AE18-004 FINANCIAL MARKETS AND INSTITUTIONS

COLLEGE OF SAINT LAWRENCE, INC.

Balagtas, Bulacan

INSTITUTIONAL PHILOSOPHY
VISION
The College of Saint Lawrence will position itself as one of the leading institutions in providing
the highest standard of quality and affordable education to our students, to recognize and enjoy financial
and economic benefits and to develop responsible citizens of our society.
MISSION
 To strictly implement the Manual of Operation and Course Syllabus as prescribed by the
Department of Education (DepEd), Technical Education and Skills Development Authority
(TESDA) and Commission on Higher Education (CHED).
 To establish targets and objectives for all members of the Faculty and Students and provide
mechanisms to check its strict implementation.
 To update and revise the said Manuals periodically to ensure its relevance and effectiveness.
 To involve and consult with parents in making relevant decisions in the affairs and education of
our students.
 To provide students with a balanced educational experience through formal education and actual
apprenticeship in various establishments so that all acquired theories, ideas, concepts and skills
shall be blended well with practical work application and proper attitude.
 To focus the development program of Science and Technology in the field of Business, Education,
Electronics, Computer and Information Technology.

SUBJECT: FINANCIAL MARKETS AND INSTITUTIONS

COURSE/YEAR: BSA-II
COURSE TOPIC: THE FINANCIAL SYSTEM
PROGRAM OBJECTIVES:
During the chapter, the learners are expected to:
 Understand the financial system in the Philippines
 Describe the structure of the Philippine Financial System
PROGRAM OUTCOMES:
After studying the chapter, the learners should be able to:

 Differentiate banks by defining their meaning and purpose.

 Identify the elements of financial system.

FINANCIAL INTERMEDIATION
One of the most familiar activities of financial firms is acting as financial intermediaries. Financial
intermediaries acts simultaneously as borrowers and lenders. The financial intermediary
actually borrows from one group in society, the surplus unit and lends to others, the deficit
spending unit, does pleasing itself at risk should some of the loans be defaulted. Some depositors
believe that they are using the bank to safe keep their deposits not realizing that they are creditors
of the bank. They in fact lent their money to the bank. We also have to take note that the financial
system provides facilities for the transfer of purchasing power from individual to individual and
from firm to firm both within the country and internationally. Since they keep detailed set of
records of transactions, the financial system is a primary source of statistics used in analyzing
national and international economic activities. The accepted measure of the aggregate output of
the economy is the gross national product. Correspondingly, the appropriate measure of the output
of any single industry is "value added" in that industry. Value added is defined as the difference
between the market value of the product produced and sold by the industry by way of financial

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intermediaries. The funds from savers to deficit spenders flow. The money market instruments
government securities, commercial papers, corporate and municipal bonds, mortgages and
common stocks are known as primary claims. This is because they are issued by the ultimate deficit
spending units mainly businesses and government. Banks, life insurance companies and mutual
funds issue claims of their own called secondary claims to attract the funds of individuals and firms.
Example of this claim includes savings deposit, life insurance policies and shares in mutual funds.
Financial intermediaries used these funds attracted through these claims to purchase the primary
claims issued by the deficit spending units.

ECONOMIC ROLE OF FINANCIAL INTERMEDIARIES

To understand the economic role of financial intermediaries, let us begin by assuming that there are
no financial institutions or markets- no banks, stock markets, money market mutual funds and so
forth. Now suppose you have P100,000 cash that you have saved and you like to earn it turn so that
the principal will grow. Unfortunately, because there are no financial institutions or markets, you
are denied of the opportunity.
Meanwhile, your neighbor Juan, a high school graduate, is on his second year of car repair shop
business. Last year, he earned 75,000 from the business using only an inexpensive, residential-
grade tools and machines. If he could get his hands on the P100,000 to purchase a modern- type
machine, he could make his services faster, more convenient and of higher quality, earn 20% per
year on his investment and boost his income appreciably. Unfortunately, there is no way Juan can
get a loan because there are no financial institutions available. He is prevented from moving up the
ladder of economic success by the absence of developed financial institutions and markets.
You and society at large are penalized by the absence of financial institutions. If you, the surplus
unit, could somehow get your funds to Juan, the prospective deficit unit, you and one could both
benefit. You could split the 20% return from his purchase of new machines. In a world without
financial intermediaries however that kind of arrangement is risky and unlikely to occur.

RISKS AND COSTS WITHOUT FINANCIAL INTERMEDIATION

Juan, learning of your desire to earn interest on your savings may approach you for a direct loan. He
may offer to pay you 10% per year on the loan suggesting that the two of you split the 20% return
on the state-of-the-art machines down the middle. But you may be reluctant to lend the money 21
because of asymmetric information which means that Juan has a better understanding of the
business. He has a better grasp of the likely risks and returns associated with a car repair shop
business than you do. asymmetric information gives rise to two problems that reduce your
willingness to lend Juan: adverse selection and moral hazard.

 Adverse selection
This is the tendency for those persons with the highest probability of experiencing financial
problems to seek out and be granted loans. (Such individuals are more likely to borrow and
are willing to pay relatively high interest rates to obtain funds) Not knowing Juan's financial
history or personal characteristics and being aware of the principle of adverse selection, you
be unwilling to make the loan.

 Moral hazard
The second problem associated with asymmetric information, moral hazard, occurs after a
loan is made. This arises because the debt contract allows the borrower to keep any and all
returns that exceed the fixed payments called for in the loan agreement. The borrower,
therefore, has an incentive to take on more risks that is consistent with the best interest of the
lender in an attempt to reap a higher return. Once you meet the loan to Juan, how can you be
sure he won't have the effort to run your P100,000 up to 1 million ? Because Juan stands to
lose only P100,000 but could gross P1 million from his risky venture, he has an incentive to
engage in "immoral" activities (from your perspective) with your money. Because you are not
well equipped to monitor Juan's activities after you make the loan to see that he does not
under risk with your funds, you may not be willing to loan him your hard-earned money.

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A major rationale for the existence of financial intermediaries is their ability to deal with
asymmetric information and the associated problems of adverse selection and moral hazard.
Financial institutions such as commercial banks, thrift institutions and finance companies specialize
in assessing credit risks of potential borrowers. Because of their access to private information such
as the loan applicant's deposit history, income, assets, liabilities and credit history, and because
they are equipped to monitor the borrowers activities, financial institutions are in a better position
to make better loan decisions.
Now consider a world with financial intermediaries. You deposit your funds in a bank or thrift
institution or by commercial paper issued by a finance company earning 5 to 7% interests in the
process. Juan approaches the bank for loan and is granted one at 16% interest. Because Juan earns
20% from his new shop and pays 16% on his loan, he comes out ahead. You're earn a 4% return on
your savings. (While the 4% rate is lower than the 10% rate you might have earned directly from
Juan, the lower default risk on your loan more than compensates you for your lower rate of return).
It goes to show that financial intermediaries are useful organizations that contribute materially to
the economic process and facilitates the flow of funds from his heartless you need to a deficit
spending unit, improving economic efficiency in the process. The society's welfare has been
enhanced capital expenditures have increased and boosted productivity and living standards.
TRANSACTION COST
Another problem associated with asymmetric information ,transaction cost, involves the money
and time spent carrying out financial transactions. An important element of this cost is the search
cost. Another element is the time and money you would likely have to spend before deciding to lend
to deficit spending units.
For example, you might have to spend time evaluating the viability of the new machines. In order to
protect yourself you might have to spend P5,000 to hire a lawyer to draw up a viable loan contract.
By pooling the fans of many savers, financial intermediaries take advantage of economies of scale,
permit diversification, specialization and division of labor. For instance, a bank or finance company
can use standard loan contract drawn up by its attorney for use in hundreds of loans. Both savers
and deficit spenders are benefited when transaction cost is reduced.
The problem of matching individual borrowers' needs with those of lenders cannot be
overestimated because borrowers and lenders have different needs. In some instances, brokers,
dealers, and investment bankers are able to mesh the needs of the borrowers and lenders directly,
through money and capital market transactions. but the predominant portion of funds transferred
today is channeled through financial intermediaries.

BENEFITS OF INTERMEDIATION
The process of intermediation does not only benefit both surplus and deficit spending units but also
the society at large that is because it increases economic efficiency and raises living standards.
 Benefits to Surplus Units
From the point of view of surplus units or savers, financial intermediaries provide certain
benefits by pooling the funds of thousands of individuals to overcome the obstacles that
stop savers from purchasing primary claims directly. Some of these obstacles are lack of
financial expertise, lack of information, limited access to financial markets, the absence of
many financial instruments in small denominations and regressive transaction costs.

Diversification, the spreading of risk made possible by pooling of funds, is extremely

important for the individual saver. Financial intermediaries have the funds to acquire the
large variety of claims needed to spread risk. While an individual may be unwilling to
purchase an individual stock with a 3% probability of default, he or she may be quite willing
to invest in a mutual fund or pension funds that hold 500 stocks each having a 3% default
probability. Likewise, an individual may be and willing to invest in a single mortgage but
quite willing to own a share of a large package of mortgages or a CD in a bank or savings and
loan association that holds thousands of similar mortgages.

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 Benefits to Deficit Units

From the viewpoint of the deficit spenders, financial intermediaries also broaden the range
of instruments, denominations and maturities an institution can issue which significantly
reduces transaction costs. It would be inconvenient for municipalities and corporations to
issue bonds in P500 and P1,000 units in order to attract funds directly from hundreds of
thousands of individual savers. If, in the absence of financial intermediaries they found it
impossible to market securities with maturities of more than 5 years, they would also
suffer. Imagine the chaos that would exist if each household seeking to take out a mortgage
on the new home had to first locate an individual or business that would lend the desired
amount at an acceptable interest rate. By reducing transaction costs and dealing more
effectively with the problem of asymmetric information, financial intermediaries increase
economic efficiency, boost economic activity and elevate living standards.

Principal
Principal Assets
Type of Intermediary Liabilities
(Uses of Funds)
(Source of Funds)
Depository Institutions:
Commercial Banks Deposits Mortgages, loans, government
securities
Savings and Loan Associations Deposits Mortgages, government securities
Mutual Savings Bank Deposits Mortgages, government securities
Credit Unions Deposits Consumer loans, small business
loans, subscribed share capital
Contractual Savings Institutions:
Life Insurance Companies Premiums Corporate bonds, mortgages
Fire Insurance Companies Premiums Bonds, stocks, government
securities
Private pension funds and Employee & Corporate stock and bonds
government retirement funds contributions
Investment Intermediaries:
Mutual Funds Shares Stocks, bonds
Finance Companies Stocks, bonds, Consumer and business loans
commercial paper
Money Market Mutual Funds Shares Money market instruments

THE PHILIPPINE FINANCIAL SYSTEM

The Philippine Financial System plays a vital role in our society and economy as a whole. It affects
the lives of every person, family, business and the government.
The financial system is greatly affected by our political, social and economic conditions in the
country. It is also greatly influenced by international entities such as the International Monetary
Fund (IMF), the Asian Development Bank (ADB) and other international institutions.
The Bangko Sentral ng Pilipinas supervises and regulates the financial system. It shall provide
policy directions in the areas of money, banking and credit. It shall have supervision over the
operation of banks and exercise such regulatory powers and other pertinent laws over the
operation of finance companies and non-bank financial institutions performing quasi-banking
functions. Its primary objective is to maintain price stability conducive to a balanced and
sustainable growth of the economy. It shall also promote and maintain monetary stability and
convertibility of the peso.
Commercial banks are considered the heart of our financial system. They hold the deposits of
millions of people, governments and business enterprises. They play a key role in the channeling of
funds. They make funds available through their lending and investing activities to borrowers who
could be businessman, business firms, governments and individuals. In so doing they facilitate the
flow of goods and services from producers to consumers including the financial activities of the
government. They help in the flow of goods and services in and out of the country.

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The ability of a bank to perform its task efficiently and harmoniously with economic needs and
economic goals depends in a large extent on the efficiency of management. Banks, just like any
other type of organization must be managed efficiently. They must be managed prudently,
profitably and safely.
Commercial banks are the heart of our financial structure since they have the ability, in
cooperation with the Bangko Sentral ng Pilipinas, to add to the money supply of the nation and thus
create additional purchasing power. When commercial banks extend new loans, money is created
in the form of new checking accounts. Whenever banks reduced loans, the money supply declines as
checks are written to be of those loans thus reducing the amount of funds in the checking accounts.
The Bangko Sentral ng Pilipinas strongly influences the ability and willingness of banks to make
loans by setting certain regulations and by utilizing certain policy tools.
Banks are the conduits through the which the Bangko Sentral ng Pilipinas implements its monetary
policies. Heading the Philippine financial system is the Bangko Sentral ng Pilipinas followed by the
Banking Institutions and the Non-Bank Financial Intermediaries.
STRUCTURE OF THE PHILIPPINE FINANCIAL SYSTEM
A. Bangko Sentral ng Pilipinas
B. Banking Institutions
a. Private Banking Institutions
i. Expanded Commercial Banks/Universal Banks (EKB/UB)
ii. Commercial Banks (KB)
iii. Thrift Banks
1. Savings and Mortgage Banks (SMB)
2. Private Development Banks (PDB)
3. Stock Savings and Loan Associations (SSLA)
iv. Rural Banks (RB)
v. Cooperative Banks
b. Government Banking Institutions
i. Development Bank of the Philippines
ii. Land Bank of the Philippines
iii. Philippine Al-Amanah Islamic Investment Bank
C. Non-Bank Financial Institutions
a. Private Non-bank Financial Institutions
i. Investment houses
ii. Investment companies
iii. Financing companies
iv. Securities dealers/brokers
v. Non-stock savings and loan associations
vi. Building and loan associations
vii. Pawnshops
viii. Lending investors
ix. Fund managers
x. Trust companies/departments
xi. Insurance companies
xii. Venture capital corporations

b. Government Non-bank Financial Institutions

i. Government Service Insurance System (GSIS)
ii. Social Security System (SSS)
iii. Pag-Ibig

A. Commercial Bank (KB) is any corporation, which accepts or creates demand deposits
subject to withdrawal by means of checks.
1. Universal Bank (UB) or Expanded Commercial Bank (EKB) is any commercial
bank, which performs the investment house function in addition to its Commercial

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Banking Authority. It may invest in the equities of allied and non allied enterprises.
Allied enterprises may either be financial or non-financial.

2. Commercial Bank or Domestic Bank (KB) is any commercial bank that is confined
only to commercial bank functions such as accepting bribes and issuing letters of
credit, discounting and negotiating promissory notes, drafts and bills of exchange, in
other evidences of debt, accepting or creating demand deposits, receiving other
types of deposits, and deposit substitutes, buying and selling foreign exchange, and
gold or silver bullions, acquiring marketable bonds and other debt securities, and
extending credit subject to such rules as the Monetary Board may promulgate.

*Thrift Banks ( TB) shall include savings and mortgage banks, stock savings and loan
association and private development banks. Their function is to accumulate the savings of
depositors and investing them together with capital loans secured by bonds, mortgages and
real estate and insured improvements thereon, chattel mortgages, bonds and other forms of
security or loans for personal or household finance, whether, secured or unsecured, foreign
financing for home building & home development; in readily marketable and debt
securities; in commercial papers and accounts receivables, drafts, bills of exchange,
acceptances or notes arising out of commercial transactions; and in such other investment
and loans which the Monetary Board may determine as necessary in the furtherance of
national economic objectives.

1. Stock Savings and Mortgage Bank ( SSMB) is any corporation organized for the
purpose of accumulating the savings of depositors and investing them, together with
its capital, in readily marketable bonds and debt securities; checks, bills of exchange,
acceptances or notes arising out of commercial transactions or in loans secured by
bonds, mortgages or real estate and insured improvements thereon and other forms
of security or in loans for personal or household finances weather secured or
unsecured and financing for house building and house development.

2. Savings and Loan Association (SLA) is any corporation engaged in the business of
accumulating the savings of its members or stockholders and using such
accumulation, together with its capital for loans and investment in securities of
productive enterprises, or insecurities of the government and its instrumentalities,
provided that they are primarily engaged in servicing the needs of household by
providing personal finance and long-term financing for home building and
development.

3. Private Development Bank (PDB) is a bank that exercises all the powers and shall
assume all the obligations of the savings and mortgage bank as provided in the
General Banking Act except as otherwise stated. The private development banks
help construct, expand and rehabilitate our agriculture and industry. It helps meet
the needs of these sectors. The Development Bank of the Philippines is the
government counterpart of the private development banks and helps the private
development banks augment their capitalization as provided under R.A. 4093 as
amended.
*Rural Banks (RB) is any bank authorized by the Central Bank to make credit available to farmers,
businessmen and cottage industries in the rural areas. Loans maybe granted by the rural banks on
the security of land without Torrents Title where the owner of private property can show 5 years or
more of peaceful continuous and uninterrupted possession of the land in the concept of ownership.
This will include portions of friar land estates or other lands administered by the Bureau of Lands
that are covered by sale contracts and purchases and have paid at least five years installment
thereon, without the necessity of prior approval and consent of the director of lands or portions of
other estates under the administration of the Department of Agrarian Reform.

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*Cooperative Banks are banks established to assist the various cooperatives by letting those funds
at reasonable interest rates.
B. Government Banks or Specialized Government Banks

1. Land Bank of the Philippines (LBP) is a government bank, which provides financial
support in implementation of the agrarian reform program (CARP) of the
government.

2. Al-Amanah Islamic Investment Bank: Republic Act No. 6048 provides the charter
of the Al-Amanah Islamic Investment Bank. This act authorizes the bank and
accelerate the socio-economic development of the Autonomous Region of Muslim
Mindanao by performing banking finance and investment operations, and to
establish and participate in agriculture, commercial and industrial ventures based
on the Islamic concept of banking.

3. Development Bank of the Philippines (DBP) provides loans for developmental

purposes, gifts loans to the agricultural sector, commercial sector and the industrial
sector.

C. Non-Bank Financial Institutions

1. Investment House is any enterprise, which engages in underwriting securities of

other corporations.

2. Financing Company is any business enterprise where the primary purpose is to

extend credit facilities to consumers into industrial, commercial or agricultural
entities either by discounting or factoring commercial papers or accounts, or by
buying installment contracts, leases, chattel mortgages or other evidences of
indebtedness, or by using motor vehicles heavy equipment and industrial
machineries and business and office equipment, appliance and other movable
properties.

3. Securities Dealer is any person engaged in the business of buying and selling
securities for his own account thereby making a profit from the difference between
is buying and selling of securities.

4. Securities Broker is any person engaged in the business of affecting securities

transactions and earn through commission basis.

5. Non-Stock Savings and Loan Association and Cooperative Credit Unions are
corporations engaged in the business of accumulating the savings of its members
which are usually confined to a well-defined group of persons and uses such
accumulated funds to lend to its own member-depositors.

6. Building and Loan Association is any corporations capital stock is periodically paid
by its stockholder members. Its purpose is to encourage frugality, homebuilding
among its members, and to loan its funds including funds it borrowed from its own
members. It also uses the accumulated funds to repay its stockholders upon
surrender of their shares.

7. Pawnshop refers to a person or entity engaged in the business of lending money or

personal property, jewelry, television, radio, camera, appliance, etc. delivered as a
security for a loan.

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D. Government Non-Bank Financial Institutions

1. Social Security System (SSS) provides retirement benefits, funeral benefits, housing
loans, personal loans, calamity loan to employees who are working in private
companies and offices.

2. Government Service Insurance System (GSIS) provides retirement benefits,

housing loans, personal loans, emergency and calamity loans to government
employees.

3. Pag-Ibig provides housing loans to both government and private employees.