CHAPTER 2: FINANCIAL INSTITUTIONS, INTRUMENTS, AND MARKETS

Learning Outcome(s): At the end of this chapter, the student should be able to;

1. describe a business environment;

2. discuss the financial system;
3. identify the elements of a financial system; and
4. differentiate bond from stocks.

2.1 THE BUSINESS ENVIRONMENT

The business does not operate in a vacuum but in an environment influenced by
various forces, variables, and systems. In marketing or entrepreneurship, the environment
where the business operates is broadly classified as either macro or micro environment. In
finance, the business environment is divided into international, regional, and local levels.
Regardless of the nomenclature on the business environmental layers, business is affected
by different outside forces.

One of the environmental layers of the macro environment is societal environment. This
environment is made up of the following systems as illustrated in figure below.

POLITICAL
SYSTEM

ECONOMIC FINANCIAL
SYSTEM SYSTEM

BUSINESS

TECHNOLO LEGAL
GICAL SYSTEM
SYSTEM
SOCIO
-CULTUR
AL
SYSTEM

A system is composed of several parts with interrelated functions. If one part of the
system is dysfunctional, the whole system is expected to be adversely affected.
2.2 THE FINANCIAL SYSTEM

The financial system at the societal environment or regional level is principally responsible
for the flow of money or funds from the lender to the borrower. It controls, regulates, and
facilitates the saving, borrowing, lending, and investing happening among the different
players in the system.

CASH RETURN CASH PAYMENTS

HOUSEHOLD
SAVINGS/SURPLUS
CASH  FINANCIAL
INSTITUTIONS BORROWERS
CASH  FINANCIAL
CASH  INDIVIDUALS
INVESM MARKETS
LOANS  CORPORATE
ENTS  FINANCIAL
BUSINESS ENTITIES
INSTRUMENTS
SAVINGS/SURPLUS
CASH

CASH RETURN

CASH PAYMENTS

In figure above is the typical structure of a financial statement. This system is highly
responsible for the channeling of funds from the savings of the household or business to the
individual and corporate organizations that need funding support through financial
institutions, financial intermediaries, and financial instruments.

The basic elements of a financial system are as follows:

1. Financial institutions
2. Financial markets
3. Financial instruments
4. Lenders and borrowers
2.3 FINANCIAL INSTITUTIONS

DEFINITION
 Institutions or organizations that provide financial services, among orders, in the
form of loan, credit, financial administration, financing, depository, and
safekeeping. It is a broad term encompasses all organizations that provide the
aforementioned financial services.

 Based on the financial services provided, are generally classified as follows:

a. Depository institutions
b. Financial intermediaries
c. Investment institutions

 DEPOSITORY INSTTUTIONS

 Financial institutions that accept deposits (savings, current, and time deposits) from
individuals and corporate entities, extend loans to borrowers, transfer funds for
investment purposes.

 It includes the following:

a. Banks
 Institutions authorized to operate and regulated by the Bangko Sentral ng
Pilipinas (BSP) under the General Banking Law of 2000. They accept
deposits and bill payment, provide loans, and facilitate the transfer of funds
domestically or abroad.
 Under BSP Circular No. 271, the major classifications of banks operating in
the Philippines are as follows.

1. UNIVERSAL BANK
 Considered the biggest bank in terms of assets, loan portfolio, and
revenue. It has the wide scope of banking activities authorized by the
BSP.
 May perform the following: involve in underwriting activities; engage in
financial activities of investment houses; and invest in equities of non
– banking institutions.

2. COMMERCIAL BANKS
 Provides commercial loans and offers investment products in addition
to the regular banking service of accepting deposits. Compared to a
universal bank, it has more limited banking services.

3. THRIFT BANK
  As defined in RA 7906, include savings and mortgage banks, private
development banks, and stock savings, loan associations, and
microfinance thrift banks that are organized under existing laws.
 Purposes are accumulating and investing the savings of depositors;
providing working capital to businesses engaged in agriculture,
service, and housing; and providing diversified financial services to
individuals and small and medium enterprises.

4. RURAL BANK AND COOPERATIVE BANK

 Organized and operating in rural areas. They are intended and
expand the rural economy by providing the people with basic financial
services.

5. ISLAMIC BANK
 Has been created and organized under RA 6848, aims to promote and
accelerate the socio – economic development of the Autonomous
Region of Muslim Mindanao by performing, financing, and investment
operations and to establish and participate in agricultural, commercial,
and industrial ventures based on the concept of banking.

b. Saving and Loan Association

 Sometimes referred to a financing and mortgage loan company, is a financial
institutions that is engaged in the business of accumulating the savings of its
members and stockholders, and using such accumulations for loans or
investments in securities of productive enterprises.
 Created and regulated under RA 3779, as amended by RA 4378.

c. TRUST COMPANIES
 Legal business entity, usually a major division of universal or commercial
bank, that acts as fiduciary agent or trustee on behalf of an individual person
or corporate entity for the purpose of management, administration, and
financial transfer of property to the beneficiary.
 It also performs the following related custodial tasks
a. Asset management
b. Ownership registration for the beneficiary
c. Stock transfer
d. Custodial arrangement like in court proceedings.

d. CREDIT UNIONS
 Financial depository institution that is mainly controlled and operated by its
members for the following purposes:
a. Extending credit to members
b. Offering competitive interest rates
c. Promoting the concept of thrift
d. Providing other types of financial services.
 EXERCISES

1. Describe the nature of savings and loan association.

2. Discuss the concept of trust company.
3. Described the organizational concept of a credit union.

 FINANCIAL INTERMEDIARIES
 A type of financial institutions that acts as the middleperson between two parties –
the investors and the borrowers. Financial intermediaries raise and accumulate
money from investors and offer the accumulated money to individuals or corporate
entities in need of financial assistance.
 Hence, Financial intermediaries refer to the following:

a. MUTUAL FUNDS
 Accumulate money by selling shares of stocks or bonds of publicly –
listed corporations to individuals or corporate investors. The funds
from the proceeds of the sale are pooled together and channeled to
the borrowers.

b. PENSION FUND
 Set up by a business for the purpose of paying the pension
requirements of all private – sector employees who retire from the
business organization upon reaching their retirement age.

c. INSURANCE COMPANIES
 Acts a financial intermediary by pooling together the proceeds of
insurance policies sold to the public and investing the accumulated
funds in high – yield maturing securities from investment houses.
 Insurance companies may offer the following products to the public:
a. Life insurance
b. Health insurance
c. Car insurance
d. Fire insurance

 INVESTMENT INSTITUTIONS
 A company engaged in buying securities of other companies which are listed in the
stock exchange for investment purposes only. Hence, buying and selling of financial
securities are not the primary business activities of an investment institution.

 It simply holds on the securities it acquired from other companies.

2.4 FINANCIAL MARKETS

Definition
 It refers to the place where the selling – buying activity occurs to trade equity
securities such as bonds and stocks, currencies, derivative securities, notes, and
mortgages.

TRADE ACTIVITY

It is the selling – buying transaction happening in the

financial market.

MARKET

It refers to the place where sellers and buyers of goods or

services meet. In the market, the major business happening is the
selling – buying activity, in which exchange occurs.

The typical financial market, among others, includes the following:

1. CAPITAL
MARKET
It is a financial where stocks and bonds are issued
for medium - and long - term periods. Stocks are
treated as equity securities hile bonds are
technically considered debt security. investors who
hold stocks receive from their investments in the
form of dividends while those who hold bonds earn
income in the form of interest

In the Philippines, the capital market is the

Philippine Stock Exchange (PSE) created in 1994
from two defunct capital ---- Manila Stock
Exchange and Makati Stock Exchange.
 2. MONEY MARKET

The financial market is classified as money

market when the financial securities being traded
have a period of less then one year. This type of
financial security is called short - term security.

Since short - term securities are not intended to be

held for more than one year, they also referred as
trading securities.

3. PRIMARY MARKET

Financial market where a corporation can issue new shares

of stock. Stock corporation that need fresh capital can raise
required funds by issuing new shares of stock

It facilitates the raising required amount when the investors

directly buy the new shares from the issuing corporation. The
trading of financial securities in this market happens between
the issuing corporation and the investors or investment
banks.

4. SECONDARY MARKET

Financial market where financial securities are traded

between oe among investors. In this market, there is no
issuance of new shares from the corporation.

It exists after the corporation has issued new shares to the

 trading go to the seller of the securities.

2.5 FINANCIAL INSTRUMENTS

5. PUBLIC MARKET
Definition

 It refer to contracts that give rise to the formation of financial assets of one entity and
It is market in which financial securities of publicly - listed corporation
at the samearetime thefollowing
traded creation of a financial liability
a standardized or an
contract equity instrument
agreement and in another
entity. procedures. Basically, a public market is an organized financial
market.
 It is involved in two parties
1. Contractual right – receive the financial assets
2. Contractual obligations – pay or deliver the financial assets.

 Common Trading
forms of in the public
financial market immediately starts during the day once the
instrument
market has been officialy opened.
a. Cash – On the part of the holder, cash is a financial asset. However, on the part
of the government such as the Bangko Sentral ng Pilipinas, cash is
financial liability.

b. Check – It is a financial asset of the payee, but is considered a financial liability of

the drawer or issuer.

c. Loan – It is a financial asset of the lender or creditor and a financial liability of the
borrower or the debtor.

d. Bond – It is a financial asset of the holder or investor but considered a financial

liability of the issuing company.

e. Stock – It is a financial asset of the investor or shareholder but equity of the

issuing company.

BONDS
 It is a financial instrument that represents a contractual debt of party issuing the
bond. The issuing party may either be a private business entity or government. This
type of financial instrument is evidenced by a certificate called bond indenture.
Business entities may raise the necessary funding requirements to support their
investing activities by issuing bonds.
  Most common types of bonds

 Term Bond – It is a bond that has a single maturity date. The bond that can
be single lone bond, or can be composed of several bonds with the same
maturity date.

 Serial Bond – It is a bond that has a series of several maturity dates instead
of a single maturity date.

 Secured Bond – It is a bond that is secured by issuing company. The security

is issued in the form of real property which serves as collateral in the event of
default on the part of the bond issuer. It is called a collateral trust bond
when it is secured by stocks or bonds of other companies.

 Debenture Bond – A bond that is considered debenture bond when it is not

supported by any collateral or security as assurance in times of non –
payment or default.

 Convertible bond – A bond which can be converted into a share of stock in

later date. The option to convert must be vested in the bondholder and not on
the issuing company.

 Callable Bond – A bond is callable when the issuing company has the option
to redeem the bond prior to maturity date. In most instances, the company
pays a higher amount, or technically called at a premium, when the bond is
redeemed prior to its maturity period.
– The issuing company redeems the bond prior to its maturity
date under the following instances:

a. The company has accumulated enough funds to continue the

investment project.

b. The investment project is finished ahead of schedule or at lesser

cost.

c. There is substantial decrease in the interest rate.

STOCKS
 It financial security that signifies ownership of the assets of the corporation. Only
stock corporations are authorized by the Security and Exchange Commission (SEC)
to issue stocks, hence, sole proprietorships and partnerships can never issue shares
of stock.
 The holders of the shares of stock as evidence by the stock certificate are called
shareholders or stockholders. The shareholder has claim on the net assets of the
business as owners of the corporation.
 Two major types of stocks

1. Common Stock or Ordinary Shares

 It is a financial instrument whose holders do not have preferences
over each other. The common stockholders have the same rights and
privileges in terms of dividend or asset distribution with other
stockholders.
 The right of the common stockholders includes the right to vote during
the election of the board director, and the right to subscribe for
additional shares to be issued.

2. Preference Stock or Preference Share

 A kind of stocks that is preferred over common stock. These
preferences are in terms of the following;
a. Distribution of earnings or dividend distribution
b. Net assets at the time of liquidation
 The privileges of preference shares outline the distinct difference
between common stockholders and preference stockholders.
However, preference shareholders do not have voting rights.

CHAPTER REVIEW

I. TRUE or FALSE

Write True if the statement is correct. If is not, write False, and state your
reason briefly.

1. The financial system exists and operates only at the regional level or societal
environment.
2. Any financial system cannot exist without the presence of financial
instrument.
3. A thrift bank may also perform the financial activities of investment houses.
4. The main target consumers of a thrift bank are farmers and agricultural
funding activities.
5. Generally, a bank is operating just like a financial intermediary.
6. Pension fund and pension fund manifest clearly the function of financial
intermediaries.
7. Share of the corporation issued for the first time are traded in the primary
market
8. A trust company acts as trustee of properties in behalf of the beneficiary for a
fee.
9. Debenture bonds are secure bonds.
10. Common stock has fixed rate of return.
II. MULTIPLE CHOICE

1. The following factors are forces of the societal environment affecting the
business except:
a. Legal system
b. Technological system
c. Operating system
d. socio – cultural system
2. The major classification of banks in Philippines under BSP Circular No. 271
include the following except:
a. Thrift bank
b. Rural bank
c. Domestic bank
d. Cooperative bank
3. Depository institutions include the following except:
a. Savings and loan association
b. Mutual fund
c. Trust companies
d. Credit unions
4. Which of the following is not considered a major category of financial
institution?
a. Financial intermediary
b. Depository institutions
c. Investment institutions
d. Financial instruments
5. Thrift bank have been recognized for the following purposes except:
a. providing financial services to small and medium enterprises
b. providing working capital to businesses engaged in service and housing
c. accumulating savings of the depositors and investing them
d. underwriting insurance policies
6. This is where the financial instruments are traded.
a. Financial institutions
b. Financial markets
c. Financial instruments
d. Financial intermediaries
7. It is a depository institution where the depositors are also the member –
borrowers.
a. Cooperative bank
b. Rural bank
c. Savings and loan association
d. Trust companies
8. In strictest sense, it is a financial institution that acts as the middleperson
between the investors and the borrowers.
a. Financial intermediary
b. Depository institutions
c. Investment institutions
 d. Financial institutions

9. Which of the following is not a financial intermediary?

a. Mutual fund
b. Trust companies
c. Pension fund
d. Insurance companies
10. It is unsecured bond that has been issued without collateral.
a. Term bond
b. Debenture bond
c. Serial bond
d. Callable bond