A.

Transaction Costs
· Financial intermediaries can substantially reduce transaction costs because they
have developed expertise in lowering them and because their large size allows them
to take advantage of economies of scale, the reduction in transaction costs per
transaction as the size (scale) of transactions increases.

B. Information Costs
· In financial markets, there is a situation where there is imperfect knowledge; one
party often does not know enough about the other party to make accurate decisions.
This inequality is called asymmetric information.
· For example: a borrower who takes out a loan usually has better information
about the potential returns and risks associated with the investment projects for which
the funds are being raised for the lender.

Lack of information creates problems in the financial system on 2 fronts: before the
transaction is entered into and after.
A. Adverse selection - is the problem created by the asymmetric information before the
transaction occurs. (good credit risks vs. bad credit risks)

B. Moral Hazard
- is the problem created by asymmetric information after the transaction occurs.

Moral hazard in the financial markets is the risk that the borrower might engage in
activities that are undesirable (immoral) from the lender’s point of view because they
make it less likely that the loan will be repaid.

Role of Financial Markets

Financial markets transfer funds from those who have excess funds (surplus units) to
those who need funds (deficit units).

1. Accommodating corporate finance needs

- Corporate finance involves corporate decisions such as how much funding to
obtain and what type of securities to issue when financing operations.
2. Accommodating investment needs
- Investment management involves decisions by the investors regarding how to
invest their funds.

Role of Financial Institutions

Financial Institutions are needed to resolve the limitations caused by market
imperfections.

Financial institutions can be classified as depository and nondepository institutions.

Role of Depository Institutions (Same as Financial Institutions)

 ● They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by the surplus units. - (asset transformation + liquidity
transformation
● They repackage funds received from deposits to provide loans of the size
maturity desired by deficit units. - (volume transformation)
● They accept the risk on loans provided. - (risk transformation)
● They have more expertise than the individual surplus units in evaluating the
creditworthiness of deficit units. (FIs have a greater incentive to collect
information, the average cost of collecting information is lower)
● They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could. (risk transformation)

Types of Depository Institutions

● Commercial Banks - the most dominant depository institution
● Savings Institutions or thrift institutions
● Credit cooperatives

Role of Nondepository Financial Institutions

Nondepository institutions generate funds from sources other than deposits but also play a major
role in financial intermediation.

● Finance Companies
● Mutual Funds
 ● Securities Firms
● Insurance Companies
● Pension Funds

Financial intermediaries
 Banking institutions and
o Universal banks
 - most of the big banks in the Philippines
 Need bigger amount of capitalization to be qualified to operate as universal bank
 Function: can have additional functions in the investments
 They can perform the function of an investment house, where they can
provide advisory services, mergers and acquisitions
 Example of universal banks
 BDO
o Investment house (BDO capital)
o
o Commercial banks
 They do not have the ability to provide advisory services
o Saving and thrift bank
o Development banks
 Similar functions of bank but in a smaller scale
o Rural banks
 Mostly cater to the agricultural sector (farmers), cooperatives
o Government banking institutions
 Landbank
 Development Bank of the Philippines
 Non-banking institutions
o Insurance Companies
o Pension Funds
o Securities Firms
o Mutual Funds
o Finance Companies
o Government non-banking
 SSS
 GSIS


Commercial Bank Operations

Commercial bank- most important and most dominant financial institution

Bank Sources of Funds

To understand how any financial institution obtains funds and uses funds, its balance sheet can be
reviewed.

Total Assets = Total Liabilities + Capital

Uses of Funds= Sources of Funds

The institution’s reported liabilities and equity indicate its sources of funds, while its reported assets
indicate its uses of funds.