Chapter 2

An Overview
of the Financial
System

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 Imagine
• A college student bought coffee at the local café,
paying for it with an ATM card.
• Then she jumped into her insured car and drove to
the university, which she attends thanks to her
student loan.
• She may have left her parents’ home, which is
mortgaged,
• Or perhaps she needed to purchase this book
online, using her credit card, before her first money
and banking class began.

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 • the financial transactions embedded in this story—
even the seemingly simple ones—are quite
complicated.
• If the café owner and the student use different
banks, paying for the coffee will require an
interbank funds transfer.
• The company that insures the student’s car has to
invest the premiums she pays until they are needed
to pay off claims.
• The student’s parents almost surely obtained their
home mortgage through a mortgage broker, whose
job was to find the cheapest mortgage available.

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 • This brief example hints at the complex web
of interdependent institutions an markets
that is the foundation for our daily financial
transactions.
• The system is so efficient that most of us
rarely take note of it.
• But a financial system is like air to an
economy:
If it disappeared suddenly,
everything would grind to a halt.
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 The Six Parts of the Financial System
Money
* to pay for our purchases and to store our wealth.
* Money once consisted of gold and silver coins.
* These were eventually replaced by paper currency, which
today is being eclipsed by electronic funds transfers.
* Methods of accessing means of payment have changed
dramatically as well.
* As recently as 1970, people customarily obtained currency
from bank tellers when they cashed their paychecks or
withdrew their savings from the local bank.
* Today, they can get cash from practically any ATM anywhere
in the world.
* Today, payments can be made automatically, and account
holders can check the transactions at any time on their bank’s
website or on their smartphone.
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 Financial Instruments

 to transfer resources from savers to investors

 to transfer risk to those who are best equipped to bear
it.
 Stocks, mortgages, and insurance policies are examples
of financial instruments.
• Financial instruments (or securities, as they are often
called) have evolved just as much as currency.
• In the last few centuries, investors could buy individual
stocks through stockbrokers, but the transactions were
costly.
• Furthermore, putting together a portfolio of even a small
number of stocks and bonds was extremely time
consuming; just collecting the information necessary to
evaluate a potential investment was a daunting task.
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 • As a result, investing was an activity
reserved for the wealthy.
• Today, financial institutions offer people
with as little as $1,000 to invest the ability
to purchase shares in mutual funds, which
pool the savings of a large number of
investors.
• Because of their size, mutual funds can
construct portfolios of hundreds or even
thousands of different stocks and/or bonds.

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 Financial Markets
– allows us to buy and sell financial instruments quickly and
cheaply.
– The Pakistan Stock Exchange is an example of a financial
market.
• Originally, financial markets were located in coffeehouses and
taverns where individuals met to exchange financial instruments.
• The next step was to create organized markets, like the New York
Stock Exchange—trading places specifically dedicated to the
buying and selling of stocks and bonds.
• Buyers and sellers obtain price information and initiate
transactions from their desktop computers or from handheld
devices.
• Because electronic networks have reduced the cost of processing
financial transactions, even small investors can afford to
participate in them.

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 Financial Institutions
– provide a myriad of services,
– including access to the financial markets
– and collection of information about prospective borrowers
to ensure they are creditworthy.
– Banks, securities firms, and insurance companies are
examples of financial institutions.
Banks began as vaults where people could store their valuables.
Gradually, they developed into institutions that accepted
deposits and made loans.
For hundreds of years, in fact, that was what bankers did.
Today, a bank is more like a financial supermarket. Walk-in and
you will discover a huge assortment of financial products and
services for sale, from access to the financial markets to
insurance policies, mortgages, consumer credit, and even
investment advice.
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 Regulatory Agencies

They are responsible for making sure that the elements of

the financial system—including its instruments, markets,
and institutions—operate in a safe and reliable manner.
The activities of government regulatory agencies and the
design of regulation have been evolving and have
entered a period of more rapid change, too.
In the aftermath of the financial crisis of 1929–1933,
when the failure of thousands of banks led to the Great
Depression, the U.S. government introduced regulatory
agencies to provide wide-ranging financial regulation—
rules for the operation of financial institutions and
markets—and supervision—oversight through
examination and enforcement.

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 Central Banks

• the sixth part of the system, monitor and stabilize the

economy. The State Bank of Pakistan is the central bank of
the Pakistan.
• While only a few central banks existed in1900, now nearly
every country in the world has one, and they have become
one of the most important institutions in government.
• Central banks control the availability of money and credit to
promote low inflation, high growth, and the stability of the
financial system.
• Because their current mission is to serve the public at large
rather than land-hungry monarchs, their operating methods
have changed as well.

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 Flows of Funds Through the
Financial System

Securities Securities

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 Function of Financial Markets

• Performs the essential function of channeling funds from

economic players that have saved surplus funds to those that
have a shortage of funds
• Direct finance: borrowers borrow funds directly from
lenders in financial markets by selling them securities.
• Securities are assets for the person who buys them but
liabilities (IOUs or debts) for the individual or firm that sells
(issues) them. For example, if
• Ford needs to borrow funds to pay for a new factory to
manufacture electric cars, it might borrow the funds from
savers by selling them a bond, a debt security that promises
to make periodic payments for a specified period of time, or a
stock, a security that entitles the owner to a share of
the company’s profits and assets.

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 Why is this channeling of funds from savers to
spenders so important to the economy?
• The answer is that the people who save are frequently not the
same people who have profitable investment opportunities
available to them, the entrepreneurs.
• Let’s first think about this on a personal level. Suppose that
you have saved $1,000 this year, but no borrowing or lending
is possible because no financial markets are available.
• If you do not have an investment opportunity that will permit
you to earn income with your savings, you will just hold on to
the $1,000 and it will earn no interest.
• However, Carl the Carpenter has a productive use for your
$1,000: He can use it to purchase a new tool that will shorten
the time it takes him to build a house, thereby earning an
extra $200 per year.
• If you could get in touch with Carl, you could lend him the
$1,000 at a rental fee (interest) of $100 per year, and both of
you would be better off.

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• In the absence of financial markets, you and Carl the
Carpenter might never get together.
• You would both be stuck with the status quo, and both of you
would be worse off.
• Without financial markets, it is hard to transfer funds from a
person who has no investment opportunities to one who has
them.
• Financial markets are thus essential to promoting economic
efficiency.
• Say that you are recently married, have a good job, and want
to buy a house.
• You earn a good salary, but because you have just started to
work, you have not saved much.
• Over time, you would have no problem saving enough to buy
the house of your dreams, but by then you would be too old
to get full enjoyment from it.
• Without financial markets, you are stuck; you cannot buy the
house and must continue to live in your tiny apartment.

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 • Promotes economic efficiency by producing
an efficient allocation of capital, which
increases production.
• Directly improve the well-being of
consumers by allowing them to time
purchases better.
• Financial markets that are operating
efficiently improve the economic welfare of
everyone in the society.

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 Structure of Financial Markets
1. Debt and equity Markets
• A firm or an individual can obtain funds in a financial market in two
ways.
• The most common method is through the issuance of a debt
instrument, such as a bond or a mortgage,
• which is a contractual agreement by the borrower to pay the holder
of the instrument fixed dollar amounts at regular intervals (interest
and principal payments) until a specified date (the maturity date),
when a final payment is made.
• The maturity of a debt instrument is the number of years (term)
until that instrument’s expiration date.
• A debt instrument is short-term if its maturity term is less than a
year and long-term if its maturity term is ten years or longer.
• Debt instruments with a maturity term between one and ten years
are said to be intermediate-term

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 • The second method of raising funds is through the
issuance of equities, such as common stock, which
are claims to share in the net income (income
after expenses and taxes) and the assets of a
business.
• Equities often make periodic payments (dividends)
to their holders and are considered long-term
securities because they have no maturity date.
• In addition, owning stock means that you own a
portion of the firm and thus have the right to vote
on issues important to the firm and to elect its
directors.

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 Disadvantage/Advantage

• The main disadvantage of owning a corporation’s

equities rather than its debt is that an equity holder
is a residual claimant;
• that is, the corporation must pay all its debt holders
before it pays its equity holders.
• The advantage of holding equities is that equity
holders benefit directly from any increases in the
corporation’s profitability or asset value because
equities confer ownership rights on the equity
holders.
• Debt holders do not share in this benefit, because
their dollar payments are fixed.

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 Structure of Financial Markets
2. Primary and secondary Markets
• A primary market is a financial market in which new issues
of a security, such as a bond or a stock, are sold to initial
buyers by the corporation or government agency borrowing
the funds.
• A secondary market is a financial market in which securities
that have been previously issued can be resold.
• The primary markets for securities are not well known to the
public because the selling of securities to initial buyers often
takes place behind closed doors.
• Investment bank assists in the initial sale of securities by
underwriting securities.
• Brokers are agents of investors who match buyers with
sellers of securities; dealers link buyers and sellers by
buying and selling securities at stated prices.
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 Structure of Financial Markets
3. Money and capital Markets
• Another way of distinguishing between markets is
on the basis of the maturity of the securities traded
in each market.
• The money market is a financial market in which
only short-term debt instruments (generally those
with original maturity terms of less than one year)
are traded;
• The capital market is the market in which longer
term debt instruments (generally those with
original maturity terms of one year or greater) and
equity instruments are traded.

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 Financial Market Instruments
1. Money Market Instruments
• U.S. Treasury Bills These short-term debt
instruments of the U.S. government are issued in
one-, three-, and six-month maturities to finance
the federal government.
• Negotiable Bank certificates of Deposit A
certificate of deposit (CD) is a debt instrument sold
by a bank to depositors that pays annual interest of
a given amount and at maturity pays back the
original purchase price.
• Commercial Paper Commercial paper is a short-
term debt instrument issued by large banks and
well-known corporations, such as Microsoft and
General Motors.
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 Financial Market Instruments
2. capital Market Instruments
• Capital market instruments are debt and equity
instruments with maturities of greater than one
year.
• They have far wider price fluctuations than money
market instruments and are considered to be fairly
risky investments.
• Mortgages are loans to households or firms to
purchase land, housing, or other real structures, in
which the structure or land itself serves as
collateral for the loans.
• Corporate Bonds These long-term bonds are
issued by corporations with very strong credit
ratings.
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 Internationalization of Financial
Markets
• Foreign Bonds: sold in a foreign country and
denominated in that country’s currency
• Eurobond: bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in
banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets:
– Also help finance the federal government

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