Overview of the

Financial System

Chapter 5
 Learning Outcomes:

• Explain what financial system is as well as its objective

• Explain how the financial system affects a nation’s economy
• Discuss the flow of funds through the financial system
• Enumerate the key components of the financial system
• Explain the main functions of the financial system
• Distinguish between adverse selection and moral hazard
• Describe how financial intermediaries (a) reduce adverse selection;
(b) reduce moral hazard problems; (c) reduce transaction costs
 Nature and Objective of the
Financial System
Financial system – consists of all financial intermediaries and
financial markets and their relations with respect to the flow of
funds to and from households, governments, business firms and
foreigners, as well as the financial infrastructure.

- Having a well-functioning financial system in place that directs

funds to their most productive use is a crucial prerequisites for
economic development.
Let’s suppose:
Juan has P100,000 cash he saved and would like to earn a return so
that his savings can grow.
Pedro, his neighbor owns a car repair shop business. He wanted to
upgrade his machinery to make his services faster and would be
needing P100,000 to purchase that said modern-type machine.

If there are no financial institutions or markets, how would Juan and

Pedro be able to realize what they want?
FLOW OF FUNDS THROUGH THE FINANCIAL SYSTEM
INDIRECT FINANCE
FINANCIAL
INTERMEDIARIES

LENDER-SAVERS BORROWER-SPENDERS
1. Households 1. Business firms
FINANCIAL
2. Business firms 2. Government
MARKETS
3. Government 3. Households
4. Foreigners 4. Foreigners
DIRECT FINANCE
 Nature and Objective of the
Financial System
DIRECT FINANCE
- Borrowers borrow funds directly from lenders in financial
markets by selling them securities (financial instruments),
which are claims on the borrower’s future income or
assets.
- Securities – are assets for the person who buys them;
but liabilities (IOUs or debts) for individual or firm that
sells (issues) them.
 KEY COMPONENTS OF
THE FINANCIAL SYSTEM

The major components of the financial system include:

a. Financial instruments
b. Financial markets and financial institutions
c. The Central Bank and Other Financial Regulators
 Functions of the
Financial System
The main task of the financial system is to channel funds from
sectors that have a surplus to sectors that have a shortage of funds.

3 Key Services that the financial system provides to savers and

borrowers:
1. Risk sharing
2. Liquidity
3. Information
 RISK SHARING

Risk – the chance that the value of financial assets will change
relative to what one expects.
Diversification – splitting of wealth into many assets to reduce risk

The financial system provides risk-sharing by allowing savers to hold

many assets. Hence, because of the ability of the financial system to
provide risk-sharing makes savers more willing to buy stocks, bonds,
and other financial assets.
 LIQUIDITY

Liquidity – is the ease with which an asset can be exchanged

for money which savers view as a benefit. Generally, assets
created by the financial system are more liquid than are
physical assets.

Securitization – the process that make it possible to buy and

sell securities based on loans
 INFORMATION

Information – facts about borrowers and expectations of

returns on financial assets.

Financial markets convey information to both savers and

borrowers by determining the prices of stocks, bonds, and
other securities. This information can help one decide
whether to continue investing in the securities or to sell to
finance a planned expansion.
 INFORMATION

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.
 INFORMATION

Two problems arising from asymmetric information:

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
 Nature and Impact of Transaction and Information Cost

Transaction Costs Information Costs

The cost of a trade or a The cost that savers incur to

financial transaction. determine the
creditworthiness of borrowers
Example: the brokerage and to monitor how they use
commission charged for the funds acquired.
buying or selling a financial
asset
 How Financial Intermediaries
Reduce “Adverse Selection”
1. Requiring borrowers to disclose material information
on their financial performance and financial position.
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
1. Specializing in monitoring borrowers and developing
effective techniques to ensure that the funds they loan
are actually used for their intended purpose.
2. Imposing Restrictive Covenants
- Restrictive covenants may involve placing limitations
on the use of funds 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
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 service produced.
2. Financial intermediaries can also take advantage of economies of scale in
other ways (e.g., standardized legal contracts; efficiency of processing
loans through specialization)
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

References:
Cabrera, E. B., Cabrera, G. B., & Cabrera, B. B. (2022). Financial Markets and Institutions. Manila, Philippines: GIC Enterprises & Co., Inc.