FINANCIAL SYSTEM

1
THE STRUCTURE AND FUNCTION
OF FINANCIAL SYSTEM

2
THE STRUCTURE AND FUNCTION
OF FINANCIAL SYSTEM

• Financial system is an interconnected

complex network of
financial markets and financial
intermediaries (institutions)
that are regulated and monitored
by supervisory and regulatory
public institutions.

3
 THE STRUCTURE AND FUNCTION
OF FINANCIAL SYSTEM

• A national financial system is a part of

tremendous and more complex international
financial system comprising other national
financial systems and international financial
organizations,
such as the IMF, World Bank, Asian
Development Bank, Bank for International
Settlements (BIS), and Organization for
Economic Cooperation and Development
(OECD). 4
Financial Markets

5
 Financial Markets
• The financial market is a market
where financial instruments are
exchanged or traded.
• Financial markets provide funds for investors
who have productive investment
opportunities but need extra funds
and for consumers
who want to spend more than their
income.
• They, also, allow savers to earn an income.
6
Financial Intermediaries
(Institutions)

7
 Financial Intermediaries (Institutions)

• Financial intermediaries are institutions

providing intermediation
between the savers and borrowers.
• They borrow funds from lenders (investors)
and lend (invest) these funds to those who
need them.

8
 Financial Intermediaries (Institutions)

• Financial intermediaries include

banks and other depository
institutions, contractual saving institutions
(insurance companies, pension
funds, and government retirement funds)
and
investment intermediaries (finance
companies and mutual funds).
9
 Financial Intermediaries (Institutions)

• The role of financial intermediaries is

to create more favorable transaction
terms than could be realized by lenders
(investors) and borrowers dealing directly
with each other in the financial market.

10
 Financial Intermediaries (Institutions)

• Financial institutions create and exchange

many financial instruments (financial assets)
in financial markets.

11
 Regulatory and
Supervisory Institutions

12
 Regulatory
and Supervisory Institutions

• Compared to most other parts of modern

capitalist economies, financial system is
relatively heavily regulated.
• This heavy regulation is needed because of
the imperfections in financial markets
leading markets failures and inefficiency.

13
 Regulatory
and Supervisory Institutions

• There is general agreement that

financial markets are susceptible
to instability;
volatility in prices and
quantities is high and
unpredictable in these markets.
• It is argued that instability is
inherent to financial markets.
14
 Regulatory
and Supervisory Institutions

• The purpose of regulation is

to reduce or completely remove
market imperfections
and improve stability and
efficiency in financial
markets.

15
 Regulatory
and Supervisory Institutions

• Financial markets have very useful and

indispensable functions in a market
economy.
• However, carrying out these functions is
subject to various forms of market failures
that make regulation and supervision
necessary.

16
 Regulatory
and Supervisory Institutions

• Some examples of the financial market

failures are:
Panics and runs
Contagion
Imperfect and asymmetric information
Market power

17
 Regulatory
and Supervisory Institutions

• Panics and runs:

In normal times, most of the
holders of financial assets keep their assets
and earn income on them.

18
 Regulatory
and Supervisory Institutions

• However, under conditions of panic,

a large majority of assets owners,
such as depositors, share
owners and bond holders
want to withdraw
their deposits and sell
their assets immediately.
• This may create a liquidity crisis, a collapse in
assets prices and hikes in the interest rates 19
 Regulatory
and Supervisory Institutions

• Contagion:
Financial markets,
domestic or international,
are interconnected, financial
difficulties hitting a financial institution, or, a
sector may quickly jump to others,
endangering the stability of
the whole financial
system. 20
 Regulatory
and Supervisory Institutions

• Imperfect and asymmetric information:

Information in financial markets is limited
and imperfect.
• Neither lenders nor borrowers have perfect
information about the future success or
failures of many projects using borrowed
funds
because it is not possible to map out
perfectly what would happen in the future. 21
 Regulatory
and Supervisory Institutions

• In addition to limited information,

there is information asymmetry
in financial markets;
one side of a deal
knows less than the other.

22
 Regulatory
and Supervisory Institutions

• For example, the information of the lenders

about the intensions and competency of the
borrowers is less than borrowers.
• The limited and asymmetric information
increases the risk and uncertainty,
and hence failures in financial markets.

23
 Regulatory
and Supervisory Institutions

• Market Power:
Financial markets are often
oligopolistic and big financial
companies operating in these markets have
the market power.
• Big companies may use their monopolistic
power for their own interests
in a way that will be harmful for
the efficiency and the social interest. 24
 Regulatory
and Supervisory Institutions

• Therefore,
regulations constraining the expansion of
financial companies
may be desirable
for protecting competition,
increasing efficiency, and serving social
interests.

25
 Regulatory
and Supervisory Institutions

• The limited and asymmetric information,

high risks and uncertainties in financial
markets create high transaction costs.
• The primary purpose of the regulation is
to reduce these costs and thereby,
to support the working of the
financial markets.

26
 Regulatory
and Supervisory Institutions

• Financial regulations serve four major

functions.
• The first is to reduce asymmetric information
by encouraging transparency.
• That usually means requiring both financial
markets and intermediaries to disclose
accurate information to investors
in a clear and timely manner.
27
 Regulatory
and Supervisory Institutions

• A second and closely related goal is to

protect savers from scammers and grifters.
• The third function of financial regulation is
to promote financial system competition
and efficiency
by ensuring that the entry and
exit of firms is as easy and cheap as
possible, consistent with their first two goals.
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 Regulatory
and Supervisory Institutions

• For example, new banks can be established

but only after their incorporators (founders)
and initial executives have been carefully
screened.
• Insurance companies can go out of business
(exit) but only after they have made
adequate provision
to fulfill their promises to
policyholders. 29
 Regulatory
and Supervisory Institutions

• Finally, regulators also try to ensure the

soundness of the financial system by acting
as a lender of last resort,
mandating deposit insurance,
and limiting competition through
restrictions on entry and interest rates.

30
 Regulatory
and Supervisory Institutions

• Limiting competition is, however,

a highly controversial means of
ensuring safety
because it extends privileges to
existing institutions over new ones.

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 Regulatory
and Supervisory Institutions

• Financial market failures provide

justifications for the regulatory interventions.
• It should be added, however, that
the mere existence of a justification for
regulation does not necessarily mean that
regulation will always serve social interests.

32
 Regulatory
and Supervisory Institutions

• Regulators attempt to
maximize macroeconomic stability and
transparency
and to minimize investor risk and loss.
• The policies they implement to do so,
however, can be controversial and are not
always effective.

33
 Regulatory
and Supervisory Institutions

• It is not surprising to see that regulators are

often captured by the industry they regulate.
• The companies with market power may
display unusual degree of influence on the
policy making process.
• That is, the industry may establish
regulations for itself by influencing the
decisions of regulators.
34
 Regulatory
and Supervisory Institutions

• The success of regulation and intervention

depends
on the degree of independence of
regulators from the political authority and
from business interests.

35
 Regulatory
and Supervisory Institutions

• Another factor influencing the success of

regulation is the technical capacity of the
regulators,
which is best guaranteed by the
employment of highly skilled staff.

36
 Regulatory
and Supervisory Institutions

• Thirdly, the rules of operation of the

authority itself should be designed in a way
that will ensure accountability and
transparency.
• The authority would also need to generate
sufficient credibility in the industry so that
the market players would believe that the
rules would be enforced fully and in an
indiscriminate manner. 37
 Regulatory
and Supervisory Institutions

• Even the existence of the above cited

conditions does not guarantee the success of
the regulation because it is not possible to
foresee all possible future contingencies.
• Especially with the rapidly improving
information and communication
technologies,
financial innovation advances
at a very rapid pace. 38
 Regulatory
and Supervisory Institutions

• Regulation and enforcement, by contrast,

advances at a slower pace.
• And this situation creates opportunities for
the market players to sidestep the
regulations.

39
 Regulatory
and Supervisory Institutions

• The existing problems of regulating financial

markets, however, do not allow governments
to undervalue the significance of financial
regulation.
• The global financial crisis of 2008 revealed
major weaknesses in the set of regulations
governing activities in the financial industry.

40
 Regulatory
and Supervisory Institutions

• In addition, it also became apparent that

regulators failed to enforce the existing
regulations.
• Large amounts of financial transactions were
moved out of the banking system,
which is regulated, to non-bank financial
institutions,
which are lightly regulated
or not regulated at all.
41
 Regulatory
and Supervisory Institutions

• Even though these non-bank financial

institutions (or the “shadow banking
system”) also engaged in significant term
transformation and were therefore subject
to panics and runs,
they did not benefit from formal
safety nets and operated with much higher
levels of leverage relative to the banking
system.
42
 Regulatory
and Supervisory Institutions

• Another shortcoming of the system is that

the regulatory system depends heavily
on risk assessments carried out by
credit rating organizations but that they do a
poor job.
• Hence the rules of the game offered
insufficient checks on excessive risk-taking
and perhaps even encouraged it.
43
 Regulatory
and Supervisory Institutions

• Another factor complicating the regulation of

financial system is globalization.
• Financial markets are possibly the most
globalized among markets for goods and
services.

44
 Regulatory
and Supervisory Institutions

• Loose regulation of domestic financial

systems may sometimes create benefits
for national economies.
• The absence of a supra-national authority
with comprehensive spatial coverage creates
a significant constraint on effective
regulation of global players.

45
 Regulatory
and Supervisory Institutions

• Principal regulations are made by legislative

bodies and the secondary regulations are
made by the regulatory institutions.
• Supervisory and regulatory institutions
implement or monitor the implementation
of the regulations by the participants in the
financial system.

46
 The Function
of Financial System

47
 The Function
of Financial System
• Financial system channels funds
from lenders who have saved surplus
funds by spending less than their income
to borrowers who have a
shortage of funds because they wish to
spend more than their income.

48
 The Function
of Financial System
• The principal lenders are
households,
business firms,
governments,
and foreigners.
• These are also the main borrowers.

49
 The Function
of Financial System
• Channeling of funds from savers to spenders
is very important to the economy
because the people who save are
frequently not the same people who have
profitable investment opportunities available
to them.

50
 The Function
of Financial System
• Without financial markets,
it is hard to transfer funds from a
person who has no investment opportunities
to one who has them.
• Additionally,
the existence of financial markets
allows consumers to spend more than their
current income.
51
 The Function
of Financial System
• For example,
financial markets provide funds
consumers who want to buy a house or a
durable good, but their existing funds are not
enough.

52
 The Function
of Financial System
• Although the basic function of financial system
is to move funds from those who have surplus
funds to those who have a shortage of funds,
this is not a
passive intermediary function.
• As we will see in our coming chapters,
the working of the financial system
influences money supply, interest rate and the
whole economy.
53
 The Function
of Financial System
• During the transfer of funds from savers
to borrower, financial markets provide
three major economic functions.
• Firstly, they determine the price of the
traded asset and the return from the
investment of funds.
• Secondly, financial markets provide liquidity.
• Liquidity is a measure of the ability to sell an
asset at its fair market value at any time. 54
 The Function
of Financial System
• Thirdly, they reduce transaction costs;
that is the time and money spent to carry
out transactions.
• Lending is most efficiently and cheaply
conducted by specialized companies very well

because they have much practice doing them

and because they tap economies of scale.

55
 The Function
of Financial System

• The fixed costs of making loans (advertising

for borrowers, buying and maintaining
computers, leasing suitable office space, and
the like) are substantial.
• To recoup those fixed costs,
to drive them toward insignificance,
lenders must do quite a
volume of business.
56
 The Function
of Financial System

• Financial intermediaries transform financial

assets,
which are less desirable for savers and
borrowers
into other financial assets
which are more widely
preferred by the public.

57
 The Function
of Financial System

• Asset transformation provides

maturity intermediation
and risk reduction via
diversification, in addition to
cost reduction for
contracting and information processing.

58
 THE STRUCTURE OF
THE TURKISH FINANCIAL SYSTEM

59
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• The financial institutions in the Turkish financial system
are the following:
A.The Central Bank of the Republic of Turkey (monetary
authority)
B.Banks
C.Financial Intermediaries
D.Funds
E.Investment Trust
F. Portfolio Management Companies
G.Independent Auditing Companies
H.Real Estate Appraisal Companies
I. Credit cooperatives
J. Insurance Companies 60
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• There are five primary regulatory and

supervisory institutions using public
authority in the Turkish Financial System.

61
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• They are:
– The CBRT,
– The Banking Regulation and Supervision
Agency (BRSA),
– The Capital Market Board (CMB),
– The Savings Deposit Insurance Fund (SDIF)
– The Insurance and Private Pension
Regulation and Supervision Agency.

62
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• The CBRT is the primary monetary authority

in Turkey.
• In addition to its role of the lender of last
resort for banks,
it has the authority for regulation
and supervision
of deposits and required
reserves.
63
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• It is assigned to take regulatory measures

with respect to money
and foreign exchange markets,
and to monitor the financial
markets.
• It is authorized by law to make all legal
and technical arrangements
necessary to ensure the smooth
operation of payments systems. 64
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• It is responsible
for establishing payment and
securities settlement systems
to ensure fast and secure
transfer and settlement of funds and
securities; and for
introducing necessary regulations
to ensure the uninterrupted operation and
oversight of the existing or future systems.
65
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• We will discuss the working and functions of

the CBRT in more details in Chapter 10.
• The Banking Regulation and Supervision
Agency (BRSA) is the most important
regulatory and supervisory institution for
financial stability.

66
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• The BRSA is responsible

for the regulation and supervision of
banks and nonbank credit
companies(leasing, factoring and consumer
finance companies) with a combined share
of about 88% in total assets of the whole
Turkish financial system.

67
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• The share of the banking sector is about 86%
and the share of the nonbank credit
companies is about 2% (see, Table 2.1).

68
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• The Savings Deposit Insurance Fund (SDIF) is

assigned
for insuring saving deposits and the
resolution of the banks that are transferred
to the Fund
and the banks with a
revoked operating license.

69
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM

• The Capital Market Board (CMB) has

the authority and responsibility to
regulate and supervise
the exchanges (stock
exchanges and the exchanges on which
precious minerals and stones are traded),
financial
intermediaries,
and investment funds and companies.
70
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• The Insurance and Private Pension
Regulation and Supervision Agency is
responsible for the regulation and
supervision of insurance and private pension
companies.

71
 Table 2.1
Asset Structure
of the Turkish Financial System as of June 2020
  Assets Sectoral shares Percentage
(Billion liras) (Percent) of GDP
Banks 5,355 85.9 119.5
Deposits Banks 4,638 74.4 103.5
Development and Investment Banks 352 5.7 7.9
Participation Banks 364 5.8 8.1

Nonbank Financial Institutions 125 2.0 2.8

Factoring Companies 64 1.0 1.4
Leasing Companies 36 0.6 0.8
Finance Companies 26 0.4 0.6

Insurance and Pension Companies 272 4.4 6.1

Investment Companies 93 1.5 2.1
Portfolio Management Companies 347 5.6 7.8
Intermediary Institutions 33 0.5 0.7
Asset Management Companies 5 0.1 0.1
72
TOTAL 6,231 100.0 139.0
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• Beside these direct regulatory and supervisory
institutions there
are institutions related to the financial system
indirectly
but with significant effects on it.
• Most important among them are
Treasury and Finance Ministry,
Trade Ministry,
and the Competition Authority.
73
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• It is known that taxing is used
both an incentive and deterrent
instrument for financial system
because taxes are a significant
component of the costs of intermediary
services.
• The regulations of the Trade Ministry
for protecting consumer rights are
binding also for financial institutions.
74
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• The mission of the Competition Authority
is to
prevent cartelization and monopolization,
increase consumer welfare,
contribute to the well-functioning of market
mechanism,
contribute to the improvement of international
competition power
and to ensure that investment environment
functions in a healthy way
by decreasing entry barriers. 75
 THE STRUCTURE
OF THE TURKISH FINANCIAL SYSTEM
• When the oligopolistic structure of the
financial markets is considered,
the significance of the Competition
Authority for the financial system is seen
clearly.

76