CHAPTER 1.

THE FINANCIAL SYSTEM

INTRODUCTION
This module will tackle the different topics in relation to financial system such as the
concept of the financial system, the financial system participants, the Bangko Sentral ng
Pilipinas, the Philippine financial system and the monetary policy.

The topics stated above will broaden the knowledge of the students regarding the
interrelationship of different financial system participants. Furthermore, the relationship of the
Bangko Sentral ng Pilipinas and the monetary policy will also be explained which will help the
students assess the current financial situation of our country.

INTENDED LEARNING OUTCOME

At the end of the module, the learners are expected to:

1. Analyze a financial system’s role in the economy.

2. Comprehend the different participants in the financial system and their roles.
3. Elaborate the role of BSP in the economic development of the Philippines.
4. Analyze the monetary policy and its role in the economic development of the country.
5. Analyze the relationship between monetary policy and financial system.
6. Illustrate how the tools of monetary policy are used to influence money supply and interest rates.

COURSE CONTENT

FINANCIAL SYSTEM: DEFINITION

Financial system describes collectively the financial markets, the financial system
participants, and the financial instruments and securities that are traded in the financial
markets. The functions of the financial system are:

- To channel the funds from the savings units (lenders) to the deficit units
(borrowers)
- To provide a medium of exchange
- To provide a mechanism for risk sharing
- To provide a channel through which the central bank can influence the economy,
in general and the financial system, in particular.

With the advent of globalization, we have a multinational financial system.

Multinational financial system refers to the collective financial transfer mechanism that
facilitate the movement of money and profits between and among financial system
participants throughout the world. These mechanisms include transfer of prices on
goods and services traded internally and internationally; intercompany loans and
leading (speeding up) and lagging (slowing down) payment, fees, and royalty charges
wherever they are located in the world; and dividend payments.
 Kidwell et al. (2013) cited the inferences that we can draw about the financial
system:

- If the financial system is competitive, the interest rate that the bank pays on
certificates of deposit (CDs) will bear at or near the highest rate that you can earn
on CDs of similar maturity and risk. At the same time, borrowers will have
borrowed at or near the lowest possible interest cost, given their risk class.
Competition among banks for deposits will drive CD rates up and loan rates
down.
- Banks and other depository institutions, such as insurance companies, gather
money from consumers in small dollar amounts, aggregate it, and then make
loans in much larger dollar amounts.
- One important function of the financial system is to allocate money to the most
productive investment projects in the economy. If the financial system is working
properly, only projects with high – risk adjusted rates of return are funded, and
those with low rates are rejected.
- Finally, banks are profit – making organizations, and the bank and other lenders
earn much of their profits from the spread between lending and borrowing rates.

From the foregoing discussion, we can see that financial system performs four basic
functions, which are also the functions of finance and financial managers.

a. Fund acquisition – a way of getting deposits and necessary funds to finance

projects and investments
b. Fund allocation – determining to which uses, projects, or investments the acquired
funds will be used
c. Fund distribution – the process by which necessary funds are given to the uses,
projects, or investments that need funds
d. Fund utilization – using the funds for its intended purpose

FINANCIAL SYSTEM PARTICIPANTS

a. Households or consumers
b. Financial institutions / intermediaries
c. Non – financial institutions
d. Government
e. Central Bank
f. Foreign participants
BANGKO SENTRAL NG PILIPINAS AND THE PHILIPPINE FINANCIAL SYSTEM

BSP VISION AND MISSION

Vision

- BSP aims to be a world – class monetary authority and a catalyst for a globally
competitive economy and financial system that delivers a high quality of life for all
Filipinos.

Mission

- BSP is committed to promote and maintain price stability and provide proactive
leadership in bringing about a string financial system conducive to a balanced
and sustainable growth of the economy. Towards this end, it shall conduct sound
monetary policy and effective supervision over financial institutions under its
jurisdiction.

OBJECTIVES OF BSP

BSP, as the central monetary authority of the country, is expected to provide the
country with a safer, more flexible, and more stable and healthy monetary and financial
system conducive to a balanced and sustainable growth of the economy. Towards this
end, it shall conduct sound monetary policy and effective supervision over financial
institutions under its jurisdiction.

1. Maintain monetary policies conducive to a balanced and sustainable growth of the

economy;
2. Maintain price stability in the country;
3. Promote and maintain monetary stability and the convertibility of the peso;
4. Maintain stability of the financial system
5. Provide payment and other financial services to the government, the public, financial
institutions, and foreign official institutions; and
6. Supervise and regulate depository institutions.

To attain its objectives, the monetary and fiscal policies of the country need to be
closely and efficiently coordinated.

The different agencies of the government, both financial and fiscal, need to
cooperate with one another. Moreover, it is important that there would be coordination
and cooperation between the government and the private sectors. These sectors are
partners in nation – building.

FUNCTIONS OF BSP

Being the primary monetary authority, BSP performs the following functions:

1. Bank of Issue
- BSP has the monopoly of printing money bills and minting money coins. This
monopoly is designed to:
a. Ensure the uniformity of design and content of money;
b. Effect government supervision over money supply
c. Give prestige and honor to the central bank; and
d. Become a good source of income for the government.

2. Government’s banker, agent, and adviser

- BSP handles the banking accounts of government agencies and
instrumentalities. All government agencies deposit their funds with BSP. It
provides foreign exchange to the government for the importation of goods and
services and for payment of foreign loans. If funds are not sufficient for the needs
of the country, BSP borrows from international financial institution like the World
Banka and International Monetary Fund.

3. Custodian of the cash reserves of banks

- All banks are regulated to have adequate reserves in proportion to their deposit
liabilities with BSP to ensure availability of cash to depositors who wish to
withdraw deposits. These reserve requirements create the interbank call loans,
 that is, when one bank lacks funds to comply with the reserve requirement of
BSP, it borrows money from other banks’ reserves with BSP for say, overnight.
The interest rate on these interbank call loans is called the reverse repo rate
(RRP), which is the overnight borrowing rate the official interest rate in the
Philippines. In the Philippines, interest rate decisions are taken by the Monetary
Board of the BSP. In case of oversupply of money creating inflation, the legal
reserve requirement is made higher to cut down liquidity or too much money in
circulation. The reserve requirement, say 20%, means that for every peso of
deposit, the bank can only lend 80 centavos because the 20 centavos is
deposited with BSP. The reserves deposited at BSP only earn minimal interest,
unlike the loans granted by the banks to borrowers. This is the reason the banks
do not like high reserve requirement, that is, they are unable to earn more
because the amount from regulating money supply, are able to help the
government in times of financial crises.

4. Custodian of the nation’s reserves of international currency

- The early years of central banking required central banks to maintain minimum
reserve of golds, and later international currency, as a guarantee for its issuance
of currency bills or notes and deposits liabilities (cash reserves of commercial
banks). This is designed to meet problems relevant to balance of payments and
maintaining the external value of the local currency. A central bank must meet its
domestic and international payments to create confidence in the people it serves
and the countries it deals with abroad.

5. Bank of rediscount and lender of last resort

- The rediscounting function of the central bank means the central bank lends
money to banks in distress on the basis of their promissory notes or the
promissory notes of the bank borrowers. When banks grant loans to borrowers,
borrowers execute a promissory note, which the bank discounts. Interest is
immediately deducted from the proceeds of the loans, for example, if the interest
is 200 on a 1,000 loan, the net proceeds that the borrower gets is 1,000 – 200 =
800. The process is known as discounting. These notes are presented by these
banks to obtain a loan from the central bank, that is why it is termed
rediscounting, that is, the discounted notes are again discounted.

6. Banks of central clearance and settlement

- The central bank acts as a sort of clearing house. This means that banks send
representatives to the clearing house at the central bank where claims are demanded
by one bank against another. Banks have their own boxes at the clearing house. All
checks placed in the boxes are payable to banks that cashed them. For example, a
representative of Bank A has the check of Bank B. The representative places the check
of Bank B in the box of Bank B. This means that Bank A demands payments from Bank
B. Through the process of bookkeeping (debits and credits), banks’ claims against other
banks are settled and cleared. These settlements are done through the reserves that all
the banks have with the central bank.

- For checks issued and cashed in Metro Manila, the clearing of checks is conducted by
the Philippine Clearing House Corporation (PCHC). Trusted as a neutral service bureau
of banks, PCHC extended its operating outfit by implementing several electronic –
based payment system services for the banking community such as the Electronic Peso
Clearing System (EPCS), Philippine Domestic Dollar Transfer System (PDDTS), and
Project Abstract Secure System (PASS). Sorting, processing and clearing of checks are
done by computers. Clearing of checks for provincial checks and Metro Manila checks
is done manually at the Manila Clearing / Regional Clearing units of BSP. Cebu, Davao,
and Bacolod have their own clearing units.

7. Controller of Credit

- Controlling money supply requires controlling credit. The higher the money supply in
circulation, the higher the prices of goods and services. Limited supply of money means
lower prices, which do not encourage production. Hence, it is imperative for the central
bank to limit, not only the money supply, but also credit. This is because credit is in
addition to the money supply in circulation. The more credit there is available, the more
production is encouraged because the consumers can also spend more if they are also
able to obtain credit.

BSP can control credit by:

a. Increasing or decreasing interest rates;

b. Increasing or decreasing the legal reserve requirement of banks
c. Regulating the margin requirements of stock exchange securities;
d. Open market operations (buying or selling government securities);
e. Imposing ceilings on total amounts bank can lend;
f. Rationing central bank credit;
g. Restricting imports;
h. Selecting projects for funding; and
i. Mora suasion (i.e., encouraging people and businesses to support and
cooperate with central bank policies and regulations).

MONETARY POLICY AND FINANCIAL SYSTEM

- Monetary policy refers to the manipulation of money supply to affect the economy
of a country as a whole. It largely impacts interest rates. Increases in the money
supply lower short – term interest rates and will encourage investments and
consumption. On the long run, however, an abundance of money supply leads to
increased prices or inflation and is undesirable. This is where BSP plays its role
as the balancer. Generally speaking, expansionary monetary policies and
contractionary monetary policies involve changing the level of the money supply
in a country. Expansionary monetary policy is simply a policy which expands
(increases) the supply of money, whereas contractionary monetary policy
contracts (decreases) the supply of a country’s currency. Money supply is the
total of currency and coins and demand deposits in the economy.

References

 CAPITAL MARKETS author Norma Dy Lopez – Mariano, PHD. (2023)

 [Link]
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 [Link]
MonetaryPolicyReport_May2022.aspx#:~:text=Baseline%20Inflation
%20Projections-,Inflation%20is%20expected%20to%20settle%20above%20the
%20target%20range%20of,the%20previous%20estimate%20of%203.7%25.
 [Link]
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