Chapter 2

An Overview of the Financial System

This chapter provides an overview of the financial system in the economy by

describing the various functions and types of financial markets and financial
institutions.
PART 1: Financial Markets
Perform the essential function of channeling funds from economic players
that have saved surplus (savers) funds to those that have a shortage of funds
(investors).
Promote economic efficiency by producing an efficient allocation of capital,
which increases production.
Directly improve the well-being of consumers by allowing them to time their
purchases better.
Increase business profits
So, well-functioning financial markets can improve the economic welfare of
everyone in the society.
Generally, we distinguish between:
Direct finance: borrowers borrow funds directly from lenders in financial
markets by selling them securities (bonds, stocks etc).
Example:

issues new bonds or shares

Indirect finance: Financial intermediaries
 PART 2: Financial Intermediaries

1. Functions of Financial Intermediaries

1. lower the transaction costs

2. reduce the exposure of investors to risk
3. deal with asymmetric information problems.
borrowers to benefit from
the existence of financial markets.
Specifically, their main functions are as follows:
Lower transaction costs:
An investor might not have required expertise or time to research what assets
he should invest in. Financial intermediaries such as professional investment
firms have the expertise and research facilities to study firms in-depth and to
reduce the transaction costs involved in searching for credit information
including all fees search and information costs.
Reducing costs is possible through the existence of Economies of scale: Since
financial intermediaries handle large number of transactions, they are able to
spread out their fixed costs. (For example, a bank can use the same loan
contract forms for every new loan).
Liquidity services: Liquidity refers to the speed and ease of converting
assets into cash that allows conducting transactions. Although the
intermediary may use its funds to make illiquid loans, its size allows it to hold
some funds as cash to provide liquidity to individual depositors
Risk Sharing (Asset Transformation): They attract funds from individuals,
businesses, and government and then repackage these funds as new financial
products, such as loans, which satisfies different needs of savers and
borrowers in relation to the amount of funds, the risk levels, and the maturity
requirement.
They transfer certain financial risks (accidents, theft, illness) to another party
(e.g., the insurance company).
Risk management expertise: They are able to obtain sensitive information

Diversification: It means lowering the cost by investing in a collection

(portfolio) of assets whose returns do not always move together. Thus, the
overall risk is lower for individual assets.
Deal with asymmetric information problems: Asymmetric (imperfect)
Information (AI) is defined as information that is known to some people but
not to others.
Two problems are related to Asymmetric Information:
Adverse Selection (before the transaction): The adverse selection refers to
the problem before a loan is made because borrowers who are bad credit risks
tend to be those who most actively seek out loans. For example, someone with
a dangerous hobby may be more likely to apply for life insurance.
Financial intermediaries can help reduce the problem of adverse selection by
gathering information about potential borrowers and screening out bad credit
risks.
SO: Gather information about potential borrower: to avoid selecting the risky
borrower.
Moral Hazard (after the transaction): Moral Hazard is a problem after a
loan is made, and refers to the risk (hazard) that the borrower might engage in
activities that are undesirable (immoral) from the lenders point of view
because it may make it less likely that the borrower will repay the loan.
Financial intermediaries can help reduce the problem of moral hazard by

SO: ensure borrower will not engage in activities that will prevent him/her
to repay the loan. (Example: Sign a contract with restrictive covenants).
2. Types of Financial Intermediaries
1-
Take deposits and make loans.
Divided into two main groups:
1.1 Commercial Banks
Largest single class of financial institution
Issue wide variety of deposit products:
- Checking deposits
- Savings deposits
- Time deposits
Carry widely diversified portfolios of loans, leases, government securities,
etc.
SO: Many different assets to minimize risk
Besides their main function of taking deposits and making loans, they offer
many different services (for example may offer trust or underwriting
services).
Because of their vital role in the well-being of the communities, they are
highly regulated.
1.2 Thrift Institutions
They include:
(S&Ls)
Mutual Savings Banks

S&Ls and Mutual Savings Banks:

Now, closely resemble commercial banks (looser restrictions on them)
Focus more on savings deposits, and time deposits.
Specialize in maturity because they borrow small amounts of money mostly
in savings deposits and lend long term loans mostly on real estate collateral
(agreement).
Credit Unions
Small cooperative institutions (closed environment- Not open to all
depositors)
The members share some meaningful common association: (Employees of

Not for profit and tax-exempt)

Restricted mostly to consumer loans (buy a car, house: real estate...)
2- Contractual savings Institutions
Acquire funds at periodic intervals on a contractual basis (like insurance
companies and pension funds).
Steady inflow of funds from contractual commitments
(the liquidity of assets is not as important a consideration for them as it is for
depository institutions).
Invest in long term securities such as corporate bonds and stocks.
2.1. Life Insurance Companies
Insure people against financial hazards following a death.
Policy holders pay premiums, which are pooled and invested mainly in
corporate bonds and mortgages.
Investment earnings cover the costs and reward the risks of the insurance
company.
With trillions of dollars in assets in the US, they are among the largest of the
contractual savings institutions.
2.2. Casualty Insurance Companies

Sources and uses of funds resemble those of life insurance companies, but
causality claims are not as predictable as death claims (they represent more
risk)
Also, They get more assets in the short run than life insurance companies
(more liquid).
2.3. Pension Funds
Help workers plan for retirement
Workers and /or employees make contributions, which are pooled and
invested mainly in corporate bonds and stocks
Actively encouraged by mant governments, through legislation and tax
incentives.
3-Investment Funds (Intermediaries)
Two main categories:
3.1 Mutual Funds (MFs)

stocks and bonds.

Shareholders can sell (redeem) shares at ant time, but MF;s shares fluctuate
greatly (because combination of diversified portfolios).
Therefore, investments in MF can be risky.
3.2 Money Market Mutual Funds (MMMFs)
Same idea as MFs, BUT:
MMMFs buy money market instruments that are safe and very liquid.
Then pay investors an interest (like a depository institution).
3.3 Finance Companies
do not take deposits; instead they

- Commercial paper (a short-term debt instrument)

- Issuing stocks and bonds

and
mortgage loans.
3.4 Investment Banks
 ties (can advise the corporation on which type
of securities to issue (e.g. stocks or bonds)

corporation at a predetermined price and then resell them in the market)

as deal makers and earn enormous feed through operations of
M&A).

Part 3: Regulation of the Financial System

- To increase the information available to investors

- To ensure the soundness of financial intermediaries

Examples:
moral hazard problems
 ECON248 Chapter 3 Salman Marhoon 6666 8202

Money: money is anything generally accepted as a medium of exchange and a unit of account, for the
flow of goods and services between economic units.
Money falls into two categories:
1- Currency: paper money and coins.
2- Deposits: deposits at the banks and other depository financial institutions are also money.
Three Concepts:
Money: is the amount of money held by a particular person. (Stock)
Wealth: the total assets minus total liabilities of a person OR all properties that a person owns, and it
store value.
Income: the earnings of a person, through salary, sale of assets, etc. (Flow)
the goods and
services are traded between the economic units. i.e., there is no money, so if a person (A) wants a good or
a service from person (B), he or she must give person (B) a good or a service to get his/her good or a

Three problems where in the barter system, mainly the double coincidence of goods and services and:
- Absence of common medium of exchange.
- Absence of a common unit of account.
- Problem of storing value.
Therefore, money was invented along with three main functions:
3 Functions of Money:

1- Medium of Exchange
2- Unit of Account
3- Store of Value

Medium of Exchange: before money is invented, the problem of a common acceptable medium of
exchange was absent, so the money was the solution to this problem, a medium of exchange must:

- be easily standardized
- be widely accepted
- be divisible
- be easy to carry
- Durable

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Cont d

Note: the medium of exchange is what distinguishes money from the other assets.

The use of money as a medium of exchange promotes economic efficiency by minimizing the time spent
in exchanging goods and services, which is called transaction cost.

Unit of Account:

- used to measure value in the economy

- reduces transaction costs
Store of Value:
- used to save purchasing power over time.
- other assets also serve this function
- Money is the most liquid of all assets but loses value during inflation
There are two types of money:
Commodity Money: valuable, easily standardized, and divisible commodities (e.g., precious
metals, cigarettes). (Has intrinsic value)
Fiat Money: paper money decreed by governments as legal tender. (Its value is pushed by the
governments)
Payments Systems:
Checks: an instruction to your bank to transfer money from your account
Electronic Payment (e.g., online bill pays or BenefitPay).
E-Money (electronic money):
Debit card
Stored-value card (smart card)
E-cash

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Part Two, measuring money:

M1 is the narrowest measurement of money, it includes only the most liquid assets in the economy.
M1 = C + D
Where:

M2 is a broader measure, where it includes M1 and few other assets:

M2 = M1 + T + S + MM + MF

Where:
M1 = C + D
T = Time Deposits (small or large denomination time deposits)
S = Saving Deposits/Accounts
MM = Money Market Deposits (certificate of deposits CD s)
MF = Mutual Funds Shares

M3 -
components of M3 (other than M2) are assets of mostly large businesses and institutions. They are very
non-liquid assets, and hence not used as medium of exchange.

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Q1: Read the following table carefully, and calculate M1 and M2:
Particulars Value is US Million Dollars
Currency inside the bank s vault 89
Currency in hands of people 75
Checkable Deposits 25
Traveler s Checks 10
Saving Deposits 125
Small-denomination time deposits 75
Noninstitutional money market mutual funds shares 50
Money market deposits 25

Answer (Show Your Calculation):

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Answer:

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From the table below, calculate M1 and M2. (All figures in trillions)

Cash Money Market Accounts Checkable Deposits Certificates of Deposit Savings Accounts

1.3 2.7 2.0 6.4 4.1

M1 = trillion.
M2 = trillion.
Ans. M1= Cash + checkable deposits
M1= 1.3 trillion + 2.0 trillion
M1= 3.3 trillion
And
M2= M1 + money market accounts + certificate of deposits + savings accounts
M2 = 3.3 trillion + 2.7 trillion + 6.4 trillion + 4.1 trillion
M2 = 16.5 trillion

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