FM101

Lecture 8
The financial system
Lent Term 2020
Dr Elisabetta Bertero
Readings: LIBOR scandal – Class 8 on Moodle (for Week 10)
article by Bodie and Merton (1995) pages 1-10 and
Finance (2020) Chapter 8 or Cecchetti (2017), Chapter 1 Essay-type questions – answers in the readings

To study for this lecture use the material on handout as

“route map”. You need to know what is on the slides. You are encouraged to prepare and discuss the answers to this
Use the readings as guidance, classwork
to understand the concepts on this handout in groups (using Zoom, LSE license),
with other students, not necessarily in the same class group.

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 1

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 2

Guidance on how to study at this point

Introduction
• Find a quiet place to concentrate
In the lectures so far we have looked at financial 
• Take lecture handout and textbook decisions from the perspective of individual 
• Study the two in parallel using lecture firms and households.
handout as road map

• Take class sheets, solutions and class notes In the next three lectures we look at three topics 

• Check understanding of all exercises that require a broader perspective.

• Check solutions to Classwork 3 and 5 and

Feedback to Classwork 3 and 5
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 3 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 4
 Overview of Lecture 8: 
Lecture 7: Overall  The financial system
corporate firm level 
• Corporate governance

Lecture 8: Overall  • Functions of the financial  1. Functions of the financial system and 

financial system level system classifications

Lecture 9: Overall 
• Financial instruments and  2. Elements of the financial system
financial markets 
level  financial institutions

Lecture 10:  Global  • Financial crises:  2007 and  3. The five principles of money in market 

systemic risk level Eurozone 2010 economies
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 6
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 5

World Economy Flow of Funds
Product Markets

Production
1.Role of the Financial System
Process of Goods
Country and Services Country
A B
– Financial systems include a variety of 
Net Net
institutions in different countries
Financial Markets
Domestic Domestic
User Flow of funds through the User

Business primary and secondary Households

Government
domestic financial markets,
including all services, Government
– The role of a financial institution (e.g. a bank) 
Interest Payment Interest Payment
Individuals interest payments and
financial claims
Business changes over time and may be different 
across countries
• A British bank today differs from a British bank in 
the 1800s and from a Saudi Arabian bank today.
Factor Markets
Country
Country
C Land, Labor, D
Capital
Source: Samuelson and Nordhaus, Economics, 1989
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 8
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 7
 Six key functions of the financial 
Functional perspective
system
• A unifying framework to understand how the  1. Transferring resources across time and space
financial system works 2. Managing risk
• Based on the classification of functions  3. Clearing and settling payments
because: 4. Pooling resources and subdividing shares
– They are more stable over time and across  5. Providing information
countries
6. Dealing with incentive problems
– Institutional forms often follow function

Reading:  Bodie and Merton (1995), pages 1‐10

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 9 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 10

1.1 Transferring resources
across time and across space 1.2 Managing risk
• A financial system provides ways to transfer  • A financial system provides ways to manage 
economic resources uncertainty by transferring, managing and sharing 
risk
– through time
• Future flows have associated risks.  Like flows, risks 
– across geographic regions may be unbundled and repackaged by the financial 
system using portfolios, financial derivatives, and 
– amongst industries guarantees
• Many financial contracts are used to transfer risk 
rather than flows. Example:  insurance, options, 
securitisation
• Example of risk‐pooling: insurance companies

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 11 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 12
 1.3 Clearing and settling payments Clearing and settling payments
• Barter 

• A financial system provides ways of clearing  • Gold (requires purity tests, heavy)
and settling payments to facilitate the 
• Paper money (restricted geographically)
exchange of goods, services, and assets
• Traveler’s checks (acceptability varies, restricted range of 
denominations)

• Credit cards (not universally accepted)

• Oyster cards, LSE Squid cards

Reading:  see also textbook, Cecchetti Part, pages 410‐419

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 13 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 14

1.4 Pooling resources and dividing  1.5 Providing information
ownership of large assets
• A financial system provides a mechanism to price 
• A financial system provides a mechanism: assets
– for the pooling of funds to undertake large‐scale  • Price information helps to coordinate decentralized 
indivisible enterprise decision‐making in various sectors of the economy
and • Investors need current prices to evaluate their 
– for the subdividing of shares in large enterprises  portfolios of quoted securities
among many owners • Quoted prices may be used to estimate the value of 
similar non‐quoted securities
– Example: crowdfunding, funding
startups FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 15 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 16
 Moral hazard: hidden action
1.6 Dealing with incentive problems

• A financial system provides ways to deal with the  • When asymmetric information creates an 
incentive problems that occur when: incentive for an individual to act, post‐
a) one party to a financial transaction has information that  contract, in a way that leads to greater 
the other party does not (asymmetric information  risk or less care in preventing the events 
leading to moral hazard and adverse selection)
OR
that give rise to that risk.
b) one party is an agent and makes decisions for another  • For example, a company buys fire 
(principal – agent problem) insurance and then takes fewer fire 
prevention measures (to reduce costs).

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 17 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 18

Insure and burn: solutions Adverse selection: hidden knowledge
Insurance companies can: 
• When asymmetric, pre‐contract, information in the 
 set higher premia hands of buyers or sellers prevent prices from being 
 require the use of modern surveillance, detection  set at the fair value. 
and protective equipment  • For example:
 understand the business of insured companies Buyers of insurance: people buy insurance against a 
particular risk if they are more likely than the average 
 insist the insured assumes some risk of loss person to be affected by that risk 
 avoid “unlucky” owners with dubious morality Sellers of used cars: seller has more information than 
 gain a reputation for aggressive forensic  the buyer about the quality of the car; the fact that 
he/she is selling is taken by buyer as revealing car is of 
investigations poor quality.

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 19 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 20
 Classification of financial systems 
Principal‐agent: examples
International Perspective
• An employee selects an airline, hotel or car 
rental company to obtain free flight mileage for 
• The larger the market economy the more developed 
personal use
and sophisticated the financial system
– The decision has been made in interest of the 
employee, rather than the company • Among countries at a similar stage of development, 
– The company may lose time, or pay a higher price for  different structures:
service
• A manager acts in her own interest (perhaps  – Bank‐based systems (Continental Europe, Japan)
maximising the size of the firm) rather than in  – Market‐based systems (US and the UK)
the shareholders’ interest (maximising their 
wealth) See also Lecture 7

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 21 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 22

2. Elements of the financial system 3. The five principles at the core of the financial 
system of market economies
1. Money 1. Time has value in market economies
2. Financial markets
3. Financial instruments 2. Risk requires compensation
4. Financial institutions
5. Regulatory agencies 3. Information at the core of decisions
6. Central banks
7. Governments and international organizations 4. Markets determine prices and allocate 
8. Families / households resources
9. TRUST also as core element
5. Stability improves welfare
See Finance (2020) Chapter 10 or Cecchetti (2017), Chapter 1
See See Finance (2020) Chapter 10 or Cecchetti (2017), Chapter 1
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 23 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 24
 Activities for this Lecture

Readings
• article by Bodie and Merton (1995) pages 1-10
• customised text Finance (2020) Chapter 8 or Cecchetti
(2017), Chapter 1

Assignment
• Classworks 8 & 9 – also an introduction to Lecture 10

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 25