The Financial System 2024-2025 PDF

Empirical Banking The Financial System Stefano Caiazza 2024-2025  The Financial System The Financial System consists of markets, intermediaries, institutions, and financial instruments designed to transfer funds from lenders to borrowers. It re...

Empirical Banking The Financial System Stefano Caiazza 2024-2025  The Financial System The Financial System consists of markets, intermediaries, institutions, and financial instruments designed to transfer funds from lenders to borrowers. It represents the structure through which financial activity takes place in a modern economy, i.e., the production, supply, and exchange of financial services and products. The Financial System performs the essential economic function of channeling funds from: Households Corporations Governments That who have saved surplus funds by spending less than their income – SURPLUS AGENTS – to those with a shortage of funds because they wish (or need) to spend more than their income – DEFICIT AGENTS.  The Financial System Financial markets are markets specialized in trading financial instruments. Financial instruments are a particular category of contracts concerning financial rights and benefits. Financial intermediaries are a particular class of companies that carry out essentially financial activities based on producing and negotiating financial instruments, offering services connected with the circulation of these instruments. The Financial System takes place in a context of rules and controls. Regulatory and Supervisory Authorities organize and supervise the correct functioning of the markets.  The Financial System Banking Sector Financial Markets  Central Banks (Inflation) C u r The Financial System r e n c Banking Sector Financial Markets Debt and Deficit i e s Funds Laws Savings Funds Supervisory Authorities Governments Services Households & Corporations Taxes Natural Economy Money-based Economy Credit-based Economy Financial-based Economy …………….. The Financial System Banking Sector Financial Markets  Natural and Money-based Economy Natural Economy: an economy in which goods are exchanged against other goods through direct bartering. Problems: Double coincidence of wants High Search Costs (counterpart) A physical place to trade (markets) Indivisibility of the goods Cost of storage of goods Arbitrary assignment of the value of the goods Summarising: High transaction costs Evolution: Money-based Economy Identification of a commodity with functions of: Unit of account Medium of exchange (payment instrument) - Shells, metals, ceramic artifacts (Store of value)  Credit-based Economy Specifically, in a credit-based economy, one agent provides money to another agent who promises to refund money later. This transaction was initially not guaranteed. The first form of credit developed systematically appeared in the Middle Ages when some people exposed the currency and the accounting records on a table (bancus in the Latin language, in turn, the translation of the ancient Greek word τράπεζα). The principal activity of the banker was to lend money to usury. Broadly speaking, a money-based economy in which money has no intrinsic value (fiat money) is a credit-based economy because any commodity does not back the money.  Financial Economy In a financial-based economy, along with banks, other institutions produce financial assets exchanged as if they were currency. The transition from a money- to a credit- to a financial-based economy results in a considerable increase in risk. If the risk of losing one's money is relevant in a credit-based economy, it is even more so in a financial economy. GDP of World Economies in 2023 Global GDP in 2023: 105 trillion$ In 2019: 87.8 trillion$ In 2009 the global GDP was 14.45 trillion$ 1 billion: 1 thousand million (109): 1,000,000,000 1 trillion = 1 million million (1012): 1,000,000,000,000 The U.S. is the largest economy in the World, accounting for 25,62% of the globe According to UBS, global wealth Source: tallies to 454 trillion$ (2023) VisualCapitalist Flows of Funds Through the Financial System: the two channels  Flows of Funds Through the Financial System Agents transfer funds in the financial system – from borrowers to lenders – through two channels: direct finance and indirect finance. ln direct finance, borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but liabilities (debts) for the individual or firm that sells (issues) them. It is essential to point out that borrowers and lenders might only get together in the presence of financial markets. Financial markets are thus critical to promoting economic efficiency. Direct finance requires lenders to bear informative costs (counterpart research) and monitoring costs (assessment of firms’ robustness). Moreover, risks for small investors increase in the absence of good governance rules that protect small shareholders, low liquidity, and a small number of listed companies.  Flows of Funds Through the Financial System ln indirect finance, financial intermediaries purchase direct claims with one set of characteristics (e.g., term to maturity, denomination) from borrowers and transform them into direct claims with different features, which they sell to the lenders. The transformation process is called intermediation. Notice that in the financial intermediation market, the lender's claim is against the financial intermediaries rather than the borrower. Lenders can invest a small amount of savings in instruments that can be withdrawn on demand in a (usually) short period with (almost) zero costs. Nothing is for free: lenders receive a lower gain on invested capital (but also a lower risk). In producing financial commodities, intermediaries perform the following asset transformation services: (1) Denomination-Divisibility; (2) Maturity-Flexibility; (3) Diversification; (4) Liquidity.