FIN2001 - FINANCIAL MARKETS

AND INSTITUTIONS

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 Chapter 1
OVERVIEW OF THE
FINANCIAL SYSTEM

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 Content

n Financial system
n Financial markets
n Financial institutions
n Central bank

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 Readings
1. Chapter 1, 4, 5; Thị trường tài chính, Financial
Markets and Institutions, 12th Edition; Jeff Madura;
South-Western Cengage Learning (2018).
2. Chapter 2, 7, 9, 10; Financial Markets and
Institutions; Federic S. Mishkin, Stanley G. Eakins;
Pearson (2017).

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 1.1 The financial system
n Financial system consists of financial markets, financial
instruments and financial institutions which interact to
facilitate the flow of funds through the financial system.
n There are two basic mechanisms by which funds flow through
the financial system:
n Direct financing: where funds flow directly through
financial markets.
n Indirect financing: where funds flow indirectly through
financial institutions (intermediaries) in the financial
intermediation market. 5
How funds flow through the financial system

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 1.2 Financial market
1.2.1 Functions of financial market

n Function of channeling funds

n Function of encouraging saving and investment
n Function of raising the financial asset’s liquidity
n Financial markets play an important role in the economy.
n Financial markets allow funds to move from people who lack
productive investment opportunities to people who have such
opportunities.
n Financial markets are critical for producing an efficient allocation
of capital, which contributes to higher production and efficiency for
the overall economy
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 1.2.2 Structure of financial market

n Debt and equity markets

n Primary and secondary markets
n Exchanged and Over-the-counter markets
n Money and capital markets

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 1.2.2 Structure of financial market
v Debt and equity markets:
A firm or an individual can obtain funds in a financial market in 2 ways:
n Issuing debt instruments: bonds, T-bills, commercial papers,
negotiable certificates of deposit (NCDs),…
n Short-term, intermediate-term and long-term instruments.
n Issuing equities: common stocks
n Advantage of holding equities is that equity holders benefit directly
from any increases in the corporation’s profitability or asset value.
n Disadvantage of owning a corporation’s equities rather than its debt is
that an equity holder is a residual claimant
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 1.2.2 Structure of financial market
v Primary and secondary markets
n A primary market is a financial market in which new issues of a
security, such as a bond or a stock, are sold to initial buyers by the
corporation or government agency borrowing the funds
n Primary market transactions provide funds to the issuer of securities
n A secondary market is a financial market in which securities
that have been previously issued can be resold.
n Secondary market transactions make the financial instruments more
liquid
n Secondary market determines the price of the security that the issuer
sells in the primary market 10
 1.2.2 Structure of financial market
v Exchanges and Over-the-counter markets
n An exchange market is a place where buyers and sellers of
securities (or their agents or brokers) meet in one central location
to conduct trades.
n An over-the-counter (OTC) market, in which dealers at
different locations who have an inventory of securities stand
ready to buy and sell securities “over the counter” to anyone who
comes to them and is willing to accept their prices.

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 1.2.2 Structure of financial market
v Money and capital markets
n A money market is a financial market in which only short-term
debt instruments (generally those with original maturity of a one
year or less) are traded.
n A capital market is a financial market in which longer term debt
(generally with original maturity of more than one year) and
equity instruments are traded.

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 1.3 Financial Institutions
1.3.1 Functions of financial institutions
n Transaction cost: Financial institutions reduce transaction
costs because of:
n expertise
n economies of scale
n Risk sharing:
n Asset transformation
n Diversification
n Asymmetric information:
n Adverse selection
n Moral hazard

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 1.3.2 Types of financial institutions

n Depository Institutions n Investment Intermediaries

n Commercial Banks n Finance Companies
n Savings and Loan Associations and Mutual n Mutual Funds
Savings Banks
n Money Market Mutual Funds
n Credit Unions
n Investment banks
n Contractual Savings Institutions n Securities Firms
n Life Insurance Companies
n Property and Casualty Insurance Companies
n Pension Funds and Government Retirement
Funds

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Types of financial intermediaries

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 1.4 Central Bank
1.4.1 Functions of a modern central bank
n Currency issuer:
n Has the monopoly rights of issuing currency notes.

n Controls the availability of money and credit.

n The Banker’s bank:

n Guarantees that sound banks can do business by lending to them, even

during crises.
n Operates a payment system for interbank payment.

n Regulates and oversees financial institutions to ensure confidence in their

soundness.
n The Government’s bank:
n Hold accounts for the government and manage its financial transactions.

n Provide advice to the government on fiscal matters and economic policies.

n Manages the country’s foreign exchange reserves 16

 1.4.2 Objectives of a central bank
n Low, stable inflation
n High, stable growth
n Financial system stability
n Stable interest rate
n Stable exchange rate

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 1.4.3 Tools of monetary policy
§ Open market operations
§ Discount lending
§ Reserve requirement

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 1.4.3 Tools of monetary policy
§ Open market operations – OMO: refers to the buying and
selling of government securities in the open market in order to
expand or contract the amount of money in the banking system,
facilitated by central banks.
§ An open market purchase leads to an expansion of reserves and
deposits in the banking system and hence to an increase in the
money supply.
§ An open market sale leads to a contraction of reserves and
deposits in the banking system and hence to a decline in the
money supply. 19
 1.4.3 Tools of monetary policy
n Discount lending: The central bank provides loans to banking
institutions through its discount window.
n A discount loan leads to an expansion of banking reserves,
which can be lent out as deposits, thereby leading to an increase
in the money supply.
n When a bank repays its discount loan and so reduces the total
amount of discount lending, banking reserves decreases along
with a decline in money supply.

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 1.4.3 Tools of monetary policy
n Reserve requirement is the amount of funds that financial
institutions must hold at the central bank in order to back their
deposits.
n A rise in reserve requirements means that banks must hold more
reserves at central bank and lower banks’ ability to lend, thereby
leading to a decline in the money supply.
n A reduction in reserve requirements means that banks are required
to hold less, thereby leading to an increase in the money supply.
n Reserve requirements have rarely been used as a monetary policy
tool because raising them can cause immediate liquidity problems
for banks with low excess reserves. 21
The State Bank of Vietnam
Students research themselves

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