AN INTRODUCTION TO FINANCIAL SYSTEMS

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Contents

1. Characteristics of a financial system

2. Advantages of using a financial system 3. Market efficiency and the real economy 4. Financial system and economic development

FINANCIAL SYSTEM

FINANCIAL SYSTEM
A financial system consists of Financial institutions Financial markets End users of the markets and institutions Regulatory authorities

(1) Financial Institutions

Depository institutions Banks Building societies Credit unions Friendly societies Non-bank institutions Insurance companies Investment banks Pension funds Unit trusts and OEICs Investment trusts Principal liabilities are deposits Principal liabilities are not deposits

(1) Financial Institutions

Services Financial intermediation Insurance and pensions Payments Portfolio adjustment Financial Institutions All Insurance companies and pension funds Banks and building societies Unit trusts, open-ended investment companies (OEICs) and investment trusts

(2) Financial market

Financial Market

Money market
assets with an initial maturity normally of up to 1 year (sometimes extended to 5 years)

Capital market
assets with an initial maturity exceeding 5 years

Money vs. Capital Markets

Money
Short-Term, < 5 Year
High Quality Issuers Debt Only Primary Market Focus Liquidity Market--Low Returns

Capital
Long-Term, >5Yr
Wide range of Issuer Quality Debt and Equity Secondary Market Focus Financing Investment--Higher Returns

Money or capital markets?

Length of time for which issuers need the funds Difference between short-term and longterm interest rates Expectations of future interest rates

(3)End Users of the Financial System

End users of a financial system are the firms, households, individuals, government that use the services offered by the institutions and markets Financial intermediation: Helps get funds from savers to investors

Overview of Financial System

(4) Regulatory Authorities

Increase information to investors
Decrease asymmetric information problem Authorities (FSA in the UK, SEC in the US) force corporations to disclose information

Ensure the soundness of financial institutions

Prevent financial panics, contagion (the high probability that one bank failure will spread to other banks) => too big too fail problem Chartering, reporting requirements, restrictions on assets and activities, deposit insurance and anticompetitive measures

Contents

1. Characteristics of a financial system

2. Advantages of using a financial system 3. Market efficiency and the real economy 4. Financial system and economic development

Advantages of Financial system

Reduce transaction costs Reduce risks Increase liquidity

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(1) Transaction Costs

Search costs to match maturity and amount of funds between lenders and borrowers Contract costs to draw up legally enforceable contract Enforcement costs to ensure contract implementation, especially loan repayment

Market and Cost Reduction

By trading standardized products Reduce search costs by using national stock market with disclosed information, investment banks, market makers Financial institutions reduce transaction costs by developing expertise and taking advantages of economics of scale

(2) Market and Liquidity

Secondary market helps create liquidity Provide portfolio adjustment facilities Support primary markets by providing information on existing securities Make securities more attractive because they can be sold quickly and for a reasonably certain price

(3) Market and Risks

Financial market helps
Reduce liquidity risk Reduce asymmetric information problem by providing information

Financial institutions help

Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (asset transformation) Lower risk by helping people to diversify portfolio Reduce adverse selection and moral hazard problems

Contents

1. Characteristics of a financial system

2. Advantages of using a financial system 3. Market efficiency and the real economy 4. Financial system and economic development

Market Efficiency and Real Economy (1) Operational efficiency: Markets ability to carry out transactions quickly, cheaply
and reliably Thus, organized markets make it easier to lend and to borrow Help customers
To buy goods and services beyond their current income Postpone consumption or bring it forward

Help the financing of real investment projects the purchase of machinery, buildings, equipment and so on that facilitates the production of goods and services Real investments require a large expenditure for which firms usually have to borrow

Market Efficiency and Real Economy

(2) Information efficiency All information relevant to the valuation of an asset is incorporated in the assets price quickly It is impossible to earn consistently abnormal rates of return Only new, and thus random, information can change prices => no pattern Assets prices are correct, ensuring funds flow to where they are most productive
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Financial Asset Valuation

Financial principle: Value of a financial asset is the sum of present values of future cash flows from the asset

Financial Asset Valuation

Bond valuation: C Coupon interest; F - Face value; k Discount rate C PV = (1+k)1 + (1+k)2 C +...+ (1+k)n C + (1+k)n F

Stock valuation: D Dividend; ke Discount rate

P0 =

t=1

Dt
(1 + ke)t

Financial Asset Valuation

Three fundamental factors affecting assets prices
Future stream of earnings Level of risk Discount rate which combines risk-free interest rate and the level of risk

Prices of financial assets are high when earnings are high and levels of risk are low, that is when firms projects are highly-valued by the society

Informational Efficiency and Resource Allocation

Firms with low risk, high share prices relative to current dividends can raise fund with low cost of capital => more projects with positive NPV => attract more funds Firms with high risk, low share prices relative to current dividends can only raise fund with high cost of capital => less projects with positive NPV => attract less funds

Contents

1. Characteristics of a financial system

2. Advantages of using a financial system 3. Market efficiency and the real economy 4. Financial system and economic development

Research on Finance and Economic Development

Schumpeter (1911), Gurley and Shaw (1955) and Hicks (1969): Financial system helps to mobilize saving and investment, promoting growth and policy should encourage the growth of financial system

Research on Finance and Economic Development

McKinnon (1973) and Shaw (1973): More on Informational efficiency and resource allocation Criticize financial repression which was characterized by high levels of government regulation of the financial system, namely high reserve requirements on banks, ceilings on interest rates

Research on Finance and Economic Development

High levels of government regulation increases cost of capital Ceilings on interest rates discourage supply, create excess demand, thus lower level of investment. Ceilings on interest rates hold down the cost of capital, thus directing limited funds to both high and low quality projects => badly affect investment quality The policy implication is to promote financial liberalization

Research on Finance and Economic Development

Empirical studies on financial repression hypothesis: Association between finance and economic growth where finance refers to the size of financial sector and liberalization hypothesis Data problem Problem in distinguishing cause and effect

Research on Finance and Economic Development

Initiated by King and Levine (1973): mainly focus on banking variables Demirguc-Kunt and Maksimovic (1998) and Levin and Zervos (1998) confirmed positive link between markets and economic growth

Research on Finance and Economic Development

Dissenting voices Joseph Stiglitz (2000) had argued that financial liberalization has led to increased instability within financial systems and is responsible for the increased frequency of financial crisis

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