Financial Management II

BBA V

Unit_1:Economics of Financial
System
By
Durga Prasad Panta
KIC

Concept of Financial System

Financial system comprises of financial institutions, markets and

financial instruments for mobilizing resources

Basic Needs Served by Financial

System
Financial system Facilitate resource transfer and
mobilizes savings to the productive sectors
thereby contributing to the economic
development
The financial sector creates value by helping households,
firms and governments to meet these basic needs
There are three types of basic needs served by
the financial system:
(i) Payments
(ii) Resource Transfer
(iii) Risk Trading

1. Payments:
One of the major functions of financial
system
Established global networks of payment
system in financial market has made
international trade possible and easy
Certain financial assets including
checking accounts and negotiable order
of withdrawal accounts serve as medium
of payments

1. Payments cont.
Payments

networks are the elemental component of any

financial system

The payment system

-- Allows secure transactions between related parties
-- Permits immediate discharge of liabilities
-- Provides a means to store of value
-- Creates records of transactions

There are three types of payments systems

--

Retail

-- Wholesale

(credit cards, debit cards, checks, cash etc.)

(for business to business payments)

-- Institutional (between major financial intermediaries)

1. Payments cont.
Credit cards issued by banks;
New innovation in payment system;
e.g., electronic payment system is
leading towards simple, safe and cost
reducing payment system
Involved intermediary institutions
facilitating payments among the
trading parties

1. Payments cont.
Warehouse banks:
Banks that keeps depositors cash in storage
In exchange for a fee they offer security and
ease of payment, accepts deposits of cash,
count and authenticate currency and safe
guard
Clearing houses:
Association of banks to facilitate clearing
Clearing: collection of checks in which
checks drawn on one bank are settled
against check drawn on another bank

2. Resource Transfer:

Households, firms and governments each face a mismatch in time

between cash flows in and cash flows out

Households
-- Need to borrow early in their life cycle to buy housing and then save in

mid- life

for retirement

Firms
-- Need to raise capital for projects early in the life-cycle of the firm, but
typically generate a cash surplus as mature companies
-- Need to manage fluctuations in working capital due to seasonality in revenues and
costs

Governments
-- Borrow to fund budget deficits during the low point of business cycles
helping to stabilize the economy

ideally

-- Borrow to create risk-free debt instruments in the economy (Government bonds,

notes and bills)

2.Resource Transfer cont

Saving, lending and investment
behavior of individuals , business firms
and government units makes possible
for transfer of resources
Financial system by providing different
mechanism facilitates the transfer of
resources as it facilitates lending.
Lending is a form of trade that Give up
purchasing power now in exchange for
purchasing power tomorrow

2. Resource Transfer cont

Diversity among the people in need
and possession of purchasing power
make it possible for trade of
purchasing power
Diversity arises among people
because of their saving, lending and
borrowing behavior
Purpose of saving is to allocate
purchasing power throughout the life

2. Resource Transfer
cont

There areTwo forms of lending

(i)Direct Lending
(ii)Indirect Lending
(i)Direct Lending:
Lending by ultimate lender to ultimate
borrower
Direct relation between the ultimate lender
and ultimate borrower
Intermediaries only facilitate the process

2. Resource Transfer
cont

Various institutions in the financial system

by making following provisions make
easier to lend
Information dissemination
Financial press- news on companies
Accounting and auditing firms- check
books of the companies
Market information on transactionevaluation of securities prices
Negotiations or contract writing
Write a loan contract or trust deed

2. Resource Transfer
cont

Underwriter negotiates the terms of loan

contract with the issuer and appoints a
trustee to monitor compliance on those
terms
Underwriter buys whole issue and resells to
the public with legal obligation to
purchasers to provide accurate information
about the risk
All these activities greatly reduce cost and
risk on lending

2. Resource Transfer
cont

(ii)Indirect Lending:
Lending by ultimate lender to financial
intermediary that then re-lends to
ultimate borrower
No relationship is established between the
ultimate lender and ultimate borrower
Intermediaries not only facilitate the
process but also are responsible for
repayment to the lenders and recovery
from the borrower.

 Advantages of indirect lending

(a) Information advantage:
Banks can have large information about its clients
whom it lends, which may not be available to the
public
(b)Specialization:
To assess creditworthiness and monitor performance
Cost reduction by making large loan
Pooling of small amount to make large loan
Cost of large loan relatively lower than small loans
(c) Continue relationship:
Individuals may lend for one or few time but banks
lend to the same borrower more frequently as it is
their main business, thereby build up relationship with
the borrower
This relationship help them to be in win-win situation

(d) Diversification:
Individual can make only a few
investment- no diversity
Banks have diversified investments
Reduction of risk from diversified
investments
(e) Liquidity:
Through pooling large number of people
having diversity in need and possession of
money, continuous liquidity is possible

3. Risk Trading:
Financial system provides
mechanism to minimize those risks
through trading of risk
Two forms of trade in risk;
i. Insurance
ii. Forward Transaction

I.Insurance
Sharing of risk of accidents, illness and
natural disaster
One who do not face a particular risk agree
to share the losses of those who do
Insurance policy: contracts with an
insurance company (insurer) under which
the insured pays a premium in exchange for
coverage of specified losses
One pay the insurers a relatively small sum
with certainty; in exchange the insurer pay
a large sum with relatively low possibility of
risk of damage
Types: Property-liability insurance; life
insurance, health insurance;

 Problems:
Tendency of insured
Selection risk for insurer: same price for different
condition; assumed to be less but becomes huge

II.Forward Transaction
Agreement in advance on the terms of trade to be
carried out in the future
Sharing of price risk
Future Markets:

 Market in standardized contracts for

future delivery of various goods
Address the problem of difficulty and
cost of finding trading partners
Role of forward intermediaries
Example; explain how both the party
benefit by signing a forward contract

Financial Systems Basic

Technology
Financial Systems Basic Technology
Includes

Delegation
Credit Substitution
Pooling
Netting

Delegation
Rather than doing the things oneself, one can
assign some one else to the work on his behalf
This is being done mostly to reduce costs and
make the operations more efficient.
Examples: indirect lending
* Consumer lending through dealers / suppliers
* Lenders delegating to underwriter task of
setting up a loan & documentation
* In forward trx, traders delegate to Futures EX.

Delegation- Reducing costs

Many costs of a trx. are indivisible eg.
Syndication of loans.
Delegation allows specialization. The
delegate representing many lenders and
lending more often acquires expertise.
The delegate can negotiate better terms.
Revealing information to one delegate
would be more acceptable to the
borrower.

Delegation- Fundamental
issue
How the delegate to be trusted?
Two possible solutions to this are:
1.Bonding: putting up of assets to
guarantee performance
2.Reputation:General estimation in
which someone is held by the public

Credit Substitution
Replacement of credit of one party to a transaction
with the (superior) credit of a financial institution.
In many cases delegation combined with credit
substitution. eg. A bank substitutes its own credit for
the credit of the borrower: depositors lend to the bank
rather than to the ultimate borrower.
Credit substitution works because the promise of
bank, insurance company or future exchange is more
acceptable than the promise of the ultimate trading
partner. This is due to following two reasons:
* Reputation of FI
* FIs resources and capabilities in fulfilling the
promise.

Delegation & Credit

substitution
Delegation & credit substitution may
not always go together.
Underwriters don't guarantee the
issues they float : there is a delegation
but not credit substitution.
When bank money is used in payment,
the bank substitutes its own credit for
the credit of the buyer: there is credit
substitution but no delegation.

POOLING
Pooling is combination of assets &
liabilities in ways that reduce risk or
improve liquidity.
Pooling makes the liabilities of an FI (the
promises it makes) safer and more liquid
than its assets (the promises to it). Eg.
pooling makes bank depositors safer and
more liquid than assets.
One reason pooling works is
diversification, other is netting.

NETTING
Netting is offset of one trx. against
another, to reduce the number of trx.s that
actually need to be executed.
Executing a trx. is costly. Netting lowers
costs by offsetting one trx. against
another.
Example: clearing of checks, by netting
banks obligations to one another reduces
the need for physical transfer and thereby
reduces costs.

Netting
Netting also creates liquidity eg. Bank
can hold relatively illiquid assets
because it can meet withdrawals out
of new deposits, without having to
liquidate the underlying assets. By
netting new deposits and withdrawals,
it reduces the need to buy and sell the
underlying assets.
Secondary markets work in much the
same way.