Introduction of Financial System

Financial System: A GlanceThe financial system is a complex set of closely interrelated components: institutions, markets, services, and instruments in the economy. Financial system is important in the economy in order to pool and utilize financial resources, reduces costs and risk; and expands and diversifies opportunities. This increases the allocative efficiency of resources and promotes the productivity and thus facilitates the economic growth. *Prepared for BBA 5th, Pokhara University - R. Gurung

Prepared for BBA 5th, Pokhara University - R. Gurung

The rapid change in financial system is driven by innovation. Two main types of innovation: - Existing needs in new ways, for example, the credit card: this provides a new way to pay for goods and services. - Existing technology to serve new needs, for example, the financial futures contract: this takes an instrument originally designed to serve the needs of grain dealers and adapts it to serve the needs of financial institutions. *Prepared for BBA 5th, Pokhara University - R. Gurung


The financial system makes the trade easier. The various types of trade are:Goods and Services, Lending, and Trade in riskThe basis of trade is diversity. People trade because they differ in what they have and in what they want.

*Prepared for BBA 5th, Pokhara University - R. Gurung


These different types of trade face similar obstacle: the problems associated with promise, incentive problems, and illiquidity. The financial system addresses to these problems. This unit focuses basically to two issues: the basic needs served by financial system and the technology adopted in serving these issues.



Unit 1: Economics of Financial SystemBasics needs served by the financial systemPaymentsResource transfer (Lending)Risk sharing (Insurance)2. The technology adopted in serving these needsDelegationCredit SubmissionPollingNetting*Prepared for BBA 5th, Pokhara University - R. Gurung


Basics needs served by the financial system continue . . .PaymentsTwo forms of trading: credit trading and cash tradingCredit trading involves exchange of value for a promise, for example mutual credit system.Cash trading involves exchange of value for value, for example barter or currency payments.Both exist problems: Trust and large set up costs (credit trading)Impossible without cash or mismatch in needs (cash trading)*Prepared for BBA 5th, Pokhara University - R. Gurung


1.1 FS Reduces the Costs of Payment in CashThe exclusive reliance on cash is costly and cumbersome. To guard them against theft, Requiring secure transportation, Counting of large amounts of currency, Authentication of cash bill. These problems existed in the trading view by another party as a profit opportunity.1.1.1 Warehouse Bank1.1.2 The Clearinghouse1.1.3 Bank Deposits as Money1.2 Fractional-Reserve Banking



1.1.1 Warehouse BanksA warehouse bank is a bank that accepts deposits of cash, count, and authenticate the currency and store it in a solid and well guarded vault. They allow depositors to make payments by transforming title to deposited cash rather than by transferring the cash itself, by writing check. The warehouse bank offer security and ease of payments in exchange for a fee.



1.1.2 The ClearinghousePhysically located place through which checks are cleared between two banks. When depositors maintain account at different bank then cash payment by one to another would by risky and inconvenient. The bank have an arrangement that makes such a physical transfer of cash unnecessary, and the arrangement is known as clearing. In this process nobody could pay the amount by physically delivering cash.



Bank Deposit as MoneyFor large payments, it is deposits that are now used as money, rather than the underlying cash. Since physical cash rarely changes hands for large payments, the cost of such payments is greatly reduced.



1.2 Fractional-Reserve BankingBanks that holds reserves of cash equal to only a fraction of its deposits liabilities.



2. LendingLending is risky and involves the varieties of difficulties:the cost of acquiring and processing information, the costs of negotiating and writing a contract, the incentive problems inherent in all lending arrangements, the cost of establishing safeguards and of monitoring borrower compliance, conflicting interests over liquidity, etc. The existence of financial system easily addresses these problems by reducing costs of lending and by improving the liquidity of loans.



2.1 Direct Lending and Financial MarketPurchasing shares and debt instruments issued by corporations and bypasses the services of the financial intermediaries. The direct lending undergoes several steps such as:Gathering InformationLoan IndentureAppointing Underwriter and TrusteeSecondary Market and LiquidityIssuing through underwriter will reduce costs. (Benefits of indivisible costs)However, public issue will make sense only when amount to be raised is substantial*Prepared for BBA 5th, Pokhara University - R. Gurung


2.2 Indirect Lending and Financial Intermediaries The funds transfer between suppliers and users of funds through financial intermediaries. Aggregation of funds by fund suppliers in a financial institutions resolves a number of problems to individuals.



2.2 Indirect Lending and Financial Intermediaries continue . . .

Informational AdvantagesPooling to Make Large LoansGains from SpecializationThe Value of Continuing RelationshipDiversification Liquidity



Direct Versus Indirect LendingThe relative merits between the direct and indirect lending are discussed as follows:Benefits to Lenders1. Indirect lending generally promises lenders less risk and more liquidity to the investors. 2. Indirect lending promises lower return due to lower level of risk. However, this losses the opportunity to investors getting richer through intelligent or clever investment in stocks markets as investors never become richer putting money in the bank.



Benefits to Borrowers1. Many of the costs are indivisible in public issue so short term or small size transactions are always costly in direct lending. 2. Many borrowers have small choice due to their lack of good credit standing and enter into direct borrowings.



Benefits to Borrowers continue . . .3. Borrowers having large requirement of funds can have benefits from direct lending. Providing large sum of money in indirect lending may not be possible always, and the capacity of the direct financial market is much larger than that of even the largest intermediaries.



Direct Versus Indirect Lending continue . . . Direct and indirect lending differs with respect to their flexibility in dealing with repayment problems. This depends on whether the difficulty in repayment is due to permanent (such as miss management) or temporary (such as a slow economy).



Direct Versus Indirect Lending continue . . .With direct lending, rescheduling loan is difficult in adverse situation (repayment problems) as there are numerous lenders and it is hard for lenders to agree on new terms of the loan and when there is a problem. The terms of contract tend to be enforced rigidly. (liquidation!)With indirect lending the bank is in a much better position to know whether the problem is permanent or temporary. As a sole lender, it can alter the terms of the loan without having to obtain the agreement of others. It can reschedule payments, waive loan covenants, or even make new loans to help the borrower.



3. Trade in RiskTwo principal forms of trade in risk are:Insurance and Forward Transactions Many people suffer in trade in risk. *Prepared for BBA 5th, Pokhara University - R. Gurung


Reciprocal InsuranceAn agreement whereby those facing a particular risk agree to share their losses. Mutual aid and gift exchange are examples of reciprocal insurance. External InsuranceAn agreement whereby those who do not face a particular risk agree to share the losses of those who do. (Natural risk such as losses from shipwrecked or satellite destroyed on launching)*Prepared for BBA 5th, Pokhara University - R. Gurung


The insurance involves two types of incentive problems:Moral Hazard and Adverse Selection



Moral HazardIt is a tendency of an insured to take greater risks because s/he is insured. For example, a ship-owner may face the choice between two routes-one safe but slow, the other fast but risky. Which one will be the ship-owners choice? If there is: No insuranceInsurance



Adverse SelectionThis is a tendency of worse risks to buy insurance and better risk not to. For example, suppose the price of insurance is the same for all ships. Then owners of ships that are in poor shape will find insurance more attractive, and will be more likely to purchase it, than owners of sound ships.



How Insurance Company Works?Insurance company sells the similar policy to the large number of policyholders. Any individual risk is only small element of a very large portfolio consisting of many insurance policies, they are essentially independent of one another.The benefits provided is small fraction of large amount collected in the form of premium. The insurance company not only transfer risk between policyholders and the insurance company, but it is also a way of sharing risk among policyholders.



Advantages of Insurance CompanyActuarial Risk and Reciprocal InsuranceNeither size nor their timing in advance is known in reciprocal insurance. It is fixed and certain in insurance policy.In reciprocal insurance, there is a greater chance that it will fail due to smaller pool. Damages might be more than the participants could handle. Insurance policy is based on the much larger and better diversified group. Insurance is also backed by the capital of the insurance company, if losses exceeds premium, the insurance promises to cover the difference.



Advantages of Insurance Company continue . . .Insurance covers variety of risksRisk to homes, automobiles, commercial property, etc. collectively known as property-liability insurance. Risk of life such as death, injury or illness known life insurance. These types of insurances are based on the pooling of many similar risks with known probability and called actuarial risk.



2. Non-Actuarial Insurance and External InsuranceIt is non-actuarial insurance whose probability of risk of losses cannot forecasted and the pool of these types of risk is also small. It is impossible to organize insurance for this sort of risk in the same way as for actuarial risks. Financial system manage non-actuarial risks and offers external insurance. Insurers not inherently exposed to the risk agree to bear part of it for a premium (may ahead by the amount of the premium)



2. Non-Actuarial Insurance and External Insurance continue . . .External insurers cope with the risk through diversification: they take an many unrelated risks, each small relative to their capital. Actuarial insurance is generally offered by insurance intermediaries, but there is an important market for external insurance - Lloyds of London. This is an exchange where groups of wealthy individuals bid to accept non-actuarial risks for a premium.



Dealing with Incentive ProblemsInsurance faces the two problems: - Moral Hazard and Adverse Selection For moral hazard, the insurance company can replicate this insurance by offering only partial coverage. The insurer will pay only a part of the loss. Adverse selection is not much of a problem for mutual aid. All members of the community are expected to participate. *Prepared for BBA 5th, Pokhara University - R. Gurung


Dealing with Incentive Problems continue . . .Adverse selection is problem for the insurance company. High-risk farmers will find the insurance a bargain and buy a policy, low risk farmers will find the insurance too expensive and not buy one. The frequency of claims will rise, and the insurance company may lose money. The best it can do is to gather as much information as possible to distinguish high-risk farmers from low, and to try to tailor its premiums to reflect risk.*Prepared for BBA 5th, Pokhara University - R. Gurung


Forward TransactionIt is an exchange of one promise for another: one party promises to buy, the other promises to sell. Forward transaction involves the default risk (replacement risk). The financial system helps in two ways to solve the problems in forward transaction: the direct forward transaction (future forward) and indirect forward transactions (forward intermediaries). They offer low transaction costs, guaranteed delivery, and greater liquidity.*Prepared for BBA 5th, Pokhara University - R. Gurung


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Introduction of Financial System