The document provides an overview of the financial system, including its key components and functions. The financial system consists of financial institutions, markets, assets, and services that facilitate the transfer of funds between borrowers, lenders, and investors. It aims to efficiently allocate resources and generate returns. Major participants include banks, stock exchanges, insurers, and individual investors. The system helps share risks, improves liquidity, and disseminates information. However, problems like adverse selection and moral hazard can arise from asymmetric information.
3. A financial system is an
economic arrangement wherein
financial institutions facilitate the
transfer of funds and assets
between borrowers, lenders, and
investors.
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4. Its goal is to efficiently distribute
economic resources to promote
economic growth and generate a
return on investment (ROI) for
market participants.
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5. A financial system consists of individuals like borrowers
and lenders and institutions like banks, stock exchanges,
and insurance companies actively involved in the funds
and assets transfer.
It gives investors the ability to grow their wealth and
assets, thus contributing to economic development.
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7. Market participants
functions at corporate,
national, and international
levels and is governed by
various rules dictating the
eligibility of participants
and the use of funds for
different purposes.
COMPONENTS OF THE
FINANCIAL SYSTEM:
Aside from financial
institutions, there are
◆ Financial Markets
◆ Financial Assets
◆ Financial Services
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8. Financial
Intermediaries
Financial
Markets
Lender – Savers
1. Households
2. Business Firms
3. Government
4. Foreigners
Borrower – Spenders
1. Business Firms
2. Government
3. Households
4. Foreigners
Funds Funds
Funds Funds
Funds
Indirect Finance
Direct Finance
9. KEY COMPONENTS OF THE
FINANCIAL SYSTEM
FINANCIAL
INSTRUMEN
TS
FINANCIAL
MARKETS
and
FINANCIAL
INSTITUTIO
NS
The
CENTRAL
BANK and
OTHER
FINANCIAL
REGULATO
RS
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12. RISK SHARING
Risk – the chance that the value of the
financial assets will change relative to
what one expects.
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13. RISK SHARING
The ability of the financial system to
provide risk sharing makes savers more
willing to buy stocks, bonds and other
financial assets.
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14. LIQUIDITY
Liquidity – the ease with which an asset can
be exchanged for money which savers view
as benefit.
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15. LIQUIDITY
Securization – process by which the financial
system has increased the liquidity of many
assets besides stocks and bonds.
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16. INFORMATION
Information – a service of financial system
that deals with the collection and
communication of facts about borrowers and
expectations of returns on financial assets.
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18. The Problems of Adverse Selection and
Moral Hazard
- A situation in which one
party has better
information that does the
other party
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19. The Problems of Adverse Selection and
Moral Hazard
Two problems arising from
asymmetric information:
Adverse Selection – the problem
investors experience in
distinguishing low-risk borrowers
from high-risk borrowers before
making an investment.
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20. The Problems of Adverse Selection and
Moral Hazard
Two problems arising from
asymmetric information:
Moral Hazard – the problem
investors experience in verifying
that borrowers are using their
funds as intended
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22. Transaction Cost – the cost or a trade of
a financial transaction.
Information Cost – the costs that savers
incur to determine the creditworthiness of
borrowers and to monitor how they use
the funds acquired.
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23. Because of transaction cost and
information cost, savers receive a
lower return on their investments
and borrowers must pay more for
the fund they borrow.
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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.
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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.
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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.
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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.
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2. Financial Intermediaries can also take advantage
of economies of scale in other ways.
3. Financial Intermediaries also take advantage of
technology to provide financial services, such as
those that automated teller machine networks
provide.
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4. Financial Intermediaries also increasingly
rely on the sophisticated software to evaluate
the credit worthiness of loan applicants.
