Financial Management IIBBA V

Unit_1:Economics of Financial System

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

-- Wholesale (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 – ideally helping to stabilize the economy

-- 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 transaction- evaluation 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 System’s Basic Technology

Financial System’s 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 * FI’s 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 bank’s 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.