Zoubida SAMLAL - MBA , CFA
Member, PHD candidate for HBS program
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The financial system is the process by which money flows from savers to users.

Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.

BASIC COMPONENTS OF THE FINANCIAL
SYSTEM: MARKETS AND INSTITUTIONS
• Financial markets are markets for financial
instruments, also called financial claims or securities.
• Financial institutions (also called financial
intermediaries) facilitate flows of funds from savers to borrowers.
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• Financial System
– Savers
– Users
– Financial Institutions
– Financial Markets
• Savings is a function of many variables.
• Funds can be transferred between users and savers directly or indirectly.

• Securities
– Financial instruments
– Obligations on the part of the issuer
• Businesses and Governments
– Provide rate of return to purchasers
• Money Market Instruments
• Bonds
• Stock

• Short-term Debt Securities
– Issued by governments, financial institutions and corporations
• Investors are paid interest for the use of their funds.
• Generally low-risk
• U.S. Treasury bills, commercial paper, and bank certificates of deposit

• Government Bonds
– Bonds sold by the U.S. Department of the
Treasury.
• Municipal Bonds
– Bonds issued by state or local governments
• Revenue bonds are used toward a project that will produce revenue

• Price is determined by risk and interest rate.
• Several firms rate bonds
– Standard & Poor’s (S&P)
– Moody’s
• Investment-grade
• Speculative/Junk

• Common stock – ownership claims in corporations.
– Vote on major company decisions
– Cash dividends
– Price appreciation
• Preferred stock – stockholders with preference in the payment of dividends.

Stockholder has the right to exchange the bond or preferred stock for a fixed number of shares of common stock.

• Primary Market – firms and governments issue securities and sell them initially to the public.
– When a firm offers a stock for sale to the general public for the first time.
• Secondary Market – collection of financial markets in which previously issued securities are traded among investors.

Stock market (exchange) – market in which common stocks are traded, such as the New York
Stock Exchange.

 Commercial Banks
 Savings Banks and Credit Unions
 Non-depository Institutions

 Insurance Companies
 Pension Funds
 Finance Companies

INTERMEDIARIES PERFORM 5 BASIC
SERVICES AS THEY TRANSFORM CLAIMS.
• Denomination Divisibility – pool savings of many small SSUs into large investments.
• Currency Transformation – buy and sell financial claims denominated in various currencies.
• Maturity Flexibility – Offer different ranges of maturities to both DSUs and SSUs.

INTERMEDIATION SERVICES, CONT.
• Credit Risk Diversification – Assume credit risks of DSUs; spread risk over many different types of
DSUs.
• Liquidity – Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.

FUNCTION OF FINANCIAL MARKETS
1. Allows transfers of funds from person or business without investment opportunities to one who has them
2. Improves economic efficiency

• Allocational Efficiency: highest/best use of funds
– DSUs try to fund projects with best cost/benefit ratios
– SSUs try to invest for best possible return for given maturity and risk
• Informational Efficiency: prices reflect relevant information
– Informationally efficient markets reprice quickly on new information;
– informationally inefficient markets offer opportunities to buy “underpriced” assets or sell “overpriced” assets
• Operational Efficiency: transactions costs minimized

• Credit or default risk : risk that a DSU may not pay as agreed
• Interest rate risk: fluctuations in a security's price or reinvestment income caused by changes in market interest rates
• Liquidity risk: risk that a financial institution may be unable to disburse required cash outflows, even if essentially profitable

• Foreign exchange risk: effect of exchange rate fluctuations on profit of financial institution
• Political risk : risk of government or regulatory action harmful to interests of financial institution.

Two Main Reasons for Regulation
1. Increase information to investors
A. Decreases adverse selection and moral hazard problems
B. Securities commissions force corporations to disclose information
2. Ensuring the soundness of financial intermediaries
A. Prevents financial panics
B. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anticompetitive measures