Banking & Financial Services ACF 2205(3)

Topic 1: Introduction to Financial System

and Financial Intermediations

Financial System
Financial system can be defined as a set of : Institutions Instruments and Markets which foster savings and channel them to the most efficient use. 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.

Financial System
The financial system is a collection of markets, institutions, law, regulations and techniques through which bonds, stocks and other securities are traded, interest rates are determined and financial services are produced and delivered.
The services that are provided by the finance industry can be termed as the financial services. Financial services refer to the array of business activities operating with money management. The financial services sector is made up of the banking sector and nonbanking sector (insurance sector, capital market and global business sector). The financial services sector can be onshore or offshore financial centres.

Financial System
In a nutshell, a financial system is a densely interconnected network of financial intermediaries, facilitators, and markets that serves three major purposes: -allocating capital, -sharing risks, and -facilitating inter-temporal trade

Importance of Financial System

Bagehot (1873) pointed out that the financial system played a pivotal role in igniting industrialization by facilitating the mobilization of capital for growth. It has been argued that the financial system acts as the brain of the economy and hence serves to allocate scare resources across time and space in the environment of uncertainty (Stiglitz, 1994). Existence of financial system facilitates economic activity and growth. Markets, institutions and instruments are the prime movers of economic growth.

Importance of Financial System

Financial system transforms household savings into funds available for investment by firms. It diverts savings to productive uses, it helps to increase output of the economy. In other words, financial system provides the intermediation between savers and investors and promotes faster economic development. An efficient functioning of the financial system facilitates the free flow of funds to more productive activities and this promotes investments which leads to economic growth and higher standard of living.

Importance of Financial System

Financial system is useful in evaluating assets, increasing liquidity and producing and spreading information. The financial system helps overcome an information asymmetry between borrowers and lenders, reducing the problems associated with both adverse selection and moral hazard. Financial system reduces the time and money spent in carrying out financial transactions.

Functions of Financial System

Financial Intermediation The financial system main function is financial intermediation so as: - to efficiently link borrowers to lenders - to link risk-averse entities called hedgers to riskloving ones known as speculators - to deal with information asymmetries (minimize)

Functions of Financial System

Savings function It acts as a medium for public savings and helps in establishing a link between the savers and the investors It allows asset-liability transformation. Banks create liabilities against themselves when they accept deposits from customers but also create assets when they provide loans to clients. Allocation function It works as an effective conduit for optimum allocation of financial resources in an economy. It helps to channel funds from sectors that have a surplus to sectors that have a shortage of funds.

Functions of Financial System

Wealth function It acts as a way to store wealth through financial instruments sold in money and capital markets. Liquidity function Provides liquidity for savers who hold financial instruments and enhances liquidity of financial claims.

Credit function Furnish credit to finance consumption and investment.

Functions of Financial System

Payment function The financial system ensures the efficient functioning of the payment mechanism in an economy. All transactions between the buyers and sellers of goods and services are effected smoothly because of financial system. Risk protection function It helps in risk transformation by diversification (as in case of mutual funds) and hence can provide protection against life, health, property, income risks.
Policy function Help to stabilize the economy and control inflation.

Direct Finance
Direct finance occurs if a sector in need of funds borrows from another sector via a financial market . In direct financing borrowers and savers exchange money and financial instruments directly. -Borrowers issue financial claims (they are claims against someone elses money at a future date) on themselves and sell directly to savers for money. The savers hold the financial claims as interest bearing instruments and they can sell it in financial markets. Upon agreed time or maturity date borrowers have to give back the savers principle plus the agreed interest rate. With indirect finance, a financial intermediary obtains funds from savers and uses these savings to make loans to a sector in need of finance.

Indirect Finance
With indirect finance, a financial intermediary obtains funds from savers and uses these savings to make loans to a sector in need of finance. -Borrowers borrow indirectly from lenders via financial intermediaries by issuing financial instruments which are claims on the borrowers future income or assets.

Structures of Financial System

Financial System
Financial Market Regulators/ Government Traders

Financial Instruments
Indirect Financial Market Commercial Banks

Direct Financial Market

Capital Market

Money Market

Finance Companies
Insurance Companies

Bond Market

Equity Market

Structures of Financial System

The financial system consists of : - financial markets (direct finance) which facilitate the flow of funds in order to finance investments by corporations, governments and individuals - financial institutions (indirect method of finance) who are the key players in the financial markets as they perform the function of intermediation and thus determine the flow of funds - financial regulators who perform the role of monitoring and regulating the participants in the financial system

Types of Financial system

Financial system can be of two types: - Market-based financial system (UK, USA) Bank-based financial system (Germany, Japan, France)

Market-based Financial System

In a market-based financial system, the majority of financial power is held by the stock market and the economic mood of the area is dependent on how well or poorly the stock market is doing. The securities markets share center stage with banks in getting society's savings to firms, exerting corporate control, and easing risk management. Banks in a market-based financial system are less dependent upon interest from loans and gain much of their revenue through fee-based services such as checking accounts. In such financial system, the wealth is spread more unevenly. It is constantly shifting and each individual within the society has the opportunity to gain or lose on any given day.

Bank-based Financial System

A bank-based financial system finds the economy dependent on how well or poorly the banking industry is doing. Banks in these systems focus their attention on loans and hold the power largely through this area. They play a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of corporate managers, and providing risk management vehicles. The stock market in these areas has little or no power over economic trends. In a bank-based financial system, the economys wealth is more evenly spread. Often only a few are given the opportunity to realize great gain.

Financial Intermediation
Financial intermediation consists of channeling funds between surplus and deficit agents. In other words, it is the channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers).
Financial intermediation is a process that occurs when a financial intermediary borrows money from one source to loan to another source for investment, funding or resources. Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.

Modern Theory of Financial Intermediation

According to the modern theory of financial intermediation, financial intermediaries are active because market imperfections prevent savers and investors from trading directly with each other in an optimal way. The most important market imperfections are the informational asymmetries between savers and investors. Financial intermediaries, banks specifically as agents and as delegated monitors, fill information gaps between ultimate savers and investors. This is because they have a comparative informational advantage over ultimate savers and investors.

Modern Theory of Financial Intermediation

Financial intermediaries, banks specifically as agents and as delegated monitors, fill information gaps between ultimate savers and investors. This is because they have a comparative informational advantage over ultimate savers and investors. They screen and monitor investors on behalf of savers. This is their basic function, which justifies the transaction costs they charge to parties. They also bridge the maturity mismatch between savers and investors and facilitate payments between economic parties by providing a payment, settlement and clearing system. Consequently, they engage in qualitative asset transformation activities.

Disintermediation
Disintermediation is the removal of intermediaries from a process. In such cases, investment of the lending of money is done directly via the financial markets whereby the middleman is removed.

Financial Intermediaries
Financial intermediaries act as the middleman for joining two unrelated parties in investing and growth. Most frequently, this process is completed through a financial institution.

Financial intermediaries are coalitions of agents that combine to provide financial services, such as commercial banks, credit unions, insurance companies, finance companies, mutual funds, pension funds, etc.

Financial Intermediaries
Financial institutions can be divided into two types: - depository and - non-depository. Depository consists of traditional banks, credit unions, and savings and loan depositories. They accept deposit and make loans acting as intermediaries in matching lenders and borrowers. Non-depository are made up of financial advisors and brokers, insurance companies, life insurance companies, mutual funds, and pension funds.

Why do Financial Intermediaries exist?

Financial Intermediaries are engaged in process of indirect finance and exist because of: Lenders and borrowers have conflicting needs Transaction costs; Asymmetric of information; and To allow risk sharing

Conflicting Needs
Most lenders prefer lending short-term Most borrowers prefer borrowing long-term That is why most intermediation is done indirectly, where intermediaries understand and reconcile the different needs of lenders and borrowers.

Transaction Costs
Transaction costs are classified into: 1) costs of search and information, Search cost can be classified as explicit costs which include expenses that may be needed to advertise ones intention to sell or purchase a financial instrument; and implicit costs which include the value of time spent in locating counterparty to the transaction Information costs are associated with assessing a financial instruments investment attributes. In a price efficient market, prices reflect the aggregate information collected by all market participants

Transaction Costs
2) costs of contracting and monitoring They are related to the costs necessary to resolve information asymmetry problems, when the two parties entering into the transaction possess limited information on each other and seek to ensure that the transaction obligations are fulfilled. 3) costs of incentive problems between buyers and sellers of financial assets. These arise when there are conflicts of interest between the two parties, having different incentives for the transactions involving financial assets. Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them, and because their large size allows them to take advantage of economies of scale.

 Asymmetry of information refers to a situation where one party to a market transaction has much more information about a product or service than the other for example when a seller (borrower, a seller of securities) knows more than a buyer (lender or investor, a buyer of securities). This lead to the problems of moral hazard and adverse selection. In the case of moral hazard, there is a tendency of one party to a contract to alter his/her behaviour in ways that are costly to the other party while with adverse selection, information known by the first party to a contract is unknown to the second and, as a result, the second party incurs major costs.

Asymmetric of Information

Asymmetric of Information
Financial intermediaries are usually equip with a better credit risk screening than individuals. This help in reducing losses due to wrong investment decision making. Financial intermediaries have developed expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard.

Risk Sharing
Financial intermediaries create and sell assets with low risk characteristics and then use the funds to purchase other assets that may have far more risk. This process of risk sharing is called asset transformation, risky assets are turned into safer assets for investors. Another way of risk sharing provided by Financial intermediaries is through diversification. Financial intermediaries invest in a collection of assets whose return do not always move together, with the result that overall risk is lower than for individual assets.

Functions of Financial Intermediaries

Pooling saving Financial intermediaries help to pool the resources of small savers. Many borrowers require large sums, while many savers offers small sums. Banks, for example, pool many small deposits and use this to make large loans. Insurance companies collect and invest many small premiums in order to pay fewer large claims. Mutual funds accept small investment amounts and pool them to buy large stock and bond portfolios. In each case, the intermediary must attract many savers, so the soundness of the institution must be widely believed.

Functions of Financial Intermediaries

Payment services The payment mechanism is facilitated through financial intermediaries. By taking advantages of economies of scale, financial intermediaries are able to provide an array of services since same are standardized and automated on a large scale, so per unit transaction costs are minimized Liquidity Liquidity refers to how easily and cheaply an asset can be converted to a means of payment. Financial intermediaries make is easy to transform various assets into a means of payment through ATMs, checking accounts, debit cards, etc.

Functions of Financial Intermediaries

Maturity Transformation Financial intermediaries convert short-term liabilities to long term assets (e.g banks deal with large number of lenders and borrowers, and reconcile their conflicting needs) Risk Transformation Converting risky investments into relatively risk-free ones, lending to multiple borrowers to spread the risk. Create and sell assets with low risk characteristics and use the funds to buy assets with more risks (also called asset transformation). Convenience Denomination Financial intermediaries match small deposits with large loans and large deposits with small loans.

Functions of Financial Intermediaries

Diversification Diversification is a powerful tool in minimizing risk for a given level of return. Financial intermediaries help investors diversify in ways they would be unable to do on their own. Mutual funds pool the funds of many investors to purchase and manage a stock portfolio so that investors achieve stock market diversification. Banks spread depositor funds over many types of loans, so the default of any one loan does not put depositor funds in jeopardy.

Functions of Financial Intermediaries

Information Financial intermediaries are experts at collecting and processing information in order to accurately gauge the risk of various investments and to price them accordingly. This need to collect/process information comes from a fundamental asymmetric information problem inherent in financial markets (the lack of information on one side creates problems before the loan is made and after the loan. )

Advantages of Financial Intermediaries

The advantages of financial intermediaries are that they: Have wide knowledge of financial markets. Financial intermediaries know their particular markets, having built up a wealth of experience. Financial intermediaries reduce risk is that by making many loans, they learn how to better predict which of the people who want to borrow money will be able to repay. Can spread their risks. Lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify while individual or small institution would struggle to achieve this.

Advantages of Financial Intermediaries

Have skills to judge They are also likely to be able to judge accurately which customers present the greatest risk to them and charge them accordingly. Lending is often less risky through an intermediary, who can, for example, diversify lending, providing the company with a variety of different loan plans. If some loans then prove themselves to be unviable, they are offset by those that are sound. Have Infrastructure They have the infrastructure to deal with transactions as well as have access to many financial providers and institutions

Advantages of Financial Intermediaries

Financial intermediaries have liquidity, which means they are in a position to convert assets to money quickly. This has obvious advantages in terms of obtaining cash when it is needed Financial intermediaries help to overcome the problem of geographical location. Lenders may not be able to locate the borrowers even within the same geographical area this mismatch can be overcome by using intermediation

Disadvantages of Financial Intermediaries

Profit motivators Financial intermediaries are in business to make profit, so using their services can result in lower returns on investment or savings than what might be possible otherwise. High fees and commission They charged for the services they provide in the form of fees or commissions Trust Clients have to put their trust in a third party who may not share the same goal.