Unit II– Financial System

Module 4 – Financial System

Learning Objectives

After studying, you should be able to

1. Explain what financial system is as well as its objective
2. Explain how the financial system affects a nation’s economy
3. Enumerate the key components of the financial system
4. Explain the main functions of the financial system

Discussion / Lecture

NATURE AND OBJECTIVE OF THE FINANCIAL SYSTEM

The financial system consists of all financial intermediaries and financial markets and
their relations with respect to the flow of funds to and from households, governments,
business firms and foreigners, as well as the financial infrastructure.
Having a well-functioning financial system in place that directs funds to their most
productive uses is a crucial prerequisite for economic development.
This process is shown schematically in Figure 5-1. Those who have saved and are
lending funds, the lender-savers, are at the left, and those who must borrow funds to
finance their spending, the borrower-spenders, are at the right. The principal lender-
savers are households, but business enterprises and the government (particularly state
and local government), as well as foreigners and their governments, sometimes also
find themselves with excess funds and so lend them out. The most important borrower-
spenders are businesses and the government (particularly the national government),
but households and foreigners also borrow to finance their purchases of cars, furniture,
and houses. The arrows show that funds flow from lenders-savers to borrower-spenders
via two routes.
In direct finance (the route at the bottom of Figure 5-1), borrowers borrow funds directly
from lenders in financial markets by selling them securities (also called financial
instruments), which are claims on the borrower's future income or assets. Securities are
assets for the person who buys them buy liabilities. (IOUS or debts) for the individual
or firm that sells (issues) them.

KEY COMPONENTS OF THE FINANCIAL SYSTEM

The major components of the financial system include
a) Financial Instruments
b) Financial Markets and Financial Institutions
c) The Central Bank and Other Financial Regulators
FUNCTIONS OF THE FINANCIAL SYSTEM

The main task of the financial system is to channel funds from sectors that have a
surplus to sectors that have a shortage of funds. In the financial system, banks,
insurance companies, mutual funds, stockbrokers, and other financial services firms
compete to provide financial services to households and businesses.

Economists believe there are three key services that the financial system provides to
savers and borrowers: risk sharing, liquidity, and information. Financial services firms
provide these services in different ways, which makes different financial assets and
financial liabilities more or less attractive to individual savers and borrowers.

a. Risk sharing
b. Liquidity
c. Information

Discussion

Risk sharing

Risk is the chance that the value off financial assets will change relative to what one
expects. One advantage of using the financial system to match individual savers and
borrowers is that it allows the sharing of risk. Most individual savers seek a steady
return on their assets rather than erratic savings between high and low earnings.
This splitting of wealth into many assets reduce risk is known as diversification.

The financial system provides risk sharing by allowing savers to hold many assets.
Hence, because of the ability of the financial system to provide risk sharing makes
savers more willing to buy stocks, bonds and other financial assets. This willingness,
in turn increases the ability of borrowers to raise funds in the financial system.
Financial intermediaries have developed expertise in holding a diversified portfolio of
innovative projects which reduces risk and promotes investment in growth
enhancing innovative activities.

Liquidity

Another key service that the financial system offers savers and borrowers is liquidity.
Liquidity is the ease with which an asset can be exchanged for money which savers
view as a benefit. Generally, assets created by the financial system such as stocks,
bonds or checking accounts, are more liquid than are physical assets such as cars,
machinery or real estate.

Financial markets and intermediaries help make financial assets more liquid.
Investors can easily sell their holdings of government securities and the stocks and
bonds of large corporations, making those assets very liquid.
 The financial system has increased the liquidity of many assets besides stocks and
bonds through process of securitization. This process has made it possible to buy
and sell securities based on loans. As a result, mortgages and other loans have
become more desirable assts for savers to hold. Savers are willing to accept interest
rates on assets with greater liquidity which reduces the costs of borrowing for many
households and firms.

Information

A third service of the financial system is the collection and communication of

information, or facts about borrowers and expectations of returns on financial assets.
Banks collect information on borrowers to forecast their likelihood of repaying loans.
Because the bank specializes in collecting and processing information, its costs for
information gathering are lower than yours would be if you tried to gather information
about a pool of borrowers. The profit the bank earns on its loans is partly
compensation for the resources and time bank employees spend to gather and store
information.

Financial markets convey information to both avers and borrowers by determining

the prices of stocks, bonds and other securities. This information can help one
decide whether to continue investing in the securities previously purchased or to sell
more stock or bonds to finance a planned expansion: The incorporation of available
information into asset prices is an important feature of well-functioning financial
markets.

The Problems or Adverse Selection and Moral Hazard

A key consideration for savers is the financial health of borrowers. Savers do not lend to
borrowers who are unlikely to pay them back. Unfortunately for borrowers in poor
financial health have an incentive to disguise this fact. For example, a company selling
bonds to investors may know that its sales are declining rapidly, and it is near
bankruptcy, but the buyers of the bonds may lack this information.
A vital service of the financial system is the collection and communication of information
or facts about borrowers and expectation of returns in financial assets. Financial
markets convey information to both savers and borrowers by determining the prices of
stocks, bonds and other securities.

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.
Two problems arising from asymmetric information are
1. Adverse selection. This is the problem investors experience in distinguishing
low-risk borrowers from high-risk borrowers before making an investment.

2. Moral hazard. This is the problem investors experience in verifying that

borrowers are using their funds as intended.
Sometimes an investor will consider the costs arising from asymmetric information to be
so great that the investor will lend only to borrowers who are transparently low risk, such
as the national government. However, more generally, there are practical solutions to
the problems of asymmetric information, in which financial markets or financial
intermediaries lower the cost of information needed to make investment decisions.
The financial system helps overcome an information asymmetry between borrowers and
lenders. An information asymmetry can occur before or after a financial contract has
been agreed upon.

Adverse Selection
The information asymmetry before the contract is agreed upon arises because
borrowers generally know more about their investment projects than lenders. Borrowers
most eager to engage in a transaction are the most likely ones to produce an
undesirable outcome Cor the lender (adverse selection). Individual savers may not have
the time, especially or means to collect and take advantage of economies of scale and
scope.

Moral Hazard
Even after a lender has gathered information on whether a borrower is a good borrower
or a lemon borrower. The lender’s information problems haven’t ended. There is still a
possibility that after a lender makes a loan to what appears to be a good borrower, the
borrower will not use the funds as intended. This situation, known as moral hazard, is
more likely to occur when the borrower has an incentive to conceal information or to act
in a way that does not coincide with the lender’s interests. Moral hazard arises because
of asymmetric information: The borrower knows more than the lender does about how
the borrowed funds will actually be used.

NATURE AND IMPACT OF TRANSACTION AND INFORMATION COSTS

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

Information Costs
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.

How Financial Intermediaries Reduce “Adverse Selection”

The problem of “adverse selection” can be minimized if not totally avoided using the
following approaches:
 1. Requiring borrowers to disclose material information on their financial
performance and financial position.
Financial market participants and the government have taken steps to try to
reduce problems of adverse selection in financial markets. The SEC requires
the publicly traded firms report their performance in financial statements, such
as balance sheets, which show the value of the firm’s assets, liabilities, and
stockholders ‘equity (the difference between the value of the firm’s assets and
the value of its liabilities), and income statements, which show a firm’s revenue,
costs, and profit. Firms must prepare these statements using standard
accounting methods. In addition, firms must disclose material information, which
is information that, if known, would likely affect the price of a firm’s stock.

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

3. Convincing lenders to require borrowers to pledge some of their assets as

collateral which the lender can claim of the borrower defaults.
How Financial Intermediaries Reduce Moral Hazard Problems

Financial Intermediaries can reduce moral hazard problems by adopting more stringent
procedures in monitoring the borrower’s use of funds. This will include:
1. Specializing in monitoring borrowers and developing effective techniques to
ensure that the funds they loan are actually used for the intended purpose.
2. Imposing Restrictive Covenants
Restrictive covenants may involve placing limitations on the uses of funds borrowed or
requiring the borrowers to pay off the debt even before maturity date if the borrower’s
net worth drop below a certain level.

Links for video / lecture

https://www.youtube.com/watch?v=MsPgw4FodgE

https://www.youtube.com/watch?v=aVvrgv4P3CY

https://www.youtube.com/watch?v=bmtov22-PyQ

Activities
SAQ

True or False.
1. The main task of the financial system is to channel funds from sectors that have
shortage to sectors that have surplus of funds.
2. The financial system is simple.
 3. It is crucial that investors and finance managers has enough knowledge about
the environment they operate.
4. Households are the principal lenders but they cannot be a borrower.
5. Moral hazard arises because of lender's interest.
6. The financial system helps overcome information symmetry between borrowers
and lenders.
7. The financial system provides information by allowing savers to hold many asset.
8. The financial system has increased the liquidity of many assets besides stocks
and bonds through the process of diversification.
9. This splitting of wealth into many assets to reduce risk is known as
diversification.
10. Asymmetric information describes the situation in which one party to an
economic transaction has better information than does the other party.

ASAQ
True or False
True or False
 UNIVERSITY OF RIZAL SYSTEM
Province of Rizal
Page 7 of 7

1. False
2. False
3. True
4. False
5. False
6. False
7. False
8. False
9. True
10. True

ASSIGNMENT:

1. Why is there a need for an efficient financial system for a country to have a
strong economy?
2. Describe the functions of the financial system.
3. Explain how financial intermediaries reduce adverse selection, reduce
moral hazard problem, and reduce transaction and information costs?

Rubrics:

Criteria
1 2 3 4
Organizatio Sequence of Students jump Presents Information is 4
n information is around the information logical and
difficult to topic in logical interesting
follow sequence
Content Cannot Demonstrate At ease with Demonstrate 4
answer basic content but s full
question concepts fails to knowledge
about subject elaborate
Grammar & Has 2 Has no 2
Spelling misspellings misspellings
and/or or grammar
grammar error
error
Total 10

DCC Code Revision Number Date of Effectivity