 households also become borrower-spenders when they borrow money to buy car

and houses.

 Funds can flow from lenders-savers to borrowers-spenders VIA TWO ROUTES:

 Direct Financing: The borrower-spenders deal directly with lenders through
selling financial instruments.
 Indirect Financing: The borrowing activity between both parties still happens
though indirectly through the intervention of a financial intermediary.

 The transfer of funds from providers to demanders allows both parties to gain some
return. The existence of the financial system is important for the growth of the economy.
 Example: Fund Providers can charge interest on the funds they want to loan out
and earn interest on it. Fund demanders can also earn interest on the investments
they wanted to pursue using the loans borrowed from the fund providers.

 Financial Markets help in creating more efficient allocation of capital which results in
higher production and efficiency that leads to economic growth. Efficient allocation of
capital happens when funds are invested in productive investments that yield returns for
the fund provider and fund demanders.

 Welfare of Individual Consumers is enhanced by a properly functioning financial

system. Funds are made available to young people to purchase what they want without
making them wait to save for the entire purchase price. As a result, funds flow faster to:
 business enterprises through profit,
 government through taxes, and
 investors through interest and dividends
Efficient financial markets enhance the economic well-being of ALL members of the
society.

 To become more efficient, the financial system addresses the problem of:
 Information Asymmetry which occurs when one stakeholder to a transaction
holds superior information than the other party. It causes inefficient allocation
of financial resources as one party may be in a better negotiating position because
of the lacking information of the other party.
 ELEMENTS OF A FINANCIAL SYSTEM

1. Lenders and Borrowers

 Who are the players?
 Lenders are the parties that have excess funds that they can lend out to other
entities for a required return.
 Borrowers are parties who are willing to pay the required return to obtain
additional funds to finance their investment initiatives.
 They are also known as fund providers and fund demanders, respectively. They
are the most essential elements that make up the foundation of a transaction in the
financial system. Financial system will not exist without these two.

2. Financial Intermediaries
 How will the exchange occur?
 This is a special type of entity that acts as a third party to facilitate the borrowing
activity between lenders and borrowers.
 It exists to fill the gap that makes the transaction to not occur. Often, potential
borrowers do not have an idea which parties or entities are willing to lend out
money to them and vice-versa. Financial intermediaries gather funds from lenders
and redistribute them to borrowers thru the use of investment vehicle like loans.
 Potential lenders and borrowers just have to visit the financial intermediary and
the transaction will occur. Probably, the lenders and borrowers do not even know
who the ultimate individual or firm is provided or demanded for the funds.

3. Financial Instruments
 What will be used?
 These are the medium of exchange of contractual obligation of a party, where
such contract can be traded.
 A contract where a party recognizes it as an asset and another is a liability, as
defined by the International Financial Reporting Standards.
 It could be intangible or tangible.
 Two types of financial instruments:
 Cash
 Derivative Financial

4. Financial Markets
 Where will it be traded?
 A market where suppliers and buyers of financial instruments meet.
 Two types of market based on the instruments traded:
 Money Market for cash financial instruments
 Capital Market for the derivative financial instruments
5. Regulatory Environment
 How it is controlled?
 It is the governance body to ensure that the transactions that occur within the
financial system complies with the laws and regulations imposed to the actors as
well as the elements that plays within the system.

6. Money Creation
 What is the value it creates?
 Money is created with the flow of financial instruments. It is used to either be
reinvested or earned out from the system flows.

7. Price Discovery
 How much is created?
 As the financial systems continue to flow and operate, the financial instruments
create value.
 Price Discovery is the process of determining or valuing the financial instrument
in the market.
 The price is normally driven by the level of risk on how the issuer of the financial
instruments.