financial system, markets and services

7/27/2019 Financial System, Markets and Services

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FINANCIAL SYSTEM

MARKETS AND SERVICES


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Financial System


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Financial System

In a market economy, the allocation of economicresources is the outcome of many private decisions.

Prices are signals that direct economic resources to their

best use.

The key suppliers and demanders of funds are

individuals, businesses, and governments.

In general, individuals are net suppliers of funds, while

businesses and governments are net demanders of

funds.


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Financial System Types of Markets:

Market for products (goods and service) and market forfactors of production (labor, capital)

Financial market is one part of the factor market. In afinancial market financial assets are exchanged(traded).

The exchange of funds from savers/investors toborrowers is done either

directly through the selling of financial claimsor

indirectly through financial institutions or intermediaries


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Direct Markets Provide a forum in which suppliers of funds and

demanders of funds can transact business directly . borrowers/issuers sell financial claims directly to

lenders/investors.

Market instruments include: stocks, corporatebonds, Treasury securities,

Participants: Investment bankers (primarymarket) brokers and dealers (secondary Market).


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Intermediary Market

The intermediary financial market consist of financialinstitutions, such as commercial banks, insurance

companies, pension funds, exchange traded funds, and

mutual funds. Financial institutions are intermediaries that channel

the savings of individuals, businesses, and

governments into loans or investments.

help to match one persons saving with another persons

investment.


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Intermediary Market

In this market, the financial institution sells financialclaims (checking accounts, savings accounts,certificates of deposit, mutual fund shares, insuranceplans etc.) to investors, and uses the proceeds topurchase claims (stocks, bonds, etc.) issued by

borrower or to create financial claims in the form of term loans, lines of credit, and mortgages.

Through their intermediary function, financial institutionscreate intermediate securities, referred to as secondary securities .


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FINANCIAL ASSETS


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FINANCIAL ASSETS An asset is any possession that has value in an exchange .

Tangible - value depends on particular physicalproperties- building, land, machinery

Intangible - legal claims to some future benefits- valuehas no relation to the form, physical or otherwise, inwhich claims are recorded.

Financial assets are intangible assets- typical benefit is aclaim to future cash flow.

Financial asset , financial instrument , security are usedinterchangeably

Entity that has agreed to make future cash flow- issuer Owner of the financial asset- investor


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Debt vs Equity Instruments

Claim that the owner of a financial asset hasmay be a fixed amount or a residual amount.

Fixed- Debt instrument- bonds Residual- Equity instrument- common stock

Some securities fall into both categories-preferred stock, convertible bonds


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Financial Assets versus Tangible Assets

Financial and Tangible assets are linked-ownership of tangible assets is financed by theissuance of some type of financial asset-either equity or debt instrument

Ultimately, cash flow for a financial asset isgenerated by some tangible asset.


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Role of Financial Assets Economic functions Financial assets:

transfer funds from those who have surplus funds tothose who need funds to invest in tangible assets.

transfer funds in such a way as to redistribute theunavoidable risk associated with the cash flowgenerated by the tangible assets among those seekingand those providing the funds

Claims held by the final wealth holders are generallydifferent from the liabilities issued by the finaldemanders of funds because of the activity of financial intermediaries that seek to transform the final liabilitiesinto the financial assets that the public prefers


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FINANCIAL MARKETS


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Financial Markets Financial assets are traded in a financial market. Economic functions Financial markets:

Price discovery- interaction of buyers and sellersdetermine the price of the traded asset

Provision of Liquidity - provide a mechanism for aninvestor to sell a financial asset

Reduction of Transaction costs Search costs (find buyers or sellers)- organized financial

markets reduce search costs Information costs- assessing the investment merits of afinancial asset- in an efficient market, prices reflect theaggregate information collected by all market participants


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Classification of financial markets

Classification by nature of claim- debt market, equity market maturity of claim- money market, capital market seasoning of claim (newly issued vs. previously

issued)- primary market, secondary market immediate or future delivery - spot market,

derivative market organizational structure- auction market, OTC

market, intermediated market


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Capital Markets Investors with long-term liabilities or long-term

investment horizon periods buy securities in thecapital markets. This includes many institutional

investors, such as life insurance companies andpensions.

The issuers of capital market securities includecorporations and governments who use themarket to finance their long-term capitalformation projects.


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Money Markets Investors use the money market to earn interest on

excess funds that they expect to have only temporarily.They also hold funds in money market securities as astore of value when they are waiting to take advantageof investment opportunities.

The sellers of money market securities use the marketto raise funds to finance their short-term assets(inventory or accounts receivable), to take care of cashneeds resulting from the lack of synchronizationbetween cash inflows and outflows from operations, orin the case of the Government, to finance thegovernments deficit or to refinance its maturing debt.


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Globalization of financial markets Factors that have led to the integration of

financial markets: Deregulation or liberalization of markets and the

activities of market participants in key financialcenters of the world

Technological advances for monitoring worldmarkets, executing orders, and analyzing financialopportunities

Increased institutionalization of financial markets-shift from domination by retail investors todomination by institutional investors


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FINANCIAL INTERMEDIARIES

AND FINANCIAL INNOVATION


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FINANCIAL INSTITUTIONS Financial enterprises financial institutions -provide

services related to: Transforming financial assets acquired through the market and

constituting them into a different and more widely preferabletype of asset which becomes their liability. Financialintermediaries

Exchanging of financial assets on behalf of their customers .Brokers

Exchanging of financial assets for their own accounts . Dealers Assisting in the creation of financial assets for their customers

and then selling these financial assets to other marketparticipants. Underwriters Providing investment advice to other market participants. Managing the portfolio of other market participants.


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Financial Intermediaries

Financial intermediaries include Depository institutions (acquire bulk of their funds

by offering their liabilities to the public mainly in

the form of deposits) Insurance companies Pension funds Finance companies- make loans; unlike

depositories do not accept deposits but rely onshort and long term debt for funding

Investment companies mutual funds


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FINANCIAL INTERMEDIARIES Financial intermediaries can be divided into

three categories:1. Depository Institutions2. Contractual Institutions3. Investment Companies

Most important contribution of intermediaries is asteady and relatively inexpensive flow of funds fromsavers to final users.

Dynamic nature- unusually rapid pace of financialinnovation- reflects and responds to arrival of sophisticated telecommunication and globalization of business


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Depository institutions

Depository institutions include commercialbanks

These institutions obtain large amounts of their funds from deposits, which they use tofund commercial and residential loans and to

purchase Treasury and other securities.


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Contractual institutions

Contractual institutions include life insurancecompanies, property and casualty insurancecompanies, and pension funds.

They obtain their funds from legal contracts toprotect businesses and households from risk(premature death, accident. etc.) and fromsavings plans.


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Investment companies Investment companies include mutual funds, money

market funds, and real estate investment trusts.

These institutions raise funds by selling equity or debtclaims, and then use the proceeds to buy debtsecurities, stocks, real estate, and other assets.

The claims they sell entitle the holder/buyer either to a

fixed income each period or a pro rata share in theownership and earnings generated from the asset fund.


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Role of Financial Intermediaries

Financial intermediaries make directinvestments . Market participants who holdthe financial claims issued by financialintermediaries make indirect investments .

commercial banks accept deposits and use theseto lend to businesses and consumers

Investment companies pool funds of marketparticipants and use these to buy portfolio of securities such as stocks and bonds


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Economic functions of financialintermediaries

Financial intermediaries play the basic role of transforming financial assets that are less desirable fora large part of the public into other financial assets(which are their liabilities) which are more widelypreferred by the public. This transformation involves atleast one of four economic functions:

Maturity intermediation Reducing risk by diversification Reducing costs of contracting and information processing Providing a payments mechanism


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Maturity intermediation

Commercial bank- Maturity of at least a portion of deposits accepted is short term. Maturity of loans isconsiderably longer.

By issuing its own financial claims transforms a longer

term asset into a shorter term one. Maturity intermediation

Provides investors with more choices concerning maturityfor their investments; borrowers have more choices for thelength of their debt obligations

Cost of long term borrowing is reduced as it usessuccessive deposits to provide the funds- individualinvestor would have charged more.


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Reducing risk by diversification

Investors who have a small sum to invest would find itdifficult to achieve the same degree of diversification.

If John has Rs. 1,000 and lends it all to Jack, then hisrisk is undiversified. The likelihood that John will getback his money depends entirely on Jacks project.

A bank makes it possible for investors to diversify theirrisk at low cost.

By depositing his money with a bank John can lend asmaller amount (e.g. Rs1000) to a larger number of borrowers.

Reducing costs of contracting and


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Reducing costs of contracting andinformation processing

Opportunity cost of time to processinformation

Contracting costs- costs of writing loandocuments

Enforcing costs- costs of enforcing the termsof the contract


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Providing a payments mechanism

Payments made by checks, credit cards, debitcards and electronic transfer of funds areprovided by certain financial intermediaries


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Financial Innovation

Market broadening instruments which increasethe liquidity of the market and availability of funds by attracting new investors and offeringnew opportunities to the borrowers

Risk management instruments which reallocatefinancial risk to those who are less averse to themor who have offsetting exposure

Arbitraging instruments and processes whichenable investors and borrowers to take advantageof differences in costs and returns betweenmarkets


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Motivation for Financial Innovation

Increased volatility of interest rates, inflation,equity prices and exchange rates

Advances in computers and

telecommunication technologies Greater sophistication and training among

professional market participants

Incentives to get around existing regulationand tax laws Changing global patterns of financial wealth


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RISKS INCURRED BY FINANCIAL

INSTITUTIONS


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CAMELS Regulators evaluation of overall safety and

soundness of a depository institution issummarized in CAMELS rating

C=capital adequacy A=asset quality M= management E= earnings L= liquidity S= sensitivity to market risk


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Risks faced by financial institutions Credit risk- risk that promised cash flows from

loans and securities held by FIs may not be paidin full

Liquidity risk- risk that a sudden and unexpectedincrease in liability withdrawal may require FIs toliquidate assets in a very short period of time andat low prices

Interest rate risk- risk incurred by FIs whenmaturities of its assets and liabilities aremismatched and interest rates are volatile


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Risks faced by financial institutions

Market risk- risk incurred in trading assets andliabilities due to changes in interest rates,exchange rates, and other asset prices

Off balance sheet risk- risk incurred by FIs as aresult of its activities related to contingent assetsand liabilities

Foreign exchange risk- risk that exchange ratechanges can affect the value of an FIs assets andliabilities denominated in foreign currencies.


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Risks faced by financial institutions Country or sovereign risk- risk that repayment by foreign

borrowers may be interrupted because of interferencefrom foreign governments or other political entities

Technology risk- risk incurred by an FI when itstechnological investments do not produce anticipated costsavings

Operational risk- risk that existing technology or supportsystem may malfunction, that fraud may occur that impactsthe FIs activities and or external shocks such as hurricanesand floods occur

Insolvency risk- risk that an FI may not have enough capitalto offset a sudden decline in the value of its assets relativeto its liabilities.


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Credit Risk Arises because of the possibility that promised cash

flows on financial claims held by FIs such as loans andbonds will not be paid in full.

FIs that make loans and buy bonds with long maturities aremore exposed. Banks, Insurance companies more exposedthan money market mutual funds

FIs need to collect information about borrowers whoseassets are in their portfolio and monitor it over time

FIs diversify credit risk exposure by lending to a largenumber of borrowers.

Diversification reduces firm specific credit risks while stillleaving the FIs exposed to systematic credit risk .


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LIQUIDITY RISK When an FIs liability holders such as depositors or

insurance policyholders demand immediate cash -liability side liquidity- or when holders of off-balancesheet loan commitments (credit lines) suddenlyexercise their right to borrow- asset side liquidity .

Serious liquidity problems may result in a run inwhich all liability claimholders seek to withdraw theirfunds simultaneously from an FI because they fear thatit will be unable to meet their demands for cash in the

near future. FIs liquidity problem can turn into a solvency problem

causing it to fail.


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INTEREST RATE RISK

Asset liability mismatch- maturities of assetsand liabilities are different.

Refinancing risk- Asset have longer maturitiesthan liabilities

Reinvestment risk- Asset have shorter maturitiesthan liabilities


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Market Risk When FIs actively trade assets and liabilities rather

than holding them for longer term investment, fundingor hedging purposes.

Market risk is the incremental risk incurred by an FIwhen interest rate risk and foreign exchange risks arecombined with an active trading strategy, especiallyone that involves short trading horizons such as a day.

The traditional roles of many FIs have changed inrecent years- an increased reliance on trading as thereis decline in income from traditional deposit taking andlending activities.


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Foreign Exchange Risk

Mismatch of assets and liabilitiesdenominated in foreign currencies

Mismatch of maturities of assets and liabilitiesdenominated in foreign currencies (foreigninterest rate changes can lead to losses)


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Country or sovereign risk

Government of the country in which a foreigncorporation is headquartered may prohibit orlimit debt repayments due to foreign currency

shortage or adverse political events- debtmoratorium


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Technology and Operational risk

BIS defines this risk as the risk of lossresulting from inadequate or failed internalprocesses, people and systems or from

external events Technology risk- technological investments do

not produce the anticipated cost savings Operational risk- partly related to technology

risk (failed ATM) but also due to employeefraud, account errors etc


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Insolvency Risk

Technically insolvency occurs when capital isdriven close to zero due to losses incurred as aresult of any of the risks discussed.

The more the equity capital to borrowedfunds an FI has the better able it is towithstand losses.


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REGULATION

REGULATORS


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REGULATORS

REGULATORS

SEBI

CORPORATEBOND

MARKETEQUITY /

DERIVATIVES

RBI

BANKING /

FOREIGNEXCHANGE

FIXED

INCOMEMARKET

FMC

COMMODITYMARKET

IRDA

INSURANCECos.

PFRDA

PENSIONFUNDS

SECURITIES AND EXCHANGE BOARD OF INDIA

RESERVE BANK OF INDIAFORWARDS MARKET COMMISSION

INSURANCE REGULATORY AND DEVELOPMENT AUTHORITY OF INDIA

PENSION FUND REGULATORY AND DEVELOPMENT AUTHORITY OF INDIA


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Regulation of Financial Markets

Main Reasons for Regulation

1. Increase Information to Investors

2. Ensure the Soundness of FinancialIntermediaries

R l i R


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Regulation Reason:Increase Investor Information

Asymmetric information in financial markets means thatinvestors may be subject to adverse selection and moralhazard problems that may hinder the efficient operation of financial markets and may also keep investors away fromfinancial markets

The Securities and Exchange Board of India (SEBI) requirescorporations issuing securities to disclose certaininformation about their sales, assets, and earnings to thepublic and restricts trading by the largest stockholders(known as insiders) in the corporation

Such government regulation can reduce adverse selectionand moral hazard problems in financial markets andincrease their efficiency by increasing the amount of information available to investors.

R l i R E S d


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Regulation Reason: Ensure Soundnessof Financial Intermediaries

Providers of funds to financial intermediaries maynot be able to assess whether the institutionsholding their funds are sound or not.

If they have doubts about the overall health of financial intermediaries, they may want to pulltheir funds out of both sound and unsoundinstitutions, with the possible outcome of a

financial panic. Such panics produces large losses for the public

and causes serious damage to the economy.

R l i R E S d


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Regulation Reason: Ensure Soundnessof Financial Intermediaries (cont.)

To protect the public and the economy from financialpanics, the government has implemented six types of regulations:

Restrictions on Entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates


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Regulation: Restriction on Entry

Restrictions on Entry Regulators have created very tight regulations as to who is

allowed to set up a financial intermediary

Individuals or groups that want to establish afinancial intermediary, such as a bank or an insurancecompany, must obtain permission/license from thegovernment

Only if they are upstanding citizens with impeccablecredentials and a large amount of initial funds will they begiven a license.


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Regulation: Disclosure

Disclosure Requirements

There are stringent reporting requirements for financialintermediaries

Their bookkeeping must follow certain strict principles, Their books are subject to periodic inspection, They must make certain information available to

the public.


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Regulation: Restriction on Assets and Activities

There are restrictions on what financial intermediariesare allowed to do and what assets they can hold

Before you put your funds into a bank or some other

such institution, you would want to know that your fundsare safe and that the bank or other financial intermediarywill be able to meet its obligations to you


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Regulation: Restriction on Assets and Activities

One way of doing this is to restrict the financialintermediary from engaging in certain riskyactivities

Another way is to restrict financial intermediariesfrom holding certain risky assets, or at least fromholding a greater quantity of these risky assetsthan is prudent


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Regulation: Deposit Insurance

The government can insure people depositors to afinancial intermediary from any financial loss if thefinancial intermediary should fail


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TYPES OF REGULATIONS structural regulations: determine the types of

activities that different forms of institution arepermitted to engage in

prudential regulations: cover the internalmanagement of financial institutions and otherfinancial service organisations in relation to capitaladequacy, liquidity and solvency

investor protection regulations: It is generally

perceived that investors are the weakest participants of the financial markets and hence need protection frommalpractice, fraud and collapse.


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Asset Liability management of

financial institutions


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Nature of LiabilitiesType Nature of

CashOutlay

Timing of CashOutlay

Example

I Known Known Fixed rate deposit,Guaranteed Investment

ContractII Known Uncertain Life Insurance Policy

III Uncertain Known Certificates of deposit-

floating rate interest

IV Uncertain Uncertain Automobile and homeinsurance policies

financial system, markets and services

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