Financial Management IIBBA VUnit_1:Economics of Financial System

ByDurga Prasad PantaKIC

Concept of Financial SystemFinancial system comprises of financial institutions, markets and financial instruments for mobilizing resources

Basic Needs Served by Financial SystemFinancial system Facilitate resource transfer and mobilizes savings to the productive sectors thereby contributing to the economic developmentThe 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 easyCertain 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 systemInvolved 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 guardClearing 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 outHouseholds-- Need to borrow early in their life cycle to buy housing and then save in mid-life for retirementFirms --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 costsGovernments --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 resourcesFinancial 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 powerDiversity arises among people because of their saving, lending and borrowing behaviorPurpose 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 borrowerDirect relation between the ultimate lender and ultimate borrowerIntermediaries only facilitate the process

2. Resource Transfer cont

Various institutions in the financial system by making following provisions make easier to lend Information disseminationFinancial press- news on companiesAccounting and auditing firms- check books of the companiesMarket information on transaction- evaluation of securities pricesNegotiations or contract writingWrite 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 termsUnderwriter buys whole issue and resells to the public with legal obligation to purchasers to provide accurate information about the riskAll 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 borrowerNo relationship is established between the ultimate lender and ultimate borrowerIntermediaries 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 performanceCost reduction by making large loanPooling of small amount to make large loanCost 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 borrowerThis relationship help them to be in win-win situation

(d) Diversification:Individual can make only a few investment- no diversityBanks have diversified investmentsReduction 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 riskTwo forms of trade in risk; i. Insurance ii. Forward Transaction

I.InsuranceSharing of risk of accidents, illness and natural disasterOne who do not face a particular risk agree to share the losses of those who doInsurance policy: contracts with an insurance company (insurer) under which the insured pays a premium in exchange for coverage of specified lossesOne pay the insurers a relatively small sum with certainty; in exchange the insurer pay a large sum with relatively low possibility of risk of damageTypes: Property-liability insurance; life insurance, health insurance;

Problems:Tendency of insuredSelection risk for insurer: same price for different condition; assumed to be less but becomes huge

II.Forward TransactionAgreement in advance on the terms of trade to be carried out in the futureSharing of price riskFuture Markets:

Market in standardized contracts for future delivery of various goodsAddress the problem of difficulty and cost of finding trading partnersRole of forward intermediariesExample; explain how both the party benefit by signing a forward contract

Financial Systems Basic Technology

Financial Systems Basic Technology Includes

DelegationCredit SubstitutionPoolingNetting

DelegationRather than doing the things oneself, one can assign some one else to the work on his behalfThis 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 costsMany 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 issueHow 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 * FIs resources and capabilities in fulfilling the promise.

Delegation & Credit substitutionDelegation & 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.

POOLINGPooling 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.

NETTINGNetting 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 banks obligations to one another reduces the need for physical transfer and thereby reduces costs.

NettingNetting 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.