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Unit I – CENTRAL BANK AND ITS FUNCTIONS AND OPERATIONS

Module 1- Philippine Financial System

Financial system, in recent condition, plays a crucial role in the economic and
social development of a developing country, like Philippines. Everyone, whether
individual or business organization are directly involved in the operation of financial
system since buying and selling goods and services, borrowing money, or investing to
different investment forms are common activities that confronted us in our day-to-day
activities. These activities are influence by different components of financial system
allow our economy to function properly.

One of the parts of the financial system is the financial sector consisting of
financial institutions and financial market, financial instruments, and the rules
governing the conduct of trade, hence, the World Bank (WB), the International
Monetary Fund (IMF), the Asian Development Bank (ADB), the Bangko Sentral ng
Pilipinas (BSP), Philippine Deposit Insurance Corporation (PDIC), and other
government agencies have tremendous effects in the allocation and matching the
supply of savings in the economy to the demanders (users) of those savings in a safe
and efficient manner. Through the work of financial system, business transactions
create beneficial effects in the economy, it increases production, gives more
employment, enhance income, as well as, the consumption.

Furthermore, this module 1 could help to understand the nature and importance
of financial system, functions and key services provided by financial system, barriers
to matching savers and borrowers, method of transferring funds, components of
Philippine financial system, bank and non-bank financial institutions, economic
benefits of financial market and its kinds, and classification of financial markets.

Learning Objectives:

At the end of the semester, the students should be able to:

1. Understand the nature and importance of financial system;

2. Explain the functions and key services provided by financial system;
3. Determine and define the barriers to matching savers and borrowers;
4. Methods of Transferring Funds;
5. Familiarize with the components of Philippine Financial System;
6. Distinct bank and non-bank financial institutions in the Philippines;
7. Understand the economic benefits of financial market and its classification;
8. Determine the classification of financial markets
9. Identify the money market instruments

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1. FINANCIAL SYSTEM DEFINED

Financial system is defined by different authors yet they are all interrelated
emphasizing one common meaning.

According to Rose, Kolari and Fraser (1993) as noted by Medina (2000) in his
book that financial system is

“…the institutional mechanism established by society to produce and

deliver financial services and allocate resources, consisting of business firms
supplying financial services, the customers of financial-service firms, and
government regulatory authorities that enforce the rules prevailing within the
financial sector” (Rose, Kolari and Fraser, 1993).

Kaufman (1992) describes the financial system as encompassing

“…the instruments, institutions, markets, and rules governing the

conduct of trade that expedite the routing of funds from buyers to sellers and
from savers to lenders.”

Cargill (1991) defines financial system as one

“…in which funds are traded between borrowers and lenders.”

Dr. Torralba, Jr. (2003) defined financial system as

“…a network of various institutions that generate, circulate and control

money and credit.”

Based on different authors definition, Cargill provides a limited idea about

financial system while Kaufman emphasizes the composition of financial system while
Rose, Kolari and Fraser identifies the financial system as an institution which allocates
and provides financial services but its policies and rules are governed by the
government authorities. While Dr. Torralba asserts a more clear and complete
definition that financial system is a structure of different financial institutions, whether
banks or non-banks, with definite functions to generate, circulate and control money
and credit between the supplier and user of funds.

The financial institution who works also as a financial intermediary provides

loan to poor families, small producers, big businessmen, and industrialist from the
funds supplier who have extra funds in investments or productive projects lend their
money in order to earn interests. Today, unlike during the primitive economy, the
lenders are now directly deal with the middlemen, a specialist or recently known as
financial intermediaries, and not directly to lenders because transaction involves a
larger market, a big loanable funds, more convenient, economical, and safer for the
lenders.

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2. FUNCTIONS AND KEY SERVICES PROVIDED BY FINANCIAL SYSTEM

A. Functions of Financial System

The financial system performs functions that are essential in making an

economic system work, namely, the credit, payments, money creation and savings
(Torreja, Jr., 2003).

1. Credit. This credit is supplied by the financial system to four sectors of the
economy which are engaged in borrowing and lending are: household,
business, government, and foreigners.

Households maybe a consumer or individual and their needs vary from day-
to-day, month-to month, and year-to-year. Their incomes may not be enough to satisfy
their consumptions. However, the more discipline an individual, they save more
money but as the household grows older, its income will tend to grow faster than its
expenses. It will, then, have excess funds. The household will now consider savings
the excess for use in the future when income will be less than their needs.

Putting the savings in a vault in the house of the saver has the advantage of
liquidity. This means that the money could be spent as fast as the need arises. The
disadvantages, however, comes in the form of loss of purchasing power due to
inflation and the opportunity to make income from investment.

Firm maybe a business firm or a business company who usually affected by

deficiency in capital, particularly when opportunities arise, therefore, when the
additional investment needed it may resort to borrowing. However, the company may
take advantage the quantity discounts for bulk purchases granted by suppliers, and
additional revenues from sales. The money borrowed by firms is added to their own
available funds to be spent on goods and services as investment expenditures. When
a firm makes purchases of plant, equipment, or material, these become the income of
another firm. Taken as a whole, firm will have two sources of income: those arising
out of household expenditures, and those arising out of investments of other firms.
Part of the firm’s revenues is paid out to households in the form of wages, dividends,
royalties, and interest.

Government maybe any government agencies, local or national government.

Its income is coming from taxes paid by households, and firms. It also borrows money
from various sources. It spends its income derived from taxes and borrowings to
purchase buildings, equipment, or supplies. Part of the amount is given out to
household in the form of wages, dividends, royalties and interest.

2. Payments. A mechanism for making payment is supplied by the financial

system. The payments system takes the forms of currency, checking accounts,
and various transaction media. Financial institutions of late have developed
new payment services which include money market and NOW (negotiable order

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of withdrawal) accounts and share drafts (all types of interest-bearing checking

accounts), tuition fee and telephone paying services, and electronic machines
that accept deposits and dispense cash.

3. Money Creation. Money is artificially created by the financial system through

the services of supplying credit and providing a mechanism for making
payments. Under modern conditions, the money supply consists of currency
(or pocketbook money) and deposits (or checkbook money). Even if the
government provides currency for circulation, additional money is created by
the banking system by facilitating the use of other means of payment like
checks.

4. Savings. The financial system serves as a venue for savings. This is made
through the means of accepting deposits and loan agreements with the use of
various financial instruments. The financial system relieves the individual
savers of the burdensome tasks of finding willing borrowers.

B. Key Service of Financial System

Aside from providing matching services to individuals with excess funds to
those that need them, the financial system also provides three key services for savers
and borrowers, namely: risk sharing, liquidity and information (Torreja, Jr., 2003).

1. Risk Sharing. Among the advantages of using the financial system to match
individual savers and borrowers is that is allows the sharing of risks. Risk is
defined as the chance that the value of financial assets will change relative to
what you expect. Example: If one buys a stock of apex Corporation for P55.00
per share, that stock might be worth P20.00 or P75.00 per share in one year,
depending on fluctuations in interest fees and Apex’s prospects.

Many individual savers are not risk–takers and seek a steady return on their
assets rather than wide swings between high and low earnings. Individuals
prefer stable returns on the collection of assets they hold. A collection of assets
is called a portfolio, which may consist of invest holding such as T-bonds,
some shares of stock, and some shares in a mutual fund. The performances
of these assets will vary in terms of their ability to generate income. One set of
assets in the portfolio, for instance, may perform well and earn much, while
another set of assets belonging to the same portfolio may turn out to be “not-
so-good” for bad performers. The high level of earnings generated by the good
performers will even out the low level of income earned by the not-so-good
performers, or even offset losses bad performers may have incurred. The
spreading of wealth into may assets to make up a portfolio is known as
diversification. The principle of efficient diversification holds that bundles of
assets should be combined to mitigate market risks. Too much or too little of
any one asset can be detrimental. In other words, there is a middle course (an

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efficient portfolio) for which the prudent decision-maker strives. The financial
system provides risk sharing by allowing savers to hold diversified assets.

This describes ways in which the financial system enables individuals to

transfer risk. Financial market has the capacity to create instruments that can
transfer risk from savers or borrowers who do not favor uncertainty in t heir
returns of payments to savers or investors who are willing to bear the risk.
Example, One might be willing to accept a lower return on an investment in
his/her mother-in-law’s business if she or one of her other investors has
guaranteed that return. In this case, there is an effective transfer of risk from
saver to borrow – but the transfer comes at a cost: the lower return. The ability
of the financial system to share risk makes savers more willing to buy the
borrower’s IOUs. This willingness, in turn, increases a borrower’s ability to raise
funds within the financial system.

2. Liquidity. It is the financial system is manifested by the ease with which an

asset can be exchanged for money to purchase other assets, goods and
services. Savers view liquidity as a benefit since they can exchange their
assets easily when they need them for their own consumption or investment.

In general, the more liquid an asset, the easier it is to exchange the asset for
another asset or for goods and services. For example, one can easily
exchange the peso bill for a candy because a peso bill is highly liquid. Likewise,
a check can also be encashed within a short period of time to buy clothes or
shoes. However, selling a house takes more time because real property is
not very liquid. By holding financial claims (such as stock or bonds) on a
factor, investors have more liquid savings than they would if they owned the
machines in the factory since they can more easily sell the claim than a
specialized machine in order to buy other assets or goods. With liquid asset,
an individual or firm can easily and quickly respond to new opportunities or
unexpected events. Financial assets created by the financial system such as
stocks, bonds, or checking accounts, are more liquid than cars, machinery, or
real estate.

Financial markets, and intermediaries provide trading systems for making

financial asset more liquid. They also provide systems for increasing the
liquidity of financial assets. In the Philippines, for instance, investors can readily
sell their holdings in government securities and stocks of large corporations,
making those assets very liquid. Investors are willing to accept a lower return
on assets with greater liquidity. The efficiency of the financial system can be
measured by the extent to which an investor can easily transform illiquid assets
into liquid claims.

3. Information. The financial system provides market players more access to

vital information about borrowers’ and lenders’ expectations, and what they
have to offer. Providing better access to information embraces the system’s
role of collecting and communication information. Gathering or collecting

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information includes finding out about prospective borrowers and what they will
do with borrowed funds. Obtaining such information would be costly and time-
consuming for savers, who of course want all the facts before lending their
money.

In general, borrowers may have undisclosed intentions or activities that could

be detrimental to the lenders’ interests. Pieces of information that are only
available or known by the borrower are called asymmetric information that
could spell out future problems in most transactions. As a result, financial
arrangement, in some cases, have to be structured so that the borrowers do
not take advantage of asymmetric information at the expense of the lenders.
Because of asymmetric information, funds borrowed for the purpose of putting
up a business that is supposed to be self-liquidating could easily be diverted to
another purpose, for instance, a trip to Europe by the borrower which is
obviously not income generating and is an outright expense. To address the
problem of asymmetric information, the financial system usually sets up a
mechanism that specializes in information gathering and monitoring.

The financial system, in providing market players more access to relevant and
useful information, should also perform the role of effectively dissemination or
communicating information. Example, if a newspaper headline announces that
a pharmaceutical company has found a cure for AIDS, how will this discovery
impact on the company’s financial position? The financial market will react in
accordance with changes of the prices of stocks, bonds, and other financial
assets. Expectation of higher future profits would boost the prices of the
pharmaceutical company’s outstanding stocks and bonds. Thus, savers and
borrowers receive the benefits of information from the financial system by
looking at asset returns. The information works its way into asset returns and
prices as long as financial market participants are informed. The incorporation
of available information in asset returns is a manifestation of well-functioning
financial markets.

3. BARRIERS TO MATCHING SAVERS AND BORROWERS

The cost of buying or selling a financial instrument, such as a stock or a bond,

are known as transaction costs. They also include brokerage, commissions,
minimum investment requirements, and lawyer’s fees. Transaction costs make
investing in debt and equity instruments in financial markets costly for small savers.
Financial intermediaries take advantage of economics of scale by pooling savers/
funds to lower transactions costs. Example, the transaction cost of buying P500,000
worth of Treasury Bills (T-bills) is not much greater than the transaction cost incurred
in in buying P50,000 worth of T-bills. Individual investors can reduce transaction cost
by combining their purchases through an intermediary. As a result, individual savers
are able to earn a higher return on their savings, and borrows realize a lower cost of
funds.

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The additional costs that will be incurred by the savers to determine the
creditworthiness of borrowers and to monitor how borrowers use the acquired funds
are called information costs. This reduces the efficiency of the financial market since
borrowers must pay higher costs of funds and reduce the expected returns to savers.
This inefficiency creates profitable opportunities for individuals and institutions that can
reduce transactions and information costs.

Asymmetric Information and Information Costs

When investors buy shares of stocks or company’s bonds, the investors and
the company’s managers are assumed to have the same information or symmetric
information. This does not, however, mean that both the investors and company’s
managers perfectly have the same information. Investors may have some information
that the company’s managers are not even aware of. In general, neither the investors
nor the company’s managers can anticipate market conditions or economic events
that are relatively influenced by market forces. Asymmetric information occurs when
one party in a transaction has better information than the other, or when the borrower
and the lender have different information about the transaction. Example, Managers
may know that the future of their firm is very shaky, but lenders continue lending to the
firm because they do not have this information. The existence of asymmetric
information makes it costly for savers and borrowers to make exchange in financial
markets.

There are two types of costs arising from asymmetric information, namely:
adverse selection and moral hazard.

1. Adverse Selection. This occurs when those firms most likely to default are
themselves most actively seeking the loans. This happens because the interest
rate offered for such loans is the most attractive to the high-risk firms. Adverse
selection is the lender’s problem of telling the good-risk applicants from the bad-
risk ones before making an investment.

How do financial intermediaries reduce adverse selection?

a) Screening. This happens before a loan is made. They develop and

implement sophisticated screening techniques to identify the good-risk
types (households or firms more likely to pay back their debts) and the bad-
risk types. Financial intermediaries use a wide range of information, based
on the borrower’s previous credit history, employment status, etc.

b) Monitoring. This happens after the loan is made. Banks monitor the
borrower (both firms and households) to make sure that funds are used as
agreed in the loan contract. Also, because credit information is collected by
reporting agencies and is accessible to lenders, financial intermediaries can
punish (by increasing the interest rate, or not lending at all) the borrowers
next time if they entail moral hazard on the bank’s current loan.

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2. Moral Hazard. This occurs when the lender is subject to the risk that the
borrower will engage in risky activities that jeopardize repayment while seeking
high returns. Notwithstanding the information gathered about the borrowers,
there is always the chance that, after the borrowers receive the funds, the funds
are not used as intended. The situation is more likely to occur when the
borrower has an incentive to conceal information or act in a way that does not
reflect the lender’s interest. Moral hazard arises because of asymmetric
information, that is, the borrower knows more than the lender does about how
the borrowed funds will actually be used, and the resulting problems increase
the lender’s costs.

One way to differentiate between adverse selection and moral hazard is to

recognize that adverse selection is a problem before the loan transaction while
moral hazard is a problem after loan transaction has been concluded.

4. METHODS OF TRANSFERRING (LENDING) FUNDS

The two method of transferring funds are direct and indirect lending through
financial markets, and indirect lending through financial intermediaries, such as banks,
finance companies and mutual funds.

1. Direct lending. This involves the transfer of funds from the ultimate lender to
the ultimate borrower, without no intermediary. Example, A private party
purchasing the securities issued by a firm. The securities are usual sold to the
public through an underwriter, someone who purchases them from the issuer
with the intention of reselling them at a profit. The underwriter (sell or disburse
the securities of borrowing institution) negotiates the terms of the contract with
the borrower and appoints a trustee, typically a commercial bank, to monitor
compliance. Under this method, the SSU gives money to the DSU in exchange
for financial claims on the DSU. The claims issued by the DSU are called direct
claims and are typically sold in direct credit markets such as the money or
capital markets. Direct financing provides SSUs with a venue for savings with
expected returns. The DSUs, as a result, are provided with a source of funds
for consumption or investment. This arrangement increases the efficiency of
the financial market.

Direct financing, however, has some disadvantages. They are follows:

1. There are few DSUs which can transact in the direct market because the
denominations of securities sold are very large (usually million of pesos).
2. It is difficult to match the requirements of SSUs and DSUs in terms of
denomination, maturity, and others.

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Methods of Direct Financing are as follows:

1. Private placements refer to the selling of securities by private negotiation

directly to insurance companies, commercial banks, pension funds, large-
scale corporate investors, and wealthy individual investors.
2. A broker is one who acts as an intermediary between buyers and sellers
but does not take title to the securities traded.
3. A dealer is one who is in the security business acting as a principal rather
than an agent. The dealer buys for his account and sells to customers from
his inventory. He makes profits by selling his inventory of securities at a
price higher than the acquisition cost.
4. The investment banker is a person who provides financial advice and who
underwrites and distributes new investment securities.

2. Indirect lending. Indirect finance (also called financial intermediaries) refers

to lending an ultimate lender to a financial intermediary then relends to ultimate
borrowers. Financial intermediaries include commercial banks, mutual savings
banks, credit unions, life insurance companies and pension funds.

It is a lending by the ultimate lender to a financial intermediary who pools the

funds of many lenders in order to re-lend at a mark-up over the cost of funds.
The ultimate borrowers are normally unknown to the ultimate lenders. A
lender faces less risk in indirect lending because, as a specialist in the field, the
zsd. Of course, lower risk usually means less gain for the lender. Indirect
lending generally offers lower cost to the ultimate borrower for small or short-
term loans. Most borrowers lack sufficient credit standing to borrow directly.
Borrowers who do have the option may find it cheaper, especially for large
sums. The capacity of the direct financial markets is much larger than that of
even the largest intermediaries.

Comparison of Risks Between Direct and Indirect Lenders

1. Both faces different problems with borrowers in financial difficulty.

Direct lending: Rescheduling a loan is problematic because the relationship

is generally at arms-length and legalistic. The risks are often unknown to the
lender.

Indirect lending: The intermediary is usually in a much better position to know

whether the problem is permanent or temporary. As the sole lender, the
intermediary can alter the terms without having to obtain the agreement of
others.

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5. COMPONENTS OF PHILIPPINE FINANCIAL SYSTEM

The financial system is composed of various elements as follows:

1. Financial Institution. It is an organization through which funds in the form of

money or claims in money are assembled and transferred from individuals with
surplus funds to other individuals and firms needing extra funds. They are
classified private or government organizations whose assets consist primarily
of claims or incomes primarily derived from dealing in and/or performing
services in connection with claims. Institutions which deal with creation and
issuance of claims against themselves, and use the proceeds to acquire and
hold claims against others, and are commonly referred to as a financial
intermediary. Such institutions act as middlemen between suppliers and users
of money.

The benefits of financial intermediation:

a. Financial intermediaries can substantially reduce transaction costs.

This happens because they have developed expertise in lowering costs
and also because the large number of transactions provide economies
of scale.
b. Reduction of moral hazard. As individual borrowers may engage in
undesirable activities after taking the loan, the lenders who directly
provide funds will be at a disadvantage. Such risk of not getting paid
back because of changes in the behavior of borrowers is called moral
hazard.

2. Financial Instruments are the evidences of debt that are bought and sold in
the market (Chandler, 1969). They consist of money, loans, and ownership
shares.

3. Financial Market. It expedites the buying and selling of securities. It is a

mechanism by which savings in one sector of the economy flows to another
sector. .

4. Rules Governing the Conduct of Trade

According to Medina (2000), the financial system is part of the economic system
which was designed to serve society. To make sure that the financial system
performs its mandated task, the government, through its various
mechanisms, monitor and control the activities of the different components
of the system

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The enactment of laws comprises the first area for government control.
Among the laws that cover the operations of financial institutions and the
financial market includes the:

a) General Banking Act;

b) The Revised Securities Act;
c) The Philippine Deposit Insurance Law;
d) The Truth in Lending Act;
e) Offshore Banking Law;
f) Uniform Currency Act Corporation Code; and
g) Negotiable Instruments Law.

Example. Financing Company Act of 1998 which makes real estate an asset
that can be the subject of financial leasing (Manila Bulletin, May 30, 1999, p.B-
1)

The second area for monitoring and controlling the financial system is through
government regulatory agencies like the BSP, the Monetary Board, and the
Securities and Exchange Commission. Various memoranda and circular are
issued by those agencies whenever circumstances require such actions.
Example. The recent approval of the implementing Rules and Regulations
(IRR) of the Financing Company Act of 1998 (R.A. No. 8556)

Since private financial institutions are also businesses, they are covered
ordinances of municipalities where they are located. Ex. Local Municipality on
Business permits and licenses.

Government agencies refer to the Monetary Board is the policy-making body

of BSP. Laws on money, credit, and banking are legislated by Congress and
through presidential decrees issued by the President of the Philippines. The
role of government agencies has a tremendous impact on the financial system.
Example is the attainment of internal and external stability of our peso.

Laws and Policies. The national government regulates and supervises the
behavior of the whole economy. Hence, it controls of the financial system is a
vital condition for the whole economic behavior. Laws and policies have been
formulated to ensure the desired levels of investment, employment, production,
income, and consumption.

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6. BANKS AND NON-BANKS FINANCIAL INSTITUTIONS IN THE PHILIPPINES

The major financial institutions in the Philippines are:

1. BANKING INSTITUTIONS

A. Privately owned:

1. Commercial Bank is organized primarily to accept drafts and to issue

letter of credit; discount and negotiate promissory notes, drafts, bills of exchange
and other evidences of indebtedness, receive deposits, buy and sell foreign
exchange, and lend money on a secured or unsecured basis. Universal bank or
expanded commercial banks ae banks that have authority, in addition to
commercial banking powers, to exercise the powers of investment houses, invest
in the equity of companies engaged in businesses not related to banking and own
up to 100% of the equity of financial allied undertakings other than commercial
banks.

2. Thrift Bank
a) Savings and Mortgage Bank
b) Private Development Banks
c) Stock Savings & Loans Association

They are organized for the following purposes:

a) Accumulate the savings of depositors and investing them, together
with capital loans secured by bonds, mortgages in real estate and
insured improvements thereon, chattel mortgage, bonds and other
forms of security for personal or household finance, whether secured
or unsecured, or in financing for homebuilding and home
development, etc.
b) Providing short-term working capital, medium and long-term
financing, to business engaged in agriculture, services, industry and
housing, and
c) Providing diversified financial and allied service for its chose market
and constituencies especially for small and medium enterprise and
individuals.

3. Rural Bank is organized primarily to make credit available and readily

accessible in the rural areas on reasonable terms. Loans and advances extended
by rural banks are primarily for the purpose of meeting the normal credit needs of
farmers and fishermen, and the credit needs of cooperatives and merchants.

4. Offshore Bank (OBU) refers to a branch, subsidiary, or affiliate of a

foreign banking corporation which is duly authorized by the BSP to transact
offshore banking business in the Philippines. Offshore banking is the conduct of
transactions in foreign currencies involving the receipt of funds principally from

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external sources and utilization of such funds. A foreign bank may operate an
offshore bank unit.

B. Government owned:

1. DBP
2. LBP
3. Al-Amanah Islamic Investment of the Philippines (AAIIB)

2. NON-BANKING INSTITUTIONS

A. Privately Owned

1. Investment House. It is any enterprise that engages or purports to

engage, whether regularly or on an isolated basis, in the underwriting
of securities of another person or enterprises, including securities of
the Government and its instrumentalities.

2. Investment Company. It is any issuer or company engaged or

purposes to engage primarily in the business of investing, reinvesting
or trading in securities.

3. Finance Companies. They are corporations, except banks,

investment houses, savings and loan associations, insurance
companies, cooperative sand other financial institutions organized or
operating under other special laws, which are primarily organized for
the purpose of extending credit facilities to consumers and other
industrial, commercial, or agricultural enterprise, by direct lending.

4. Securities Brokers and Dealers.

Security Dealer is any person other than a salesman who engages
either for all or part of his time in the business of selling securities
issued by another person or purchasing or otherwise acquiring such
securities for the purpose of reselling them.

Security Broker is any person engaged in the business of effecting

transactions in securities for the account of another but does not
include a bank.

5. Lending Investors are persons who make a practice of lending

money for themselves or others at an interest and mainly for
themselves or others at an interest and mainly for personal
consumption. They are newcomers to the Philippine financial scene.

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Their borrowers include individuals who are employed or engaged in

business.

6. Pawnshop refers to a person or entity engaged in the business of

lending money on personal property delivered as security for loans.

7. Venture Capital Corporations are organized to assist small and

medium scale enterprises primarily in the form of equity
financing.

8. Insurance Companies generate their income from premiums

collected from policyholders and income from investment and loans.

B. Government Owned

1. GSIS
2. SSS

7. ECONOMIC BENEFITS OF FINANCIAL MARKET AND ITS CLASSIFICATION

Financial Markets facilitate transactions between investor and savers as well

as provide venues for financial institutions that include banks, investment bankers,
insurance companies, thrift institutions and finance companies. It acts as the vehicle
through which the forces of demand and supply for a specific type of financial claim
are brought together.

How does the economy benefit from financial markets?

1. Increase production. Financial markets bring together people who have

productive projects with those who have excess funds with no immediate
productive use.

2. Increased Welfare. Transferring funds to people who need most, or when they
need it most.

8. CLASSIFICATION OF FINANCIAL MARKET

1. Money Market is composed of the offshore and local market, and it is a network
of institutions and facilities for trading debt securities with maturity of one year
or less.

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Participants in the Philippine Money Market

The following are active participants in the local money market:

1. BSP. It participates in the money market through the conduct of open-

market operations to attain its objective of maintaining price stability. This
involves the purchase and sale by the BSP of government securities.

2. Commercial banks. It represents a large segment of financial

intermediary. By taking deposits and making loans, commercial banks
expedite the flow of funds from savers to borrowers. Commercial banks are
the major means by the BSP controls the money supply and interest rates
because money market transactions mainly flow through them. They
perform a valuable function for the entire economy.

3. Brokers act as the go-between in the money market.

Broker and Dealers in the financial system consist of commercial banks,

thrift banks, rural banks, non-bank, financial intermediaries and non-bank
thrift institutions. Most of these institutions, in one way or another, deal or
broke money market transactions.

4. Corporates and institutional investors have at times large sums of

excess funds that are place in short-term money market instruments.

5. Non-residents have direct foreign investments in money market or bank

deposits. These includes all debt instruments, such as but not limited to
bonds and bills payable issued by private domestic firms. On the other
hand, investments in bank deposits mean both peso savings and time
deposits with an authorized agent bank.

2. Capital Market is a market for bond and equity shares with long term
maturities. A capital market is any domestic or international market in which
governments, banks, multilateral organizations and companies can borrow or
invest large amounts of money for medium to long-term period. The capital
market is different from the money market primarily because most money
market instruments have maturities not exceeding 12 months, or 2 years at
most. It makes funds available through the issue of equities and medium to
long-term debt instruments, such as bonds and notes, which can either be
domestic or international. The type of instruments issued in the local capital
market are debt (like bond notes, floating rate notes), equity (like common
shares and preferred shares), and hybrids (like convertible loan stock). It
consists of the primary market and the secondary market.
I

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Primary and Secondary Capital Market Distribution

1. In the Primary Market, new shares are issued and sold to the investing
public for the first time through an initial public offering (IPO). Proceeds of
the sale go directly to the issuer, which is the company.

2. Secondary market, investors can buy and sell shares of stock, which have
been issued to the public in the primary market. It is the venue where an
investor can buy additional shares of stocks or sell his initial shares of
stocks. The proceeds of the sales do not go directly to the company but to
the owners of the shares. Secondary markets include the stock exchange
and the over-the counter market

Bond Market

Bonds are debt securities that a company can raise capital. Differences
between capital stock and bond:
1. Bondholders are creditors while stockholders are owners of the corporation.
2. No voting rights but common stockholders have voting rights.
3. Do not participate in the earnings of the corporation while stockholders
participate have
4. They receive interest payments while stockholders receive dividends.
5. Bonds have a specific maturity date while stock remain outstanding
indefinitely and have no maturity date.

In the Philippine capital markets, the bond is not a common form of a

long-term finance among private companies. The national government,
however, regularly issues Treasury Bonds, through the Bureau of Treasury, to
finance various program and projects. The bond market in the Philippines
consists of the primary and secondary markets. In the primary market, the
auction for Treasury Bonds and other government securities was assumed by
the Bureau of Treasury (BTr).

3. Foreign Exchange Market is a market where all claims to foreign currency

payable abroad, whether consisting of funds held in foreign currency, with
banks abroad, or bills or checks payable abroad are dealt with. It provides a
mechanism for the transfer of purchasing power from one currency to another.
It is a network of telephone and computer connections among banks, foreign
exchange dealers and brokers.

4. Derivatives are contract whose value is derived from the value of some
underlying assets, such as currencies, equities, or commodities, from an
indicator like interest rates; or from a stock market or other index.

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9. MONEY MARKET INSTRUMENTS

The characteristics of the money market instruments are short-term, low risk,
highly negotiable and liquid. The following are the money market instruments
available in the Philippines:

1. Negotiable certificates of deposit like bank certificate of deposits (CDs)

are short-term negotiable instruments issued by banks for a fixed duration
of 1-12 months at a pre-agreed interest rate. It is an interest-bearing
instrument and quoted on a yield basis. It has good liquidity due to its
tradability in the secondary market. These certificates are a significant
source of funding for commercial banks. The issuing banks bear the credit
risk associated with Negotiable Certificates of Deposits (NCDs). The yields
of NCDs are usually higher than the treasury bills and inter-bank repos.

Treasury-Bills are government securities that mature in less than a year.

Tenors are 91 days, 182 days, and 364 day bills. The number of day is
based on the universal practice around the world of ensuring that the bills
mature on a business day.

Treasury Notes maturities are from 2,5, and 7 years while the T-bonds
maturities are from 10 to 30 years. Both treasury notes and treasury bonds
can either be quoted on a yield or price basis. Both the long-term bonds
have very good liquidity in most countries. The government bears the risk
associated with the issuance of these instruments.

2. Short-term and long-term commercial papers

Commercial Papers (CPs) are promissory notes issued by corporate

borrowers that are usually large, well-known firms with good credit ratings.
Bu issuing commercial papers, they gain access to the money market.

Short-term commercial papers are unsecured short-term corporate

borrowings with maturities ranging from 3 to 6 months. It is issued on a
discount basis and quoted on a yield basis in terms of discount. It has
limited liquidity and the issuing company assumes the credit risk.

Long-term commercial paper (Long-term) are corporate borrowings with

maturities ranging from 2 to 7 years. This commercial paper, which is
quoted on a discount margin basis, bears a floating rate coupon (usually
indexed to the 91-day T-bill for peso denominated issued). It has limited
liquidity and the issuing company assumes the credit risk.

3. Bankers Acceptances (Bas) are short-term debt obligations guaranteed

by large commercial banks. Bas are short-term trade related debt and have
very good liquidity. They are usually accepted or endorsed by banks. They
typical maturities are from 3 to a maximum of 6 months. They are issued

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on a discount basis and quoted on a yield basis. The yields of Bas are
usually lower than the commercial papers because they carry the name of
the bank. The credit risk is on the accepting bank.

4. Regular Repos/Reverse Repos

Call money are amounts traded in the interbank call loan market (IBCL) that
corresponds to the reserves excess or deficiency of each bank. These are
overnight placements and computed based on the previous day’s deposit
balance of a bank.

IBCL Transactions represent overnight placements by banks with excess

cash in other banks with temporary reserve deficiencies, are the most
activity trade instruments in the Philippine market. The volume of inter-bank
loans, accounting for more than half of total transactions in the money
market.

Banks can either deal securitized (collateralized) and unsecuritized (clean)

lendings/borrowings as well as repurchase agreements in the inter-bank
market.

Repurchase Agreements (repos) are generally short-term sale of GS with

an agreement to repurchase on the agreed maturity date. Repos are
extensively used as a means of short-term financing by GS dealers and by
banks. The interbank market can either deal securitized (collateralized) or
usecuritized (clean lendings/borrowing, and repurchase agreements.
Repos can be classified into overnight or for a fixed-terms. The volume of
transaction in Repos is huge.

References:

a. Medina, R. G. (2000). Money, credit & banking. Valenzuela City, Mutya

Publishing House.
b. Croushore, D. (2014). Money and banking, Second edition. Ortigas Ave.,
Quezon City: Cengage Learning Asia Pte Ltd (Philippine Branch).
c. Nolledo, M. S. (2004). The new central bank act (Republic Act No. 7653).
Mandaluyong City: National Book Store.
d. Miranda, G. S. (2004). Essential of money, credit and banking. Revised
edition, 2004). San Juan, M.M.: L & G Business House.

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ACTIVITY #1 – 25 points
Instruction: Please insert in each column the specific classification of financial
institutions. You can answer as many as you want.
Privately Own Government Own Privately Own Government Own
Bank Financial Bank Financial Non-Bank Non-Bank
Institutions Institutions Financial Financial
Institutions Institutions

ANSWER FOR ACTIVITY #1

Privately Own Government Own Privately Own Government
Bank Financial Bank Financial Non-Bank Financial Own Non-Bank
Institutions Institutions Institutions Financial
Institutions
Ordinary Development Bank Investment GSIS
Commercial banks of the Philippines House/Bank
Universal Banks Al-Amanah Islamic Investment Company SSS
Investment Bank
of the Philippines
Rural Banks Land Bank of the Security Philippine Export
Philippines Broker/Dealer and Foreign Loan
Guarantee Corp.
Savings & Building & Loan National Home
Mortgage Bank Association Mortgage
Finance Corp.
Savings and Loan Credit Union
Association
Private Private Insurance
Development Bank Company
Rural Banks Pawnshop
Offshore Bank Trust Companies
Thrift Bank Non-Stock Savings
and Loan Association
Microfinance Bank Financing Co.
Lending Investor
Venture Capital Corp.

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ACTIVITY #2

Instruction: Enumerate the answers from the given question below:

A. What are the 4 components of financial system?

1. 2. 3. 4.
B. What are the 4 methods of direct financing?
5. 6. 7. 8.
C. What are the laws that govern the conduct of trade?
9. 10. 11. 12.
D. Who are participants in the Phil. Money Market?
13. 14. 15. 16.
E. What are the money market instruments available in the Philippines?
17. 18. 19. 20.

ANSWER FOR ACTIVITY #2

1. Financial instrument
2. Financial institution
3. Financial market
4. Government laws govern the conduct of trade
5. Private placement
6. Security Broker
7. Security Dealer
8. Investment Banker/House
9. General Banking Act
10. The Revised Securities Act
11. The Philippine Deposit Insurance Law
12. The Truth in Lending Act
13. BSP
14. Commercial Bank
15. Brokers
16. Corporates and institutional investors
17. Negotiable Certificates of Deposit
18. Short-term and long-term commercial papers
19. Banker’s Acceptance
20. Regular repos/reverse repos

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SAQ #1

Instruction: Match column A with column B. Write your answer in the first
column.
ANSWER COLUMN A COLUMN B
1. It occurs when one party in a transaction has A. Transaction Cost
better information than the other.
2. It is a network of financial institution which B. NOW
generate, circulate and control money and
credit.
3. It is a collection of assets C. Information Cost
4. It refers to uncertainty. D. Financial System
5. It is the spreading of wealth into many assets E. Liquidity
to make up a portfolio
6. It is a new payment services which include F. Diversification
money market.
7. A sector who commonly provides a big G. Asymmetric
amount of savings to banking institutions Information
8. It is manifested by the ease with which an H. Household
asset can be exchanged for money.
9. The cost of buying or selling a financial I. Risk
instrument
10. The cost incurs in determining the J Portfolio
creditworthiness of borrowers.

ASAQ #1

1. G
2. D
3. J
4. I
5. F
6. B
7. H
8. E
9. A
10. C

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SAQ #2

Instruction: Please identify the correct answer for each item given below:
1. It is generally a short-term sale of GS with an agreement to
repurchase on the agreed maturity date.
2. It is an amount traded in the interbank call loan market that
corresponds to the reserves excess or deficiency of each
bank.
3. A promissory notes issued by corporate borrowers that are
usually large, well-known firms with good credit ratings.
4. It is a short-term negotiable instrument issued by banks for
a fixed duration of 1-12 months at a pre-agreed interest rate.
5. It a new share issued and sold to the investing public for
the first time through an initial public offering.
6. It is a market for bond and equity shares with long term
maturities.
7. It participates in the money market through the conduct of
open-market operations.to attain its object of maintaining
price stability.
8. It facilitate the buying and selling of securities.
9. It a network of institutions and facilitates the trading debt
securities with maturity of one year or less.
10. It a contract whose value is derived from the value of
some underlying assets such as currencies, equities or
commodities.

ASAQ #2

1. Repurchase agreements.
2. Call money
3. Commercial paper
4. Negotiable certificate of deposit
5. Primary market
6. Capital market
7. BSP
8. Financial market
9. Money Market
10. Derivatives

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