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Introduction to the Financial System

What is financial system?• A financial system consist of institutional units and markets that interact, typically in a

complex manner, for the purpose of mobilizing funds for investment, and providing facilities, including payment system, for financing of commercial activity.

• The collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world.

• The role of financial institutions within the system is primarily to intermediate between those that provide the funds and those that need the funds, and typically involves transforming and managing risk.

• Financial markets provide a forum within which financial claims can be traded under established rules of conduct, and can facilitate the management and transformation risk. They also play important role in identifying market prices (price discovery). (IMF(http//:IMF.ORG., Nov.2004)

• Its primary task is to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the global economy can grow and increase the standard of living enjoyed by its citizens.

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Circular Flow of Income, Payments, and Productionin the Global Economic System

Producing units (mainly business firms and

governments)Consuming units (mainly

households)

The basic function of the economic system is to allocate scarce resources – land, labor, management skill, and capital – to produce the goods and services needed by society.

The global economy generates a flow of production in return for a flow of payments.

The circular flow of production and income is interdependent and never ending.

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The Role of Markets in the Global Economic System

• Most economies around the world rely principally upon markets to carry out the complex task of allocating scarce resources.

• The marketplace is dynamic. It determines what goods and services will be produced and in what quantities through their prices.

• Markets also distribute income by rewarding superior producers with increased profits, higher wages, and other economic benefits.

• There are essentially three types of markets within the global economic system. The factor markets allocate factors of production (land, labor, skills, capital) and

distribute income (wages, rent) to the owners of productive resources. Consuming units use most of their income from factor markets to purchase goods and

services in the product markets. The financial markets channel savings to those individuals and institutions needing

more funds for spending that are provided by their current incomes.

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Types of Markets

Producing units (mainly business firms

and governments)Consuming units

(mainly households)

Flow of funds (savings)Flow of financial

services, income, and financial claims

Financial marketsFlow of p

roduction

Product markets

Goods and servicesFlow of paymen

ts

Flow of payments for

consumption and taxes

Flow of incomes

Flow of incomes Factor markets

Productive s

ervice

s

Productive services

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Financial SystemFinancial System

Households Firms Government

Borrowers

Households Firms Government

Savers

Returns

Funds

Returns

Funds

Funds

Returns

Returns

Funds

Transfer of funds in the financial system

Source: Hubbard (2005)

Government Involvement

Financial Intermediaries

Financial Market

Infrastructure and Environtment

Infrastructure and Environtment

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RiskSharing

Information

Financial System

Financial Market

Financial Intermediaries

Liquidity

Funds

Returns

Funds

ReturnsFirms Governmen

ts

Households Firms Governments

BorrowersHouseholds

Savers

The role of financial system

Source: Hubbard (2005)

Issues: •Asymmetric information•Moral Hazard•Adverse Selection

Issues: •The Law of large number•Pooled Information•Free Riding

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The Global Financial System:Channel for Savings and Investment

Flow of financial services, incomes, and financial claims

Demanders of funds (mainly business firms

and governments)

Flow of loanable funds (savings)Suppliers of

funds (mainly households)

• Nature of savings Households: current income – tax payments – consumption expenditures Businesses: retained earnings Governments: current revenues – expenditures

• Nature of investment Households: purchase of a home Businesses: expenditures on capital goods and inventories Governments: building/maintaining public facilities

• The financial markets enable the exchange of current income for future income and the transformation of savings into investment so that production, employment, and income can grow, and living standards can improve.•The suppliers of funds to the financial system expect not only to recover their original funds but also to earn additional income as a reward for waiting and assuming risk.

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Functions Performed by the Global Financial System and the Financial Markets

• Savings function. The global system of financial markets and institutions provides a conduit for the public’s savings.

• Wealth function. The financial instruments sold in the money and capital markets provide an excellent way to store wealth.

• Liquidity function. Financial markets provide liquidity for savers who hold financial instruments but are in need of money.

• Credit function. Global financial markets furnish credit to finance consumption and investment spending.

• Payments function. The global financial system provides a mechanism for making payments for goods and services, in the form of currency, checking accounts, debit cards, credit cards, digital cash, etc.

• Risk protection function. The financial markets offer protection against life, health, property, and income risks, by permitting individuals and institutions to engage in both risk-sharing and risk reduction.

• Policy function. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation.

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Financial Intermediaries

Source: Chatterji (2001)

Commercial BanksCommercial Banks

Securities Companies (Investment Banks)

Securities Companies (Investment Banks)

InsuranceInsurance

Pension FundPension Fund

MultifinanceMultifinance

MicrofinanceMicrofinance

Pawn ShopPawn Shop

- Saving and Loan Products - other fee based products

- Saving and Loan Products - other fee based products

Brokerage, Trading and securities transaction, Underwriting, investment management (including mutual fund), asset management,

financial advisory

Brokerage, Trading and securities transaction, Underwriting, investment management (including mutual fund), asset management,

financial advisory

- Life Insurance- General insurance

- Reinsurance

- Life Insurance- General insurance

- Reinsurance

- Defined Benefit and Defined Contribution - Defined Benefit and Defined Contribution

- Leasing, Consumer Financing, credit cards, and Factoring - Leasing, Consumer Financing, credit cards, and Factoring

- SME Financing, personal financing - SME Financing, personal financing

- Personal Financing- Personal Financing

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Money market vs Capital market

Primary vs secondary markets.(Financial capital is raised when new securities are sold in the primary markets. Security trading in the secondary markets then provides liquidity for the investors)

Open vs Negotiated markets(In open markets, financial instruments are sold to the highest bidder, and they can be traded as often as is desirable before they mature.In negotiated markets, the instruments are sold to one or a few buyers under private contract.)

Spot vs Futures, Forward, and Option markets(In the spot market, assets are traded for immediate delivery (usually within one or two business days). A futures or forward market is designed to trade contracts calling for the future delivery of financial instruments. Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time to be traded Organized vs Over-the-counter markets

Stock vs debt (fixed income) marketsForeign exchange marketsInternational vs domestic markets

Types of financial markets

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•Capital market instruments - long-term maturity (more than 1 year)- corporate stock- corporate bonds- government bonds- municipal bonds- eurobonds- mortgages

Money market instruments – short-term maturity (less than 1year)- treasury bills (T-Bills)- negotiable certificate of deposits (NCDs)- bankers’ acceptance - commercial paper- federal funds- eurocurrencies- Sertifikat Bank Indonesia

Financial market instruments

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Factors Tying All Financial Markets Together

• Credit, the common commodity. The shifting of borrowers among markets helps to weld the financial system together and to balance the costs of credit in the different markets.

• Speculation and arbitrage. Speculators who gamble on their market forecasts and arbitrageurs who watch for profitable arbitrage opportunities help to level out prices and maintain price consistency among the markets.

• Perfect and efficient markets. There is some research evidence suggesting that financial markets are closely tied to one another due to their near perfection and efficiency.

• Financial markets in the real world. In the real world however, market imperfection and information asymmetry exist.

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Types of Financial Intermediaries

in the US

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Sistem Keuangan di Indonesia

Sistem Keuangan

Sistem Keuangan

Sistem MoneterSistem Moneter

Di luar Sistem Moneter

Di luar Sistem Moneter

Otoritas MoneterOtoritas Moneter Bank IndonesiaBank Indonesia

Bank UmumBank UmumPerbankanPerbankan

BPRBPR

Lembaga Pembiayaan

Lembaga Pembiayaan

Lembaga Lainnya

Lembaga Lainnya

Modal VenturaModal Ventura

LeasingLeasing

FactoringFactoring

Kartu KreditKartu Kredit

Pembiayaan Konsumen

Pembiayaan Konsumen

AsuransiAsuransi

Dana PensiunDana Pensiun

Pasar ModalPasar Modal

Kantor PosKantor Pos

PegadaianPegadaian

Pialang Pasar UangPialang Pasar Uang

PefindoPefindo

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Ratio of Assets of Financial Intermediaries to GDP of several countries

  Indonesia Malaysia Thailand Singapore

AssetsUS$

billion % of GDP US$ billion % of GDPUS$

billion% of GDP

US$

billion % of GDP

Commercial banks 138 56% 166 160% 172 115% 213 233%

Insurance firms 10 4% 20 20% 5 3% 46 50%

Mutual funds 8 3% 21 20% 18 12% 18 20%

Pension funds 4 2% 58 56% 7 5% 60 66%

Stock market capitalization 55 22% 168 162% 119 79% 148 162%

Funds raised through capital market 4 2% 7 7% n/a   n/a  

GDP 247   104   150   91  

Exchange rate 8.441   4   39,7   1,7

 

Source: Srinivas, PS (2004)

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Structure of Assests of Nonbank Financial Institutions in Indonesia

  2001 2002 2003

Investasi Amount % Amount % Amount %

Pension Funds            

- Bank deposits 23 69 28 69 27 57

- SBI 0 1 0 0 1 1

- Shares 2 5 2 4 2 4

- Corporate bonds 3 10 5 12 9 19

- Government bonds 0 0 0 0 2 4

- Direct investment 2 7 0 0 2 5

- Land & Buildings 2 7 2 6 2 3

- Mutual funds 0 1 1 1 2 4

- Others 0 1 3 7 1 3

Total 34 100 40 100 47 100

Insurance            

- Bank deposits 31 59 37 58 35 44

- SBI 1 3 1 1 1 1

- Shares 1 2 3 4 4 5

- Bonds 5 9 10 16 21 27

- Direct investment 4 7 4 6 5 6

- Land & Buildings 1 2 2 3 2 2

- Mutual funds 4 7 1 2 3 4

- Others 6 11 6 9 8 11

Total 53 100 64 100 80 100

             

Source: Srinivas, P.S. (2004)

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Banks’ dominance of Indonesia’s Financial System

Keterangan

Tahun 2001 Tahun 2002 Tahun 2003

Asset Kontribusi Asset Kontribusi Asset Kontribusi

Bank Umum 1,099.7 88.0% 1,112.2 86.4% 1,213.5 85.1%

Bank Perkreditan Rakyat 4.7 0.4% 6.4 0.5% 9.1 0.6%

Perusahaan Asuransi 64.8 5.2% 77.6 6.0% 94.1 6.6%

Dana Pensiun 34.9 2.8% 41.2 3.2% 49.4 3.5%

Perusahaan Pembiayaan 37.3 3.0% 39.9 3.1% 47.2 3.3%

Perusahaan Sekuritas 6.7 0.5% 7.8 0.6% 10.0 0.7%

Pegadaian 1.8 0.1% 2.4 0.2% 2.7 0.2%

Total 1.249,9 100% 1.287,5 100% 1.426,0 100%

Source : BI, MoF.