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Overview of the Financial System
Fintmed Session 2
Second Term
Academic Year 2013 - 2014
Recall: Function of Financial Markets
Allows transfers of funds from person orbusiness without investments to one who hasthem
Improves economic efficiency.
Recall: The Financial System
Demander offunds
(mainly firms andgovernments)
Supplier offunds(mainly
households and
businesses)
Flow of financial securities
Incomes, and financial claims
Flow of funds (savings)
Recall: The Financial Intermediation Process
FinancialSystem
IndividualsBusinessesInstitutionsGovernment
IndividualsBusinessesInstitutionsGovernment
Funds Funds
Returns Returns
Suppliers
Lenders
Borrowers
UsersRisk management,
liquidity, andinformation
Source: Santos, Essentials of Investments
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Alternative View of Financial Markets
FinancialIntermediaries
Financial Markets
Funds
FundsFunds
Borrower-Spenders1. Business Firms2. Government3. Households4. Foreigners
Lenders-Savers1. Households2. Business Firms3. Government4. Foreigners
Funds Funds
INDIRECT FINANCE
DIRECT FINANCE
Structure of Financial Markets
Debt and Equity Markets Defined
Ways a firm or an individual can obtain funds in a
financial market:
1. Issue a debt instrument (bond or mortgage)
2. Issuing equities (common stock)
Structure of Financial Markets
Primary and Secondary Markets Defined
Primary new issues of security such as a bond or
stock are sold to initial buyers
Secondary securities which have beenpreviously issued can be resold
Classifications of Financial Markets
1. Debt Markets1.1 Short-Term (maturity < 1 year) Money Market
1.2 Long-Term (maturity > 1 year) Capital Market
2. Equity Markets2.1 Common Stock
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Transactions Costs
Financial intermediaries make profits byreducing transactions costs
Reduce transactions costs by developingexpertise and taking advantage of economies of
scale
Asymmetric Information
An inequality brought about when one party does
not know enough about the other party to make
accurate decisions.
For example: banks and financial institutions
spend time and resources through credit/
background information of the borrower to
ascertain whether to lend or not
Problems Created by Asymmetric Information
Adverse Selection
The problem created by asymmetric selection
before the transaction occurs
Potential borrowers most likely to produceadverse outcomes are ones most likely to seek
the loan and be selected
Problems Created by Asymmetric Information
Moral Hazard
The problem created after the transaction
(loosely described as conflict of interest)
Hazard that the borrower has incentives toengage in undesirable (immoral) activities
making it more likely that it wont pay the loan
back
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Financial Intermediation Process
The trick should be that financial intermediaries
reduce adverse selection and moral hazard
problems, enabling them to make profits.
Ensuring Soundness of Financial Intermediaries
Restrictions on Entry
Disclosure Restriction on Assets and Activities Deposit Insurance Limits on Competition Restriction on Interest Rates
Investment Houses
Involved in underwriting of securities, financial consultancy(issue management and underwriting of public offering ofdebt and equity securities, loan syndication and financialpackaging and advisory for corporate mergers, acquisitionsand restructuring) among others.
Enabling laws: PD 129 series of 1973 and RA 8366 seriesof 1997.
May be allowed to perform quasi-banking functions asapproved by the Monetary Board
Minimum capital requirement of P 300 M Foreign ownership allowed up to 60%
Financing Companies
Enabling law: RA 8556, amending RA 5980 'Financing companies' hereinafter called companies, are
corporations, except banks, investments houses, savingsand loan associations, insurance companies, cooperatives,and other financial institutions organized or operatingunder other special laws, which are primarily organized forthe purpose of extending credit facilities to consumers and
to industrial, commercial, or agricultural enterprises, bydirect lending or by discounting or factoring commercialpapers or accounts receivable, or by buying and sellingcontracts, leases, chattel mortgages, or other evidences ofindebtedness, or by financial leasing of movable as well asimmovable property;
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Financing Companies
Financing companies shall be organized in theform of stock corporations at least forty percent
(40%) of the voting stock of which is owned bycitizens of the Philippines and shall have a paid-up capital of not less than Ten million pesos(P10,000,000) in case the financing company islocated in Metro Manila and other first classcities, Five million pesos (P5,000,000) in otherclasses of cities and Two million five hundredthousand pesos (P2,500,000) in municipalities:
Securities Dealers
Buying and selling of securities
Minimum capital of P 5.0 M Mostly members of the Philippine Stock
Exchange
Lending Companies/Lending Investors
Enabling law: RA 9474 series of 2007 Lending Company shall refer to a corporation engaged in
granting loans from its own capital funds or from fundssourced from not more than nineteen (19) persons. It shallnot be deemed to include banking institutions, investmenthouses, savings and loan associations, financing companies,
pawnshops, insurance companies, cooperatives and othercredit institutions already regulated by law. The term shallbe synonymous with lending investors.
Minimum capital requirement: P 1.0 M
Investment Companies
Sells its own securities to the public and invest the
proceeds in stocks and bonds (bond fund)
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Insurance Companies
Engaged in property-liability (non-life), lifeinsurance, and/or multiple-line products
Minimum capital of P 100 M. Recent regulationallow for adjustment of risk
Regulated by the Insurance Commission Sellers (agents) are carefully screened
Pre-Need Companies
Sells pension, education, memorial plans subject to theapproval of the SEC and the Insurance Commission
Capital Requirements: Minimum paid-up capital of P 100M. Existing pre-need companies shall comply with thefollowing minimum unimpaired paid-up capital:
P 100M for companies selling at least three (3) types ofplan;
P 75 M for companies selling two (2) types of plan; P 50M for companies selling a single type of plan. Existing pre-need companies with traditional education
plans shall have a minimum unimpaired paid-up capitalP 100M
Regulation of Financial MarketsThree Main Reasons
Increase Information to Investors Decreases adverse selection and moral hazard
problems
Forces corporations to disclose information Ensuring the Soundness of Financial Intermediaries
Prevents financial panic Chartering, reporting requirements, restrictions onassets and activities, deposit insurance, and anti-
competitive measures
Improving Monetary Control Reserve requirements Deposit insurance to prevent bank panic