A Modern Financial System

Lecture Outline
What is a Financial System Components of a Financial system Role of Money in an economy Flow of Funds/Financial Flows Functions of a Financial system Importance of a Financial system

What is a Financial System

Definitions 1. In finance, the financial system is a system that allows the transfer of money between savers and borrowers. 2. The complex of institutions.that facilitate payments and link lenders with borrowers and investors with the assets they invest in.

What is a Financial System

3. A financial system is that part of the economy which includes all the institutions involved in moving savings from savers to borrowers, and in transferring, sharing and insuring risks (Reserve Bank of Fiji). 4. A financial system is a network of markets and institutions to bring savers and borrowers together (Hubbard, RG, 1994).

Constituents of a Modern Financial System

1. Financial Institutions Formal structures/entities providing financial products and services and performing financial functions. Non formal financial institutions belonging to informal financial sector are also included. Banks and non-banks/type of services provided : -Deposit-taking institutions, risk pooling institutions, market makers, specialized sectoral financiers, financial service providers. 2. Financial Markets- provide an ordered and often regulated structure in which the creation, sale and transfer of financial assets may take place.

Constituents of a Modern Financial System..

3. Financial Assets/Instruments
are the medium by which the value of financial transactions within the financial system is created and recognized. Issued by DSUs and purchased by SSUs

4. Government and Regulatory Bodies

to maintain confidence and stability in the financial institutions and the financial system generally. Rules and regulations ensure efficient and orderly function of the financial system.

Role of money in an economy

Early forms of exchange- barter Functions of money Acts as medium of exchange/legal tender Allows specialisation in production Solves the divisibility problem; i.e. where medium of exchange does not represent equal value for the parties to the transaction Facilitates saving Represents a store of wealth

Need for Exchange or Flow of Funds

Funds are needed for productive investments or business projects; acquisition of assets; consumption Savings/surplus funds- Surplus Spending Units (SSUs) or savers Deficit Spending Units (DSUs) Mismatch between income and spending needs create an opportunity for trade Double coincidence of wants satisfied A transaction between two parties that meets their mutual needs

Types of Financial Flows Direct Finance

Direct Finance Funds flow directly from savers to users involving one set of contract Advantages
Avoids costs of intermediation Simple

Disadvantages
Matching of preferences (risk, return, liquidity, maturity, Search and transaction costs Assessment of risk

Indirect Finance/Intermediated Flows

Funds flow from saver to user through an intermediary Lenders and borrowers contract with an intermediary (2 sets of contract) Advantages
asset and maturity transformation, risk diversification, increased/improved liquidity, reduced distribution and search costs.

Flow of Funds Markets

Financial markets facilitate the flow of funds between a borrower and a lender giving rise to financial claims/financial assets; Financial Markets provide an ordered and regulated structure in which the creation, sale and transfer of financial assets take place. Generic types of Financial Markets Primary markets - involves the issue of new instruments Secondary markets involves the trading of existing financial instruments

Functions of a Financial System

Facilitates efficient flow of funds between SSUs (lenders) and DSUs (borrowers) Allows individuals to allocate funds according to current and future consumption Encourages savings and accumulation of savings (wealth creation and accumulation) Facilitates economic growth and development by providing finance to business.

Functions of the Financial System

Facilitate portfolio structuring and restructuring Provider of financial and economic information to market participants to allow informed decisions to made. Encouraging savings to build capital investments and thus improve productive capacity in a country. Facilitates the implementation of government policiesmonetary; Well functioning financial system increases the flow of savings and ensures that such savings are directed to most efficient users.

1.1 Functions of a financial system (cont.)

(cont.)

Importance of a financial system

The financial system including banks and other financial intermediaries, equity markets, and debt markets solves the problems faced savers and investors by agglomerating capital from many smaller savers, allocating capital to the most important uses, and monitoring to ensure that it is being used well. At the same time, the financial system transfers, pools, and reduces risk, increases liquidity, and conveys information. Financing/intermediary role; payments role; Informational and risk sharing role.

Importance of a financial system..

Since 2007, the financial markets have been characterised by a great deal of volatility What started as a liquidation of credit derivatives sparked by a fall in house prices in the United States has become a watershed moment in modern financial history As nations continue to battle the economic effects of the GFC, debate continues to rage about the regulatory response necessary to bring stability to the system