Lesson 8: Financial System

Financial System

- A network of institutions, markets, and contracts that bring together lenders and borrowers.

- Lenders and borrowers agree to fulfill their goals through the following exchanges:

- Banking system

- Bond market

- Stock market

Components of the Financial System

- Financial Institutions: Intermediaries that connect savers and borrowers.

- Financial Instruments: Assets traded in financial markets.

- Regulatory Framework: Rules and regulations that govern the financial system to ensure transparency,
fairness, and stability.

- Financial Markets: Platforms where financial instruments are traded.

- Financial Services: Activities provided by financial institutions.

Functions of the Financial System

- Mobilization of savings: Gathering funds from savers.

- Allocation of resources: Directing funds to borrowers.

- Facilitation of payments: Enabling transactions between buyers and sellers.

- Risk management: Assessing and mitigating financial risks.

- Liquidity provision: Providing access to funds when needed.

- Price discovery: Determining the fair value of financial instruments.

- Reduction of information asymmetry: Reducing the imbalance of information between lenders and
borrowers.

Importance of the Financial System

- Economic growth: Providing capital for investment and innovation.

- Job creation: Supporting businesses and creating employment opportunities.

- Stability: Maintaining a stable financial environment.

- Global trade: Facilitating international transactions and investments.

Types of Financial System

- Bank-based Financial System: Banks play a dominant role in mobilizing savings and directing funds
towards investments.

- Market-based Financial System: Capital markets like stock and bond markets are more dominant than
banks in providing funds for businesses.

Financial Institutions and Its Services

- Banking Services

- A financial institution licensed to receive deposits and make loans.

- Banks also provide other financial services like wealth management, currency exchange, and safe
deposit boxes.

- Types of banks are:

- Commercial banks

- Investment banks

- Savings and Loan Associations (S&Ls)

- Credit unions

- Development banks

- Banco Sentral ng Pilipinas is the governing authority responsible for overseeing a country's monetary
policy and regulating the banking system. Its function include controlling inflation, supervising banks,
and issuing currency.

- Insurance Services

- Insurance company is a financial institution that creates contracts known as insurance policies which
provide protection against financial losses in exchange for premium payments.

- Types of insurance companies are:

- Life insurance companies

- Health insurance companies

- Property and casualty insurance companies

- Commercial insurance companies

- Specialty insurance companies

- Reinsurance companies

- Insurance Commission is the regulatory body overseeing the insurance industry in various countries. Its
primary role is to supervise and regulate insurance companies, brokers, mutual benefit associations, and
health maintenance organizations (HMOs) to ensure they operate in compliance with national laws and
standards.

- Investment Banks

- Pension Funds

- A pool of assets that is set aside to provide retirement income for employees after they retire from
their employment.

- Types of pension funds are:

- Defined-contribution plans

- Defined-benefit plans

- Corporate pension funds

- Public and private pension funds

- Multi-employer or union pension funds

- Mutual Fund and Hedge Fund

Financial Market

- A broad term encompassing marketplaces where individuals, companies, and governments can trade
financial securities, commodities, and other fungible assets.

- These markets are fundamental to modern economies, as they facilitate the flow of capital, support
economic growth, enable investment, and provide mechanisms for managing financial risk.

- Importance of the Financial Market

- Economic growth

- Employment creation

- Global trade and development

- Innovation

- Types of Financial Market

- Capital Markets

- Facilitate long-term financing through the trading of securities like stocks and bonds.

- They are subdivided into:

- Stock market

- Bond market

- Money Market

- Deal with short-term debt instruments, typically maturing within one year. These instruments provide
liquidity for governments, corporations, and financial institutions.

- Treasury bills

- Certificate of Deposit

- Commercial paper

- Time deposits
- Derivatives

- Derive their value from underlying assets such as commodities, stock, interest rates, or currencies.

- Derivative markets are used for hedging risks and speculative investments:

- Futures and forwards

- Options

- Swaps

- Commodities

- Markets are where raw materials or primary agricultural products are bought and sold. They allow
producers and consumers to hedge against price volatility.

- Energy commodities

- Agricultural commodities

- Metals

- Foreign Exchange

- The Forex market is where currencies are traded. Currency trading supports international trade,
investment, and risk management.

- Cryptocurrency

- The cryptocurrency market involves digital assets, or cryptocurrencies, like Bitcoin and Ethereum.
Transactions occur through decentralized networks using blockchain technology.

Financial Instrument

- Types of Financial Instruments

- Equity Instruments

- Represent ownership in a company and typically entitle the holder to a share of the profits. Examples:

- Common stock

- Preferred stock

- Debt Instruments
- Represent a loan made by an investor to a borrower (typically corporate or governmental). Examples:

- Bonds

- Treasury bills

- Commercial paper

- Derivative Instruments

- Derive their value from the price of an underlying asset (e.g., stocks, bonds, commodities). Examples:

- Futures

- Options

- Swaps

- Hybrid Instruments

- Combine characteristics of both debt and equity, potentially offering both fixed income and typical
equity-like returns. Examples:

- Convertible bonds

- Preferred shares with warrants

- Money Market Instruments

- Highly liquid debt instruments often used to manage short-term cash needs. Examples:

- Certificate of Deposit (CDs)

- Repurchase Agreements (Repos)

Financial System in Economic Development

- Labor and employment

- Savings and investment

- Capital and securities market

- Trade development

- Infrastructure and technology

Challenges Facing Financial System

- Financial crises

- Inequality

- Regulatory failures

Function of Financial Market

- Capital formation

- Liquidity

- Price discovery

- Efficient allocation of resources

Purposes and Uses of Financial Instruments

- Liquidity and cash management

- Risk management and hedging

- Income generation

- Capital formation

- Investment and speculation

Types of Market Instruments

- Primary Market Instruments

- Instruments issued for the first time to raise new capital, such as IPOs (initial public offerings) or new
bond issues.

- Secondary Market Instruments

- Existing instruments traded between investors on stock exchanges or bond markets.

- Secondary markets provide liquidity, enabling investors to buy and sell financial instruments easily.