Chapter 2: 

Functions performed by the Financial System and the

Financial Markets
Topic/s:
- Savings Function
- Wealth Function
- Liquidity Function
Learning Outcomes: At the end of this module, you are expected to: 

1.  Understand the functions and roles played by the system of financial

markets in the global economy and in our daily living.
2.  Define key terms and concepts about the financial markets that will be
used throughout the course.
3.  Explain the importance of the functions performed by the financial
system and the financial markets to both lenders and users of funds.
 
INTRODUCTION
Financial markets transfer funds from those who have excess funds to those
who need funds. They enable college students to obtain student loans, families
to obtain mortgages, businesses to finance their growth, and governments to
finance many of their expenditures. Many households and businesses with
excess funds are willing to supply funds to financial markets because they
earn a return on their investment. If funds were not supplied, the financial
markets would not be able to transfer funds to those who need them.
 
LESSON PROPER
Role of Financial Markets
Those participants who receive more money than they spend are referred to
as surplus units (or investors). They provide their net savings to the financial
markets. Those participants who spend more money than they receive are
referred to as deficit units. They access funds from financial markets so that
they can spend more money than they receive. Many individuals provide funds
to financial markets in some periods and access funds in other periods.
Many deficit units such as firms and government agencies access funds from
financial markets by issuing securities, which represent a claim on the issuer.
Debt securities represent debt (also called credit or borrowed funds) incurred
by the issuer. Deficit units that issue the debt securities are borrowers. The
surplus units that purchase debt securities are creditors, and they receive
interest on a periodic basis (such as every six months). Debt securities have a
maturity date, at which time the surplus units can redeem the securities in
order to receive the principal (race value) from the deficit units that issued
them.
Equity securities (also called stocks) represent equity or ownership in the firm.
Some businesses prefer to issue equity securities rather than debt securities
when they need funds but might not be financially capable of making the
periodic interest payments required for debt securities. For example, a new
social media company might want to reinvest all of its profits in the business to
support its growth, so it would prefer to sell shares of stock in the company
(issue equity securities) rather than make interest payments on debt securities.
 
1-1a Accommodating Corporate Finance Needs
A key role of financial markets is to accommodate corporate finance activity.
Corporate finance (also called financial management) involves corporate
decisions such as how much funding to obtain and what types of securities to
issue when financing operations. The financial markets serve as the
mechanism whereby corporations (acting as deficit units) can obtain funds
from investors (acting as surplus units).
 
1-1b Accommodating Investment Needs
Another key role of financial markets is accommodating surplus units who
want to invest in either debt or equity securities. Investment management
involves decisions by investors regarding how to invest their funds. The
financial markets offer investors access to a wide variety of investment
opportunities, including securities issued by the U.S. Treasury ( Bureau of
Treasury in the Philippines) and government agencies as well as securities
issued by corporations. Financial institutions serve as intermediaries within
the financial markets. They channel funds from surplus units to deficit units.
For example, they channel funds received from individuals to corporations.
Thus they connect the investment management activity with the corporate
finance activity, as shown in Exhibit 1.1. They also commonly serve as
investors and channel their own funds to corporations.
Exhibit 1.1 How Financial Markets Facilitate Corporate Finance and
Investment Management

Investment Management                               Corporate Finance

(Financial Management)
 
NOTE:
The black arrow represents the flow (use) of money invested while the shallow
arrow represents the flow of securities.
Functions of the Financial System
 
  Savings Function
 
o  The financial system is providing a potentially profitable, low-risk
outlet tor the public’s savings. As we noted earlier, the system of
financial markets and institutions provides a conduit for the
public's savings. Bonds, stocks. and other financial claims sold in
the money and capital markets provide a profitable, relatively low-
risk outlet for the public's savings, which flow through the
financial markets into investment so that more goods and services
can be produced, increasing society's standard of living. When
savings flows decline, investment and living standards begin to fall.

Relationship between Saving and Income

o  A direct relationship exists between saving and income. This

means, if income increases, saving also increases but in less
proportion in comparison to income.
o  When income level is low, saving is negative. In the initial stages
when income is low, consumption expenditure is more than in
 comparison to the level of earning, so there is no saving .i.e. dis-
saving.
 
REMEMBER: Since savings and income is directly related, this means
that one’s capacity to save (level of savings) could be based on their level
of income.
How Savings Help Consumers and the Overall Economy
To be sure, higher savings reserves
mean that consumers have
cushions that can help absorb
overwhelming expenses without
digging the hole deeper. But just as
importantly, having a higher portion
of income allocated to savings
means that living expenses are
lower–and consumers can adjust
their budgets to spend a larger
chunk of income on increased
mortgage payments or better
compensate if they lose their jobs.
 That ability to cope with financial
hardship ultimately means that
the economy recovers much
faster. After all, when the bills
are being paid, the banks,
utilities, and grocery stores can
keep their doors open–and their
workers employed.
The Risk of Savings
The section above is not to say that savings are without risk; anyone who held
stocks in their retirement accounts at the outset of the Great Recession–in
October 2008–can attest to that. Even government intervention can work
against savers; stimulus spending and increased inflation can both work
against the power of cash savings.
When a government provides an economic stimulus package to its citizens, it
typically finances those expenses through additional sovereign debt (which will
eventually have to be paid off by future generations). From one perspective, this
means that savers are forced to bail out non-savers at some point in the future.
Simply printing more money is another way that governments may pay for
legislation that includes a federal stimulus. When this happens, there's a
higher risk of inflation. Inflation can be said to be the number-one killer of
savings.
With inflation, each dollar in your savings account has less real purchasing
power. Purchasing power is the value of a currency expressed in terms of the
amount of goods or services that one unit of money can buy. When there are
high rates of inflation, one unit of currency–for example, one U.S. dollar–is not
capable of purchasing the same amount of goods as in a prior period.
While the risks of inflation are real, when there are high rates of personal
savings, there is less need for government stimulus. This is because the
nation's finances are shored up at the consumer level. As with most economic
crises, the national savings rate shot up in the aftermath of the Great
Recession. This trend was likely partially the result of those people who could
afford to save making the decision to stash their cash in anticipation of tougher
times ahead.
 
  Wealth Function
o  The financial system provides a means to store purchasing power
until needed for future spending or goods and services. For those
businesses and individuals choosing to save, the financial
instruments sold in the money and capital markets provide an
 excellent way to store wealth (i.e., preserve the value of assets we
hold) until funds are needed for spending. Although we might
choose to store our wealth in "things” (e.g., automobiles), such
items are subject to depreciation and often carry great risk of loss.
However, bonds, stocks, and other financial instruments do not
wear out over time and usually generate income; moreover, their
risk of loss often is much less than for other forms of stored
wealth.
 
What is wealth?
For any individual, business firm, or government, wealth is the sum of
the values of all assets held. Some authorities prefer a concept called net
wealth that equals all the assets held by an economic unit minus the
debts (liabilities) it owes. Both wealth and net wealth are built up by a
combination of current savings plus income earned on previously
accumulated wealth.
 
Wealth measures the value of all the assets of worth owned by a person,
community, company, or country. Wealth is determined by taking the
total market value of all physical and intangible assets owned, then
subtracting all debts. Essentially, wealth is the accumulation of scarce
resources. Specific people, organizations, and nations are said to be
wealthy when they are able to accumulate many valuable resources or
goods. Wealth can be contrasted to income in that wealth is a stock and
income is a flow, and it can be seen in either absolute or relative terms.
NOTE:
Wealth is an accumulation of valuable economic resources that can be
measured in terms of either real goods or money value.
 
Net worth is the most common measure of wealth.
 
The concept of wealth is usually applied only to scarce economic goods; goods
that are
 
  Liquidity Function
o  The financial system provides a means of raising funds by
converting securities and other financial assets into cash balances.
For wealth stored in financial instruments, the financial
 marketplace provides a means of converting those instruments
into cash with little risk of loss. Thus, the financial markets
provide liquidity for savers who hold financial instruments but are
in need of money. In modern societies, money consists mainly of
deposits held in banks and is the only financial instrument
possessing perfect liquidity. Money can be spent as it is without
the necessity of converting it into some other form. However,
money generally earns the lowest rate of return of all assets traded
in the financial system, and its purchasing power is seriously
eroded by inflation. That is why savers generally minimize their
holdings of money and hold other financial instruments until they
really need spendable funds.
REMEMBER:

Before investing in any asset, it's important to keep in mind the asset's liquidity
levels since it could be difficult or take time to convert back into cash. Of course,
other than selling an asset, cash can be obtained by borrowing against an
asset. For example, banks lend money to companies, taking the companies'
assets as collateral to protect the bank from a default. The company receives
cash but must pay back the original loan amount plus interest to the bank.
Liquidity in the Market
 
Market liquidity refers to a market's ability to allow assets to be bought and
sold easily and quickly, such as a country's financial markets or real estate
market.
The market for a stock is liquid if its shares can be quickly bought and sold
and the trade has little impact on the stock's price. Company stocks traded
on the major exchanges are typically considered liquid.

If an exchange has a high volume of trade, the price a buyer offers per share
(the bid price) and the price the seller is willing to accept (the ask price) should
be close to each other. In other words, the buyer wouldn't have to pay more to
buy the stock and would be able to liquidate it easily. When the spread
between the bid and ask prices widens, the market becomes less liquid. For
less liquid stocks, the spread can be much wider, amounting to a few
percentage points of the trading price.
 
The time of day is important too. If you're trading stocks or investments after
hours, there may be fewer market participants. Also, if you're trading an
overseas instrument like currencies, liquidity might be less for the euro
during, for example, Asian trading hours. As a result, the bid-offer-spread
might be much wider than had you traded the euro during European trading
hours.
 
BOTTOMLINE
Liquidity is important among markets, in companies, and for individuals.
While the total value of assets owned may be high, a company or individual
could run into liquidity issues if the assets cannot be readily converted to
cash. For companies that have loans to banks and creditors, a lack of liquidity
can force the company to sell assets they don't want to liquidate in order to meet
short-term obligations. Banks play an important role in the market by lending
cash to companies while holding assets as collateral.
 
Market liquidity is critical if investors want to be able to get in and out of
investments easily and smoothly with no delays. As a result, you have to be
sure to monitor the liquidity of a stock, mutual fund, security or financial
market before entering a position.
*** END of LESSON ***