UNIVERSITY OF SAINT LOUIS

Tuguegarao City
SCHOOL OF ACCOUNTANCY BUSINESS and HOSPITALITY
Accountancy Department
Week 4 Learning Material in Financial Markets

Lesson 4: Lending and Borrowing in the Financial System (Part I)

Topic/s: - The Evolution of Financial Transactions
- Direct Finance
- Indirect Finance
- Semi Direct Finance
- Classification of Financial Institutions

Learning Outcomes: After this week, you are expected to be able to:

- Examine the different ways in which funds flow from lenders to borrowers within
financial system.
- Understand critical roles played by financial intermediaries and other financial
institutions in lending and borrowing within the financial system
- Differentiate financial institutions in terms of their specific functions.

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Introduction:
The financial system is the mechanism through which loanable funds reach borrowers. Through the
operation of the financial markets, money is exchanged for financial claims in the form of stocks, bonds, and
other securities, And through the exchange of money for financial claims, the economy’s capacity to produce
goods and services is increased. This happens because the money and capital markets provide the financial
resources needed for real investment. Although it is true that the financial markets deal mainly in the exchange
of paper claims and bookkeeping entries, these markets provide an indispensable conduit for the
transformation of savings into real investment, accelerating the economy's growth and developing new
businesses and jobs.

Lending and Borrowing in the Financial System

Business firms, households. and governments play a wide variety of roles in modern financial systems.
It s quite common for an individual or institution to be a lender of funds in one period and a borrower in the next
or to do both simultaneously. Indeed, financial intermediaries, such as banks and insurance companies.
operate on both sides of the financial markets, borrowing funds from customers by issuing attractive financial
claims and simultaneous!y making loans available to other customers. Virtually, all of us at one point or
another in our lifetimes will be involved in the financial system as both a borrower and a lender of funds.

Deficit budget unit Balanced budget unit Surplus budget unit

- this unit is considered as net
borrower of funds they are the
ones whose expenditures are
greater than their receipts
(revenue)
- they are also called net demander
of funds from the financial system,
selling financial assets, issuing
new debt or selling new stock.
- this unit is considered as neither
a net lender nor a net borrower,
they are the one’s whose
expenditure is equal to their
receipts.
- this unit is considered as net
lender of funds they are the ones
whose expenditures are lesser
than their receipts (revenue).
- they are also called net supplier
of funds to the financial system.
They accomplish this function by
purchasing financial assets, paying
off debt, or retiring equity (stock).

The Evolution of Financial Transactions

Financial systems are never static. They change constantly in response to shifting demands from the
public, the development of new technology, and changes in laws and regulations Competition in the financial
marketplace forces financial institutions to respond to public need by developing better and more convenient
financial services. Over time, the system of financial markets has evolved from simple to more complex ways
of carrying out financial transactions. The growth of industrial centers with enormous capital investment needs
and the emergence of a huge middle class of savers have played major roles in the gradual evolution of the
financial system.

Whether simple or complex, all financial systems perform at least one basic function. They move
scarce funds from those who save and lend (surplus-budget units) to those who wish to borrow and invest
(deficit-budget units). In the process, money is exchanged for financial assets. However, the transfer of funds

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from savers to borrowers can be accomplished in at least three different ways. We label these methods of
funds transfer: (1) direct finance. (2) semi-direct finance, and (3) indirect finance. Most financial systems have
evolved gradually over time toward greater reliance on indirect finance.

DIRECT FINANCE

- with direct finance, borrower and lender meet each other and exchange funds in return for financial assets.

- claims arising from direct finance are called primary securities because they flow directly from the borrower to
the lender of funds.

Disadvantages:

- both borrower and lender must desire to exchange the same amount of funds at the same time. Without
fundamental coincidence, direct finance breaks down.

- both lender and borrower must frequently incur substantial information costs simply to find each other. The
borrower may have to contact many lenders before finding the right lender with the right amount of funds and is
willing to take the borrower’s IOU.

SEMI-DIRECT FINANCE

- semi-direct finance is an improvement over direct finance in a number of ways. 1) it lowers the search
(information) costs for participants in the financial markets., 2) the dealer can split up large issue of primary
securities into smaller units, thus, making it affordable to buyers of modest means (this expands the flow of
savings into investment)., 3) brokers and dealers facilitate the development of a secondary markets in which
securities can be offered for a resale.

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Disadvantages:

- the ultimate lender still winds up holding the borrower’s securities, and, therefore, the lender must be willing
to accept the risk and maturity characteristics of the borrower’s IOU.

- there still must be a fundamental coincidence of wants and needs between the borrower and lender of funds.

Broker is merely an individual or a financial institution who provides information concerning possible
purchases and sales of securities. Either buyer or a seller of securities may contact a broker whose job is
simply to bring buyers and sellers together.

Dealer also serves as an intermediary between buyers and sellers, but the dealer actually acquires the seller’s
securities in hope of marketing them at a later time, at a favorable price. They take a position of risk because
by purchasing securities outright for their own portfolios, they are subject to losses if those securities decline in
value.

INDIRECT FINANCE

- the limitations of both direct and semi-direct finance simulated the development of indirect finance carried out
with the help of financial intermediaries.

- the fundamental role of financial intermediaries in the financial system is to serve both ultimate lenders and
borrowers in a much more complete way than brokers and dealers do. They issue securities of their own
(secondary securities) to ultimate lenders and at the same time accept IOU’s from borrowers (primary
securities).

- for the most part, secondary securities are liquid and, therefore, can be converted back to cash easily with
little risk of significant loss.

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- one of the benefits of the development of efficient financial intermediation (indirect finance) has been to
smooth out consumption spending by household and investment spending business over time despite
variations of income because intermediation makes saving and borrowing easier and safer.

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Depository Institutions

- include commercial banks, savings and loan associations, savings banks and credit unions. They derive the
bulk of their loanable funds from deposit accounts sold to the public

Contractual Institutions

- include insurance companies and pension funds. They attract funds by offering legal contract to protect the
saver against risk.

Investment Institutions

- include investment companies, money market funds and real estate investment trusts. They sell shares to the
public and invest the proceeds in stocks, bonds and other assets.

*****END of TOPICS*****

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