Presentation by Group 1

OVERVIEW
OF THE
FINANCIAL
SYSTEM
 Introduction

A healthy economy requires financial system that makes or channel funds

from people who save to people who have productive investment. The
financial system is complicated in structure and its functions. A developed
economy relies on financial markets and financial institutions for efficient
transfer of funds. The financial system has an impact on each person's life,
family, company, and government.
 Introduction
Over the past few decades changing technology and improving
communications have increased cross-border transactions and
expanded the scope and efficiency of the global financial
system. Companies routinely raise funds throughout the world to
finance projects all around the globe. These investors helped
spur global economic growth by providing capital to an
increasing number of individual throughout the world.

 Introduction

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 the 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.
Having a well-functioning financial system in place that
directs funds to their most productively uses is a crucial
prerequisite for economic development.

The arrows show that funds flow from lenders-savers to

borrowers-spenders via two routes.
In direct finance, borrowers borrow funds directly from
lenders in financial markets by selling them securities,
which are claims on the borrower's future income or
assets. Securities are assets for the person who buys
them buy liabilities.(IOU's or debts) for the individual or
firm that sells them.
 Key Components of
the Financial
System
The major components of the financial system include

A.) Financial Intermediaries

B.) Financial Markets and Financial Institutions

C.) The Central Bank and Other Financial Regulators

 Functions of the Financial
System
The primary function of the financial system is to transfer money
from sectors with a surplus to those with a shortage.

Banks, insurance companies, mutual funds, stock brokers, and

other financial services companies compete in the financial system
to offer financial services to individuals and businesses.
 Functions of the Financial
System
There are three key services that the financial system provides to
savers and borrowers and that is: risk sharing, liquidity, and
information.

And this financial services firms provide these services in three

different ways in which different financial assets and financial
liabilities makes more or less attractive to individual savers and
borrowers.

 01 Risk Sharing
Risk is the possibility that the value of financial assets will
fluctuate in relation to expectations. The ability to share risk is
one benefit of using the financial system to match individual
savers and borrowers. Instead of fluctuating funds between
high and low earning periods, the majority of individual savers
want a consistent return on their assets.

Diversification is the process of dividing up assets to spread

risk over a larger portfolio. Because the financial system
permits savers to possess a variety of assets, risk is shared.
 02 Liquidity
Liquidity is another key service that financial system offers savers and
borrowers is liquidity. It is the ease with which an asset can be
exchanged money in which savers view as a benefit. Generally, asset
is created by the financial system from stocks, bonds or checking
accounts, that are more liquid than physical assets such as cars,
machinery or real estate.

Financial markets and intermediaries helps financial assets more liquid

that the investors can easily sell their holdings of government
securities, stocks and bonds of large corporations and making those
assets a liquid.
 02 Liquidity

Financial system increase the liquidity of many assets besides stocks

and bonds through securitization. And this process made it possible to
buy and sell securities based on loans. And as a result of mortgages
and other loans jave been more desirable assets for savers to hold.
 03 Information
The third service of financial system is the collection and
communication of information, facts about borrowers
and expectations of returns in financial assets. Banks
collect information on borrowers to forecast their
likelihood of repaying laons. Cause the banks specializes
on collecting and processing the information, and its
costs information gathering are lower than yours would
be if you tried to gather information about a pool of
borrowers.

 03 Information
The profits of the bank earns on its loan is partly compensation for
the resources and time bank employees spend to gather and store
information. The financial markets convey the information to both
savers and borrowers by determining the stocks, bonds and other
securities prices.

This information can help one to decide whether they continue to

invest in the securities previously purchased or to sell more stocks
or bonds. Information into asset prices is important feature of
well-functioning financial markets.
The Problems of Adverse
Selection and Moral
Hazard
A key consideration for savers is the financial health of borrowers.
Savers do not lend to borrowers who are unlikely to pay them back.
Unfortunately for savers, borrowers in poor financial health have an
incentive to disguise this fact.

A vital service of the financial system is the collection and

communication of information or facts about borrowers and
expectations of returns in financial assets. Financial Market
convey information to both savers and borrowers by determining
the prices of stocks, bonds, and other securities.
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.

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.
 Sometimes an investor will consider the costs arising from
asymmetric information to be so great that the investor will lend
only to borrowers who are transparently low risk, such as the
national government. However, more generally, there are practical
solutions to the problems asymmetric information, in which
financial markets and financial intermediaries lower the cost of
information needed to make investment decisions.
The financial system helps overcome an information
asymmetry between borrowers and lenders. An
information asymmetry can occur before or after a
financial contract has been agreed upon.
Adverse Selection
The information asymmetry before the contract is agreed
upon arises because borrowers generally know more
about their investment projects than lenders. Borrowers
most eager to engage in a transaction are the most likely
ones to produce an undesirable outcome for the lender
(adverser selection). Individual savers may not have the
time, especially or means to collect and take advantage
of economies of scale and scope.
 Moral Hazard

Even after a lender has gathered information on whether

a borrower is a good borrower or a lemon borrower, the
lender's information problems haven't ended. There is a
situation called the moral hazard were there is possibility
that after a lender makes a loan to what appears to be a
good borrower. the borrower will not use the fund as
intended.
 Moral Hazard

Moral hazard is likely to occur when the borrower has

an incentive to conceal information or to act in a way
that does not coincide with the lender's interests.
Moral hazard arise because of asymmetric
information: The borrower knows more than the lender
does about how the borrowed funds will actually be
used.
 Nature and Impact of
Transaction and Information
Costs

Transaction Costs

The cost of trade or a financial transaction; for example,

the brokerage commission charged for buying or selling a
financial asset.
 Nature and Impact of
Transaction and Information
Costs

Information Costs

The cost that savers incur to determine the

creditworthiness of borrowers and to monitor how they
use the funds acquired.
 Nature and Impact of
Transaction and Information
Costs
Because of transaction costs and information costs, savers receive a lower
return on their investments and borrowers must pay more for the funds they
borrow. These cost can sometimes mean that funds are never lent or borrowed
at all. Although transactions cost and information cost reduce the effieciency
of the financial system, they also create a profit oppurtunity for individuals
and firms that can discover ways to reduce those costs.
 How Financial Intermediaries
Reduce "Adverse Selection"
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 perfomance and financial position.
Financial market participants and the goverriment have taken steps to try
to reduce problems of adverse selection in financial markets. The SEC
requires the publicly traded firms report their performance in financial
statements, such as balance sheets, which show the value of the firm’s
assets, liabilities, and stockholders’ equity (the difference between the
value of the firm’s assets and the value of its liabilities), and income
statements, which show a firm’s revenue, costs, and profit.
 How Financial Intermediaries
Reduce "Adverse Selection"
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 perfomance and financial position.

Firms must prepare these statements using standard accounting methods.

In addition, firms must disclose material information, which is information
that, if known, would likely affect the price of a firm’s stock.
 How Financial Intermediaries
Reduce "Adverse Selection"
The problem of "adverse selection" can be minimized if not
totally avoided using the following approaches:

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.
 How Financial Intermediaries
Reduce Moral Hazard
Problems
Financial Intermediaries can reduce moral hazard problems by adopting more
stringent procedures in monitoring the borrowers 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
purposes.
 How Financial Intermediaries
Reduce Moral Hazard
Problems

2. Imposing Restrictive Covenants

Restrictive covenants may involve placing limitations on the uses

of funds and borrowed or requiring the borrowers to pay off the
debt even before maturity date if the borrower's net worth drop
below a certain level.
 How Financial
Intermediaries Reduce
Transaction costs
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 services produced.

2. Financial Intermerdiaries can also take advantage of

economies of scale in other ways.
 How Financial
Intermediaries Reduce
Transaction costs
Transaction costs may be reduced by adopting the
following techniques:

3. Financial Intermediaries also take advantage of

technology to provide financial services, such as those
that automated teller machine networks provide.

4. Financial intermediaries also increasingly rely on

sophisticated software to evaluate the credit worthiness
of loan applicants.
Thank You
So Much!