Financial System: A Glance

The financial system is a complex set of

closely
interrelated
components:
institutions, markets, services, and
instruments in the economy.
Financial system is important in the
economy in order to pool and utilize
financial resources, reduces costs and
risk; and expands and diversifies
opportunities.
This increases the allocative efficiency
of
resources
and
promotes
the
productivity and thus facilitates the
economic growth.
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 The rapid change in financial system is

driven by innovation.
Two main types of innovation:
- Existing needs in new ways, for example,
the credit card: this provides a new way
to pay for goods and services.
- Existing technology to serve new needs,
for example, the financial futures
contract: this takes an instrument
originally designed to serve the needs of
grain dealers and adapts it to serve the
needs of financial institutions.
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 The financial system makes the trade

easier. The various types of trade are:
Goods and Services,
Lending, and
Trade in risk

The basis of trade is diversity.

People trade because they differ in
what they have and in what they
want.
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 These different types of trade face

similar
obstacle:
the
problems
associated with promise, incentive
problems, and illiquidity.
The financial system addresses to
these problems.
This unit focuses basically to two
issues: the basic needs served by
financial system and the technology
adopted in serving these issues.
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Unit 1: Economics of Financial System

1. Basics needs served by the financial
system
Payments
Resource transfer (Lending)
Risk sharing (Insurance)
2. The technology adopted in serving
these needs
Delegation
Credit Submission
Polling
Netting
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Basics needs served by the financial system

continue . . .

1. Payments
Two forms of trading: credit trading and cash
trading
Credit trading involves exchange of value for a
promise, for example mutual credit system.
Cash trading involves exchange of value for
value,
for
example
barter
or
currency
payments.
Both exist problems:
Trust and large set up costs (credit trading)
Impossible without cash or mismatch in needs
(cash trading)
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1.1 FS Reduces the Costs of Payment in

Cash
The exclusive reliance on cash is costly
and cumbersome.
To guard them against theft,
Requiring secure transportation,
Counting of large amounts of currency,
Authentication of cash bill.
These problems existed in the trading view
by another party as a profit opportunity.
1.1.1 Warehouse Bank
1.1.2 The Clearinghouse
1.1.3 Bank Deposits as Money
1.2 Fractional-Reserve Banking
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1.1.1 Warehouse Banks

A warehouse bank is a bank that
accepts deposits of cash, count, and
authenticate the currency and store it
in a solid and well guarded vault.
They
allow
depositors
to
make
payments by transforming title to
deposited
cash
rather
than
by
transferring the cash itself, by writing
check.
The warehouse bank offer security and
ease of payments in exchange for a
fee.
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1.1.2 The Clearinghouse

Physically located place through which checks
are cleared between two banks.
When depositors maintain account at different
bank then cash payment by one to another
would by risky and inconvenient.
The bank have an arrangement that makes such
a physical transfer of cash unnecessary, and the
arrangement is known as clearing. In this
process nobody could pay the amount by
physically delivering cash.

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Bank Deposit as Money

For large payments, it is deposits
that are now used as money,
rather than the underlying cash.
Since physical cash rarely changes
hands for large payments, the cost
of such payments is greatly
reduced.

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1.2 Fractional-Reserve Banking

Banks that holds reserves of cash
equal to only a fraction of its
deposits liabilities.

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2. Lending
Lending is risky and involves the varieties of
difficulties:
the cost of acquiring and processing
information,
the costs of negotiating and writing a
contract,
the incentive problems
inherent in all
lending arrangements,
the cost of establishing safeguards and of
monitoring borrower compliance,
conflicting interests over liquidity, etc.
The existence of financial system easily
addresses these problems by reducing costs
of lending and by improving the liquidity of
loans.
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2.1 Direct Lending and Financial Market

Purchasing shares and debt instruments
issued by corporations and bypasses the
services of the financial intermediaries.
The direct lending undergoes several steps
such as:
a.Gathering Information
b.Loan Indenture
c.Appointing Underwriter and Trustee
d.Secondary Market and Liquidity
Issuing through underwriter will reduce
costs. (Benefits of indivisible costs)
However, public issue will make sense only
when amount to be raised is substantial
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2.2 Indirect Lending and Financial

Intermediaries
The funds transfer between suppliers
and users of funds through financial
intermediaries.
Aggregation of funds by fund suppliers in a
financial institutions resolves a number of
problems to individuals.

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2.2 Indirect Lending and Financial

Intermediaries continue . . .

a. Informational Advantages
b. Pooling to Make Large Loans
c. Gains from Specialization
d. The Value of Continuing
Relationship
e. Diversification
f. Liquidity
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Direct Versus Indirect Lending

The relative merits between the direct and
indirect lending are discussed as follows:
Benefits to Lenders
1. Indirect lending generally promises
lenders less risk and more liquidity to the
investors.
2. Indirect lending promises lower return
due to lower level of risk. However, this
losses the opportunity to investors
getting richer through intelligent or
clever investment in stocks markets as
investors never become richer putting
money in the bank.
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Benefits to Borrowers
1. Many of the costs are indivisible in
public issue so short term or small
size transactions are always costly in
direct lending.
2. Many borrowers have small choice
due to their lack of good credit
standing
and
enter
into
direct
borrowings.

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Benefits to Borrowers

continue . . .

3. Borrowers having large requirement

of funds can have benefits from

direct lending. Providing large sum of
money in indirect lending may not be
possible always, and the capacity of
the direct financial market is much
larger than that of even the largest
intermediaries.

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Direct

Versus

Indirect

Lending

continue . . .

Direct and indirect lending differs

with respect to their flexibility in
dealing with repayment problems. This
depends on whether the difficulty in
repayment is due to permanent (such
as miss management) or temporary
(such as a slow economy).

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Direct Versus Indirect Lending continue . . .

With direct lending, rescheduling loan is
difficult in adverse situation (repayment
problems) as there are numerous lenders
and it is hard for lenders to agree on new
terms of the loan and when there is a
problem. The terms of contract tend to be
enforced rigidly. (liquidation!)
With indirect lending the bank is in a much
better position to know whether the problem
is permanent or temporary. As a sole lender,
it can alter the terms of the loan without
having to obtain the agreement of others. It
can
reschedule
payments,
waive
loan
covenants, or even make new loans to help
the borrower.
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3. Trade in Risk
Two principal forms of trade in risk
are:
Insurance and
Forward Transactions
Many people suffer in trade in risk.

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Reciprocal Insurance
An agreement whereby those facing a
particular risk agree to share their
losses. Mutual aid and gift exchange
are examples of reciprocal insurance.
External Insurance
An agreement whereby those who do
not face a particular risk agree to
share the losses of those who do.
(Natural risk such as losses from
shipwrecked or satellite destroyed on
launching)
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The insurance involves two types

of incentive problems:
Moral Hazard and
Adverse Selection

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Moral Hazard
It is a tendency of an insured to take
greater risks because s/he is insured.
For example, a ship-owner may face
the choice between two routes-one
safe but slow, the other fast but
risky.
Which one will be the ship-owners
choice? If there is:
No insurance
Insurance
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Adverse Selection
This is a tendency of worse risks to buy
insurance and better risk not to.
For example, suppose the price of
insurance is the same for all ships.
Then owners of ships that are in poor
shape will find insurance more
attractive, and will be more likely to
purchase it, than owners of sound
ships.

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How Insurance Company Works?

Insurance company sells the similar
policy
to
the
large
number
of
policyholders.
Any individual risk is only small element
of a very large portfolio consisting of
many
insurance
policies,
they
are
essentially independent of one another.
The benefits provided is small fraction of
large amount collected in the form of
premium.
The insurance company not only transfer
risk between policyholders and the
insurance company, but it is also a way of
sharing risk among policyholders.
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Advantages of Insurance Company

1.Actuarial Risk and Reciprocal Insurance
Neither size nor their timing in advance is
known in reciprocal insurance. It is fixed
and certain in insurance policy.
In reciprocal insurance, there is a greater
chance that it will fail due to smaller pool.
Damages might be more than the
participants could handle. Insurance policy
is based on the much larger and better
diversified group.
Insurance is also backed by the capital of
the insurance company, if losses exceeds
premium, the insurance promises to cover
the difference.
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Advantages of Insurance Company

continue . . .

Insurance covers variety of risks

Risk
to
homes,
automobiles,
commercial property, etc. collectively
known as property-liability insurance.
Risk of life such as death, injury or
illness known life insurance.
These types of insurances are based
on the pooling of many similar risks
with known probability and called
actuarial risk.
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2. Non-Actuarial Insurance and External

Insurance

It
is
non-actuarial
insurance
whose
probability of risk of losses cannot
forecasted and the pool of these types of
risk is also small.
It is impossible to organize insurance for
this sort of risk in the same way as for
actuarial risks.
Financial system manage non-actuarial
risks and offers external insurance.
Insurers not inherently exposed to the risk
agree to bear part of it for a premium (may
ahead by the amount of the premium)
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2. Non-Actuarial Insurance and External

Insurance continue . . .
External insurers cope with the risk
through diversification: they take an
many unrelated risks, each small
relative to their capital.
Actuarial insurance is generally offered
by insurance intermediaries, but there
is an important market for external
insurance - Lloyds of London. This is
an exchange where groups of wealthy
individuals bid to accept non-actuarial
risks for a premium.
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Dealing with Incentive Problems

Insurance faces the two problems:
- Moral Hazard and
- Adverse Selection
For moral hazard, the insurance
company can replicate this insurance
by offering only partial coverage. The
insurer will pay only a part of the loss.
Adverse selection is not much of a
problem for mutual aid. All members
of the community are expected to
participate.
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Dealing with Incentive Problems

continue . . .
Adverse selection is problem for the
insurance company. High-risk farmers will
find the insurance a bargain and buy a
policy, low risk farmers will find the
insurance too expensive and not buy one.
The frequency of claims will rise, and the
insurance company may lose money.
The best it can do is to gather as much
information as possible to distinguish
high-risk farmers from low, and to try to
tailor its premiums to reflect risk.
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Forward Transaction
It is an exchange of one promise for
another: one party promises to buy, the
other promises to sell.
Forward transaction involves the default
risk (replacement risk).
The financial system helps in two ways to
solve the problems in forward transaction:
the direct forward transaction (future
forward) and indirect forward transactions
(forward intermediaries).
They
offer
low
transaction
costs,
guaranteed delivery, and greater liquidity.
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