Introduction: the nancial system

Objectives

What you will learn in this chapter:

lWhat are the components of a nancial system

lWhat a nancial system does

lThe key features of nancial intermediaries

lThe key features of nancial markets

lWho the users of the system are, and the benets they receive

In this rst chapter we want to nd a preliminary answer to two questions. We want

to know what is meant by the expression the ‘nancial system’ and we want to

know what such a system does.

For the purposes of this book, we shall dene a nancial system fairly narrowly, to

consist of a set of markets, individuals and institutions which trade in those markets

and the supervisory bodies responsible for their regulation. The end-users of the

system are people and rms whose desire is to lend and to borrow.

Faced with a desire to lend or borrow, the end-users of most nancial systems have

a choice between three broad approaches. Firstly, they may decide to deal directly

with one another, though this, as we shall see, is costly, risky, inefcient and, con-

sequently, not very likely. More typically they may decide to use one or more of many

organised markets. In these markets, lenders buy the liabilities issued by borrowers.

If the liability is newly issued, the issuer receives funds directly from the lender. More

frequently, however, a lender will buy an existing liability from another lender. In

effect, this renances the original loan, though the borrower is completely unaware

of this ‘secondary’ transaction. The best-known markets are the stock exchanges in

major nancial centres such as London, New York and Tokyo. These and other

markets are used by individuals as well as by nancial and non-nancial rms.

Alternatively, borrowers and lenders may decide to deal via institutions or

‘intermediaries’. In this case lenders have an asset – a bank or building society deposit,

or contributions to a life assurance or pension fund – which cannot be traded but

can only be returned to the intermediary. Similarly, intermediaries create liabilities,

typically in the form of loans, for borrowers. These too remain in the intermediaries’

1

..

FINM_C01.qxd 1/18/07 11:18 AM Page 2

Chapter 1 • Introduction: the nancial system

Figure 1.1

balance sheets until they are repaid. Intermediaries themselves will also make use of

markets, issuing securities to nance some of their activities and buying shares and

bonds as part of their asset portfolio. The choice between dealing directly, dealing

through intermediaries and dealing through markets is summarised in Figure 1.1.

Helping funds to ow from lenders to borrowers is a characteristic of most com-

ponents of the nancial system. However, there are a number of other functions,

each of which tends to be associated with a particular part of the system.

For example, the nancial system usually provides a means of making payments.

In most cases this is the responsibility of deposit-taking institutions (or a subset of

them). Such institutions are usually members of a network (a ‘clearing system’) and

accept instructions from their clients to make transfers of deposits to the accounts of

other clients. Traditionally this was done by issuing a paper instruction (a ‘cheque’)

but today it is done increasingly by electronic means.

We assume that most people are risk-averse. That is, they are prepared to make

a payment (or sacrice some income) in order to avoid uncertainty, especially if

the uncertainty may mean the possibility of a serious loss. Among the non-deposit-

taking institutions, this service is carried out by insurance companies. They allow

people to choose the certainty of a slightly reduced current income (reduced by the

premiums they pay) in exchange for avoiding a catastrophic loss of income (or wealth)

if some accident should occur.

Pension funds, unit trusts and investment trusts all offer savers the opportunity to

accumulate a diversied portfolio of nancial assets, though each does it in a slightly

different way. Pension funds, in particular, help people to accumulate wealth over

a long period and then to exchange this for income to cover the (uncertain) period

between retirement and death.

Lastly, it should always be remembered that while savers may be building up a

portfolio of wealth by acquiring nancial assets, they want to be able to rearrange that

portfolio from time to time as they observe changes in the risk/return characteristics

of the assets which they hold. If we use the phrase ‘net acquisition’ to describe the

additional assets that a household is able to add to its portfolio each year, we must

2

....

FINM_C01.qxd 1/18/07 11:18 AM Page 3