Chapter 2

CHAPTER 2
AN OVERVIEW OF THE FINANCIAL SYSTEM

 LEARNING OBJECTIVES
2.1 Compare and contrast direct and indirect finance.
2.2 Identify the structure and components of financial markets.
2.3 List and describe the different types of financial market instruments.
2.4 Recognize the international dimensions of financial markets.
2.5 Summarize the roles of transaction costs, risk sharing, and information costs as they relate to
financial intermediaries.
2.6 List and describe the different types of financial intermediaries( địa chế tài chính trung gian).
2.7 Identify the reasons for and list the types of financial market regulations.
FLOWS OF FUNDS THROUGH THE FINANCIAL SYSTEM
The arrows show that funds flow from lender-savers to borrower-spenders via two routes: direct
finance, in which borrowers borrow funds directly from financial markets by selling securities, and
indirect finance, in which a financial intermediary borrows funds from lender-savers and then uses
these funds to make loans to borrower-spenders
 FUNCTION OF FINANCIAL MARKETS
 Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them
securities
 Promotes economic efficiency by producing an efficient allocation of capital, which increases
production
 Directly improve the well-being of consumers by allowing them to time purchases better
 STRUCTURE OF FINANCIAL MARKETS
A firm or an individual can obtain funds in a financial market in two ways.
 Debt and Equity Markets (thị trường nợ và vốn chủ sở hữu):
- Debt instruments (maturity) (công cụ nợ- kỳ hạn thanh toán)
+ Debt instruments with a maturity term between one and ten years are said to be
intermediate-term. đáo hạn từ một năm đến mười năm được cho là trung hạn.
- Equities (dividends) (vốn chủ sở hữu- cổ tức)
 Primary and Secondary Markets
- Investment banks underwrite securities in primary markets.
+ A primary market is a financial market in which new issues of a security, such as a
bond or a stock, are sold to initial buyers by the corporation or government agency
borrowing the funds
- Brokers and dealers work in secondary markets. Brokers (người môi giới) are agents of
investors who match buyers with sellers of securities; dealers (đại lí) link buyers and
sellers by buying and selling securities at stated prices.
+ A secondary market is a financial market in which securities that have been previously
issued can be resold.
 Money and Capital Markets:
– Money markets deal in short-term debt instruments (giao dịch các công cụ nợ ngắn hạn)
– Capital markets deal in longer-term debt and equity instruments (xử lý nợ dài hạn và vốn
chủ sở hữu dụng cụ)
 INTERNATIONALIZATION OF FINANCIAL MARKETS
• Foreign Bonds: sold in a foreign country and denominated in that country’s currency
• Eurobond: bond denominated in a currency other than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in banks outside the home country – Eurodollars:
U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S.
banks
• World Stock Markets: – help finance corporations in the United States and the U.S. federal
government
 FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE
The process of indirect financing using financial intermediaries, called financial intermediation:
trung gian tài chính
• Lower transaction costs (time and money spent in carrying out financial transactions)
– Economies of scale (the reduction in transaction costs per dollar of transactions as the size (scale)
of transactions increases.)
– Liquidity services
• Reduce the exposure of investors to risk
– Risk sharing (asset transformation) :risky assets are turned into safer assets for investors
– Diversification: entails investing in a collection (portfolio) of assets whose returns do not always
move together, with the result that overall risk is lower than for individual assets.
Deal with asymmetric information problems: thông tin mất đối xứng.
– Adverse Selection (before the transaction) (lựa chọn bất lợi): try to avoid selecting the risky
borrower by gathering information about them
– Moral Hazard (after the transaction) (mối nguy đạo đức): ensure borrower will not engage in
activities that will prevent him/her to repay the loan.
▪ Sign a contract with restrictive covenants.
Financial intermediaries can also achieve economies of scope; that is, they can lower the cost of
information production for each service by applying one information resource to many different
services, but they can also create potential costs in terms of conflicts of interest.
• Overall conclusion:
– Financial intermediaries allow “small” savers and borrowers to benefit from the existence of
financial markets.
 TYPES OF FINANCIAL INTERMEDIARIES
Depository Institutions (các tổ chức nhận tiền gửi):
These institutions include commercial banks and the so-called thrift institutions (định chế tiết
kiệm) (thrifts): savings and loan associations, mutual savings banks, and credit unions
- Commercial banks: the largest financial intermediary and have the most diversified
portfolios (collections) of assets.-> checkable deposits; savings deposits; time deposits.
- Savings and loan associations & Mutual savings banks: savings deposits (often called
shares) and time and checkable deposits; In the past mostly made mortgage loans for
residential housing.
- Credit unions: acquire funds from deposits called shares and primarily make consumer
loans.
Contractual savings institutions (Các tổ chức tiết kiệm theo hợp đồng): are financial
intermediaries that acquire funds at periodic intervals on a contractual basis- là những trung
gian tài chính thu nhận vốn theo định kỳ trên cơ sở các hợp đồng đã ký kết với khách hàng.
- Life insurance companies: insure people against financial hazards following a death and
sell annuities (annual income payments upon retirement); acquire funds from the premiums
that people pay to keep their policies in force -> buy corporate bonds and mortgages.
- Fire and Casualty Insurance Companies: have a greater possibility of losing funds if
major disasters occur-> buy more liquid assets than life insurance companies do. Their
largest holding of assets consists of municipal bonds;
- Pension Funds and Government Retirement Funds (quỹ hưu trí): The largest asset
holdings of pension funds are corporate bonds and stocks.
Investment intermediaries:
 REGULATION OF THE FINANCIAL SYSTEM (quy định về hệ thống tài chính):

 To increase the information available to investors:
– Reduce adverse selection and moral hazard problems
– Reduce insider trading (SEC)
 To ensure the soundness of financial intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– 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
Financial system in Vietnam:
- Quite completed-> has laws, regulation to regulate the financial system.

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CHAPTER 2

AN OVERVIEW OF THE FINANCIAL SYSTEM

 REGULATION OF THE FINANCIAL SYSTEM (quy định về hệ thống tài chính):

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