CHAPTER 5 OVERVIEW OF THE FINANCIAL SYSTEM

ESSAY POSSIBILITY
FINANCIAL SYSTEM
- Complex structure and functions throughout the world

Why does the financial system important

- It is a necessary ingredient for a growing and prosperous economy
- Companies raising capital to finance capital expenditures and investors saving to
accumulate funds for future use require well-functioning financial markets and
institutions
NATURE AND OBJECTIVE OF FINANCIAL SYSTEM
Having a well-functioning financial system in place that directs funds to their most productive
uses is a crucial prerequisite for economic development.

Flow of funds through financial system

Funds of:
Lenders-savers
1. Households
2. Business firms
3. Government
4. Foreigners

Funds will GO TO:

Indirect finance – Financial Intermediaries
Direct finance – Financial markets
What is direct finance?
- Direct finance - lets the borrowers borrow directly from the lenders in FINANCIAL MARKETS by
selling them securities (also called financial instruments)
From Direct/Indirect to:
Borrowers/spenders
1. Business firms
 2. Government
3. Households
4. Foreigners

KEY COMPONENTS OF THE FINANCIAL SYSTEM

1. Financial instruments
2. Financial markets and financial institutions
3. The central bank and other financial regulators

Functions of the financial system

What is the function of the financial system?
- To channel funds from sectors that have a surplus to sectors that have a shortage of
funds
1. Risk sharing
- Is 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 is known as

2. Liquidity
- Is the ease with which an asset can be exchanged for money which savers view as a
benefit.
Securitization – the financial system has increased the liquidity of many assets besides stocks
and bonds through the process of

3. Information
- Third service of the financial system
- Collection and communication of information

The problems of adverse selection and moral hazard

- Savers do not lend to borrower’s wo are unlikely to pay them back
INFORMATION
- Is the vital service of the financial system is the collection and communication of

The problems of adverse selection and moral hazard

Asymmetric information – it describes the situation in which one party to an economic
transaction has better information than does the other party

Two problems arising from asymmetric Information are

1. Adverse selection – this is the one of the investors problems faced in distinguishing low-
risk borrowers from high-risk borrowers before making an investment.
2. Moral hazard – It is one of the investors problems in assuring that the borrowers are
using their fund as intended.

Adverse selection
- Information asymmetry arises because usually borrowers have more knowledge or
information about their investment project than lenders
- Borrowers who are most eager to engage in a transaction are the most likely ones to
produce an undesirable outcome

NATURE AND IMPACT OF TRANSACTIONS AND INFORMATION COST

1. Transaction cost
- The cost of the trade or the financial transaction
2. Information cost
- Cost that savers incur to determine the creditworthiness of borrowers and to monitor
how they used the funds acquired

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
2. Imposing restrictive covenants
- Limitations on the uses of fund borrowed
- Immediate payment of loan if the borrower’s net worth drops

EXPLAIN ECONOMIES OF SCALE

CHAPTER 6
STRUCTURE OF THE PHILIPPINE FINANCIAL SYSTEM
I. Bangko Sentral ng Pilipinas
II. Namkimg imstitutions
III. Non-Financial Institutions

II. BANKING INSTITUTION

A. Private banking Institutions
1. Expanded Commercial Banks/Universal Banks
2. Commercial Banks
3. Thrift Banks
a. Savings and mortgage banks (SMB)
b. Private Development banks (PDB)
c. Stock Savings and Loan Association (SSLA)
4. Rural Banks
5. Cooperative Banks

B. Government Banking Institutions

1. Development Bank of the Philippines (DBP)
2. Land Bank of the Philippines (LBP)
3. Philippine Al-Amanah Islamic Investment Bank
III. Non-Bank Financial Institutions
A. Private Non-Bank Financial Institutions
1. Investment Houses
2. Investment banks
3. Financing Companies
4. Securities dealers/brokers
5. Savings and loan associations
6. Mutual funds
7. Pawnshops
8. Lending Investors
9. Pension funds
10. Insurance Companies
11. Credit union

B. Government non-bank financial institutions

1. Government Service Insurance System (GSIS)
2. Social Security System
3. Pag-ibig

BRIEF DESCIPTION OF THE FINANCIAL INSTITUTIONS

Banking institutions
A. Private Banking institutions
1. Expanded commercial bank/Universal Bank
- Any commercial bank, which performs the investment house function in addition to its
commercial banking authority
2. Commercial bank or Domestic bank
- A commercial bank that is confined only to a commercial bank function
- Such as accepting drafts
- Issuing letters of credit
3. Thrift Banks
- Include savings and mortgage banks, stock savings and loan associations and private
development banks
- Their function is to accumulate the savings of depositors and investment them together
with their capital, loans secured by Bonds, mortgages
 A. Stock Savings and Mortgage Bank
- Is Any corporation organized for the purpose of accumulating the savings of depositors
- Readily marketable bonds and securities
B. Private development Banks
- Is a bank that exercises all the powers and assumes all the obligations of the savings and
mortgage bank
C. Stock Savings and Loan Association (SLA)
- Is any corporation engaged in business of accumulating the savings of its members or
stockholders
4. Rural Bank
- Is any bank authorized by the Central Banks to accept Deposits and make Credit
available to farmers,
5. Cooperative Banks
- Banks established to assist the various cooperatives by lending those funds at
reasonable interest rates.

B. GOVERNMENT BANKS or Specialized Government Banking Institutions

1. Development Bank of the Philippines (DBP)
- Provides loans for developmental purposes
- Gives loans to the agricultural sector
2. Land Bank of the Philippines
- Is a government bank, which provides financial support in the implementation of CARP
3. Al-Amanah Islamic Investment Bank
- Republic act 6048
- Development of Autonomous region

Non-Bank Financial Institutions

1. Investment House –
- Any enterprise which engages in underwriting securities
- Also generate income from sale of investment in securities
2. Investment banks
- Goldman Sachs & Morgan Stanley
- Provide advice to firms issuing stock
3. Financing Company
 - Any business enterprise where the primary purpose is o extend credit facilities to
consumers
4. Securities Dealer
- Any person or entity engage in the business of buying and selling securities for his own
or its client
5. Savings and Loan Associates (S&Ls)
- Traditionally served individual savers and residential and commercial mortgage
borrowers, accumulate funds of many small savers
6. Mutual funds
- Are corporations which accept money from the savers and then use these funds to buy
stocks
7. Pawnshops
- Refer to person engaged in the business of lending money with personal property
8. Lending Investor
- Is any person or entity engaged in the business of effecting securities transactions
9. Pension funds
- Are retirement plans funded by corporations or government agencies for their workers
10. Insurance companies
- Take savings in the form of ANNUAL PREMIUMS, then invest these funds in stocks, bonds
11. Credit Unions
- Are cooperative associations whose members have a common bond such as being
employees of the same firm.

Government Non-bank Financial Institutions

1. Government Service Insurance System (GSIS)
- Provides retirement benefits, housing loans personal loans
2. Social Security System
- Provides retirement benefits, funeral benefits, housing and personal loans
3. Pag-Ibig
- Provides housing loans to both government and private employees

FOUR REGULATORY AGENCIES

1. BSP
2. SEC
3. IC
 4. PDIC

Regulatory Landscape
A. Alignment with Global standards
- BSP Circular No. 975
B. Deepening Capital Markets
Alternative options for raising funds or for investing money
- Dollar denominated securities
- Exchange-traded funds
- Green bonds (upcoming)
- Personal equity and retirement account
- PHP government fund FORWARD
- Public private partnership shares, and
- Real estate investment trust
C. Strengthening surveillance

CURRENT RISK IN THE PHILIPPINE FIANCNIAL SYSTEM

A. Repricing, Refinancing, Repayment risk (3rs)
B. Developments in credit market
C. Continuous demand for credit by corporate enterprises and households is evident in the
domestic economy
CHAPTER 8
Money markets
- Is a network of corporation, financial institution, investors and governments which deal
with the flow of short-term capital.
- SHORT-TERM LIQUIDITY TRANSACTION
What does the Money markets do
- Buying and selling of debt instruments
- One year or less
Money markets
- Is a short-term instrument with an original maturity of less than one year
TYPES OF MONEY-MARKETS INSTRUMENTS
Commercial paper
- Is a short-term debt obligation of a private-sector firm or a government-sponsored
corporation.
- Only good credit rating corporation
- Lifetime or maturity of greater than 90 days but less than 9 months
Banker’s Acceptance
- Banker’s acceptance is the main way for firms to raise short-term funds in the money
markets.
- Is a promissory note issued by a non-financial firm to a bank in return for a loan.
Treasury bills
- Also known as T-BILLS
- It is a securities with a maturity of one year or less, issued by national government
- Safest of all possible investment in that currency
Government agency notes
- National government agencies and government sponsored corporations are heavy
borrowers in the money markets
Local government notes
- Are issued by, provincial or local governments and by agencies of these governments
Interbank loans
- Loan extended from one bank to another with which it has no affiliation are called
interbank loans.

Time deposits
- Other name for Certificate of Deposit, are interest-bearing bank deposits that cannot be
withdrawn without penalty before a specific date.
Repos
- They serve to keep the markets highly-liquid
- It is a combination of two transaction
1. A securities dealer such as banks, sells its own securities it owns to an investor
2. The seller and buyer must have an agreement that the seller must repurchase the
securities at a specified higher price at a future date
Capital Markets
- Is a financial market where longer-term debt and equity instrument are traded,
- Bond, Stocks, mortgages
Capital Market Participants
Primary issuers of capital market securities
1. National and local government – issue long term notes and bonds
2. Corporations – both bonds and stock
Capital Market Trading
- Occurs in either primary market or secondary market
Primary market
- Where the new issues of stocks and bonds are introduced
IPO
- When the firms sell securities for the very first time, the issue is an
Secondary market
- Is the place where the sale of previously issued securities take place
TWO TYPES OF EXCHANGES IN SECONDARY MARKET
1. Organized exchange – Has a building where securities (stocks, bonds, options, futures)
are exchange
2. Over-the-counter exchange

BONDS
- Is any long-term promissory note issued by the firm
- A bond certificate is the tangible evidence of debt issued by a corporation or a
governmental body.

Trading process of corporate bonds.

- The initial or primary sale of corporate bond issues OCCURS through a PUBLIC
OFFERING using an investment bank as a security under writer or through a private
placement of a small group of investors
Other arrangement can be as follows
1. Competitive sale
- Can purchase the bond through competitive bidding
2. Negotiated sale
- A single investment banks obtain the exclusive rights
3. Best effort underwriting basis
- The investment bank does not guarantee a firm price for the issuer

Advantage and dis advantage of using bonds.

Advantage
1. Long-term debt is generally less expensive than other form of financing
2. Bondholders does not participate in extraordinary profits
3. Bondholders do not have voting rights
4. Flotation cost is less than those ordinary equity shares
Disadvantage
1. Debt result to interest payment that if not met, can force the firm into bankruptcy
2. Debt produces fix charges
3. Debt must be repaid at maturity
4. Restrictive nature of indenture covenants may limit the firm’s future financial flexibility
Bond Features and prices
1. Par value
- Face value of the bond that is return to the bondholder
2. Coupon interest rate
- Percentage value of the bond that will be paid annually in the form of interest
3. Maturity
- Length of the time until the bond issuer returns the par value

4. Indenture
- Agreement between the firm issuing bonds and the bond trustee
5. Current yield
- Refers to the ratio of annual interest payment
6. Yield to maturity
- Bond’s internal rate of return
- It is the discount rate

Credit quality risk

- Is the chance that the bond issuer can’t make timely payments
Bond ratings are favorably affected by:
a. A low utilization of financial leverage
b. Profitable operation
c. A low variability of past earnings
d. Large firm size
e. Little use of subordinated debt
Types of bonds
A. Unsecured Long-term bonds
Debentures
- Unsecured long-term debt and is backed only by the reputation and financial stability of
the corporation
Subordinated debentures
- Claims of bondholders of subordinated debentures are honored only after the claims of
secured debt
Income bonds
- Income bonds requires interest payments only if earned and non-payment of interest
does not lead to bankruptcy

B. Secured Long-term bonds

Mortgage bonds
- Is bond secured by a lien on real property
Mortgage bonds can further be subclassified as follows
a. First mortgage bonds
- Has the senior claim on the secured assets
b. Second mortgage bonds
- Have the second claim on assets
c. Blanket or general mortgage bonds
- All assets of the firm are used as security
d. Closed-end mortgage bonds
- Forbid the further use of the pledged assets security for other bonds
e. Open-end mortgage bonds
- Allow the issuance of additional mortgage bonds using the same secured assets as
security
f. Limited open-end mortgage bonds
- Allows the issuance of additional bonds up to a limited amount
Other types of bonds
1. Floating rate or Variable rate bonds
- Is one which interest payment changes with market condition
- In a period of unstable interest rates this type of debt offering becomes appealing
2. Junk or Low-rated bonds
- Rated BB or below
- Major participant of this market are new firms that do not have an established record
3. Eurobonds
- These are bonds payable or denominated in the borrower’s currency
- Denominated by bonds stated in US DOLLARS
4. Treasury Bonds
- Carry the “full-faith-and-credit” backing

ORDINARY Equity shares

Is a form of long-term equity that represents ownership interest of the firm
Residual owners – ordinary equity shareholders are called

Features of ORDINARY EQUITY SHARES

1. Par value/No par value
- May be sold with or without par value
2. Authorized, Issued, and Outstanding
-Authorized shares is the maximum number of shares that a corporation may issue WITHOUT
amending its charter.
Issued shares – Number of authorized shares that have been SOLD
Outstanding shares – shares held by the public
Treasury shares – Previously issued shares that are reacquired
3. No maturity
- Ordinary share has no maturity and is a permanent form of long-term financing
Tender offer – formal offer to purchase shares of corporation
4. Voting Rights
- Each ordinary equity generally entitles the holder to vote
Proxy – is temporary transfer of the right to vote to another party
Majority voting – entitles each shareholders to cast one vote
Cumulative voting – permits shareholders to cast multiple votes

5. Book value per share

- Accounting value of an ordinary equity share is equal to the ordinary share equity
6. Numerous right of stockholders

Pre-emptive right- right to share proportionally in the purchase of any NEW ISSUANCE of
equity shares
C. Preferred Share
Preferred share – is a class of equity shares which has preference over ordinary equity shares
Preference – means only that the holders of the preferred share must receive a dividend

Preferred share features

1. Par value
- Is the face value that appears on stock certificate
2. Dividends
- Percentage of the par value and are commonly fixed and paid quarterly
3. Cumulative and non-cumulative dividends
4. No definite maturity date
5. Convertible preferred share
6. Voting rights
7. Participating features
8. Protective features
9. Call provision
10. Maturity

Preferred share - is share that has a claim against income and asset before ordinary share