Finance and

Financial Markets

Course Material No. 2

Overview of the Financial
System

Richard A. Perez, CPA, MBA, CTT, MRITax

2 Overview of the Financial System • NU LAGUNA

Rationale in Studying
Financial Markets and
Institutions 2
LEARNING OUTCOMES

Here’s what I will teach you in this course material:

LESSON OUTLINE
1. Explain what financial system is and as well its objective
 Nature of
Financial System 2. Enumerate and Explain the key components of the Financial
System
Unit Outline
 Objective of 3. Explain the main functions of the financial system
Financial system
4. Distinguish between adverse selection and moral hazard
5. Discuss how financial intermediaries reduce adverse selection,
 Components of moral hazard problem and transaction cost.
Financial System

 Function of
Financial System
RESOURCES NEEDED

 Adverse For this lesson, you would need the following resources:
selection and
Moral Hazard  Financial Markets and Institution by Cabrera 2020
Overview of the Financial System • NU LAGUNA 3

TABLE OF CONTENTS

Pretest 3 Questions for Review and

Discussion
Before you start, try answering the following
questions.
4 Accountant’s Word Hunt

1. Why is there a need for an efficient financial system

for a country to have strong economy? Nature, Concept and
_________________________________________ 5 Objective of Financial System
_________________________________________
_________________________________________
_________________________________________
_________________________________________ 11 Test Yourself

_________________________________________
_________________________________________
CVP Multiple Product
2. Explain the nature and main objective of the 12
financial system?
_________________________________________
_________________________________________
_________________________________________
14 Lesson Summary

_________________________________________
_________________________________________
_________________________________________ Key Terms
_________________________________________ 13
3. What are the transaction cost and information cost?
_________________________________________
_________________________________________
15 Posttest

_________________________________________
_________________________________________
_________________________________________ References
_________________________________________ 19
_________________________________________
_________________________________________
_________________________________________
4
Financial System Overview of the Financial System • NU LAGUNA

Key Point
This overview will give you
enough understanding about
the general aspect of
Financial System and its
component.

Accountant’s Word Hunt

4 PICS 1 WORD

A
Overview of the Financial System • NU LAGUNA 5

Nature, Concept and Objective of Financial System

Hi Class! Do you know class that Financial System is a subset of one of the branch of economics which
is Financial Economics?

Financial System
Economics
Financial
Economics

To further discuss class, allow me to define Financial Economics.

So what is Financial Economics?

Financial Economics is defined as a branch of economics that analyzes the use of and distribution
of resources in markets in which decisions are made under uncertainty.

We will cut the definition of Financial Economics, (RUD)

People or businesses have unlimited wants while the RESOURCES are only limited. If I will ask you,
what will you buy if you have unlimited money? Yes. You can think of a house, cars, clothes, gadgets,
gaming set, and many more. Are you willing to work if you have unlimited money? Of course not. You
will just enjoy every moment of your life. However, your money is only limited that is why you need to
make a right Decision in every circumstance. Why do we need to make a right decision? Because there
are uncertainties (risk) in every decisions we make. For example, you have P10.00 pesos. You are on your
way home and the transportation fee is P8.00. You have a materials that should be copied which cost
P5.00. Clearly, your money is not enough. So, you will decide on how you will spend your P10.00. or if you
want to satisfy both needs, you need to borrow money from your TRUE friend. 
6 Overview of the Financial System • NU LAGUNA

Needless to say, the nature of financial system came from the economics. Its concepts is based on
how the resources are being allocated to the country’s economic growth. Financial system is a set of
institutions, such as banks, insurance companies, and stock exchanges that permit the exchange of funds.

What is the objective of financial system? (CS)

1. The main objective of financial system is to Contribute to the growth of the economy.
2. Since it is a system, one of the objective is to Standardized financial transactions so that
there are common denominator for all transactions.

Do you know that financial systems has its flow of funds? Allow me to illustrate it to you by using figures.

Indirect Finance

Financial
Funds Funds
Intermediaries

Lenders/Savers Borrower/Spender
1. Household Financial 1. Household
2. Business Firms Markets 2. Business Firms
3. Government 3. Government
4. Foreigners 4. Foreigners

Funds

Direct Finance

Class, the flow of funds has two types. Direct and Indirect Finance. When the saver/lenders directly
give the funds to the borrower/spender, it is called direct financing. On the other hand, When the fund
goes to financial intermediaries (banks, financial institutions), it is indirect.

Also class, the flow of funds give you the Key Components of the Financial System. It includes the
following.

1. Financial Instruments
2. Financial Markets and Financial Institutions
3. Financial Regulator
Overview of the Financial System • NU LAGUNA 7

As I was saying class, the main task of Financial System is to channel funds from sectors that have
a surplus to sectors that have a shortage of funds. Economists believe that there are three key services
that the Financial System Provides. It is as follows:

1. Risk Sharing
2. Liquidity
3. Information

Risk Sharing

Do you know class what is risk? It is the chance that the value of financial assets will change relative
to one expects. I will give you the sample of risk sharing.

Below is the sample of individual creditor lend money to individual debtor. The risk of non-payment
of the debt will fall only to the creditor.

Creditor
Debtor

On the other hand, if the creditor decided to just put the money to the bank, then the bank will lend the
money to the debtor, the risk has been shared by bank and the depositor. In cases, the bank also hired third
party such as insurance to give assurance in cases of default. This is called Risk Diversification.

Bank Bank
Depositor Depositor Debtor
8 Overview of the Financial System • NU LAGUNA

In order for you to have additional knowledge in other risks, I recommend you to watch this video in
youtube. (https://www.youtube.com/watch?v=RvqrzvY3Sm8)

Answer the following questions. Justify and support your

answer. (Indicate your sources)

Test yourself
Task 1: Case Analysis for Risk Sharing

Coca Cola Amatil (CCL) is one of Asia-Pacific’s largest bottlers and distributors of alcoholic and non-
alcoholic beverages. The majority of its products are non-alcoholic and high in sugar. For many
years, Pendal Group Limited (Pendal) has held concerns regarding headwinds from structural shifts
in consumer demand for healthier options and regulatory risks relating to sugar consumption and
their associated impacts on corporate profitability. Pendal has held an underweight position in CCL
across its Australian fixed income funds for a number of years, given these concerns.
Pendal’s position on the company reflects its view that the social risks around high sugar and its links
to diabetes and obesity have not been priced in to the issuer’s credit spread and hence Pendal
expected CCL’s credit spreads to underperform over time. There are also regulatory risks
surrounding potential imposition of sugar taxes in key markets. From a financial perspective, CCL’s
credit spreads have been tight and, in Pendal’s view, have not factored in social risks relative to
similarly rated issuers.

Pendal’s credit analysis process incorporates fundamental issuer analysis and proprietary
quantitative modelling to assess investment opportunities. In particular, the credit selection
framework focuses on four categories:

1. Business profile (such as competitive position and quality of management);

2. Financial profile (such as cash flow metrics and debt maturity schedules);

3. Risk factors (including regulation and funding sources); and

4. Valuation factors (such as relative value, technical and covenants strength).

ESG factors are typically captured in the business profile and risk factors categories.

Pendal’s credit selection framework is based on an integrated credit research approach that includes
considering its equity team’s research as well as internal and external ESG research. Pendal’s issuer
research is significantly enhanced through collaboration with its equity teams to obtain insights
from their investment analysis and direct company engagements, as well as discussions with
Pendal’s head of responsible investments regarding ESG issues that are deemed material to the
issuer being reviewed. This broadened research approach promotes a more dynamic process with
greater awareness of market conditions.
Overview of the Financial System • NU LAGUNA 9

Cont…

Another avenue through which ESG factors are incorporated is through explicit sustainability
(best of sector) and ethical screens that are applied across Pendal’s dedicated sustainability
fixed income funds. For these strategies, each credit issuer is rated on a comprehensive set of
ESG categories. Issuers with ESG scores that do not meet the quality threshold are excluded
from the fund’s investable universe. In this case, CCL’s poor ESG rating excluded the issuer from
the investable universe of Pendal’s dedicated sustainability strategies even before the bottom-
up credit selection process outlined above was applied.
Both the credit selection process (applied across all of Pendal’s income and fixed interest funds)
and the dedicated sustainability screening process incorporate internal and external sources of
ESG information. The third-party ESG data providers conduct in-depth analysis of issuers’ (CCL
in this example) non-financial characteristics and risks using their independent ESG research.
As can be seen from the chart below, CCL credit spreads underperformed against similar
consumer sector peers in 2017 and into 2018 as social trends changed and competition
intensified (see figure below).
In April 2017, the soft drink bottler issued a profit warning based on volume and price pressures
as its core high-sugar products have struggled with dwindling demand. Pendal’s investment
case was further reinforced in March 2018 after CCL was downgraded from BBB+ to BBB by
Fitch, reflecting continued deterioration in the performance of the company’s Australian
business due to structural challenges (falling demand for carbonated soft drinks) and increased
competition in still beverages. CCL’s credit spreads have continued to underperform since this
latest credit rating downgrade.

Required: Give your insights and reflect your answer. Justify your answer.
10 Overview of the Financial System • NU LAGUNA

Liquidity
Class, do you know the meaning of liquidity? Liquidity is the ease with which an asset
can be exchanged for money (Cabrera 2020).
As a matter of rule, the company or individual should be liquid so that the liabilities
or obligations can be paid without any challenges. Normally, financial systems create assets
such as stocks, bonds, checking accounts which is more liquid than physical assets such as
property plant and equipment.
The reason why financial system offers liquidity as a service is because they made
sure that the financial instruments that it created will be exchanged and can be exchanged
in a wide range such as bonds and stocks that were transferable.
In business, we provide a computation to test if the company is liquid. The formula
is as follows:

Current Ratio: Current Assets divided by Current Liabilities (CA/CL)

The current ratio is a liquidity ratio that measures a company's ability to pay short-term
obligations or those due within one year.

Allow me to give you an example of current ratio.

Richard Company
Current Assets Current Liabilities
Cash 150,000.00 Accounts Payable 250,000.00
Short term investments 250,000.00 Accrued Payables 50,000.00
Accounts Receivables 200,000.00 Other current liabilities 200,000.00
Inventories 300,000.00
Prepaid Expenses 100,000.00
Total Current Assets 1,000,000.00 Total Current Liabilities 500,000.00

Perez Company
Current Assets Current Liabilities
Cash 50,000.00 Accounts Payable 250,000.00
Short term investments 150,000.00 Accrued Payables 50,000.00
Accounts Receivables 50,000.00 Other current liabilities 200,000.00
Inventories 15,000.00
Prepaid Expenses 35,000.00
Total Current Assets 300,000.00 Total Current Liabilities 500,000.00
Overview of the Financial System • NU LAGUNA 11

There are two samples. The computations were as follows:

Richard Company Perez Company

Current Assets 1,000,000.00 300,000.00
divided by: Current Liabilities 500,000.00 500,000.00
Current Ratio 2 times 0.60 times

If you will interpret it,

Richard Company can pay 2 pesos for every 1 peso liability. That means Richard Company
can pay its liability this coming year when it is due.
Perez Company can pay .60 cents for every 1 peso liability. That means Perez Company
cannot pay its liability this coming year when it is due. Therefore, managers will suggest that the
company borrows money or ask for additional investment from the owners.

Another liquidity measures is the quick ratio or acid test ratio. The main difference is that
it does not consider inventory as asset that can be converted to cash today. The reason is because in
the normal business cycle, when the inventory is sold, the normal terms is credit (meaning accounts
receivable) and will wait for another days to convert it into cash. Some prepaid expenses also cannot
be considered since it cannot be used for payments. In exceptional cases, if the prepaid expenses can
be converted to cash immediately, then it can be included in the computation of quick assets.

Quick Ratio: Quick Assets divided by Current Liabilities (QA/CL)

Same illustration, the computation were as follows.

Richard Company Perez Company

Current Assets
Cash 150,000.00 50,000.00
Short term investments 250,000.00 150,000.00
Accounts Receivables 200,000.00 50,000.00
Total Quick Assets 600,000.00 250,000.00
divided by: Current Liabilities 500,000.00 500,000.00
Quick Ratio 1.20 times 0.50 times

If you will interpret it,

Richard Company can pay 1.20 pesos for every 1 peso liability. That means Richard
Company can pay its liability immediately when it is demanded.
Perez Company can pay .50 cents for every 1 peso liability. That means Perez Company
cannot pay its liability immediately when it is demanded. Therefore, managers will suggest that the
company borrows money or ask for additional investment from the owners.
 12 Overview of the Financial System • NU LAGUNA

Also, if you will notice, Inventory and Prepaid Expenses were not included in the computation of Quick
Assets.

Test yourself
Task 2: Case Analysis for liquidity
Richard Company presents its November 2020 Statement of Financial Position.
ASSETS LIABILTIES AND EQUITY
Current Assets Current Liabilities
Cash 250,000.00 Accounts Payable 250,000.00
Short term investments 180,000.00 Accrued Payables 50,000.00
Accounts Receivables 350,000.00 Other current liabilities 200,000.00
Inventories 420,000.00 Total Current Liabilities 500,000.00
Prepaid Expenses 100,000.00
Total Current Assets 1,300,000.00 Non-Current Liabilities
Loans Payable -
Non-Current Assets
Property, Plant and
Equipment 2,500,000.00 Equity
Other Non-Current Assets 1,500,000.00 Share Capital 2,500,000.00
Total Non-Current Assets 4,000,000.00 Retained Earnings 2,300,000.00

TOTAL ASSETS 5,300,000.00 TOTAL LIAB AND EQUITY 5,300,000.00

Richard Company is planning on expansion and wanted to buy another business entity worth
1,500,000 million. The bank offers the following bank loans.
a. Loans worth 1,500,000 payable in lump sum, Maturity date is 2 years after the loan with
10% interest.
b. Loans worth 1,500,000 payable in equal installment of 50,000 per month. 12% interest
compounded monthly.
c. Loans worth 1,500,000 payable within the year of 2021. 12% interest compounded
monthly.
d. Ask the owner if they can make an additional investment of 1,500,000.

What do you think is the problem of the company? He also asked you which alternative is
better for the company. Justify your answer.
Overview of the Financial System • NU LAGUNA 13

Next is the Information.

Financial markets convey information to both savers and borrowers by determining the
prizes of stocks, bonds, and other securities. (Cabrera 2020) This information that the
financial system provides the borrower and savers the choice if they will invest or spend the
money.

On the other hand class, some information are not available to one party. This is called
Asymmetric Information.

We all know that you will not lend money to those person who does not have the capacity
to pay and therefore, those borrowers tend to keep some information to the borrowers.
Also, some investors are blinded by the institution who will be the spender. The challenges
that created by asymmetric information are adverse selection and moral hazard.

As a matter of fact, these two provides challenges to the investor or lender. Allow me to give
you an example.

1. Adverse Selection – this is when the investors cannot distinguish whether the borrower is a
high risk or low risk borrowers before making the investment.

2. Moral Hazard – this is when the investors cannot verify if the borrowers used their
money/funds as intended.

Allow me to give you a figurative example of the two problems arising from asymmetric information

ADVERSE
SELECTION MORAL HAZARDS

TYPE OF PERSON BEHAVIOR OF

CAUSES A BIAS PERSON CAUSES
ASYMMETRIC A BIAS
BEFORE INFORMATION
ENTERING TO AFTER ENTERING
CONTRACT TO CONTRACT

TYPES OF PEOPLE THAT

ARE ATTRACTED TO CONTRACT INCENTIVES
CONTRACT
14 Overview of the Financial System • NU LAGUNA

Illustration of the two

Health Insurance

Low Payment Premium: If the High Payment Premium: If the

person has a low risk that the person has a high risk that the
disease may be incurred. disease may be incurred.
(Sample if the person is a (Sample if the person is a heavy
healthy and young) smokes or if the person is old)

ADVERSE SELECTION
MORAL HAZARDS
Sample: if you are a
heavy smoker and Sample: If you actually
you fill out that you intends to get sick to
are not smoking to avail the benefits of the
avail the low insurance contracts.
payment premium.

Class, take note that usually, these problems can happen at

the same time although there are times that only one
problems arise depending on the situation.
Overview of the Financial System • NU LAGUNA 15

We have some tips that reduce both adverse selection and moral hazards.

Adverse Selection Moral Hazard

Requiring borrowers to disclose Specializing in monitoring the
material information on their borrowers and developing effective
financial performance and financial techniques to ensure that the funds that
position they loan are actually used for their
1 intended purpose
Collecting information on firms Imposing restrictive covenants
and selling that information to
2 investors
Convincing lenders to require
borrowers to pledge some of their
assets as collateral which lender can
3 claim of the borrower defaults
 16 Overview of the Financial System • NU LAGUNA

FOR ASYNCHRONOUS CLASS

Test yourself
Watch or Read the Synopsis of the movie “The Accountant” 2016 movie.

1. https://www.youtube.com/watch?v=CF1HhTSS_J4 - video
2. https://www.imdb.com/title/tt2140479/plotsummary - Synopsis

Required:
a. Find the adverse selection and moral hazard in the movie.
b. Find the preventive and corrective solution to the problem.

You can upload your answer in MS Forms which will be sent during the synchronous class before the
asynchronous class.

Deadline of Submission: Next Synchronous Class

File Type: PDF
Group: 3-5 members (Only the leader or representative will send the file and encode their group
members on the MS Forms
Overview of the Financial System • NU LAGUNA 17

LESSON SUMMARY

1. A vibrant and healthy economy requires a financial system that makes or

channels funds from people who save to people who have productive investment
opportunities. The financial system is complex in structure and functions
throughout the world. A developed economy relies on financial markets and
institutions for efficient transfer of funds. Every person’s life, family, business,
and government are affected by the financial system.
2. A strong financial system is a necessary ingredient for a growing and prosperous
economy. Companies raising capital to finance capital expenditures and
investors saving to accumulate funds for future use require well-functioning
financial markets and institutions.
3. Having a well-functioning financial system in place that directs funds to their
most productive uses is a crucial prerequisite for economic development.
4. 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.
5. Asymmetric information describes the situation in which one party to an
economic transaction has better information than does the other party. In
financial transactions, typically the borrower has more information than does the
lender.

Key Terms

Financial Economics Financial System Financial Market

Financial Instruments Financial Regulators Risk Sharing
Liquidity Asymmetric Information Moral Hazards
Adverse Selection Borrower/Spender Saver/Investor
18 Overview of the Financial System • NU LAGUNA

Post Test

Theories

1. Every financial market has the following characteristic:

a. It determines the level of interest rates.
b. It allows common stock to be traded.
c. It allows loans to be made.
d. It channels funds from lenders-savers to borrowers-spenders.
2. Financial markets have the basic function of
a. bringing together people with funds to lend and people who want to borrow funds.
b. assuring that the swings in the business cycle are less pronounced.
c. assuring that governments need never resort to printing money.
d. both (A) and (B) of the above.
e. both (B) and (C) of the above.
3. Which of the following can be described as involving direct finance?
a. A corporation’s stock is traded in an over-the-counter market.
b. People buy shares in a mutual fund.
c. A pension fund manager buys commercial paper in the secondary market.
d. An insurance company buys shares of common stock in the over-the-counter markets.
e. None of the above.
4. Which of the following can be described as involving direct finance?
a. A corporation’s stock is traded in an over-the-counter market.
b. A corporation buys commercial paper issued by another corporation.
c. A pension fund manager buys commercial paper from the issuing corporation.
d. Both (A) and (B) of the above.
e. Both (B) and (C) of the above.
5. Which of the following can be described as involving indirect finance?
a. A corporation takes out loans from a bank.
b. People buy shares in a mutual fund.
c. A corporation buys commercial paper in a secondary market.
d. All of the above.
e. Only (A) and (B) of the above.
6. Financial markets improve economic welfare because
a. they allow funds to move from those without productive investment
opportunities to those who have such opportunities.
b. they allow consumers to time their purchases better.
c. they weed out inefficient firms.
d. they do all of the above.
e. they do (A) and (B) of the above.
7. Which of the following financial intermediaries are depository institutions?
a. A savings and loan association
b. A commercial bank
c. A credit union
d. All of the above
e. Only (A) and (C) of the above
Overview of the Financial System • NU LAGUNA 19

8. Which of the following is a contractual savings institution?

a. A life insurance company
b. A credit union
c. A savings and loan association
d. A mutual fund
9. Which of the following are not investment intermediaries?
a. A life insurance company
b. A pension fund
c. A mutual fund
d. Only (A) and (B) of the above
10. The government regulates financial markets for three main reasons:
a. to ensure soundness of the financial system, to improve control of monetary
policy, and to increase the information available to investors.
b. to improve control of monetary policy, to ensure that financial
intermediaries earn a normal rate of return, and to increase the information
available to investors.
c. to ensure that financial intermediaries do not earn more than the normal
rate of return, to ensure soundness of the financial system, and to improve
control of monetary policy.
d. to ensure soundness of financial intermediaries, to increase the information
available to investors, and to prevent financial intermediaries from earning
less than the normal rate of return.

True or False: If false, write what makes it false.

1. Every financial market allows loans to be made.

2. An example of direct financing is if you were to lend money to your neighbor.
3. The Philippine Stock Exchange is an example of a primary market.
4. Commercial paper is not traded in the capital market.
5. Dollar are traded in the money market.
6. The process of financial intermediation is also known as direct finance.
7. A mutual fund is not a depository institution.
8. A pension fund is not a contractual savings institution.
9. Equity represents an ownership interest in a firm and entitles the holder to the
residual cash flows.
10. Adverse selection refers to those most at risk being most aggressive in their search
for funds.
20 Overview of the Financial System • NU LAGUNA

Reference

Books and Journals

Cabrera, ME & Cabrera A., Financial Markets and Institutions 2020 Edition, GIC Enterprises &
Co Inc