MONEY AND BANKING

Lecturer: Tran Thi Minh Tram

Email: tramttm@ftu.edu.vn

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CHAPTER 2: FINANCIAL SYSTEM
Sources:
• Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc.
• Timothy J.G (2013), Financial Management: Principle and
practices, 6th ed, Freeload Press Publishers. [chapter 2]
• Mishkin, F.S. (2010),
th
The Economics of Money, Banking and
Financial markets, 9 ed, The Addison – Wesley Series in
Economics
• Mandura, J.(2011), Financial Markets and Institutions, 10th ed,
South Western

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 LEARNING OBJECTIVES
• After studying this chapter you should be able to
1. Summarize the basic function performed by financial
system
2. Describe the principal financial instruments
3. Explain why financial markets are classified as debt
and equity markets, primary and secondary markets,
exchanges and over-the-counter markets, and
money and capital markets
4. Describe the principal financial intermediaries
5. Express why the government regulates financial
markets and financial intermediaries

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Chapter 2: Financial system

OVERVIEW OF FINANCIAL SYSTEM

FLOW OF FUNDS

FINANCIAL INSTRUMENTS/ SECURITIES

FINANCIAL MARKETS

FINANCIAL INTERMEDIARIES

FINANCIAL CRISIS AND FINANCIAL REGULATION

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 CHAPTER 2.1: FINANCIAL
SYSTEM & FLOWS OF FUNDS

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 A Model of the Economy
• As in Principles of Macro, divide the economy
into different sectors and see how those
sectors interact:
– “Agents” in the Economy
– Markets where Agents Interact
– Equilibrium

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 The Agents in the System
• There are four agents that we will focus on
when constructing a model of the economy:
– Households
– Firms
– Government
– “The Rest of the World” (ROW)

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 Markets
• There are three markets that we typically
focus on in macroeconomics:
– The Factor Market
– The Goods Market
– The Financial Market (- we examine in detail in this
course)

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 FINANCIAL SYSTEM

The flows of funds through the financial system 9

 Financial system
• Financial system (FS) – a framework for
describing set of markets, organisations, and
individuals that engage in the transaction of
financial instruments (securities), as well as
regulatory institutions.

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 Financial system
• The basic function of FS is essentially channelling of funds
within the different units of the economy – from surplus
units to deficit units for productive purposes.
– Surplus economic units have funds left over after spending all they
wish to spend
– Deficit economic units need to acquire additional funds to sustain
their operations
• To enable funds to move through the financial system, funds
are exchanged for securities.
– Securities are documents that represents the right to receive funds
in the future.
• Securities are traded in financial markets.
• Financial intermediaries often help to facilitate this process
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 THE FLOW OF FUNDS
• There are interactions among the various
players in the financial system.
• Funds flow through the financial system
from the entities that have a surplus of
funds to those that have a deficit of
funds:
– Directly
– Through markets
– Through intermediaries

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 The flow of funds
Markets

Surplus unit Deficit unit

Intermediaries

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 Fund flows: disintermediation
Markets

Surplus unit Deficit unit

Intermediaries

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 Fund flows via Market
Markets

Surplus unit Deficit unit

Intermediaries

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 Fund flows via Intermediaries
Markets

Surplus unit Deficit unit

Intermediaries

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 Fund flows via Intermediaries and
Markets
Markets

Surplus unit Deficit unit

Intermediaries

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 Fund flows via Market and
Intermediaries
Markets

Surplus unit Deficit unit

Intermediaries

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Funds Flow: Secured Credit

Markets

Poor Credit Risk

Surplus Units Deficit Units

Intermediaries

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 What Does the Financial System Do?
• Economists believe there are three key
services that the financial system provides to
savers and borrowers: risk sharing, liquidity,
and information.

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 Risk sharing
• Risk sharing: A service the financial system
provides that allows savers to spread and
transfer risk.
– The financial system provides risk sharing by
allowing savers to hold many assets
(diversification).
– Diversification: Splitting wealth among many
different assets to reduce risk.

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 Liquidity
• The second service that the financial system offers
savers and borrowers is liquidity, which is the ease
with which an asset can be exchanged for money.
• More liquid assets can be quickly and easily exchanged
for money, while less liquid—or illiquid—assets can be
exchanged for money only after a delay or by incurring
costs.
• Assets created by the financial system are more liquid
than physical assets.
• Financial markets and intermediaries help make
financial assets more liquid.

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 Information
• Information: Facts about borrowers and about
expectations of returns on financial assets.
• A third service of the financial system is the
collection and communication of
information.
• Financial markets convey information to both
savers and borrowers by determining the
prices of stocks, bonds, and other securities.

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 Review questions
1. What is a financial system?
2. What does the financial system do?
3. Who is in charge of a financial system?

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