What Is the Financial System?
The financial system is the set of institutions, markets,
instruments and rules that helps funds move from those with
surplus funds to those who need funds.
Savers Income > spending→ Financial system
markets + institutions→ Borrowers
spending/investment > current
funds
*The financial system connects savings
with productive use.*
The Participants of the Financial System
Savers / Lenders
• Have funds available now
• Supply funds to the
system
• Expect repayment,
income or ownership return
Financial Markets
• Places or systems
where securities are
issued and traded*
• Examples: bond
market, stock market, money market
Borrowers / Spenders
• Need funds now
• Seek funds to finance
spending or investment
Intermediaries
• Stand between savers and
borrowers – “go-betweens”
• Examples: banks, credit
unions, insurance firms, Mutual funds
Explanation of key terms
Issued
A security is created and sold
for the first time.
Traded
An existing security is bought
and sold after it has already
been issued.
How Can Company A Finance Its Investment?
Company A has a profitable investment opportunity but
needs additional funds to finance it.
Internal finance
• Retained earnings
• Existing cash reserves
External finance
• Additional funds contributed by the owners
• Borrowing from a financial institution
• Raising funds through financial markets by issuing securities
An Institutional Overview of the Financial System
• Markets and instruments:
• stock markets, bond markets, money markets, foreign exchange
markets and derivatives markets.
• Financial intermediaries:
• banks, credit unions, insurance companies, pension funds, mutual
funds, finance companies, investment banks and venture capital
funds.
• Information providers:
• credit-rating agencies, auditors, analysts, financial media and data
providers.
• Public institutions and regulators:
• central banks, financial regulators, governments, legal systems and
international organisations.
• Users of the system:
• households, firms, governments and foreign participants.
Direct Financing/ Lending
Direct finance occurs when borrowers raise funds directly from
from savers or investors by issuing securities such as bonds or
shares
How it works
• The investor provides funds
directly to the borrower.
• In return, the investor receives
a security, such as a bond or
share.
• A bond gives the investor the
right to receive agreed interest
and repayment, while a share
represents an ownership
interest in the company.
Indirect Financing/ Lending
Indirect finance occurs when a financial intermediary stands
between savers and borrowers
Indirect finance/financial
intermediation
• Savers provide funds to the
intermediary.
• The intermediary pools funds
from many savers.
• It then makes loans or
investments.
• The saver holds a claim against
the intermediary, not directly
against the ultimate borrower.
Example:
*You deposit $2,000 in a
bank. The bank combines
your deposit with other
deposits and makes a
$200,000 business loan.
Saver → Bank → Business*
Why Do We Need a Financial System?
The fundamental role of the financial system is to move financial
resources from those with surplus funds to those who can use
funds for consumption and productive investment.
A well-functioning financial system
helps to:
• mobilise savings;
• finance productive investment;
• facilitate payments and economic
exchange;
• manage and share financial risks;
• provide information for decision-making;
• reduce some problems involved in lending and investing
The Financial System Performs Several Important Functions
1. Clearing and settling payments
Allows money and financial assets to move efficiently between parties.
2. Pooling resources
Combines relatively small amounts of savings into larger pools of funds.
3. Transferring resources
Moves financial resources across time, individuals, businesses, industries
and geographical areas.
4. Managing risk
Allows financial risks to be shared, transferred and diversified.
5. Providing information
Produces prices and interest rates that help households, firms and
investors make decisions.
6. Dealing with information and incentive problems
Helps reduce problems arising because the parties to financial
transactions may not possess the same information or have identical
incentives.
Function 1: Clearing and Settling Payments
A financial system provides the arrangements needed to make,
process
When you pay with a debit card, the payment
system authorises the transaction, processes it
and transfers funds from your account to the
merchant.
Function 2: Pooling Resources
Pooling occurs when the financial system combines relatively small
amounts of savings from many individuals or institutions into larger
pools of funds.
Simple numerical example:
1,000 savers × $1,000 each = $1 million available for
investment
Function 3: Transferring Resources
The financial system transfers economic resources across time,
between savers and borrowers, among sectors and across
geographical areas.
Example:
*A mortgage allows a household to purchase a home now and repay over many years.*
Function 4: Managing Risk
Financial decisions involve uncertainty. The financial system
provides mechanisms for individuals and businesses to transfer, share and reduce financial risks. It
Key principle
*Do not put all financial risk in one place*
Function 5: Providing Information
Financial markets and institutions generate information that helps
households, businesses, governments and investors make financial
Interest rates
Example:
*If mortgage rates rise sharply, some households may
postpone buying a home. If borrowing becomes
expensive, a business may postpone building a new
factory.*
Financial asset prices
Example:
*An overvalued company may attract more investment than its
underlying performance justifies while a good company that
is undervalued may find it more difficult to attract finance.*
Function 6: Information and Incentive Problems
Financial transactions often involve situations in which one party
knows more than the other or where the interests of the parties are
not fully aligned.
Some Key Concepts: Surplus and Deficit Units
Surplus units / savers
• Have income or funds greater than
current spending needs.
• Supply funds to the financial system.
• May receive interest, dividends, capital
gains or other returns.
Deficit units / borrowers
• Need more funds than they currently
have.
• Demand credit or investment capital.
• May include households, firms,
governments and foreign borrowers.
Simple rule
Income > spending → potential saver
Spending or investment need > current funds → potential borrower
*Direct finance and indirect finance are two ways of linking surplus units with deficit units.*
Primary and Secondary Markets
Primary market
• Market where newly issued securities are
sold to initial buyers.
• The issuing firm or government receives
funds.
*Example: a company issues new shares
to raise capital.*
Secondary market
• Market where previously issued
securities are bought and sold.
• The issuing company usually does not
receive new funds from these trades.
*Example: investors buy and sell shares
already listed on a stock exchange.*
Why secondary markets matter?
They make securities more liquid and help determine prices that affect future capital raising.
Debt Securities and Financial Instruments
A security, or financial instrument, is a financial claim on an issuer’s
future income or assets.
Debt security
• Represents borrowing by the issuer.
• The issuer promises to repay principal
and usually to make interest payments.
• For the issuer, debt is a liability.
• For the investor, debt is an asset.
Example: bond
• A bond is a debt security .
• It usually pays interest until maturity .
• At maturity, the issuer repays the face
value or principal of the bond.
• Firms and governments often issue
bonds to raise funds for long-term
projects and spending.
Debt and Equity Instruments
Debt
Basic meaning: borrowing by the issuer.
Investor receives: interest and repayment
of principal.
Risk position: lower than equity, but
default is possible.
*Examples: Treasury bills, corporate bonds.*
Equity
Basic meaning: ownership claim in a firm.
Investor receives: dividends and/or capital
gains if the firm performs well.
Risk position: higher risk; owners are paid
after creditors.
*Examples: stock (shares)*
Categories of Financial Intermediaries
Depository institutions
Banks, credit unions and
similar institutions that accept
deposits and make loans.
Contractual savings
institutions
Insurance companies and
pension funds that obtain
funds through premiums or
contributions.
Investment intermediaries
Mutual funds, finance
companies and investment
banks that support investing,
lending and capital raising.
How to distinguish them
• Source of funds: where the intermediary obtains money.
• Use of funds: what the intermediary does with the money.
• Maturity structure: whether funds are short-term or long-term.
• Risk and liquidity profile: how risky and liquid the assets and liabilities are.
Depository Institutions: Banks and Credit Unions
Depository institutions accept deposits from customers and use
these funds mainly to provide loans and other financial services.
Source of funds
• chequing/current accounts
• savings accounts
• time deposits and certificates of deposit
• other deposit-like liabilities
Use of funds
• business loans
• consumer loans
• mortgages
• government securities and other
permitted investments
Note:
Deposits are liabilities for the bank but assets for depositors.
Loans are assets for the bank but liabilities for borrowers.
Contractual Savings Institutions
Contractual savings institutions acquire funds periodically on the
basis of contracts and invest these funds to meet future obligations.
Insurance companies
• Source of funds: premiums paid by
policyholders.
• Purpose: protect policyholders against
specified losses or life events.
• Assets: may include bonds, shares,
mortgages and government securities.
Pension funds
• Source of funds: employer and/or
employee contributions.
• Purpose: provide retirement income to
members.
• Assets: often include bonds, shares
and pooled investment vehicles.
These institutions can often predict future outflows better than banks,
so they may hold more long-term assets.
Investment Intermediaries
Finance companies
• Provide consumer,
business or mortgage
lending.
• Raise funds differently
from banks and may
not offer full
transactional banking
services.
Mutual funds
• Pool money from
investors and invest in
a portfolio of
securities.
• Can lower transaction
costs and provide
diversification.
Investment banks
• Assist firms and
governments in
issuing new debt or
equity.
• Advise on mergers,
acquisitions and
corporate finance
transactions.
Financial Intermediation: Why It Improves Efficiency
Financial intermediation improves efficiency because
intermediaries specialise in moving funds, managing risks and
producing information.
Key advantages
• Small savings can be combined into larger
loans or investments.
• Households and small firms may obtain
finance that would be difficult through
direct markets.
• Intermediaries reduce the cost of finding
and evaluating borrowers.
• They monitor borrowers and manage
default risk across many relationships.
Transaction Costs and Economies of Scale
Transaction costs are the time and money spent in carrying out
financial transactions.
Why transaction costs matter
• Finding a borrower or lender can be costly.
• Writing and enforcing contracts can be
costly.
• Collecting information and monitoring
repayment can be costly.
• High costs can prevent small savers and
borrowers from using finance effectively.
How intermediaries reduce them
• They specialise in financial
transactions.
• They use standardised contracts and
procedures.
• They spread fixed costs across many
transactions.
• This creates economies of scale: lower
cost per dollar or per transaction as
volume increases.
It is cheaper for one bank to write many standard loan contracts
than for every saver to pay for a separate custom contract.
Asset Transformation
Asset transformation occurs when financial intermediaries collect
funds in one form and use them to provide financing or invest in
assets with different characteristics.
Bank example
• Depositors usually want funds to be safe
and available when needed.
• Borrowers often need larger, longer-term
and less liquid loans.
• Banks bridge this mismatch by
transforming the characteristics of
financial claims.
Four Types of Transformation
Maturity transformation
Banks use shorter-term deposits to
provide longer-term loans.
“Borrow short and lend long.”
Size transformation
Banks collect many small deposits
and provide larger loans to
borrowers.
Liquidity transformation
Depositors hold liquid claims, while
banks hold less liquid loans and
investments.
Risk transformation
Depositors view bank deposits as
relatively safe, while banks manage
the risk of loans that may default.
Asymmetric Information: The Core Problem
Asymmetric information exists when one party to a financial
transaction has more or better information than the other party.
Simple lending example
• A bank receives two loan applications for
$100,000.
• Business A has stable sales, an experienced
owner and a strong chance of repayment.
• Business B has unstable sales and wants to
fund a highly risky project.
• The business owners know more about their
true risks than the bank initially knows.
Why it matters
• The bank may charge a higher interest rate.
• It may require collateral.
• It may refuse some applications.
• Some good borrowers may still fail to
obtain finance.
Adverse Selection: Before the Transaction
Adverse selection is an asymmetric-information problem that
occurs before a financial transaction takes place.
Adverse selection = BEFORE finance is provided
Continue the loan example
• Business B is willing to borrow even at a
high interest rate because the risky project
could produce a large payoff.
• Business A may refuse the high interest
rate because the loan becomes too
expensive for a safer project.
• The bank may therefore attract more high-
risk borrowers than it intended.
The “Lemons” Problem: A Simple Analogy
Used-car example
• Two people are selling used cars.
• One car is in excellent condition.
• The other has serious mechanical
problems — a “lemon”.
• Sellers know more about the true
condition of their cars than buyers do.
What can happen?
• Buyers offer a lower average price
because they fear buying a lemon.
• Owners of good cars may withdraw
from the market because the price is
too low.
• Poor-quality cars become more
common among cars still offered for
sale.
Reducing Adverse Selection
The financial system cannot completely remove asymmetric
information, but it can reduce the problem.
Private information production
• Credit-rating agencies,
analysts, auditors and credit
bureaus gather and assess
information.
• This helps investors and
lenders distinguish stronger
borrowers from weaker ones.
Disclosure and regulation
• Firms seeking finance may be
required to release reliable
financial information.
• Examples include audited
financial statements,
accounting standards and
securities-market disclosure
rules.
Financial intermediaries
• Banks specialise in
collecting information,
screening borrowers and
assessing
creditworthiness.
• Their expertise helps
explain why indirect
finance is so important.
Moral Hazard: After the Transaction
Moral hazard is an asymmetric-information problem that arises
after a financial transaction has taken place.
Moral hazard = AFTER finance is provided
The incentive problem
The borrower may take actions that increase
risk or reduce repayment chances, while the
lender cannot perfectly observe or control
those actions.
Reducing Moral Hazard
Lenders and financial intermediaries use several tools to reduce
moral hazard after finance is provided.
• Monitoring: checking the borrower’s performance
and use of funds.
• Collateral: requiring the borrower to pledge an
asset that can be claimed if the loan is not repaid.
• Restrictive covenants: contractual rules that limit
certain borrower activities.
• Borrower equity/net worth: requiring the borrower
to put some of their own funds at risk.
• Renegotiation or recall provisions: allowing the
lender to respond if risk increases or terms are
violated.
Note:
Adverse selection → screen
before lending
Moral hazard → monitor after
lending
Potential Problems in Credit Markets
Adverse selection and moral hazard can inhibit credit and financial
markets, causing them to operate inefficiently or, in extreme cases,
break down.
What can go wrong?
• Good borrowers may be unable to obtain
finance.
• Borrowing costs may rise because
lenders fear hidden risks.
• Risk may build up inside financial
institutions.
• Confidence may weaken, reducing
lending and investment.
What helps?
• Screening and monitoring by
intermediaries
• Collateral and covenants
• Credit information and ratings
• Disclosure rules and regulation
• Effective risk management
Finance is not only about moving money.
It is also about trust, information, contracts, incentives and risk.