Introduction

Principles of Banking and Finance

Financial Systems
an overview of financial systems, their
functions and general structure.

Functions of financial systems

provide the mechanisms by which funds can be
transferred from units in surplus to units with a
shortage of funds in order to directly or
indirectly facilitate lending and borrowing
(as shown in Figure 2.1)
enable wealth holders to adjust the composition
of their portfolios
provide payment mechanisms
provide mechanisms for risk transfer

Figure 2.1

The 3 Major Entities

Nature and characteristics of the three
major entities that compose financial
systems.
Financial intermediaries, securities and
financial markets

Financial markets
markets in which funds are moved from
people who have an excess of available
funds (and lack of investment
opportunities)
to people who have investment
opportunities (and lack of funds).

Financial markets
(such as bond and stock markets) are
markets in which securities are traded.

Stock Certificates

Bond

Portfolio

Treasury Bills

Securities
Securities
(also
called
financial
instruments) are financial claims on the
issuers future income or assets.
They represent financial liabilities for the
individual or firm that sells them
(borrower or issuer of the financial
claim) in return for money, and financial
assets for the buyer (lender or investor
in the financial claim).

Financial intermediaries
are economic agents who specialise in
the activities of buying and selling (at
the same time) financial contracts
(loans and deposits) and securities
(bonds and stocks).
Note that financial securities are easily
marketable, while financial contracts
cannot be easily sold (marketed).

Depository institutions
Depository institutions: intermediaries
with a significant proportion of their
funds derived from customer deposits
include: commercial banks savings
institutions and credit unions.

Commercial banks
Commercial banks accept deposits
(liabilities) to make loans (assets)
and to buy government securities.
Deposits are broad in range, including
checkable deposits (deposits on which
cheques can be written),

Commercial banks
Savings deposits (deposits that are
payable on demand, but do not allow
depositors to write cheques), time
deposits (deposits with a fixed term to
maturity).
Loans include consumer, commercial
and mortgage loans.

Foreign Bank

Savings and loan associations

Historically
savings
and
loan
associations
(S&Ls)
and
thrift
institutions have concentrated mostly on
residential mortgages by acquiring
funds primarily through savings deposits

Credit unions
Credit unions are non-profit institutions
mutually organised and owned by their
members (depositors).
Their primary objective is to satisfy the
depository and lending needs of their
members, who have to belong to a
particular group (identified occupation,
association, geographical location).

Contractual savings
institutions
Contractual savings institutions acquire
funds at periodic intervals on a
contractual basis.
The industry is classified into two major
groups:
insurance companies and pension
funds.

Contractual savings
institutions
The liquidity of their assets is less
important than for depository institutions
because they can predict with
reasonable
accuracy
the
future
payments due to their customers.
As a consequence they invest their
funds in long-term securities (such as
corporate
bonds,
stocks
and
mortgages).

Insurance companies
The primary objective of insurance
companies is to protect individuals and
firms (known as policy-holders) from
adverse events. Insurance companies
receive premiums from policy-holders,
and promise to pay compensation to
policy-holders if particular events occur.

Insurance companies
There are two main segments in the
industry: life insurance on the one hand,
and property and causality insurance on
the other.

Pension funds
Pension funds provide retirement
income (in the form of annuities) to
employees covered by a pension plan.
They
receive
contributions
from
employers or employees and invest
these amounts in corporate bonds and
stocks. There are private pension funds
and public pension funds.

Investment intermediaries
Investment intermediaries comprise
mutual funds, finance companies,
investment banks and securities firm.s

Mutual funds
Mutual funds pool resources from many
individuals and companies and invest
these resources in diversified portfolios
of bonds, stocks and money market
instruments.

Finance companies
Finance companies make loans to
individuals
and
corporations
by
providing consumer lending, business
lending and mortgage financing.
Some of their loans are similar to those
provided by commercial banks

Three major types of finance

companies:
Sales finance institutions that make
loans to customers of a particular
retailer or manufacturer (e.g. Ford Motor
Credit).
Personal credit institutions that make
loans to consumers perceived as too
risky by commercial banks (e.g.
Household Finance Corp).

Three major types of finance

companies
Business credit institutions that provide
financing to companies, especially
through equipment leasing and factoring
(purchase by the finance company of
accounts receivable from corporate
customers).

Group Discussion
Throughout this guide, there are a lot of
key terms, all collected in the Key
terms section at the end of each
section. Compile your own glossary with
full definitions and comments on each of
these terms, and use it for revision.