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Financial services: (251fin)

An Introduction to the Financial System

By

Dr Jacinta Nwachukwu

Principal Lecturer in Finance

School of Economics, Finance and Accounting

[email protected]

Room Number: WM319

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Learning outcomes

The characteristics of a country’s financial system

The role of banks and other financial intermediaries

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Lecture outline

Definition of concepts

What services are provided by banks and other financial intermediaries?

Why would banks and other financial intermediaries be needed at all?

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Definition of Concepts

(1) Financial Intermediaries

Examples include commercial banks, insurance companies, pension finds, mutual funds, alternative banks are institutions which act as a bridge between savers and borrowers in the economy

They offer a wide range of financial services to savers (or surplus-spending units) to encourage them to deposit and invest in a well diversified pool of assets

They transfer these savings in the form of loans to borrowers or deficit-spending units for investment in productive ventures

The spread between the cost of attracting deposits and the yield on loans is the profit margin for the intermediaries

The higher the profit margin, the more likely the intermediaries are to grow in size and expand their customer base and services

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Definition of Concepts

(2) Surplus-spending individuals, families, institutions and governments have current receipts from income and other sources which exceed their current spending on goods, services and investment in plant and equipment in the case of firms.

Hence, they have surplus funds to save and invest in interest bearing assets such as bonds, shares and properties.

(3) Deficit-spending individuals, families, institutions and governments have current consumption and investment expenditures which exceed their receipts from income and other sources.

Therefore, they need to raise funds from external agents through borrowing and/or by selling new shares (in the case of firms) or bonds (in the case of firms and governments)

(3) Financial market is a composite term describing any physical or virtual marketplace where different types of securities are traded. Example of traded assets include: Treasury bonds, bonds, equities, currency, derivatives, properties.

Some markets (such as NYSE) are large with high level of activity, trading trillions of dollars of securities in a day.

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Leading Financial institutions

Banks

Building societies

Alternative banks

Credit unions

Mutual funds

Pension funds

Insurance companies

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2.services that are provided by financial institutions

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Services offered by Financial Institutions

(1) Savings deposits such as current accounts

(2) Granting loans including mortgages to individuals, families, governments and businesses

(3) Currency exchange by trading one form of currency for another

(4) Safekeeping/certification of valuables such as gold, paintings and documents

(5) Financial advisory services

(6) Selling standard insurance policies either as agents or underwriters of such policies

(7) Dealing in securities, executing buy and sell orders for security trading firms

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Why do we need financial intermediaries?

Imperfections in the financial system

Liquidity risk management

Information asymmetry

Transaction costs

Delegated monitoring

Economies of scale

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Imperfections in the financial system

The assumption that the financial market is perfectly efficient is not really the case. In particular not all assets are available in denominations that all participants can afford.

For example, treasury bills and property have minimum amounts which are well beyond the reach of most savers and investors

Mutual funds collect money from millions of savers and use the money raised to purchase these assets

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2. Liquidity Risk Management

Financial institutions are experienced in the management of liquidity risk arising from the funding of highly illiquid loans to borrowers with funds raised by selling highly liquid deposit accounts to savers.

Financial intermediaries are able to satisfy simultaneously the incompatible desire of both savers (surplus-spenders) and borrowers (deficit-spenders).

1. Savers’ requirements

(i) To have immediate access to their funds when needed regardless of the maturity term for the loans which they support

(ii) The highest possible return

(iii) The minimum transaction costs

(iv) the minimum risk of default by borrowers

2. Borrowers’ requirements

(i) Enough funds at a particular specified date

(ii) Funds for a specified period of time, say over a long term for firms borrowing to purchase capital equipment

(iii) Funds provided at the lowest possible cost

(iv) Investment advice

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3. Information Asymmetry

Access to quality information on prices of assets, financial investments and customer creditworthiness is expensive

Financial institutions have the resources and skill to acquire and evaluate the potential returns on investment

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Transaction Costs

Transaction costs relate to expenses associated with:

(i) Searching for counterparty to the financial transaction,

(ii) Obtaining information about them,

(iii) Negotiating the contract,

(iv) Monitoring the borrowers and

(v) Enforcing the contract should the borrowers fail to repay the loan

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4. Delegated Monitoring

Most savers, investors and borrowers prefer to keep their financial affairs confidential.

Financial intermediaries are required by law to maintain the confidentiality of their customers

Then too, depositors have neither the time nor the skill to choose between good and bad borrowers

They delegate such roles to agents who act on their behalf for a service charge.

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5. Economies of Scale

Financial intermediaries make large volume of loans to different types of borrowers, helping them to reduce transaction cost per unit of loans.

Such helps to diversify their risk of exposure, resulting in an increased safety for the savers’ funds

Moreover, borrowing customers are more likely to receive a stamp of approval in terms of their credit rating when they raise funds from formally regulated institutions rather then from individuals

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End of lecture

Further reading

Peter S. Rose., and Sylvia C. Hudgins (2013), Bank Management and Financial Services, Ninth Edition, McGraw-Hill International Edition, Chapter 1

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Take home assignment

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An overview of the changing financial sector

1. How has the banking and financial sectors changed in the recent years, especially in the aftermath of the financial crisis 2007-2009?

2. What major forces are shaping financial markets and institutions today?

3. Which of the forces identified in (item 2) do you think will persist into the future?

4. What do you think the financial services industry will look like 20 years from now?

5. What are the implications of your projections for the management of the financial services industry today?

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Take home assignment 2 Building your financial plan

https://www.youtube.com/watch?v=aNcYoLRiiE4

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Financial structure explained

https://www.youtube.com/watch?v=6OoMQiClXCs