Basic Elements of the Financial System

For an economy to function properly, various systems are needed to be putin place. One of
these refers to the financial system. As a functioning financial system is a prerequisite to
economic development. A discussion of this topic becomes important.

This chapter presents the nature, the purposes, and the components of the financial system.

WHAT IS A FINANCIAL SYSTEM

Borrowers and lenders are complementary sectors of our economy. It will be difficult, however,
for the individual borrowers and lenders to seek out one another, sit on the bargaining table, and
agree on all aspects of a financial transaction. For instance, Mr. Fernando Flores needs one
million pesos for business expansion. He wants to borrow that amount from a lender who will
accept repayment after five years at a reasonable rate of interest.

Mr. Flores will then start searching for the willing lender. Since he is not an expert in searching
for lenders, it will take him sometime and some money to find one who will match his needs.

Even if Mr. Flores finds a lender, the difficulty attached to searching minimizes opportunities for
more participants in the lending process for this reason, the financial system was invented.
Since there was already established economic need, the remedy was not far behind. The
solution to the problem of Mr. Flores contributed immensely to the current economic stature of
developed countries like the United States, Great Britain, Germany, and France.

Financial System Defined

The following are definitions of the financial system as provided by various writers:

The financial system is defined by Rose, Kolari, and Fraser as

".. the institutional mechanism established by society to produce and deliver financial-services
and allocate resources, consisting of the business firms supplying financial services, the
customers of financial-service firms,and government regulatory authorities that enforce the rules
prevailing within the financial sector."

Kaufman describes the finarncial systerm as encompassing

the instruments, institutions, markets, and rules governing the conduct of trade that expedite the
routing of funds from buyers to sellersal from savers to lenders"

Cagill deines inencial systerm as one "in which funds are traded betweenorrowere and tenders"
Cargill's definition provides a limited view of the financial systemKaufin'a description is more
explicit by mentioning the various componentsof the yutem The definition of Rose and others is
more applicable to modernrequirenente because it includes the regulatory actions of the
government.

FUNCTIONS OF THE FINANCIAL SYSTEM

The financial system performs functions that are essential in making aneconenic system work.
These functions are as follows:

1. Credit
2. Payments
3. Money creation
4. Savings

Credit is supplied by the financial system to three types of borrowers: (1)consumers, (2)
business, and (3) government. When borrowers are provided with funds, the purchases they
make strengthen the viability of firms they patronize. In turn these firms provide employment to
many people, make various products and services available, and pay taxes to the government

Payments
A mechanism for making payments is supplied by the financial system.The payments system
takes the forms of currency, checking accounts and various transactions media./Financial
institutions of late have developed new payment services which include money market and
NOW (Negotiable Order of Withdrawal) accounts and share drafts (all types of
interest-bearnscheckin8 accounts), tuition fee and telephone paying services, and electro
machines that accept deposits and dispense cash.

Money Creation
Money is artificially created by the financial system through the server of supplying credit and
providing a mechanism for making payments modern conditions, the money supply consists of
currency (pocketbook money) and deposits (or checkbook money)

Even if the government provides currency for circulation, additicnalmones is created by the
banking system by facilitating the use of other means of payment like checks.

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 task of finding willing
borrowers.

COMPONENTS OF THE FINANCIAL SYSTEM

The financial system is composed of various elements as follows:
 1. financial instruments
2. the financial sector consisting of financial markets and financial institutions, and
3. rules governing the conduct of trade.

Financial instruments are the evidence of debt that are bought and sold in the market. They
consist of money, loans (debts), and ownership shares.

The financial market is a mechanism by which savings in one sector of the economy flows to
another sector.

A financial institution 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.

There are certain rules which the various players in the financial system must observe. These
rules were designed to keep the financial system intactand well-functioning.

The rules governing the conduct of trade consist of the following:

1. pertinent laws concerning financial institutions;
2. memoranda, circulars, and issuances of concerned government agencies,
3. pertinent ordinances of local government units where the financial institution is situated;
4. customs and traditions inherent to the area where the financial institution is situated.

CONNECTING BORROWERS WITH LENDERS

Borrowers and lenders are two important segments of the economy.Interactions between them
drums up economic activity. The services provided intermediaries in the financial system make
the interactions more brisk and productive.

Exhibit 1

THE FINANCIAL SYSTEM AND ITS COMPONENTS

FINANCIAL SYSTEM
● Financial Instrument
● Financial Sector
● Rules Governing The Conduct Of Trade

under FINANCIAL SECTOR

● Financial Institution
● Financial Markets

Four sectors of the economy which are engaged in borrowing and lending are: (1) households,
(2) firms, (3) the government, and (4) foreigners.
Household income comes from wages, dividends, royalties, and interest paid by firms. This
income is spent mostly on goods and services. Part of the income not spent is loaned. The
financial system absorbs most of the savings and channel them to firms.

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, firms will have two
sources of income (1) those arising out of household expenditures, and (2) 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. As the cycle is completed, it will be repeated all over again Exhibit 3.2 shows an
illustration of the low of funds in the financial system with the households and firms interacting.

If the government is included, the flow of funds will be a little complicated. The government will
have its income 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 this amount is given out to households in the form of wages dividends, royalties, and
interest. These flow of funds are illustrated in Figure 3.3

Exhibit 3.2

THE FINANCIAL SYSTEM AND THE FLOW OF FUNDS

WHY HOUSEHOLDS SAVE AND LEND

The needs of households vary from day-to-day, month-to-month, and year-to-year. A newly
married couple for instance, will need a place (a house to be exact) to stay. If there are no
apartments or houses available for rent in the air where they work, they may need to buy or
construct one. They may even need to purchase a motor vehicle. At this point, their incomes
may not be enough to make capital expenditures, So, the couple may decide to save a part of
their monthly income to put up enough funds to construct a house and buy a car. The more
disciplined individual, however, will save money years ahead of marriage

As the household grows older, its income will tend to grow faster thanits expenses. lt will then
have excess funds. The household will now consider saving 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.

Exhibit 3.4 shows the relationship between household income and spending at various stages in
the life cycle.

Exhibit 3.4

RELATIONSHIP BETWEEN HOUSEHOLD INCOME AND SPENDING AT VARIOUS STAGES

Stage in the Life Cycle of the Household

● new
● middle age
● retirement
Income
● smaller than expenses
● bigger than expenses
● smaller than expenses

Financial Decision
● Spend savings or borrow
● build up savings and liquidate borrowings
● spend savings

WHY FIRMS INVEST AND BORROW

Firms, at one time or another, are affected by deficiency in capital. It happens when
opportunities for investment come by. Additional investment may bring additional income or
economies in operation. A drug retailing firm for instance, may expand by opening branches in
various places. The immediate advantages that may be derived are as follows:

1. quantity discounts for bulk purchases granted by suppliers, and

2. additional resources from sales.

When the owners of the firm cannot provide additional capital, they will resort to borrowing. This
situation happens not only to small firms but to big firms as well.

A system must be able to address that particular economic need. The answer lies in the
operation and maintenance of a financial system.

Examples of firms which borrowed or intend to borrow from the financial systems in 2014 are as
follows:

1. SM Prime Holdings - P25 billion

2. JG Summit Holdings - P30 billion
3. PLDT - PI5 billion
4. ABS-CBN - P10 billion
5. Filinvest Development Corporation - Pl0 billion.

TRANSFERRING FUNDS FROM LENDERS TO BORROWERS

The financial system is concerned with transferring funds from lenders to borrowers. The
lenders are those whose revenues exceeded their expenditures providing enough reason to be
referred to as surplus spending units (SSUs).The borrowers, on the other hand, have
expenditures exceeding their revenues,ad ths, are referred to as deficit spending units
(DSUs).
Transferring funds from SSUs to DSUs basically consists of two methods.They are direct and
indirect finance.

Direct finance refers to lending by ultimate borrowers with no intermediary.Linder 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 expenditures. 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.

There are few DSUs which can transact in the direct market because the denominations of
securities sold are very large (usually millions of pesos)

TRANSFER OF FUNDS FROM LENDERS TO BORROWERS

2. It is difficult to match the requirements of SSUs and DSUs in terms of denomination, maturity,
and others.

Methods of Direct Financing.

There are various means used in direct financing.

1. private placements
2. brokers and dealers
3. investment bankers.
Private placement refers to the selling of securities by private negotiation directly to insurance
companies, commercial banks, pension funds, large-scale corporate investors, and wealthy
individual investors.

A broker is one who acts as an intermediary between buyers and sellers but does not take title
to the securities traded.

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.

The investment banker is a person who provides financial advice and who underwrites and
distributes new investment securities.

Indirect Finance
Indirect finance (also called financial intermediation) refers to lending byan ultimate lender to a
financial intermediary that then relends to ultimate borrowers. Financial intermediaries include
commercial banks, mutual savings banks, credit unions, life insurance companies, and pension
funds.

The inefficiencies of direct financing brought to the fore the services of financial intermediaries.
Direct claims with one set of characteristics are purchased from borrowers, then transformed
into indirect claims with different sets of characteristics and then sold to lenders.

THE BENEFITS OF FINANCIAL INTERMEDIATION

Financial intermediation offers the following benefits:

1. 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.
2. 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 a moral hazard.

When lenders deal with financial intermediaries, the moal hazard is eliminated partly if not
completely. The risk does not pose a real problem in financial intermediaries because they have
already developed the expertise to deal with them.

KINDS OF FINANCIAL INTERMEDIATION

There are several kinds of intermediation performed by financial intermediaries..

Denomination Intermediation - this refers to the intermediation performed by financial
intermediaries where large denomination claims in the form of loans and securities are accepted
from borrowing customers while simultaneously issuing relatively low-denomination financial
instruments to savers to attract as many savers as possible and pool their funds to make the
large-denomination loans requested by the borrowing customers.

Default Risk Intermediation - this refers to the intermediation performed by the financial
intermediary here risky claims in the form of loans and securities are accepted against
borrowing customers while simultaneously issuing relatively safe financial instruments to savers
to attract their funds.

Maturity Intermediation - this refers to the practice of borrowing comparatively short-term

funds from savers and making long term loans to borrowers who require a lengthy commitment
of funds

Information Intermediation - refers to the process by which financial intermediaries substitute

their skill in the marketplace for that of savers who frequently have neither the time nor the
access to relevant information about market conditions and investment opportunities

CATEGORIES OF FINANCIAL INTERMEDIARIES

According to the functions they perform, financial intermediaries may be categorized into
various types.

1. Depository Intermediaries they are called as such because the sources of their
loanable funds (secondary securities) consist of deposits received from businesses,
households, and governments Included in this group are commercial banks, credit
unions, savings and loans associations, and savings banks

2. Contractual Intermediaries - this type enter into contracts with theirCustomers to

promote saving and/or financial protection against loss of life or property. Contractual
intermediaries consist of life and nonlife insurance companies, the Government Service
Insurance System(GSIS), the Social Security System (SSS), private pension funds, and
educational plan companies.
The newest type of contractual intermediaries are educational plan companies like Ayala
Plans, Inc. and Loyola Education Systems Inc. These companies sell contracts covering
educational insurance of children.

3. Secondary Intermediaries - these are called as such because they depend heavily on
other financial intermediaries like commercial banks for loanable funds, Included in this
category are finance companies, mortgage banks, and real estate investment trusts.

4. Investment Intermediaries - this type offers the public securities that can be held
indefinitely as a long-term investment and which can be sold quickly when the customer
 needs his funds returned. Investment intermediaries include mutual stock funds, bond
funds, and money market funds.

REGULATION OF THE FINANCIAL SYSTEM

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.

The enactment of laws comprises the first area for government controlAmong the laws that
cover the operations of financial ínstitutions and the financial market include the General
Banking Act, the Revised Securities Act,the Philippine Deposit Insurance Law, the Truth in
Lending Act, Offshore Banking Law, Uniform Currency Act, Corporation Code, and Negotiable
Instruments Law. A specific instance of regulation for example, is provided under the Financing
Company Act of 1998 which makes real estate an asset that can be the subject of financial
leasing.

The second area for monitoring and controlling the financial system is through government
regulatory agencies like the Bangko Sentral ng ilipinas,the Monetary Board, and the Securities
and Exchange Commission. Various memoranda and circulars are issued by these agencies
whenever circumstances require such actions. An example is the recent approval of the
ImplementingRules and Regulations (IRR) Of the Financing Company Act of 1998 (RA.
No8556). Asummary of the important provisions of the IRR are shown in Exhibit 3.7.

Since private financial institutions are also businesses, they are covered by ordinances of
municipalities where they are located. Examples of focal requirements are business permits and
licenses.

FINANCIAL INTERMEDIARIES AND THEIR SOURCES OF FUNDS