HAF122-BANKING AND

FINANCE
Semester Two, 2024

COURSE COORDINATOR:
Mrs. Margaret SELLERS
 LECTURE 2

Unit 1: Introduction to Financial Systems

Topic:The structure of financial system and classification
of financial intermediaries
Learning Outcome:
After the completion of this topic you will:
1.explain why financial systems exist (i.e. explain the functions of financial
systems)
2.Outline the structure of financial systems (i.e. describe the three main entities
that compose financial systems: financial intermediaries, securities and financial
markets)
3.describe which financial intermediaries operate in financial systems in the USA
and explain their characteristics.
* 3/
 Introduction
⮚We start the unit with an overview of financial systems, their
functions and general structure. Then we investigate the nature and
characteristics of the three major entities that compose financial
systems. These are financial intermediaries, securities and
financial markets.
⮚In our review of different countries, we restrict ourselves to large
economies with well-developed financial systems, notably the USA,
UK, France and Germany. Specifically, we take a US view, therefore in
in this lecture other countries are compared with the US financial system.
 1.2 Functions of financial systems
⮚Financial systems perform the essential economic function of channeling funds
from units who have saved surplus funds to units who have a shortage of funds. The
units who have saved can lend funds: they are known as lender-savers [lenders].
The units with a shortage of funds must borrow funds to finance their spending:
they are the borrower-spenders [borrower]. The most important lenders are
usually households; while the typical borrowers are firms and the government.
⮚The channeling of funds from savers to spenders is very important for two
reasons:
1.lenders (with excess of available funds) do not frequently have profitable
investment opportunities, while borrowers have investment opportunities but lack
of funds.
2.borrowers may want to invest in excess their current income or to adjust the
composition of their wealth (preferences for current versus future consumption).
TYPES OF FINANCE
There are two types of Finance borrowing:

⮚ In DIRECT finance, borrowers borrow funds directly from lenders in the

financial markets by selling them securities [see figure 1.1].
⮚In INDIRECT finance, a financial intermediary stands between the lenders and
the borrowers: the intermediary helps to transfer funds from one to the other. This
suggests that financial markets and intermediaries are alternatives that perform
more or less the same function but in different ways. However, the process of
indirect finance, known as financial intermediation, is the most important way
of transferring funds from lenders to borrowers [see figure 1.1].
⮚Another important function of a financial system is the monetary function. The
introduction of money into the economy enables savers and spenders to separate
the act of sale from the act of purchase and allows them to overcome the main
problem of barter.
The financial system provides a variety of payment mechanisms e.g. cheques, debit
cards and credit cards to enable one party to pay another.
* ⮚Financial systems also provide mechanisms for risk to be transferred. For
example insurance contracts allow a party such as a firm or household to transfer
the risk of loss of wealth due to theft or fire to another party such as an insurance
company.
⮚The firm or household will pay a fee (insurance premium) for this transfer. The
insurance company, by providing a large number of insurance contracts, is better able
to manage the risk than an individual firm or household as they can obtain benefits
of pooling and diversification. Thus a more efficient allocation of risk results.
⮚In summary, the main functions of financial systems are:
❑To provide the mechanisms by which funds can be transferred from surplus units
to deficit units in order to directly or indirectly facilitate lending and borrowing (see
Figure 1.1)
.To enable wealth holders to adjust the composition of their portfolios
.To provide payment mechanisms
.To provide mechanisms for risk transfer

Figure 1.1: Direct and indirect lending performed by a financial system

* 1.3 The structure of financial systems:
* i. financial markets, ii. securities and iii. financial intermediaries
⮚From a structural point of view a financial system can be seen in terms of the
entities [bodies] that compose the system. A financial system comprises financial
markets, securities and financial intermediaries.
1. Financial markets
⮚Financial markets are markets in which funds are moved from people who
have an excess of available funds (and lack of investment opportunities) to people
who have investment opportunities (and lack of funds). They also have direct
effects on personal wealth, and the behaviors of businesses and consumers.
Therefore, they contribute to increase the production and the efficiency in the
overall economy. Financial markets (such as bond and stock markets) are markets
in which securities are traded.
 2. Securities
⮚Securities (also called financial instruments) are financial claims on the issuer’s
future income or assets. They represent financial liabilities for the individual or
firm that sells them (borrower or issuer of the financial claim) in return for
money, and financial assets for the buyer (lender or investor in the financial
claim).
⮚Governments and corporations raise funds to finance their activities by issuing
debt instruments (bonds) and equity instruments (shares, known in the USA as
stocks). Bonds are securities that promise to make periodic payments of a sum
of money for a specified period of time. Stocks/shares are securities that
represent a share of ownership in the firm.
 * 3.Financial Intermediaries
⮚Financial intermediaries are economic agents who specialize in the activities
of buying and selling (at the same time) financial contracts (loans and deposits) and
securities (bonds and stocks).
⮚Financial securities are easily marketable, while financial contracts cannot be easily
sold (marketed). Banks form the largest financial institution in US economy. They
accept deposits (loans by individuals or firms to banks) and make loans (sums of
money lent by banks to individuals or firms): therefore, they borrow deposits from
people who have saved and in turn make loans to others.
⮚In recent years, other financial intermediaries, such as mutual funds, pension funds,
insurance companies and investment banks, have been growing at the expense of
banks.
1.4 Taxonomy or classification of financial intermediaries
⮚We begin by looking at the USA, the largest economy and financial system
in the world. In the USA the three major groups of financial intermediaries
are: depository institutions, contractual savings institutions and investment
intermediaries
1.4.1 Depository institutions
⮚Depository institutions: intermediaries with a significant proportion of
their funds derived from customer deposits. These include: commercial
banks [savings institutions] and credit unions.
Commercial banks
⮚Commercial banks accept deposits (liabilities) to make loans (assets) and to buy
government securities. Deposits are broad in range, including checkable deposits
(deposits on which cheques can be written), savings deposits (deposits that are
payable on demand), time deposits (deposits with a fixed term to maturity). Loans
include consumer, commercial and mortgage loans.

⮚In the USA, commercial banks are the largest group of financial intermediary: in
2006 there were 7,402 with aggregate total assets of $10.1 trillion (according to
the FDIC Quarterly Banking Profile).

⮚This is also applicable in Papua New Guinea financial system, the four commercial
banks, namely Bank South Pacific [BSP] Limited, Australia and New Zealand [ANZ]
Group Limited , Westpac Limited and recently Kina Bank Limited form the largest
financial intermediary in our economy.
The balance sheet structure of US commercial banks reflects the main assets
and liabilities of their business. The aggregated balance sheet values for US
banks in 2006 are reported in Table 1.1. As shown, loans constituted around
58 per cent of their assets (compared with 62 per cent in 1990), whereas
investments in securities represented 16 per cent of their assets.
Interest-bearing deposits instead constituted 54 per cent of their liabilities.

Table 1.1: Aggregate balance sheet values for US commercial banks [$million, 2006] Source: Table created using data from FDIC website
(www2.fdic.gov/hsob/)
 Savings and loan associations
⮚Historically savings and loan associations (S&Ls) have concentrated
mostly on residential mortgages by acquiring funds primarily through
savings deposits. In terms of number of institutions, they are the
second largest group of financial intermediaries (1,279 associations
with $1.8 trillion of total assets in 2006 according to FDIC Quarterly
Banking Profile).
⮚The evolution in the number and size (in terms of total assets) of
both commercial banks and S&Ls is shown in Figures 1.3 and 1.4.
Figure 1.3: Trend in the size of US depository institutions Source: Table created using data from FDIC website
(www2.fdic.gov/hsob/)
Figure 1.4: Trend in the number of US depository institutions Source: Table
created using data from FDIC website (www2.fdic.gov/hsob/)
Credit unions
⮚Credit unions are non-profit institutions mutually organized and owned by their
members (depositors).
⮚Their primary objective is to satisfy the depository and lending needs of their
members, who have to belong to a particular group (identified by occupation,
association, geographical location).
⮚The members’ deposits are used to provide loans to other members, and
earnings from these loans are used to pay a higher rate of interest to member
depositors. They are the most numerous among the institutions composing
depository institutions, totaling about 8,535 in 2006 according to the Credit
Union National Association.
Contractual savings institutions
⮚Contractual savings institutions acquire funds at periodic intervals on a
contractual basis. The industry is classified into two major groups: insurance
companies and pension funds. The liquidity of their assets is less important than
for depository institutions because they can predict with reasonable accuracy
the future payments due to their customers. As a consequence they invest their
funds in long-term securities (such as corporate bonds, stocks and mortgages).
Insurance companies

⮚The primary objective of insurance companies is to protect individuals and

firms (known as policy-holders) from adverse events. Insurance companies
receive premiums from policy-holders, and promise to pay compensation to
policy-holders if particular events occur. There are two main segments in the
industry: life insurance, and property and causality insurance.
1.Life insurance protects against death, illness and retirement. Companies acquire
premiums from the policy-holders, and use them mainly to buy corporate bonds,
mortgages, and stocks (amount limited by legislation).
2.Property and causality insurance provides protection against personal injury and
liabilities such as accidents, theft and fire. Pension funds
⮚Pension funds provide retirement income (in the form of annuities) to employees
covered by a pension plan. They receive contributions from employers or
employees and invest these amounts in corporate bonds and stocks. There are
private pension funds and public pension funds. The US government has promoted
the establishment of pension funds, and the expectation is of further
developments in pension funds in terms of number and variety of options. In PNG
we say superannuation fund/industry, example of superannuation fund or pension
fund in PNG include NASFUND Limited and Nambawan Super Limited
 1.4.2 Investment intermediaries
⮚Investment intermediaries comprise mutual funds, finance companies,
investment banks and securities firms. .
1. Mutual funds
⮚Mutual funds pool resources from many individuals and companies and invest
these resources in diversified portfolios of bonds, stocks and money market
instruments.

Two main advantages characterize mutual funds.

1.mutual funds provide opportunities to small investors to invest in financial
securities and diversify risk.
2.mutual funds take advantage of lower transaction costs when they buy larger
blocks of financial securities.
 Mutual Fund Industry
There are two segments in the mutual fund industry: long-term funds and
short-term funds.
1.Long-term funds comprise bond funds (funds that contain fixed-income debt
securities), equity funds (funds that contain stock securities) and hybrid funds
(funds that contain both debt and stock securities).
2.Short-term funds are represented by money market mutual funds, funds that
contain various mixes of money market securities and partially allow
shareholders to write cheques against the value of their holdings.

⮚In the USA mutual funds are the second most important financial
intermediary in terms of asset size. In fact, they are larger than the insurance
industry, but smaller than the commercial bank industry.
Figure 1.5: Intermediated funds by type of financial intermediary Source: Table
created using data from FDIC website (www2.fdic.gov/hsob/)
⮚Summing up, as shown in Figure 1.5, the total funds intermediated by US financial
intermediaries are US$25.17 trillion in 2006. Commercial banks account for the
highest proportion, followed by mutual funds, insurance companies and S&Ls.

3. Finance companies
⮚Finance companies make loans to individuals and corporations by providing
consumer lending, business lending and mortgage financing. Some of their loans are
similar to those provided by commercial banks.

⮚However, finance companies differ from commercial banks because they do not
accept deposits. They raise funds by selling commercial paper (a short-term debt
instrument) and by issuing stocks and bonds. Moreover, finance companies often
lend to customers perceived as too risky by commercial banks.
 2. Major types of finance companies:
There are three major types of finance companies:

❑Sales finance institutions that make loans to customers of a particular

retailer or manufacturer (e.g. Ford Motor Credit).

❑Personal credit institutions that make loans to consumers perceived as too

risky by commercial banks (e.g. Household Finance Corp).

❑Business credit institutions that provide financing to companies, especially

through equipment leasing and factoring (purchase by the finance company of
accounts receivable from corporate customers).
4. Investment banks
⮚Investment banks assist corporations or governments in the issue of new debt or equity
securities. Investment banking includes:
❑the origination, underwriting and placement of securities in primary financial markets
(primary and secondary markets will be discussed later). The process of underwriting a stock
or bond issue requires the investment bank to purchase the entire issue at a predetermined
price and then to resell it in the market. The investment bank then bears the risk that they are
not able to resell the entire issue in which case it will hold the unsold stock on its own balance
sheet. In return for taking on this risk the investment company receives an underwriting fee
from the issuing company.
❑financial advisory on corporate finance activities (such as advising on mergers and
acquisitions). Mergers and acquisitions (M&A) is the area of corporate finances,
management and strategy dealing with purchasing and/or joining with other companies. In a
merger, two organizations join forces to become a new business, usually with a new
name[example in PNG would be PNGBC and BSP merge to become BSP now]
⮚Typically, investment banks earn their income from fees charged to clients. These fees are
usually set as a fixed percentage of the size of the deal being worked.
 5. Security Firms

⮚Securities firms assist in the trading of existing securities in the secondary

markets. There are two main categories of securities firms:
1. Brokers - agents of investors who match buyers with sellers of securities.
They earn a commission for their service
2. Dealers - agents who link buyers and sellers by buying and selling securities.
They hold inventories of securities, and sell these securities for a slightly
higher price than they paid for them. They thus earn the bid-ask spread,
the difference between the best ask (lowest price charged for immediate
purchase of stock) and the best bid (highest price received for an immediate
sale of a unit of stock).
 SECURITY ORDERS
⮚The main service offered by brokers is securities orders. Orders are trade
instructions specifying what traders want to trade, whether to buy or sell, how
much, when and how to trade, and on what terms. Traders issue orders when they
cannot personally negotiate their trades.

⮚There are two primary types of orders: market orders and limit orders.
1. Market orders are instructions to trade at the best price currently available in
the market. Market order traders pay the bid-ask spread (they demand
immediately).
2. Limit orders instead are instructions to trade at the best price available, but
only if it is no worse that the limit price specified by the trader.
 ORDER EXAMPLE,
⮚For example, you submit a limit order to buy 100 shares of BSP at K15 per
share. The order will be executed if there is a seller willing to give you his shares
for K15 or less. In such a case, there is no price uncertainty but there is
execution uncertainty.
Retail banks and wholesale banks
⮚Commercial banking can also be separated into retail and wholesale banking.
⮚The difference between retail and wholesale banking is essentially one of size.
Retail banks have traditionally provided intermediation and payment services to
individuals and small businesses dealing with a large number of small value
transactions.
⮚This is in contrast with the wholesale banks, which deal with a smaller number
of larger value transactions.
⮚In practice it is difficult to identify purely retail banks. In the UK, USA and even
in PNG and many other developed countries, large banks combine retail and
wholesale activities.
 References

❖Rose, Peter S. Bank management & financial services / Peter S. Rose, Sylvia C.
Hudgins.-9th ed., Published by McGraw-Hill, a business unit of The McGraw-Hill
Companies, lnc., 1221 Avenue of the Americas, New York

❖Artem V. Arkhipov, Anna S. Bogdyukevich,Viktor K. Shpringel. http:// Principles

of Banking and Finance. (2016)
 Tutorial Questions
1.2 Explain the functions of financial system in an economy.
1.3 Differentiate direct financing from indirect financing using diagram.
1.4 Explain the following structure of financial systems
❑ Financial markets
❑ Securities
❑ Financial intermediaries
1.5 Briefly explain these USA financial intermediaries; Depository institutions
Pension funds Commercial banks Mutual funds Savings and loans Finance
companies Credit Union Investment Banks Security firms Contractual savings
institutions Insurance companies
1.6 Differentiate between Retail and Whole sale banking