PaolaFerretti_B&FMs_2021-2022

BANKING AND FINANCIAL

MARKETS

PAOLA FERRETTI
PAOLA.FERRETTI@UNIPI.IT

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FINANCIAL MARKETS: AN OVERVIEW AND
MAIN FEATURES

 Indirect financing (financial intermediation):

where funds flow indirectly through
financial institutions in the financial
intermediation market
 The reason that financial institutions are
called financial intermediaries is because
they are middlemen, facilitating
transactions between surplus and deficit
units

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 FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

 Particularly, financial intermediaries are agents

providing financial services
 They are banks, insurance companies, mutual funds,
pension funds…
 In most countries indirect financing represents the
main channel for moving funds from surpuls to deficit
units
 These countries have a bank-based system
(Continental Europe), while those that rely more on
financial markets (USA and UK) have a market-based
system

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 FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

 The indirect financing is particularly suitable in

presence of small and medium enterprises (SMEs),
because they are not able to sell their debt (bonds)
or equity (stock) directly to investors: they have
not the expert knowedge and the amount of their
financial needs is not so high to be of interest for
big investors
 When these firms need funds, the most
convenient choice is to borrow in the indirect
market from a financial institution
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 FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

 In indirect financing the financial institution stands

between the surplus unit and the deficit unit and it
transforms financial claims in a way that makes
them attractive to both the surplus and the deficit
unit
 For indirect financing to take place, the deficit unit
must be willing to issue a security with
characteristics (e.g. maturity) that match exactly
the desires of the surplus unit.
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 EXAMPLE

 Bob, a student, has 5.000 USD to invest for 3 months

 To meet Bob’s needs a bank sells Bob a 3-months
certificate of deposit (CD)
 Then, the bank pools it with other CDs and so it is able
to use the money to make small business loans
 In essence, banks raise money by selling services such
as checking accounts, saving accounts and certificates
of deposit and then uses money to make loans to
firms (or consumers)
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 FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

Difference between direct and indirect financing

 In the direct financing the form of the securities remains

unchanged, because securities flow from surplus to deficit
unit
 In the indirect financing, securities are repackaged and thus
their form is changed
 By repackaging securities, financial intermediaries tailor a
wide range of financial products and services to meet the
needs of customers (consumers, small businesses and large
corporate)
 As said, their products and services are particularly
important for certain categories of customers, such as
SMEs, which do not have easy access to direct financial
markets PaolaFerretti_B&FMs_2021-2022 7
FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

 Anyway, regardless of the financing

mechanism (direct or indirect), the final goal of
the financial system is to bring the parties
toghether at the least possible cost and with
the least inconvenience
 An efficient financial system is important
because it ensures that the (scarce) existing
resources finance the investments that
promise the best return and therefore generate
economic growth

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FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

 If the financial system works properly, firms

with the most promising investment
opportunities receive funds and those with
low and bad opportunities receive no
funding (or funding is more expensive)
 The role of the financial system is to
facilitate the flow and efficient allocation
of funds throughout the economy

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 FINANCIAL SYSTEM : AN OVERVIEW AND
MAIN FEATURES

 There are two important functions of the financial

system

 The reduction of information and transaction

costs
 The facilitation of the trading, diversification and
management of risks

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THE REDUCTION OF INFORMATION
AND TRANSACTION COSTS (1/9)

 The financial system helps overcome the

information asymmetry (market failure)
between borrowers and lenders
 Information asymmetry can occur before
(ex ante) and after (ex post) a financial
contract has been agreed

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THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (2/9)

 Ex ante information asymmetry arises

because borrowers generally know more
about their investment projects than
lenders
 The borrowers that are most eager to engage
in a transaction are the most likely ones to
produce an undesiderable outcome for the
lender (adverse selection).
 It is difficult and costly to evaluate potential
borrowers

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