Chapter 1

OVERVIEW OF THE
FINANCIAL SYSTEM

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 Content
n  Financial system
n  Financial market
n  Financial intermediaries
n  Central bank

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 Readings
①  Chương 2, 9 và 10, “Financial Markets and Institutions” ;
Federic S. Mishkin, Stanley G. Eakins; Pearson (2012).
②  Chương 1, 2 và 3, “Financial Institutions, Markets &
Money” ; David S. Kidwell, David W. Blackwell, David A.
Whidbee, Richard W. Sias; John Wiley & Sons (2012).
③  Nghiệp vụ ngân hàng Trung Ương; PGS. TS. Lê Thị Mận
(2012)

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 1.1 The financial system
n  Financial system consists of financial markets, financial
instruments and financial institutions which interact to facilitate
the flow of funds through the financial system.
n  There are two basic mechanisms by which funds flow through
the financial system:
n  Direct financing: where funds flow directly through

financial market.
n  Indirect financing: where funds flow indirectly through

financial institutions in the financial intermediation market.

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How funds flow through the financial system

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 1.2 Financial market
1.2.1 Functions of financial market:
n  Function of channeling funds
n  Function of encouraging saving and investment.
n  Function of raising the financial asset’s liquidity
n  Financial markets play an important role in the economy.
n  Financial markets allow funds to move from people who lack
productive investment opportunities to people who have such
opportunities.
n  Financial markets are critical for producing an efficient allocation
of capital, which contributes to higher production and efficiency for
the overall economy
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 1.2 Financial market
1.2.2 Structure of financial market
n  Debt and equity markets
n  Primary and secondary markets
n  Exchanged and Over-the-counter Markets
n  Money and capital markets

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 1.2.2 Structure of financial market
1.2.2.1 Debt and equity markets: A firm or an individual can
obtain funds in a financial market in two ways:
n  Issuing debt instruments: bonds, T-bills, commercial papers,
negotiable certificates of deposit (NCDs),…
n  Short-term, intermediate-term and long-term instruments.
n  Issuing equities: common stocks
n  Advantage of holding equities is that equity holders benefit
directly from any increases in the corporation’s profitability or asset
value.
n  Disadvantage of owning a corporation’s equities rather than its

debt is that an equity holder is a residual claimant

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 1.2.2 Structure of financial market
1.2.2.2 Primary and secondary markets
n  A primary market is a financial market in which new issues of a
security, such as a bond or a stock, are sold to initial buyers by the
corporation or government agency borrowing the funds
n  A secondary market is a financial market in which securities that
have been previously issued can be resold.
n  Secondary market:
n  makes the financial instruments more liquid
n  determines the price of the security that the issuing firm sells in the
primary market

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Primary and secondary markets

IPO

Primary Secondary
market market

SPO

Primary
market
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 1.2.2 Structure of financial market
1.2.2.3 Exchanges and Over-the-counter markets
n  An exchanges market is a place where buyers and sellers of
securities (or their agents or brokers) meet in one central location to
conduct trades.
n  An over-the-counter (OTC) market, in which dealers at different
locations who have an inventory of securities stand ready to buy and
sell securities “over the counter” to anyone who comes to them and
is willing to accept their prices.
n  over the- counter dealers are in computer contact
n  the OTC market is very competitive

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 1.2 Structure of financial market
1.2.3.4 Money and capital markets
n  The money market is a financial market in which only short-term
debt instruments (generally those with original maturity of a one
year or less) are traded.
n  The capital market is the market in which longer term debt
(generally with original maturity of more than one year) and equity
instruments are traded.

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How funds flow through the financial system

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 1.3 Financial Intermediaries
1.3.1 Functions of financial intermediaries
n  Transaction cost: Financial intermediaries reduce transaction
costs because:
n  expertise
n  economies of scale
n  Risk sharing:
n  Asset transformation
n  Diversification
n  Asymmetric information:
n  Adverse selection
n  Moral hazard

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Investor A Bonds

Investor B fund Mutual Shares

certificates
Fund

Other
Investor C securities
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 1.3 Financial Intermediaries
1.3.2 Types of financial intermediaries:
n  Depository Institutions
n  Commercial Banks
n  Savings and Loan Associations (S&Ls) and Mutual Savings Banks
n  Credit Unions
n  Contractual Savings Institutions
n  Life Insurance Companies
n  Property and Casualty Insurance Companies
n  Pension Funds and Government Retirement Funds

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 1.3 Financial Intermediaries
1.3.2 Types of financial intermediaries (cont.)
n  Investment Intermediaries
n  Finance Companies
n  Mutual Funds
n  Money Market Mutual Funds
n  Investment banks
n  Securities Firms

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Types of financial intermediaries

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 1.4 Central Bank
1.4.1 Functions of a modern central bank
n  The Government’s bank:
n  Manages the finance of the government

n  Through interest rate, controls the availability of money and

credit.
n  The Banker’s bank:

n  Guarantees that sound banks can do business by lending to

them, even during crises.

n  Operates a payment system for interbank payment.

n  Oversees financial institutions to ensure confidence in their

soundness. 19
 1.4 Central bank
1.4.2 Objectives of a modern central bank
n  Low, stable inflation
n  High, stable growth
n  Financial system stability
n  Stable interest rate
n  Stable exchange rate

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 1.4 Central bank
1.4.3 Tools of monetary policy:
§  Open market operations
§  Discount rate
§  Reserve requirement

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 1.4.3 Tools of monetary policy
n  Discount rate: The interest rate charged to commercial banks
and other depository institutisons for loans received from the
central bank’s discount window.
n  Reserve requirement: Reserve requirements are requirements
regarding the amount of cash a bank must hold in reserve
against deposits made by customers. This money must be in the
bank's vaults or at the closest of central banks.

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Tools of monetary policy
①  Open Market Operations
②  Discount policy
③  Reserve requirement

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 Open Marker Operation
§  Open market operations – OMO: refers to the buying and
selling of government securities in the open market in order to
expand or contract the amount of money in the banking system,
facilitated by central banks.
§  An open market purchase leads to an expansion of reserves and
deposits in the banking system and hence to an expansion of the
monetary base and the money supply.
§  An open market sale leads to a contraction of reserves and
deposits in the banking system and hence to a decline in the
monetary base and the money supply

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Open Marker Operation

Increasing
money
supply

Reducing
money
supply
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 Discount policy
n  A discount loan leads to an expansion of reserves, which can be
lent out as deposits, thereby leading to an expansion of the
monetary base and the money supply.
n  When a bank repays its discount loan and so reduces the total
amount of discount lending, the amount of reserves decreases
along with the monetary base and the money supply.

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Discount policy
lending
Increasing
money
supply

repay Reducing
money
supply
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 Reserve requirement
n  Reserve requirement is the amount of funds that financial institutions
must hold at the Fed in order to back their deposit.
n  A rise in reserve requirements leads to a decline of the monetary
multiplier and the money supply.
n  A reduction leads to an expansion in the monetary multiplier and the
money supply
n  Reserve requirements have rarely been used as a monetary policy tool
because raising them can cause immediate liquidity problems for
banks with low excess reserves.

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 Reserve requirement

Increasing
money
supply

Reducing reserve requirements

Reducing
money
supply
Raising reserve requirements 29
1.4.5 The State Bank of Vietnam
Students research themselves

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