Introduction to the Financial System

Structure and Regulation of the Financial System

• Definition and Core Purpose:

  • The financial system is the network of institutions responsible for circulating money flows within an economy.
  • Its primary objective is to channel funds from savers (entities with surplus funds) to individuals or organizations seeking to make productive investments (entities with deficit funds).
  • The entities facilitating this transfer are known as financial intermediaries or financial markets.
  • The mechanisms and financial instruments used to transfer these savings to productive units are termed financial instruments.

• System Composition:

  • Comprises banking institutions, financial companies, and other public or private legal entities duly authorized to perform financial intermediation.
  • Financial Intermediation is defined as the habitual activity carried out by authorized institutions to collect funds from the public under various modalities and allocate them in the form of credits, loans, and investments.

• Legal and Regulatory Framework:

  • National laws establish the regulatory and supervisory framework governing companies operating in the financial and insurance systems, as well as firms conducting complementary or related activities.
  • Regulatory Exemption: Central reserve banks are explicitly excluded from this standard regulatory framework.

• Setting Interest Rates, Commissions, and Fees:

  • Financial institutions are free to determine interest rates, commissions, and expenses for their active operations (loans), passive operations (deposits), and services.
  • Interest Rate Limits: When setting interest rates, financial companies must adhere to maximum or operational limits established by central reserve banks.
  • Insurance System Freedom: Companies in the insurance sector freely establish policy conditions, premium rates, and fee structures.
  • Public Disclosure: Interest rates, commissions, fees, and insurance policy conditions must be made transparent to the public according to regulations set by the national Superintendency of Banking and Insurance (Superintendencia de Banca y Seguros - SBS).

Key Concepts and Mechanisms in Financial Intermediation

• Savings ($\text{Ahorros}$):

  • Consist of total monetary deposits, in any modality, made by domestic or foreign natural persons (individuals) or legal entities (corporations) within financial system institutions.
  • Includes direct deposits as well as the acquisition of debt representative instruments issued by financial entities.

• Provisions ($\text{Provisiones}$):

  • Financial charges recorded in profit and loss statements by companies conducting operations exposed to credit risk.
  • Provisions are categorized as generic or specific based on credit risk ratings.
  • Quantitative Threshold: Generic provisions must not exceed $1\%$ of the normal credit portfolio ($\text{cartera normal}$), unless explicit statutory exceptions apply.

• Bank Secrecy ($\text{Secreto Bancario}$):

  • Prohibits financial system companies, their directors, and employees from disclosing any information regarding passive operations (deposits) of their clients.
  • Exception: Information can only be released with explicit written authorization from the account holder.

• Deposit Insurance Fund ($\text{Fondo de Seguro de Depósito}$):

  • A special private legal entity regulated by financial system law, statutory provisions, and its charter.
  • Primary Purpose: Protect depositors within financial system companies.
  • Key Powers and Functions:
    • Provide deposit insurance coverage.
    • Facilitate the transfer of deposits and assets from institutions placed under regulatory intervention.
    • Execute exceptional measures dictated by the Superintendency aimed at strengthening equity when a member company is subjected to a surveillance regime ($\text{régimen de vigilancia}$).

• Risk Center / Credit Bureau ($\text{Central de Riesgos}$):

  • An integrated financial, credit, commercial, and insurance risk registry containing consolidated and classified debtor information.
  • Data is accessible to financial and insurance companies, the Central Reserve Bank, commercial enterprises, and the general public.
  • Scope: Registers domestic and international financial and credit risks, domestic commercial risks, credit insurance risks, and general insurance risks.

• Reserve Requirement ($\text{Encaje}$):

  • Mandatory reserve required from financial institutions based on the nature of their obligations or operational activities, as established by the Central Reserve Bank.
  • Monetary Policy Usage: Central reserve banks can impose additional or marginal reserve requirements for monetary policy control.
  • Interest Compensation: Central reserve banks are authorized to pay interest on reserve funds at rates established by their board of directors.
  • Asset Composition and Foreign Currency Restrictions:
    • Reserves must consist of cash held in institutional vaults and/or cash deposits placed at the Central Reserve Bank.
    • Foreign currency cannot fulfill reserve obligations for national currency liabilities, and national currency cannot satisfy reserve obligations for foreign currency liabilities.

• Trust ($\text{Fideicomiso}$):

  • A legal relationship in which a trustor ($\text{fideicomitente}$) transfers assets to a trustee ($\text{fiduciario}$) to form an independent trust estate ($\text{patrimonio fideicometido}$).
  • The estate is subject to fiduciary ownership and restricted to executing a specific purpose for the benefit of the trustor or a designated beneficiary ($\text{fideicomisario}$).

• Investment Banks ($\text{Bancos de Inversión}$):

  • Corporations ($\text{sociedades anónimas}$) established to promote general investments domestically and internationally.
  • Act as direct investors or as intermediaries between investors and entrepreneurs facing capital requirements.
  • Operational Boundary: Investment banks operate exclusively within negotiable portfolios ($\text{cartera negociable}$) and are exposed to market risk fluctuations.

Capital Transfer Channels and Financial Market Types

• Modes of Capital Transfer:

  • Capital transfers between capital-surplus entities (savers) and capital-deficit entities occur through four primary mechanisms:
    1. Direct transfers of cash and financial securities.
    2. Transfers via stockbrokers or agents acting as intermediaries to facilitate security issuances.
    3. Transfers through financial intermediaries (e.g., commercial banks obtaining funds from savers and issuing their own instruments, transforming capital structures to increase overall market efficiency).
    4. Portfolio management conducted on behalf of other market participants.

• Financial Markets Overview:

  • Financial markets exist whenever a financial transaction takes place and financial assets are exchanged.
  • Connect entities needing capital (businesses, individuals, governments) with entities holding income exceeding current expenditures.
  • Each market trades specific securities, serves distinct client bases, and operates across various regional or international locations.

• Categorization of Financial Markets:

  • Physical Asset vs. Financial Asset Markets:
    • Physical Asset Market: Also called tangible or real asset markets; involves physical goods such as automobiles, computers, wheat, and real estate.
    • Financial Asset Market: Involves financial claims such as stocks, bonds, and mortgage notes ($\text{letras hipotecarias}$).
  • Spot Market vs. Futures Market:
    • Spot Market: Settlement and asset delivery occur immediately or within a few days.
    • Futures Market: Transactions are agreed upon to be executed at specified future dates, such as $6\text{ months}$ or $1\text{ year}$.
  • Money Market ($\text{Mercado de Dinero}$):
    • Markets trading short-term instruments with maturities of less than $1\text{ year}$ ($< 1\text{ year}$).
    • Created by intangible networks connecting suppliers and demanders of short-term funds.
    • Exist because corporations, individuals, governments, and financial intermediaries hold temporary excess cash and seek liquid, interest-bearing short-term placements.
    • Transactions are primarily executed by brokers or conducted via telephone and electronic channels.
    • The New York money market is the largest globally, dominated by major U.S. banks and international branches from London, Paris, and Tokyo.
  • Capital Market ($\text{Mercado de Capitales}$):
    • Markets dedicated to long-term debt instruments and corporate equity stocks.
    • Provide permanent long-term capital necessary for structural economic growth (e.g., business expansion funding).
    • The New York Stock Exchange (NYSE) serves as a primary example, handling bonds and stocks of major U.S. corporations, while smaller firm securities are traded in secondary capital market segments.

Stock Exchanges, Trading Floor Operations, and Market Indicators

• The Stock Exchange ($\text{Bolsa de Valores}$):

  • Functions as the structural core of the capital market.
  • Organized as a non-profit civil association ($\text{asociación civil sin fines de lucro}$) providing a public service.
  • Primary Functions: Promote, regulate, and supervise the securities market.
  • Economic Benefits:
    • Facilitates investment by providing a centralized transaction venue.
    • Enables precise valuation of corporate entities.
    • Promotes stability in security pricing.
    • Assists financial markets in absorbing newly issued securities.

• Trading Mechanisms — Stock Trading Floor ($\text{Rueda de Bolsa}$):

  • The traditional daily trading session where stockbrokerage companies ($\text{sociedades de bolsa}$) and individual stockbrokers negotiate buy and sell orders for listed securities.
  • Traded Instruments: Includes variable-income securities (stocks) and fixed-income securities (bonds and debt obligations).

• Stock Market Performance Indicators:

  • General Stock Market Index (Índice General de la Bolsa de Valores - IGBV):
    • A price index reflecting average price movements of major listed stocks within a selected representative portfolio.
    • Calculation includes stock price variations, cash dividend distributions, and bonus share issuances ($\text{acciones liberadas}$).
    • Uses a fixed base reference value of $100\%$ ($100$ base points).
    • Percentage variations reflect overall trends in the primary stock market.
  • Selective Stock Market Index (Índice Selectivo de la Bolsa de Valores):
    • A price index computed using a smaller, highly selective group of the most liquid and representative stocks.
  • Sectoral and Subsectoral Indices:
    • Price indices tracking stock performance across specific economic sectors.
    • Sectors: Agricultural, Banking & Financial, Industrial, Investment, Mining, and Services.
    • Subsectors: Food & Beverages, Rubber & Plastic, Electrical, Machinery & Electrical Equipment, Non-metallic Minerals, Chemicals, and Telecommunications.
    • Utility: Allows comparative analysis between individual stock performance and overall sector performance.
  • Market Capitalization ($\text{Capitalización Bursátil}$):
    • The total monetary value of a company's listed shares at a given date:

$\text{Market Capitalization} = \text{Number of Outstanding Shares} \times \text{Market Price}$

*   *Profitability Index ($\text{Índice de Lucratividad - IL}$)*:
    *   Measures the cumulative year-to-date return of a stock.
*   *Trading Frequency ($\text{Frecuencia de Negociación - FN}$)*:
    *   A liquidity indicator assessing how rapidly a security can be converted into cash based on session activity:

$\text{FN} = \frac{\text{Sessions Traded}}{\text{Total Sessions}}$

    *   *Calculation Example*: If a stock trades in $10$ out of the last $20$ floor sessions, its trading frequency is:

$\text{FN} = \frac{10}{20} = 50\%$

    *   If traded in $20$ out of $20$ sessions, $\text{FN} = 100\%$. Higher trading frequency denotes greater stock liquidity.
*   *Price-to-Book Ratio ($\text{Ratio Precio/Valor Contable}$)*:
    *   Evaluates whether stock market price is higher or lower than accounting net worth per share:

$\text{Book Value Per Share} = \frac{\text{Net Equity Accounting Value}}{\text{Number of Outstanding Shares}}$

*   *Price-to-Earnings Ratio ($\text{PER / Price Earning Rate / Ratio Precio/Utilidad}$)*:
    *   Measures the ratio between stock price (invested capital) and earnings per share (EPS) generated over the prior year:

$\text{PER} = \frac{\text{Stock Price}}{\text{Earnings Per Share}}$

    *   *Interpretation*: Assuming complete distribution of corporate earnings and stable annual performance, PER indicates the number of years required to recover the initial investment. Evaluates relative valuation (whether a stock is expensive or cheap).

Special Financial Markets, Globalization, and Derivatives

• Mortgage Market ($\text{Mercado Hipotecario}$):

  • Covers all loan and financing activities dedicated to residential housing, real estate, and corporate construction projects.

• Consumer Credit Market ($\text{Mercado de Crédito de Consumo}$):

  • Encompasses loans provided for personal consumption, including travel, vacations, automobiles, and retail department store purchases.

• Primary Market ($\text{Mercado Primario}$):

  • The market segment where newly issued financial instruments are bought and sold for the first time.
  • Refers to initial issuance transactions rather than a single physical location.

• Secondary Market ($\text{Mercado Secundario}$):

  • The market segment where previously issued, existing financial instruments are traded among investors.
  • Examples include ongoing security trading on the New York Stock Exchange (NYSE) and the Lima Stock Exchange ($\text{Bolsa de Valores de Lima}$).

• Bond Market ($\text{Mercado de Bonos}$):

  • Bonds are traded more frequently than equities, with a substantial portion traded outside formal exchanges (over-the-counter).
  • High institutional volume driven by transactions among major financial institutions, private pension fund administrators ($\text{AFPs}$), and insurance companies.

• Globalization of Financial Markets:

  • Entities seeking capital are no longer constrained to domestic markets or domestic currency assets, actively accessing global financial markets.
  • Drivers of Globalization:
    1. Market Liberalization: Deregulation of financial activities across international financial hubs.
    2. Technological Advances: Modern technology enables global integration, continuous market monitoring, real-time order execution, and complex analytical evaluation, leading to increased institutionalization.

• Derivatives Market ($\text{Mercados Derivados}$):

  • Financial markets trading contracts that confer rights or obligations to buy or sell a financial asset at a future date.
  • Derivation of Value: Derivative contract values derive directly from the price of the underlying financial asset.
  • Two Fundamental Derivative Instruments:
    1. Futures and forward contracts ($\text{contratos a futuro y a plazos}$).
    2. Option contracts ($\text{contratos de opción}$).
  • Main Economic Function: Provide structured mechanisms for risk control, hedging, and risk management.