Introduction to Banking and Financial Institutions
Money
• store of value, which means people can save it and
use it later—smoothing their purchases over time;
• unit of account, that is, provide a common base for
prices; or
• medium of exchange, something that people can
use to buy and sell from one another.
FINANCIAL SYSTEM
• A financial system is a set of institutions, such as
banks, insurance companies, and stock exchanges,
that permit the exchange of funds
• Financial systems exist on firm, regional, and global
levels. Borrowers, lenders, and investors exchange
current funds to finance projects, either for
consumption or productive investments, and to
pursue a return on their financial assets.
• The financial system also includes sets of rules and
practices that borrowers and lenders use to decide
which projects get financed, who finances projects,
and terms of financial deals.
Five Parts of Financial System
1. Money – To pay for our purchases and to store our
wealth.
2. Financial Instruments – to transfer resources from
savers to investors and to transfer risk to those
who are best equipped to bear it. (Ex. securities)
3. Financial Markets – allows us to buy and sell
financial instruments quickly and cheaply. (Ex.
New York Stock Exchange, PSEi – Philippine Stock
Exchange Inc.)
4. Financial Institutions – provide a myriad of
services, including access to the financial markets
and collection of information about prospective
borrowers to ensure they are credit worthy. (Ex.
Banks, insurance companies)
5. Central Banks – monitor and stabilize the economy
(Ex. BSP – Banko Sentral ng Pilipinas)
FINANCIAL INSTITUTIONS
• Firms that provide access to financial markets,
both to savers who wish to purchase financial
instruments directly to the borrowers who want to
issue them.
• Also known as financial intermediaries.
• Banks, insurance companies, securities firms, and
pension funds are all financial intermediaries.
Structure of Financial Industry
 Depository Institutions – they are what most
people think of as banks, whether they are
commercial banks, savings and loans, or credit
unions.
 Non-depository Institutions – include
insurance companies, securities firms, mutual
fund companies, finance companies and
pension funds.
Major Groups of Financial Institutions
1. Depository Institutions
– Take deposits and make loans
– Commercial banks, savings banks and credit
unions
2. Insurance Companies
– Accept premiums, which they invest in
securities and real estate (their asset), in
return for promising compensation to policy
holders should certain events occur (their
liabilities).
– Life insurers protect the against untimely
death. Property and casualty insurers protect
against personal injury loss and losses from
theft, accidents and fire.
3. Pension Funds
– Invest individual and company contributions
in stocks, bonds and real estate (their assets)
in order to provide payments to retired
workers (their liabilities).
4. Securities Firms
– Include brokers, investment banks, and
mutual fund companies. Brokers and
investment banks issues stocks and bonds to
corporate customers, trade them and advise
customers.
5. Finance Companies
– Raise funds directly in the financial markets in
order to make loans to individuals and firms.
(ex. Home credit)
– Finance companies tend to specialize in
particular types of loans such as mortgage,
automobile, or certain types of business
equipment.
Government-sponsored enterprises
– Credit agencies that provide loans directly for
farmers and home mortgagors. They also
guarantee programs that insure loans made
by private lenders.
Financial Instruments, Financial Institutions and Financial
Markets
FINANCIAL INSTRUMENTS – is a written legal obligation of
one party to transfer something of value, to another party
at some future date, under certain conditions.
Uses of Financial Instruments
• Can act as a means of payment – purchase of goods and
services
• Can also be stores of value – transfer of purchasing
power into the future
• Allow trading of risk – transfer of risk from one person
or company to another
wheat futures contract – a financial instrument in
which two parties agree to exchange a fixed quantity of
wheat on a prearranged future date at a specified price.
Two Fundamental Classes of Financial Instruments
1. Underlying Instrument
- Sometimes called as primitive securities
- Used by savers/lenders to transfer resources directly
to investors and borrowers. Through these
instruments, financial system improves the efficient
allocation of resources in the real economy.
- Examples: Stocks and bonds
2. Derivative Instruments
- Their value and payoffs are derived from the
behavior of the underlying instruments.
- Examples: futures and options
What makes financial instrument valuable?
• Size : payments that are larger are more valuable
• Timing : payments that re made sooner are more
valuable
• Likelihood : payments that are more likely to be made
are more valuable
• Circumstances : payments that are made when we
need them most are more valuable
Examples of Financial Instruments
Financial Instruments Used Primarily as Stores of Value
• Bank Loans - Borrower obtains resources from a
lender to be repaid in the future
• Bonds - A form of a loan issued by a corporation or
government.
• Home Mortgages - Home buyers usually need to
borrow using the home as for the loan
• Stocks - The holder owns a small piece of the firm and
entitled to part of its profits
• Asset-backed securities - Shares in the returns or
payments arising from specific assets, such as home
mortgages and student loans
Financial Instruments Used Primarily to Transfer Risk
• Insurance contracts - Primary purpose is to assure
that payments will be made under particular, and
often rare, circumstances
• Futures contracts - An agreement between two
parties to exchange a fixed quantity of a
commodity or an asset at a fixed price on a set
future date.
• Options - Derivative instruments whose prices are
based on the value of an underlying asset.
FINANCIAL INSTITUTIONS
• The firms that provide access to the financial
markets, both to savers who wish to purchase
financial instruments directly and to borrowers
who want to issue them.
• Because financial institutions sit between savers
and borrowers, they are also known as financial
intermediaries and what they do is known as
financial intermediation.
• Banks, insurance companies, securities firms and
pension funds are all financial intermediaries.
Financial systems would not work for the number of
reasons:
• Individual transactions between saver-lenders and
spender-borrowers would likely be extremely
expensive. Not only would the two sides having
two difficulty finding each other, but even if they
did, writing contract to effect the transaction
would be very costly.
• Lenders need to evaluate the creditworthiness of
borrowers and then monitor them to ensure that
they don’t abscond with the funds. Individuals are
not specialists in monitoring.
• Most borrowers want to borrow for the long term,
while lenders favor more liquid short-term loans.
The Role of Financial Institutions
• Reduce transaction costs by specializing in the
issuance of standardized securities.
• Reduce the information costs of screening and
monitoring borrowers to make sure they are
creditworthy and they use the proceeds of a loan
or security issue properly.
• Curb information asymmetries and the problems
that go along with them, helping resources to their
most productive uses.
• Make long-term loans, and also give savers ready
access to their funds. That is, they issue short-term
liabilities to lenders while making long-term loan to
borrowers.
 • Provide savers with financial instruments that are
both more liquid and less risky than the individual
stocks and bonds they would purchase directly in
financial markets.

The Simplified Balance Sheet of a Financial Institution

• Assets – bonds, stocks, loans, real estate
• Liabilities – deposits, insurance policies

FINANCIAL MARKETS
• The places where financial instruments are bought
and sold.
• They are the economy’s central nervous system,
relaying and reacting to information quickly, allocating
resources and setting prices.

The Roles of Financial Markets

• Liquidity – ensure that owners of financial
instruments can buy and sell them cheaply and easily.
• Information – pool and communicate information
about the issuer of a financial instrument.
• Risk Sharing – provide individuals with a place to buy
and sell risks, sharing them with others.

The Structure of Financial Markets

Primary versus Secondary Markets

• Primary Market – markets where newly-issued
securities are sold.
• Secondary Markets – markets where existing
securities are traded.

Centralized Exchanges versus Over-the-Counter Markets

• Centralized exchanges – secondary markets where
buyers and sellers meet in a central, physical
location.
• Over-the-counter markets – decentralized
secondary markets where dealers stand ready to
buy and sell securities electronically.

Debt and Equity versus Derivatives Markets

• Debt and equity markets – markets where

financial claims are bought and sold for immediate
cash payment.
• Derivatives markets – markets where claims based
on an underlying asset are traded for payment at a
later date.