Basic Elements of the Financial System

Dr. Edita C. Bayona

CBFS
University of Makati
 What is a Financial System?
As define by Rose, Kolari and Fraser:
Financial System is the institutional
mechanism established by society to
produce and deliver financial-
services and allocate resources,
consisting of the business firms
supplying financial services, the
customers of financial-service firms,
and the government regulatory
authorities that enforce the rules
prevailing within the financial sector.
• It is the instruments,
institutions, markets and
rules governing the
conduct of trade that
expedite the routing of
funds from buyers to
sellers from savers to
lenders. (Kaufman)
• It is one in which funds are
traded between
borrowers and lenders
(Cargill)
Functions of the Financial
System
• Credit
– It supplied by the financial
system to three types of
borrowers: consumers,
business and government
• Payment
• Money creation- is composed
of currency and deposits
• Savings
 Components of Financial
System
• Financial Instruments
• The financial sector
consisting of financial
markets and financial
institutions
• Rules governing the
conduct of trade
• Financial instruments are the evidences
of debt that are brought and sold in the
market.
• Financial market is a mechanism by
which savings in one sector of the
economy flows to another sector.
• A financial institution is an organization
through which funds in the form of
money or claims in money are
assembled and transferred from
individuals with surplus funds to other
individuals and firms needing extra
funds
 Rules governing the conduct of trade in the
financial system
• Pertinent laws concerning
financial institutions;
• Memoranda, circulars, and
issuances of concerned
government agencies;
• Pertinent ordinances of local
government units where the
financial institutions is situated;
• Customs and traditions inherent
to the area where the financial
institution is situated
 Financial System and Its
Components

Financial System

Rules Governing
Financial
Financial Sector the Conduct of
Instruments
Trade

Financial
Markets

Financial
Institution
 Four Sectors of the Economy Engaged in
Borrowing and Lending
• Households
• Firms- sources of income
are those arising out of
household expenditures
and those arising out of
investments of other firms
• Government
• Foreigners
 Relationship Between Household Income and
Spending at Various Stages
Stage in the Life Income Financial Decision
Cycle of the
Household
New Smaller than Spend savings or
Expenses borrow
Middle Age Bigger than Build up savings and
Expenses liquidate borrowings
Retirement Smaller than Spend savings
expenses
Why Firms Invest and
Borrow
• Deficiency in Capital due to
Opportunities
• Additional investment may
bring additional income or
economies in operation
• Avail quantity discounts for
bulk purchases from
suppliers
• Additional revenues from
sales financed by loans or
investments
Transferring Funds from the Lenders
to Borrowers
• The financial system is
concerned with
transferring funds from
lenders to borrowers
• The lenders are those
whose revenues exceeded
their expenditures. They
are referred to as Surplus
Spending Units (SSUs)
• The borrowers have
expenditures exceeding
their revenue and thus are
referred to as deficit
spending units (DSUs)
 Methods of Transferring funds from SSUs to
DSUs
• Direct Finance
• Indirect Finance

1. Direct Finance – refers to lending by

ultimate borrowers with no
intermediary. Under this method
the SSUs gives money to DSU in
exchange of financial claims on the
DSU. The claim issued by the DSU is
called direct claims and are typically
sold in direct credit markets such as
the money or capital markets.
 Disadvantages of Direct
Financing
• There are few DSU which can
transact in the direct market
because of the denominations
of securities sold are very large
usually millions of pesos
• It is difficult to match the
requirements of SSUs and DSUs
in terms of denominations,
maturity and others.
 Methods of Direct
Financing
• Private placements
• Brokers and dealers
• Investment bankers
– Private placement refers to
selling of securities by
negotiation directly to insurance
companies, commercial banks,
pension funds, large-scale
corporate investors, and
wealthy individual investors
• Broker is on who acts as an intermediary
between buyers and sellers but does not
take title to the securities traded
• Dealer is one who is in the security
business acting as a principal rather than an
agent. The dealer buys for this account and
sells to customers from his inventory. He
makes profits by selling his inventory of
securities at a price higher than the
acquisition cost.
• Investment banker is a person who
provides financial advise and who
underwrites and distributes new
investment securities.
Methods of Transferring Funds from Lenders to
Borrowers
2. Indirect Finance is also called
financial intermediation and it
refers to lending by an ultimate
lender to a financial
intermediary that then relends
to ultimate borrowers. It
includes commercial banks,
mutual saving banks, credit
unions, life insurance
companies, and pension funds.
 Benefits of Financial
Intermediaries
• It substantially reduces transaction costs. This
happens because they have developed expertise in
lowering the costs and also because the large
number of transactions provide economies of
scale.
• Reduction of Moral Hazard. As individual
borrowers may engage in undesirable activities
after taking the loan, the lenders who directly
provide funds will be at a disadvantage. Such risk
of not getting paid back because of changes in the
behaviour of the borrowers is called moral hazard.
When lenders deal with financial intermediaries,
the moral hazard is eliminated partly if not
completely. The risk does not pose a real problem to
financial intermediaries because they have already
developed the expertise to deal with them.
 Kinds of Financial Intermediation
• Denomination intermediation-refers to the intermediation
performed by financial intermediaries where large-denomination
claims in the form of loans and securities are accepted from
borrowing customers while simultaneously issuing relatively low-
denomination
• Default-risk Intermediation- refers to the intermediation performed
by the financial intermediaries where risky claims in the forms of
loans and securities are accepted against borrowing customers
while simultaneously issuing relatively safe financial instruments to
savers to attract their funds.
• Maturity Intermediation- refers to the practice of borrowing
comparatively short-term funds from savers and making long-term
loans to borrowers who require a lengthy commitments of funds.
• Information Intermediation- refers to the process by which financial
intermediaries substitute their skill in the market place for that of
savers who frequently have neither the time nor the access to
relevant information about market conditions and investment
opportunities.
 Categories of Financial
Intermediaries
• Depository Intermediaries- they are called as such because
the sources of their loanable funds came from the deposits
of household, businesses, and governments.
• Contractual Intermediaries- this type enter into contracts
with their customers to promote savings and or financial
protection against loss of life or property.
• Secondary Intermediaries- they are called as such because
they depend heavily on the financial intermediaries like
commercial banks for loanable funds. Ex. Finance
companies, mortgage banks and real estate investment
trusts.
• Investment Intermediaries- this type offers public securities
that can be held indefinitely as a long-term investment and
which can be sold quickly when the customer needs his
funds returned. Investment intermediaries are mutual stock
funds, bond funds and money market.
 Regulations of the
Financial System
• In order to ensure that the financial system performs its
mandated tasks, the government, through its various
mechanisms, monitor and control the different components of
the system
• Enactment of laws comprises the first area of the control. These
are General Banking Act, The Revised Securities Act, The
Philippine Deposit Insurance Law, The Truth in Lending Act,
Offshore Banking Law, Uniform Currency Act, Corporation Code
and Negotiable Instruments. Example is the Financing Company
Act of 1998, which makes real estate an asset that can the
subject of financial leasing.
• The second area of monitoring and control is through
government regulatory agencies like Bangko Sentral ng Pilipinas,
The Monetary Board and the Securities and Exchange
Commission. Other memoranda and circulars are issued by these
agencies whenever circumstances requires such action.
• Since private organizations are businesses, they also covered by
municipalities and cities ordinances where their businesses are
located. Example of these requirements are the business permits
and licences
 Financial Intermediaries and their
Sources of Funds
Types of Intermediaries Sources of Funds
Commercial Banks Deposits (Checking, Savings and time
Savings and Loans Association Deposits (Checking, Savings and time

Mutual Savings Banks or Coop Deposits (Checking, Savings and time

Credit Unions Deposits (Checking, Savings and time

Life Insurance Companies Premium from Policyholders
Nonlife Insurance Companies Premium from Policyholders
Pension Fund Companies, GSIS, SSS Employers and Employees Contributions
Finance Companies Issues commercial papers, stocks and bonds
Mutual Funds Issues Shares
Money market and mutual funds Issues Shares
Important Features of the Implementing Rules and
Regulations of the Financing Company Act of 1998

• Foreign investors are allowed to own up to 60% of the

voting stocks of a finance company.
• A required minimum paid-up capital of P10m is set for
financing companies in Metro Manila, P5m in other first
class cities and P2.5 in municipalities
• Finance Companies are authorized to:

– Engage in quasi-banking operations and money market

operations with the approval of the Bangko Sentral ng Pilipinas
– Engage in the trust operations subject to the provisions of the
General Banking Act upon prior approval by the BSP
– Issue bonds and other capital instruments subject to pertinent
rules and regulations from the BSP,
– Rediscounts their papers with government financial institutions
subject to relevant laws, rules and regulations;
– Participate in special loan or credit programs sponsored by or
made available through government financial institutions; and
– Provide foreign currency loans and leases to enterprises who
earn foreign currency by exports or other means subject to
existing laws and rule sand regulations promulgated by the BSP
• Loans and investment of
financing companies to
real estate are limited to
25% of its net worth, to
directors, officers,
stockholders, and related
interest to 15% of its
networth, to any person,
company, corporation, or
firm to 20 percent of its
networth.
• Financing companies must set up 100%
allowance for probable losses for:
– Clean loan and advances that has been past due
to a period of more than six months;
– Past due loans secured by a collateral which have
declined in value by more than 50%
– Past due loans secured by a real estate mortgage
which title is subject to an adverse claim, when
borrower or co-maker or guarantor is insolvent
or their whereabout is unknown or their earning
power is permanently impaired;
– Uncollected accrued interest receivable for a
period of six months form the maturity date of
the loan
– Accounts receivable that has been past due for at
least 361 days