Overview of the
Financial System
LESSON 1
Expected Learning Outcomes
After this chapter, you should be able to:
• Explain what financial system is as well as its objective
• Explain how the financial system affects a nation’s economy.
• Discuss the flow of funds through the financial system.
• Enumerate the key components of the financial system.
• Give and describe examples of financial assets and financial liabilities.
• Explain the main functions of the financial system.
• Distinguish between adverse selection and moral hazard.
• Describe how financial intermediaries
• Reduce adverse selection
• Reduce moral hazard problems
• Reduce transaction costs
A vibrant and healthy economy requires a financial system that makes or
channels funds from people who save to people who have productive
investment opportunities. The financial system is complex in structure
and functions throughout the world. A developed economy relies on
financial markets and institutions for efficient transfer of funds. Every
person's life, family, business, and government are affected by the
financial system.
A strong financial system is a necessary ingredient for a growing and
prosperous economy. Companies raising capital to finance capital
expenditures and investors saving to accumulate funds for future use
require well-functioning financial markets and institutions.
NATURE AND
OBJECTIVE OF
THE FINANCIAL
SYSTEM
The financial system consists of all
financial intermediaries and financial
markets and their relations with respect to
the flow of funds to and from households,
governments, business firms and
foreigners, as well as the financial
infrastructure.
Having a well-functioning financial
system in place that directs funds to
their most productive uses is a crucial
prerequisite for economic development.
Figure 5-1: Flow of Funds through the Financial
System
KEY COMPONENTS OF THE
FINANCIAL SYSTEM
The major components of the financial system include:
a) Financial Instruments
b) Financial Markets and Financial Institutions
c) The Central Bank and Other Financial Regulators
FUNCTIONS OF THE FINANCIAL SYSTEM
The main task of the financial system is to channel
funds from sectors that have a surplus to sectors that
have a shortage of funds. In the financial system,
banks, insurance companies, mutual funds,
stockbrokers, and other financial services firms
compete to provide financial services to households
and businesses.
FUNCTIONS OF THE FINANCIAL SYSTEM
Economists believe there are three key services that the
financial system provides to savers and borrowers: risk sharing,
liquidity, and information. Financial services firms provide
these services in different ways, which makes different
financial assets and financial liabilities more or less attractive
to individual savers and borrowers.
a. Risk sharing
b. Liquidity
c. Information
RISK SHARING
Risk is the chance that the value of financial assets will change relative to what
one expects. One advantage of using the financial system to match individual
savers and borrowers is that it allows the sharing of risk. Most individual
savers seek a steady return on their assets rather than erratic savings between
high and low earnings. This splitting of wealth into many assets to reduce risk
is known as diversification.
The financial system provides risk sharing by allowing savers to hold many
assets. Hence, because of the ability of the financial system to provide risk
sharing makes savers more willing to buy stocks, bonds and other financial
assets. This willingness, in turn increases the ability of borrowers to raise funds
in the financial system. Financial intermediaries have developed expertise in
holding a diversified portfolio of innovative projects which reduces risk and
promotes investment in growth enhancing innovative activities.
LIQUIDITY
Another key service that the financial system offers savers and borrowers is liquidity.
Liquidity is the case with which an asset can be exchanged for money which savers
view as a benefit. Generally, assets created by the financial system such as stocks,
bonds or checking accounts, are more liquid than are physical assets such as cars,
machinery or real estate.
Financial markets and intermediaries help make financial assets more liquid. Investors
can easily sell their holdings of government securities and the stocks and bonds of large
corporations, making those assets very liquid.
The financial system has increased the liquidity of many assets besides stocks and
bonds through the process of securitization. This process has made it possible to buy
and sell securities based on loans. As a result, mortgages and other loans have become
more desirable assets for savers to hold. Savers are willing to accept interest rates on
assets with greater liquidity which reduces the costs of borrowing for many households
and firms.
INFORMATION
A third service of the financial system is the collection and communication of
information, or facts about borrowers and expectations of returns on financial assets.
Banks collect information on borrowers to forecast their likelihood of repaying loans.
Because the bank specializes in collecting and processing information, its costs for
information gathering are lower than yours would be if you tried to gather information
about a pool of borrowers. The profit the bank earns on its loans is partly compensation
for the resources and time bank employees spend to gather and store information.
Financial markets convey information to both savers and borrowers by determining the
prices of stocks, bonds, and other securities. This information can help one decide
whether to continue investing in the securities previously purchased or to sell more
stock or bonds to finance a planned expansion: The incorporation of available
information into asset prices is an important feature of well-functioning financial
markets.
The Problems of Adverse Selection and Moral Hazard
A key consideration for savers is the financial health of borrowers. Savers do
not lend to borrowers who are unlikely to pay them back. Unfortunately for
savers, borrowers in poor financial health have an incentive to disguise this
fact. For example, a company selling bonds to investors may know that its
sales declining rapidly, and it is near bankruptcy, but the buyers of the bonds
may lack this information.
A vital service of the financial system is the collection and communication of
information or facts about borrowers and expectation of returns in financial
assets. Financial markets convey information to both savers and borrowers by
determining the prices of stocks, bonds and other securities.
Asymmetric information describes the situation in which one party to an economic
transaction has better information than does the other party. In financial transactions,
typically the borrower has more information than does the lender.
Two problems arising from asymmetric information are
1. Adverse selection. This is the problem investors experience in distinguishing low-risk
borrowers from high-risk borrowers before making an investment.
2. Moral hazard. This is the problem investors experience in verifying that borrowers are
using their funds as intended.
Sometimes an investor will consider the costs arising from asymmetric information to be so
great that the investor will lend only to borrowers who are transparently low risk, such as
the national government. However, more generally, there are practical solutions to the
problems of asymmetric information, in which financial markets or financial intermediaries
lower the cost of information needed to make investment decisions.
The financial system helps overcome an information asymmetry between borrowers and
lenders. An information asymmetry can occur before or after a financial contract has been
agreed upon.
Adverse Selection
The information asymmetry before the contract is agreed upon arises because borrowers
generally know more about their investment projects than lenders. Borrowers most eager to
engage in a transaction are the most likely ones to produce an undesirable outcome for the
lender (adverse selection). Individual savers may not have the time, especially or means to
collect and take advantage of economies of scale and scope.
Moral Hazard
Even after a lender has gathered information on whether a borrower is a good borrower or a
lemon borrower, the lender's information problems haven't ended. There is still a possibility
that after a lender makes a loan to what appears to be a good borrower, the borrower will
not use the funds as intended. This situation, known as moral hazard, is more likely to occur
when the borrower has an incentive to conceal information or to act in a way that does not
coincide with the lender's interests. Moral hazard arises because of asymmetric information:
The borrower knows more than the lender does about how the borrowed funds will actually
be used.
NATURE AND IMPACT OF TRANSACTION AND INFORMATION
COSTS
Transaction Costs
The cost of a trade or a financial transaction; for example, the brokerage commission
charged for buying or selling a financial asset.
Information Costs
The costs that savers incur to determine the creditworthiness of borrowers and to
monitor how they use the funds acquired.
Because of transaction costs and information costs, savers receive a lower return on
their investments and borrowers must pay more for the funds they borrow. As we have
just seen, these costs can sometimes mean that funds are never lent or borrowed at all.
Although transactions costs and information costs reduce the efficiency of the financial
system, they also create a profit opportunity for individuals and firms that can discover
ways to reduce those costs.
How Financial Intermediaries Reduce "Adverse Selection"
The problem of "adverse selection" can be minimized if not totally avoided using the following
approaches:
1. Requiring borrowers to disclose material information on their financial performance and
financial position.
Financial market participants and the government have taken steps to try to reduce problems of
adverse selection in financial markets. The SEC requires the publicly traded firms report their
performance in financial statements, such as balance sheets, which show the value of the firm's
assets, liabilities, and stockholders' equity (the difference between the value of the firm's assets and
the value of its liabilities), and income statements, which show a firm's revenue, costs, and profit.
Firms must prepare these statements using standard accounting methods. In addition, firms must
disclose material information, which is information that, if known, would likely affect the price of
a firm's stock.
2. Collecting information on firms and that information to investors.
3. Convincing lenders to require borrowers to pledge some of their assets as collateral which the
lender can claim of the borrower defaults.
How Financial Intermediaries Reduce Moral Hazard Problems
Financial Intermediaries can reduce moral hazard problems by adopting more
stringent procedures in monitoring the borrower's use of funds. This will
include:
1. Specializing in monitoring borrowers and developing effective techniques to
ensure that the funds they loan are actually used for their intended purpose.
2. Imposing Restrictive Covenants
Restrictive covenants may involve placing limitations on the uses of funds
borrowed or requiring the borrowers to pay off the debt even before maturity
date if the borrower's net worth drop below a certain level.
How Financial Intermediaries Reduce Transaction costs
Transaction costs may be reduced by adopting the following techniques:
1. Financial intermediaries take advantage of economies of scale, which refers to the reduction in
average cost that results from an increase in the volume of a good or service produced. For
example, the fees dealers in Treasury bonds charge investors to purchase P10 million worth of
bonds are not much higher than the fees they charge to purchase P11 million worth of bonds. By
buying P500 worth of shares in a bond mutual fund that purchases millions of pesos’ worth of
bonds, an individual investor can take advantage of economies of scale.
2. Financial intermediaries can also take advantage of economies of scale in other ways. For
example, because banks make many loans, they rely on standardized legal contracts, so the costs of
writing the contracts are spread over many loans. Similarly, bank loan officers devote their time to
evaluating and processing loans, and through this specialization, they are able to process loans
efficiently, reducing the time required - and, therefore, the cost per loan.
3. Financial intermediaries also take advantage of technology to provide financial services, such as
those that automated teller machine networks provide.
4. Financial intermediaries also increasingly rely on sophisticated software to evaluate the credit
worthiness of loan applicants.
