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The Financial System

The document provides an overview of the financial system including: 1) It describes how the financial system allows money to flow from savers to users through financial institutions and markets. 2) It outlines the key components of the financial system including households, businesses, financial institutions, securities markets, and the different types of securities like money market instruments, bonds, and stocks. 3) It discusses several financial markets and institutions that make up the system including commercial banks, the Federal Reserve, and stock exchanges.

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Ken Tuazon

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0% found this document useful (0 votes)

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The Financial System

Uploaded by

Ken Tuazon

Available Formats

Download as DOCX, PDF, TXT or read online on Scribd

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The Financial System

The financial system is the process by which money flows from savers to users.

A businessperson may need additional capital for inventory, and individuals and governments earn a rate
of return from their savings. Businesses can borrow from the bank to obtain capital to purchase
inventory. These are typical transactions that make up the financial system.

Understanding the Financial System

• Financial System
– Savers
– Users
– Financial Institutions
– Financial Markets

Households, businesses, government,

financial institutions, and financial markets
make up the financial system. There are
households, businesses and government
entities that are categorized as savers and/or
users.

• Savings is a function of many

variables.
• Funds can be transferred between users and savers directly or indirectly.

Types of Securities
• Securities
– Financial instruments
– Obligations on the part of the issuer
• Businesses and Governments
– Provide rate of return to purchasers
Money market instruments and bonds are both debt securities, and stocks are units of ownership in
corporations.

Money Market Instruments

• Bonds
• Stock

Money Market Instruments

• Short-term Debt Securities

– Issued by governments, financial institutions and corporations
• Investors are paid interest for the use of their funds.
• Generally low-risk
• U.S. Treasury bills, commercial paper, and bank certificates of deposit
Treasury bills are issued by the US Treasury and backed by the full faith and credit of the US
government. Treasury bonds are considered risk free. Commercial paper is securities sold by
corporations. Commercial paper is slightly riskier than Treasury bills. A certificate of deposit is a time
deposit with a financial institution such as a bank.
Bonds

• Government Bonds
– Bonds sold by the U.S. Department of the Treasury.
• Municipal Bonds
– Bonds issued by state or local governments
• Revenue bonds are used toward a project that will produce revenue, General
Obligation Bonds are not.
Bondholders are creditors of a corporation. By selling bonds, a firm obtains long-term debt capital.
Bondholders are creditors; they have a claim on the firm’s assets.

Bond Ratings

• Price is determined by risk and interest rate.

• Several firms rate bonds
– Standard & Poor’s (S&P)
– Moody’s
• Investment-grade
• Speculative/Junk

S&P and Moody’s rate bonds. The price of the bonds is determined by risk and return. Bonds with
ratings of BBB and above are classified as investment-grade bonds. Bonds with ratings of BB and below
are classified as speculative or junk bonds. Investors like to invest in junk bonds as they provide a high
return.

Stocks

• Common stock – ownership claims in corporations.

– Vote on major company decisions
– Cash dividends
– Price appreciation
• Preferred stock – stockholders with preference in the payment of dividends.
• Convertible Securities
Stockholder has the right to exchange the bond or preferred stock for a fixed number of shares of
common stock.

Financial Markets

• Primary Market – firms and governments issue securities and sell them initially to the public.
– When a firm offers a stock for sale to the general public for the first time.
• Secondary Market – collection of financial markets in which previously issued securities are
traded among investors.

Understanding Stock Markets

Stock market (exchange) – market in which common stocks are traded, such as the New York Stock
Exchange.

Stock Exchanges
• The New York Stock Exchange – the Big Board is the most famous and one of the oldest stock
markets in the world. More than 3,000 stocks are listed on NYSE.
• The Nasdaq Stock Market – the second largest stock market. Over 5,000 companies have their
stocks listed on Nasdaq but many are smaller firms.
• Other U.S. Stock Markets
– The American Stock Exchange/AMEX
– Regional Stock Exchanges
– Foreign Markets

ECNs and The Future of Stock Markets

• ECNs – electronic communication networks

th
– The 4 Market
– Buyers and sellers meet in a virtual market and exchange with one another
– Take place on INET or Archipelago
• INET and Archipelago have been purchased by Nasdaq and NYSE
• Investor Participation in the Stock Markets
• Investors use brokerage firms, they:
1) Establish an account
2) Enter orders
3) Trade stock
• The brokerage firm executes the trade on behalf of the investor, charging a fee for the order
– Market Order
– Limit Order

Financial Institutions

 Commercial Banks
 Savings Banks and Credit Unions
 Non-depository Institutions

Electronic Banking

 An increasing amount of funds move through electronic funds transfer (EFTs).

 Millions of businesses and consumers now pay bills and receive payments electronically.
 Most employees directly deposit employee paychecks.
 Social security and other federal payments are made each year electronically.
 Automated Teller Machines (ATMs) continue to grow in popularity.
 More than 1/3 of American households use some online banking.

Federal Deposit Insurance

• Enacted by the Banking Act of 1933

• Restore public confidence in the banking system
• Before deposit insurance, runs were common as people rushed to withdraw their money from the
bank
• Deposit insurance shifts the risk of bank failures from individuals to the FDIC

Savings Banks and Credit Unions

• Offer a variety of consumer services

• 85% of their loans are real estate loans
• Credit unions are cooperative financial institutions that are owned by depositors/members.
• Credit unions are created to serve consumers.
– Insured by National Credit Union Administration (NCUA) which functions the same as the
FDIC
Non Depository Financial Institutions

 Insurance Companies
 Pension Funds
 Finance Companies
The Role of the Federal Reserve

• Created In 1913
• Central bank of the United States
• Regulate commercial banks
• Perform banking-related activities for the U.S. Department of Treasury
• Providing services for banks
• Setting monetary policy

Organization of the Federal Reserve

• 12 Federal reserve districts

– Own federal reserve bank
• District banks are run by a nine-member board of directors.
• The board of governors is the governing body.
• Politically independent

Federal Open Markets Committee (FOMC) sets most policies concerning monetary policy and
interest rates.

Check Clearing and the Fed

• Americans still write billions of paper checks.

• The process by which funds are transferred from the check writer to receiver
• The multiple-step process is managed and cleared by the FED.
st
• The Check Clearing for the 21 Century Act is making this process more electronic.

Monetary Policy

• Supply of money and credit

• Measures of the money supply: M1 & M2
• The FED requires banks to maintain reserves.
• Set the discount rate
• Open Market Operations
M1 & M2 Graphic

Regulation of the Financial System

• Bank Regulation
• Government Regulation of the Financial Markets
• Industry Self-Regulation
– Rules of conduct by professional organizations like National Association of Securities
Dealers
– Market Surveillance