Unit II: Financial
System
CHAPTER 5
Overview of
the Financial
Sytem Prepared by:
Aranas, Glyka Cristlefaith
Veranio, Jee Clyde
What is a Financial
System?
A financial system is a system that
allows the exchange of funds between
financial market participants.
The financial system is complex in
structure and functions throughout
the world. A developed country relies
on financial market institutions for
transfer of funds.
Nature and Objective
of the Financial
System
The Financial system
The flow of funds
consists of all financial
intermediaries and through the
financial markets and financial system
their relations with can be either
respect to the flow of Indirect Finance
funds to and from or Direct Finance
various sources.
Flow of Funds through the Financial System
Indirect Finance
Financial
Fund Fund
Intermediaries
s s
Fund
Lenders-Savers s Borrowers-
1. Households
Fund Fund
Spenders
2. Business- s s 1. Business Firms
Firms
Financial
2. Government
3. Government Markets 3. Households
4. Foreigners 4. Foreigners
Direct Finance
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.
Economist believe there are three key services
that the financial system provides to savers
and borrowers which are:
a. Risk Sharing
b. Liquidity
Functions of the Financial
System
Risk Sharing - The financial system provides
risk sharing by allowing savers to hold many
assets. It makes savers more willing to buy
stocks, bonds, and other financial assets.
Liquidity - Assets created by the financial
system such as stocks, bonds, or checking
accounts are more liquid than physical
assets.
Functions of the Financial
System
Information - The financial system provides
facts about borrowers and expectations of
returns on financial assets. Financial markets
convey information to both savers and
borrowers by determining the prices of stocks
and other securities to help them in decision-
making.
The Problems of Adverse Selection And
Moral Hazard
Why Savers and Borrowers Need Transparency ?
• Savers want to lend money to those who can repay.
• Borrowers with poor financial health may hide the truth
about their situation.
• Financial systems play a vital role by sharing information
and setting fair prices.
What is Asymmetric
Information?
Asymmetric information:
• When one party has more or better knowledge than the
other.
In finance:
• Borrowers know more about their financial situation than
lenders.
Problems Caused by
Asymmetric Information
1. Adverse Selection:
- Happens before a financial deal. - “Before the Deal”
Example: A risky borrower pretending to be safe. (Adverse Selection)
2. Moral Hazard:
- Happens after the deal.
Example: A borrower misusing funds.
“After the Deal”
(Moral Hazard)
Adverse Selection – Before the
Deal
The Risk of Choosing Poor Borrowers
- Borrowers with high risks (e.g., failing
businesses) are often the most eager
to borrow.
- Lenders face challenges:
• Limited time and resources to
investigate every borrower.
• Individuals can't benefit from
economies of scale like big
financial institutions.
Moral Hazard – After the Deal
When Borrowers Misuse Funds
-Even if a borrower seems trustworthy,
risks remain:
• The borrower might not use funds
as promised.
• Lenders struggle to monitor
borrower behavior after the loan is
given.
NATURE AND IMPACT OF TRANSACTION AND
INFORMATION COST
Barriers to Efficient Lending and Borrowing
1. Transaction Costs:
- Costs to complete financial trades (e.g., brokerage fees).
2. Information Costs:
- Costs for lenders to check borrower creditworthiness. - Costs
to ensure borrowers are using funds properly.
How Financial Intermediaries Reduce
"Adverse Selection"
Minimizing Adverse Selection
1. Requiring Borrowers to Disclose Financial Information:
- Borrowers must provide financial performance data, including:
• Balance Sheets: Showing assets, liabilities, and stockholders' equity.
• Income Statements: Detailing revenue, costs, and profit.
2. Collecting and Selling Information:
• Financial intermediaries gather data about firms and sell it to investors.
• This helps investors make informed decisions about potential borrowers.
3. Requiring Collateral:
• Borrowers must pledge assets as collateral.
• If a borrower defaults, the lender can claim the collateral to minimize losses.
How Financial Intermediaries Reduce
"Moral Hazard
Managing Moral Hazard
1. Specialized Monitoring:
• Banks and other intermediaries monitor borrowers closely.
• They develop techniques to ensure funds are used as intended.
2. Imposing Restrictive Covenants:
-Contracts include specific rules for borrowers, such as:
• Limiting Fund Usage: Borrowed funds can only be used for approved purposes.
• Early Repayment Triggers: Borrowers must repay loans early if their financial health
declines (e.g., net worth drops below a certain level).
How Financial Intermediaries Reduce
Transaction Costs
1. Reducing Costs Through Large Volumes ( Economies of Scale)
• Pooling Resources: - They process large transactions, lowering costs per
transaction.
• Standardized Contracts: - Reuse of loan contracts spreads costs over many
borrowers.
2. Faster and Cheaper Processing (Specialization)
• Expert Staff: - Loan officers specialize in loans, making processing quicker and
cheaper.
• Lower Costs: - Efficiency reduces expenses for both banks and borrowers.
How Financial Intermediaries Reduce
Transaction Costs
3. Using Tools to Cut Costs (Advance Technology)
• ATMs: - Offer 24/7 service, reducing the need for branches and staff.
• Software: - Quickly checks borrower credit and processes applications.
4. Using Software for Better Decisions ( Credit Evaluation)
• Sophisticated Tools: - Financial intermediaries use advanced software to evaluate
borrowers.
• Faster Decisions: - Automation reduces time and costs for credit checks.
Thank You