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Chapter 2 Notes Overview of Financial System

The financial system facilitates the transfer of funds from savers to borrowers, enhancing economic productivity and growth. It encompasses various types of finance, financial markets, instruments, intermediaries, and regulations that ensure efficient allocation of resources and market integrity. Key functions include channeling funds, providing liquidity, and enabling risk sharing, with regulatory bodies overseeing practices to protect investors.

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22 views3 pages

Chapter 2 Notes Overview of Financial System

The financial system facilitates the transfer of funds from savers to borrowers, enhancing economic productivity and growth. It encompasses various types of finance, financial markets, instruments, intermediaries, and regulations that ensure efficient allocation of resources and market integrity. Key functions include channeling funds, providing liquidity, and enabling risk sharing, with regulatory bodies overseeing practices to protect investors.

Uploaded by

iharraz71
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CHAPTER 2: An Overview of the Financial System

1. Purpose of the Financial System


The financial system facilitates the transfer of funds from individuals or institutions with excess funds

(savers) to those who need funds for productive purposes (borrowers). This enhances economic

productivity and growth by ensuring that resources are allocated to their most efficient use. For

example, an inventor with a great idea but no capital can use the financial system to obtain funding

from a saver.

2. Types of Finance
Direct finance involves borrowing funds directly from financial markets by issuing instruments like

bonds and stocks. In contrast, indirect finance uses intermediaries such as banks and insurance

companies to channel funds from savers to borrowers. This is often more efficient for small savers

and borrowers.

3. Functions of Financial Markets


- Channeling Funds: Connects savers to borrowers.

- Efficient Allocation: Directs capital to its most productive uses.

- Consumer Welfare: Helps individuals manage timing of expenditures.

- Liquidity: Enables easy buying and selling of assets.

- Risk Sharing: Allows diversification of investment portfolios.

4. Structure of Financial Markets


a. Debt vs Equity Markets:

- Debt instruments (e.g., bonds) provide fixed payments.

- Equity instruments (e.g., stocks) represent ownership and residual claims.


b. Primary vs Secondary Markets:

- Primary: New securities issued for the first time.

- Secondary: Existing securities traded among investors.

c. Exchanges vs OTC Markets:

- Exchanges are centralized (e.g., NYSE).

- OTC markets are decentralized (e.g., forex).

d. Money vs Capital Markets:

- Money Markets: Short-term instruments (<1 year).

- Capital Markets: Long-term instruments (>1 year).

5. Financial Instruments
Financial instruments are the tools used in financial markets to transfer resources. Money market

instruments include Treasury bills and commercial papers for short-term borrowing. Capital market

instruments include stocks and bonds for long-term investment.

6. Financial Intermediaries
a. Types:

- Depository Institutions: Banks that accept deposits.

- Contractual Savings Institutions: Collect savings through contracts (e.g., insurance).

- Investment Intermediaries: Pool funds to invest (e.g., mutual funds).

b. Functions:

- Reduce transaction costs and provide liquidity.

- Facilitate risk sharing and portfolio diversification.


- Address asymmetric information through screening (adverse selection) and monitoring (moral

hazard).

7. Regulation of Financial System


Financial regulations ensure market integrity and protect investors. They aim to:

- Enhance transparency via disclosure requirements.

- Maintain stability through prudent operational rules.

- Provide deposit insurance to protect savers.

- Limit anti-competitive practices.

Regulatory bodies include the SEC, Federal Reserve, and FDIC, among others.

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