Banking and Financial Institutions

• Financial System


  Composed of the myriad markets and institutions through which funds flow between lenders and borrowers

  
• Financial markets and financial institutions

  • Serve as channels by which funds will be facilitated to flow between the lenders and the borrowers
  • Involve financial securities and assets

  
• Process of Financial System

  1. Individuals, businesses, or governments have excess funds that they invest and turn into financial assets, depositing cash into bank deposits

  2. As the bank collects funds from savers, the bank will lend the cash to borrowers or investors who need capital

  3. The bank may also buy money market instruments like stocks and bonds

  4. Borrowers, such as individuals, businesses, and governments, require funds and approach financial institutions to borrow money or issue debt instruments like bonds to raise capital

  5. Intermediation via institutional investors provides a platform for the buying and selling of financial assets
• Private Placement


  The sale of a company's shares to a number of pre-selected investors, taking place privately
• Indirect loan


  An installment loan in which the lender - either the original issuer of the debt or the current holder of the debt - does not have a direct relationship with the borrower
• Financial Markets


  • Equity Market
  • Corporate Market
  • Money Market
• Financial Market


  A marketplace where creation and trading of financial assets, such as shares, debentures, bonds, derivatives, currencies, etc. take place
• Two Kinds of Financial Market

  • Money Market
  • Capital Market
• Money Market


  Provide for transactions in short-term debt instruments that are generally issued by borrowers, maturing within a year
• Capital Market


  Provide for transactions in the long-term financial instruments
• Capital Market


  • Primary Market
  • Secondary Market
• Primary Market


  Where securities are created and firms sell (float) new stocks and bonds to the public for the first time, with the objective of raising funds
• Secondary Market


  Where already issued securities both shares and debt can be bought and sold by the investors, with the objective of capital appreciation
• Financial Institutions


  Intermediaries that channel the savings of individuals, businesses, and governments into loans and investment
• Classifications of Financial Institutions

  • Banking Institutions
  • Non-banking Institutions
• Banking Institutions


  Engaged in the lending of funds obtained from the public primarily through the receipt of deposits of any kind
• Non-banking Institutions


  Functions include lending, investing, or placement of funds or evidence of indebtedness or equity deposited with or otherwise acquired by them, either for their own account or for the account of others
• Dividing line between banks and non-banks

  In the receipt of deposits of any kind. Non-banks could not receive deposits from the general public.
• Key Services Provided by the Financial System

  • Risk-sharing
  • Diversification
  • Liquidity
  • Information
• Risk-sharing


  Allows savers to hold their diversified assets
• Diversification


  The spreading of wealth into many assets to make up a portfolio and to mitigate risks
• Liquidity


  The ease with which an asset, or security, can be converted into ready cash without affecting its market price
• Information


  Provides market players more access to vital information about borrowers' and lenders' expectations, and what they have to offer
• Basic Function of the Financial System

  To provide channels to transfer funds from savers with an excess of funds to spenders facing a shortage of funds
• Types of lending


  • Direct Lending
  • Indirect Lending
• Direct Lending


  Involves transfer of funds from the ultimate lender to the ultimate borrower, most often through a third party
• Indirect Lending


  Involves lending by the ultimate lender to a financial intermediary who pools the funds of many lenders in order to relend at a mark-up over the cost of funds. The ultimate borrowers are normally unknown to the ultimate lenders.
• Lenders/Net savers: Household, Firms, Government, Non-residents deposit cash to financial markets (direct finance) and financial intermediaries (Indirect finance)
• Financial Intermediaries: Credit institutions, Other monetary financial institutions, others lend funds to the borrowers as well as in the financial market
• Borrowers/Net spenders: Households, firms, government, non-residents borrow money from the lenders
• Financial Markets: Money market and Capital Market lend funds to borrowers and financial intermediaries
• Term Transformation


  Proceeds when banks finance long-term loans to companies through the short-term deposit liabilities
• Economies of scale and diversification in the use of funds

  Combining savings of the small depositors to finance the large-scale investments of corporations
• Technical Expertise


  Financial institutions maintain personnels who are knowledgeable in their business activities, ensuring savers that the bank will invest their funds at high yields with low transaction costs
• Bank


  Institution which deals in money and credit, accepting deposits from the public and granting loans and advances to those who are in need of funds for various purposes
• Banking


  An activity which involves acceptance of deposits for the purpose of lending or investing, as well as providing various other services along with its main banking activity
• Main Operation of a Bank

  Financial Intermediation - Savers deposit to bank, bank advances loans or lets funds be used by borrowers, borrowers return high rate of interest payment to banks, banks return low rate of interest payment to savers
• Essentially, banking is about confidence or trust - the belief that the bank has the money to honor its obligation. Any crack in that confidence can trigger a run and potentially a bank failure, even bringing down solvent institutions.
• Solvent institutions


  Positive net worth and assets compared to its liabilities
• Different Roles Banks Play in the Economy

  • Intermediation Role
  • Payments Role
  • Guarantor Role
  • Risk Management Role
  • Investment Advisor Role
  • Agency Role
  • Safekeeping/Certification of Value Role
  • Policy Role