1. TOPIC 2
OVERVIEW OF
A FINANCIAL SYSTEM

2. Purpose of Financial System
Channeling funds from surplus units to deficit units
Surplus units: person/business without investment opportunities- Lend/Save-Supplier of funds
Deficit units: person/business with investment opportunities but shortage of funds-Borrow/Spend –Demander of funds
Often, surplus units (particularly savers) ≠ people who have profitable investment opportunities
1. The financial system provides channels to transfer funds from individuals and groups who have saved money to individuals and groups who want to borrow money.
2. Savers are suppliers of funds, providing funds to borrowers in return for promises of repayment of even more funds in the future.
3. Borrowers are demanders of funds for consumer durables, houses, or business plant and equipment, promising to repay borrowed funds based on their expectation of having higher incomes in the future.
4. The promises of repayment that borrowers give to savers are liabilities to the borrowers and assets to the savers.
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3. Figure 2.2 Channels of Flow of Funds
The financial system transfers funds from savers to borrowers. Borrowers transfer returns back to savers through the financial system. Savers and borrowers include domestic and foreign households, businesses, and governments.
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4. Channels of Funds Flow
Direct Finance
Borrowers borrow directly from lenders in financial markets by selling financial instruments/securities
Financial markets issue claims on borrowers directly to savers
Securities: Asset to buyers (lenders) but liabilities to issuers (borrowers)
Example: General Motors needs to borrow funds to pay for a new factory to manufacture electric cars, it might borrow the funds from savers by selling them a bond or a stock
Why is this channeling of funds from savers to spenders so important to the economy?
-The people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs
-Example: You have saved $1,000 this year, but no borrowing or lending. What is the effect?
(Figure 3.1)
The financial system transfers funds from savers to borrowers. Borrowers transfer returns back to savers through the financial system. Savers and borrowers include domestic and foreign households, businesses, and governments.
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5. Channels of Funds Flow
Indirect Finance
Financial intermediaries act as middle-man by holding a portfolio of assets and issuing claims to savers
Borrowers borrow indirectly from lenders via financial intermediaries (FI)
FI established to source both loanable funds and loan opportunities
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6. Importance of Financial System
FMs critical for enabling efficient allocation of capital
Funds transferred from savers to entrepreneurs
Nonproductive (idle) to productive purposes
Contributes to higher production and efficiency for overall economy
FMs improve economic well-being
Savers-saving returns; borrowers-use opportunities (spend)
Both can share profit
Without FM, status quo or even worse off
Improve well being of consumers by allowing better timing of purchases

7. 2. STRUCTURE OF FINANCIAL MARKETS
How to categorize financial markets? In terms of
How to obtain funds: Debt and equity
Type of markets: Primary and secondary
Types of maturities: Short-term and long-term

8. 2. CLASSIFICATION OF FINANCIAL MARKETS
How funds are obtained in the financial markets? Debt versus equity markets
Issue 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, when the final payment is made
Buyers of debt instruments are suppliers (of capital) to the firm, not owners of the firm
Debt instruments have a finite life or maturity date
Advantage: debt instrument is a contractual promise to pay with legal rights to enforce repayment
Disadvantage: return/profit is fixed or limited

9. 2. CLASSIFICATION OF FINANCIAL MARKETS
How funds are obtain in the financial markets? Debt versus equity markets
Issue equity - Claims to share in net income and assets of a business
Periodic payments in the form of dividends to holders and have no maturity date
Investors are owners of the firm
Own a portion of the firm
Have voting rights on important issues to the firm and elect its directors
Common stock has no finite life or maturity date
Advantage: potential high income since return is not fixed or limited
Disadvantage: debt payments must be made before equity payments can be made

10. CLASSIFICATIONS OF FINANCIAL MARKETS
Primary Market
A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.
Investment bank assists in the sale of securities in the primary market. Involves underwriting: guarantees a price for a corporation’s securities and sells them to the public
Secondary Market
A secondary market is a financial market in which securities that have been previously issued can be resold, or Securities previously issued are bought and sold (resell)
Examples: KLSE, NYSE, NIKKEI and bond markets
2 important functions: Make it easier to sell the financial instruments (liquidity) & Determine the price of the security that the issuing firm sells in the primary market

11. CLASSIFICATIONS OF FINANCIAL MARKETS
2 TYPES of secondary market:
1. Organized Exchanges
Trades conducted in central locations: Buyers & sellers meet in one central location (e.g., New York Stock Exchange, KLSE)
2. Over-the-Counter (OTC) Markets
Dealers/ remisiers at different locations buy and sell
Have an inventory of securities to sell OTC to anyone who comes to them and is willing to accept their prices
Very competitive

12. CLASSIFICATIONS OF FINANCIAL MARKETS
Basis of maturity: Number of years until the instrument’s expiration date
1. Money market
Financial market in which only short-term debt instruments are traded
Short-term (maturity < 1 year)
2. Capital market
Financial market in which long-term debt and equity instruments are traded
Intermediate-term (maturity between 1 to 10 years) and long-term (maturity > 10 years)

13. Money market & Capital market
Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. The short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily.
Capital market securities, such as stocks and long-term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.
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14. 3. FUNCTIONS OF FINANCIAL INTERMEDIARIES
Facts about Financial Intermediaries (FIs)
Engage in process of indirect finance: match savers and borrowers
More important source of finance than financial markets
Perform specific tasks: risk-sharing, liquidity, and information services
Needed because of transactions costs and asymmetric information

15. Function of Financial Intermediaries
1. Transactions Costs
FIs make profits by reducing transactions costs by:
-Developing expertise
-Taking advantage of economies of scale
FI’s low transaction costs mean that it can provide its customers with liquidity services:
-Services that make it easier for customers to conduct transactions
-Banks provide depositors with checking accounts that enable them to pay their bills easily
-Depositors can earn interest on checking and savings accounts and yet still convert them into cash whenever necessary

16. Function of Financial Intermediaries
Risk Sharing
FIs help reduce 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
Example: lend out to your friend OR save it and bank lend it out

17. Function of Financial Intermediaries
3. Asymmetric Information
Adverse Selection
Before transaction occurs
Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected
Moral Hazard
After transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that the loan will not be paid back
Financial intermediaries reduce adverse selection and moral hazard problems by building expertise to screen and monitor borrowers

18. 4. TYPES OF FINANCIAL INTERMEDIARIES

19. Size of Financial Intermediaries

20. Goals of Financial Regulation
Provision of information: to increase information to investors
Maintenance of financial stability: to ensure soundness of financial intermediaries
Controlling the money supply: to improve monetary control
Encouraging particular activities (like home ownership)
Regulation affects ability of financial markets and institutions to provide risk-sharing, liquidity, and information services
1. Governments around the world regulate financial markets and institutions in order to promote the provision of information, the maintenance of financial stability, and other policy objectives.
2. The federal government in the United States has intervened in financial markets to require issuers of financial instruments to disclose information about their financial condition.
3. Most regulation of the financial system is aimed at ensuring financial stability in the sense of maintaining the ability of the financial system to provide risk-sharing, liquidity, and information services in the face of economic disturbance.
4. Other policy objectives advanced by financial regulation include controlling the money supply and encouraging particular activities.
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21. Regulation of the Financial System
1. To Increase Information Available to Investors
AI in FMs means that investors may be subject to adverse selection and moral hazard problems: may hinder efficient operation of FMs and keep investors away from FMs
Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation
Such government regulation can reduce adverse selection and moral hazard problems in FMs and increase their efficiency by increasing the amount of information available to investors

22. Regulation of Financial System
2. To Ensure Soundness of Financial Intermediaries
Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not, if they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions, with the possible outcome of a financial panic that produces large losses for the public and causes serious damage to the economy
To protect the public and the economy from financial panics, the government has implemented six types of regulations:
Restrictions on Entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates

23. Ensuring Soundness of Financial Intermediaries
1. Restrictions on Entry
Regulators have created very tight regulations as to who is allowed to set up a financial intermediary, licencing
Individuals or groups that want to establish an FI, such as a bank or an insurance company, must obtain a charter from the state or the federal government
Only if they are upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter

24. Ensuring Soundness of Financial Intermediaries
2. Disclosure Requirements: There are stringent reporting requirements for financial intermediaries
Their bookkeeping must follow certain strict principles
Their books are subject to periodic inspection
They must make certain information available to the public
Frequent reporting to reduce asymmetric information

25. Ensuring Soundness of Financial Intermediaries
3. Restrictions on Assets and Activities:
on what FIs are allowed to do and what assets they can hold
Customers want to ensure that their funds are safe and the bank will be able to meet its obligations to the customers
One way of doing this is to restrict the FIs from engaging in certain risky activities
Another way is to restrict FI from holding certain risky assets, or at least from holding a greater quantity of these risky assets

26. Ensuring Soundness of Financial Intermediaries
4. Deposit Insurance: government can insure people providing funds to a FI from any financial loss if the financial intermediary should fail
The Federal Deposit Insurance Corporation (FDIC), insures each depositor at a commercial bank or mutual savings bank up to a loss of $100,000 per account
Similar concepts sometimes being applied in other FIs and in other countries
Maintain investor confidence

27. Ensuring Soundness of Financial Intermediaries
5. Limits on Competition: Although the evidence that unbridled competition among Fis promotes failures that will harm the public is extremely weak, it has not stopped the state and federal governments from imposing many restrictive regulations
In the past, banks were not allowed to open up branches in other states, and in some states banks were restricted from opening additional locations
6. Restrictions on Interest Rates: Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits
These regulations were instituted because of the widespread belief that unrestricted interest-rate competition helped encourage bank failures during the Great Depression
Later evidence does not seem to support this view, and restrictions on interest rates have been abolished

28. Regulation of Financial System
3. To Improve Monetary Control
Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy), much regulation of these financial intermediaries is intended to improve control over the money supply
One such regulation is reserve requirements, which make it obligatory for all depository institutions to keep a certain fraction of their deposits in accounts with the central
Reserve requirements help the central banks to exercise more precise control over the money supply

29. Table 3.1 Regulation of Financial Institutions and Markets in the United States
Regulation affects the ability of financial markets to provide risk-sharing, liquidity, and information services.
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