NAGA COLLEGE FOUNDATION, INC.

M.T. Villanueva Avenue, Naga City

College of Business and Accountancy
Banking and Financial Institution

Lecture Handout No. 1

Overview of the Philippine Financial System

OVERVIEW
To better understand banking and other financial institutions, we should first acquire knowledge
as to what financial system is. Banks and financial institutions are just only components of this
system.

Through this lecture handout, we will try to understand how the financial system works where
does banking and financial institutions stand in this system?

LEARNING OBJECTIVES
At the end of the lesson, students should be able to:
1. Understand the financial system
2. Understand how funds flow in the financial system
3. Understand the importance of saving and lending, and investing and borrowing
4. Identify the methods of financing

DISCUSSION

FINANCIAL SYSTEM

INTRODUCTION
Financial system is defined by Rose, Kolari, and Fraser as “the institutional mechanism
established by society to produce and deliver financial-services and allocate resources,
consisting of the business firms supplying financial services, the customer of financial-service
firms, and government regulatory authorities that enforce the rules prevailing within the financial
sector.”

Functions of the Financial System

The following are the functions of the financial system:
1. CREDIT
 Credit refers to the mechanism of borrowing funds from another sector. Credit is supplied
by the financial system to three types of borrowers: (1) consumers, (2) business, (3)
government. Credits are main sources of additional funds.
2. PAYMENT
The payment system takes the form of currency, checking accounts, and other medias.
Through breakthroughs in the global age, payment is can also be done electronically
through various payments application.

3. MONEY CREATION
Even though the government provides currency for the circulation, additional money is
created by the banking system by facilitating the use of other means of payment. Hence,
transactions in financial system are not being limited by physical money.

4. SAVINGS
The financial system serves as the main venue to invest excess funds by savers. This is
made through the means of accepting deposits and loan agreements with the use of
financial instruments.

Components of the Financial System

The financial system is composed of various elements as follows:

1. Financial Instruments
These are evidences of debt and ownership that are brought and sold in the market.
They facilitate easy transfer of funds since these are tangible documents that provides
reliability to both lenders and borrowers.

2. Financial Sector
The financial sector is consisted of:
a. Financial Market – is a mechanism by which savings in one sector of the economy
flows to another sector.
b. Financial Institutions – is an organization through which funds in the form of money
or claims in money are assembled and transferred from individuals with surplus
funds to other individuals or firms needing extra funds.

3. Rules Governing Conduct of Trade

Certain rules are designed to keep the financial system intact and well-functioning:
a. Pertinent laws concerning financial institutions
b. Memoranda, circulars, and issuances of concerned government agencies
c. Pertinent ordinances of local government units where the financial institution is
situated
d. Customs and traditions inherent to the area where the financial institution is situated

The Flow of Funds in the Financial System

The financial system is mainly composed of three sectors: (1) household, (2) firms and (3)
government.

Household income comes from wages and interest paid by firms. The income is spent mostly on
gods and services. The excess the goes to savings which is then facilitated by the financial
system. This saving is then being lent to firms for available funds.
Through the additional fund borrowed, firms will have enough resources to operate and
generate revenue. Part of the firm’s revenue is paid out to households in the form of wages and
interest.

If the government is included, the flow of funds will be a little complicated. The government will
have its income coming from taxes paid by the households and firms. It also borrows money
from various resources. It spends its income derived from taxes and borrowing to purchase
buildings, equipment or supplies. Part of this amount is also paid out to households in the form
of wages and interest.

Saving and Lending

In the financial system savers connotes lenders. These are individuals or firms whose revenues
exceeded their expenditures; hence, creating an excess funds. They are also called as surplus
spending units (SSUs). The excess funds that they have are then being saved in financial
institutions.

Households usually save money for future use or consumption. Their savings are usually
dependent on the salaries and needs. Below is a summary of the relationship between
household income and spending at various stages:

Stages in Life Cycle of the Income Financial Decisions

Household
New Smaller than expenses Spend savings or borrow
Middle Age Bigger than expenses Build up savings and
liquidate borrowings
Retirement Smaller than expenses Spend savings

Firm’s excess funds are then saved in financial institutions or invested on business opportunities
to gain additional income through the form of interest or dividends.

Borrowing
Borrowers are those whose expenditures exceeds their revenues and are also being referred to
as deficit spending units (DSUs).

Households or individuals usually borrows money to be used for necessities such as daily
consumptions or acquiring of long-term possessions such as houses and cars.
Firms, on the other hand borrows for two reasons:
1. They need resources to fund their operations
2. They need additional resources for business opportunities and investments.

Transfer of Funds from Lenders to Borrowers

The financial system is concerned with transferring of funds from lenders (SSUs) to borrowers
or (DSUs). The excess fund created by these SSUs are saved in financial institutions for
investment and safekeeping. These excess funds are then being lent by these institutions to
borrowers (DSUs) who need them.

Transferring funds from SSUs to DSUs is basically composed of two methods:

1. DIRECT FINANCE
Direct finance refers to lending by ultimate borrowers with no intermediary. Under this
method, the SSU gives money to the DSU in exchange for financial claims on the DSU.
The claims issued by the DSU are called direct claims.

2. INDIRECT FINANCE
Indirect finance (also called as financial intermediation) refers to lending by the ultimate
lender to a financial intermediary that then relends to ultimate borrowers. A financial
intermediary is an entity that acts as the middleman between two parties in a financial
transaction. Financial intermediaries include commercial banks, mutual savings banks,
credit unions, life insurance companies, and pension funds.

CATEGORIES OF FINANCIAL INTERMEDIARIES

1. Depository Intermediaries
They are called as such because the sources of their loanable funds consist of deposits
received from businesses, households, and governments. Included in this group are
commercial banks, credit unions, savings and loans associations, and savings banks.

2. Contractual Intermediaries
This type enters into contracts with their customers to promote saving and/or financial
protection against loss of life and property. Contractual intermediaries consist of life and
nonlife insurance companies, the Government Service Insurance System (GSIS), Social
Security System (SSS), private pension funds, and educational plan companies.

3. Secondary Intermediaries
These are called as such because they depend heavily on other financial intermediaries
like commercial banks to loanable funds. Included in this category are finance
companies, mortgage banks, and real estate investments trusts.

4. Investment Intermediaries
 This type offers the public securities that can be held indefinitely as a long-term
investment and which can be sold quickly when the customer needs his funds returned.
Investment intermediaries include mutual stock funds, bond funds, and money market
funds.

Type of Intermediary Sources of Funds

Commercial banks Deposits

Savings and loan association Deposits
Mutual savings bank (or cooperative) Deposits
Credit unions Deposits
Life insurance companies Premium from policyholders
Nonlife insurance companies Premium from policyholders
Pension fund companies, GSIS, SSS Employer and employee contributions
Finance companies Issues of commercial paper, stocks, bonds
Mutual funds Issues of shares
Money market mutual funds Issues of shares

REFERENCES:

Money, Credit and Banking by Dr. Roberto G. Medina

https://www.investopedia.com/terms/f/financialintermediary