Chapter 1

Role of Financial Markets and

Institutions

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
We examine the role of the financial system in an
advanced economy. Topics include:

Function of Financial Market

Structure of Financial Market
Types of financial markets
Securities traded in financial markets
Global financial markets
Function of Financial Markets
A financial market is a market in which financial
assets (securities) can be purchased or sold
Financial markets facilitate transfers of funds from
person or business without investment opportunities
(i.e., “Lender-Savers”, or “Surplus Unit”) to those
who have them (i.e., “Borrower-Spenders”, or
“Deficit Unit”)
Segments of Financial Markets
Direct Financing
Funds are transferred directly from ultimate savers
to ultimate borrowers
Indirect Financing
A financial "intermediary" transforms financial
claims with one set of characteristics into financial
claims with other characteristics e.g. deposits are
used to make loans.
Transfer of Funds on Financial Market
Function of Financial Intermediaries

Provide customers with liquidity service

Help to repackage the risk
Willing to create and sell assets with lesser risk to
one party in order to buy assets with greater risk
form another party
This process is referred to as asset
transformation
Types of Financial Markets
Financial markets can be distinguished by the
maturity structure and trading structure of its
securities
Money versus capital markets
The flow of short-term funds is facilitated by money
markets
The flow of long-term funds is facilitated by capital
markets
Types of Financial Markets
Primary versus secondary markets
Primary markets facilitate the issuance of new securities
e.g., the sale of new corporate stock or new Treasury securities
Secondary markets facilitate the trading of existing
securities
e.g., the sale of existing stock
Securities traded in secondary markets should be liquid
Types of Financial Markets (cont’d)
Organized versus over-the-counter markets
A visible marketplace for secondary market transactions is
an organized exchange
Some transactions occur in the over-the-counter (OTC)
market (a telecommunications network)
Knowledge of financial markets is power
Decide which markets to use to achieve our investment
goals or financing needs
Decide which markets to use as part of your job
Avoid common mistakes in investing and borrowing
Securities Traded in Financial Markets

Money market securities

Money market securities are debt securities with
a maturity of one year or less
Characteristics:
Liquid
Low expected return
Low degree of risk
Securities Traded in Financial Markets
(cont’d)
Capital market securities
Capital market securities are those with a
maturity of more than one year
Bonds and mortgages
Stocks
Capital market securities have a higher expected
return and more risk than money market securities
Securities Traded in Financial Markets
(cont’d)
Bonds and mortgages
Bonds are long-term debt obligations issued by
corporations and government agencies
Mortgages are long-term debt obligations created
to finance the purchase of real estate
Bonds and mortgages specify the amount and
timing of interest and principal payments
Securities Traded in Financial Markets
(cont’d)
Stocks
Stocks (equity) are certificates representing partial
ownership in corporations
Investors may earn a return by receiving dividends
and capital gains
Stocks have a higher expected return and higher
risk than long-term debt securities
Securities Traded in Financial Markets
(cont’d)
Derivative securities
Derivative securities are financial contracts whose values
are derived from the values of underlying assets
Speculating with derivatives allow investors to benefit
from increases or decreases in the underlying asset
Risk management with derivatives generates gains if the
value of the underlying security declines
Role of Financial Institutions in
Financial Markets (cont’d)
Role of depository institutions
Depository institutions accept deposits from
surplus units and provide credit to deficit units
Depository institutions are popular because:
Deposits are liquid
They customize loans
They accept the risk of loans
They have expertise in evaluating creditworthiness
They diversify their loans
Role of Financial Institutions in
Financial Markets (cont’d)
Commercial banks
Are the most dominant depository institution
Offer a wide variety of deposit accounts
Transfer deposited funds by providing direct loans
or purchasing debt securities
Serve both the public and the private sector
Role of Financial Institutions in
Financial Markets (cont’d)
Savings institutions
Include savings and loan associations (S&Ls) and savings
banks
Are mostly owned by depositors (mutual)
Concentrate on residential mortgage loans
Credit unions
Are nonprofit organizations
Restrict their business to credit union members
Tend to be much smaller than other depository institutions
Role of Financial Institutions in
Financial Markets (cont’d)
Role of nondepository financial institutions
Nondepository institutions generate funds from
sources other than deposits
Finance companies
Obtain funds by issuing securities
Lend funds to individuals and small businesses
Role of Financial Institutions in
Financial Markets (cont’d)
Mutual funds
Sell shares to surplus units
Use funds to purchase a portfolio of securities
Some focus on capital market securities (e.g., stocks or
bonds)
Money market mutual funds concentrate on money
market securities
Role of Financial Institutions in
Financial Markets (cont’d)
Securities firms
Broker function
Execute securities transactions between two parties
Charge a fee in the form of a bid-ask spread
Investment banking function
Underwrite newly issued securities
Dealer function
Securities firms make a market in specific securities by adjusting
their inventory
Role of Financial Institutions in
Financial Markets (cont’d)
Insurance companies
Provide insurance policies to individuals and
firms for death, illness, and damage to property
Charge premiums
Invest in stocks or bonds issued by corporations
Role of Financial Institutions in
Financial Markets (cont’d)
Pension funds
Offered by most corporations and government
agencies
Manage funds until they are withdrawn from the
retirement account
Invest in stocks or bonds issued by corporations or
in bonds issued by the government
Comparison of Roles among Financial
Institutions
Deposit
s
Depositor
y
Institution
Purchase s
Surplus Units Securities
Finance
Companies Deficit Units
(Firms, Government
Agencies, Some
Purchase Shares
Mutual Funds Individuals

Premiums Insurance
Policyholders Companies

Employee
Employers Contribution
Employees s Pension Funds
Overview of Financial Institutions

Competition between financial institutions

Financial institutions should operate to maximize
the value of their owners
Present value of future cash flows
Depends on:
Growth and profitability
Degree of risk
Overview of Financial Institutions
(cont’d)
Consolidation of financial institutions
Reduction in regulations has resulted in more opportunities
to capitalize on:
Economies of scale
Economies of scope
Mergers have resulted in financial conglomerates
Consolidation may increase expected cash flows or reduce
risk, or both
Summary of International Sources and Uses of Funds

Financial Institutions Main Sources of Main Uses of Funds

Funds
Commercial banks Deposits from Purchases of
households, government and
businesses, and loans to businesses
government agenciesand households
Savings institutions Deposits from Purchases of
households, government and
businesses, and corporate securities;
government agenciesmortgages and other
loans to households;
some loans to
businesses
Credit unions Deposits from credit Loans to credit union
union members members
Summary of International Sources and Uses of Funds

Financial Institutions Main Sources of Main Uses of Funds

Funds
Mutual funds Shares sold to Purchase of long-
households, term government and
businesses, and corporate securities
government agencies
Money market funds Shares sold to Purchase of short-
households, term government and
businesses, and corporate securities
government agencies
Insurance companies Insurance premiums Purchase of long-
and earnings from term government and
investments corporate securities
Pension funds Employer/ employee Purchase of long-
contributions term government and
Banks in Indonesia
Definition based on UU No. 10 tahun 1998: a business entity that collects
funds from the public in the form of savings and distributes them to the
public in the form of credit and or other forms in order to improve the
standard of living of the community at large
Two principles of banks
Prudent
Trust
Banks’s function as intermediary institution and payment traffic service
provider
Banks are divided in 3 forms based on their function: conventional, sharia
and rural banks
3 Types of Banks
Conventional Banks: supports financial intermediary
and payment services
Rural Banks (BPR): only provides intermediary
function limited to savings and deposit account.
Prohibited from any foreign currency transactions.
Bank Syariah: based on sharia principle
Mudharabah (partnership profit sharing)
Musharakah (joint venture profit and loss sharing)
Murabahah (buying and selling principle)
Ijarah (rent or lease princple)
Wadiah (for savings)
Bank’s Levels in Indonesia
Banks are divided as stated by POJK nomor 12 /POJK.03/2021
tentang KBMI (Kelompok Bank Modal Inti) based on its capitals

Level Capitals required (IDR)

KBMI 1 <6T
KBMI 2 6 – 14 T
KBMI 3 14 – 70 T
KBMI 4 > 70 T
Traditional Services Offered By Banks

Carrying Out Currency Exchange

Business Loans
Offering Savings Deposits
Safekeeping of Valuables
Supporting Government Activities with Credit
Offering Checking Accounts
Offering Time Deposits
More Recent Services Offered by Banks
Granting Consumer Loans
Providing Financial Advice
Managing Cash
Offering Equipment Leasing
Making Venture Capital Loans
Selling Insurance Policies
Selling Retirement Plans
Providing digital banking
Branchless system
Offering Security Brokerage and Investment
Banking Services

Underwriting Securities
Offering Mutual Funds and Annuities
Offering Merchant Banking Services
Offering Risk Management and Hedging Services
Trends Affecting Banks and Other Financial
Service Firms Today
Service Proliferation
Rising Competition
Government Deregulation
Increased Interest Rate Sensitivity
Technological Change and Automation
Consolidation and Geographic Expansion
E-Banking and E-Commerce
Convergence
Globalization
Discussion for Next Week
Recently BI has just announced BI Fast system with lower cost
of IDR 2.500 instead of IDR 6.500. Each student should
research about this BI Fast system and answer the following
questions:
What is the difference between BI Fast, GPN (Gerbang Pembayaran
Nasional) and QRIS system? Explain each functions and its advantages
offered to us, customers!
Do you think BI Fast or GPN can replace Visa or Mastercard in 3 to 5
years? Explain your answer by comparing the local and foreign
payment service provider
What are the challenges and obstacles faced by BI Fast and GPN
ahead?
https://voi.id/en/economy/100626/
bank-indonesia-aims-to-use-bi-fast-to-serve-cross-border-transactions-in-the-fut
ure
https://www.thejakartapost.com/adv/2021/11/03/bank-indonesia-launching-bi
-fast-in-december-2021-to-offer-fast-and-low-cost-transactions.
html

Submit your answer in pdf form, before Wednesday,

March 16th on 23.59 max of 3 pages pdf and citing its
sources