Financial Institutions - Week 6

Financial System Overview

• The financial system consists of various components:

  • Lenders-Savers

  • Borrowers-Spenders

  • Financial Intermediaries

  • Financial Markets

  • Regulators

Financial Institutions

• Organizations or intermediaries that facilitate the transfer of funds from savers to borrowers, including:

  • Banks: Accept deposits and make loans.

  • Other Financial Institutions:

    • Insurance companies

    • Finance companies

    • Pension funds

    • Mutual funds and investment companies

  • Financial Markets: Physical and electronic spaces for fund transactions.

Functions of the Financial System

MONETARY

• Creating Money: Essential for a functioning monetary system.

• Transferring Money: Facilitates movement of funds to where they are needed.

  FI

• Accumulating& Investing Savings: Financial institutions play a key role in saving processes.

  FM

• Marketing Financial Assets: Helps in the promotion of financial instruments.

• Transferring Financial Assets: Enhances liquidity and marketability of financial products.

Money and Monetary Policy

• Definition of Money: Acceptable payment medium for goods and services.

• Role in Business Cycles: Influences economic expansions and recessions.

• Monetary Theory: Links changes in the money supply to economic activity levels.

Money and Inflation

• Aggregate Price Level: Average price for goods and services.

• Inflation Impact: A perpetual rise affects all economic players.

• Correlation: Higher money supply growth leads to higher inflation.

Fiscal Policy vs. Monetary Policy

• Monetary Policy: Handled by central banks to manage money supply and interest rates.

• Fiscal Policy: Government spending and taxation strategies.

• Budgetary Terms:

  • Budget Deficit: Expenditures exceed revenues.

  • Budget Surplus: Revenues exceed expenditures.

External Financing Patterns

• Financing Sources:

  • Stocks are less significant for external business financing.

  • Indirect finance through intermediaries overshadows direct financing methods.

  • Banks: The main external fund source for businesses.

Transaction Costs and Financial Structure

• High transaction costs can limit investment opportunities.

• Financial intermediaries mitigate costs by leveraging economies of scale.

Functions of Financial Intermediaries

• Cost Reduction: Lower transactional expenses for lending.

• Liquidity Services: Offer checking and savings accounts for easy access to funds.

• Risk Management: Provide diversification and risk-sharing opportunities.

• Asymmetric Information Solutions:

  • Adverse Selection: Screening untrustworthy borrowers.

  • Moral Hazard: Monitoring borrower behavior post-loan.

Adverse Selection

• Definition: Issues arise from hidden information impacting loan decisions.

• Lemon Problem: Poor quality assets may lead to market inefficiencies if not distinguishable from high-quality ones.

Moral Hazard

• Definition: Borrower may take risks post-lending, jeopardizing loan repayment.

• Principal-Agent Problem: Differences in objectives between shareholders and managers resulting in suboptimal decisions.

Regulatory Framework

• Purpose of Regulation:

  • Enhance investor information access

  • Maintain financial intermediary soundness

  • Combat insider trading

Key Regulatory Agencies in the US

• Securities and Exchange Commission (SEC): Oversees exchanges, enforces disclosure requirements.

• Federal Reserve System: Central bank managing monetary policy and overseeing banks.

• Federal Deposit Insurance Corporation (FDIC): Guarantees deposits in banks and thrift institutions.

• Commodities Futures Trading Commission (CFTC): Regulates futures markets.