FINANCIAL MARKETS AND INSTITUTIONS: IMPORTANT FUNCTIONS

Economic system relies heavily on financial resources and transactions, and economic efficiency rests in part on
efficient financial markets.

Financial markets consist of agents, brokers, institutions, and intermediaries transacting purchases and sales of
securities. The many persons and institutions operating in the financial markets are linked by contracts,
communications networks which form an externally visible financial structure, laws, and friendships. The
financial market is divided between investors and financial institutions.

The term financial institution is a broad phrase referring to organizations which act as agents, brokers, and
intermediaries in financial transactions. Agents and brokers contract on behalf of others; intermediaries sell for
their own account. Financial intermediaries purchase securities for their own account and sell their own liabilities
and common stock. For example, a stockbroker buys and sells stocks for us as our agent, but a savings and loan
borrows our money (savings account) and lends it to others (mortgage loan). The stockbroker is classified as an
agent and broker, and savings and loan is called a financial intermediary. Brokers and savings and loans, like all
financial institutions, buy and sell securities, but they are classified separately, because the primary activity of
brokers is buying and selling rather than buying and holding an investment portfolio. Financial institutions are
classified according to their primary activity, although they frequently engage in overlapping activities. The
classification of financial market participants is outlined in Figure 1.

Financial markets provide our specialized, interdependent economy with many financial services, including time
preference, distribution of risk, diversification of risk, transactions economy, transmutation of contractual
arrangements, and financial management.

Time Preference

Time preference refers to the value of money spent now relative to money available for spending in the future.
Businesses are frequently making decisions among short-term and long-term uses of funds, and business
executives must judge between outlays which provide a return in the near term and those which pay off many
years from now. They must decide upon commitments requiring funds now and those requiring funds later, by
allocating not only funds that they expect to receive currently, but also those that they expect to receive in the
future.

The money and capital markets price funds so that businesses and governments can make rational economic
allocations of capital. The price of capital is set in a competitive marketplace by supply and demand forces. The
market price of capital is compared by businesses to the expected returns in proposed capital expenditures.
Businesses allocate their capital to real investments whose return is at above the cost of capital. Long-term
investments are compared to short-term investments using the financial-market-determined cost of capital.
Consequently, the allocation of capital between short-and long-term investments depends on the free play of
supply and demand in an open market.

Like businesspersons, consumers may decide upon a time pattern for expenditures that does not necessarily
coincide with their current or expected income flows. Financial markets allow us to implement time adjustments
in the payments for goods. Without them, there would be no opportunity to earn interest on savings, and
expenditures would be limited to current receipts and cash. Savings allows many consumers to postpone
consumption and to receive returns from investments.

Risk Distribution

The financial markets distribute economic risks. Employment and investment risks are separated by the creation
and distribution of financial securities. On a larger scale, the money and capital markets transfer the massive risks
from people actually performing the work (employment risks) to savers who accept the risk of an uncertain return.
The chance of failure for a 100 million € mobile phones manufacturer may be divided among thousands of
investors living and working all over the world. If the mobile phones business fails, each investor loses only part
of his or her wealth and may continue to receive income from other investments and employment.
Figure 1 Classification of participants in the financial markets

Participants Classification

Commercial Banks
Savings Banks
Savings and Loans
Credit Unions
Finance Companies Financial Financial
Life Insurance Companies Intermediaries Institutions
Financial
Pension Funds Institutions
Investment Companies
Real Estate Investment Funds
Mortgage Bankers Agents and Securities Market
Investment Bankers Brokers Institutions
Securities Dealers and Brokers
Clearing Houses
Stock Exchanges
People who own stocks, bonds,
and other securities

People who borrow money with

mortgages, installment loans, Investors and Borrowers
and other instruments

Businesses (Non financial)

Governments

Diversification of risk

In addition to permitting individuals to separate employment and investment risks, the financial markets allow
individuals to diversify among investments. Diversification means combining securities with different attributes
into a portfolio. Ordinarily, a diversified portfolio of financial claims is less risky than a portfolio consisting of
one or at most a handful of similar securities. Total risk is reduced because losses in some investments are offset
by gains in others. The benefits of diversification are possible due to the existence of large, diversified financial
markets where investors may buy and sell securities with minimum transactions cost, regulatory interference, and
so forth.
 Functions of Financial Intermediaries

Financial markets facilitate the movement of funds from those who save money to those who invest money in
capital assets. Savings are distributed among investments and expenditures through securities traded in the
financial markets. Financial institutions facilitate and improve the distribution of funds, money, and capital in
several respects:

1. Payments mechanism
2. Security trading
3. Transmutation
4. Risk diversification
5. Portfolio management

All of these functions are important to an efficient financial system, and managers are improving execution
capability through improved electronic communication, computer processing, and institutional design. Note that
these functions are characteristic of agents. Financial intermediaries are special types of agents that collect
information about economic entities, evaluate financial information, and package financial claims.

The financial intermediary, by purchasing primary securities and issuing secondary securities adds choices to
borrowers and lenders. Issues of financial intermediaries are termed secondary securities. The process of changing
the terms of money bought and sold by financial intermediaries is termed transmutation. For example, savings and
loan associations obtain money with short-term, small-balance savings deposits to make 20- to- 30 year mortgage
loans in amounts usually exceeding 10,000 €. Timing and amount are usually changed through transmutation,
with alterations limited only by the creativity of the financial institution and the acceptance of its customers.

Financial institutions also act as portfolio managers and advisers over most of the primary securities
owned by investors. The private financial sector manages most of the home mortgages, commercial
mortgages, consumer loans, state and local government securities, and business loans. In addition, nearly
one-fourth of outstanding common stocks are managed by investment companies, and a large portion of
the remaining shares of stock are invested with the advice of trust institutions. The most important
reasons for obtaining institutional management are:
 convenience,
 protection against fraud,
 quality of investment selection, and
 a low transaction cost.
Financial institutions provide a convenient place where savers can safely invest excess money and consumers can
easily borrow funds. Investments are protected against unscrupulous borrowers by the institution’s qualified loan
officers and a bevy of collectors and attorneys. Well-trained investment analysts and loan officers seek good
investment opportunities and screen prospective securities so as to obtain the best yield available for the risk level
that suits the investor’s preferences.

Income tax differentials among individuals and businesses are mitigated by intermediaries who transfer tax
deductions from low-to high-income taxpayers and provide tax-free services in place of taxable interest. For
example, pension funds owe their existence to tax differentials. Income invested in and earned by pension funds is
not taxed until retirement when rates are generally lower than before retirement. Commercial banks reward
depositors with “free services”, which are nontaxable, rather than pay interest, which is taxable. The depositors
receive nontaxable benefits such as checking accounts, traveler’s checks, and low-rate loans in return for the use
of their money. Leasing intermediaries, a type of finance company, pass depreciation tax shields from equipment
users in low-tax brackets to equipment owners in high-tax brackets. The depreciation expense reduces income
taxes more for high-than for low-tax-bracket owners.