LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
1. Intermediary Role
FINANCIAL SYSTEM - The financial system acts
A financial system is a network of as an intermediary
institutions, markets, instruments, and between entities with
services that facilitate the flow of funds surplus funds (savers)
between savers, investors, borrowers, and those in need of
and lenders. It plays a crucial role in funds (borrowers). It
promoting economic growth by channels funds from
allocating resources, managing risks, households, businesses,
and providing a mechanism for saving, and governments into
investing, and borrowing. The financial productive investments.
system also helps to stabilize
economies by efficiently matching the 2. Facilitating Transactions
demand for capital with its supply. - It facilitates economic
transactions by providing
The financial system is complex, mechanisms for payments
comprising many different types of (such as credit cards, electronic
private sector financial institutions, transfers, etc.), and supporting
including: the exchange of goods and
● Banks services.
● Insurance companies
● Finance companies 3. Risk Management
● Mutual funds and - Through various financial
● Investment banks all of which instruments like derivatives,
are regulated by the insurance, and hedging
government. products, the system helps
manage risks associated with
investments, market volatility,
NATURE OF FINANCIAL SYSTEM
and interest rate fluctuations.
The financial system operates through
both formal and informal structures,
incorporating various participants and
intermediaries. Its main nature can be
summarized as follows:
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
FLOW OF FUNDS THROUGH FINANCIAL
4. Liquidity Creation SYSTEMS
- Ensures that assets can be
easily converted into cash to
meet short-term needs.
5. Mobilization of Savings
- The financial system
encourages savings by
providing instruments such as
savings accounts, bonds, and
mutual funds that earn returns,
facilitating capital formation in
the economy. KEY COMPONENTS OF FINANCIAL
SYSTEM
6.Regulatory Framework The major components of the financial
- It operates under a regulatory system include:
structure governed by central a. Financial Instruments (Chapter
banks, regulatory authorities 4)
(e.g., the SEC), and financial b. Financial Markets and Financial
market regulations to ensure Institutions (Chapter 7 to 15)
stability, transparency, and the c. The Central Bank and Other
protection of investors. Financial Regulators (Chapter 16
to 17)
FUNCTIONS OF 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
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
The splitting of wealth into many
provide financial services to assets to reduce risk is known as
households and businesses. diversification.
Economists believe that there are three ● Example: Mutual funds allow
key services that the financial system individuals to invest in a
provides to savers and borrowers: diversified portfolio of stocks,
bonds, or other securities. By
● Risk sharing doing so, individual investors
● Liquidity reduce the risk of a loss from
● Information any single investment. The
mutual fund shares the overall
Financial services firms provide these market risk across many
services in different ways, which makes participants.
different financial assets, financial
liabilities more or less attractive to ● Role of Financial Markets:
individual savers and borrowers. Derivatives markets (like options
and futures) enable firms and
investors to hedge against price
RISK CHANGES
changes in assets, helping to
The financial system allows
mitigate risks. For instance, an
participants to share and spread risk.
airline company may use
Investors typically want to take on
futures contracts to hedge
higher risks for the potential of higher
against potential increases in
returns, while others may seek lower-
fuel prices.
risk options. Financial institutions (like
banks, insurance companies, and
investment funds) and markets help LIQUIDITY
facilitate risk sharing by pooling risks Liquidity refers to the ability to quickly
and spreading them among various convert an asset into cash without
participants. significantly affecting its price. The
financial system provides liquidity by
offering a wide variety of assets that
can be easily bought and sold. This
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
intermediaries (like banks, credit rating
flexibility helps participants meet their agencies) also help gather and
short-term needs without losing value evaluate information about borrowers
on their investments. and investment opportunities.
● Example: Stock markets provide ● Example: Stock prices on an
liquidity for investors who need exchange reflect all publicly
to convert their stock holdings available information about a
into cash. Without a liquid company, such as its financial
market, selling stocks quickly health, growth prospects, and
could lead to a significant drop management quality. Investors
in price. rely on this information to make
decisions.
● Role of Financial Institutions:
Banks, for example, provide ● Role of Financial Institutions:
liquidity through deposits and Credit rating agencies, for
loans. They enable depositors to instance, provide information on
withdraw funds on demand, the creditworthiness of
while offering loans to borrowers. This helps lenders
businesses and individuals. assess the risk involved in
Money market instruments (like lending money or issuing bonds.
treasury bills) also offer high Similarly, banks gather
liquidity with minimal risk. information on potential
borrowers to determine whether
to grant a loan and at what
INFORMATION
interest rate.
The financial system is crucial for
gathering, processing, and
THE PROBLEM OF ADVERSE SELECTION
disseminating information, which helps
AND MORAL HAZARD
in the efficient allocation of resources.
Adverse selection and moral hazard
Financial markets reflect the collective
are two key problems that arise due to
information and expectations of
information asymmetry* in financial
participants about the value of
markets. Both are crucial issues in
different assets, while financial
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
economics and finance,
insured individuals that is skewed
especially in the context of insurance, toward high-risk people, which
banking, and credit markets. Let's dive forces insurers to raise premiums.
into each concept. High premiums may further drive
away healthy individuals, worsening
the risk pool (known as the "death
Asymmetric Information – describes
spiral").
the situation in which one party to an
economic transaction has better
information than does the other party. EXAMPLE IN LENDING
In financial transactions, typically the
In the credit market, adverse
borrower has more information than
selection happens when lenders
does the lender. cannot differentiate between high-
risk and low-risk borrowers. High-risk
1. Adverse Selection borrowers, knowing their risk level,
- This is the problem may seek loans at the market
investors experience in interest rate. Lenders may respond
by charging higher interest rates to
distinguishing low-risk
account for the unknown risk, which
borrowers from high-risk
drives away safer borrowers.
borrowers before making Consequently, the pool of borrowers
an investment. becomes riskier, increasing the
likelihood of defaults.
HOW IT WORKS
MITIGATION
In markets like health insurance,
individuals have better knowledge of Financial institutions try to reduce
their health conditions than the adverse selection through screening
insurance company. People who are mechanisms, such as requiring
more likely to need medical care (i.e., medical exams for health insurance
high-risk individuals) are more or credit scoring for loans. These help
inclined to purchase comprehensive gather information about the true
health insurance, while healthier risk profile of individuals.
(low-risk) individuals may opt out or
buy less coverage.
This imbalance leads to a pool of
2. Moral Hazard
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
- This is the
can use mechanisms like
problem investors deductibles in insurance policies,
experience in verifying which force policyholders to bear
that borrowers are using part of the cost of their claims,
their funds as intended. incentivizing them to avoid risky
behavior. In lending and banking,
regulations like capital requirements
HOW IT WORKS or performance-based incentives for
managers can help reduce the
Once insured, an individual might
moral hazard problem
engage in riskier behavior because
they know the insurance company
will bear the cost of an adverse
event. For instance, someone with
car insurance might drive more
recklessly because they know they
are financially protected in case of
an accident.
EXAMPLE IN BANKING
Moral hazard can occur in the
banking sector when banks take
excessive risks, knowing that they
might be bailed out by the
government (as seen in the 2008
financial crisis). Banks, knowing they
are "too big to fail," may engage in
risky lending practices or speculative
investments because they believe
they will not suffer the full
consequences if things go wrong. .
MITIGATION
To combat moral hazard, institutions Key Differences
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
● Moral Hazard
- After buying insurance,
FACTOR ADVERSE MORAL
SELECTION HAZARD individuals may overuse
medical services because
Timing of Before the After the
they are not paying the
Problem transactio transactio
full cost.
n (due to n (due to
hidden changed
informatio behavior) 2. Credit Markets:
n) ● Adverse Selection
- Lenders face difficulties
Main Informatio Informatio
distinguishing between
Cause n n
asymmetr asymmetr risky and safe borrowers,
y (hidden y (hidden leading to higher interest
characteri actions) rates.
stics)
Typical Insurance Insurance, ● Moral Hazard
Examples markets, banking, - Borrowers who have
credit manageria already received a loan
markets l behavior may take riskier business
decisions, knowing they
Mitigation Screening, Monitoring,
Technique signaling contractua already have the lender's
s (e.g., credit l money
scores) incentives,
regulation 3. Banking:
s
● Adverse Selection
- Banks may lend to high-
REAL-WORLD EXAMPLES risk borrowers because
1. Health Insurance: they can’t accurately
● Adverse Selection assess their risk.
- Individuals with pre-
existing health conditions ● Moral Hazard
may be more likely to buy - After receiving the loan,
health insurance. borrowers may use the
funds for riskier
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
investments than they individuals and firms that can discover
originally disclosed. ways to reduce those costs.
NATURE AND IMPACT OF HOW FINANCIAL INTERMEDIARIES
TRANSACTION AND INFORMATION
REDUCE “ADVERSE SELECTION”
COSTS
1. Transaction Costs
1. Requiring borrowers to disclose
- The cost of a trade or a
material information on their
financial transaction.
financial performance and
Example: The brokerage
financial position.
commission charged for
2. Collecting information on firms
buying or selling a
and selling that information to
financial asset.
investors.
3. Convincing lenders to require
2. Information Costs
borrowers to pledge some of
- The cost that savers incur
their assets as collateral which
to determine the
the lender can claim if the
creditworthiness of
borrower defaults.
borrowers and to monitor
how they use the funds
acquired. HOW FINANCIAL INTERMEDIARIES
REDUCE “MORAL HAZARD PROBLEMS”
Because of transaction costs and 1. Specializing in monitoring
information costs, savers receive a borrowers and developing
lower return on their investments and effective techniques to ensure
borrowers must pay more for the funds that funds they loan are actually
they borrow. As we have just seen, used for their intended purpose.
these costs can sometimes mean that
funds are never lent or borrowed at all.
Although transaction costs and
information cost reduce the efficiency 2. Imposing Restrictive Covenants
of the financial system, they also - Restrictive covenants may
create a profit opportunity for involve placing limitations on
the uses of funds borrowed or
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
requiring the 2. Information Costs Reduction
borrowers to pay off the debt - Financial intermediaries reduce
even before the maturity date if information asymmetry
the borrower’s net worth drops between borrowers and lenders.
below a certain level. They invest in research,
technology, and expertise to
assess the creditworthiness of
HOW FINANCIAL INTERMEDIARIES
borrowers, making it easier for
REDUCE “TRANSACTION COST”
lenders to trust that their money
Financial intermediaries, such as
is being lent to credible
banks, credit unions, and other
borrowers. In the Philippines,
financial institutions, play a crucial role
credit risk assessment tools and
in reducing transaction costs in an
centralized credit bureaus help
economy. Here are some key ways in
intermediaries reduce risks and
which they do so:
costs associated with lending.
1. Economies of Scale
3. Risk Pooling and Diversification
- Financial intermediaries pool
- By diversifying investments
funds from numerous small
across various sectors and
savers and investors, which
borrowers, financial
allows them to take advantage
intermediaries lower the risk
of economies of scale. Handling
associated with lending. They
large volumes of transactions
absorb some of the risks that
makes it possible for banks to
individual investors would have
lower their costs per transaction,
to bear if they were engaging in
reducing fees for individual
direct financial markets.
customers. Banks like BDO
Philippine financial institutions,
Unibank and Bank of the
such as Land Bank of the
Philippine Islands (BPI) offer
Philippines, spread risk by
various financial services at
providing loans to different
lower costs than if individuals
sectors like agriculture, real
were to engage in direct
estate, and small businesses,
finance.
reducing the cost for individual
transactions.
LESSON 9
OVERVIEW OF FINANCIAL SYSTEMS
Finance and Financial Markets| 1st Semester
transactions. Many banks have
4. Liquidity Provision developed mobile banking apps
- Financial intermediaries in the and platforms that allow
Philippines provide liquidity by customers to transact quickly
offering financial instruments and conveniently, reducing the
that can be easily converted opportunity costs associated
into cash, such as savings with time delays in financial
accounts, time deposits, and dealings.
government bonds. This reduces
the cost for individuals who 7. Credit Access and Development
need liquidity but do not want to - Financial intermediaries in the
engage in costly or time- Philippines help bridge the gap
consuming processes to sell between savers and borrowers.
assets. By offering various forms of
credit (from microloans to large
5. Payment System Facilitation business loans), intermediaries
- Intermediaries in the Philippines enable access to funds at lower
provide cost -efficient payment costs than individuals would
systems that reduce the need incur if they tried to secure
for cash handling and physical credit themselves. Rural banks
transaction processes. Digital and microfinance institutions
payment platforms and play an especially significant
electronic fund transfers (such role in providing affordable
as those through GCash or credit to underserved sectors
PayMaya) reduce the costs like small enterprises and rural
associated with manual farmers.
processing of payments.
6. Lowering Transaction Time
- By providing banking networks
and online platforms,
intermediaries reduce the time
required to complete
