ECON75 Lecture III. Financial System

FINANCIAL SYSTEM
MODULE 2
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At the end of the topics the student must be able to:
1. define financial system;

2. discuss the functions of financial system;
3. discuss the components of financial system
4. Discuss the Financial System of the Philippines
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WHAT IS FINANCIAL SYSTEM?
➢A financial system refers to a system which enables the transfer of
money between investors and borrowers. A financial system could be
defined at an international, regional or organization level. The term
“system” in “Financial System” indicates a group of complex and
closely linked institutions, agents, procedures, markets, transactions,
claims and liabilities within an economy.
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WHAT IS FINANCIAL SYSTEM?
➢ A set of arrangements / conventions embracing the lending and borrowing

of funds by non- financial economic units and the intermediation of this
function by financial intermediaries in order to facilitate the transfer of funds,
to create additional money when required, and to
create markets in debt and equity instruments (and their derivatives) so that the
price and allocation of funds are determined efficiently.
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OVERVIEW OF PHILIPPINES FINANCIAL SYSTEM
➢ The current Filipino financial system has been in place for the last
73 years and is constantly and consistently growing
➢ Currently ranks as the 47th largest economy in the world
➢ Member of the World Trade Organization and World Bank
➢ Has consistently been a strong market in Asia
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SIX (6) ELEMENTS OF FINANCIAL SYSTEM
1. BORROWERS AND LENDERS

- The same non-financial economic sectors appear on the other side of the
financial system as ultimate lenders. The members of the four sectors are
either lenders or borrowers or both at the same time. An example of the latter
is government: the governments of most countries are permanent borrowers
(usually long-term), while at the same time having short-term funds in their
accounts at the central bank (and the private banks in some cases), pending
spending. As noted before, borrowing and lending takes place either directly or
indirectly via the financial intermediaries.
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- The ultimate lenders (= surplus economic units) and borrowers (= deficit economic
units),
i.e. the non-financial economic units that undertake the lending and borrowing
process. The ultimate lenders lend to borrowers either directly or indirectly via financial
intermediaries, by
buying the securities they issue.
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• BORROWER (Spenders)
• A person or company that has received money from another party with the
agreement tha t the money will be repaid.
• LENDER (Savers)
• A Lender gives money to a borrower with the expectation of repayment in a timely
manner, almost always with interest.
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Gurley and Shaw created these terms in the 1960s2. They showed that each of the sectors
of the economy conform to the following identity (notation amended):
Three budget conditions:
I – E = ΔFA – ΔDE. ➢ Deficit unit = E > I; therefore ΔDE > ΔFA,
meaning that the economic unit is a
Where :
net borrower of funds.
I = Income ➢Surplus unit = I > E; therefore ΔFA > ΔDE,
E = Expenditure meaning that the economic unit is a
FA = Financial Assets net lender of funds.
DE = Debt or Equity ➢ Balanced unit = I = E; therefore ΔFA = ΔDE,
meaning that the economic unit is neither a net
borrower of funds nor a net lender of funds.
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2. FINANCIAL INTERMEDIARIES
Financial intermediaries exist because there is a conflict between lenders and borrowers in
terms of their financial requirements (term, risk, volume, etc.). For example, members of
the household sector as lenders generally have a need for current account deposits (i.e.
essentially 1-day deposits), while government's borrowing needs range from 3 months to
30 years. Another example: a surplus company may wish to lend for 3 months, while a
deficit company may wish to borrow for 2 years.
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2. FINANCIAL INTERMEDIARIES
The financial intermediaries solve these divergent requirements by (for example) investing
in the instruments of debt of government with the short-term funds of the household sector
invested with them. They also perform many other functions such as lessening of risk for
lenders, creating a payments system, the efficacy of monetary policy, and so on.
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Direct & Indirect Financing
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Direct & Indirect Financing

Direct Finance - Borrowers borrow directly from lenders in financial markets
by selling financial instruments which are claims on the borrower’s future
income or assets.
Indirect Finance - Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable funds and loan
opportunities) by issuing financial instruments which are claims on the
borrower’s future income or assets.
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TYPES OF FINANCIAL INTERMEDIARIES
Mutual Fund Companies: The mutual fund organizations club the amount
collected from various investors. These investors have identical investment
objectives and risk- taking ability. The funds are then collectively invested in
the securities, bonds, and other investment options, to ensure a capital gain in
the long run.
Insurance Companies: These companies provide insurance policies to the
individuals
and business entities to secure them against accident, death, risk, uncertainties
and default. For this purpose, they accept deposits in the form of premium,
which is pooled into profitable investments to gain returns. The insured person
can claim the money in case of any mishap as per the agreement.
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Banks: The central and commercial banks are the most well known financial
intermediaries simplifying the lending and borrowing process, along with
providing various other services to its customers on a large scale.
Credit Unions: These are the cooperative financial units which facilitate
lending and borrowing of funds to provide financial assistance to its members.
Non-Banking Finance Companies: A NBFC is a financial company engaged
in activities such as advancing loans to its clients at a very high rate of interest.
Stock Exchanges: The stock exchange facilitate the trading of securities and
stocks, and in every trading activity, it charges the brokerage from each party
which is its profit.
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Financial Advisers or Brokers: The investment brokers also collect the funds
from various investors to invest it in the securities, bonds, equities, etc. The
financial advisers even provide guidance and expert opinions to the investors.
Investment Bankers: These banks specialize in services like initial public
offerings (IPO), other equity offerings, proving for mergers and acquisitions,
institutional client’s
broker services, underwriting debts, etc. As a result of constant mediation,
between the investor or public and the companies issuing securities.
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Escrow Companies: It is a third party acting as an intermediary and
responsible for getting all the conditions fulfilled at the time of loan provided
by one party to the other
for the real estate mortgage.
Pension Funds: The government entities initiate a pension fund. A certain
amount is deducted from the salary of the employees each month. This
collected sum is then invested in different schemes to gain profits. The
investor’s fund is returned with interest after their retirement.
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Building Societies: These financial intermediaries are similar to the credit
unions, owned and facilitating mortgage loans and demand deposits to its
members.
Collective Investment Schemes: Under this scheme, the various investors with
common investment objective come together to pool their funds and
collectively invest this
amount into a profitable investment option. Later they distribute the interest
among themselves as per the agreement.
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ADVANTAGES OF FINANCIAL INTERMEDIARIES

The financial intermediaries are as crucial to the economy as the blood is to the
body. Some of its significant benefits are discussed below: Advantages of
Financial Intermediaries
Low Risk: The involvement of intermediaries reduces the risk of fraudulent,
default and even capital loss for the lender.
Convenience: Exchange becomes suitable for the investor as well as the
borrower. Since both, the parties do not need to invest time and money in
searching for each other.
Instead, they have to approach the intermediary for the purpose.
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Economies of Scale: The cost involved in the lending and borrowing of funds
like analyzing credit position, operational expenses and cost of paperwork
decreases to a large extent. The financial intermediaries perform such activities
on a massive scale.
Financial Specialization: These organizations or companies specialize in fund
management and investing activities providing better returns to the investors
and easy loans to the borrowers.
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Greater Liquidity: The financial intermediaries like banks allow investors or
depositors to withdraw their amount at any point of time, as per their
requirement.
Safe Investment: For the investor’s point of view, financial intermediaries are
considered to be more trustworthy and reliable than lending money directly to
an individual to yield interest.
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3. FINANCIAL MARKETS
- All the instruments mentioned above are issued in so-called primary
markets, and the already- issued marketable instruments of debt (including
deposits) and shares are traded in secondary markets. Thus, as depicted in
Figure 5, when a primary issue is made the issuer (= borrower) acquires new
funds, whereas in the secondary market the seller gets the funds (not the
issuer).
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OTC and exchange-driven markets
Secondary financial markets evolved to satisfy the needs of lenders (investors)
to buy and sell (exchange) securities when the need arises. Some markets
naturally exist in a safe (i.e. low risk) environment, while for others a safe
environment has been created. The former markets are called over- the-counter
(OTC) markets, and the latter the formalized (or exchange-driven) markets.
By and large, the foreign exchange and money markets of the world are OTC
markets, and they essentially are the domain of the well-capitalized banks,
while the share and bond markets are exchange- driven markets. Derivative
instruments fall under both categories.
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4. MONEY CREATION
Money creation is an integral part of the financial system, and a significant part
of the investment environment in terms of new financial instrument (debt)
creation, inflation and interest rates. Interest rates are important for many
reasons, including being a target / reflection of monetary policy actions and the
valuation of financial instrument (debt and shares) and income-property assets.
Money is anything that is generally accepted as a means of payment. In the
distant past money has been many different objects, but stuck in our financial
psyches are gold and silver coins. Today, money has two components:
- central bank notes and coins (N&C) and
- bank deposits (BD)
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4. MONEY CREATION
held by the local non-bank private sector (NBPS). The outstanding amount of
these (measured monthly in most countries) is therefore the amount of money
in circulation (AMIC or just M, also called the money stock26). There are
many different measures of money; for the sake of simplicity we use M3,
which encompasses all deposits of the NBPS plus its holdings of notes and
coins (but from hereon we call it M):
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5. FINANCIAL INSTRUMENTS
- As a result of the process of financial intermediation, and in order to satisfy
the investment requirements of the ultimate lenders and the financial
intermediaries (in their capacity as borrowers and lenders), a wide array of
financial instruments exist. The instruments are either non-marketable (e.g.
retirement annuities, insurance policies), which means that their markets are
only primary markets (see later), or marketable (e.g. treasury bills, bonds),
which means that they are issued in their primary markets and traded in their
secondary nukes (detailed later).
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Financial intermediaries & instruments / securities

As indicated in Figure 3, the instruments issued by borrowers are in a broad
sense called securities (aka instruments and assets). They represent claims on
the issuers / borrowers. Figure 4 presents the detail. As we have seen, the
instruments issued by the ultimate borrowers (the ultimate investments) are
twofold:
- Debt instruments.
- Share (aka equity and stock) instruments.
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Financial intermediaries & instruments / securities

Debt and share instruments represent permanent or semi-permanent funds (aka
capital) for the borrowers. Generally, debt instruments have a fixed term to
maturity and thus represent semi-permanent capital for the borrower, and there
are two classes of shares: ordinary shares which are shares in the capital of
companies which have no maturity date (= permanent capital) and preference
shares which generally have a fixed term to maturity (= semi-permanent
capital).
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6. PRICE DISCOVERY
- The prices of debt (= interest rates, from which prices are derived) and shares (= prices,
influenced by interest rates) are discovered in the financial markets, by the interplay of
demand and supply. Or are they - when the supply of credit is unlimited (in the sense that
credit is supplied if the individual borrower is creditworthy or the corporate project is
viable)?
- Given such a monetary system, it is evident that a referee (a Central Bank) is required and
that interest rates cannot be "free to find their own levels". The reason is clear: because the
CB uses interest rates to
influence the growth rate in the demand for loans / credit and therefore in M. Thus, the CB in
essence "sets" the lower point of the yield curve29 (see Figure 14) and this point becomes
the reference point for all interest rates. Even rates for 20 to 30-year investments are
affected by the short-term rates.
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ALLIED PARTICIPANTS
The allied participants, who play a major role in terms of facilitating the lending and
borrowing process (the primary market) and the secondary markets are the financial
exchanges and their members. Also we need to mention the fund managers, who are
actively involved in sophisticated financial market research and therefore play a
major role price discovery, and the regulators of the financial markets. Thus the allied
non-principal participants in the financial markets are:
1. Brokers and Dealers
The members of exchanges and/or financial intermediaries that facilitate the trade in
financial instruments (which we refer to here collectively as broker-dealers).
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Broker Dealer
✓ A person who executes the trade on ✓ Dealer is a person who trade business
behalf of others. on their own behalf.
✓ One who will buy and sell for their ✓ Person who will buy and sell securities
clients. on their account.
✓ Brokers seldom this freedom and rights. ✓ Have all the rights and freedom
regarding the buying and selling of
securities.
✓ Has only a little experience in the ✓ Has also been seen that brokers
field compared to dealers. become dealers once they get
experience.
✓ Normally paid a commission for ✓ Not paid a commission and he /she is
transacting the business.
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ALLIED PARTICIPANTS
Will kenton Broker - dealer is a person or firm in the business of buying and selling
securities for its own account or on behalf of its customers. - the term broker -dealer
is used in U.S securities regulations parlance to describe stock broker ages because
most of them act as both agents and principals. A brokerage acts or broker (agent)
when it executes order in behalf of its clients, whereas it acts as a dealer ( or
principal) when it trades for its own account. - fulfill several important functions in
the financial industry. Types of broker - dealer
1) Wire house - a firm that sells its own product to customers.
2) Independent - a firm that sells products from outside sources.
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ALLIED PARTICIPANTS
2. Fund Managers
The corporate entities or departments of financial intermediaries that manage funds
on behalf of principals (owners or holders of money).
3. Financial Exchange
Allow the broker-dealers to facilitate trading in securities, and create the mechanism
for clearing and settlement of trades in a risk-minimizing manner.
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ALLIED PARTICIPANTS
4. Credit Rating Agencies

Analyze relevant financial and economic data pertaining to the issuers of securities
and assign ratings to the securities reflecting the probability of the issuers meeting
their financial obligations (interest and principal).
5. Financial Regulators
Regulate and supervise all players in the financial system
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FOUR (4) SECTORS THAT CONSTITUTE THE NON-FINANCIAL
LENDERS AND BORROWERS
1. Household sector (= individuals).
Consists of individuals and families, but also includes private charitable, religious and
non-profit bodies serving households. It includes unincorporated businesses such
as farmers, retailers and professional partnerships, as the transactions of these
businesses cannot be separated from the personal transactions of their owners.
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2. Corporate sector (= companies - unincorporated businesses and government

owned).
Comprises all companies not classified as financial institutions and therefore covers
business enterprises directly or indirectly engaged in the production and distribution
of goods and services.
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2. Corporate sector (= companies - private and government owned).
The business sector is where production takes place in the economy. The individual
agents making up the business sector are called firms. These are the organizations
within which entrepreneurship brings together land, labor and capital for the
production of goods or services.
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2. Corporate sector (= companies - private and government owned).
Corporate financial systems represent the business analysis phase of a company.

Large companies -- particularly publicly held companies -- use a financial system to
help assess financial performance. In some cases, the corporate financial system is a
bridge between accounting and management.
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Three primary functions
- Firstly, a capital investment may be the most important task of the corporate
finance department of a company and is primarily concerned with capital
budgeting. Capital budgeting helps the department identify capital expenditures,
future cash flow estimates from proposed projects, and compares the planned
investments with potential projects and decides which ones to include.
- - Secondly, the department is also responsible for raising funds through debt,
equity or both. It may borrow from a commercial bank or other financial
intermediaries or may raise funds by issuing debt securities in the capital markets
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Three primary functions
- Firstly, a capital investment may be the most important task of the corporate
finance department of a company and is primarily concerned with capital
budgeting. Capital budgeting helps the department identify capital expenditures,
future cash flow estimates from proposed projects, and compares the planned
investments with potential projects and decides which ones to include.
- - Secondly, the department is also responsible for raising funds through debt,
equity or both. It may borrow from a commercial bank or other financial
intermediaries or may raise funds by issuing debt securities in the capital markets
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3. Government sector = all levels of government - local, provincial, central).

Consists of the central government, provincial governments (where they exist), local
authorities, and non-financial public enterprises.
4. Foreign sector (= any foreign entity - corporate sector, financial intermediaries
such as retirement funds).
Comprises all organizations, persons and assets resident or situated in the rest of the
world.
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3. Government sector = all levels of government - local, provincial, central).

Consists of the central government, provincial governments (where they exist), local
authorities, and non-financial public enterprises.
4. Foreign sector (= any foreign entity - corporate sector, financial intermediaries
such as retirement funds).
Comprises all organizations, persons and assets resident or situated in the rest of the
world.
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The members of these sectors may be either lenders or borrowers or both at the same
time. For example, a member of the household sector may have a mortgage bond (=
borrower by the issue of a non-marketable debt instrument) and at the same time
hold a balance on your accounts at the bank (= a lender; a holder of money).
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ThankYou
April Hansson
+1 23 987 6554
april@treyresearch.com
Trey Research
TREY
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FINANCIAL SYSTEM

1. define financial system;

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➢ A set of arrangements / conventions embracing the lending and borrowing

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1. BORROWERS AND LENDERS

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1. BORROWERS AND LENDERS

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1. BORROWERS AND LENDERS

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Direct & Indirect Financing

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Direct & Indirect Financing

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TYPES OF FINANCIAL INTERMEDIARIES

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TYPES OF FINANCIAL INTERMEDIARIES

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TYPES OF FINANCIAL INTERMEDIARIES

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ADVANTAGES OF FINANCIAL INTERMEDIARIES

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ADVANTAGES OF FINANCIAL INTERMEDIARIES

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Financial intermediaries & instruments / securities

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Financial intermediaries & instruments / securities

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4. Credit Rating Agencies

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1. Household sector (= individuals).

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2. Corporate sector (= companies - unincorporated businesses and government

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2. Corporate sector (= companies - private and government owned).

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2. Corporate sector (= companies - private and government owned).

Corporate financial systems represent the business analysis phase of a company.

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3. Government sector = all levels of government - local, provincial, central).

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3. Government sector = all levels of government - local, provincial, central).

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FOUR (4) SECTORS THAT CONSTITUTE THE NON-FINANCIAL

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