KEY COMPONENTS OF THE FINANCIAL SYSTEM

The Major components of the financial System include:

A) Financial Instruments
B) Financial Markets and Financial Institutions
C) The Central Bank and Other Financial Regulators

FUNCTIONS OF FINANCIAL MARKETS:

FINANCIAL MARKETS ( bonds and stock markets ) and financial intermediaries ( banks,
insurance companies among others ) have the basic function of getting people together by
moving funds from those who have a surplus of funds to those who have a shortage of
funds. Well-functioning financial markets and financial intermediaries are crucial to our
economic health. Indeed, when the financial system breaks down, as it has in Europe and in
Southeast Asia recently, severe economic hardship results.

To determine the effects of financial markets and financial intermediaries on the economy
we need to acquire an understanding of their general structure and operation.

THE FUNCTION THAT FINANCIAL MARKETS PERFORM IS SHOWN BELOW:

INDIRECT FINANCE

Funds FUNDS

FUNDS

FUNDS FUNDS

Overview of: FINANCIAL INSTITUTIONS AND INTERMEDIARIES

What is a Financial Institution?

A. FINANCIAL INSTITUTION - is a company engaged in the business of dealing with

financial and monetary transactions such as deposits, loans, investments, and currency
exchange.

> encompass a broad range of business operations within the financial services
sector including, banks, trust companies, insurance companies, brokerage firms and
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investment dealers. Virtually everyone living in a developed and developing economy has
ongoing or at least periodic need from the services of financial institutions.
 > financial institution can operate at several scales from local community credit
unions to international investment banks.

The Financial System matches savers and borrowers through 2 channels:

(1) Financial Markets and
(2) Banks and other Financial Intermediaries
These 2 channels are distinguished by how funds flow from savers, or lendes, to borrowers
and by the financial institutions involved. Funds flow from lenders to borrowers DIRECTLY
through financial markets such as the New York Stock Exchange and Philippine Stock
Exchange or INDIRECTLY through financial intermediaries, such as banks.

AN OVERVIEW OF HOW FUNDS FLOW FROM SAVERS TO BORROWERS OR MOVING FUNDS

THROUGH THE FINANCIAL SYSTEM

SAVERS

Funds Funds

Returns Returns

Financial System Returns

Returns Funds Funds

FINANCIAL INTERMEDIARIES

A FINANCIAL INTERMEDIARIES is a financial firm. Such as a bank, that borrows funds from
savers and lends them to borrowers.

BASIC STRUCTURE OF FINANCIAL INSTITUTIONS/ INTERMEDIARIES

A. DEPOSITORY INSTITUTIONS
1. Commercial Banks/Universal Banks
2. Savings and Loans Associations
3. Mutual Savings Bank
4. Credit Union PAGE \* MERGEFORMAT 1
B. CONTRACTUAL SAVINGS INSTITUTIONS
1. Insurance Companies
2. Pension Funds
C. INVESTMENTS INTERMEDIARIES

Household Firms Government

s
1. Investment Banks
2. Mutual Funds
3. Hedge Funds
4. Finance COmpanies
5. Money Market Mutual Funds

DEPOSITORY INSTITUTIONS

COMMERCIAL BANKS - are the most important intermediaries. Commercial banks play a key
role in the financial system by taking in deposits from households and firms and investing
most of those deposits, either by making loans to household and firm or by buying
securities, such as government bonds, or securitized loans.

Many firm rely on bank loans to meet their short-term needs for credit, such as funds to pay
for inventories ( which are goods firms have produced or purchased but not yet sold ) or to
meet their payrolls. Many firms rely on bank loans to bridge the gap between the time they
must pay for inventories meet their payrolls and when they receive revenues from the sales
of goods and services. Some firms also rely on bank loans to meet their long-term credit
needs, such as funds they require to physically expand the firm.

UNIVERSAL BANK - referred to as a full-service financial institutions, a universal bank

provides a large array of services including those of commercial banks and investment
banks.

THE TYPES OF SERVICES OFFERED INCLUDES:

1. Deposit accounts such as checking and savings
2. Loans and Credit
3. Asset and Wealth Management
4. Buying and Selling Securities
5. Financial and Investment advice
6. Insurance Products

Examples of Universak Banks are:

* Deutsche Bank, ING Bank, UBS, Credit Service, HSBC, Banks of America, JP Morgan Chase,
Wells Fargo, BPI; BDO

SAVINGS AND LOANS ASSOCIATIONS, MUTUAL SAVINGS BANK, CREDIT UNIONS -are the
other depository institutions .

CONTRACTUAL SAVINGS INSTITUTIONS

These are financial intermediaries that receive payments from individual as a result of a
contract and uses the funds to make investments.

INSURANCE COMPANIES - specialize in writing contracts to protect their policyholders from

the risk of financial losses associated with particular events, such as automobile accidents or
fires. Insurance companies collect
PAGEpremiums from policyholders,
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invest then obtain the funds necessary to pay claims to policyholders and to cover their
other costs. So, for instance, when you buy an automobile insurance policy, the insurance
company may lend the premiums you pay to a hotel chain that needs funds to expand.
The Insurance Industry has two segments:

A) LIFE INSURANCE COMPANIES - sell policies to protect households against a loss of

earnings from the disability; retirement or death of the insurance person. Example: Insular
Life Corporation and Philam Life Insurance Corporation.

B) PROPERTY AND CASUALTY COMPANIES - sell policies to protect household and

firms from the risks of illness, theft, fire, accidents and natural disaster. Examples are
Standard Insurance Company and Malayan Insurance Corporation

PENSION FUNDS - is a financial intermediary that invest contributions of workers and firm in
stocks, bonds, and mortgages to provide pension benefit payments during workers’
retirements.

For many people, saving for retirement is the most important form of savings in two ways:
> through pension funds sponsored by employers or through personal savings accounts.

Most notable EXAMPLES of PENSION FUNDS are:

1. Social Security System (SSS) - for employees of private companies
2. GSIS- Government Service Insurance System for government employees.

PENSION FUNDS - invest contrivutions from workers and firms is stocks, bonds, and
mortgages to earn the money necessary to pay pension benefit paymnets during worker’s
retirements. The SSS and government pension funds are important source of demand for
financial securities.

2 BASIC TYPES OF PENSION FUNDS PLAN:

A) DEFINED CONTRIBUTION PLAN

B) DEFINED BENEFIT PLAN

DEFINED CONTRIBUTION PLAN HAS THE FOLLOWING GEATURES!

A) Employer places contributions from employer into investments, such as mutual

funds, chosen by the employees. Employees own the value of the funds in the plan. They
also bear the risk of poor investment returns.

B) If employee’s investments are profitable, employer’s income during retirement will

be high. On the other hand if the employees investment are not profitable, employee’s
income during retirement will be low.

C) Most private employer’s “Defined Contribution Plans - in the United States are 401
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(k) plans. Some emplyers match emplyee’s contribution up to a certain amount. Many 401
(k) participants invest through mutual funds, which enable them to hold a large collection of
assets at a modest cost.
DEFINED BENEFIT PLAN

A) An employer promises employees a particular peso benefit payment, based on each

employee’s earnings and years of service. The benefit payments may or may not be indexed
to increase with inflation.

B) If the funds in the pension plan exceed the amount promised, the excess remains
with the employer managing the fund.

C) If the funds in the pension plan are insufficient to pay the promised benefit, the plan
is underfunded and the employer is liable for the difference.

INVESTMENT INTERMEDIARIES

INVESTMENT INTERMEDIARIES - are financial firms that raise funds to invest in loan and securities.
The most important investment intermediaries are investment banks, mutual funds, hedge funds
finance companies and money market mutual fund. Mutual funds and hedge funds, in particular,
have come to play an increasingly important role in the financial system.

INVESTMENT BANK - investment banks such as Goldman, Sachs and Morgan Stanley, Merrill Lynch
differ from commercial banks in that they do not take in deposits and until very recently rarely lent
directly to households. ( In late 2016, Goldman Sachs began engaging in fintech online lending.
Offering loans of up to $30,000 to households with high credit card balances but good credit
histories.) Instead, they concentrate on providing advice to firms issuing stocks and bonds or
considering mergers with other firms. They also engage in underwriting, in which they guarantee a
price to a firm issuing stocks or bonds and then make a profit by selling the stocks or bonds at a higher
price. In the the late 1990’s investment banks increased their importance as financial intermediaries
by becoming heavily involved in the securitization of loans, particularly mortgage loans. Investment
banks also began to engage in propriety trading which involves earning profits by buying and selling
securities.

MUTUAL FUNDS these financial intermediaries allow savers to purchase shares in protfolio of
financial assets, including stocks, bonds, mortgages, and money market securities. Mututal funds
offers savers the advantage of reducing transactions costs. Rather than buy many stocks, bonds, or
other financial assets individually - each with its own transaction costs . Rather than buy many stocks,
bonds, or other financial assets individually - each with its own transactions cost - a saver can buy a
proportional share of these assets by buying into the fund with one purchase.
> Mutual funds provide risk-sharing benefits by offering a diversified portfolio of assets and liquidity
benefits because savers can easily sell the shares. Moreover, the company managing the fund - for
example, BPI MUTUAL FUNDS, specializes in gathering information about different investments.

TYPES OF MUTUAL FUNDS

1. Closed - end Mutual Funds

2. Open- End Mutual Fund

HEDGE FUNDS - are financial firms organized as a partnership of wealthy investors that make
relatively high risk, speculative investment. It is similar to mutual funds in that they accept money
from investors and use the funds to buy a portfolio of assets. However, a hedge fund typically has no
more than 99 investors, all of whom are\*wealthy
PAGE individuals
MERGEFORMAT 1 or institutions such as pension funds.
> Hedge funds usually make riskier investments than do mutual funds, and they charge investors
much higher fees.

SHORT- SELLING - can cause security prices to fall by increasing the volume of securities being sold.
> Investment in hedge funds are typically illiquid with investors often not allow to withdraw their
funds for one or three years. And even then, investors are typically given only a narrow window of
time within which they can redeem their investment.

> Despite these criticisms, many economists believe that hedge funds play an important role in the
financial system because hedge funds are able to mobilize large amount of money and leverage the
money when buying securities. Hence, they are able to force price changes that can correct market
inefficiencies.

FINANCE COMAPANIES - are nonbank financial intermediaries that raise funds through sales of
commercial paper and other securities and use the funds to make small loans to household and firms.

> raise funds by selling commercial paper ( a short-term debt investment ) and by issuing stocks and
bonds. They lend these funds to consumers, who make purchases of such items as cars, furnitures
and home improvements and to small business.
> some finance companies are organized by a parent corporation to help sell its product.

The 3 main types of Finance Companies:

1. Consumer Finance Companies
2. Business Finance Companies
3. Sales Finance Companies

MONEY MARKET MUTUTAL FUNDS

These are relatively new financial institutions that have the attributes of a mututal fund but also
function to some extent as a depositing institution because they offer deposit-type accounts. Like
most mutual funds, they sell shares to acquire funds that are then used to buy money market
instruments that are both safe and very liquid. The interest on these assets is then paid out to the
shareholders. These money market mutual funds invest exclusively in short-term assets, such as
treasury bills, negotiable certifcates of deposit and commercial paper.

Anne A. Tablizo
Financial Institutions and Intermediaries
Financial Markets

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