Overview of the Financial System

Financial System

• Describes the financial markets, participants, requirements, and securities traded within those markets collectively.

Functions of the Financial System

• Channels funds from savings units (lenders) to deficit units (borrowers).
• Provides a medium of exchange.
• Offers a mechanism for risk sharing.
• Provides a channel for central bank influence over the economy and financial system.

Other

• Fund Acquisition: Securing deposits and funds for projects.
• Fund Allocation: Determining how acquired funds will be used, by project/investment.
• Fund Distribution: Giving necessary funds to projects that need them.
• Fund Utilization: Using funds for their intended purpose.
• Multinational Financial System: Collective transfer mechanisms facilitating money and profit movement globally among financial participants.

Financial System Participants

• Households or consumers: Receive income (wages/salaries), spend on goods/services, and save.
• Financial Institutions/Intermediaries: Bridge surplus units (SUs)/investors/lenders and deficit units (DUs)/borrowers, channelling funds between them. They act as lenders, borrowers, underwriters, brokers and dealers.
• Non-financial institutions: Businesses outside the financial sector. Includes entities like trade, manufacturing, constructions. Can be borrowers or lenders, like households and financial institutions.
• Government: National, provincial, municipal, or city governments, including the Bureau of the Treasury (BTR) in the Philippines. The BTR acts as borrower when issuing securities and investor when buying them.
• Central Bank: Mandated to ensure a stable, healthy financial system, overseeing operations and setting monetary policies. For the Philippines, this is the Bangko Sentral ng Pilipinas.
• Foreign Participants: Households, Financial institutions and governments from outside the country. Engage in cross-border exchange of goods, services, and financial instruments.

Vision and Mission of BSP

• VISION: To be a world-class monetary authority fostering a globally competitive economy and high quality of life for Filipinos.
• MISSION: To promote price stability, provide leadership for a strong financial system, balanced sustainable economic growth.

Objectives of BSP

• To provide a safer, more flexible, stable, and healthy monetary and financial system.
• Maintain monetary policies for balanced, sustainable economic growth.
• Maintain price stability.
• Promote monetary stability and peso convertibility.
• Maintain financial system stability.
• Provide payment and other financial services to the government, public, financial institutions, and foreign entities.
• Supervise and regulate depository institutions.

Functions of BSP

• Bank of issue: Has sole authority to print money bills and mint coins.
• Government's banker, agent, and adviser: Manages banking accounts for government agencies. Provides foreign exchange and advises the government on investments.
• Custodian of cash reserves of banks: Regulates banks to maintain adequate reserves for deposit liabilities.
• Custodian of nation's reserves of international currency: Maintain reserves to guarantee currency issuance.
• Bank of central clearance and settlement: Acts as a clearing house for interbank claims.

Monetary Policy and Financial System

• Monetary policy: Managing money supply to influence the economy.
• Tools: Open market operations, reserve requirements, discount rates, interest rates, credit controls.
• Objective: To promote price stability for balanced, sustainable economic growth as per Republic Act 7653.
• Money Supply: Total currency, coins, and demand deposits in the economy.
• Expansionary Monetary Policy: Expands the supply of money.
  • Lowering the interest rate
  • Lowering the discount rate
  • Decrease the reserve requirements
• Contractionary Monetary Policy: Decreases the money supply.
  • Increasing the interest rate
  • Increasing government discount rate
  • Increasing reserve requirement on banks

Financial Markets

• Structures through which funds flow and facilitate financial claim transactions.

Primary vs. Secondary Markets

• Primary Markets: Where users of funds (corporations) raise funds through new financial instruments (stocks/bonds). The government acts as a borrower (bonds/Treasury bills).
  • Financial intermediary: Acts as the middleman between deficit and surplus units.
  • Investment banks/merchant banks: Help corporations issuing stocks/bonds sell to investors.
  • Trading Products: Equity Securities, Debt Securities, Foreign Exchange, Derivatives.
• Secondary Markets: Financial instruments are re-bought and resold.
  • Transfer ownership without affecting outstanding shares/securities.
  • Exist for marketability/easy selling/transfer of ownership and liquidity/easy convertibility to cash.
  • Commercial banks' trust and treasury departments are major secondary market players.
  • Trust departments recommend securities.
  • Treasury departments manage market security inventories.

Money vs. Capital Markets

• Money Markets: Short-term debt instruments issued by high-credit companies consisting of a network of institutions for trading debt with maturity of one year or less.
  • Government uses money markets for daily operations.
  • Open market transactions occur due to impersonal nature.
  • Banks with cash surpluses set up interbank call markets.
• Capital Markets: Long-term securities (notes, bonds, mortgages, leases, stocks).
  • Corporations issue stocks, and government issues bonds.
  • Securities market: Companies issue stocks/bonds to obtain long-term funds.
  • Stock market: Medium for equity exchange.
  • Bond market: Where bonds are issued and traded (Treasury, municipal, corporate bonds)
  • Derivative securities market: Where derivative securities are traded (price depends on underlying assets).
• Negotiated or non-securities market: Does not involve securities.
  • Loan market: One-on-one transactions between borrower/lender.
  • Mortgage market: Real property secures loans.
  • Lease market: Property is rented out.
  • Operating Lease: Short-term use without ownership transfer.
  • Finance Lease: Lessee has ownership rewards, the option to acquire, and responsible to the property.
• Other markets: Combination of money and capital markets (short and long-term loans and securities):
  • Consumer Credit Market: Loans for households to buy properties.
  • Organized Market: Exchanges for stocks or derivatives.
  • Over-the-Counter (OTC) Market: Less formal networks of dealers.
  • Auction Market: independent party matches buy/sell orders.
  • Foreign exchange market: Currency exchange between countries.
  • Spot Market: Immediate delivery and payment transactions.
  • Futures market: Contracts to buy something in the future at a set price.
  • Forward markets: Agreements to exchange non-standardized assets for cash later.
  • Options market: Trade stock options (warrants by corporations, calls by individuals).
  • Swap Market: Exchanging periodic cash flows based on an underlying instrument.

Investors

• Risk-averse: Prefer risk-free assets with equal expected returns
• Risk-taker: Ready to pay more regardless of risk.
• Risk-neutral: Do not consider risks, focus only on expected returns.

Financial Instrument

• Monetary/mutual contracts between parties.

Money Market Instrument (MMI)

• Provide businesses, banks, and government with low-cost capital for a short time.
  • Short-term instruments increasing liquidity.
  • Easily converted to cash
  • Traded over the counter via certified brokers or money market mutual funds.

Classification of MMI:

• Cash Management Bills: Government securities maturing in less than 91 days (35 or 45 days).
• Treasury Bills (T-bills): Issued by the Bureau of the Treasury (91, 182, 364-day). Do not earn interest, earnings are discount yield or margin.
• Banker's Acceptance: Time draft bank issues payable to seller.
• Letters of Credit: For domestic and international purchases.
• Negotiable Certificates: Bank-issued time deposit with interest and maturity date, negotiable.
• Repurchase Agreements: Sales of securities with repurchase commitment.
• Money Market Deposit Accounts (MMDAs): PDIC-insured deposit accounts managed by banks/brokerages.
• Money Market Mutual Funds (MMMFs): Investment funds pooling money into money market instruments.
• Certificate of Assignment: Transfers security rights to the buyer.
• Eurodollar CDs: Dollar deposits held offshore in US bank branches.
• Eurocommercial Papers: Issued in Europe by dealers without involving a bank.

Capital Market Instrument

• Include corporate stocks, mortgages, corporate bonds, treasury securities, state and local government bonds, US government agency securities, non-negotiable bank loans and leases

Types of capital market instruments

• Non-negotiable/non-marketable instruments
  • Loans: Direct borrowing from surplus units like banks.
  • Leases: Rent agreement.
  • Mortgages: Property secures loans.
  • Line of credit: Bank commitment to lend a specific amount.
• Negotiable/marketable instruments
  • Corporate stocks: Evidence of ownership.

Classification for Shares of Stocks

• Par Value Shares: Fixed money value known on the face of the stock certificate. Fixes minimum issue price.
• No Par Value Shares: No money value on the certificate.
• Common Shares: Ownership form representing claim on assets and earnings.
• Preferred Shares as to assets upon liquidation: Preference over common shares in asset distribution.

As to Dividends:

• Cumulative Preferred Shares: Receive all past dividends in arrears.
• Non-Cumulative Preferred Shares: Not entitled to past dividends.
• Participating Preferred Shares: Right to receive dividends based on a specified rate, plus an additional dividend based on a pre-determined condition.

Characteristics

• Non- Participating Preferred Shares: Dividend is paid at a fixed rate, not determined by company earnings.

Dividends

• Distribution of company earnings to shareholders by board of directors:
  • Liquidating Dividends: return of investments in liquidation/bankruptcy.
  • Dividends out of earnings
    • Cash Dividend: cash distributions
    • Stock Dividend: shares of company stock.
    • Property Dividend: Non-cash assets distributions.
    • Scrip Dividend: Deferred cash dividends.

Bonds

• Debt instruments by private companies and governments to borrow large sums.
  • Corporate Bond: Certificate of indebtedness.
• As to security secured bonds, unsecured bonds
• As to interest rate variable rates, fixed rates
• As to retirement - Mutable, callable/redeemable, convertible bonds.
• Treasury Bonds: Government securities maturing beyond one year.

Municipal Bonds

• Used by State/local governments for capital projects.
  • General obligation bonds are used to raise funds to cover expenses
  • Revenue bonds: for Infrastructure projects with the income generated by those projects supporting the bonds.

Long-term negotiable certificates of deposit (LTNCDs)

• Negotiable certificates of deposit with a designated maturity or tenor beyond 1 year.

Mortgage-Backed Securities

• Securitization of mortgages into securities.