THE FINANCIAL SYSTEM
A strong financial
system is vitally important—not for wall street, not for bankers, but for
working men and women. When our markets work, people throughout our economy
benefit—men and women seeking to buy a car or buy a home, families borrowing to
pay for college, innovators borrowing on the strength of a good idea for a new
product or technology, and businesses financing investments that create new
jobs. And when our financial system is under stress, millions of working men and
women bear the consequences. Government had a responsibility to make sure our
financial system is regulated effectively. And in this area, we can do a better
job. In sum, the ultimate beneficiaries from improved financial regulation are
men and women workers, families, and businesses-both large and small.
-Henry
M. Paulson, Jr., then Secretary of the U.S. Department of the Treasury, March
31, 2008
Some changes done by Arshad. A
THE FINANCIAL SYSTEM
A financial system makes
possible a more efficient transfer of funds by mitigating the information
asymmetry problem between those with funds to invest and those needing funds.
In addition to the lenders and the borrowers, the financial system has three
components: (1) Financial Markets, where transactions take place; (2) Financial
Intermediaries, who facilitate the transactions; and (3) Regulators of
Financial activities, who try to make sure that everyone is playing fair.
Financial Assets
An Asset is any
resource that we expect to provide future benefits and, hence, has economic
value. We can categorize assets into two types: Tangible Assets and
Intangible Assets. The value of a tangible asset depends on its
physical properties. Buildings, aircraft, land, and machinery are examples of
tangible assets, which we often refer to as Fixed Assets.
An intangible asset
represents a legal claim to some future economic benefit or benefits.
Every financial instrument
as securities, there is a minimum of two parties. The party that has agreed to
make future cash payments is the issuer; the party that owns the financial
instrument and therefore the right to receive the payments made by the issuer
is the investor.
Why do we need
Financial Assets?
Financial assets serve two
principal functions:
1.
They
allow the transference of funds from those entities that have surplus funds to
invest to those who need funds to invest in tangible assets.
2.
They
permit the transference of funds in such a way as to redistribute the unavoidable
risk associated with the tangible assets’ cash flow among those seeking and
those providing the funds.
What is the
Difference between Debt and Equity?
We can classify a
financial instrument by the type of claims that the investor has on the issuer.
A financial instrument in which the issuer agrees to pay the investor interest,
plus repay the amount borrowed, is a debt instrument or, simply, debt. A debt can
be in the form of a note, bond, or loan.
The classification of debt and equity is important for two
legal reasons. First, in the case of a bankruptcy of the issuer, investors in
debt instruments have a priority on the claim on the issuer’s assets over
equity investors. Second, the tax treatment of the payment by the issuer
differs depending on the types of class. Specifically, interest payments made
on debt instrument are tax deductible to the issuer, whereas dividends are not.
The role of Financial
Markets
Investors exchange
financial instruments in a financial market. The more popular term used for the
exchanging of financial instruments is that they are “traded.” Financial
markets provide the following three major economic functions: (1) price discovery,
(2) liquidity, and (3) reduced transaction costs.
Price Discovery means that the interactions of buyers and sellers in a
financial market determine the price of the traded asset. Equivalently, they
determine the required return that participants in a financial market demand in
order to buy a financial instrument. Financial market demand in order to buy a
financial instrument. Financial markets signal how the funds available from
those who want to lend or invest funds are allocated among those needing funds.
This is because the motive for those seeking funds depends on the required
return that investors demand.
Second, financial markets provide a forum for investors to
sell a financial instrument and therefore offer investors liquidity. Liquidity
is the presence of buyers and sellers ready to trade. This is an appealing
feature when circumstance arise that either force or motivate an investor to
sell a financial instrument. Without liquidity, an investor would be compelled
to hold onto a financial instrument until either (1) conditions arise that
allow for the disposal of the financial instrument, or (2) the issuer is
contractually obligated to pay it off. For a debt instrument, that is when it
matures, but for an equity instrument that does not mature—but rather, is a
perpetual security—it is until the company is either voluntarily or
involuntarily liquidated. All financial markets provide some from of liquidity.
However, the degree of liquidity is one of the factors the characterize
different financial markets.
The Third economic
function of a financial market is that it reduces the cost of transacting when
parties want to trade a financial instrument. In general, we can classify the
costs associated with transacting into two types: Search costs and Information
costs
Search costs in turn fall into two categories: explicit
costs and implicit costs. Explicit costs include expenses to advertise one’s
intention to sell or purchase a financial instrument. Implicit costs include
the value of time spent in locating a counterparty—that is, a buyer for a
seller or a seller for a buyer—to the transaction. The presence of some from of
organized financial market reduces search costs.
Information costs are costs associated with assessing a
financial instrument’s investment attributes. In a price-efficient market,
prices reflect the aggregate information collected by all market participants.
The Role of Financial
Intermediaries
The role of financial intermediaries is to create more
favorable transaction terms than could be realized by lenders/investors and
borrowers dealing directly with each other in the financial market. Financial
intermediaries accomplish this in a two-step process:
1.
Obtaining
funds from lenders or inverstors.
2.
Lending
or investing the funds that they borrow to those who need funds.
The funds that a financial
intermediary acquires become, depending on the financial claim, either the debt
of the financial intermediary or equity participants of the financial
intermediary. The funds that a financial intermediary.
Consider two examples using financial intermediaries that
we will elaborate upon further:
Ex.1 A Commercial Bank
A commercial bank is a
type of depository institution. Everyone knows that a bank accepts deposits
from individuals, corporations, and governments. These depositors are the
lenders to the commercial bank. The funds received by the commercial bank
become the liability of the commercial bank. In turn, as explained later, a
bank lends these funds by either making loans or buying securities. The loans
and securities become the assets of the commercial bank.
Ex.2 A Mutual Fund
A mutual fund is one type
of regulated investments company. A mutual fund accepts funds from investors
who in exchange receive mutual fund shares. In turn, the mutual fund invests
those funds in a portfolio of financial instruments. The mutual fund shares
represent an equity interest in the portfolio of financial instrument and the
financial instrument are the assets of the mutual fund.
We now discuss the three economic functions of financial
intermediaries when they transform financial assets.
Maturity
Intermediation
The implications of maturity intermediation for financial
systems are twofold. The first implication is that lenders/investors have more
choices with respect to the maturity for the financial instruments in which
they invest and borrowers have more alternatives for the length of their debt
obligations. The second implication is that because investors are reluctant to
commit funds for a long time, they require long-term borrowers to pay a higher
interest rate than on short-term borrowing. However, a financial intermediary
is willing to make longer-term loan, and at a lower cost to the borrower than
an individual investor would because the financial intermediary can rely on
successive funding sources over a long time period (although at some risk).
Risk Reduction via
Diversification
Diversification is the
reduction in risk from investing in assets whose returns do not move in the
same direction at the same time.
Investors with a small sun to invest would find it
difficult to achieve the same degree of diversification as a mutual fund
because of their lack of sufficient funds to buy shares of a large number of
companies. Yet by investing in the mutual fund for the same dollar investment,
investors can achieve this diversification, thereby reducing risk.
Financial intermediaries
perform the economic function of diversification, transforming more risky
assets into less risky ones.
Reducing the Costs of
Contracting and Information Processing
The opportunity cost of
the time to process the information about the financial asset and its issuer,
we must consider the costs. The costs associated with writing loan agreements
are contracting costs. Another aspect of contracting costs is the cost
of enforcing the terms of the long agreement.
It is clearly cost
effective for financial intermediaries to maintain such staffs because
investing funds is their normal
business. There are economies of scales that financial intermediaries realize
in contracting and processing information about financial assets because of the
amount of funds that they manage. These reduced costs, compared to what
individual investors would have to incur to provide funds to those who need
them, accrue to the benefit of (1)investors who purchase a financial claim of
the financial intermediary; and (2)issuers o financial assets (a result of
lower funding costs).
Regulating Financial
Activities
Although the degree of
regulation varies from country to country, regulation takes one of four forms:
1.
Disclosure
regulation.
2.
Financial
activity regulation.
3.
Regulation
of financial institutions.
4.
Regulation
of foreign participants.
Disclosure
regulation requires that any publicly traded company provide financial
information and nonfinancial information on a timely basis that would be
expected to affect the value of its security to actual and potential investors.
Rules
about traders of securities and trading on financial markets comprise financial
activity regulation. Probably the best example of this type of regulation is
the set of rules prohibiting the trading of a security by those who, because of
their privileged position in a corporation, know more about the issuer’s
economic prospects that the general investing public.
The
regulation of financial institutions is a from of governmental monitoring that
restricts their activities. Such regulation is justified by governments because
of the vital role played by financial institutions in a country’s economy.
Government
regulation of foreign participants involves the imposition of restrictions on
the roles that foreign firms can play in a country’s internal market and the
ownership or control of financial institutions. Although many countries have
this from of regulation, there has been a trend to lessen these restrictions.
§
An
advanced-warning system, which would attempt to identify systemic risks before
they affect the general economy.
§
Increased
transparency in consumer finance, mortgage brokerage, asset-baked securities,
and complex securities.
§
Increased
transparency of credit-rating firms.
§
Enhanced
consumer protections.
§
Increased
regulation of nonbank lenders.
§
Some
measure to address the issue of financial institutions that may be so large
that their financial distress affects the rest of the economy.
Coming up Types of
Financial Markets
This Article is Taken form
The Basic of Finance
Written by Arshad. A
