Overview of the Financial System

Structure of Financial Markets and Financial Institutions

To aid in the flow of funds from the lenders to the borrowers, we have the direct finance which is
channeling the funds through the financial markets and then we have the indirect finance which is
channeling the funds through the financial intermediaries.

I. Direct Finance
- is when borrowers borrow funds directly from the financial market without using a third-
party service, such as a financial intermediary.

In direct finance, borrowers borrow funds directly from lenders in financial markets by
selling them securities (also called financial instruments), which are claims on the borrower’s
future income or assets.

1. To obtain funds in a financial market

A. Issue debt instrument such as bonds or a mortgage
Contractual agreement by the borrower to pay the holder of the instrument fixed
amounts at regular intervals until a specified date when final payment is made.

Here, it is through the financial market that the bonds will be secured. There will be
consideration on the bond price, on the yield, on the coupon rate, and then the term of
the bonds. The term of the bonds would rely on the maturity date.

Maturity date – short bonds (2 years or less), intermediate bonds (2 – 10 years), long
bonds (more than 10 years)
 B. Issuing equities such as common stock
Equities usually make periodic payments called dividends to their holders are
considered long term securities because they have no maturity date.

2. Where securities are sold

A. Primary Market
- is a financial market in which new issues of a security, such as bond or stock, are
sold to initial buyers by the corporation or government agency borrowing the funds.

- through an investment bank that does it by underwriting securities.

B. Secondary Market
- is a financial market in which securities that have been previously issued (and are
thus secondhand) can be resold.

- Examples: through stock exchanges, brokers, dealers (organized exchange and

over-the-counter markets).

- makes it easier to sell the financial instruments to raise cash. They make the
financial instruments more liquid.

3. Distinguishing markets based on the maturity of the securities traded

A. Money Market
- is a financial market in which only short-term debt instruments are traded, generally
those with original maturity of less than 1 year.

B. Capital Market
- is the market in which longer-term debt and equity instruments are traded.

II. Indirect Finance

- is where borrowers borrow funds from the financial market through indirect means, such as
through a financial intermediary.

- The process of indirect finance using financial intermediaries, called financial

intermediation, is the primary route for moving funds from lenders to borrowers.

(Although much attention is given to securities markets, such as the stock market, Financial
Intermediaries are a far more important source of financing for corporations than securities
markets.)