Financial Economics 2021-I Rafael Serrano

A Primer on Financial Systems

Contents
1 Introduction 1

2 Financial systems 1
2.1 Financial markets and securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.2 Financial services and institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3 Functions of financial systems 5

1 Introduction
Every individual earns and spends money during most of their life, but very rarely their money income
matches exactly their outcome or consumption needs. At times, money income is more than what is
needed for spending, but on other occasions consumption desires or needs exceeds what money income
can afford. These imbalances lead to either borrowing or saving money in order to maximize long-run
benefits. Indeed, if current income exceeds consumption desires, people can save the excess by, say,
putting the money under a mattress or burying it in the backyard until some time in the future, once
consumption desires exceed income. Once they retrieve their savings from the mattress or backyard,
they will have the same amount they saved.
Another -possibly more profitable- prospect is to undertake an investment, that is, give up the
possession of these savings or other resources, which could otherwise be devoted to immediate con-
sumption, in exchange for a future stream of payments that will compensate the deferred consump-
tion. This notion of investment includes investments by corporations in plant and equipment and
investments by individuals in stocks, bonds, commodities, or real estate. The “investor” can be an
individual, a firm, a financial institution, a government, etc. In these notes, we will focus on financial
investments.

2 Financial systems
The term financial system refers to a global, regional or firm-specific set of entities and mechanisms
that allows the exchange of funds and the transfer of assets and risks. These transfers take
place whenever someone trades one asset or financial contract for another, and can be from one entity
or market participant to another, from one place to another, and from one point in time to another.
Financial systems also comprise sets of rules and practices that market participants use to decide
which projects get financed, who finances projects, and terms of financial deals. There are mainly
three components of a financial system: financial market, financial securities and financial institutions
(intermediaries).

2.1 Financial markets and securities

Financial market refers to the marketplace where buyers and sellers interact with each others and
participate in the creation and trading of financial securities. Financial markets play a vital role
in the allocation of resources and operation of modern economies by bridging the gap between
those who have excess of funds (lender-savers) and those who need additional money (borrower-
spenders). Financial markets allow the exchange of current funds that are used to finance projects,
either for productive investments or expenditure consumption (purchase of goods and services), and
to pursue a financial return that must be paid by borrowers-lenders.

Savers Deposits Financial Loans Borrowers

- Lenders Markets - Spenders

Flows of funds from lender-savers to borrower-spenders can follow two routes: direct finance,
in which borrowers borrow funds directly from lenders in financial markets by selling claims on the
borrower’s future income or assets in the form of financial securities, and indirect finance, in which
a financial intermediary borrows funds from lender-savers and then uses these funds to make loans
to borrower-spenders.
Participants of financial markets can be loosely classified in two groups: the involved and the un-
involved. The first of these are the market participants of economic theory. They are fully informed
at each instant of time and are active participants in the dynamic management of their portfolio of
financial assets. The second group of uninvolved are usually described as uninformed, since they
make decisions with limited information on both the nature of the financial claims involved and the
most recent information on fair market value. It is to this group that the financial intermediary offers
participation services. These may be provided by offering information to the uninformed investor, by
investing on their behalf, or by offering a fixed income claim against the intermediary’s balance sheet.
In any case, the investor gains access to the market through the intermediary’s services, which add
value to the transaction by reducing the perceived participation costs of the uninformed investor.
Financial securities are legal contracts representing the right to receive future benefits under
a stated set of conditions, tradable in the financial market. For instance, if you buy a share of a
company, you become a shareholder, and will receive dividends as decided by the company’s board
of directors. However, when you take out a student loan or a mortgage on a house, you sign a financial
contract that is also a financial asset for the lending institution. In this case, the lender will have the

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right to receive periodic payments in accordance to a certain interest rate stated in the contract. Even
so, it is not a tradable security as it is held by the bank and not sold or traded in financial markets.
Securities are assets for the person who buys them, but they are liabilities (debts) for the individual
or firm that sells (issues) them. For example, if a firm needs to borrow funds to pay for a new factory
to manufacture a certain consumption good, it might borrow the funds from savers by selling them a
bond, a debt security that promises to make payments periodically 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.
Traditionally, financial securities used to be physical certificates. Nowadays, they are mostly elec-
tronic. An investor can choose to purchase directly one of number of different securities, many of
which represent a type of claim on a private or government entity. Alternatively, intermediaries such
as mutual funds may bundle direct investments and then sells shares of their investment portfolio. We
can broadly categorize markets for financial securities in two categories, depending on the maturity
of the claim:

• Money market (short-term)

• Capital market (fixed-income or equity, long term)

These markets are not single institutions but broad components of the global financial system. The
money market is a place for individuals, banks, other companies, and governments that want to save
cash for a short period of time, usually one year or less. It exists so that businesses and governments
that need cash to operate can get it quickly at a reasonable cost, and so that businesses that have
more cash than they need can put it to use.
The returns in money markets are usually modest but with lower risks. The instruments used in
the money markets include deposits, collateral loans, acceptances, and bills of exchange. Institutions
operating in the money markets include central and commercial banks. Companies or governments
issue short-term debt usually to cover routine operating expenses or supply working capital, not for
capital improvements or large-scale projects.
The money market plays a key role in ensuring that banks, other companies, and governments
maintain the appropriate level of liquidity on a daily basis, without falling short and needing a more
expensive loan and without hoarding excess cash that is not earning interest. Individual investors
may use the money markets to invest their savings in a safe and accessible place. Many choices
are available, including mutual funds that focus on state money market funds, municipal funds, and
treasury funds. In many countries, government funds are tax-free, and money-markets funds can be
opened at most commercial banks.
The capital market is where stocks and bonds are traded. Here, the word capital refers to
financial capital, that is, any economic resource that can be measured in monetary terms, exists in
the form of cash or securities, and is used by firms to buy what they need for their to business operation.
Financial capital can be either internal retained earnings generated from the business activities of a
firm, or funds provided by lenders and investors in order to purchase real capital equipment or services
for producing new goods or services. In contrast, real (or economic) capital consists of physical goods
or assets that help in the business activities.

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 The capital market is roughly divided into a primary market and a secondary market. A company
that issues a round of stock or a new bond places it in the primary market for sale directly to investors
or institutions. If and when those buyers decide to sell their shares or bonds, they do so on the
secondary market. The original issuer of those stocks or bonds does not immediately benefit from
their resale, although companies certainly have an interest in the price of their stock shares rising over
time.
The overriding goal of the companies institutions that enter into the capital markets is to raise
money for their long-term purposes, which usually come down to expanding their businesses and
increasing their revenues. They do this by issuing stock shares and by selling corporate bonds. Capital
markets can therefore be characterized by the following features

• Liquidity of instruments traded

• Competitiveness

• Conversion of net assets in fixed investments

Movements of capital markets are constantly monitored from hour to hour and analyzed for clues
as to the health of the economy at large, the status of every industry in it, and the consensus for
the short-term future. The development and growth of the capital markets is directly associated to
the economic development of a country, given its crucial role as mechanism for allocation of financial
resources, especially for business in need of funding for their development projects. Markets can also
be classified by the timing of delivery into

• Spot or cash market. The market where the transaction between buyers and sellers are settled
in real-time, or with a slight delay.

• Futures Market. Futures market is one where the delivery or settlement of commodities takes
place at a future specified date.

and by organizational structure into

• Exchange-Traded Market. It is a financial market which has a centralised organisation with

the standardised procedure.

• Over-the-Counter Market. An OTC is characterised by a decentralised organisation, having

customised procedures.

2.2 Financial services and institutions

Financial institutions encompass a broad range of business operations within the financial services
sector including banks, trust companies, insurance companies, brokerage firms, and investment deal-
ers. Virtually everyone living in a developed economy has an ongoing or at least periodic need for

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the services of financial institutions. Financial institutions can operate at several scales from local
community credit unions to international investment banks.
The specific services offered vary widely between different types of financial institutions

• Commercial banks. A commercial bank is a type of financial institution that accepts deposits,
offers checking account services, makes business, personal, and mortgage loans, and offers basic
financial products like certificates of deposit (CDs) and savings accounts to individuals and
small businesses. A commercial bank is where most people do their banking, as opposed to an
investment bank.
Banks and similar business entities, such as thrifts or credit unions, offer the most commonly
recognized and frequently used financial services: checking and savings accounts, home mort-
gages, and other types of loans for retail and commercial customers. Banks also act as payment
agents via credit cards, wire transfers, and currency exchange.

• Investment Banks. Investment banks specialize in providing services designed to facilitate

business operations, such as capital expenditure financing and equity offerings, including ini-
tial public offerings (IPOs). They also commonly offer brokerage services for investors, act as
market makers for trading exchanges, and manage mergers, acquisitions, and other corporate
restructurings.

• Insurance companies. Among the most familiar non-bank financial institutions are insurance
companies. Providing insurance, whether for individuals or corporations, is one of the oldest
financial services. Protection of assets and protection against financial risk, secured through
insurance products, is an essential service that facilitates individual and corporate investments
that fuel economic growth.

• Investment companies and brokerage firms. Investment companies and brokerages, such
as mutual funds and exchange-traded funds (ETFs), specialize in providing investment services
that include wealth management and financial advisory services. They also provide access
to investment products that may range from stocks and bonds all the way to lesser-known
alternative investments, such as hedge funds and private equity investments.

3 Functions of financial systems

Financial systems facilitate the following basic services that in turn help promote economic growth.

1. Trade and provision of liquidity to tradeable assets. The invention of money diminished
the need for barter used in primitive economies. This thereby increased commercial transactions
and trade. In modern economies, it is not enough to have money to facilitate transactions, as it
needs to be moved around.
Financial systems help moving money from one party to the other, often across national bound-
aries, by providing mechanisms that record and clear multilateral financial transactions. They

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 also provide liquidity to tradable assets, by facilitating the exchange, as the investors can readily
sell their securities and convert assets into cash.

2. Saving money for the future. We have already mentioned that people often have money that
they choose not to spend now but they will want available in the future. For example, employees
who save for their retirements need to move some of their current earnings into the future. Once
they retire, they will use their savings to replace the wages that they will no longer be earning.
Similarly, companies save money from their sales revenue so that they can pay vendors when
their bills come due, repay debt, or acquire assets in the future.
Savers can move money from the present to the future by depositing money in savings accounts,
buy notes, certificates of deposit, bonds, stocks, mutual funds, or real assets such as real estate.
In the case of investors, they can sell (divest) the purchased assets in the future to fund their
future expenditures. These alternatives generally provide a better expected rate of return
than simply storing money, as they must compensate savers and investors for the use of their
money and the risk that they may lose money if the investment fails or if inflation reduces the
real value of their investments.
The financial system facilitates savings when institutions create investment tools, such as
bank deposits, notes, stocks, and mutual funds, that investors can acquire and sell without
paying substantial transaction costs. Fair pricing of these instruments promotes their trading,
as investors will use them to save more.

3. Borrowing money and mobilization of resources for current use. Individuals, compa-
nies, and governments often want to spend money now that they do not have. Individuals may
borrow to pay for such items as vacations, homes, cars, or education. They generally borrow
through personal loans and mortgages, or by using credit cards, and will typically repay these
loans with money they earn later.
Companies often require money to fund current operations or to engage in new capital projects.
They can obtain money to fund projects that they wish to undertake now by borrowing it.
They may borrow the needed funds in a variety of ways, such as arranging a loan or a line of
credit with a bank or selling fixed income securities to investors. Companies typically repay
their borrowing with income generated in the future.
Governments may borrow money to pay salaries and other expenses, to fund projects, to provide
welfare benefits to their citizens and residents, and to subsidize various activities. Governments
borrow by selling bills, notes, or bonds. Governments repay their debt using future revenues
from taxes and in some instances from the projects funded by these debts.
Borrowers can borrow from lenders only if the lenders believe that they will be repaid. If the
lenders believe, however, that repayment with interest may not occur, they will demand higher
rates of interest to cover their expected losses and to compensate them for the distress they
experience wondering whether they will lose their money. To lower the costs of borrowing,
borrowers often pledge assets as collateral for their loans. The assets pledged as collateral
often include those that will be purchased by the proceeds of the loan. If the borrowers do not
repay their loans, the lenders can sell the collateral and use the proceeds to settle the loans.

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 Lenders often will not loan to borrowers who intend to invest in risky projects, especially if
the borrowers cannot pledge other collateral. Investors may still be willing to supply capital
for these risky projects if they believe that the projects will likely produce valuable future cash
flows. Rather than lending money, however, they will contribute capital in exchange for equity
in the projects.
Credit bureaus, credit rating agencies, and governments also promote borrowing. Indeed, credit
bureaus and credit rating agencies collect and disseminate information that lenders need to
analyze credit prospects and governments do so by establishing bankruptcy codes and courts
that define and enforce the rights of borrowers and lenders. If the transaction costs of loans (i.e.,
the costs of arranging, monitoring, and collecting them) are low, borrowers can borrow more to
fund current expenditures with credible promises to return the money in the future

4. Raising capital and mobilization of resources for productive use. In addition to bor-
rowing, companies may raise funds by issuing debt or selling ownership interests via equity
contracts. A debt contract is similar to a bank loan: the lender is promised as repayment the
original loan amount plus some interest. An equity contract allows a business wishing to raise
capital to sell an ownership stake in the company to investors willing to provide the external
financing that the business needs.
A debt claim has both a stated maturity and priority over equity. Stated maturity means
that the debt contract stipulates that the lender must be fully repaid by a certain date. Priority
over equity means that debt holders must be fully repaid before shareholders can be paid.
Consumers finance primarily with debt contracts since a loan taken by a consumer is essentially
a financial claim by the lender on the borrower’s labor income, hence it is relatively easy for the
borrower to simply withhold the supply of this labor income – for example, by quitting work –
and make the lender’s claim worthless. A debt contract, with a requirement to fully repay by
a certain date and penalties for failure to repay, provides better incentives for the borrower to
pay off the debt claim.
Businesses finance with both debt and equity. In fact, the mix of debt and equity financing
to use is an important decision for any business. The reason why equity financing is viable
for businesses is that the financial system provides corporate governance to keep managerial
actions roughly aligned with the interests of the financiers of the business, and businesses have
powerful incentives to keep producing profits for a variety of reasons, so there are strong inherent
incentives to not withhold the supply of productive inputs like labor.
Although equity instruments legally represent ownership in companies rather than loans to the
companies, selling equity to raise capital is simply another mechanism for moving money from the
future to the present. Once shareholders or partners contribute capital to a company, it obtains
money in the present in exchange for equity instruments that will be entitled to distributions
in the future. Although the repayment of the money is not scheduled as it would be for loans,
equity instruments also represent potential claims on money in the future.
The mobilization of funds by financial markets facilitates the capitalization of firms and the
productive use of financial resources. For instance, investment banks help companies issue

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 equities, analysts value the securities that companies sell, and regulatory reporting requirements
and accounting standards attempt to ensure the production of meaningful financial disclosures.
The financial system also helps promote capital formation by producing the financial information
needed to determine fair prices for equity.
Liquidity is also an important factor that help companies raise capital. In liquid markets,
shareholders can easily divest their equities as desired. Investors in markets in which equities
are easily valued and traded are more willing to fund reasonable projects that companies wish
to undertake.

5. Collecting and processing information that helps capital allocation. Participants in

financial markets do not have to waste resources to find probable buyers or sellers of securities.
Further, financial systems reduce cost by providing valuable information, regarding the securi-
ties traded in the financial market. Indeed, financial institutions and intermediaries have the
resources and expertise to obtain and process information that allows them to evaluate firms and
projects, as well as identify securities, contracts, and other assets that their research indicate
are under- or overvalued.
Financial systems also enable the discovery of the rates of return that equate aggregate savings
with aggregate borrowings. This in turn allow investors to select security types with the risk-
return characteristics that best suit their preferences, so each security can be sold for the best
possible price.
If information collected by investors and intermediaries is used for strategic capital allocation,
capital supply for firms that need to raise capital to finance their investments is encouraged.
This in turn facilitates the process of building the economy’s stock of real assets, as well as
the supply of capital that is ultimately channeled to businesses that make investments that fuel
economic growth.

6. Exchanging exchange assets for immediate and future deliveries. People and companies
often trade one asset for another that they rate more highly or, equivalently, that is more useful
to them. They may trade one currency for another currency, or money for a needed commodity
or right. The following are some examples that illustrate these trades:

• Volkswagen pays its German workers in euros, but the company receives dollars when it
sells cars in the United States. To convert money from dollars to euros, Volkswagen trades
in the foreign exchange markets.
• A Mexican investor who is worried about the prospects for peso inflation or a potential
devaluation of the peso may buy gold in the spot gold market. (This transaction may
hedge against the risk of devaluation of the peso because the value of gold may increase
with inflation.)
• A plastic producer must buy carbon credits to emit carbon dioxide when burning fuel to
comply with environmental regulations. The carbon credit is a legal right that the producer
must have to engage in activities that emit carbon dioxide.

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 In each of these cases, the trades are considered spot market trades because the instruments
trade for immediate delivery. The financial system facilitates these exchanges when liquid spot
markets exist in which people can arrange and settle trades without substantial transaction
costs.
In these markets, the spot price is the current market price of a security, currency, or commodity
available to be bought/sold for immediate settlement. In other words, it is the price at which
the sellers and buyers value an asset right now. Although spot prices can vary by time and
geographic regions, the prices are fairly homogeneous in financial markets. The uniformity of
prices across different financial markets does not allow market participants to exploit arbitrage
opportunities from significant price disparities for the same asset in different markets.
Alternatively, payment and delivery can be delayed to the future using derivative contracts such
as forwards and futures. In fact, spot prices are usually considered in the context of these
contracts, since they permit to lock in the desired spot price of a commodity at some future
date because prices constantly change due to fluctuations in supply and demand.
The spot price is a key variable in determining the price of a futures contract. It can indicate
expectations about fluctuations in future commodity prices.

7. Risk management. Individuals, companies, and governments face several financial risks
when investing in the financial market: default risk, risk of changes in interest rates, exchange
rates, raw material prices, and sale prices, etc. These risks are often managed by trading
contracts that serve as hedges for the risks.
For example, a farmer and a food processor both face risks related to the price of grain. The
farmer fears that prices will be lower than expected when his grain is ready for sale whereas
the food processor fears that prices will be higher than expected when grain must be purchased
in the future. They both can eliminate their exposures to these risks if they enter a binding
forward contract for the farmer to sell a specified quantity of grain to the food processor at a
future date at a mutually agreed upon price. By entering a forward contract that sets the future
trade price, they both eliminate their exposure to changing grain prices.
In general, hedgers trade to offset or insure against risks that concern them. In addition to
forward contracts, they may use futures contracts, option contracts, or insurance contracts to
transfer risk to other entities more willing to bear the risks. Often the hedger and the other
entity face exactly the opposite risks, so the transfer makes both more secure, as in the grain
example.
The financial system facilitates risk management when liquid markets exist in which risk man-
agers can trade instruments that are correlated (or inversely correlated) with the risks that
concern them without incurring substantial transaction costs. Investment banks, exchanges,
and insurance companies devote substantial resources to designing such contracts and to ensur-
ing that they will trade in liquid markets. Under those conditions, people can manage the risks
more efficiently and often are more willing to undertake risky activities that they expect will be
profitable.

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8. Information-based trading. Traders that negotiate securities motivated on information seek
to profit from news, reports, expert knowledge and research that they believe allows them to
predict future prices. Like all other traders, they hope to buy at low prices and sell at higher
prices. Unlike pure investors, however, they expect to earn a return on their information in
addition to the normal return expected for bearing risk through time.
Active investment managers are information-motivated traders who collect and analyze infor-
mation to identify securities, contracts, and other assets that their analyses indicate are under-
or overvalued. They then buy those that they consider undervalued and sell those that they
consider overvalued. If successful, they obtain a greater return than the unconditional return
that would be expected for bearing the risk in their positions. The return that they expect to
obtain is a conditional return earned based on the information in their analyses. Practitioners
often refer to this process as active portfolio management.
Note that the distinction between pure investors and information-motivated traders depends on
their motives for trading and not on the risks that they take or their expected holding periods.
Investors trade to move wealth from the present to the future whereas information-motivated
traders trade to profit from superior information about future values. For example, a bank
treasurer may only need to move money overnight and might use money market instruments
trading in an interbank funds market to accomplish that. A pension fund, however, may need
to move money 30 years forward and might do that by using shares trading in a stock market.
Both are investors although their expected holding periods and the risks in the instruments that
they trade are vastly different.
In contrast, information-motivated traders trade because their information-based analyses sug-
gest to them that prices of various instruments will increase or decrease in the future at a rate
faster than others without their information or analytical models would expect. After establish-
ing their positions, they hope that prices will change quickly in their favor so that they can close
their positions, realize their profits, and redeploy their capital. These price changes may occur
almost instantaneously, or they may take years to occur if information about the mispricing is
difficult to obtain or understand.
The two categories of traders are not mutually exclusive. Investors also are often information-
motivated traders. Many investors who want to move wealth forward through time collect and
analyze information to select securities that will allow them to obtain conditional returns that
are greater than the unconditional returns expected for securities in their asset classes. If they
have rational reasons to expect that their efforts will indeed produce superior returns, they are
information-motivated traders. If they consistently fail to produce such returns, their efforts
will be futile, and they would have been better off simply buying and holding well-diversified
portfolios.
The financial system facilitates information-motivated trading when liquid markets allow active
managers to trade without significant transaction costs. Accounting standards and reporting
requirements that produce meaningful financial disclosures reduce the costs of being well in-
formed, but do not necessarily help informed traders profit because they often compete. The
most profitable well-informed traders are often those that have the most unique insights into
future values.

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