Economic Functions of the Financial Institutions
The Financial System
 The financial system is the collection of markets, institutions, regulations, and techniques
through which bonds, stocks, and other securities are traded, interest rates are determined,
and financial services are produced and delivered around the world.
 The financial system is the mechanism through which loanable funds reach borrowers.
Financial Assets
 A financial asset is …
 A claim against the income or wealth of a business firm, household, or unit of
government,
 Represented usually by a certificate, receipt, computer record file, or other legal
document,
 And usually created by or related to the lending of money.
 Characteristics of Financial Assets
 Financial assets are sought after because they promise future returns to their owners
and serve as a store of value (purchasing power).
 They do not depreciate like physical goods, and their physical condition or form is
usually not relevant in determining their market value.
 Their cost of transportation and storage is low, such that they have little or no value
as a commodity.
 Financial assets can easily be changed in form and substituted for other assets.
 Different Kinds of Financial Assets
 Money: any financial asset that is generally accepted in payment for the purchases of
goods and services. Examples include currency and checking accounts.
 Equities: represent ownership shares in a business firm and are claims against the
firm’s profits and proceeds from the sale of its assets. Common stock and preferred
stock are equities.
 Debt securities: entitle their holders to a priority claim over the holders of equities to
the assets and income of an economic unit. They are either negotiable or
nonnegotiable. Examples include bonds, notes, accounts payable, and savings
deposits.
 Derivatives: have a market value that is tied to or influenced by the value or return
on a financial asset. Examples include futures contracts, options, and swaps.
 The Creation Process for Financial Assets
 To acquire assets, households and business firms may use current income and
accumulated savings – internal financing.
 An economic unit may also raise funds by issuing financial liabilities (debt) or stock
(equities), provided that a buyer can be found – external financing.
 The act of borrowing or of issuing new stock simultaneously gives rise to the creation
of an equal volume of financial assets.
 For example, a $10,000 financial asset held by a household that had lent money
will be exactly matched by a $10,000 liability of the business firm that had
borrowed the money.
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
Volume of financial assets created for lenders
= Volume of liabilities issued by borrowers
 For the balance sheet of any economic unit,
Total assets = Total liabilities + Net worth
where assets = real assets + financial assets
 For the whole economy and financial system,
Total financial assets = Total liabilities
 So, for the economy as a whole,
Total real assets = Total net worth
Intermediation and Direct Financial Investment
 Direct financial investment occurs when lenders supply funds to ultimate borrowers,
with the assistance of brokers or investment bankers
 Indirect financial investment supplies funds to financial institutions, which issue
secondary securities in return
 Primary securities
 Second securities
 Intermediation occurs when institutions transform secondary securities into primary
securities through direct investments
Benefits of Financial Intermediation
 Search Costs
 Financial institutions provide ways to identify entities with excess funds and those
needing funds, and eliminate the need for individual lenders and borrowers to find
one another
 Portfolio Selection Costs
 Investors wish to invest in financial assets in different dollar amounts, with
different maturities, or with different risk levels
 Financial institutions issue secondary securities to lenders, and then repackage
funds in forms attractive to borrowers
 Monitoring Costs
 Asymmetric information exists when managers have one set of information and
investors have a different set of information
 Information asymmetry gives rise to monitoring costs - ongoing expenses
incurred by investors to gather information so they can intervene if borrowers’
financial situations change
 Financial institutions provide economies of scale in monitoring, thereby reducing
lenders’ monitoring costs
 Risk Management Costs
 Investors can avoid the risk inherent in a single claim against a party who may fail
to meet its obligations by holding shares in a mutual fund
 Insurance companies can pool premiums and provide risk management services at
much lower cost
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 Maturity Intermediation and Liquidity
 Banks accept small amounts from small investors as deposits and transform them
into longer-term loans
 Bank customers can write checks backed by the bank and do not have to carry
cash. They can also use a credit card or have funds electronically wired. These
services increase the economy’s liquidity
Types of Financial Institutions
 Although all financial institutions hold predominantly financial assets and low
percentages of fixed assets, they specialize in varying types of financial assets and
services
 The major types are depository, finance, contractual, investment, and securities firms.
 Depository institutions are financial institutions that take deposits and make loans
including commercial banks, savings institutions, and credit unions
 Finance companies specialize in loans to businesses and consumers. They acquire
funds by selling commercial paper and bonds and by borrowing from commercial
banks
 Insurance companies and pension funds are called contractual savings
institutions.They operate under formal agreements with policyholders or
pensioners who entrust their funds to these firms
 Investment companies include mutual funds, money market funds, and REITs.
Small savers can pool funds to invest in a variety of financial instruments.
Economies of scale offer the benefits of professional management, reduced costs,
and reduced risk exposure within large, diversified portfolios
 Securities firms assist customers with purchasing and selling stocks, bonds, and
other financial assets
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