FINANCIAL SYSTEM
AND ITS
TRANSFORMATION
Basic definitions and concepts
Lecturer – Oleg Deev
oleg@mail.muni.cz
Contents
•  Financial system: types and structure
•  Financial system: key vulnerabilities
•  Economic transformation and transition
•  The choice of the financial system model
•  Financial development and economic growth
Essential readings
1.  Mishkin, F. S., and Eakins, S. G. (2009). Financial Markets and
Institutions, 6th edition. Pearson. – Chapters 1-2, 9-11, 15.
2.  Dowd, K. (1996). The Case for Financial Laissez-Faire. The
Economic Journal, vol. 106, no. 436, pp. 679-687.
3.  Dow, S.C. (1996). Why the Banking System Should Be Regulated.
The Economic Journal, vol. 106, no. 436, pp. 698-707.
4.  Levine, R. (1997). Financial Development and Economic Growth:
Views and Agenda. Journal of Economic Literature, vol. 35, no. 2,
pp. 688-726.
Economics and finance
• Economics – a social science that studies the
production, consumption and distribution of goods
and services, with an aim explaining how
economies work and how their agents interact.
•  Focuses on the optimization of valued goals
• Finance – a fund management science, which
deals with the interrelation of the concepts of
time, risk and money.
•  Focuses entirely on the maximization of wealth
Functions of finance
1.  Facilitating the exchange of goods and services –
monetary function
2.  Mobilizing and pooling savings from a large
number of investors – financial intermediation
3.  Allocating society’s savings to its most productive
use (reducing information and transaction costs)
4.  Diversifying and reducing liquidity and
intertemporal risk
5.  Monitoring managers and exerting corporate
control
The structure of financial system
• Financial markets
• Securities (financial instruments)
•  Debt instruments
•  Equity instruments
• Financial intermediaries
Financial system and infrastructure
•  Financial system – the system of all financial
intermediaries and financial markets and their relations
with respect to the flow of funds to and from households,
governments, business firms, and foreigners, as well as
financial infrastructure.
•  Financial infrastructure – the set of institutions that
enables effective operation of financial intermediaries and
financial markets:
•  payment systems
•  credit information bureaus
•  collateral registries
Financial system participants
•  Lenders/Savers
•  Individuals/Households
•  Companies
•  Government
•  Intermediaries
•  Banks
•  Insurance companies
•  Pension funds
•  Mutual funds
•  Borrowers/Spenders
•  Individuals
•  Companies
•  Governments
•  Municipalities
•  Public corporations
Borrower ↔ Lender
Issuer ↔ Investor
Seller ↔ Buyer
Types of the financial system model
• Financial market-based system (US, UK)
•  Relies on the capital market and on segmented banking
•  High economic and organizational prerequisites for the
efficiency
• Bank-based system (continental Europe, Japan)
•  Collects short-term deposits
•  Handles transfers of funds to business
•  Integration of banking and commerce – close
relationship between banks and firms
•  Well capitalized to cover ordinary banking risks
Financial market
• Financial market is a mechanism that allows
people and entities to buy and sell financial
securities, commodities and other fungible items
of value at low transaction costs and at prices that
reflect supply and demand
• Financial markets facilitate:
•  The raising of capital (capital markets)
•  The transfer of risk (derivatives markets)
•  The transfer of liquidity (money markets)
•  International trade (currency markets)
Structure of financial markets
•  Nature of the financial securities traded
•  Primary market
•  Secondary market
•  Forms of organization
•  Organized exchanges
•  Over-the-counter (OTC) markets
•  Maturity of financial instruments traded
•  Capital markets
•  Money markets
•  Forms of trade intermediation
•  Quote-driven dealer markets
•  Order-driven markets
•  Brokered markets
Types of financial markets
• Capital markets
•  Stock markets
•  Bond markets
• Commodity markets
• Money markets
• Interbank markets
• Derivatives markets
• Futures markets
• Insurance markets
• Foreign exchange markets
Taxonomy of financial intermediaries (1)
Depository institutions
•  Commercial banks
•  Retail banking
•  Private banking
•  Wholesale banking
•  Savings and loan associations (USA) / Cooperative
banks (Germany, Italy) / Mortgage banks (Buildings
Societies in the UK)
•  Credit unions (USA) / Savings banks (Germany)
•  Contractual savings institutions
•  Insurance companies
•  Pension funds
Taxonomy of financial intermediaries (2)
Investment intermediaries
•  Mutual funds
•  Finance companies
•  Investment (merchant) banks
•  Securities firms
•  brokers
•  dealers
•  Clearing banks
Why financial markets are regulated?
•  Asymmetric information – a situation in which one party of
the transaction has more or superior information
compared to another
•  Consequences of asymmetric information:
•  Adverse selection – immoral behavior that takes advantage of
asymmetric information before a transaction (ex ante)
•  Moral hazard - immoral behavior that takes advantage of
asymmetric information after a transaction (ex poste)
•  Principal-agent problem – stockholders (principals) own firm’s equity,
but usually they are not managers
•  How asymmetric information influences financial
structure?
How to reduce/solve problems arising
from asymmetric information
•  Reducing adverse selection:
•  Private production and sale of information – activities of information
agencies and rating agencies
•  Government regulation – to ensure that firms disclose full
information to potential investors
•  Financial intermediaries – loans are insured by collateral; banks
produce more accurate valuations of firms
•  Reducing moral hazard
•  Monitoring (auditing)
•  Government regulation to increase information
•  Standard accounting practices
•  Criminal penalties for fraud
•  Financial intermediaries active in the equity market
•  Debt contracts
Transformation or transition
• Changes of the economic system as a whole
• For our purposes, it is the process of changing an
economic system from centrally planned
economy to a free market after some major
political changes (former Soviet Union countries
and communist bloc countries of Europe) or
deliberate choice (China)
• The process is characterized by the changing and
creating of institutions
Possible forms of economic system
• Traditional economy
• Barter economy
• Market economy
• Planned economy
• Mixed economy
Transition process
• Early reform steps
•  Price liberalization
•  Liberalization of foreign trade
•  Restructuring and privatization
•  Elimination of state aids for companies
•  Set of capital and financial market
•  Liberalization of proprietorship
• Long-term tasks
•  Legal framework
•  Changes in justice (especially, competition policies)
Economic transition (IMF definition)
•  Liberalizing economic activity, prices, and market
operations, along with reallocating resources to their most
efficient use
•  Developing indirect, market-oriented instruments for
macroeconomic stabilization
•  Achieving effective enterprise management and economic
efficiency, usually through privatization
•  Imposing hard budget constraints, which provides
incentives to improve efficiency
•  Establishing an institutional and legal framework to secure
property rights, the rule of law, and transparent marketentry
regulations
Transformation approaches
• Gradualism
•  Slow pace of reforms
•  All negative factors could be limited
•  Optimistic situation in business
•  Social pressures
• Shock therapy
•  Quick pace of reforms
•  Basic reforms in short time horizon
•  Accompanied by stabilization policy and withdrawal of
government interventions
Key components of modern financial
system
•  Stable money and money markets
•  Sound banks and banking systems
•  An effective central bank
•  Stable public finances and markets for government debt
securities
•  Efficient securities markets for business firms’ debts
(bonds) and equities (stocks)
•  Sound insurance companies and insurance markets
•  Corporations with limited liability to facilitate equity share
issuance and ownership
The choice of the financial system model
•  The quality of information about private firms?
•  Investors’ behavior?
•  Possibilities for savings?
•  Is a bank-based financial structure better than a marketbased
one to foster economic development?
•  Historically transition economies choose bank-based
system
•  Universal banking
•  Foreign bank entries are preferable
•  Control and monitoring (creditor rights, contract enforcement,
accounting standards)
•  Securities markets should provide informational feedback because they
provide prices for different types of assets
Finance and economic growth
•  The development of financial markets and institutions is a
critical and inextricable part of the growth process
•  Relationship between financial development and economic
growth is a long-debated issue
•  Theory does not point to obvious growth benefits from having a
large and developed financial sector in the economy
•  Channels to growth:
•  capital accumulation
•  technological innovation
•  There are important non-linearities even in the intermediationgrowth
relationship
•  most of the growth benefit comes through enterprise credit
•  most of the credit growth in advanced countries over recent years has
been in household credit
Financial development
• Financial deepening
•  the extent to which past savings has been transformed
into investments
•  measures as increase in the ratio of financial assets to
GDP
•  indicates how effectively financial institutions have
mobilized savings for investment
• Financial broadening
•  an increase in the variety of financial institutions and
instruments (including different types of securities,
market participants, growth of institutional investors)
•  implies a greater choice for savers and investors
Financial development
• What type of financial development is integral to
the growth of the economy?
• An effective financial system facilitates the
sharing of information between investment
projects and potential investors for an efficient
allocation of risk on satisfying temporal terms
• The complex of interacting markets provides
multiple channels for revealing and responding to
economic shocks
Measurement of financial development
Institutions Markets
Depth
Private Sector Credit to GDP
M2 to GDP
Deposits to GDP
Gross value added of the financial
sector to GDP
Stock Market Capitalization to GDP
Private Debt securities to GDP
Public Debt Securities to GDP
Stocks traded to GDP
Access
Accounts per thousand adults
Branches per 100,000 adults
% of firms with line of credit
Ratio of domestic to total debt securities
Ratio of private to total debt securities
Ratio of new corporate bond issues to GDP
Efficiency
Net interest margin
Lending-deposits spread
Non-interest income to total income
Profitability (ROE, ROA)
Level of competition (HHI)
Turnover ratio for stock market
Price synchronicity (co-movement)
Liquidity/transaction cost
Quoted bid-ask spread for government
bonds
Stability
Capital adequacy ratios
Asset quality ratios
Liquidity ratios
Volatility of stock price index
Volatility of sovereign bond index
Vulnerability to earnings manipulation
Price/earnings ratio
Financial development and economic
growth
• Financial development is important not only for
fostering the economic growth process, but also
for dampening the volatility of the growth process
• Which specific types of financial development are
crucial for economic development?
• Countries with better functioning banks and
markets grow faster
• The impact of financial sector deepening on firm
performance and growth is stronger for SMEs
than for large enterprises
Readings for the next topic
1.  Mishkin, F. S., and Eakins, S. G. (2009). Financial
Markets and Institutions, 6th edition. Pearson. –
Chapters 14, 17-18.
2.  Judis, J.B. (2009). Debt Man Walking. US Department
of State eJournal, vol.14, 5, pp. 9-12.
3.  Vedder, R. (2009). The Evolving Global Financial
System. US Department of State eJournal, vol.14, 5, pp.
27-30.
4.  Wyman. O. (2009). The Future of the Global Financial
System. World Economic Forum’s World Scenarios
Series. [EXCERPT]