Chapter 2

An Overview of the Financial

System
 Ch.2

This chapter provides an overview of the financial

system in the economy by describing the various
types of financial markets, financial instruments,
and financial institutions.

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The Financial System
The financial sector plays a vital role in the economy:

1.Provides efficient flow of funds from saving to investment by bringing

savers and borrowers together via financial markets and financial
institutions.

2.Financial development is linked to economic growth.

3.The role of the financial system is to facilitate production, employment,

and consumption.

4.Resources are funneled through the system so resources flow to their

most efficient uses.

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Funds Flowing through the Financial System

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Function of Financial Markets

• Perform the essential function of channeling funds from

economic players that have saved surplus funds to those
that have a shortage of funds.

• Direct finance: borrowers borrow funds directly from

lenders in financial markets by selling them securities
(bonds, stocks etc).

Example:

• You take a loan directly from your friend

• Corporation issues new bonds or shares

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Function of Financial Markets (cont…)

• Promotes economic efficiency by producing an efficient

allocation of capital, which increases production

• Directly improve the well-being of consumers by

allowing them to time their purchases better.

• Increases business profits

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Function of Financial Intermediaries
• It is the process of obtaining or investing funds through
third party institutions such as banks.

• Among businesses and individuals, indirect finance is far

more common than direct finance.

• In every country including US and Japan credit extended

by Japan, financial intermediaries is larger as a % of
GDP than stocks and bonds.

• Most prominent financial intermediaries are Commercial

banks, mutual funds, pension funds, credit unions,
savings and loan associations, and insurance
companies.
Mishkin, F. (2010) Adapted by Dr. 7
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Function of Financial Intermediaries: Indirect Finance

1. lower the transaction costs

2. reduce the exposure of investors to risk
3. deal with asymmetric information problems.

Financial intermediaries allow “small” savers and

borrowers to benefit from the existence of financial
markets. Specifically, their functions are as follows:

Mishkin, F. (2010) Adapted by Dr. 8

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Function of Financial Intermediaries

1. Lower transaction costs:

An investor might not have required expertise or time to research what
assets he should invest in. Financial intermediaries such as
professional investment firms have the expertise and research facilities
to study firms in-depth and to reduce the transaction costs involved in
searching for credit information including all fees search and
information costs.

2. Economies of scale:
Since they handle large number of transactions, they are able to
spread out their fixed costs.

For example, a bank can use the same loan contract forms for every
new loan.

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Function of Financial Intermediaries (Cont.)
3. Liquidity services: Liquidity refers to the speed and ease of
converting assets into cash and to conduct transactions. Although the
intermediary may use its funds to make illiquid loans its size allows it to
hold some funds as cash to provide liquidity to individual depositors
depositors.

4. Risk Sharing (Asset Transformation): They attract funds from

individuals, businesses, and government and then repackage these
funds as new financial products, such as loans, which satisfies different
needs of savers and borrowers in relation to the amount of funds, the
risk levels, and the maturity requirement.

They transfer certain financial risks (accidents, theft, illness) to another

party (e.g., the insurance company).

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Function of Financial Intermediaries (Cont.)

5. Risk management expertise: They are able to obtain sensitive

information about a borrower’s financial condition.

6. Diversification: ( Assume credit risks of borrowers, spread risk

over many different types of borrowers.) It means lowering the cost
by investing in a collection (portfolio) of assets whose returns do not
always move together. Thus, the overall risk is lower for individual
assets.

7. Deal with asymmetric information problems : Asymmetric

(imperfect ) Information (AI) is defined as information that is known
to some people but not to other.

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Function of Financial Intermediaries (Cont.)

Two problems related to Asymmetric Information:

1. Adverse Selection (before the transaction): The adverse

selection refers to the problem before a loan is made because
borrowers who are bad credit risks tend to be those who most
actively seek out loans. For example, someone with a dangerous
hobby may be more likely to apply for life insurance.

Financial intermediaries can help reduce the problem of adverse

selection by gathering information about potential borrowers and
screening out bad credit risks.

to avoid selecting the risky borrower.

• Gather information about potential borrower.

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2. Moral Hazard (after the transaction) : Moral Hazard is a problem after a
loan is made, and refers to the risk (hazard) that the borrower might
engage in activities that are undesirable (immoral) from the lenders point of
view because it may make it less likely that the borrower will repay the
loan.

Financial intermediaries can help reduce the problem of moral hazard by

monitoring borrowers’ activities.

ensure borrower will not engage in activities that will prevent

him/her to repay the loan.

• Sign a contract with restrictive covenants.

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Types of Financial Intermediaries

1.“Depository” Institutions

Take deposits and make loans.

1.1 Commercial Banks

1.2 Thrift Institutions

• Savings & Loan Associations

• Savings Banks
• Credit Unions

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 1.1 Commercial Banks

• Largest single class of financial institution

• Issue wide variety of deposit products - checking, savings,

time deposits

• Carry widely diversified portfolios of loans, leases,

government securities.

• May offer trust or underwriting services.

• Because of their vital role in the well-being of the

communities, they are highly regulated.

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1.2 Thrift Institutions

A (Savings and Loan Associations and mutual savings

banks)

• Closely resemble commercial banks

• Focus more on real estate loans, savings deposits,

and time deposits.

• Specialize in maturity and denomination

intermediation because they borrow small amounts of
money in savings deposits and lend long term on real
estate.

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2. Contractual Savings Institutions

• Bring long-term savers and borrowers together.

• Stead inflow of funds from contractual commitments

with their insurance policy holders and pension fund
participants.

• Invest in long term securities such as bonds

2.1. Life Insurance Companies

2.2. Casualty Insurance Companies
2.3. Pension Funds

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3.Investment Funds

(help small investors share the benefits of large investments)

3.1 Mutual Funds provide intermediated access to various

capital markets

- shareholders’ money is pooled and invested in stocks, bonds,

or other securities according to some objective.

3.2 Money Market Mutual Funds (“MMMFs”) are uninsured

substitutes for deposit accounts.

- MMMFs buy money market instruments wholesale, pay

investors interest, and allow limited check-writing.

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4. “Other” Institutions

4.1 Finance Companies,

Make loans but do not take deposits; raise loanable funds in
commercial paper market and from shareholders. They tend
to specialize in certain types of loans, e.g., automobile or
mortgage loans.

4.2 Federal Agencies,

Issue “agency securities” backed by government and lend at
sub-market rates for favored social purposes .

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Table 3 Primary Assets and Liabilities of Financial Intermediaries

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 Regulation of the Financial System

• To increase the information available to

investors:

– Reduce adverse selection and moral hazard problems

– Reduce insider trading (SEC).

• To ensure the soundness of financial intermediaries:

– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control holding of
risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates

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• Financial intermediation and leverage in the US has
shifted away from traditional banks and toward other
financial institutions less subject to government
regulations.

– Brokerages, insurers, hedge funds, etc.

• These have become known as shadow banks.

– Provide services that compete with banks but do not
accept deposits.

– Take on more risk than traditional banks and are less

transparent.

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• The rise of highly leveraged shadow banks, combined with
government relaxation of rules for traditional banks, permitted a rise of
leverage in the financial system as a whole.
– This made it more vulnerable to shocks.

• The financial crisis transformed shadow banking.

– The largest US brokerages failed, merged, or converted themselves into
traditional banks to gain access to funding.

• The crisis has encourage government to scrutinize any financial

institution that could, by risk taking, pose a threat to the financial
system.

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