Elements of Banking and

Finance (FINA 1001)

Semester 1 (2020/2021)

Lecture 1
The Financial System

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 COVID-19 HOUSEKEEPING
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the designated EXIT, which will be identified for you now.
 The Financial System: Topics

• Overview of the system: Its participants

• The functional perspective: The functions
• Some key financial terms
• The classification of financial intermediaries
• Incentives & information in the financial system

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Overview- Financial System & Markets

• What is the financial system and is there a need for a financial

system? What is its purpose?

• Defined as a set of institutions, instruments, and markets which

foster savings and directs funds to their most efficient use.

• Co-ordinates and allocates the coincidence of wants of

economic actors. Transfer funds from savers to borrowers.
• Video Link- Introduction to the Financial System:
https://www.youtube.com/watch?v=Sqq-XBZEH-4
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 The Participants of the
Financial System

•Savers are considered the suppliers of funds.

•Borrowers are demanders of funds.
•Financial markets serves as the meeting place where
transactions between borrowers (units with a shortage
of funds) and lenders (units with excess funds) are
conducted.
•Financial intermediaries act as “go-betweens” or
“middle men”.

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Motivation to understanding the financial
system

• BICO Ltd. needs money for expansion purposes.

Where do they obtain such financing?
• Financial markets
• The banks
• Own resources

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 An Institutional Overview of
the Financial System

• Markets & instruments

• Stock-, bond-, money-, foreign exchange (FX)- and commodity markets
• Derivatives markets in developed exchanges for all the above.
• Intermediaries
• Deposit banks, investment banks, private banks, insurance firms,
mutual funds, pension funds, venture capital funds, trusts, etc.
• Information providers
• Rating firms (any in the Caribbean?), analysts, Reuters, Bloomberg.
• Public institutions & regulators
• Regulators, legal fraternity, central banks, tax payer, international
bodies (BIS, IMF, IBRD (World Bank), etc)
• Governments and households
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 The Financial System -
Circular Flow of Resources
Direct

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Indirect
 Direct Financing/ Lending

• Borrowers/spenders borrow funds directly from

lenders/savers in the financial markets by selling them
securities.
• These transactions involve brokers and dealers
• Brokers – agents of investors who perform the task of matching
buyers and sellers of securities.
• Dealers – link buyers and sellers by buying and selling securities
(i.e. hold inventories of securities). Dealers hope that they can sell
higher than they paid for securities.
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 Indirect Financing/ Lending

• A financial intermediary stands between savers and borrowers and

allows for the transfer from one to the other.
• Saver lends to the financial intermediary who then pools the
funds of many savers. The FI then re-lends funds at a markup
over the cost of the funds.
• This suggests that financial markets and intermediaries are
alternatives that basically perform a similar function but in a
different way.
• However, financial intermediation (the indirect finance
practice) is the most important manner of transferring funds
from savers and borrowers. 10
 The Functions of the
Financial System
Markets create value: savers get interest income that they
can spend afterwards, while investors make profits
sometimes higher than the interest payments on savings
The primary function of any financial system is to facilitate
the allocation and deployment of economic resources in an
uncertain environment.
or The function is to facilitate efficient allocation of capital
and risk.
Video Link- Overview of Financial System:
https://www.youtube.com/watch?v=RcIxTjJJ_2Y

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 The Functions of the
Financial System

1. Clearing and settling payments

2. Pooling resources
3. Transferring resources & specialisation
4. Managing risk
5. Providing information
6. Dealing with incentive problems

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Functions: Clearance and Settlement
A financial system provides a means of clearing and settling
payments to facilitate the exchange of goods, services, and assets.

Provides for the development of a set of institutional arrangements handling

the payment system
Example depository institutions:Use of wire transfers, chequing accounts,
Automated Teller Machines or Automated Banking Machines (ABM) , credit/debit
cards
Foreign exchange payment arrangements

Clearing and settling arrangements for securities transactions

Allows the efficient handling of risks & costs related to the fulfilment of terms
Collateral, netting arrangements and credit extension
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 Functions: Pooling

A financial system provides a mechanism for pooling of funds to

undertake large-scale indivisible enterprise or for sub-division
which provides diversification.

The optimal economic scale for production of goods and services is

much larger than an individual, family, or even a village’s total savings.

A mutual fund, for example provides a good example of pooling.

Securitization is an efficient vehicle for pooling non-traded securities

and subdividing by selling claims on the pool on the market (e.g. asset-
backed securities)
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 Functions: Transferring Resources

A financial system provides the means to transfer economic resources

through time, across geographic regions and, among industries.

A properly functioning system affords the efficient life-cycle

allocations of household consumption and and the efficient allocation
of physical capital to its most productive use in the business sector.

Efficient financing over various time horizons (maturity);

• Short-term deposits used to finance long-term lending
• Roll-over loans for financing infinite projects (e.g. going
concern firms)
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 Functions: Managing Risk

A financial system provides ways to manage uncertainty and

control risk.

• Facilitate the efficient allocation of risk-bearing by creating

mechanisms for both diversification and pooling of risks;

• Allows an efficient life-cycle risk-bearing by households (e.g.

mortgage financing);

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Functions: Providing Information

A financial system provides price information that helps co-ordinate

decentralised decision-making in various sectors of the economy.

The invisible hand of the market economy relies on prices reflecting the
individual choices
Distortions from true market prices leads to inefficient
allocations of resources, e.g. subsidies.

Interest rates and security prices are information used by households

in making consumption-saving decisions, and by firms making
investment decisions

Prices of traded assets in well-functioning, efficient and liquid markets

constitutes the base for the valuation of all non-traded assets, relying on
the principle of relative pricing (valuation using comparables).
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 Functions: Dealing with
Incentive Problems
A financial system provides ways to deal with the incentive problems when one
party to a financial transaction has information the other party does not, or
when one party is an agent for another.

Reduces the incentive problems that make financial contracting

difficult and costly

Arises because parties cannot easily observe or control one another,

and because contractual enforcement mechanisms can be impossible, or
very costly, to invoke

Moral hazard, adverse selection, free riding, asymmetric

information.

Incentive problems make it more costly for companies to raise

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external capital.
 The Financial System –
Some key concepts
• Entities with surplus funds – savers - ( Income >
Consumption) through the financial system lend to those who
have a shortage of funds – demanders of credit – borrowers
(Consumption > Income).
• Direct finance refers to those instances where entities borrow
directly from lenders without the intervention of an
intermediary (indirect finance). There are risks. What are
some of these risks?
Example:
 Company A borrows money from directly from Company B
 OR
 An investor through an internal agreement makes a direct investment into
a company, or buys a new issue of stock directly from an issuing
company.
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 The Financial System –
Some key concepts

•Primary markets are those in which newly-issued instruments

are offered to initial buyers.
•Secondary markets refer to markets in which previously-issued
instruments are offered for resale.
•In the region, the stock exchanges tend to offer securities in
which market - the secondary or primary market?
•Risk-sharing, liquidity, and information services are provided in
the secondary markets.
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 The Financial System –
Some key concepts

• Indirect finance – Occurs when there is the use of

an intermediary in the execution of a transaction.
• Debt Securities represent the claims on the
activities/assets of the security issuer.
• They serve as assets for the person who buys them, and
liabilities for the individual or firm that sells or issues them.
• Example: If Banks Holdings needs to borrow funds in order
to build a new brewery, it can directly borrow funds from a
lender by selling bonds.

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 The Financial System –
Some key concepts

Financial instruments can be classified into two broad groups: debt

instruments and equity instruments
Debt Securities– Instruments that provide the holder with a claim on the
assets of the issuer. Example bills, notes and bonds.
Bonds represent debt owed by the issuer to the investor. These claims pay
periodic interest (coupon payments) until the maturity date when the issuer pays
back the par value (face value)
Equity –The holder is in an ownership position and only has a residual claim
on the assets of the issuer.
Residual claim means that any benefit of the firm’s income is derived AFTER all
others have been paid including interest pmts, wages, taxes. Note dividends are
paid from NET INCOME and is at the discretion of the firm
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 The Financial System –
Some key concepts
Money vs. Capital Markets
Money markets – Financial markets where short-term debt instruments are traded.
These debt securities have less than one year to maturity. Considered safe, and liquid.
Firms and FIs manage their short-term liquidity needs.

Capital markets – Markets where long-term securities (equity and debt with
more than one year to maturity) are traded. Considered riskier. These securities are
often held by pension funds, mutual funds and insurance companies.
Money Market Instruments:
- Treasury Bills (T-bills) with 3, 6, or 12 month maturities. (Considered risk-free
securities of the government denominated in local currency.)
- Commercial paper – short-term debt instruments issued by corporations to holders,
such as other large companies, insurance companies or banks.
- Banker's Acceptances – A short-term credit instrument guaranteed by a bank
typically to facilitate international trade. Bank guarantees payment, usually of an
import order. 23
 The Financial Market:
Some Basic Terms

Capital Market Instruments:

• Mortgages - Debt secured by real property (land and/or
buildings). Largest debt market in US. Note securitization
of mortgage industry
• Corporate Bonds: Long-term debt instruments to finance
firm operations.
• Government bonds: Long-term debt instruments issued by
the government e.g. Treasury notes and debentures. Note
issues by statutory corporations, municipalities and states.
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 Financial Intermediaries

• Importance of financial markets – There are benefits to those

with savings/excess funds. You have $5,000 to invest for a
period of time. There are thousands of investment
opportunities to choose from. You benefit through the receipt
of a rate of return, a reward for postponing consumption.
• Benefits those who either have a great business idea or
invention but have no funds. It is not always the case where
those with good ideas have money. 

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 Financial Intermediaries

• Three categories of financial intermediaries:

• Depository savings institutions (banks, credit unions)
• Contractual savings institutions (insurance companies and
pension funds)
• Investment intermediaries (finance companies, mutual
funds, money market funds, etc.)
• The sources and uses of funds, or the composition of liabilities
and assets, or maturities, help to pinpoint the differences among
the categories of intermediaries.
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 Financial Intermediaries

• Banks and depository intermediaries accept deposits in the

form of chequing, saving and time deposits (or certificates of
deposits (CDs) which tend to offer a fixed term to maturity).
These deposits are liabilities for the bank and provide a source
of funds used to finance assets.

• Depository institutions tend to lend the money out in the form of business
loans, consumer loans, and mortgages. These are assets of the bank. Banks
also invest in Government securities and municipal/statutory corporation
bonds. Usually not allowed to own stocks, as there are regulatory
restrictions on the portfolio of their investments/trading book.

• Profitable venture : Eg. financial intermediaries typically pay 0.5-1% to

attract deposits or other funds, then lend at 6-12%.
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 Financial Intermediaries

Contractual Savings Institutions: Are financial intermediaries that

acquire funds at periodic intervals on a contractual basis.
Unlike depository institutions can predict outflows with greater
degree of accuracy hence the liquidity of assets is not as important as
consideration for them and they tend to invest their funds primarily in
long-term securities such as corporate bonds, stocks, and mortgages.

Insurance Companies - source of funds: premiums. Assets: stocks, bonds,

mortgages, T-bonds. Mostly long-term assets based on actuarial
projections.
Pension funds - Employer/employee or solicited contributions provide
source of funds. Assets are bonds and stocks, usually through mutual
funds.
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 Financial Intermediaries

Investment Intermediaries: Comprise of mutual funds, finance

companies and investment banks
Finance companies - Take money market deposits, issue commercial paper, bonds
and stocks to attract funds. Lend out commercial loans
Mutual funds - An professionally-managed investment vehicle that is made up of a
pool of funds collected from many investors for the purpose of investing in securities
such as stocks, bonds, money market instruments and similar assets.
Source of funds: savers/investors buying shares. Assets: portfolios of stocks and
bonds (capital markets).

Advantages: 1) lowers transactions cost for investors by pooling large sums of

money and 2) provides excellent diversification - most mutual funds have
ownership rights in a large number of companies.

Investment banks- Assist corporations or governments in the issue of new debt or

equity securities and act as the deal makers for mergers or acquisitions. That is it
provides advice and sells (underwrite) the se securities. 29
 Financial Intermediation

Financial intermediaries improve the efficiency of financial

markets. The reasons are the following:
1)Individuals’ small savings can get a higher interest rate when they are
marketed as a part of a larger loan.
2)Households and small firms, for which it would be impossible to get funds as
direct finance, can get relatively large loans from banks.
3)Financial intermediaries reduce the costs of collecting information of all
borrowers and lenders. It would be very expensive for lenders to identify all
potential borrowers, and for borrowers to identify all potential lenders.
4)If a lender/saver finds a potential borrower, that individual has the problem
of finding out whether the borrower is likely to repay his debts. Financial
intermediaries, on the other hand, have regular information of the financial
situation and credibility of their clients by following the movements on their
accounts. This gives them superior information when compared with non-
financial entities in evaluating the risk related to a certain client.
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 Financial Intermediation

5)Financial intermediaries reduce the transaction costs which would have to be

paid if every lender and borrower himself writes an appropriate loan contract
or pays the brokerage commission for the transaction. Smaller transaction
costs related to one large loan as compared with many small loans creates
economies of scale (lower unit costs at a larger scale of operation) into the
lending business.
6)Financial intermediaries create maturity transformations between financial
agreements. From a continuous inflow of small short-term deposits from
various sources with varying interest rates, a bank can issue large long-term
loans with a fixed interest rate. The deposit base represents a pool of stable
funds (Many people withdraw money every day!)
7)The expertise and education of the personnel in banks allows them to make
better investment decisions as compared with small savers with less
information. The investing of large sums of money may though create 31large
losses in the case banks make unsuccessful investment decisions.
 Financial Intermediation

8) If a bank has enough independent depositors and borrowers, the risks

related to one client do not threaten the existence of the whole bank,
which might happen in the case of a small financial unit.
9) Serve as a conduit or transmission path for monetary policy.

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 Asset Transformation

• Financial intermediaries satisfy the long-term capital needs of

borrowers and the desire of lenders (savers) for liquidity in
their asset holdings (deposits are the assets of savers). Banks
for example issue liabilities (deposits) with relatively risk
free, short-term, high liquidity characteristics to acquire high-
risk, larger size and illiquid claims by firms.
• Financial intermediaries therefore carry out four main
transformations:
• Maturity transformation – The traditional role of the bank is to
make long term loans and fund them through short term deposits; i.e.
“borrow short and lend long”. Remember that the liabilities of FIs
generally mature faster than their assets.
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 Asset Transformation (cont’d)

• Liquidity transformation – FIs provide financial claims to

depositors that are very liquid by nature and low-risk. On the other
hand, loans are illiquid and a higher risk asset than deposits. FIs
diversify their portfolios by holding assets and liabilities of
varying liquidity features.
• Risk transformation – Lenders consider their deposits as safe.
However, FIs may face default risk (a borrower does not repay its
debt when it is due). Basically, banks transform risky loans to
riskless deposits.
• Size transformation – FIs collect small amounts by way of
lenders (savers) and distribute them into larger amounts needed by
borrowers.
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 Financial Intermediaries

Generally it is observed that:

In relative terms issuing equities is not the most important source of
external financing
The issuance of marketable debt (bonds) ranks highly but contrary to
popular belief is not the primary source of financing for firms
Indirect financing through intermediaries, such as banks or venture
capital firms, is a much more important source of financing

Also note that:

• The financial system is heavily regulated; and
Collateral is a prevalent feature of debt for both households and firms
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Adverse selection: “The Lemons Problem”

The presence of asymmetric information drives the probability of adverse or

negative selection.
Adverse selection is an asymmetric information problem that occurs before
the transaction. Potential bad credit risks are the ones who most actively seek
out loans.
Intermediaries reduce adverse selection (“lemons problem”)
Problem is reduced by the provision of information
Adverse selection reduces the attractiveness of direct finance
The key role of intermediaries, especially banks, is that they reduce
asymmetric information in financial markets.
Other mechanisms to reduce problems caused by the information gap
Rating agencies
Regulation: laws on information releases, insider rules etc..
(see additional notes o slide 27)
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 Lemons problem

• Existence of asymmetric information - Inequality of information. Borrower may

not reveal all information to the lender about the riskiness of the project, potential
payoffs.

• Example: The trade-in your old car.

• You have better knowledge of the problems than the average buyer.
• Generally, the dealer has better knowledge of the market for used cars.

• Example: In securities markets (stocks and bonds)

• Issuers have more information than potential investors.

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• Generally, investors cannot distinguish between good and bad firms.
 Solutions to reduce adverse selection
(additional notes)

• Private production of information

• Private companies such as Standards & Poor’s and Moody’s (credit rating
agencies) produce and sell information needed by potential investors to
differentiate good and bad firms in the selection of their securities.
• Regulation by government
• Governments ensure that companies operating in financial markets (public firms)
disclose full information to potential borrowers.
• The Barbados Central Securities Depository (BCSD) is the government agency
responsible for the adherence to standard accounting principles and information
disclosure.
• Financial intermediaries
• FIs have the expertise in the production of information and are able to select good
credit risks as well as value firms. 38
 Moral Hazard Problem

• Moral hazard is an asymmetric information problem that

occurs after the transaction is made. It is the risk (hazard) that
the borrower will engage in activities that are undesirable for
the lender.
• Mechanisms to reduce moral hazard
• Monitoring by stakeholders
• Government regulation: regulations with respect to standard
accounting principles; criminal penalties in the case of fraud

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 Moral Hazard Problem

• Intermediaries reduce moral hazard problems

• Intermediaries use frequent debt renegotiations, collateral, or
the right to call back loans
• Other tools: incentive compatible debt contracts (align the incentives of
the borrowers and lenders); restrictive covenants (controls the borrower’s
activity)
• Intermediary firms themselves are prone to exert moral
hazard pressure which is one reason why bank panics become
so severe, and why they can often cripple the whole economy
• Solved mainly by regulation since bank panics lead to tax payers paying
more for bailouts
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 Potential Problems in
Credit Markets
• Adverse selection and moral hazard can inhibit credit/financial
markets, causing them to operate inefficiently or break down
completely.
• However, banks are not always able to totally circumvent
these risks in the case in a declining economic environment,
and similar to high inflation (hyperinflation), war or poor
economic policies cause inefficiencies in the economic system

• And this requires effective and efficient risk management (to

be discussed in later sessions)
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 References

• Financial Markets and Institutions: Frederic S.

Mishkin and Stanley G. Eakins, Prentice Hall, 8th
Edition.

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