Money, Financial

Markets & Financial

Institutions

Atty. Rene B. Betita

 Why Study Financial Markets?

1. Channel funds from savers to investors,

thereby promoting economic efficiency.

2. Affect personal wealth and behavior of

business firms.

© 2004 Pearson 1-2

Addison-Wesley. All
 Why Study Banking and Financial
Institutions?
1. Financial Intermediation
Helps get funds from savers to
investors

2. Banks and Money Supply

Crucial role in creation of money

3. Financial Innovation

© 2004 Pearson 1-3

Addison-Wesley. All
 Why Study Money and Monetary
Policy?

Influence on business cycles, inflation,

and interest rates

© 2004 Pearson 1-4

Addison-Wesley. All
MONEY AND THE PAYMENTS SYSTEM

What is money?
How do we use money?
How do we measure money?
DEFINITION OF MONEY

Money is an asset that is generally accepted

as payment for goods and services or
repayment of debt.
MONEY: CHARACTERISTICS

1. Means of payment: Used in exchange

for goods & services

2. Unit of account: Used to quote prices

3. Store of value: Used to move purchasing

power into the future
Gold as money

 widely accepted
 divisible
 easy to measure
 easy to carry
 non-perishable (although it wears out)
 impossible to forge
Paper money
1659 The earliest British cheque is issued This
is an order to the London goldsmiths Morris
and Clayton to pay a Mr Delboe £ 400.

Because notes are accepted as evidence of

ability to pay they are a convenient alternative
to handling coins or bullion.
Paper money

was initially a claim on gold

has no natural (intrinsic value), hence

acceptance is backed by guarantees from a
central authority

during tumultuous economic periods, drove

gold out of circulation
HOW WE PAY FOR THINGS
Commodity Money: Objects with intrinsic
value

Fiat Money: Value comes from government

decree (or fiat)

Checks: Instructions to the bank to shifts

funds from your account to that of the
person or firm whose name is written in the
“Pay to the Order of” line.
HOW WE PAY FOR THINGS
Credit Cards
Debit Cards
Electronic Funds transfers:
Stored Value Cards
E-Money
CREDIT AND DEBIT CARDS
Credit cards:
Deferred payment
Issuer makes payment for you
You have to pay it back
Debit cards:
Like a check
Electronic message to your bank to
transfer funds immediately
THE FUTURE OF MONEY
Question: Which function of money will be
with us for a long time?
Answer:
Means of payment: disappearing
Unit of account: likely to remain
Store of value: disappearing
TECHNOLOGICAL ADVANCES AND
PAYMENT METHODS
Technological advances create new
methods of payment.
Cell phones and other types of hand-held
mobile devices are providing access to the
payments system.
What will be next?
Flow of Funds Through The Financial
System
INDIRECT FINANCE

Financial Intermediaries

Lenders – Savers Borrowers - Spenders

1. Households 1. Business Firms

2. Business Firms Financial Markets 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

DIRECT FINANCE
Lenders – Savers Direct Finance
1. Households
2. Business Firms
3. Government
4. Foreigners

Financial Markets

Borrowers - Spenders

1. Business Firms
2. Government
3. Households
4. Foreigners
Function of Financial Markets

FINANCIAL MARKETS channel funds

from savers to spenders

FINANCIAL MARKETS are important

because
They improve the economy
They improve the welfare of
consumers
Structure of Financial Markets

DEBT & EQUITY MARKETS

Debt Market (Borrowings)

e.g. Bond
Mortgage

Equity Market (Shareholdings)

e.g. Common Stock
Preferred Stock
Structure of Financial Markets

Primary and Secondary Markets

Primary Market
Initial Public Offering (IPO)
Rights Offering
Private Placement

Secondary Market
Exchanges
Over-the-Counter (OTC) Market
 OTC in the Philippines

Stocks sold over the counter are outside

the jurisdiction of the PSE

Some securities such as bonds sold are

subject to the requirements of the
Bangko Sentral ng Pilipinas (BSP)
Circular 392 and its related regulations,
including the rules governing the Over-
the-Counter (OTC) Fixed Income Market
issued by the Securities Exchange and
Commissions (SEC) Memorandum
Circular 14.
 Structure of Financial Markets
Primary Market:
Sample IPO Process ISSUER

Other Inv. Originating Inv. Other Inv.

Bankers Banker Bankers

SELLING
GROUP
Underwriting
Syndicate

INVESTORS
Structure of Financial Markets

Money & Capital Markets

Money Market
Security Traded: Debt
Maturity: < One Year

Capital Market
Security Traded: Debt and Equity
Maturity: At least One Year (for debt)
No Maturity for Equity
Internationalization of Financial
Markets

International bond market

(foreign bonds)

Eurobonds

Eurocurrencies

World stock markets

Lenders – Savers
Indirect Finance
1. Households
2. Business Firms
3. Government
4. Foreigners

Financial
Intermediaries

Borrowers - Spenders

1. Business Firms
2. Government
3. Households
4. Foreigners
Function of Financial
Intermediaries

FINANCIAL INTERMEDIARIES are

institutions that borrow funds from
savers and then lends these funds
to others

FINANCIAL INTERMEDIATION is the

process of indirect finance
whereby financial intermediaries
link savers and borrowers
Function of Financial
Intermediaries
Financial intermediaries are important
because:
They can reduce transaction costs
They can provide customers with liquidity
services

Other Concepts
Risk sharing (asset transformation)
Asymmetric information – financial panic
Adverse Selection
Moral Hazard
Financial Intermediaries in
the Philippines
Type of Institution Components Regulator/s
Banking Universal, Commercial, Thrift, BSP, SEC
Rural, Specialized Government,
Microfinance
Non-Bank Financial Investment Houses BSP, SEC
Financial Companies SEC
Securities Dealers SEC
Investment Companies SEC
Insurance Companies SEC, IC
Pawnshops SEC, BSP
Pre-need Companies SEC
Venture Capital Corporations SEC
Non-Bank Thrift Mutual Building and Loan SEC
Associations
Non-stock Savings and Loans SEC
Why Do Financial
Institutions Exist?
Why do Financial
Institutions Exist?

TRANSACTION COSTS are the time

and money spent trying to
exchange financial assets, goods or
services.

Financial Intermediaries reduce

transaction costs via:

Economies of Scale
Expertise
Basic Facts About Financial
Structure Throughout the World

FACT
I. Stocks are not the most important source of
external financing
II. Marketable Securities are not the primary
source of finance
III. Indirect Finance is more important than direct
finance
IV. Financial Intermediaries, especially Banks,
are the most important source of external
funds
Basic Facts About Financial Structure
Throughout the World

FACT
V. The Financial System is heavily regulated
VI. Only large, well-established firms have access
to securities markets
VII. Collateral is prevalent in debt contracts
VIII Debt contracts have numerous restrictive
covenants
Asymmetric Information

ASYMMETRIC INFORMATION is the inequality of

knowledge that each party to a transaction has
about the other party.

Example: banks and financial institutions spend time and

resources through credit/background information of the
borrower to ascertain whether to lend or not

It leads to two types of problems:

Adverse Selection
Moral Hazard
 Adverse Selection

ADVERSE SELECTION is a problem wherein the

people who are the most undesirable from the
other party’s point of view are the ones who are
most likely to want to engage in the financial
transaction

It is an asymmetric information problem that

occurs before the transaction takes place
Moral Hazard

MORAL HAZARD is the risk that one

party to a transaction will engage in
behavior that is undesirable from
the other party’s point of view.

It is an asymmetric information
problem that occurs after the
transaction takes place
 Moral Hazard

Moral hazard in EQUITY CONTRACTS is

referred to as the PRINCIPAL – AGENT
PROBLEM.

It occurs when the managers in control (the

agents) act in their own interest rather than in
the interest of the owners (the principals) due
to differing sets of incentives.
Regulation of the Financial System
Three Main Reasons For Regulation:

1. To increase information available to investors

Decreases adverse selection and moral hazard problems
Forces corporations to disclose information

2. To insure soundness of the financial system

Prevents financial panic
Chartering, reporting requirements, restrictions on assets
and activities, deposit insurance, and anti-competitive
measures

3. To improve control of monetary policy

Reserve requirements
Deposit insurance to prevent bank panic
Ensuring Soundness of Financial
Intermediaries

Restrictions on Entry
Disclosure
Restriction on Assets and Activities
Deposit Insurance
Limits on Competition
Restriction on Interest Rates
Financial Intermediaries in the
Philippines
Type of Institution Components Regulator/s
Banking Universal, Commercial, Thrift, BSP, SEC
Rural, Specialized Government,
Microfinance
Non-Bank Financial Investment Houses BSP, SEC
Financial Companies SEC
Securities Dealers SEC
Investment Companies SEC
Insurance Companies SEC, IC
Pawnshops SEC, BSP
Pre-need Companies SEC
Venture Capital Corporations SEC
Non-Bank Thrift Mutual Building and Loan SEC
Associations
Non-stock Savings and Loans SEC
 Investment House
Involved in underwriting of securities, financial
consultancy (issue management and underwriting of
public offering of debt and equity securities, loan
syndication and financial packaging and advisory for
corporate mergers, acquisitions and restructuring)
among others.
Enabling laws: PD 129 series of 1973 and RA 8366
series of 1997.
May be allowed to perform quasi-banking functions as
approved by the Monetary Board
Minimum capital requirement of P 300 M
Foreign ownership allowed up to 60%
 Financing Companies
Enabling law: RA 8556, amending RA 5980
'Financing companies' hereinafter called companies,
are corporations, except banks, investments houses,
savings and loan associations, insurance companies,
cooperatives, and other financial institutions
organized or operating under other special laws,
which are primarily organized for the purpose of
extending credit facilities to consumers and to
industrial, commercial, or agricultural enterprises, by
direct lending or by discounting or factoring
commercial papers or accounts receivable, or by
buying and selling contracts, leases, chattel
mortgages, or other evidences of indebtedness, or by
financial leasing of movable as well as immovable
property;
 Financing Companies

Financing companies shall be organized in the form of

stock corporations at least forty percent (40%) of the
voting stock of which is owned by citizens of the
Philippines and shall have a paid-up capital of not less
than Ten million pesos (P10,000,000) in case the
financing company is located in Metro Manila and
other first class cities, Five million pesos (P5,000,000)
in other classes of cities and Two million five hundred
thousand pesos (P2,500,000) in municipalities:
 Securities Dealers

Buying and selling of securities

Minimum capital of P 5.0 M

Mostly members of the Philippine Stock Exchange

Lending Companies/Lending Investors
Enabling law: RA 9474 series of 2007

Lending Company shall refer to a corporation engaged

in granting loans from its own capital funds or from
funds sourced from not more than nineteen (19)
persons. It shall not be deemed to include banking
institutions, investment houses, savings and loan
associations, financing companies, pawnshops,
insurance companies, cooperatives and other credit
institutions already regulated by law. The term shall be
synonymous with lending investors.

Minimum capital requirement: P 1.0 M

Investment Companies
Sells its own securities to the public and
invest the proceeds in stocks and bonds
(MUTUAL FUNDS)
Insurance Companies

Engaged in property-liability (non-life), life

insurance, and/or multiple-line products

Minimum capital of P 100 M. Recent

regulation allow for adjustment of risk

Regulated by the Insurance Commission

Sellers (agents) are carefully screened
 Pre – Need Companies
Sells pension, education, memorial plans subject to
the approval of the SEC and the Insurance
Commission
Capital Requirements: Minimum paid-up capital of P
100 M. Existing pre-need companies shall comply with
the following minimum unimpaired paid-up capital:
P 100M for companies selling at least three (3)
types of plan;
P 75 M for companies selling two (2) types of plan;
P 50M for companies selling a single type of plan.
Existing pre-need companies with traditional
education plans shall have a minimum unimpaired
paid-up capital P 100M
 What is happening in the PH/PHL?

1. Banks dominate the financial system.

2. Non-banks are underdeveloped and have grown

unevenly.

3. Conglomerates are an important feature of the

Philippine economy.
 Structure of PH/PHL Business
As of 2015 count of the Department of Trade and
Industry, there are 783,065 business enterprises
operating in the Philippines:
1. 99.7% (780,469) are micro, small, and medium
enterprises (MSMEs) and the remaining 0.3% (2,596)
are large enterprises.
2. Of the total number of MSMEs, 92% (720,191) are
micro enterprises, 7.3% (57,439) are small
enterprises, and 0.4% (2,839) are medium
enterprises.
 Recall: The Financial Intermediation
Process
Suppliers Borrowers

Individuals Funds Funds Individuals

Businesses Financial Businesses
Institutions Returns Institutions
Returns System
Government Government

Risk management,
Lenders liquidity, and information Users

Source: Santos, Essentials of Investments

George Akerlof’s Lemons Problem
Lemons Problem in Securities Markets
If one can’t distinguish between good and bad
securities, one might be willing to pay only the
average of good and bad securities’ value.

Result: Good securities are undervalued and

firms won’t issue them; bad securities are
overvalued so too many are issued
Investors won’t buy bad securities, so the
market won’t function well.

Less asymmetric information for well known

firms, so smaller lemons problems
Financial crises are caused by increases
in adverse selection and moral hazard
problems that prevent financial markets
from channeling funds to people with
productive investment opportunities,
leading to a sharp contraction in
economic activity.
Financial Crises

FINANCIAL CRISES are major

disruptions in financial markets

They are characterized by sharp

declines in asset prices and the
failures of many financial and non-
financial firms
 Financial Crises
Four Factors that Lead to Financial Crises:

in interest rates

in uncertainty

Asset market effects on balance sheets

Stock market effects on net worth
Unanticipated deflation
Cash flow effects

Bank Panics
 Typical Financial Crisis
Deterioration in Increase in Stock Market Increase in
Banks’ Balance Sheet Interest Rates Decline Uncertainty

Adverse Selection and

Moral Hazard
Problems Worsen Typical
Financial
Economic Activity Declines Crisis
Bank Panic

Adverse Selection and

Moral Hazard
Problems Worsen

Unanticipated Decline
in Price Level

Adverse Selection and Debt

Moral Hazard Deflation
Problems Worsen Factors

Economic Activity Declines Consequences

 The Big Picture

The Global Financial Crisis is a

case where adverse selection
and moral hazard have taken a
turn for the worse…
The Subprime Crisis
The Subprime Crisis
The Subprime Crisis