Lending and Borrowing in the Financial System

The financing system is necessary to mobilize surplus funds from people and organizations, and
to allocate them among deficit people and organizations. An investor (who invests in securities)
is an example of a surplus unit, whereas a borrower is an example of a deficit unit. Mobilizing
funds generates returns for surplus units, which generally enhances their wealth and economic
well-being. It also allows deficit units to enhance their productive and purchasing capacities, and
thus improves an economy's production and consumption potential.
Funds are mobilized either as debt or equity. Debt funds are supplied as a loan and generally the
repayments are scheduled, whereas equity funds acquire part ownership of a business and their
returns depend on the future profitability of the business. The financing process allows
prospective users of funds to compete for them and creates the incentive for funds to be supplied.
In essence, the financial system should ensure the supply of funds when their use has a net
present value. That is, the user of the funds expects to earn a return that exceeds the returns paid
to the supplier of the funds.
There are at least two fundamental problems that must be solved by the financing system. First,
deficit units seek funds for terms that, on average, are longer than the periods for which funds are
supplied by surplus units, posing the problem of a maturity mismatch between the supply and
demand for funds. This means that financing processes have to be able to transform the maturity
of funds - a process referred to as maturity transformation. Second, financing processes have to
develop means for coping with the risks faced by the suppliers of funds.
Helping funds to flow from lenders to borrowers is a characteristic of most components of the
financial system. However, there are a number of functions, each of which tends to be associated
with a particular part of the system. For example, the financial system usually provides a means
of making payments. In most cases this is the responsibility of deposit taking institutions (or a
subset of them). Such institutions are usually members of a network (a clearing system) and
accept instructions from their clients to make transfers of deposits to the accounts of clients.
Traditionally, this was done by issuing a paper instruction (a check) but today it is done
increasingly by electronic means.
We assume that most people are risk-averse. That is, most people are prepared to make a
payment (or sacrifice some income) in order to avoid uncertainty, especially if the uncertainty
mean possibility of a serious loss. Amongst the non-deposit taking institutions this service is
carried out by insurance companies. They allow people to choose the certainty of a slightly
reduced current income (reduced by the premiums they pay) in exchange for avoiding a
catastrophic loss of income (or wealth) if some accident should occur.
Pension funds, unit trusts and investment trusts all offer savers the opportunity to accumulate a
diversified portfolio of financial assets, though each does it in a slightly different way. Pension
funds in particular help people to accumulate wealth over a long period and then to exchange this
for income to cover the (uncertain) period between retirement and death.
Lastly, it should always be remembered that while savers may be building up a portfolio of
wealth by acquiring financial assets, they want to be able to rearrange that portfolio from time to
time as they observe changes in the risk/return characteristics of the assets which they hold. If we
use the phrase net acquisition to describe the additional assets that a household is able to add to
its portfolio each year, we must remember that total purchase of assets may be much larger
because there may also have been sales of some assets already in the portfolio as part of the
portfolio adjustment process.
Financial markets provide the following three major economic functions:

1) Price discovery: price discovery function means that transactions between buyers and sellers
of financial instruments in a financial market determine the price of the traded asset. At the
same time the required return from the investment of funds is determined by the
participants in a financial market. The motivation for those seeking funds (deficit units)
depends on the required return that investors demand. It is these functions of financial
markets that signal how the funds available from those who want to lend or invest funds will be
allocated among those needing funds and raise those funds by issuing financial
instruments.

2) Liquidity: Liquidity function provides an opportunity for investors to sell a financial

instrument, since it is referred to as a measure of the ability to sell an asset at its fair market
value at any time. Without liquidity, an investor would be forced to hold a financial
instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off.
Debt instrument is liquidated when it matures, and equity instrument is until the company
is either voluntarily or involuntarily liquidated. All financial markets provide some form of
liquidity. However, different financial markets are characterized by the degree of liquidity.

3) Reduction of transaction costs: The function of reduction of transaction costs is performed,

when financial market participants are charged and/or bear the costs of trading a financial
instrument. In market economies the economic rationale for the existence of institutions
and instruments is related to transaction costs, thus the surviving institutions and instruments
are those that have the lowest transaction costs.

Classification of financial markets

1, based on financial claim
Debt vs. equity markets
Debt(ex: bond or mortgage) - a borrower pays a fixed amount of money at regular intervals until
a Specified (maturity) date
- It is Predictability and independence from shareholders influence

- Low risk than equity instrument

Equities claims to net income (after taxes and expenses) and the assets of a business -
sometimes these pay dividends
the financial market where such instruments are traded is referred to as the equity market
- An equity holder is residual claimant (they only get paid after debt is repaid)
- Payments to debt holders are fixed, those to stockholders are not these rise with profitability
and increases in asset value.
-High risk than debt because estimated future cash flow is uncertain.
2, based on the maturity of financial assets
Money market vs. capital market
Money Market - The money market is the market that involves the short-term lending and
borrowing of funds among a range of participants. The typical instruments traded in a money
market have a short maturity and include treasury bills, central bank bills, certificates of deposit,
bankers acceptances, and commercial paper.
They also include borrowing through repurchase agreements and similar arrangements. It is the
market that can provide short-term liquidity to governments and financial and nonfinancial
corporations.
An active money market allows entities to manage their liquidity in an efficient manner, by
facilitating
investment of excess holdings of cash in interest bearing assets, which can be drawn upon when
needed, and by providing a source of funds for those short of liquidity, or who wish to finance
short-term positions in other markets.
Capital Market - trades only in longer maturity debt (longer than 1 year)
- These securities often held by financial intermediaries (ex: insurance companies and pensions
funds)
- Their prices fluctuate more than do money market instruments
- They are less liquid than money market instruments
- Least volatile prices due to their short maturities
3. Classification by origin
Primary vs. secondary market

On this basis, financial markets are classified into primary market and secondary market.
Primary market: Primary markets are those markets which deal in the new securities.
Therefore, they are also known as new issue markets. These are markets where securities are
issued for the first time. In other words, these are the markets for the securities issued directly by
the companies. The primary markets mobilize savings and supply fresh or additional
capital to business units. In short, primary market is a market for raising fresh capital in the
form of shares and debentures.
Secondary market: Secondary markets are those markets which deal in existing securities.
Existing securities are those securities that have already been issued and are already outstanding.
Secondary market consists of stock exchanges

4. Based on organizational structure

Organized versus over the counter
Secondary market can be organized in to two ways.
Organize exchange: in this market buyers and sellers (their agents) meet in one central location
to conduct trade.
In this market buyers and sellers doesnt have central location to exchange. They are in computer
contact.
5. Classification on the basis of timing of delivery:
On this basis, financial markets may be classified into cash/spot market and forward / future
market.
Cash / Spot market: This is the market where the buying and selling of commodities
happens or stocks are sold for cash and delivered immediately after the purchase or sale of
commodities or securities.
Forward/Future market: This is the market where participants buy and sell
stocks/commodities, contracts and the delivery of commodities or securities occurs at a pre-
determined time in future.