporations and government, but households and non-
residents also sometimes borrow to finance their purchases.

Funds flow from lenders to borrowers via two routes. In direct or market-based finance, debtors
borrow funds directly from investors operating on the financial markets by selling them financial
instruments, also called securities (such as debt securities and shares), which are claims on the
borrower’s future income or assets. If financial intermediaries play an additional role in the
channeling of funds, one refers to indirect finance. Financial intermediaries can be classified into
credit institutions, other monetary financial institutions and other financial intermediaries, and
they are part of the financial system. One of the key features of a well-functioning financial
system is that it fosters an allocation of capital that is most beneficial to economic growth. Well-
functioning financial systems do not easily drift into financial crises and can perform their basic
tasks even under difficult financial conditions. The infrastructure of the financial system refers to
payment and settlement systems through which financial market operations are concretely
carried out. A smooth and reliable functioning of payment and settlement systems promotes
effective capital movements in the economy and thereby supports financial stability.

Direct vs. indirect lending

The financial system offers two different ways to lend: (1) direct lending through financial
markets, and (2) indirect lending through financial intermediaries, such as banks, finance
companies, and mutual funds.

Direct Lending

Direct lending involves the transfer of funds from the ultimate lender to the ultimate borrower,
most often through a third party. An example is a private party purchasing the securities issued
by a firm. The securities are usually sold to the public through an underwriter, someone who
purchases them from the issuer with the intention of reselling them at a profit. The underwriter
negotiates the terms of the contract with the borrower and appoints a trustee, typically a
commercial bank, to monitor compliance. Because of the costs involved, the issue of securities
makes sense for the borrower only when the amount to be raised is substantial.

If the security is a bond issue, the borrower is obligated to return the principal at maturity and to
pay interest during the period of the loan. If the securities are equities, the borrower has no
obligation to return the principal, but is expected to pay dividends. What if the lender needs his
money back immediately? The only solution is to sell the security in the secondary market.
However a secondary market will exist only if someone has created it.
Indirect Lending

Indirect lending is lending by the ultimate lender to a financial intermediary who pools the funds
of many lenders in order to re-lend at a markup over the cost of the funds. The ultimate
borrowers are normally unknown to the ultimate lenders. A lender faces less risk in indirect
lending because, as a specialist in the field, the intermediary normally has a well-established
credit standing. Of course, lower risk usually means less gain for the lender.

Indirect lending generally offers lower cost to the ultimate borrower for small or short-term
loans. Most borrowers lack sufficient credit standing to borrow directly. Borrowers who do
have that option may find it cheaper, especially for large sums. In fact it may not even be
possible to borrow large sums indirectly through intermediaries. The capacity of the direct
financial markets is much larger than that of even the largest intermediaries.

Comparison of Risks

The two types of lenders face different problems with borrowers in financial difficulty. With
direct lending, rescheduling a loan is problematic because the relationship is generally at arm’s
length and legalistic. The risks are often unknown to the lender. With indirect lending, the
intermediary is usually in a much better position to know whether the problem is permanent or
temporary. As the sole lender, the intermediary can alter the terms without having to obtain the
agreement of others.