Chapter 2

FINANCIAL SYSTEM
OVERVIEW OF FINANCIAL SYSTEMS
Nature and Objective of the Financial System
Financial System – consists of all financial intermediaries and financial markets and their relations
with respect to the flow of funds to and from households, governments, business firms and
foreigners, as well as the financial infrastructure.

Having a well-functioning financial system in place that directs funds to their most productive uses
is a crucial prerequisite for economic development.

Flow of Funds through the Financial System

Those who have saved and are lending funds, the lenders-savers, are at the left, and those who
must borrow funds to finance their spending, the borrowers-spenders, are at the right.

The principal lender-savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their government, sometimes
also find themselves with excess funds and so lend them out. The most important borrowers-
spenders are businesses and the governments (particularly the national government), but
households and foreigners also borrow to finance their purchase of cars, furniture, and houses.

The arrows show that funds flow from lenders-savers to borrowers-spenders via two routes.
In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them
securities (also called financial instruments), which are claims on the borrower’s future income or
assets. Securities are assets for the person who buys them, buy liabilities. (IOUs or debts) for the
individual or firm that sells (issues) them.

Key Components of the Financial System

a. Financial Instruments
b. Financial Markets and Financial Institutions
c. The Central Bank and Other Financial Regulators

Functions of the Financial System

The main task of the financial system is to channel funds from sectors that have a surplus to
sectors that have a shortage of funds.

In the financial system, banks, insurance companies, mutual funds, stock brokers, and other
financial services firms compete to provide financial services to households and businesses.

Three Key Services Provided by Financial Systems

1. Risk sharing,
2. Liquidity, and
3. Information

 Financial services firms provide these services in different ways, which makes different
financial assets and financial liabilities more or less attractive to individual savers and
borrowers.

Risk Sharing
Risk – the chance that the value of financial assets will change relative to what one expects.
One advantage of using the financial system to match individual savers and borrowers is that it
allows the sharing of risk. Most individual savers. Most individual savers seek a steady return on
their assets rather than erratic savings between high and low earnings.
Diversification – the splitting of wealth into many assets to reduce risk.

The financial system provides risk sharing by allowing savers to hold many assets. Hence, because
of the ability of the financial system to provide risk sharing makes savers more willing to buy
stocks, bonds and other financial assets. This willingness, in turn increases the ability of borrowers
to raise funds in the financial system.
Financial intermediaries have developed expertise in holding a diversified portfolio of innovative
projects which reduces risk and promotes investment in growth enhancing innovative activities.

Liquidity
Liquidity – is the ease with which an asset can be exchanged for money which savers view as a
benefit.

Financial markets and intermediaries help make financial assets more liquid. Investors can easily
sell their holdings of government securities and the stocks and bonds of large corporations,
making those assets very liquid.

The financial system has increased the liquidity of many assets besides stocks and bonds through
the process of securitization. This process has made it possible to buy and sell securities based on
loans. As a result, mortgages and other loans have become more desirable assets for savers to
hold. Savers are willing to accept interest rates on assets with greater liquidity which reduces the
costs of borrowing for many households and firms.

Information
A third service of the financial system is the collection and communication of information, or facts
about borrowers and expectations of returns on financial assets.
 Banks collect information on borrowers to forecast their likelihood of repaying loans.
Because the bank specializes in collecting and processing information, its costs for
information gathering are lower than yours would be if you tried to gather information
about a pool of borrowers. The profit the bank earns on its loans is partly compensation for
the resources and time bank employees spend to gather and store information.
 Financial markets convey information to both savers and borrowers by determining the
prices of stocks, bonds, and other securities. This information can help one decide whether
to continue investing in the securities previously purchased or to sell more stock or bonds
to finance a planned expansion. The incorporation of available information into asset prices
is an important feature of well-functioning financial markets.

The Problems of Adverse Selection and Moral Hazard

A key consideration for savers is the financial health of borrowers. Savers do not lend to borrowers
who are unlikely to pay them back. Unfortunately for savers, borrowers in poor financial health
have an incentive to disguise this fact.
Example:
A company selling bonds to investors may know that its sales are declining rapidly, and its
near bankruptcy, but the buyers of the bonds may lack this information.

A vital service of the financial system is the collection and communication of information or facts
about borrowers and expectations of returns in financial assets. Financial markets convey
information to both savers and borrowers by determining the prices of stocks, bonds, and other
securities.

Asymmetric information – describes the situation in which one party to an economic transaction
has better information than does the other party.
In financial transactions, typically the borrower has more information than does the lender.
The financial system helps overcome an information asymmetry between borrowers and lenders.
An information asymmetry can occur before or after a financial contract has been agreed upon.
Two Problems from Asymmetric Information
1. Adverse selection – the problem investors experience in distinguishing low-risk borrowers
from high-risk borrowers before making an investment.
The information asymmetry before the contract is agreed upon arises because
borrowers generally know more about their investment projects than lenders.
Borrowers most eager to engage in a transaction are the most likely ones to produce
an undesirable outcome for the lender (adverse selection). Individual savers may not
have the time, especially or means to collect and take advantage of economies of
scale and scope.
2. Moral hazard – the problem investors experience in verifying that borrowers are using their
funds as intended.
Even after a lender has gathered information on whether a borrower is a good
borrower or a lemon borrower, the lender’s information problems haven’t ended.
There is still a possibility that after a lender makes a loan to what appears to be a
good borrower, the borrower will not use the fund s intended.
This situation is more likely to occur when the borrower has an incentive to conceal
information or to act in a way that does not coincide with the lender’s interests.
Moral hazard arises because of asymmetric information: The borrower knows more
than the lender does about how the borrowed funds will actually be used.

Nature and Impact of Transaction and Information Costs

 Transaction Costs
The cost of a trade or a financial transaction; for example, the brokerage
commission charged for buying or selling a financial asset.
 Information Costs
The cost that savers incur to determine the credit worthiness of borrowers and to
monitor how they use the funds acquired.

Because of transaction costs and information costs, savers receive a lower return on investments
and borrowers must pay more for the funds they borrow. Although transaction costs and
information costs reduce the efficiency of the financial system, they also create a profit
opportunity for individuals and firms that can discover ways to reduce those costs.

How Financial Intermediaries Reduce “Adverse Selection”

1. Requiring borrowers to disclose material information on their financial performance and
financial position.
 SEC requires publicly traded firms report their performance in financial statement. Firms
must prepare these statements using standard accounting methods. In addition, they
must disclose material information that, if known, would likely affect the price of a firm’s
stock.
2. Collecting information on firms and selling that information to investors.
3. Convincing lenders to require borrowers to pledge some of their assets as collateral which
the lender can claim if the borrower defaults.

How Financial Intermediaries Reduce “Moral Hazard” Problems

 1. Specializing in monitoring borrowers and developing effective techniques to ensure that the
funds they loan are actually used for their intended purpose.
2. Imposing restrictive covenants
Restrictive covenants may involve placing limitations on the uses of funds borrowed
or requiring the borrowers to pay off the debt even before maturity date if the
borrower’s net worth drop below a certain level.

How Financial Intermediaries Reduce Transaction Costs

1. Financial intermediaries take advantage of economies of scale, which refers to the

reduction in average cost that results from an increase in the volume of a good or service
produced.
Example:
The fees dealers in Treasury bonds charge investors to purchase P10 million worth
of bonds are not much higher than the fees they charge to purchase P11 million worth of
bonds. By buying P500 worth of shares in a bond mutual fund that purchases millions of
pesos worth of bonds, an individual investor can take advantage of economies of scale.

2. Financial intermediaries can also take advantage of economies of scale in other ways.
Example:
Because banks make many loans, they rely on standardized legal contracts, so the
costs of writing the contracts are spread over many loans. Similarly, bank loan officers
devote their time to evaluating and processing loans, and through this specialization, they
are able to process loans efficiently, reducing the time required – and, therefore, the cost
per loan.

3. Financial intermediaries also take advantage of technology to provide financial services,

such as those that automated teller machine networks provide.
4. Financial intermediaries also increasingly rely on sophisticated software to evaluate the
credit worthiness of loan applicants.

THE PHILIPPINE FINANCIAL SYSTEM

 Well-functioning financial system is crucial to a country’s economic health so much that
when the financial system breaks down, severe economic hardship results.

Example: Russia, South East Asia

 The financial system, through the various financial markets and financial intermediaries,
has the basic function of moving funds from those who have a surplus to those who have a
shortage of funds.

Structure of the Philippine Financial System

I. Bangko Sentral ng Pilipinas
II. Banking Institutions
A. Private Banking Institutions
1. Expanded Commercial Banks/Universal Banks (EKB/UB)
2. Commercial Banks (KB)
3. Thrift Banks (TB)
 a. Savings and Mortgage Banks (SMB)
b. Private Development Banks (PDB)
c. Stock Savings and Loan Association (SSLA)
4. Rural Banks (RB)
5. Cooperative Banks)
B. Government Banking Institutions
1. Development Bank of the Philippines (DBP)
2. Landbank of the Philippines (LBP)
3. Philippine Al-Amanah Islamic Investment Bank
III. Non-Bank Financial Institutions
A. Private Non-Bank Financial Institutions
1. Investment Houses
2. Investment Banks
3. Financing Companies
4. Securities Dealers/Brokers
5. Savings and Loans Associations
6. Mutual Funds
7. Pawnshops
8. Lending Investors
9. Pension Funds
10. Insurance Companies
11. Credit Union
B. Government Non-Bank Financial Institutions
1. Government Service Insurance System (GSIS)
2. Social Security System (SSS)
3. PAG-IBIG

The Evolving Philippine Financial System

To counteract the downside risks and smooth functioning of the Philippine financial system more
stringent initiatives are being pursued by the four regulatory agencies, namely:

1. Bangko Sentral ng Pilipinas (BSP)

2. Securities and Exchange Commission (SEC)
3. Insurance Commission (IC)
4. Philippine Deposit Insurance Commission (PDIC)

Regulatory Landscape

a. Alignment with global standards

b. Deepening capital markets
c. Strengthening surveillance

Signs of Growth in the Domestic Market

a. The Philippine banking system has been consistently posting double-digit asset
growth since January 2016.
b. Total assets of the insurance industry more than doubled from 2008 to 2016. There
has been a steady increase in the industry’s revenues relative to GDP after the GFC.
 The life insurance segment continues to be the driver of the insurance companies’
revenues.
c. The securities market has also exhibited growth. The bond market is comprised
mostly of peso-dominated government issued securities, to which outstanding
amount as of end-March 2018 grew by 7.1 percent. The equities market registered
12 additional companies with the PSE bringing the total listed companies to 268,
equivalent to Php 17.31 trillion market capitalization as of end-October 2017.

Current Risks in the Philippine Financial System

A. Repricing, Refinancing and Repayment Risks (3Rs)

B. Developments in the Credit Market
C. Continuous Demand for Credit by Corporate Enterprises and Households is evident in the
domestic economy