IMPROVE YOUR FINANCIAL SYSTEM KNOWLEDGE

THE FINANCIAL SYSTEM

A strong financial system is vitally important—not for wall street, not for bankers, but for working men and women. When our markets work, people throughout our economy benefit—men and women seeking to buy a car or buy a home, families borrowing to pay for college, innovators borrowing on the strength of a good idea for a new product or technology, and businesses financing investments that create new jobs. And when our financial system is under stress, millions of working men and women bear the consequences. Government had a responsibility to make sure our financial system is regulated effectively. And in this area, we can do a better job. In sum, the ultimate beneficiaries from improved financial regulation are men and women workers, families, and businesses-both large and small.

                   -Henry M. Paulson, Jr., then Secretary of the U.S. Department of the Treasury, March 31, 2008

Some changes done by Arshad. A

THE FINANCIAL KNOWLEDGE…

THE FINANCIAL SYSTEM

A financial system makes possible a more efficient transfer of funds by mitigating the information asymmetry problem between those with funds to invest and those needing funds. In addition to the lenders and the borrowers, the financial system has three components: (1) Financial Markets, where transactions take place; (2) Financial Intermediaries, who facilitate the transactions; and (3) Regulators of Financial activities, who try to make sure that everyone is playing fair.

Financial Assets

An Asset is any resource that we expect to provide future benefits and, hence, has economic value. We can categorize assets into two types: Tangible Assets and Intangible Assets. The value of a tangible asset depends on its physical properties. Buildings, aircraft, land, and machinery are examples of tangible assets, which we often refer to as Fixed Assets.

An intangible asset represents a legal claim to some future economic benefit or benefits.

Every financial instrument as securities, there is a minimum of two parties. The party that has agreed to make future cash payments is the issuer; the party that owns the financial instrument and therefore the right to receive the payments made by the issuer is the investor.

Why do we need Financial Assets?

Financial assets serve two principal functions:

1.   They allow the transference of funds from those entities that have surplus funds to invest to those who need funds to invest in tangible assets.

2.   They permit the transference of funds in such a way as to redistribute the unavoidable risk associated with the tangible assets’ cash flow among those seeking and those providing the funds.

What is the Difference between Debt and Equity?

We can classify a financial instrument by the type of claims that the investor has on the issuer. A financial instrument in which the issuer agrees to pay the investor interest, plus repay the amount borrowed, is a debt instrument or, simply, debt. A debt can be in the form of a note, bond, or loan.

          The classification of debt and equity is important for two legal reasons. First, in the case of a bankruptcy of the issuer, investors in debt instruments have a priority on the claim on the issuer’s assets over equity investors. Second, the tax treatment of the payment by the issuer differs depending on the types of class. Specifically, interest payments made on debt instrument are tax deductible to the issuer, whereas dividends are not.

The role of Financial Markets

Investors exchange financial instruments in a financial market. The more popular term used for the exchanging of financial instruments is that they are “traded.” Financial markets provide the following three major economic functions: (1) price discovery, (2) liquidity, and (3) reduced transaction costs.

Price Discovery means that the interactions of buyers and sellers in a financial market determine the price of the traded asset. Equivalently, they determine the required return that participants in a financial market demand in order to buy a financial instrument. Financial market demand in order to buy a financial instrument. Financial markets signal how the funds available from those who want to lend or invest funds are allocated among those needing funds. This is because the motive for those seeking funds depends on the required return that investors demand.

Second, financial markets provide a forum for investors to sell a financial instrument and therefore offer investors liquidity. Liquidity is the presence of buyers and sellers ready to trade. This is an appealing feature when circumstance arise that either force or motivate an investor to sell a financial instrument. Without liquidity, an investor would be compelled to hold onto a financial instrument until either (1) conditions arise that allow for the disposal of the financial instrument, or (2) the issuer is contractually obligated to pay it off. For a debt instrument, that is when it matures, but for an equity instrument that does not mature—but rather, is a perpetual security—it is until the company is either voluntarily or involuntarily liquidated. All financial markets provide some from of liquidity. However, the degree of liquidity is one of the factors the characterize different financial markets.

The Third economic function of a financial market is that it reduces the cost of transacting when parties want to trade a financial instrument. In general, we can classify the costs associated with transacting into two types: Search costs and Information costs

          Search costs in turn fall into two categories: explicit costs and implicit costs. Explicit costs include expenses to advertise one’s intention to sell or purchase a financial instrument. Implicit costs include the value of time spent in locating a counterparty—that is, a buyer for a seller or a seller for a buyer—to the transaction. The presence of some from of organized financial market reduces search costs.

          Information costs are costs associated with assessing a financial instrument’s investment attributes. In a price-efficient market, prices reflect the aggregate information collected by all market participants.

The Role of Financial Intermediaries

          The role of financial intermediaries is to create more favorable transaction terms than could be realized by lenders/investors and borrowers dealing directly with each other in the financial market. Financial intermediaries accomplish this in a two-step process:

1.   Obtaining funds from lenders or inverstors.

2.   Lending or investing the funds that they borrow to those who need funds.

The funds that a financial intermediary acquires become, depending on the financial claim, either the debt of the financial intermediary or equity participants of the financial intermediary. The funds that a financial intermediary.

          Consider two examples using financial intermediaries that we will elaborate upon further:

Ex.1 A Commercial Bank

A commercial bank is a type of depository institution. Everyone knows that a bank accepts deposits from individuals, corporations, and governments. These depositors are the lenders to the commercial bank. The funds received by the commercial bank become the liability of the commercial bank. In turn, as explained later, a bank lends these funds by either making loans or buying securities. The loans and securities become the assets of the commercial bank.

Ex.2 A Mutual Fund

A mutual fund is one type of regulated investments company. A mutual fund accepts funds from investors who in exchange receive mutual fund shares. In turn, the mutual fund invests those funds in a portfolio of financial instruments. The mutual fund shares represent an equity interest in the portfolio of financial instrument and the financial instrument are the assets of the mutual fund.

          We now discuss the three economic functions of financial intermediaries when they transform financial assets.

Maturity Intermediation

          The implications of maturity intermediation for financial systems are twofold. The first implication is that lenders/investors have more choices with respect to the maturity for the financial instruments in which they invest and borrowers have more alternatives for the length of their debt obligations. The second implication is that because investors are reluctant to commit funds for a long time, they require long-term borrowers to pay a higher interest rate than on short-term borrowing. However, a financial intermediary is willing to make longer-term loan, and at a lower cost to the borrower than an individual investor would because the financial intermediary can rely on successive funding sources over a long time period (although at some risk).

Risk Reduction via Diversification

Diversification is the reduction in risk from investing in assets whose returns do not move in the same direction at the same time.

          Investors with a small sun to invest would find it difficult to achieve the same degree of diversification as a mutual fund because of their lack of sufficient funds to buy shares of a large number of companies. Yet by investing in the mutual fund for the same dollar investment, investors can achieve this diversification, thereby reducing risk.

Financial intermediaries perform the economic function of diversification, transforming more risky assets into less risky ones.

Reducing the Costs of Contracting and Information Processing

The opportunity cost of the time to process the information about the financial asset and its issuer, we must consider the costs. The costs associated with writing loan agreements are contracting costs. Another aspect of contracting costs is the cost of enforcing the terms of the long agreement.

It is clearly cost effective for financial intermediaries to maintain such staffs because investing  funds is their normal business. There are economies of scales that financial intermediaries realize in contracting and processing information about financial assets because of the amount of funds that they manage. These reduced costs, compared to what individual investors would have to incur to provide funds to those who need them, accrue to the benefit of (1)investors who purchase a financial claim of the financial intermediary; and (2)issuers o financial assets (a result of lower funding costs).

Regulating Financial Activities

Although the degree of regulation varies from country to country, regulation takes one of four forms:

1.   Disclosure regulation.

2.   Financial activity regulation.

3.   Regulation of financial institutions.

4.   Regulation of foreign participants.

Disclosure regulation requires that any publicly traded company provide financial information and nonfinancial information on a timely basis that would be expected to affect the value of its security to actual and potential investors.

Rules about traders of securities and trading on financial markets comprise financial activity regulation. Probably the best example of this type of regulation is the set of rules prohibiting the trading of a security by those who, because of their privileged position in a corporation, know more about the issuer’s economic prospects that the general investing public.

The regulation of financial institutions is a from of governmental monitoring that restricts their activities. Such regulation is justified by governments because of the vital role played by financial institutions in a country’s economy.

Government regulation of foreign participants involves the imposition of restrictions on the roles that foreign firms can play in a country’s internal market and the ownership or control of financial institutions. Although many countries have this from of regulation, there has been a trend to lessen these restrictions.

§  An advanced-warning system, which would attempt to identify systemic risks before they affect the general economy.

§  Increased transparency in consumer finance, mortgage brokerage, asset-baked securities, and complex securities.

§  Increased transparency of credit-rating firms.

§  Enhanced consumer protections.

§  Increased regulation of nonbank lenders.

§  Some measure to address the issue of financial institutions that may be so large that their financial distress affects the rest of the economy.

Coming up Types of Financial Markets

This Article is Taken form The Basic of Finance

Written by Arshad. A

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