Recall: Function of Financial Markets

! Allows transfers of funds from person or business without investments to one who has them ! Improves economic efficiency.

Overview of the Financial System

Fintmed Session 2 Second Term Academic Year 2013 - 2014

Recall: The Financial System

Recall: The Financial Intermediation Process

Suppliers Borrowers

Demander of funds (mainly firms and governments)

Flow of funds (savings)

Flow of financial securities

Incomes, and financial claims

Supplier of funds (mainly households and businesses)

Individuals Businesses Institutions Government

Funds Returns

Funds

Financial System

Returns

Individuals Businesses Institutions Government

Lenders

Risk management, liquidity, and information

Users

Source: Santos, Essentials of Investments

Alternative View of Financial Markets

INDIRECT FINANCE Financial Intermediaries Funds Funds

Structure of Financial Markets

Debt and Equity Markets Defined Ways a firm or an individual can obtain funds in a financial market: 1. Issue a debt instrument (bond or mortgage) 2. Issuing equities (common stock)

Funds
Borrower-Spenders 1.! Business Firms 2.! Government 3.! Households 4.! Foreigners

Lenders-Savers 1.! Households 2.! Business Firms 3.! Government 4.! Foreigners

Funds

Financial Markets Funds

DIRECT FINANCE

Structure of Financial Markets

Primary and Secondary Markets Defined Primary new issues of security such as a bond or stock are sold to initial buyers Secondary securities which have been previously issued can be resold

Classifications of Financial Markets

1.! Debt Markets
1.1 1.2 Short-Term (maturity < 1 year) Money Market Long-Term (maturity > 1 year) Capital Market

2.! Equity Markets 2.1 Common Stock

Role of Investment Banks

Primary issues are usually handled by an investment bank. Investment banks do this through underwriting: guarantees a price for the security and then sells them to the public

Exchanges and Over-the-Counter Markets Secondary markets are organized in two ways: 1. Exchanges such as the stock market (that is why it is also known as the Philippine Stock Exchange) 2. Over-the-counter (OTC) market dealers buy and sell their inventory of securities to anyone who come to them and is willing to accept their prices.

OTCs in the Philippines

! Stocks sold over the counter are outside the jurisdiction of the PSE ! Some securities such as bonds sold are subject to the requirements of the Bangko Sentral ng Pilipinas (BSP) Circular 392 and its related regulations, including the rules governing the Overthe-Counter (OTC) Fixed Income Market issued by the Securities Exchange and Commissions (SEC) Memorandum Circular 14.

Function of Financial Intermediaries

! Engage in process of indirect finance ! More important source of finance other securities markets ! Needed because of transactions and asymmetric information

Transactions Costs
! Financial intermediaries make profits by reducing transactions costs ! Reduce transactions costs by developing expertise and taking advantage of economies of scale

Asymmetric Information
An inequality brought about when one party does not know enough about the other party to make accurate decisions. For example: banks and financial institutions spend time and resources through credit/ background information of the borrower to ascertain whether to lend or not

Problems Created by Asymmetric Information

Problems Created by Asymmetric Information

Adverse Selection The problem created by asymmetric selection before the transaction occurs Potential borrowers most likely to produce adverse outcomes are ones most likely to seek the loan and be selected

Moral Hazard The problem created after the transaction (loosely described as conflict of interest) Hazard that the borrower has incentives to engage in undesirable (immoral) activities making it more likely that it wont pay the loan back

Financial Intermediation Process

The trick should be that financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits.

Ensuring Soundness of Financial Intermediaries

! ! ! ! ! !

Restrictions on Entry Disclosure Restriction on Assets and Activities Deposit Insurance Limits on Competition Restriction on Interest Rates

Investment Houses
! Involved in underwriting of securities, financial consultancy (issue management and underwriting of public offering of debt and equity securities, loan syndication and financial packaging and advisory for corporate mergers, acquisitions and restructuring) among others. ! Enabling laws: PD 129 series of 1973 and RA 8366 series of 1997. ! May be allowed to perform quasi-banking functions as approved by the Monetary Board ! Minimum capital requirement of P 300 M ! Foreign ownership allowed up to 60%

Financing Companies
! Enabling law: RA 8556, amending RA 5980 ! 'Financing companies' hereinafter called companies, are corporations, except banks, investments houses, savings and loan associations, insurance companies, cooperatives, and other financial institutions organized or operating under other special laws, which are primarily organized for the purpose of extending credit facilities to consumers and to industrial, commercial, or agricultural enterprises, by direct lending or by discounting or factoring commercial papers or accounts receivable, or by buying and selling contracts, leases, chattel mortgages, or other evidences of indebtedness, or by financial leasing of movable as well as immovable property;

Financing Companies
Financing companies shall be organized in the form of stock corporations at least forty percent (40%) of the voting stock of which is owned by citizens of the Philippines and shall have a paidup capital of not less than Ten million pesos (P10,000,000) in case the financing company is located in Metro Manila and other first class cities, Five million pesos (P5,000,000) in other classes of cities and Two million five hundred thousand pesos (P2,500,000) in municipalities:

Securities Dealers
! Buying and selling of securities ! Minimum capital of P 5.0 M ! Mostly members of the Philippine Stock Exchange

Lending Companies/Lending Investors

! Enabling law: RA 9474 series of 2007 ! Lending Company shall refer to a corporation engaged in granting loans from its own capital funds or from funds sourced from not more than nineteen (19) persons. It shall not be deemed to include banking institutions, investment houses, savings and loan associations, financing companies, pawnshops, insurance companies, cooperatives and other credit institutions already regulated by law. The term shall be synonymous with lending investors. ! Minimum capital requirement: P 1.0 M

Investment Companies

Sells its own securities to the public and invest the proceeds in stocks and bonds (bond fund)

Insurance Companies
! Engaged in property-liability (non-life), life insurance, and/or multiple-line products ! Minimum capital of P 100 M. Recent regulation allow for adjustment of risk ! Regulated by the Insurance Commission ! Sellers (agents) are carefully screened

Pre-Need Companies
! Sells pension, education, memorial plans subject to the approval of the SEC and the Insurance Commission ! Capital Requirements: Minimum paid-up capital of P 100 M. Existing pre-need companies shall comply with the following minimum unimpaired paid-up capital: ! P 100M for companies selling at least three (3) types of plan; ! P 75 M for companies selling two (2) types of plan; ! P 50M for companies selling a single type of plan. ! Existing pre-need companies with traditional education plans shall have a minimum unimpaired paid-up capital P 100M

Regulation of Financial Markets

Three Main Reasons ! Increase Information to Investors ! Decreases adverse selection and moral hazard problems ! Forces corporations to disclose information ! Ensuring the Soundness of Financial Intermediaries ! Prevents financial panic ! Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anticompetitive measures ! Improving Monetary Control ! Reserve requirements ! Deposit insurance to prevent bank panic