Understanding The Financial System

The Financial System

• The growth of output in any economy hinges on increasing savings and investment.
• A financial system aims to encourage individuals and institutions to save.
• It transfers savings to parties planning new investments.
• Encouraging savings and converting this into investments boosts economic growth, creates jobs, and improves living standards.
• The financial system is a network of institutions, instruments, and markets fostering savings.
• The financial system channels savings to their most efficient uses by individuals (savers), intermediaries, markets, and users of savings.

Financial Intermediaries (FI)

• FIs include commercial banks, savings and loan associations, investment and insurance companies, and pension funds.
• A key role of intermediaries is ensuring the consistent, relatively inexpensive flow of funds from savers to final users or investors.
• FIs carry out important financial functions for individuals, households, corporations, small businesses, new businesses, and governments.
• Financial institutions transform financial assets via markets into a more preferable asset type, which becomes a liability to them.
• Exchanging financial assets can be done on behalf of customers or for their own accounts.
• Financial institutions aid customers in creating financial assets and the resale to other market participants.
• FIs offer investment advice and portfolio management to market participants.
• Financial Intermediaries obtain funds by issuing financial claims against themselves to market participants.
• They subsequently invest these funds often in loans or securities; this is also called direct investments.
• Market participants holding financial claims made by financial intermediaries have made indirect investment.
• Financial intermediaries act as mobilizers and depositories of savings.
• FIs are purveyors of credit or finance in the community and offer a variety of financial services.
• Banks accept deposits as liabilities and then convert them into assets like loans, known as liability-asset transformation.
• They provide large volumes of finance on the basis of small deposits, known as size transformation.
• FIs reduce risk through diversification, known as risk transformation.
• FIs offer differing deposit forms based on saver's liquidity preferences and also provide borrowers with loan maturity options, known as maturity transformation
• Commercial banks transform short-term assets into long-term ones.
• They provide borrowers with loans for the requested period and also offer depositors a financial asset for the desired investment timeframe.
• Maturity intermediation also provides depositors with more maturity choices and borrowers with debt obligation lengths.
• Maturity intermediation reduces long-term borrowing costs.
• Financial intermediaries transform riskier assets into less risky ones, which is referred to as diversification.
• Investors with modest funds may find it hard to adequately diversify due to insufficient resources to buy shares in many companies.
• Investors in an investment company benefit from risk reduction through diversification using the same amount of money.
• Individual investors can achieve diversification on their own, however it may not match the cost efficiency of financial intermediaries dependent on investment funds.
• Information processing costs equals opportunity plus collection costs.
• The large funds managed by financial intermediaries enable economies of scale when contracting and processing information about financial assets.
• Lower costs from economies of scale benefit investors buying financial intermediary claims and issuers of financial assets due to reduced borrowing costs.
• Financial intermediaries facilitate payments through methods like checks, credit cards, and electronic transfers.
• Liabilities are closely related to the investment strategy a financial institution pursues.
• Liabilities equal the amount and timing of cash outflows required to meet the contractual terms of obligations.
• FI liabilities can be categorized into these four types:
• Type I: Known amount of cash outlay and time (fixed-rate deposits).
• Type II: Known amount, but uncertain time (life insurance policies).
• Type III: Uncertain amount, but known time (certificate of deposit with fluctuating interest).
• Type IV: Uncertain amount and time (automobile and home insurance policies)

Liquidity Concerns

• Uncertainty around the amount or timing of cash outflows requires FIs to maintain sufficient cash to meet obligations.
• Possible reduction in cash inflows could occur due to the inability to obtain deposits.
• Certificate of deposit depositors may request funds before maturity, incurring an early withdrawal penalty.

Advantages of Financial Institutions

• Reduce information and transaction costs
• Grant long-term loans
• Provide liquid claims and pool risks
• Economize costs of both borrowers and lenders
• Banks mobilize savings from many small, insured depositors.
• Banks perform a single expert credit standing investigation saving on several amateur investigations.

Financial Markets (FM)

• Financial markets provide facilities for buying and selling financial claims and services.
• Corporations, FIs, individuals, and governments participate here, either directly or through regulated brokers and dealers.
• Financial Markets are classified as primary and secondary markets.
• Primary markets deal in new financial claims or new securities to mobilize savings and supply fresh capital to business entities.
• Secondary markets trade in already issued or outstanding securities, providing liquidity.

Financial Markets Classification

• Nature of claim: Debt or Equity Market.
• Maturity of claim: Money or Capital Market.
• Seasoning of claim: Primary or Secondary Market.
• Immediate or future delivery: Spot or Derivatives Market.
• Organizational structure: Over the counter or Standardized Market.

Financial Institutions Classification

• Banking or non-Banking institutions classification
• Banking institutions participate in the economy's payments mechanism and provide transaction services.
• Their deposit liabilities make up a large part of the national money supply.
• Banks can advance credit by creating claims against themselves.
• Banks can be defined by: economic functions ; the services offered; and legal basis for existence.
• Banks transfer funds from savers to borrowers (financial intermediation) and used in paying for goods and services.
• They offer checking accounts, savings plans, and loans for businesses, consumers, and governments.
• Bank services are expanding, including investment banking, insurance, financial planning, merging advice and risk-management.
• Banks now offer general financial services.
• Functions/services of banks are changing, as are competitors.
• Many firms try to be as similar to banks as possible.
• These firms include leading security dealers, investment bankers, brokerage firms, credit unions, thrift institutions, mutual funds, and insurance companies.

Bank Services Offered

• Payment services for commerce and markets (checks, credit cards, Web sites).
• Risk protection services for savers and investors (insurance policies, derivative contracts).
• Liquidity services for converting property into immediate spending power.
• Credit services by way of loans.

Non-Banking Institutions

Deposit Type Institutions

• Saving and Loan Associations specialize in selling deposits and offering home mortgage loans/credit to individuals and families
• Credit unions do the following: collect deposits; loan to members and function as associations for individuals who share a common bond.

Non-depository Institutions

• Life/property insurance companies protect against risks; manage pension plans, and handle individual retirement funds.

Other Financial Intermediaries

• Hedge funds sell shares to upscale investors in assets (commodities, real estate, loans, and risky assets).
• Finance companies offer loans to commercial enterprises (auto/appliance dealers) and individuals/families sourced from open market.
• Money market funds collect short-term, liquid funds from individuals/institutions and invest in quality short securities.
• Mutual Funds (investment companies) sell shares to the public who seek interest in professionally managed stocks/bonds.
• Investment banks provide professional advice to corporations/governments raising marketplace funds or to make business acquisitions.
• Security brokers/dealers buy/sell securities for customers as well as own accounts.
• Financial holding companies (FHCs) often include cards, insurance, service providers, finance and broker/dealer firms.

Financial System and Economic Development

• Efficiency: use and allocation of factors to the most productive purposes
• Information arbitrage efficiency: Prices in an efficient market reflect all relevant data, rendering inside information useless.
• Fundamental Valuation efficiency: Market price of an equity = intrinsic value (present value of future cash flow + asset investment).
• Full insurance efficiency: Extent of hedging indicates this, where greater capacities to hedge/reduce risk increase market efficiency.
• Functional/Operational Efficiency: Minimizing transaction costs and maximizing convenience while providing fair returns to financial intermediaries.
• Allocational Efficiency: Financial markets channeling resources into investment projects where risk-adjusted marginal capital efficiency is highest.
• Innovations: Introduction of instruments/new processes for existing funds and markets.
• Financial Engineering: Formulating creative solutions to problems in finance.
• Financial revolution: A term referring to the speed and scope of changes in the financial sector.
• Diversification: Development of wide array of financial institutions, markets, instruments, services, and practices.
• Disintermediation: Decline in the share of financial intermediaries in the aggregate financial assets in an economy.
• Markets can be broad, wide, deep or shallow. Deep markets have sufficient orders for buying and selling at fine quotations.
• Financial repression: Government policies distorting financial prices and interest rates that discourage savings and investment.
• Deregulation and Financial liberalization: Policies that increase the allocative efficiency of available saving, promote private sector growth, and enhance banking sector viability.
• Privatisation: More ownership, management, and control by individuals and privately incorporated entities.
• Prudential Regulation: Regulation to enhance transparency and accountability in operation and restore credibility and confidence in the FS.
• Integration: Close connections or effective linkages between financial system parts.
• Internationalization and Globalization: Expanding activities of a financial system beyond its national boundaries.

Securitisation

• Firms increasingly tap bonds, commercial paper, and share markets, to seek finance.
• Existing assets are sold or removed from the balance sheets through funding by other investors.