CHAPTER OBJECTIVES

What you will learn in this chapter:

o What are the components of a financial system

o What a financial system does

o The key features of financial intermediaries

o The key features of financial markets

o Who the users of the system are, and the benefits they
receive
 INTRODUCTION

o In this first chapter we want to find a preliminary answer to

two questions;

I. We want to know what is meant by the expression the

‘financial system’ and

II. we want to know what such a system.

 INTRODUCTION

Financial System: Definition

o We shall define a financial system fairly narrowly, “to consist

of a set of markets, individuals and institutions which trade
in those markets and the supervisory bodies responsible for
their regulation”.

o The end-users of the system are people and firms whose

desire is to lend and to borrow.

o Faced with a desire to lend or borrow, the end-users of

most financial systems have a choice between three broad
approaches.
 INTRODUCTION

Financial System: Private Direct Finance

o Firstly, they may decide to deal directly with one another.

o It is costly, risky, inefficient and, consequently, not very

likely.

o More typically they may decide to use one or more of many

organized markets
 INTRODUCTION

Financial System: Financial Markets

o In these markets, lenders buy the liabilities issued by

borrowers.

o If the liability is newly issued, the issuer receives funds

directly from the lender i.e. Primary Market.

o More frequently, however, a lender will buy an existing

liability from another lender i.e. Secondary Market.

o he best-known markets are the stock exchanges in major

financial centers such as London, New York and Tokyo.
 INTRODUCTION

Financial System: Financial Intermediaries

o Alternatively, borrowers and lenders may decide to deal via

institutions or ‘intermediaries’.

o In this case lenders have an asset –

o a bank or building society deposit,

o or contributions to a life assurance or pension fund –

which cannot be traded but can only be returned to
the intermediary.

o Similarly, intermediaries create liabilities, typically in the

form of loans, for borrowers.
INTRODUCTION
 INTRODUCTION

Financial System: Functions of Financial System

A financial system

 channels funds from lenders to borrowers

 creates liquidity and money

 provides a payments mechanism

 provides financial services such as insurance and

pensions

 offers portfolio adjustment facilities

FINANCIAL INSTITUTIONS
 FINANCIAL INSTITUTIONS

Financial Institutions as Firms

o Financial institutions are firms and their behavior can be

analyzed in much the same way that economists analyze
any other type of firm.

o FI are profit maximizers; the profit arises from charging

interest to borrowers at a rate which exceeds that paid to
lenders.

o In terms of size they are large;

o profits are being maximized for shareholders rather

than for ‘entrepreneurs’ manage the firms.
 FINANCIAL INSTITUTIONS

Financial Institutions as Firms

o For simplicity, that a firm’s output consists of loans and

o That the major variable input is the deposits.

o Financial firms tend to be large because economies of scale

are very common in the production of financial products.

o This has inevitably led to situations where some financial

business is dominated by a few, large organizations -
Oligopolistic.

o little apparent competition over prices but a great deal

of effort into product differentiation.
 FINANCIAL INSTITUTIONS

Some deposit and non-deposit-taking intermediaries

 FINANCIAL INSTITUTIONS

Financial Institutions as ‘Intermediaries’

o As a general rule, financial institutions are all engaged to

some degree in what is called intermediation.

o The parties here are usually called lenders and borrowers or

sometimes surplus sectors or units, and deficit sectors or
units.

o As a general rule, what financial intermediaries do is:

to create assets for savers and liabilities for borrowers which

are more attractive to each than would be the case if the
parties had to deal with each other directly.
FINANCIAL INTERMEDIATION
Nature & Role
 FINANCIAL INTERMEDIATION

Financial Institutions as ‘Intermediaries’

o Financial intermediary:

An organization which borrows funds from lenders and

lends them to borrowers on terms which are better for both
parties than if they dealt directly with each other.
 FINANCIAL INTERMEDIATION

Financial Institutions as ‘Intermediaries’

The Creation of Assets and Liabilities

o General consequences of financial intermediation is to the

creation of financial claims.

o Financial assets for Lenders/savers

o Financial liabilities for borrowers.

o The second general consequence of the intervention of

financial institutions is that lending and borrowing have
become easier

o Lower the ‘transaction costs’

 FINANCIAL INSTITUTIONS

Financial Institutions as ‘Intermediaries’

o In Direct Finance, the borrowing–lending process does not

require the existence of financial intermediaries.

o However, two types of barriers can be identified to the

direct financing process:

1. The difficulty and expense of matching the complex

needs of individual borrowers and lenders;

2. The incompatibility of the financial needs of borrowers

and lenders.
THE NATURE OF FINANCIAL INTERMEDIATION

Lenders’ requirements

o The minimization of risk.

o This includes the minimization of the risk of default (the

borrower not meeting its repayment obligations) and
the risk of the assets dropping in value.

o The minimization of cost.

o Lenders aim to minimize their costs.

THE NATURE OF FINANCIAL INTERMEDIATION

Lenders’ requirements

o Liquidity.

o Lenders value the ease of converting a financial claim

into cash without loss of capital value; therefore they
prefer holding assets that are more easily converted
into cash.

o One reason for this is the lack of knowledge of future

events, which results in lenders preferring short-term
lending to long-term.
THE NATURE OF FINANCIAL INTERMEDIATION

Borrowers’ requirements

o Funds at a particular specified date.

o Funds for a specific period of time;

o preferably long-term (think of the case of a company

borrowing to purchase capital equipment which will
only achieve positive returns in the longer term or of an
individual borrowing to purchase a house).

o Funds at the lowest possible cost.

THE NATURE OF FINANCIAL INTERMEDIATION

Summary

In summary, the majority of lenders want to lend their assets

for short periods of time and for the highest possible return.

In contrast the majority of borrowers demand liabilities that

are cheap and for long periods.
 THE ROLE OF FINANCIAL INTERMEDIATION

o Financial intermediaries can bridge the gap between

borrowers and lenders and reconcile their often
incompatible needs and objectives.

o They do so by offering suppliers of funds safety and

liquidity by using funds deposited for loans and
investments.

o Financial intermediaries help minimize the with direct

lending – particularly transactions costs and those derived
from information asymmetries.
 THE ROLE OF FINANCIAL INTERMEDIATION

Transactions costs

o Cost relate to the costs of searching for a counterparty to a

financial transaction;

o The costs of obtaining information about them;

o The costs of negotiating the contract;

o The costs of monitoring the borrowers; and the eventual

enforcements costs should the borrower not fulfil its
commitments.
 THE ROLE OF FINANCIAL INTERMEDIATION

Asymmetric information.

o Lenders are also faced with the problems caused by

asymmetric information.

o These problems arise because one party has better

information than the counterparty.

o In this context, the borrower has better information about

the investment (in terms of risk and returns of the project)
than the lender.

o Information asymmetries create problems in all stages of

the lending process.
 THE ROLE OF FINANCIAL INTERMEDIATION

In a net shell

o Transaction costs and information asymmetries are

examples of market failures;

o that is, they act as obstacles to the efficient functioning

of financial markets.

o One solution is the creation of organized financial markets.

However, transaction costs and information asymmetries,
though reduced, still remain.
 THE ROLE OF FINANCIAL INTERMEDIATION

In a net shell

o Another solution is the emergence of financial

intermediaries.

o Organized financial markets and financial

intermediaries co-exist in most economies; the flow of
funds from units in surplus to unit in deficit in the
context of direct and indirect finance are illustrated in
Figure 1.3.
FINANCIAL MARKETS
 FINANCIAL MARKETS

o In economics a market is an organizational device which

brings together buyers and sellers.

o Financial markets offer some of the best examples of buyers

and sellers interacting over a widely dispersed geographical
area.

o Markets for foreign exchange, for example.

o Financial market: An organizational framework within which

financial instruments can be bought and sold.
 FINANCIAL MARKETS

Types of Products

o Market wherein some sort of financial product is being

traded.

o By product we simply mean what we have hitherto been

referring to as an asset or liability.

o As a briefer alternative to ‘asset and liability’ it is common

to talk about the trading of financial claims.

o Claims exist in many specific forms.

o The specific form which a claim takes is a financial

instrument.
 FINANCIAL MARKETS

Types of Products: Selection of Instruments

o Bank deposits
o Building society deposits
o National Savings certificates
o Treasury bills
o Government bonds
o Commercial bills
o Equities
o Life insurance policies
o Eurobonds
o Certificates of deposit
 FINANCIAL MARKETS
Types of Products: Categories

Products can be categorized

- In terms of traded directly between holders into

 Securities: Instruments which can be bought and sold

between third parties. E.g. Shares/Stocks.

 Non-securities: by contrast, cannot be bought and sold

in this way. E.g. National Savings certificates and
building society deposits.

• The only way to ‘dispose’ of such an asset is to ‘sell’

it back to its originator.
 FINANCIAL MARKETS
Types of Products: Categories

Products can be categorized

- In terms of Fixed or Variable Rate into

 Fixed Rate Instruments: instruments which are issued

with a fixed rate of interest for as long as they exist –
government bonds, for example.

 Variable Rate Instruments: those assets whose yield

varies according to market conditions.

• The latter category includes a wide range of claims

from bank deposits to company shares.
 FINANCIAL MARKETS
Types of Products: Categories

Products can be categorized

- In terms of maturity of the instrument into

• Maturity: The length of time that has to elapse before

an asset matures or is repaid.

• Occasionally ‘initial maturity’, the time to maturity from

the day the asset is first created;

• more frequently ‘residual maturity’, the remaining time

to maturity reckoned from today.
 FINANCIAL MARKETS
Types of Products: Categories

Products can be categorized

- In terms of maturity of the instrument into

 Capital Market Claims:

• With company shares, for example, it is theoretically
infinity.
• Some government stocks are issued with twenty-five
years to maturity.

 Money Market Claims:

• 90 days Treasury Bills

FINANCIAL MARKETS
 FINANCIAL MARKETS

In Class Exercise

The Liquidity of Financial Assets

Take any five of the financial products

which you experienced so far and rank
them for liquidity, beginning with the
most and finishing with the least liquid.
FINANCIAL MARKETS

Lenders and Borrowers

 QUESTIONS FOR DISCUSSION

1. Distinguish between ‘saving’ and a ‘financial

surplus’.

2. How are financial intermediaries able to engage in

maturity transformation?

3. Why do people simultaneously hold financial

assets and liabilities?

4. Suggest a suitable asset for someone who wished

to avoid the following types of riskat all cost:
(a) capital risk; (b) income risk