2. Financial Institutions

What are Financial Markets

Any system or platform that brings buyers and sellers together to trade financial assets

What are surplus units

An economic entity that generates more income/revenue than it spends over a given period leaving it with excess funds to save, invest or lend

Savers and Lenders

What are deficit units

An economic entity whose expenditure exceeds its income/revenue over a given period, requiring it to borrow money or issue securities

Borrowers

What is direct financing

Where deficit units (borrowers) obtain funds directly from surplus units (lenders and investors) in the financial market without using a traditional financial intermediary such as a commercial bank

Examples of direct financing

Stock markets and bond markets

What is indirect financing

Where funds flow from deficit units (borrowers) to surplus units (savers) through a financial intermediary such as a bank, mutual fund etc.

Examples of financial intermediaries

Banks

Finance Companies

Mutual Funds

Insurance Companies

Pension Funds

What is a financial asset

A claim to receive money in the future, either as a one off payment or as a series of payments

What is a financial claim

An obligation for the issuer to pay interest regularly and repay the original amount at an agreed time

e.g. IOU

What is a financial liability

An obligation to pay money or another financial asset to another party in the future

Cons of Direct Financing

Search Costs (Time and Money)

Information Gap - borrowers know more about their reliability to pay back than the lenders do

Different Requirements

Why do financial intermediaries and indirect financing exist

Due to the differences in requirements between lenders and borrowers

Generally the requirements between lenders and borrowers are in contrast

What are the requirements of savers

Minimisation of Risk

Minimisation of Cost

Liquidity (ease of converting a financial claim into cash without loss of capital value and in a short period of time)

Invest/Hold financial assets for a short period of time and for the highest possible return

What are the requirements of borrowers

Funds at a particular specified date

Funds for a specific period of time

Funds at the lowest possible cost

Prefer to hold financial liabilities for a long period of time and for the lowest possible costs

What are the two main functions of financial intermediaries

The brokerage function

The Asset Transformation function

What is the brokerage function

Financial Intermediaries match transactors, provide transactions and other services. Hence, they reduce transaction costs and remove information costs

What is the asset transformation function

The process by which financial intermediaries transform the financial assets of savers into assets that meet the needs of borrows

e.g. taking deposits from savers and using them to provide long term loans to borrowers

Roles of financial intermediaries

Pooling the resources of small savers

Providing safekeeping and accounting services, as well as access to payment system

Supplying liquidity by converting savers’ balances directly into a means of payment whenever needed

Providing ways to diversify risk

Collecting and processing information in ways that reduce information costs.