Structure of Financial System

Sopheap Pich on March 26, 2010

The financial system is complex in structure and function through the world, it was created in purpose to facilitate the flow of funds from savers to investors. It includes many different types of institutions: Financial intermediaries (banks, insurance companies and mutual funds), Financial markets (stock and bond markets).

Flow of Funds Through Financial System

Financial Markets Categories

  1. Primary market: is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency. This market is not well known to the public because the selling of securities to initial buyers often takes place behind closed doors.  An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public.
  2. Secondary market: is a financial market in which securities that have been previously issued can be resold. The New York Stock Exchange (NYSE) and National Association of Securities Dealers Automated Quotation System (NASDAQ) are the best-known examples for secondary markets.
  3. Money market: is a financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded. Shorter term securities have smaller fluctuations in prices than long-term securities, making them safer to invest. As a result, corporations and banks actively use the money market to earn interest on surplus working capital and to finance for shortage working capital. Money market instruments includes: U.S Treasury bill, Commercial Paper, Bank Certification of Deposit etc.
  4. Capital market: is a financial market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded. Long term securities are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future. Capital market instruments includes: Stock, U.S Treasury bond, Corporate bond, Mortgage etc.

Direct Finance: Funds are flew through institutions that provide brokerage services including investment banking such as Bank of America, and investment brokerage firms etc. They work as a channel of direct financing, in which businesses can raise funds directly from lenders in financial markets especially during initial public offering (IPO).

Indirect Finance: Funds are flew through financial intermediaries - including depository institutions, financing companies, insurance companies and mutual funds. They work as a channel of indirect financing by pooling saver funds then invest those funds through to businesses that want to spend them. Currently, majority of financing capital are made through indirect finance as securities have been bought primarily by financial intermediaries especially insurance companies, pension funds and mutual funds.

Why are financial intermediaries and indirect finance so important in financial markets?

  1. Transaction cost is the time and money spent in carrying out financial transactions. Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them, and because their large size allows them to take advantage of economies of scale.
  2. Risk sharing : Financial intermediaries sell assets with risk characteristics that people are comfortable with and then use the funds to purchase other assets that may have far more risk. This process of risk sharing is called asset transformation, risky assets are turned into safer assets for investors. Another way of risk sharing provided was through diversification; financial intermediaries invest in a collection of assets whose return do not always move together, with the result that overall risk is lower than for individual assets.
  3. Asymmetric information : Financial intermediaries usually equip with a better credit risk screening than individuals, therefore reducing losses due to wrong investment decision making. They have developed expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard.

Regulation of Financial System

Financial markets have important effect not only to domestic but whole global economy, thus financial system usually is the most heavily regulated sectors by governments. Two primary reasons in which government needs to regulate financial system are:

  • Increasing information available to investors, and protecting them from the abuse of financial market. Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets and earnings to the public and restricts insider tradings in the corporations.
  • Ensuring the soundness of financial intermediaries, the widespread collapse of financial intermediaries encourage investors pull back funds from financial market, thus can drag down the whole financial system. Regulators such as SEC and Federal Reserve System have implemented regulations including restriction on entry, restriction on assets and activities of financial intermediaries, and disclosure requirements etc.

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