Financial System PDF

FINANCIAL SYSTEM Topic 3 OVERVIEW OF THE FINANCIAL SYSTEM A strong financial system is a necessary ingredient for a growing and prosperous economy. Companies raising capital to finance capital expenditures and investors saving to accumulate funds for future use require well-functionin...

FINANCIAL SYSTEM Topic 3 OVERVIEW OF THE FINANCIAL SYSTEM A strong financial system is a necessary ingredient for a growing and prosperous economy. Companies raising capital to finance capital expenditures and investors saving to accumulate funds for future use require well-functioning financial markets and institutions. OVERVIEW OF THE FINANCIAL SYSTEM The financial system is complex, comprising many different types of private sector financial institutions, including banks, insurance companies, finance companies, mutual funds, and investment banks, all of which are regulated by the government. Nature and Objective of the Financial System The financial system consists of all financial intermediaries and financial markets and their relations with respect to the flow of funds to and from households, government, business firms and foreigners, as well as the financial infrastructure. Nature and Objective of the Financial System A well-functioning financial system in place that directs funds to their most productive uses is a crucial prerequisite for economic development. Nature and Objective of the Financial System Key Components of the Financial System The major components of the financial system include a) Financial instruments b) Financial markets and financial institutions c) The Central Bank and Other Financial Regulators Functions of the Financial System The main task of the financial system is to channel funds from sectors that have a surplus to sectors that have a shortage of funds. In the financial system, banks, insurance companies, mutual funds, stockbrokers, and other financial services firms compete to provide financial services to households and businesses. Functions of the Financial System Economists believe there are three key aspects that the financial system provides to savers and borrowers – risk sharing, liquidity and information. Financial services firms provide these services in different ways, which makes different financial assets and financial liabilities more or less attractive to individual savers and borrowers. Risk Sharing Risk is the chance that the value of financial assets will change relative to what one expects. One advantage of using the financial system to match individual savers and borrowers is that it allows the sharing the risk. Risk Sharing The financial system provides risk sharing by allowing savers to hold many assets. The ability of the financial system to provide risk sharing makes more savers more willing to buy shares, bonds and other financial assets. Risk Sharing This willingness, in turn increases the ability of borrowers to raise funds in the financial system. Financial intermediaries have developed expertise in holding a diversified portfolio of innovative projects which reduces risk and promotes investment in growth enhancing innovative activities. Liquidity Liquidity is the ease with which an asset can be exchanged for money which savers view as a benefit. Generally, assets created by the financial system such as shares, bonds, or checking accounts are more liquid than physical assets such as cars, machinery and real estate. Liquidity Financial markets and intermediaries help make financial assets more liquid. Investors can easily sell their holdings of government securities and the shares and bonds of large corporations, making those assets very liquid. Liquidity The financial system has increased the liquidity of many assets besides shares and bonds through the process of securitization. The process has made it possible to buy and sell securities based on loans. Liquidity As a result, mortgages and other loans have become more desirable assets for savers to hold. Savers are willing to accept interest rates on assets with greater liquidity which reduces the costs of borrowing for many households and firms. Information A third service of the financial system is the collection and communication of information, or facts about borrowers and expectations of returns on financial assets. Information Financial markets convey information to both savers and borrowers by determining the prices of shares, bonds, and other securities. This information can help one decide whether to continue investing in the securities previously purchased or sell more share or bonds to finance a planned expansion. The Problems of Adverse Selection and Moral Hazard A vital service of the financial system is the collection and communication of information or facts about borrowers and expectation of returns in financial assets. Financial markets convey information to both savers and borrowers by determining the prices of shares, bonds, and other securities. The Problems of Adverse Selection and Moral Hazard Asymmetric information describes the situation in which one party to an economic transaction has better information than does the other party. In financial transactions, typically the borrower has more information than does the lender. The Problems of Adverse Selection and Moral Hazard Two problems arising from asymmetric information are: 1. Adverse selection - This is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment. 2. Moral hazard – This is the problem investors experience in verifying that borrowers are using their funds as intended. Nature and Impact of Transaction and Information Costs Transaction costs The cost of a trade or a financial transaction Information costs The costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds required. Nature and Impact of Transaction and Information Costs Transaction costs and information costs cause savers to receive lower return on their investments and borrowers must pay more for the funds they borrow. Although these costs reduce efficiency of the financial system, they also create a profit opportunity for individuals and firms that can discover ways to reduce those costs. Reduction of Adverse Selection by Financial Intermediaries The problem of adverse selection can be minimized if not totally avoided using the following approaches: 1. Requiring borrowers to disclose material information on their financial performance and financial position. 2. Collecting information on firms and selling that information to investors. 3. Convincing lenders to require borrowers to pledge some of their assets as collateral which the lender can claim of the borrower defaults. Reduction of Moral Hazard by Financial Intermediaries Financial intermediaries can reduce moral hazard problems by adopting more stringent procedures in monitoring the borrower’s use of funds. This will include: 1. Specializing in monitoring borrowers and developing effective techniques to ensure that the funds they loan are actually used for their intended purpose. 2. Imposing restrictive covenants Reduction of Transaction Costs by Financial Intermediaries Transaction costs may be reduced by adopting the following techniques: 1. Financial intermediaries take advantage of economies of scale, which refers to the reduction in average cost that results from an increase in the volume of a good or service produced. 2. Financial intermediaries can also take advantage of economies of scale in other ways. Reduction of Transaction Costs by Financial Intermediaries 3. Financial intermediaries also take advantage of technology to provide financial services. 4. Financial intermediaries also increasingly rely on sophisticated software to evaluate the credit worthiness of loan applicants. End of Topic 3