Big Picture A

Week 1–3: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Discuss the importance of an efficient financial system.
b. Differentiate the types of financial markets.

Big Picture in Focus: ULOa. Discuss the importance of an efficient

financial system.

Metalanguage
For you to demonstrate ULOa, you will need operational understanding of the
terms enumerated below.
1. Financial System. This refers to a network that facilitates a more efficient
transfer of funds between savers and borrowers.

2. Financial Markets. This refers to the system that allows buy and sell of
financial instruments by the market participants

3. Financial Institutions / Financial Intermediaries. This refers to the banks or

non-bank institutions that act as mediators to facilitate financial transactions.

4. Financial Regulators. This refers to the government agencies that supervises

the financial activities and ensures to maintain safety and protection of the
investing public.

5. Asymmetric Information. This refers to information that market participants

may have about their opportunities or activities that they do not disclose and
can take advantage of it.

6. Direct Transfer. This refers to the condition wherein a corporation sells its
stock or debt directly to investors without going through a financial institution.

7. Indirect Transfer. This refers to the transfer of funds between suppliers and
users of funds through a financial institution.

8. Price Risk. This refers to the risk that an asset’s sale price will be lower than
its purchase price.
Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the first 3 weeks of
the course, you need to fully understand the following essential knowledge lay
down in the succeeding pages. Please note that you are not limited to exclusively
refer to these resources. Thus, you are expected to utilize other books, research
articles and other resources that are available in the university’s library e.g. ebrary,
search.proquest.com etc., and even online tutorial websites.
1. Financial System. In finance, the term financial system is used to describe a
system that allows money to flow between savers and borrowers. It plays the key
role in the economy as this system provides channels to transfer funds from
individual and groups who have saved money to individuals and group who want
to borrow money in a safe and efficient manner.
2. Functions of Financial System. The functions of financial system include the
following:
• Works as an effective channel for optimum allocation of financial resources
in an economy.
• Helps in establishing a link between the savers and the investors.
• Allows ‘asset-liability transformation’. Banks create claims (liabilities) against
themselves when they accept deposits from customers but also create
assets when they provide loans to clients.
• Facilitate transfers of economic resources (i.e., funds) from one party to
another.
• Ensures the efficient functioning of the payment mechanism in an economy.
• Helps in risk transformation by diversification, as in case of mutual funds.
• Enhances liquidity of financial claims.
• Helps price discovery of financial assets resulting from the interaction of
buyers and sellers. For example, the prices of securities are determined by
demand and supply forces in the capital market.
• Helps reducing the cost of transactions.

3. Services Provided by the Financial System.

3.1 Risk Sharing: Financial system provides risk sharing by allowing savers to
hold many assets which means it enables individuals to transfer risk. The
ability of the financial system to provide risk sharing makes savers more
willing to buy borrowers’ IOUs. This willingness, in turn, increases
borrowers’ ability to raise funds in the financial system.

3.2 Liquidity: The financial system provides savers and borrowers liquidity.
This means that an asset can be easily converted to money to purchase
other assets or exchanges for goods and services. Generally, savers would
want to hold highly liquid assets to be more flexible that allows them to
respond quickly to new opportunities or unexpected events.

3.3 Information: The financial system has two informational roles, namely:
collection and communication of information. The first informational role
the financial system play is to gather information about the prospective
 borrowers and what they will do with the funds. This is important because of
the presence of asymmetric information which refers to information that
borrowers may have about their opportunities or activities that they do not
disclose to lenders or creditors and can take advantage of it. The second
informational role that financial system plays is communication of
information. Financial system thru the financial market can incorporate
information into the prices of stocks, bonds, and other financial assets. For
as long as market participants are informed, the information would be
reflected into asset returns and prices.

4. The three main components of financial system and their roles are:

4.1 Financial markets. This component is a system that enables participants to

buy and sell financial instruments and facilitates the flow of funds to finance
investments of corporations, government, and individuals.

4.2 Financial institutions. This component represents the key players in the
financial markets as they perform intermediary functions; therefore,
determine the flow of funds. This includes banks and non-bank institutions
like insurance companies, investment houses, financing companies,
securities dealers and brokers, pawnshops, non-stock savings and loan
associations, cooperatives, and the like.

Importance of Financial Institutions

Without financial institutions, there would be a direct transfer of funds from

suppliers of funds to users of funds. In the same manner, financial claims
would flow directly from users of funds to suppliers of funds. In this situation,
suppliers of fund will not be attracted to invest which will result to a low level
of flow of funds and lesser financial market activities. This is likely to happen
because without financial institutions, there will be:
1. high monitoring costs
2. liquidity concerns
3. price risk

With the presence of financial institutions in the financial system, there is

indirect transfer of funds from the suppliers to the ultimate users of funds.
The following are the services performed by the financial institutions:

Services benefiting suppliers of funds:

1. Lower monitoring costs

2. Higher liquidity and lower price risk
3. Reduced transaction costs
4. Maturity intermediation – financial institutions can better handle
mismatching of maturities of their assets and liabilities
5. Denomination intermediation – financial institutions allow small investors
to overcome constraints to buying assets imposed by large minimum
denomination size
 Services benefiting the overall economy:

1. Money supply transmission

2. Credit allocation
3. Intergenerational wealth transfers – financial institutions provide savers
with the ability to transfer wealth from one generation to the next.
Example: life insurance companies and pension funds.
4. Payment services

4.3 Financial regulators. This component is responsible for monitoring and

regulating the participants in the financial system for the purpose of
ensuring safety and security. Among the regulatory bodies in the Philippines
are as follows:
• Securities and Exchange Commission (SEC) is a national regulatory
agency that oversees corporations, capital market participants, and the
securities and investment instrument market, to protect the investing public.
• Bangko Sentral ng Pilipinas (BSP) supervises operations of banks and
exercises regulatory powers over non-bank financial institutions with quasi-
banking functions.
• Insurance Commission (IC) regulates and supervises the insurance, pre-
need, and Health Maintenance Organization (HMO) industries in the
Philippines.
• Philippine Stock Exchange (PSE) is the only stock exchange in the
Philippines.

5. How Financial System Works. The activities in a financial system are depicted
in the diagram below:

Financial Regulators

Financial Institutions
[

Savings (Indirect) Lending

Savers
(those who have excess Borrowers
cash to invest: (those who need cash:
SURPLUS units) Lending DEFICIT units)

Savings
Lending
Financial Markets
[

(Direct)

Figure 1. How Financial System Works

Figure 1 shows that in a society there will always be individuals, firms, government
or any other institutions that either looking for good investments to place their
excess money (the savers or surplus units) or looking for funds to finance their
cash needs (the borrowers or deficit units). Primarily, the financial system
facilitates the matching of the supply and demand for funds through the financial
institutions and the financial markets. The savers have two options: save their
money through financial institutions or invest it directly to financial markets. Either
way, the objective of the saver is to increase the value of his money with the
earnings that he can get from his investment. Earnings from such investment vary
relative to the risk associated with the investment. Meanwhile, the collected
deposits by the financial institutions will then be made available by extending loans
to those qualified borrowers who will opt to get their financing needs from a financial
institution or financial institutions may also make the funds available to the
borrowers through the financial markets. Some borrowers may opt to get their
financing needs from the financial markets through issuance of financial
instruments like shares, bonds, money market, etc.

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Alimar-Mutya, R. F. (2017). Introduction to money, credit and banking.

Mandaluyong City: Anvil Publishing, Inc.

Darškuvienė, V. (2010). Financial markets. Retrieved from

https://www.bcci.bg/projects/latvia/pdf/7_Financial_markets.pdf.

Francis, A. (2010). Financial system – meaning, functions and services. Retrieved

from MBA Knowledge Base website: https://www.mbaknol.com/business-
finance/financial-system-and-its-functions

Laman, R. B., Laman, V. B., & Evia, Emiliana P. (2015). Financial system, market &
management: the basics. Manila: GIC Enterprises & Co., Inc.

Let’s Check

Activity 1:

TRUE or FALSE. Write TRUE if the statement is correct and FALSE if it incorrect.

__________ 1. Financial markets, financial institutions and financial regulators

must be present for a financial system to work efficiently and
effectively.
__________ 2. Financial system increases the liquidity of financial assets.
__________ 3. In a financial system, all information is always available to the
investing public.
__________ 4. Financial system allows risk sharing by making it possible for an
investor to hold various types of assets.
__________ 5. Financial institutions include only all types of banks.
__________ 6. It would be more beneficial if there are no financial institutions
because without them, financial costs will be lower.
__________ 7. Financial regulators ensure the safety and security of all the
participants in the financial system.
__________ 8. Direct transfer of funds from suppliers to borrowers is better
compared to indirect fund transfers.
__________ 9. Financial system provides risk sharing, liquidity and information.
__________ 10. Financial system collects information and communicates them to
the participants.

Activity 2:

ENUMERATION. Enumerate the following:

1. What are the three components of the financial system?

1.1 ___________________________________________________________
1.2 ___________________________________________________________
1.3 ___________________________________________________________

2. Give at least five (5) functions of the financial system?

2.1 ___________________________________________________________
2.2 ___________________________________________________________
2.3 ___________________________________________________________
2.4 ___________________________________________________________
2.5 ___________________________________________________________

3. What are the three components of the financial system?

3.1 ___________________________________________________________
3.2 ___________________________________________________________
3.3 ___________________________________________________________

Let’s Analyze

Activity 1. In this activity, you are required to elaborate your answer to the given
questions below.

1. Explain how financial system works.

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2. Discuss the importance of an efficient financial system in relation to a

country’s economy.

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In a Nutshell

Grasping the basic concepts of how financial system works is important towards
better investment decision making in the future. Based on the concepts presented,
write the three remarkable lessons you learned.

1. _____________________________________________________________
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2. _____________________________________________________________
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3. _____________________________________________________________
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Q&A List

Do you have any question for clarification? Write them here.

Questions/Issues Answers

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Keyword Index

Asymmetric information
Financial system
Financial markets
Financial institutions
Financial regulators