Chapter 2: Introduction to financial
The aim of this chapter is to investigate financial systems from both a functional and a structural perspective. We set out a taxonomy of financial intermediaries, securities and financial markets, and give an overview of the peculiarities of national financial systems.
By the end of this chapter, and having completed the essential readings and activities, you will be able to:
• explain why financial systems exist (i.e. explain the functions of financial systems)
• outline the structure of financial systems (i.e. describe the three main entities that compose financial systems: financial intermediaries, securities and financial markets)
• describe which financial intermediaries operate in financial systems in the USA in particular and, more generally, around the world (e.g. depository institutions, contractual savings institutions and investment intermediaries) and explain their characteristics
• explain which financial securities are traded on financial markets (bonds, notes, bills and stocks), and explain their nature
• discuss the various theories that attempt to explain the shape of the yield curve
• explain the structure of financial markets in the USA and around the world (primary versus secondary markets, money versus capital markets, organised versus over-the-counter markets, quote-driven dealer markets versus order-driven markets and brokered markets). Essential reading
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT Press, 2001) Chapter 3.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London: Addison Wesley, 2009) Chapters 1, 2 and 10.
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston, London: McGraw-Hill/Irwin, 2010) Chapter 14.
Buckle, M. and J. Thompson The UK Financial System. (Manchester: Manchester University Press, 2004) Chapter 1.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The MIT Press, 2008) Chapter 2.
Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk Management Approach. (New York, McGraw-Hill/Irwin, 2007) Chapters 2, 3, 4, 5 and 6.
24 Principles of banking and finance
We start the unit with an overview of financial systems, their functions and general structure. Then we investigate the nature and characteristics of the three major entities that compose financial systems. These are financial intermediaries, securities and financial markets. We will return to a more detailed investigation of each of these entities in later chapters. In our review of different countries, we restrict ourselves to large economies with well-developed financial systems, notably the USA, UK, France and Germany. Specifically, we take a US view and US terminology, therefore in Part I other countries are compared with the US system. Functions of financial systems
Financial systems perform the essential economic function of channelling funds from units who have saved surplus funds to units who have a shortage of funds. The units who have saved can lend funds: they are known as lender-savers. The units with a shortage of funds must borrow funds to finance their spending: they are the borrower-spenders. The most important lender-savers are usually households; while the typical borrower-spenders are firms and the government.
The channelling of funds from savers to spenders is very important for two reasons:
• First, lender-savers (with excess of available funds) do not frequently have profitable investment opportunities, while borrower-spenders have investment opportunities but lack of funds.
• Second, even for purposes other than investment opportunities in businesses, borrower-spenders may want to invest in excess of their current income or to adjust the composition of their wealth (reconciliation of the preferences for current versus future consumption).
In direct finance,...
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