Chapter 5 Overview of the Financial System (Written Report)

Introduction

The financial system encompasses institutions, markets, and intermediaries that

facilitate the flow of funds between savers and borrowers. It includes banks, stock
exchanges, bond markets, insurance companies, and regulatory bodies. Its
primary functions include channeling funds from savers to borrowers, providing
liquidity, facilitating risk management, and enabling price discovery. The financial
system plays a crucial role in allocating resources, fostering economic growth, and
stabilizing the economy.

The financial system plays a crucial role in the economy by facilitating the
allocation of capital, managing risks, providing liquidity, and supporting economic
growth and development. It also influences monetary policy transmission, wealth
creation, and income distribution within society. Overall, a well-functioning
financial system is essential for the efficient functioning of
modern economies.

Nature and Objective of Financial System

Objectives of the Financial System:

The primary objective of the financial system is to allocate financial resources

(capital) from savers to borrowers in a manner that maximizes economic efficiency
and productivity, thereby promoting economic growth and development.

It aims to provide mechanisms for individuals, businesses, and governments to

manage and mitigate financial risks, ensuring the stability and resilience of the
financial system.

The financial system strives to promote access to financial services for all
segments of society, including individuals and businesses, particularly those that
are underserved or marginalized, thereby fostering inclusive economic growth.

KEY COMPONENTS OF THE FINANCIAL SYSTEM

The major components of the financial system include
 Financial Instruments
  Financial Markets and Financial Institutions
 The Central Bank and Other Financial Regulators

The flow of funds through the financial system involves several stages and actors:

1. Savers: Individuals, businesses, and governments who have excess funds that
they want to invest or save for future use. Savers can include households saving
for retirement, corporations with surplus cash, and governments with budget
surpluses.

2. Financial Institutions: Intermediaries such as banks, credit unions, and mutual

funds, which gather funds from savers and channel them to borrowers. Financial
institutions offer various financial products and services, including deposit-taking,
lending, investment management, and risk management.

3. Borrowers: Entities, including individuals, businesses, and governments, that

require funds to finance investments, operations, or consumption. Borrowers may
seek funds to start or expand businesses, purchase homes, fund infrastructure
projects, or finance government expenditures.

4. Financial Markets: Platforms where savers and borrowers interact to buy and
sell financial assets. Financial markets include stock exchanges, bond markets,
money markets, foreign exchange markets, and commodity markets. These
markets provide liquidity and facilitate the trading of various financial
instruments.

5. Financial Instruments: Contracts or securities representing financial claims or

ownership stakes. Examples include stocks, bonds, loans, derivatives, and
insurance policies. Financial instruments enable the transfer of funds between
savers and borrowers and provide opportunities for investors to earn returns on
their investments.

6. Intermediaries and Market Participants: Financial intermediaries, such as

banks and mutual funds, play a crucial role in facilitating the flow of funds by
acting as intermediaries between savers and borrowers. Market participants,
including investors, traders, and speculators, engage in buying and selling financial
assets in financial markets, contributing to price discovery and liquidity provision.

Overall, the flow of funds through the financial system involves the transfer of
funds from savers to borrowers through various intermediaries, markets, and
financial instruments, facilitating capital allocation, investment, and economic
growth.

Functions of the Financial System

Three key services provided by the financial system:

1. Risk Sharing: The financial system allows individuals and businesses to spread
and mitigate risks by diversifying their investments across various assets and
financial instruments. This includes insurance products, mutual funds, and other
risk-sharing mechanisms.

2. Liquidity: Financial markets and institutions provide liquidity by enabling

investors to quickly buy or sell assets without significantly impacting their prices.
This liquidity allows for efficient capital allocation and helps ensure that funds are
readily available when needed.

3. Information: The financial system facilitates the flow of information by

providing transparent pricing, financial statements, market data, and research
reports. Access to accurate and timely information helps investors make informed
decisions and promotes market efficiency.
Asymmetric information describes the situation in which one party to an
economic transaction has better information than does the other party. In
financial transactions, typically the borrower has more information than does the
lender.

Adverse selection and moral hazard are two significant problems stemming from
asymmetric information in the financial system:

1. Adverse Selection: This occurs when one party in a transaction has more
information than the other, leading to a situation where the party with less
information is at a disadvantage. For example, in insurance markets, individuals
with higher risks are more likely to seek insurance coverage, leaving insurers with
a pool of policyholders who are riskier than average. This can result in higher
premiums or the withdrawal of insurance providers from the market.

2. Moral Hazard: Moral hazard arises when one party, typically after entering into
a transaction, has an incentive to take risks that the other party cannot observe or
anticipate. For instance, in the context of lending, borrowers may engage in riskier
behavior knowing that they are insured or that the lender will bear the majority of
the losses. This can lead to excessive risk-taking and financial instability.

Nature and Impact of Transaction and Information Costs

Transaction Costs is the cost of a trade or a financial transaction; for example, the
brokerage commission charged for buying or selling a financial asset.

Information Costs is the costs that savers incur to determine the creditworthiness
of borrowers and to monitor how they use the funds acquired.
Because of transaction costs and information costs, savers receive a lower return
on their investments and borrowers must pay more for the funds they borrow. As
we have just seen, these costs can sometimes mean that funds are never lent or
borrowed at all. Although transactions costs and information costs reduce the
efficiency of the financial system, they also create a profit opportunity for
individuals and firms that can discover ways to reduce those costs.

Financial intermediaries use various approaches to reduce adverse selection:

1. Requiring borrowers to disclose: Intermediaries require borrowers to disclose

comprehensive information about their financial condition, business operations,
and future prospects. This transparency helps mitigate adverse selection by
allowing lenders to make more informed decisions based on accurate information
rather than relying solely on incomplete or misleading data provided by
borrowers.

2. Collecting information on firms and selling that information to investors:

Intermediaries conduct thorough due diligence on potential borrowers, gathering
detailed information about their creditworthiness, industry trends, and market
conditions. They then package this information and sell it to investors, enabling
them to make better-informed investment decisions and reducing the risk of
adverse selection.

3. Convincing lenders to require borrowers to pledge collateral: Financial

intermediaries persuade lenders to require borrowers to pledge collateral, such as
real estate or inventory, to secure their loans. This reduces adverse selection by
providing lenders with an additional source of repayment in case borrowers
default on their obligations. Collateralization incentivizes borrowers to maintain
their creditworthiness and reduces the risk of opportunistic behavior.

Financial intermediaries reduce moral hazard through the imposition of

restrictive covenants and specialization in monitoring borrowers, along with the
development of effective techniques:
1. Imposing Restrictive Covenants: Financial intermediaries include restrictive
covenants in loan agreements that limit borrowers' actions, such as restricting
excessive risk-taking, limiting dividend payouts, or specifying investment
requirements. By imposing these restrictions, intermediaries mitigate moral
hazard by aligning the interests of borrowers with those of lenders. Borrowers are
less likely to engage in opportunistic behavior knowing that their actions are
constrained by contractual obligations.

2. Specializing in Monitoring Borrowers: Financial intermediaries dedicate

resources to monitoring the behavior and financial performance of borrowers
throughout the duration of the lending relationship. This specialized monitoring
involves regular assessments of borrowers' activities, financial statements, and
compliance with loan agreements. By closely monitoring borrowers,
intermediaries can detect early signs of moral hazard, such as deviations from
agreed-upon terms or deteriorating financial health, and take appropriate
measures to mitigate risks.

3. Developing Effective Techniques: Financial intermediaries continuously refine

their techniques for assessing credit risk and monitoring borrower behavior. This
may involve the use of advanced data analytics, predictive modeling, and industry
expertise to identify patterns of behavior indicative of moral hazard. By
developing effective techniques for risk assessment and monitoring,
intermediaries can proactively manage moral hazard and maintain the quality of
their loan portfolios.

Transaction costs may be reduced by adopting the following techniques:

-
 Financial intermediaries take advantage of economies of scale, which refers
to the reduction in average cost that results from an increase in the volume
of a good or service produced. For example, the fees dealers in Treasury
bonds charge investors to purchase P10 million worth of bonds are not much
higher than the fees they charge to purchase PI| million worth of bonds. By
buying P500 worth of shares in a bond mutual fund that purchases millions
of pesos worth of bonds, an individual investor can take advantage of
economies of scale
 Financial intermediaries can also take advantage of economies of scale in
other ways. For example, because banks make many loans. they rely on
 standardized legal contracts, so the costs of writing the contracts are spread
over many loans. Similarly, bank loan officers devote their time to
evaluating and processing loans, and through this specialization, they are
able to process loans efficiently, reducing the time required and, therefore.
the cost per loan.
 Financial intermediaries also take advantage of technology to provide
financial services, such as those that automated teller machine networks
provide
 Financial intermediaries also increasingly rely on sophisticated software to
evaluate the credit worthiness of loan applicants