Revision 1

Surplus units (as lenders) - economic agents in excess of funds

Deficit Units (as borrowers) - economic agents in deficit of funds typically corporations, governments

A financial assets - is a claim for a payment of future sum of money and or periodic payment of future sum of money.

A financial claim carries an obligation on the issuer to pay interest periodically and to redeem the claim at a stated value.

Non intermediated financing is when surplus units(Lenders) and deficit units(borrowers) meet informally to arrange a transaction without the intermediation of financial institutions or financial markets

Surplus units(Lenders) requirements

• Look to minimise risk

• Minimise cost

• look for Liquidity

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

Deficit unit (borrowers) requirements

Look for liabilities with low cost and longer periods

• Want funds at a specific date

• Want funds at a Specific time

• Funds at the lowest cost

Who Bridge the gap between Borrowers and Lenders?

Financial Markets - facilitate the transfer of funds from surplus units to deficit units. Examples - equity Markets, bond markets, derivatives markets

Depositary institutions - accept deposits from surplus units and provide credit to deficit units through loans and purchase of assets. Examples include commercial banks, saving institutions, Credit unions

Non-depositary institutions - generate funds from sources other than deposits, Include finance companies, mutual funds, securities firms, insurance companies and pension funds.

Who else participates in the system?

Government and central banks - FI are highly regulated to protect the system against a disruption in the provision of the financial services.

Central banks through the monetary policy oversight the financial system, from a macro perspective.

Regulators and Supervisors - the former defines the set of rules FI comply with and the latter monitors the actual compliance with these rules

Why is it a system?

Systemic risk is the spread of financial problems, among financial institutions and across financial markets, that could cause a collapse in the financial market.

Functions of financial intermediatiaries

• The brokerage function - financial intermediaries match transactors, provide transactions and other services. As a result they reduce transaction costs and remove information costs

• The asset transformation function - financial institutions issue claims that are far more attractive to savers (in terms of monitoring costs, lower liquidity costs and lower price risk) than claims issued directly by corporations

Role of financial intermediaries

• Pooling the resources of small savers

• Providing safekeeping and accounting services, aswell 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

Collecting and processing information

Since the borrower knows better about its own quality, while the

lender faces substantial costs to obtain that information, there is an

information asymmetry problem.

By collecting intermediaries and processing standardized information, financial reduce the problems that information asymmetries

create.

The relatively large size of the FI allows the collection of information to

be accomplished at a lower average cost (economies of scale) than it

would be for individuals.