Unit 1: Introduction to Financial Management

Lesson 1.5
Financial System
Contents
Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 4

Participants in the Financial System 5
Lenders 5
Borrowers 6
Functions of the Financial System 6
Flow of Funds 7
Roles of the Financial Manager 9
The Financial System and the Economy 11

Case Study 12

Keep in Mind 13

Try This 15

Practice Your Skills 16

Challenge Yourself 18

Bibliography 19
Unit 1: Introduction to Financial Management

Lesson 1.5

Financial System

Introduction

Financial decisions made by individuals and households greatly impact the economy. When
people obtain funds (e.g., from salaries) and decide where to spend and save them, this
could result in an efficient flow of funds from all financial units of the economy. Imagine
when you receive your allowance from your parents for the week. Just by allocating 70% of it
for your weekly expenses (e.g., by buying needs and/or wants from businesses) and 30% for
savings (e.g., placing it in your bank account), you help circulate the money in the economy.

In the same way, businesses and governments are also important units of the economy.
Because of financial management, they are able to create wise financial decisions
appropriate for their organization’s needs. When they lack the capital to operate, they can
borrow from different financial institutions (e.g., banks) for expansion, project development,

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and payment of operating expenses. In return, they need to pay the principal amount plus
interest upon the end of the loan term. This is how the business and government sectors
contribute to the continuity of the flow of funds within the economy.

All of these units work together in the financial system to create a healthy economy. If the
financial system works efficiently, then it could lead to economic sustainability. In this
lesson, you will learn about the financial system, how it works, and its importance to the
economy.

Learning Objectives DepEd Competency

● Explain the flow of funds within an

In this lesson, you should be able to do the
organization - through and from the
following:
enterprise - and the role of a financial
● Identify the components, functions, and manager (ABF_BF12-IIIa-5).

participants of the financial system.

● Discuss the flow of funds within the
financial system.
● Analyze the importance of the financial
system in real-life situations.
● Synthesize the role of a financial
manager in the flow of funds within an
enterprise.

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Unit 1: Introduction to Financial Management

Quick Look

Role of Banks in the Financial System

The Bangko Sentral ng Pilipinas (BSP) was established in accordance with Republic Act No.
7653 or also known as the New Central Bank Act. Under Sec. 3 of this Act, the responsibility
of BSP is to supervise and regulate the operations of all banks in the Philippines. Its primary
aim is to maintain price stability conducive to a balanced and sustainable growth of the
economy. Upon its establishment, one of its roles is to act as the monetary body authorized
by the law to create and supply money in the financial system.

In order to achieve BSP’s primary objective, it is tasked to regulate the two major operating
activities of any bank in the Philippines: (1) accepting deposits, and (2) lending money. As
you have previously learned, banks serve as intermediaries between those who have excess
funds (depositors) and those who have insufficient funds (borrowers). When individuals
decide to place their savings or money in the bank, the bank lends this money to different
borrowing units like individuals and businesses. Banks earn profits through interests. Thus,
there is a continuous flow of funds within the different financial units.

Questions to Ponder
1. According to the text, what is the role of banks in the financial system and economy?
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2. As an individual, what are the ways to contribute to the efficiency of fund circulation?
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3. How do banks help in the maximization of the wealth of individuals? You may cite
examples based on your experience.
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Learn the Basics

In order to achieve the primary goal of financial management, businesses must create sound
and appropriate financial decisions. Yet, these decisions greatly rely on how the financial
system works and give opportunities to businesses.

Essential Question

Can the decisions of financial managers impact the financial and economic
system?

A financial system is a broad network of financial units that interact with one another to
mobilize financial resources through payment systems and facilities in the financial market
(Beray et al. 2013, 195). In other words, this network operates to allow the channeling of
funds using money and various financial instruments through financial institutions and
financial markets.

Remember that there are three components of the financial system namely financial
institutions, financial markets, and financial instruments. Financial institutions act as
mediators between lenders and borrowers. Financial markets are platforms where the
exchange of funds takes place. Financial instruments are mediums used to transfer the
fund. All these components harmoniously work together to create an efficient flow of funds
and capital within a financial system. Otherwise, the financial system collapses.

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Closer Look

Regulating the Financial System

Since banks are considered the largest components of the financial
system, the Bangko Sentral ng Pilipinas (BSP) plays a vital role not only in
the Philippine financial system but in the economy as a whole. In
accordance with the mandated objective of Sec. 3 of R.A. 7653, the major
roles played by BSP in the financial system are (a) lender of last resort, (b)
controller of money supply in the Philippines, and (c) creator of monetary
policies. With these functions, the BSP regulates the financial system,
which aids in the attainment of balanced and sustainable growth of the
Philippine economy.

Check Your Progress

How does the financial system work?

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Participants in the Financial System

Individuals and households, businesses or firms, and governments contribute to an efficient
financial system. Depending on their needs, decisions, and actions, their role in the financial
system can be categorized into two: as lenders or as borrowers.

Lenders
Lenders, or net savers, are the surplus units in the financial system. They provide excess
funds through savings and investments. Normally, the lenders are individuals and
households (Suomen Pankki 2021). When they spend less than their earnings, their savings
are usually placed in bank accounts or in different investments. Here are some ways
individuals take part in the lending process (Beray et al. 2013, 203):

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a) Money deposited in bank accounts;

b) Premium payments to insurance companies;
c) Investment in stocks, bonds, and mutual funds; and
d) Contribution to pension plans.

Borrowers
Banks, as mediators, lend the money deposited in them to the deficit units called borrowers.
They are also considered debtors because they are the ones who need funds. The typical
borrowers are firms and governments since they need to raise capital to fund their
operations and projects. However, individuals and households can also borrow money to
finance their needs (Suomen Pankki 2021). Oftentimes, borrowers are presented with great
opportunities but they lack funds. Let’s say you want to establish a sari-sari store but you do
not have enough capital to start the business. And so, you go to banks and other lending
institutions to acquire the funds necessary for your business simulation.

Conflicts between lenders and borrowers may arise due to terms of disagreement, loanable
amount, and even the risks associated with each loan. Thus, having financial institutions or
intermediaries helps settle the conflict between the two parties. As a part of the financial
system, financial institutions exist to create negotiable contracts, provide payment facilities,
and diversify risks by investing in different financial instruments.

Check Your Progress

Differentiate a lender from a borrower in terms of their role in the financial

system.
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Functions of the Financial System

Money is the lifeblood of the financial system; without it, the system will not function.
Financial systems exist primarily to aid in the circulation and transfer of money from surplus
units to deficit units. Thus, to efficiently create smooth transactions, this broad system is

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governed by monetary policies and legal and tax frameworks to generate, control, and
supply money and credit (Beray et al. 2013, 196).

The most essential function of a financial system is to provide the channel to transfer
funds from one unit to another. It aims to allocate the supply of money in the economy from
the savers to the demanders in a smooth and efficient manner. In addition to this, here are
some of its functions:
1) Create liquidity to the deficit units.
2) Gather and disseminate information to market participants about the expectations of
lenders and borrowers.
3) Diversify risks through investments.

Flow of Funds
The flow of funds (FOF) is a macroeconomic concept that is used to track and analyze the
movement of money among individuals and industries (Hayes 2021). There are two ways by
which the funds flow from lenders to borrowers: direct financing and indirect financing.

Figure 1. Funds and capital flow in the financial system through direct and indirect financing.

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Direct financing, sometimes referred to as market-based financing, is a method of

channeling funds directly from the ultimate lender to the ultimate borrower through
financial markets. The lenders can directly buy their financial instruments or securities from
borrowers for liquidity. Imagine that you lend your friend a certain sum of money; this is an
example of direct financing. In the corporate setup, direct financing occurs when you
purchase stocks directly from corporations through the stock market. In direct financing,
direct lenders have the flexibility and full control over the lending process because they work
hand-in-hand with the borrower. However, they are exposed to higher risks because of the
direct negotiation. Upon selling of equity securities, risks are now passed on to the lenders.

On the other hand, indirect financing is the process of lending money to borrowers through
financial intermediaries or third parties like financial managers. Financial intermediaries
usually pool the funds of various sellers in order to resupply these funds to different buyers
for a cost. An example of indirect financing is investing in mutual funds. Mutual funds are
pooled funds that are mixed by financial experts to align with the financial objectives of the
investors. Indirect lenders can spend minimal time on the process because the funds are
being managed by financial managers. In addition, they have multiple loan and investment
opportunities. The lender also faces less risk, as compared to direct lenders, because the
third parties involved are knowledgeable on the risks associated with the funds and help
diversify these risks. Table 1 summarizes the differences between direct financing and
indirect financing.

Table 1. Comparison of direct financing and indirect financing

Criteria Direct Financing Indirect Financing

Definition and Direct financing is a method of Indirect financing is a method

nature transferring funds directly from of lending funds from the
the ultimate lender to the ultimate lender to the ultimate
ultimate borrower. borrower that involves a third
party.

Component of Financial markets such as money Financial intermediaries like

financial markets and capital markets credit institutions and banks
system involved

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Advantages ● Flexibility ● Minimal time spent on

● Full control of lender and the process
borrower over the process ● Multiple opportunities

Disadvantage ● Takes too much time ● Additional costs or fees

● Additional research costs for financial
because lenders guide intermediaries or
themselves. managers who manage
your fund.

Risk involved ● Higher risk ● Less risk

Check Your Progress

How do funds flow from lenders to borrowers? Cite the difference between
the two methods in the lending process.
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Roles of the Financial Manager

A financial manager’s role is a key to the success of a business. The main goal of financial
managers is to ensure the maximization of wealth of an individual or entity. Always
remember that maximizing profit does not always result in the maximization of wealth.
Financial managers must consider the short-term and long-term consequences of the firm’s
decisions and actions (Gitman et al. 2018, 1446).

In companies, financial managers are responsible for the financial health and analysis of
performance. They must produce financial plans, reports, and forecasts, and develop
long-term financial strategies to achieve the organizational objectives. Moreover, they are
also responsible for how the cash flows within the enterprise (see Fig. 1), regardless of the
company’s size. The cash inflows could be from sales, owner’s investments, borrowed

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funds, sale of fixed assets, or collection of accounts receivable. These inflows can be
sustained through financial planning and the raising of funds facilitated by the financial
manager.

Meanwhile, the cash outflows include the purchase of fixed assets, payment of dividends
to owners, purchase of inventories, and payment of expenses. Financial managers must
plan and project these expenditures to avoid unnecessary expenditures.

Figure 2. The decisions of financial managers affect the flow of funds in an enterprise.

For individuals, indirect lenders often consult financial managers to manage their funds in
accordance with their financial objectives. They are experts and professionals in giving
financial advice and managing money on behalf of their clients (Ross 2019).

The task of financial managers in the financial system is very challenging. They are expected
to make sound and wise decisions for the benefit of their clients. They ensure that there is a
continuous and efficient flow of funds within the financial system. In addition, here are the
key activities of financial managers (Gitman et al. 2018, 1445):
a. Financial planning: includes preparation of financial reports and projections;
b. Investment decisions: investing in different projects and financial securities to
acquire more funds; and
c. Financing decisions: involve the proper mixture of debt and equity financing.

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Check Your Progress

How would you describe the role of a financial manager in (a) a business
organization and (b) the financial system?
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The Financial System and the Economy

The financial system performs an essential role in the economy as well as in society (Beray et
al. 2013, 205), which involves the study of the behavior of units of society. Understanding
how the financial system works is essential because it involves individuals, households,
businesses, and the government. Here are some of the reasons why financial system is
necessary for the economy (eStartIndia Administration 2021):
1. It encourages people to save and keeps excess funds from being idle by channeling
these to borrowers.
2. It helps monitor the financial health and performance of companies.
3. It serves as a linkage between savers and borrowers.
4. It aids the government in creating and implementing monetary policies.
5. It helps increase the profits and earnings of individuals, firms, and governments.

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Case Study

Consumer Expectations Survey

The Department of Economic Statistics, in coordination with the Bangko
Sentral ng Pilipinas, conducts a quarterly Consumer Expectations Survey.
For the years 2019 to 2021, here are the percentages of households with
savings in the Philippines for the third quarter of each year: Q3 2019 -
37.5%; Q3 2020 - 24.7%; Q3 2021 - 25.2%.

Respondents of the survey come from low-, middle- and high-income

groups. The results showed the top five reasons for saving: (a) for
emergencies, (b) for health and hospitalization, (c) for retirement, (d) for
education, and (e) for investment in businesses. Throughout the years,
banks are still the most preferred saving institutions.

However, the results of the Q3 2020 surveys showed how the COVID-19
pandemic affected the allocation of income for savings regardless of the
income level of households. Most of them said that they set aside money
and tried to decrease expenses because they expected an increase in
unemployment rate for the current and succeeding years.

This situation wherein people are saving but are not spending or
demanding goods poses a challenge for the financial system as it affects
the flow of money in the economy. One of the actions done by central
banks was to lower the interest rates to encourage individuals to borrow
money and spend it for their needs and/or business activities.

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Consumer Confidence Improves in Q3 and for Q4 2021, but is

Less Optimistic for Next 12 Months
Bangko Sentral ng Pilipinas, “Consumer Confidence Improves
in Q3 and for Q4 2021, but is Less Optimistic for Next 12
Months,” Consumer Expectations Survey Third Quarter of
2021 (Bangko Sentral ng Pilipinas),
https://www.bsp.gov.ph/Lists/Consumer%20Expectation%20R
eport/Attachments/20/CES_3qtr2021.pdf, last accessed on
November 3, 2021.

Keep in Mind

● A financial system is a broad network that operates to allow the channeling of funds
using money and various financial instruments through financial institutions and
financial markets.
● The main participants in a financial system are lenders and borrowers. The key
function of financial systems is to provide a channel between lenders and borrowers
in the transfer process of funds. In relation to this, the flow of funds is a
macroeconomic concept that describes how the funds are circulated within the
financial system. The diagram below shows this concept.

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● A financial manager ensures that the maximization of wealth of an individual or

entity is achieved. He is responsible for monitoring and sustaining the financial health
of an individual, business, and/or government.
● The financial system is important because of the following reasons:
○ encourages people to save
○ monitors the financial health and performance of companies
○ serves as a linkage between savers and investors,
○ aids the government in creating and implementing monetary policies
○ helps increase the profits and earnings of individuals, firms, and governments.

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