The Financial System

Date: 2015-10-07; view: 400.

The financial system is the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, financial services are produced and delivered around the world. The financial system is an integral part of the economic system and cannot be viewed in isolation from it. Its primary task is to move scarce loanable funds from those who save to those who borrow for consumption and investment. By making funds available for lending and borrowing (credit) the financial system provides the means whereby modern economies grow and increase the standard of living of their citizens. Most of the credit goes to purchase machinery and equipment, to construct new highways, factories, and schools, and to stock the shelves of businesses with goods.

The financial system determines both the cost of credit and how much credit will be available to pay for the thousands of different goods and services we purchase daily. When credit becomes more costly and less available, total spending for goods and services falls. As a result, unemployment rises and the economy's growth slows down as businesses cut back production and reduce their inventories. In contrast, when the cost of credit declines and loanable funds become more readily available, total spending in the economy increases, more jobs are created, and the economy's growth accelerates.

For every real transaction there is a financial transaction that mirrors it. When you buy a house, you'll probably pay for part of that house with a mortgage, which requires that you borrow money from a bank. The bank, in turn, borrows from individuals the money it lends to you. Similar situation can be observed when you buy a car or refrigerator on credit. Thus there's a financial transaction reflecting every real transaction. The financial sector is important for the real sector. If the financial sector doesn't work, the real sector doesn't work. All trade involves both the real sector and the financial sector.

To understand the financial sector and its relation to the real sector, you must understand: (1) what financial assets are, (2) how financial institutions work, (3) what financial markets are, and (4) how they work. Real assets are created by real economic activity. For example, a house or a machine must be built. Financial assets are created whenever somebody takes on a financial liability. For example, say Mr. Smith promises to pay Mr. Jones $1,000,000 in the future. Mr. Jones now has a financial asset and Mr. Smith has a financial liability. Understand­ing that financial assets can be created by a simple agreement of two people is fundamentally important to understanding how the financial sector works.

Nearly all financial trans­actions between buyers and sellers involve the creation or destruction of a special kind of asset—a financial asset. Financial assets possess a number of characteristics that make them unique among all the assets held by individuals and institutions. What is a financial asset? It is a claim against the income or wealth of a business firm, household, or unit of government, represented usually by a certificate, receipt, or other legal document, and usually created by the lending of money. Examples include stocks, bonds, insurance policies, and deposits held in a commercial bank, credit union, or savings bank.

Thus an asset is something that provides its owner with expected future benefits. There are two types of assets: real assets and financial assets. Real assets are assets such as houses or machinery whose services provide direct benefits to their owners, either now or in the future. A house is a real asset—you can live in it. A machine is a real asset—you can produce goods with it. Financial assetsare assets, such as stocks or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations. These obligations are called financial liabilities. Every financial asset has a corresponding financial liability; it's the financial liability that gives the financial asset its value. In the case of bonds, for example, a company's agreement to pay interest and repay the principal gives bonds their value. If the company goes bankrupt, the asset becomes worthless.

The financial liability created by a financial asset can be either anequity liabilityor adebt liability. An example of an equity liability is a share of stock that a firm issues. It is a liability of the firm; it gives the holder ownership rights which are spelled out in the financial asset. An equity liability, such as a stock, usually conveys a general right to dividends, but only if the company's board of directors decides to pay them. A debt liability conveys no ownership right. It's a type of loan. An example of a debt liability is a bond that a firm issues. A debt liability, such as a bond, usually conveys legal rights to interest payments and repayment of principal.

Look through the text once again and say which statements are true. Correct the false ones.

1. The financial system is the body of laws and regulations.

2. The financial system is an integral part of the economic system.

3. Its primary task is to create funds.

4. Most of the credit goes to purchase goods and services.

5. The financial system determines both the cost of credit and how much credit will be available to pay for different goods and services.

6. When credit becomes less costly, total spending for goods and services falls.

7. When the cost of credits falls, total spending grows.

8. The financial asset doesn't provide its owner with any benefit.

9. Every financial asset has corresponding financial liabilities.

10. Debt liability conveys certain ownership rights.