Chapter-1-An Overview of the Financial System Lecture Handout

CHAPTER-ONE

An Overview of the Financial System

What is financial system?

A financial system is the system that covers financial transactions and the exchange of money
between investors, lenders and borrowers. A financial system can be defined at the global,
regional or firm specific level. Financial systems are made of intricate and complex models that
portray financial services, institutions and markets that link depositors with investors.

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.

There are multiple components making up the financial system of different levels: Within a firm,
the financial system encompasses all aspects of finances. For example, it would include
accounting measures, revenue and expense schedules, wages and balance sheet verification.
Regional financial systems would include banks and other financial institutions, financial
markets, financial services in a global view, financial systems would include the International
Monetary Fund, central banks, World Bank and major banks that practice overseas lending.

 A financial system is the set of implemented procedures that track the financial activities
of the company.
 Include accounting measures, revenue and expense schedules, wages and balance sheet
verifications.
 Is the system that enables lenders and borrowers to exchange funds.
 Include banks and other financial institutions, financial markets and financial services.
 Financial system is basically a broader regional system that encompasses all financial
institutions, borrowers and lenders within the global economy.
 It includes the international monetary fund, central banks, World Bank, and major banks
practice overseas lending.
 A financial system consists of a set of organized markets and institutions together with
regulators of those markets and institutions.
 The end users of the system are people and firms whose desire is to lend and to borrow.
 The financial system assists our economy by supporting and facilitating exchange
through a payments system and by serving as an intermediary between savers and
borrowers.
Financial system refers to the financial institutions, financial markets, and the set of rules and
regulations that affect how money circulates in the economy and make it easier to use money for
its various purposes.

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Our financial system provides an effective payments system. The efficiency of our financial
system and its institutions (banks, trust companies, credit unions, and so on) enables billions of
exchanges to occur each year among millions of people. The financial system helps the process
of exchange in two key ways. First, our financial system makes it easier to exchange goods and
services by enabling consumers to purchase goods and services using money that the system
helps to provide and circulate. Consumers exchange money for goods and services by using cash
that is circulated via the financial system. Producers willingly accept the money due to its
widespread acceptance throughout the economy. Producers can use the money they receive to
cover their costs and earn an income that enables them to purchase what they need and want.
Money and the financial system greatly facilitate exchange by providing an effective payments
system. Now, you may say that money alone can do this. Why do we need a financial system?
The second key way in which our financial system helps the process of exchange is by enabling
the use of checks. In an economy with only cash, all transactions have to be made in cash. That
can be burdensome, as well as a little risky. Imagine carrying $10,000 in cash to buy a car, or
$150,000 or more to buy a house. Financial institutions and a financial system overcome the
problems and risks of dealing in cash. Checks can be used to make many transactions,
particularly larger ones, easier and safer. Instead of carrying $10,000 in cash to buy a car, you
can carry a little piece of paper (a check) that can handle the transaction for you. Much easier and
much safer. In addition to providing an effective payments system, the financial system acts as
an intermediary, linking savers and borrowers and enabling current purchasing power to be
transferred from one group to another.
In a system without financial institutions and only cash, people might save their money in cookie
jars, under mattresses, and so on. The funds being saved in the cookie jar or under the mattress
aren’t readily available to anyone in need of funds. Maybe a borrower could find someone, a
friend, who might lend the money. But many borrowers would find it hard to get the funds they
need. People wanting to borrow large sums of money like many of today’s companies and
governments would find it especially difficult.
Financial institutions, and a financial system, make it easier to link savers and borrowers. Today,
it is possible for people, organizations, and companies to borrow large sums of money thousands,
millions, even billions of dollars. These funds represent the savings of those who do not require
the funds today, and they are made available to borrowers by the financial system. Why do

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savers and borrowers need to be linked, you may ask? Good question. The answer is that this link
helps our economy to grow to expand its ability to produce goods and services, create wealth for
our society, and increase our standard of living. Funds not currently required for spending are
deposited by savers at the various financial institutions. The financial institutions then use these
funds to provide loans to those seeking funds for spending/investment purposes.
By directing funds from those who currently don’t need them to those who do, the financial
institutions help to support investment and growth in our economy. Without these financial
institutions and the loans they can provide, many investments could never take place. Much of
our technology, plants, factories, and equipment would never be developed. Therefore, our
financial system helps our economy by;
(i) Providing a payments system that facilitates the process of trade and exchange and
(ii) Linking savers with borrowers, thereby promoting investment, growth, and
improvements in our standard of living over time. The financial system comprises a large
number of different kinds of financial institutions that provide various services to the
system.
According to structural approach, the financial system of an economy consists of three main
components:

i) Financial Institutions (intermediaries)

ii) Financial Markets iii) Financial
Regulators

• Flow of funds:-
Funds flow through the financial system from entities that have a surplus of funds to those that
have a deficit. Often these fund flows take place through a financial intermediary. Flow of funds
is flows of saving, investment, and external financing among different economic sectors over a
period.
Funds arrive directly or indirectly to the users.

1) Direct financing
• Is the simplest way for funds to flow.
• Deficit spending Units and surplus spending Units find each other and bargain.
• Surplus spending Units transfers funds directly to Deficit spending Units.
2) Indirect financing
• An institution stands between lender and borrower.

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• A financial intermediary transforms financial claims with set of characteristics into

financial claims with other characteristics.
• Example: deposits are used to make loans.
• This transformation process is called financial intermediation.
• Disintermediation is the reveres process (SSUs take their money from financial
institutions and invest in direct claims.
Who are the players?
 Households
• Businesses
• Governments
• And others
All acts at one point in time or another as borrowers and providers.
Functions of the Financial System
The financial system performs the following interrelated functions that are essential to a modern
economy:
It provides a payment system for the exchange of goods and services.
It enables the pooling of funds for undertaking large-scale enterprises.
It provides a mechanism for spatial and temporal transfer of resources.
It provides a way for managing uncertainty and controlling risk.
It generates information that helps in coordinating decentralized decision making.
It helps in dealing with the incentive problem when one party has an informational
advantage.
Payment System: Depository financial intermediaries such as banks are the pivot of the payment
system. Credit card companies play a supplementary role. To realize the importance of this
function, simply look at the hardship and inconvenience caused when the payment system breaks
down Pooling of Funds: Modern business enterprises require large investments, which are often
beyond the means of an individual or even of hundreds of individuals. Mechanisms like financial
markets and financial intermediaries, which are an integral part of the financial system, facilitate
the pooling of household savings for financing business. If you look at it from the other side, the
financial system enables households to participate in large indivisible enterprises. Transfer of
Resources: The financial system facilitates the transfer of economic resources across time and
space. As Robert Merton says:“A well-developed, smooth-functioning financial system
facilitates the efficient life-cycle allocations of household consumption and the efficient
allocation of physical capital to its most productive use in the business sector.”“A welldeveloped,
smooth-functioning capital market also makes possible the efficient separation ownership from
management of the firm. This in turn makes feasible efficient specialization in production
according to the principle of comparative advantage.”

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1.1. The Role of Financial system in the economy

Role of the Financial System is saving mobilization: Obtaining funds from the savers or
surplus units such as household individuals, business firms, public sector units, central
government, state governments, etc. is an important role played by financial markets.
A financial market or system is a market in which people and entities can trade financial
securities, commodities, and other tangible items. Financial systems, i.e. financial intermediaries
and financial markets, channel funds from those who have savings to those who have uses that
are more productive 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.

i) 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.
ii) Transformation of the risk characteristics of assets: - 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

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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.
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.
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.

1.2. Financial Assets: Role and Properties

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 equipment’s and real estate. Some
examples of financial assets are: stocks, bonds, bank deposits, loans. A financial asset is a
nonphysical asset whose value is derived from a contractual claim, such as bank deposits, bonds,
and stocks. Financial assets are usually more liquid than other tangible assets, such as
commodities or real estate, and may be traded on financial markets. The basic types of financial
assets traded in markets are debt, equity, and derivatives.

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 Debt instruments are issued by anyone who borrows money firms, governments, and
households.
 Equity is the claim of the owners of a firm. Equity securities issued by corporations are
called common stocks.
 Derivatives are financial instruments such as options and futures contracts that derive their
value from the prices of one or more other assets.
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.

1.3. Financial markets: Role, Classifications and Participants

Financial markets are markets in which securities, commodities, and fungible items are traded
at prices representing supply and demand. The term "market" typically means the institution of
aggregate exchanges of possible buyers and sellers of such items.
A financial market is a market in which people trade financial securities, commodities, and other
fungible items of value at low transaction costs and at prices that reflect supply and demand.
Securities include stocks and bonds, and commodities include precious metals or agricultural
products. In economics, typically, the term market means the aggregate of possible buyers and
sellers of a certain good or service and the transactions between them. The term "market" is
sometimes used for what are more strictly exchanges, organizations that facilitate the trade in
financial securities, e.g., a stock exchange or commodity exchange. This may be a physical
location (like the NYSE). Much trading of stocks takes place on an exchange; still, corporate
actions (merger, spinoff) are outside an exchange, while any two companies or people, for
whatever reason, may agree to sell stock from the one to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a
stock exchange, and people are building electronic systems for these as well, similar to stock
exchanges.

Role of financial markets: - One of the important sustainability requisite for the accelerated
development of an economy is the existence of a dynamic financial market. A financial market
helps the economy in the following manner.

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Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments etc. is an
important role played by financial markets.
Investment: Financial markets play a crucial role in arranging to invest funds thus collected in
those units which are in need of the same.
National Growth: An important role played by financial market is that, they contribute to a
nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for
productive purposes is also made possible.
Entrepreneurship growth: Financial market contributes to the development of the
entrepreneurial claw by making available the necessary financial resources.
Industrial development: The different components of financial markets help an accelerated
growth of industrial and economic development of a country, thus contributing to raising the
standard of living and the society of well-being.
Types of financial markets: - Within the financial sector, the term "financial markets" is often
used to refer just to the markets that are used to raise finance: for long term finance, the Capital
markets; for short term finance, the Money markets. Another common use of the term is as a
catchall for all the markets in the financial sector, as per examples in the breakdown below.

Capital markets: - which to consist of Stock markets, which provide financing through the
issuance of shares or common stock, and enable the subsequent trading thereof.

Bond markets: - which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.

Commodity markets: - which facilitate the trading of commodities.

Money markets: - which provide short term debt financing and investment.

Derivatives markets: - which provide instruments for the management of financial risk.

Futures markets: - which provide standardized forward contracts for trading products at some
future date; see also forward market.

Foreign exchange markets: - which facilitate the trading of foreign exchange.

The capital markets may also be divided into primary markets and secondary markets. Newly
formed (issued) securities are bought or sold in primary markets, such as during initial public
offerings. Secondary markets allow investors to buy and sell existing securities. The transactions
in primary markets exist between issuers and investors, while secondary market transactions
exist among investors. Liquidity is a crucial aspect of securities that are traded in secondary
markets. Liquidity refers to the ease with which a security can be sold without a loss of value.
Securities with an active secondary market mean that there are many buyers and sellers at a given
point in time. Investors benefit from liquid securities because they can sell their assets whenever
they want; an illiquid security may force the seller to get rid of their asset at a large discount.

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1.4. Lending and borrowing in the financial system

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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 wellbeing. 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 see &
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.

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