An Overview

of the
Financial
System
 Function of Financial Markets

• Perform the essential function of channeling funds from

economic players that have saved surplus funds to those that
have a shortage of funds
• Direct finance: borrowers borrow funds directly from lenders
in financial markets by selling them securities
• Promotes economic efficiency by producing an efficient
allocation of capital, which increases production
• Directly improve the well-being of consumers by allowing
them to time purchases better
Flows of Funds Through the Financial System
 Structure of Financial Markets
• Debt and Equity Markets
– Debt instruments (Bonds)
o Simply a loan
o Principal Payment and fixed Interest
o Maturity
o Long term v/s Short term
o Corporate or Government bonds
Bond Credit Rating
 Structure of Financial Markets
• Debt and Equity Markets
– Equities (Securities/Stocks)
o Simply purchase of ownership
o Stock Price
o Dividends at the end of the fiscal year
o No Maturity
 Structure of Financial Markets

• Primary Markets – New issues of a securities, such as a Bond or a

Stock, sold to initial buyers aka “Institutional Buyers”
o Investment Banks underwrite securities in primary markets
o Examples: Goldman Sax, JP Morgan, Morgan Stanley etc
 Structure of Financial Markets
• Secondary Markets – Securities, such as a Bond or a Stock, are
bought and sold which were previously issued in the primary
markets.
o Brokers and dealers work in secondary markets
o Examples: NYSE, NASDAQ, DSE etc
 Structure of Financial Markets

Types of Secondary Markets

o Exchanges – Where buyers and sellers of securities meet

in one central location to conduct trade. Example: Chicago
Board of Trade for Commodities (wheat, corn, silver etc).

o Over the counter (OTC) – Where dealers at different

location have inventories of securities stands ready to buy
and sell securities “over the counter” to anyone who
comes to them and willing to accept the price. Example:
Stock exchanges etc.
 Structure of Financial Markets

• Money Markets: Deals in short-term debt instruments (less than one year)
 Treasury Bills
 Commercial Papers
 Repurchase agreements (Repos)
 Federal Funds

• Capital Markets: Deals in long-term debt instruments (more than one year)
 Stocks
 Mortgages
 Corporate Bonds
 Bank commercial loans
 Function of Financial Intermediaries
We now turn our attention to the top part of the Figure
– Indirect finance (most important source of finance)

Financial intermediary
(such as a bank) plays as
the middleman:

• The intermediary obtains

funds from savers
• The intermediary then
makes
loans/investments with
borrowers
 Function of Financial Intermediaries

1. Lower transactions Costs

 Financial intermediaries make profits by reducing
transactions costs by developing expertise and taking
advantage of economies of scale
2. A financial intermediary’s low transaction costs mean that it
can provide its customers with liquidity services, services that
make it easier for customers to conduct transactions
 Banks provide depositors with checking accounts that
enable them to pay their bills easily, where depositors can
earn interest on checking and savings accounts
 Function of Financial Intermediaries
3. Reduce the exposure of investors to risk, through a process
known as risk sharing
 FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another
party
 This process is referred to as asset transformation, because in
a sense risky assets are turned into safer assets for investors
4. Helps by providing the means for individuals and businesses to
diversify their asset holdings.
 Low transaction costs allow them to buy a range of assets,
pool them, and then sell rights to the diversified pool to
individuals.
 Function of Financial Intermediaries

5. Deals with asymmetric information problems - One party lacks

crucial information about another party, impacting decision-making

 (Before the transaction) Adverse Selection: try to avoid

selecting the risky borrower. Gather information about potential
borrower.

 Lemons Problem in Securities Markets

If we can't distinguish between good and bad securities,
willing pay only average of good and bad securities’ value

Result: Good securities undervalued and firms won't issue them;

bad securities overvalued so too many issued
 Function of Financial Intermediaries

 (After the transaction) Moral Hazard: ensure borrower will

not engage in activities that will prevent him/her to repay the
loan. Sign a contract with restrictive covenants.

Owner V/S Manager

How will you incentivize the manager have to work hard?

Conclusion: Financial intermediaries allow “small” savers and

borrowers to benefit by reduce adverse selection and moral hazard
problems, enabling them to make profits.
 Financial Intermediaries : Global Perspective
• Studies show that firms in the U.S., Canada, the U.K., and
other developed nations usually obtain funds from financial
intermediaries, not directly from capital markets.
• Financing from financial intermediaries exceeds capital
market financing 10-fold.
 Regulation of the Financial System
• To increase the information available to investors:
– Reduce adverse selection and moral hazard problems
– Reduce insider trading (SEC).
• To ensure the soundness of financial intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control holding of
risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates
For more information:
https://www.bb.org.bd/fnansys/