Week 1 The Modern Financial System

What is the purpose of the financial system?

To transfer funds from surplus units (lenders) to deficit units (borrowers), enabling investment and economic activity.

Who are surplus units?

Economic agents with excess funds available to lend, such as households, corporations, government agencies, multinational companies, and financial institutions.

Who are deficit units?

Economic agents requiring funds, typically corporations, governments, municipalities, households, and financial institutions.

What is direct financing?

The transfer of funds directly from surplus units to deficit units through financial markets.

What is indirect financing?

The transfer of funds through financial intermediaries such as banks, insurance companies, and pension funds.

What is a financial asset?

A claim to future payments of money, such as deposits, bonds, shares, loans, and insurance policies.

Why do financial assets involve risk?

Because payments are expected in the future and may not be received as promised.

What is a financial liability?

The obligation of an issuer to make promised future payments on a financial claim.

What three main characteristics do lenders seek?

Safety, liquidity, and high returns.

What is liquidity?

The ease of converting a financial claim into cash quickly and without significant loss of value.

What do borrowers typically want?

Long-term funding at the lowest possible cost.

Why is there a conflict between lenders and borrowers?

Lenders prefer short-term, liquid, low-risk investments, whereas borrowers prefer long-term, low-cost funding.

Why do lenders demand higher returns?

To compensate for the risks they bear.

What are financial markets?

Markets that facilitate the transfer of funds between lenders and borrowers, including equity, bond, and derivatives markets.

What are depository institutions?

Institutions that accept deposits from surplus units and provide credit to deficit units through loans and asset purchases.

What are non-depository institutions?

Institutions that obtain funds from sources other than deposits, such as insurance companies, pension funds, mutual funds, and finance companies.

Give three examples of depository institutions.

Commercial banks, savings institutions, and credit unions.

Why are financial institutions regulated?

To protect the financial system from disruption and minimise economic and social costs.

What is the role of central banks?

To oversee the financial system from a macroeconomic perspective, primarily through monetary policy.

What is the difference between regulators and supervisors?

Regulators create rules, while supervisors monitor compliance and institutional soundness.

What four important components have become more significant in recent decades?

Credit rating agencies, OTC markets, shadow banking, and fintech/crypto sectors.

What is shadow banking?

Financial activities occurring outside the traditional banking sector but performing similar functions.

Why are fintech and shadow banking important?

They provide financial services while often operating partially outside traditional regulation.

What is systemic risk?

The spread of financial problems across institutions and markets that can threaten the entire financial system.

Why was the 2007-2008 financial crisis considered systemic?

Because it affected the whole financial system and spread into the real economy.

What caused the 2007-2008 financial crisis according to the lecture?

US sub-prime mortgages and the global spread of mortgage-backed securities.

What is the brokerage function of financial intermediaries?

Matching transactors and reducing transaction and information costs.

What is the asset transformation function?

Creating claims that are more attractive to savers than those issued directly by borrowers.

What are the five major roles of financial intermediaries?

Pooling savings, providing payment services, supplying liquidity, diversifying risk, and reducing information costs.

How do banks pool savings?

By combining many small deposits and using them to make large loans.

What must banks do to successfully pool savings?

Attract many savers and convince them of the bank's soundness.

What is a payment system?

A network that enables the transfer of funds and exchange of goods, services, and assets.

Why are efficient payment systems important?

They increase reliability and reduce transaction costs throughout the economy.

Name two modern competitors to banks in payment services.

PayPal and Apple Pay.

How do banks provide liquidity?

By holding sufficient liquid assets while lending out the remainder of deposited funds.

How do financial institutions reduce risk?

Through diversification across many loans and investments.

Why does diversification reduce risk?

Because losses on individual investments have a smaller impact on a large portfolio.

What is information asymmetry?

A situation where one party possesses more information than another.

In lending, who usually has more information?

The borrower.

How do financial institutions reduce information asymmetry?

By collecting, processing, and standardising information about borrowers.

Why can financial institutions gather information more cheaply than individuals?

Because they benefit from economies of scale.

Explain why information asymmetry creates a role for financial intermediaries.

Financial institutions have expertise and economies of scale that allow them to gather and process borrower information more efficiently than individual lenders.