ECN 135: Overview of Financial
System
Chapter 2
By
Derek Stimel, Ph.D.
Outline
• Economic Role of the Financial System
• Direct vs. Indirect Finance
• Financial Markets
• Financial Intermediaries
• Financial Regulation
2
Financial System and Its Societal Role
• Financial System consists of…
▫ Financial Markets (e.g. bond market, stock
market).
▫ Financial Intermediaries (e.g. commercial banks,
mutual funds).
• Promotes Economic Efficiency and Productivity
of Financial Resources (sometimes called
“financial capital”)
▫ Lender/Savers vs Borrower/Spenders
▫ Welfare Enhancing Timing of Purchases
Basic Terminology for Finance
• A security is a financial instrument or financial
contract involving a claim on the security issuers
future income or assets.
▫ Debt securities (e.g. bonds)
▫ Equity securities (e.g. shares of stock)
• Commercial Banks vs Investment Banks
• Primary vs Secondary Markets
• Additional Key Vocabulary
▫ Time to Maturity (n)
▫ Interest Rate (i)
Direct vs Indirect Finance
• Who is the contract between?
▫ Direct Finance
 Originator of Funds (e.g. Savers/Lenders) and End
User of Funds (e.g. Borrowers/Spenders)
 Example: Individual bond and stock purchases
through a brokerage account
▫ Indirect Finance
 Originator of Funds and Intermediary and then
Intermediary and End User of Funds
 Example: Deposits into a bank and loans made by
the bank.
Financial Markets
• Tradable Securities
▫ Exchanges
 Public
 Private
▫ Over the Counter (OTC)
• Money vs Capital Markets
▫ Money markets: short-term debt securities (initial
time to maturity of a year or less)
▫ Capital markets: longer-term debt and equity
securities (initial time to maturity over a year)
Money Market Examples ($billions)
Capital Market Examples ($billions)
Financial Intermediaries: Data Facts
Type of
Intermediary
Commercial
banks, savings
and loans, and
mutual savings
banks
Credit unions
Life insurance
companies
Fire and casualty
insurance
companies
Pension funds
(private)
State and local
government
retirement funds
Finance
companies
Mutual funds
Money market
mutual funds
Value of
Assets ($
billions, end
of year)
1990
Value of
Assets ($
billions, end
of year)
2000
Value of
Assets ($
billions, end
of year)
2010
Value of
Assets ($
billions, end
of year)
2019
4,744
7,687
12,821
18,518
217
441
876
1,534
1,367
3,136
5,168
8,508
533
866
1,361
2,650
1,619
4,423
6,614
10,919
820
2,290
4,779
9,335
612
1,140
1,589
1,528
608
4,435
7,873
17,660
493
1,812
2,755
3,634
Economic Rationale for Intermediaries
• Reduced Transaction Costs
▫ Economies of Scale
▫ Liquidity Services
• Limit Risk Exposure for Source of Fund (Savers)
▫ Asset Transformation
▫ Diversification
• Reduce Asymmetric Information Problems
▫ Adverse Selection (before a transaction)
▫ Moral Hazard (after a transaction)
Financial Regulation
• Financial System is Heavily Regulated
▫ Example: Banks
 Office of the Comptroller (all federal banks)
 State Banking Commission (all state banks)
 Federal Deposit Insurance Corporation (all insured
banks)
 Federal Reserve (all banks)
• Role: Improve Information Flows
▫ Limit Asymmetric Information Problems
▫ Promote Transparency
• Prevent Illegal Activity
Financial Regulation for Intermediaries
• Restrictions on entry (chartering process).
• Disclosure of information (call reports).
• Restrictions on Assets and Activities (control
holding of risky assets).
• Deposit Insurance (avoid bank runs).
• Limits on Competition (mostly in the past):
 Branching
 Restrictions on Interest Rates