L1 - Introduction to Economics of the Financial System Flashcards
How is the term Financial System defined?
- A process that facilitates an exchange of funds
- financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals.
- These systems can differ from country to country
What is an important issue around regulations in the Financial System?
- Investors are always looking for a way around them
- That’s why they always need adapting, refining and modifying as time goes on
Who are the Participants in the Financial System?
- Depository Institutions (banks)
- Contractual Savings Institutions
- Investment Intermediaries
- Merchant Banks
- Companies/Firms
- The Individual
- Government
- The Central Bank
- Regulators
What is the role of Depository Institutions in the Financial System?
- Depository institutions (for simplicity, we refer to these as banks throughout this text) are financial intermediaries that accept deposits from individuals and institutions and make loans.
- These institutions include commercial banks and the so-called thrift institutions (thrifts) : savings and loan associations, mutual savings banks, and credit unions.
What is the role of Commercial Banks in the Financial System?
- These financial intermediaries raise funds primarily by issuing checkable deposits (deposits on which checks can be written), savings deposits (deposits that are payable on demand but do not allow their owner to write checks), and time deposits (deposits with fixed terms to maturity).
- They then use these funds to make commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds. Around 5,000 commercial banks are found in the United States, and as a group, they are the largest financial intermediary and have the most diversified portfolios (collections) of assets.
What is the role of Saving and Loan Associations and Mutual Savings Banks in the Financial System?
These depository institutions, of which there are approximately 900, obtain funds primarily through savings deposits (often called shares ) and time and checkable deposits. In the past, these institutions were constrained in their activities and mostly made mortgage loans for residential housing.
Over time, these restrictions have been loosened so the distinction between these depository institutions and commercial banks has blurred. These intermediaries have become more alike and are now more competitive with each other.
What is the role of Credit Unions in the Financial System?
These financial institutions, numbering about 7,000, are typically very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans.
What is the role of Contractual Saving Institutions in the Financial System?
Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis.
Because they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years, they do not have to worry as much as
As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages.
What is the role of Life Insurance Companies in the Financial System?
Life insurance companies insure people against financial hazards following a death and sell annuities (annual income payments upon retirement).
They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages.
They also purchase stocks but are restricted in the amount that they can hold. Currently, with $6.4 trillion in assets, they are among the largest of the contractual savings institution
What is the role of Fire and Casualty Insurance Companies in the Financial System?
These companies insure their policyholders against loss from theft, fire, and accidents. They are very much like life insurance companies, receiving funds through premiums for their policies, but they have a greater possibility of loss of funds if major disasters occur.
For this reason, they use their funds to buy more liquid assets than life insurance companies do. Their largest holding of assets consists of municipal bonds; they also hold corporate bonds and stocks and U.S. government securities.
What is the role of Pension Funds and Government Retirement Funds in the Financial System?
Private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan.
Funds are acquired by contributions from employers and from employees, who either have a contribution automatically deducted from their pay checks or contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and stocks.
The establishment of pension funds has been actively encouraged by the federal government, both through legislation requiring pension plans and through tax incentives to encourage contributions.
What are the different sections under-investment intermediaries?
This category of financial intermediaries includes finance companies, mutual funds, money market mutual funds, and investment banks.
What is the role of Finance Companies in the Financial System?
Finance companies raise funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and bonds. They lend these funds to consumers (who make purchases of such items as furniture, automobiles, and home improvements) and to small businesses.
Some finance companies are organized by a parent corporation to help sell its product. For example, Ford Motor Credit Company makes loans to consumers who purchase Ford automobiles.
What is the role of Mutual Funds in the Financial System?
These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds.
Mutual funds allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds.
In addition, mutual funds allow shareholders to hold more diversified portfolios than they otherwise would.
Shareholders can sell (redeem) shares at any time, but the value of these shares will be determined by the value of the mutual fund’s holdings of securities. Because these fluctuate greatly, the value of mutual fund shares does, too; therefore, investments in mutual funds can be risky.
What is the role of Money Market Mutual Funds in the Financial System?
These financial institutions have the characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that are then used to buy money market instruments that are both safe and very liquid.
The interest on these assets is paid out to the shareholders. A key feature of these funds is that shareholders can write checks against the value of their shareholdings. In effect, shares in a money market mutual fund function like checking account deposits that pay interest.
Money market mutual funds have experienced extraordinary growth since 1971, when they first appeared. By the end of 2015, their assets had climbed to nearly $2.7 trillion.
What is the role of Hedge Funds in the Financial System?
Hedge funds are a type of mutual fund with special characteristics. Hedge funds are organized as limited partnerships with minimum investments ranging from $100,000 to, more typically, $1 million or more.
These limitations mean that hedge funds are subject to much weaker regulation than other mutual funds. Hedge funds invest in many types of assets, with some specializing in stocks, others in bonds, others in foreign currencies, and still others in far more exotic assets.
What is the role of Investment Banks in the Financial System?
Investment Banks Despite its name, an investment bank is not a bank or a financial intermediary in the ordinary sense; that is, it does not take in deposits and then lend them out. Instead, an investment bank is a different type of intermediary that helps a corporation issue securities.
First it advises the corporation on which type of securities to issue (stocks or bonds); then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market.
Investment banks also act as deal makers and earn enormous fees by helping corporations acquire other companies through mergers or acquisitions.
What is the role of Merchant Banks in the Financial System?
A merchant bank is a company that conducts underwriting, loan services, financial advising, and fundraising services for large corporations and high net worth individuals.
Unlike retail or commercial banks, merchant banks do not provide services to the general public. They do not provide regular banking services like checking accounts and do not take deposits.
These banks are experts in international trade, which makes them specialists in dealing with multinational corporations. Some of the largest merchant banks in the world include J.P. Morgan, Goldman Sachs, and Citigroup.
What is the role of Companies/Firms in the Financial System?
- Raise money on the various stock markets in exchange for a percentage ownership of their company
- Investment intermediaries buy these instruments in hopes of their price rising in order to make money for their clients.
- Also directly supply funds to be lent out to other business.
What is the role of the individual in the Financial System?
- Supplying money to banks through bank deposits
- Use of pension funds and mutual funds
- Retail traders are involved directly in the financial market usually trading derivatives and risk.
- Borrowing money for mortgages or business loans
What is the role of Government in the Financial System?
- Regulations e.g. Volker Rule
- Fiscal and Monetary policy
- Auction of Government Bonds
- Bailout
- Raising Finance
What is the role of Regulators in the Financial System?
- Federal and state governments have a myriad of agencies in place that regulate and oversee financial markets and companies.
- These agencies each have a specific range of duties and responsibilities that enable them to act independently of each other while they work to accomplish similar objectives.
- Although opinions vary on the efficiency, effectiveness and even the need for some of these agencies, they were each designed with specific goals and will most likely be around for some time.
- With that in mind, the following article is a complete review of each regulatory body.
What is the role of the Central bank in the Financial System?
- The central bank has been described as “the lender of last resort,” which means it is responsible for providing its nation’s economy with funds when commercial banks cannot cover a supply shortage.
- In other words, the central bank prevents the country’s banking system from failing. However, the primary goal of central banks is to provide their countries’ currencies with price stability by controlling inflation.
- A central bank also acts as the regulatory authority of a country’s monetary policy and is the sole provider and printer of notes and coins in circulation.
- Time has proved that the central bank can best function in these capacities by remaining independent from government fiscal policy and therefore uninfluenced by the political concerns of any regime.
- A central bank should also be completely divested of any commercial banking interests.
What is the Money Market?
Said to be unorganised
The Money market refers to the market where borrowers and lenders exchange short term funds to solve their liquidity needs. Money market instruments are generally financial claims that have low default risk, maturities under one year and high marketability
What is the Capital Market?
- Much more organised than the money market
- The Capital market is a market for financial investments that are direct or indirect claims to capital. It is wider than the Securities Market and embraces all forms of lending and borrowing, whether or not evidenced by the creation of a negotiable financial instrument.
- The Capital Market comprises the complex of institutions and mechanisms through which intermediate term funds and long-term funds are pooled and made available to business, government and individuals.
- The Capital Market also encompasses the process by which securities already outstanding are transferred.
- Primary market: A primary market where the fresh issue of securities are offered to the public
- Secondary market: A secondary market where issued securities are traded between the investors.
What is an Organised Market?
Organized market is that part of the financial markets, which operates under a defined set of rules, regulations and legal provisions and the statutory authorities such as the Central Government, the Central Bank the Exchange Commission (such as SEBI in India), etc. The organized market may also be called the official or formal market.
What is an Unorganised market?
- Unorganized is that part of the financial markets, which is not standardized and is outside the preview of government control. In India, the rural money lenders and traders form the unorganized market.
- The basic feature of unorganized market are high interest rates, fluctuating and varying interest rates, absence of precise rules, upfront payment of interest, unsystematic arrangements etc.
What is a Dealer?
- Dealers are people or firms who buy and sell securities for their own account, whether through a broker or otherwise.
- A dealer acts as a principal in trading for its own account, as opposed to a broker who acts as an agent who executes orders on behalf of its clients.
- Dealers are important figures in the market. They make markets in securities, underwrite securities, and provide investment services to investors.
- That means dealers are the market makers who provide the bid and ask quotes you see when you look up the price of a security in the over-the-counter market. They also help create liquidity in the markets and boost long-term growth.
