The Philippine Financial System

Basic Building Blocks of a Financial System

Introduction

The financial system is analogous to the human heart; if it stops working, the
person dies, and if the financial system stops working, the economy collapses. The law
of supply and demand is inherent in all societies. There will always be those with surplus
resources and those with deficits. The Financial System is crucial in allocating these
resources.

What is a Financial System?

• It is a set of institutions such as banks, insurance companies and stock

exchanges.
• The financial system generates, circulates, and controls money and credit.
• It provides intermediation between the suppliers and users of credit.

The financial system is all about taking money from someone who has plenty of it and
directing it to those who can best use it. This ensures that economic resources are
allocated most efficiently and that the best returns are obtained. Economic transactions
are done by various organizations like banks, pension funds, organized exchanges, and
insurance companies and many more. They are financial institutions that use a variety
of financial instruments such as bonds, stocks, interest on deposits, credit to borrowers,
and so on.
 A financial system is comprised of three parts: savers (lenders), financial
institutions, and borrowers (spenders). Savings are placed in financial systems such as
banks. These banks then lend money to investors (borrowers), who profit by investing
in their company and repaying the investment with interest. The financial institutions
then profit from the interest and return a portion of it to the savers.

Importance of Financial System

• Transfer of money can improve consumption pattern and resource allocation.

• These will create more employment, income and consumption.

Five Basic Components of Financial System

• Financial Institutions
• Financial Markets
• Financial Instruments (Assets or Securities)
• Financial Services
• Money

Financial Institutions

➢ Financial institutions provide financial services for members and clients. It is also
termed as financial intermediaries because they act as middlemen between the
savers and borrowers.

Financial institutions facilitate the smooth operation of the financial

system by bringing together investors and borrowers. They mobilize investors'
savings either directly or indirectly through financial markets, using various
financial instruments and the services of numerous financial service providers.
They can be classified as Regulatory, Intermediaries, Non-intermediaries,
and others. They provide services to organizations seeking advice on a variety of
issues ranging from restructuring to diversification strategies. They provide a
comprehensive range of services to organizations seeking to raise funds from the
markets and manage financial assets such as deposits, securities, and loans.
To put it simply, these financial institutions are called banks. Banks are
financial intermediaries that lend money to borrowers generate revenue and
accept deposits. They are typically regulated heavily, as they provide market
stability and consumer protection.
Financial Markets

➢ Financial markets are markets in which securities, commodities, and fungible

items are traded at prices representing supply and demand. The term "market"
typically means the institution of aggregate exchanges of possible buyers and
sellers of such items.

In financial markets, the exchange of financial assets is involved in

terms of both the creation and transfer of the same. The difference between this
and a real transaction is that there is no direct money involved in the exchange
process, and instead of products or services, deposits, loans, and other financial
assets are used. The markets make it easy for buyers and sellers to trade their
financial holdings. Financial markets create securities products that provide a
return to those with excess funds (investors/lenders) while also making these
funds available to those in need of additional funds (borrowers).
The stock market is just one type of financial market. Financial markets
are created by buying and selling various financial instruments such as stocks,
bonds, currencies, and derivatives. Financial markets rely heavily on
information transparency to ensure that markets set efficient and appropriate
prices.

Financial Instruments
This is an important component of financial system. The products which are
traded in a financial market are financial assets, securities or other type of financial
instruments. There is a wide range of securities in the markets since the needs of
investors and credit seekers are different. They indicate a claim on the settlement of
principal down the road or payment of a regular amount by means of interest or
dividend. Equity shares, debentures, bonds, etc are some examples.

Here are the two parts of financial instruments to further identify it,

a) Cash instruments- a cash instrument's value is determined directly by markets.

they may include securities, loans, and deposits.
Such that, without the involvement of third parties, the money has an immediate value.
Cash is cash. Money is money. It is still considered cash whether it is in the form of
physical cash, loans, deposits, and so on.

b) Derivative instruments- a derivative instrument is a contract that derives its

value from one or more underlying entities (including an asset, index, or interest rate)
Such that, our derivative instruments have no actual value yet, and we require an
underlying entity to determine the value of derivative instruments. These derivative
instruments are typically classified as assets, indexes, or interest rates.

Financial Services
Financial services consist of services provided by Asset Management and
Liability Management Companies. They help to get the necessary funds and also
make sure that they are efficiently deployed. They assist to determine the financing
combination and extend their professional services upto the stage of servicing of
lenders. They help with borrowing, selling and purchasing securities, lending and
investing, making and allowing payments and settlements and taking care of risk
exposures in financial markets. These range from the leasing companies, mutual fund
houses, merchant bankers, portfolio managers, bill discounting and acceptance
houses.

Money
This may be mentioned at the last but it is undoubtedly one of the most
important components of the financial system. Money is understood to be anything
that is accepted for payment of products and services or for the repayment of debt.

Financial Decisions of Households and Corporation

WHAT IS HOUSEHOLD
● Household are sellers in the market for resources. Households sells land, capital,
and entrepreneurial activity in exchange for money, which in this case is called
income.
● Household are buyers in the market for goods and services. Household exchange
income for goods and services.
● Households consist of one or more persons who live in the same housing unit,
such as a family. Households own all the economic resources in the economy.
The economic resources are land, labor, capital, and entrepreneurial ability.
HOUSEHOLD FINANCIAL DECISION MAKING
● Household financial decision-making is critical to household wealth
accumulation. It determines how much money is saved, how household financial
resources are invested, what investment products are utilized, how much risk is
taken, and therefore how much return can be achieved. These actions, in turn,
directly lead to differences in household wealth. In the household context, who
makes financial decisions for the household can be as critical as the financial
decisions to make. In the intra-household bargaining framework, whether a
person assumes financial decision-making responsibility for the household
depends on their bargaining power. In the collective model, whether a person
takes financial responsibility depends on the relative weights that the household
assigns to this person’s utility function. To this stream of literature, we introduce
collective rationality and comparative advantages to household financial
decision-making responsibility allocation.
● Family is considered as the decision- making unit for many economic activities.
Economic models dominate the research on financial decisions such as income,
spending, savings, borrowing, asset accumulation, and investing, mostly at
individual or household levels.
WHAT IS CORPORATION AND HOW THEY MAKE A FINANCIAL DECISION?
● A corporation is a legal entity created by individuals, stockholders, or
shareholders, with the purpose of operating for profit.
● Corporate decision-makers are the professionals who make choices among
multiple alternatives to achieve the organization's goal and solve issues. They
 gather information, evaluate evidence, and act after identifying the best option
for their situation. They have the power to make operating, tactical, policy or
financial decisions. They may be responsible for strategic decisions like capital
investment business, expansion, or acquisitions.

According to Summit Agarwal and Brent W. Ambrose, Financial economists have

long studied how corporations utilize financial instruments, yet relatively little is
understood about how consumers and household utilize various credit alternatives in
managing their consumption and savings objectives. However, with increasing interest
I issues surrounding household behavioral finance, research into household financial
decision-making processes is becoming increasingly important. For example, at the
2006 American Finance Association Presidential Address, Professor John Camphell
raised a number of critical insights toward our understanding household participation
and diversification decisions in the financial markets, as well as their mortgage
refinancing decisions. However, Professor Camphell admittedly neglected many other
important issues related to household’ choice of credit, use or repayment of credit card
debt, payday lending, and other relevant issues related to household credits.
There are generally four different kinds of financial decisions:
1. Capital Budgeting Decision:
Capital budgeting decision helps the financial manager to analyze the size of the firm
and to take decisions like where the amount is to be invested and how to invest it. It’s
basically a process of planning and managing the firm’s long-term investment. It aids
in identifying the profitable investment opportunity for the company by assessing the
size, risk in future cash flows (inflows and outflows), and timings. An ineffective capital
budgeting decision gives rise to the operating and business risk of the company.
2. Capital Structure Decision:
It is rightly said, ‘the most favorable capital structure for any organization is one which
minimizes the overall cost of capital and maximizes the firm’s value’.
3. Dividend Decision:
After payment of tax, whether the profit of the business should be retained or distributed
amongst the shareholders or both. Dividend decision helps to answer these questions.
It is very important for a company to strike a balance between dividends and retained
earnings to meet the needs of investors. A low dividend payout is generally riskier but
has a high return and vice versa. Hence organizations rely on risk-return trade-offs.
4. Working Capital Management Decision:
A working capital management decision helps the financial manager to know the
possible sources of short-term funds and the proportion in which these funds need to
be raised from the investors. It also helps to know the appropriate level of cash and
inventory. Basically, working capital management is all about managing a firm’s short-
term funds.
It is essential for the finance manager to have an optimal level of working capital
management. Working capital impacts the liquidity and profitability of the firm. High
liquidity means more current assets, i.e. decrease in profit. This will reduce the risk of
default in meeting short-term obligations in the organization.
What Is Corporate Finance?
Corporate finance is a subfield of finance that deals with how corporations address
funding sources, capital structuring, accounting, and investment decisions.
Corporate finance departments are charged with managing their firms' financial
activities and capital investment decisions. Such decisions include whether to pursue a
proposed investment and whether to pay for the investment with equity, debt, or both.
They also include whether shareholders should receive dividends, and if so, at what
dividend yield. Additionally, the finance department manages current assets, current
liabilities, and inventory control.

Roles of Financial Market

Financial Market

- a marketplace where creation, introduction and exchange/trading of long term and

short term financial instruments takes place, is Financial Market.

Financial Market is divided into four:

1. Money Markets

-provide short term loan finance for businesses and households, including inter-bank
lending; commercial banks providing liquidity to each other.

Example: Savings, Demand deposit, Time deposit, Treasury bill, and Commercial
papers.

2. Capital Market

-are where securities like shares and bonds are issued to raise medium to long-term
finance for businesses and governments.

Example: Government securities, corporate bonds, Common stocks, and preferred

stocks.

3. Foreign Exchange Markets (Forex Market)

-are where currencies get exchanged and traded to allow the smooth transaction of
international commerce.

Example:

USD/PHP=55.17 Philippine peso

 NZD/PHP=34.77 Philippine peso

EUR/PHP=59.12 Philippine peso

4. Derivatives Market

-provide for price discovery and risk transfer for securities, commodities, and
currencies.

Example: Options, Forward, Swap and Future contract.

Six Key Roles of Financial Markets:

1. To facilitate saving by business and households: Offering a secure place to store

money and earn interest.
2. To lend to businesses and individuals: Financial markets provide an intermediary
between savers and borrowers.
3. To allocate funs to productive uses: Financial markets allocate capital to where the
risk-adjusted rate of return is highest.
4. To facilitate the final exchange of goods and services such as contactless payments
systems, foreign exchange etc.
5. To provide forward markets in currencies and commodities: Forward markets allow
agents to insure against price volatility.
6. To provide a market for equities Allowing businesses to raise fresh equity to fund
their capital investment and expansion.