chapter 2
An Overview
of the Financial System
Function of Financial Markets
Indirect Finance
Financial
Intermediaries
Lenders-Savers (+)
• Households
• Firms
• Government
• Foreigners
Financial
Markets
Direct Finance
Borrowers-Spenders (-)
• Business-Firms
• Government
• Households
• Foreigners
Function of Financial Markets
Financial markets perform the function of channeling funds from
people with a surplus of funds (savers-lenders) to people with a
shortage of funds (borrowers-spenders).
 In other words, lenders finance spending by borrowers.
The finance process can be either direct or indirect:
Direct finance: borrowers borrow from lenders through
financial markets by selling securities (financial instruments),
which are defined as claims on the borrower's future income or
assets. Example:
Indirect finance: borrowers borrow through financial
intermediaries (e.g. banks) who receive funds from savers and
lend them to borrowers. Example:

Why the channeling of funds is important to the
economy?
 Savers not necessarily have investment projects.
 In the absence of financial markets, it is difficult
for savers and borrowers to meet.
 With financial markets both benefit, the saver and
the borrower.
 As a result, the whole economy is better off as
more income is generated and more output is
produced.
 Thus financial markets promote economic
efficiency.
Structure of Financial Markets
1. Debt and Equity Markets

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Firms and individuals can obtain funds in a financial market in
two ways:
A. Issue a debt instrument (e.g. bond) by which the borrower
pays the holder of the instrument specified amounts in the
future.
Debt instruments are defined by their maturity as follows:
Short term Instruments: instruments that mature in 3 to 12
months.
Long term Instruments: Instruments that mature in more
than one year.
B. Issue equities (e.g. common stocks), which are claims to share
in the net income and assets of a business.


The owner of the equity receives dividends (fraction of profits)
at specified periods plus receiving part of the business assets if
it goes bankrupt.
Disadvantage: equity holder is a residual claimant (i.e. is paid
whatever lefts paying debt holders)
2. Primary and Secondary Markets
 A primary market is a financial market in which
new issues of a security (e.g. bond, stock) are sold
to initial buyers.
 A secondary market is a financial market in
which securities that have been previously issued
are resold.
 Secondary markets serve two functions:
A. They make financial instruments more liquid.
B. They determine the price of the security
(through supply and demand).
3. Exchanges and Over the Counter Markets
Secondary markets can be organized in two ways:
Exchanges: Trades are conducted in central
locations where sellers and buyers (or their agents
or brokers) meet.
Over-the-Counter Markets: Dealers at different
locations, connected by computers, buy and sell
securities.
4. Money and Capital Markets

Another way of distinguishing between markets is on the
basis of the maturity of the securities traded in each
market.
Money Market: Financial market in which only shortterm debt instruments are traded.
Example: Treasury Bills, Commercial Papers.
Capital Market: Financial market in which longer-term
debt and equity instruments are traded.
Example: Government Bonds, Corporate Bonds, Stocks.
Money and Capital market Instruments
Money market
Instruments
Government
Companies
Capital market
Instruments
Function of Financial Intermediaries
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Funds move through financial intermediaries (FIs) as
they acquire funds from Savers and use them to make
loans to Borrowers.
They do so for three reasons:
A. Transaction Costs:
Definition: time and money spent on financial
transactions.
It can be reduced by (FIs) through experience and
their large size which allows them to take advantage
of economies of scale.
B. Risk Sharing
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Financial intermediaries reduce exposure of investors
to risk (uncertainty about the returns on assets)
through risk sharing (selling assets with low risk, then
use the funds to purchase other assets with higher
risk).
Low transaction costs enable (FIs) to do risk sharing at
low cost, allowing them to earn profit on the spread
between the returns of the low and high risk assets
(also called asset transformation).
FIs also help individuals in diversifying their assets
and therefore lowering their exposure to risk by
creating portfolios.
C. Asymmetric Information (or inequality):

Definition: One party to a financial transaction (e.g.
borrower) knows more about the risk and return of the
transaction than the other party (e.g. lender).

This leads to two problems:
1. Adverse Selection: a problem created by asymmetric
information occurs before the transaction takes place. It
leads to undesirable outcome (e.g. bad borrowers selected).
2. Moral Hazard: a problem created by asymmetric
information occurs after the transaction takes place (e.g.
borrowers take actions undesirable by lenders).
Financial Intermediaries
A. Depository Institutions:

Take deposits and make loans. They include:
1. Commercial Banks: take deposits to use them in making
loans and buying bonds.
2. Saving and Loan Associations: take deposits and make
mortgage loans.
3. Mutual Saving Banks: similar to (S&Ls) but differ by
being owned by their depositors.
4. Credit Unions: very small cooperatives organized by a
group (union members, etc).
Take deposits (called shares) to make consumer and mortgage
loans.
B. Contractual Savings Institutions:

Acquire funds at periodic intervals on contractual basis.
1. Life Insurance Companies:
Insure against financial hazards.
They acquire funds from premiums and use them to buy
corporate bonds and stocks.
2. Fire and Casualty Insurance Companies:
Insure against loss and damage of property.
They acquire funds from premiums and use them to buy liquid
assets.
3. Pension Funds And Government Retirement Funds:
Acquire funds from employees and employers and use them to
pay retirement incomes.
C. Investment Intermediaries:
1. Finance Companies:
Acquire funds by selling commercial papers and issuing stocks
and bonds then lend them to consumers and small businesses.
2. Mutual Funds:
Acquire funds by selling shares and use them to buy
diversified portfolios of stocks and bonds.
3. Money Market Mutual Funds:
Similar to mutual funds and depository institutions because
they offer deposit-type accounts. Acquire funds by selling
shares to use them in buying money market instruments.
Then, pay shareholders interest on assets.
Size of Financial Intermediaries
Regulation of the Financial System
For two main reasons:
1.Increasing information available to investors to lower the
problem of asymmetric information in financial markets to
increase their efficiency.
2.Ensuring the soundness of (FIs) to prevent financial panics
caused by asymmetric information problem through:
A. Restrictions on entry
B. Disclosure
C. Restrictions on assets and activities
D. Deposit insurance
E. Limits on competition
F. Restrictions on interest rates
Regulatory
Agencies