Financial system

The financial system conveys resources from lenders to borrowers and allocates risks among those who wish to avoid them or are prepared take them. It is a complex interactive system, events in one component of which can have significant repercussions elsewhere. International linkages often add to its complexity by enabling developments in one country to generate consequences elsewhere. Under normal circumstances, national and international financial systems contribute to the economic efficiency of their users, but their malfunction can cause widespread economic damage.

(The termninology of this article is based upon The American Banker Bankers Glossary [1]. Terms shown in italics are defined in the glossary on the related articles subpage) Template:TOC-right

Overview

The primary function of a financial system is to transfer resources from those who own them but do not wish to use them, to those who wish to use them but do not own them. A secondary function is the transfer of risk from those who wish to limit their exposure to it, to those willing to accept it for a fee.
The system performs those functions by trading in financial instruments that represent promises to perform services in return for payment. The promises that they represent include promises to make fixed payments (represented by bonds); promises to pay dividends (represented by shares); promises to provide retirement income (represented by pension agreements); promises to bear some of the costs of accidents or financial losses (represented by insurance policies ), promises to provide a cash flow, such as mortgage repayments (represented by securitised assets) - and promises, such as options, concerning transactions in other promises (represented by "derivatives"). The channeling of money from lenders to borrowers has traditionally been done mainly by commercial (or "retail") banks that raise money by accepting deposits, and use it to finance loans to companies and individuals, but recently by banks and other organisations that finance long-term loans by short-term by borrowing.

The components of the system

Financial instruments

Bonds

In the terminology of this article, the term "bond" normally refers to an instrument, issued by a company or by local or central government, that represents a loan that is repayable after an interval of not less than a year (but in economics terminology it refers to any of the entire category of fixed-interest loan instruments). The term is also applied in some contexts to investments that do not conform to that definition - such as "investment bonds" (collections of investment funds) and "premium bonds" (a type of lottery). Unlike most other loan instruments, a bond can be bought or sold without reference to its issuer - normally on the bond market (see below). Bonds issued by the government are termed "Treasury bonds" (or "T-bonds") in the United States and "Gilt-edged securities" (or "gilts") in the United Kingdom.

The simplest form of bond is the "straight" (or "plain vanilla") bond, that makes a regular fixed interest payment and is repaid (or "redeemed") on a predetermined date. The sum of money for which the bond is to be redeemed, is called its "par value", the annual interest rate that is paid is called its "coupon", and its date of repayment is called its "maturity date". A bond's coupon divided by its market price is called its "current yield" and its internal rate of return taking account of the eventual repayment is termed its "yield to maturity".

Other forms of bond can be categorised as particular adaptations of the above payment conditions. Strictly speaking an "irredeemable bond" (or "perpetual bond" or "consol") is not a loan, but only an undertaking to make stipulated and indefinitely continuing fixed interest payments. A "zero-coupon bond", on the other hand, pays no interest, is issued at a price that is below its par value, and is held in order to obtain a capital gain. A "callable bond" has a redemption date that is at the discretion of the issuer. Convertible bonds include an option, under stated conditions, to exchange them for an equivalent amount of the issuer's equity. The interest rate paid on a “tracker bond” is related to the bank or Treasury bond rate, and the redemption payment of an “index-linked” bond is related to the current level of a consumer price index.

Bonds can also be categorised according to the degree of security provided to their purchasers. A "covered bond" is a bond that is secured by other assets so that the investor can lay claim to those assets should the issuer of the bond become insolvent. In the United Kingdom the term "debenture" refers to a company loan secured by a claim on the company's assets, but in the United States the term is applied to unsecured loans (and debentures are sometimes referred to as bonds). In the UK a "fixed-charge debenture" specifies the assets against which it is secured, whereas a "floating-charge debenture" is secured on the issuer's assets as a whole. Repayment of a "guaranteed bond" is guaranteed by a body other than the issuer - such as its parent company or its government. The term "default risk means the risk that the issuer will be unable to repay the loan and the "risk premium" (or "spread") is the difference between the yield on a bond and the yield on a government bond – except that “sovereign spread” is the difference between the yield on a government bond and the yield on the least risky government bond that is available. Default risk premia are linked to risk ratings issued by credit risk agencies (see below). Bonds that are rated below a minimum credit risk level (Baa for Moody’s or BBB for Standard and Poor) are termed "junk bonds" (or "high-yielding bonds") and bonds rated above that level are termed "investment-grade bonds".

Finally, bonds can be categorised according to their currency of denomination. The term "eurobond" (or "global bond") refers to a bond that is traded outside the country in whose currency it is denominated - so called because it is often applied to a bond issued by a non-European company for sale in Europe.

Money market securities

Money market securities are short term loan instruments issued by governments banks and businesses. Those that can be bought and sold during the period between issue and repayment are termed “negotiable”. Those that a marketed on a “yield basis” are repaid on the due date by the amount invested, together with a stipulated interest payment. The category of money market security that are marketed on a yield basis includes "money market deposits" which are repayable after intervals ranging from one day to one year and are not negotiable, and “certificates of deposit” which are receipts from banks for deposits made with them, and are negotiable. Money market securities that are marketed on a “discount basis” are sold at a price "below par" (– ie below the amount to be repaid), but without any additional interest payment. That category includes Treasury bills, which are promises to repay loans to the government – usually after 90 days; "bills of exchange" (or "trade bills", or "commercial bills") which are similar to Treasury bills but are issued by companies; and "bankers acceptances" which are negotiable, and "commercial paper" which consists of unsecured promissory notes issued by companies.

Shares

A share in a corporation is evidence of a share in the ownership (or "equity") of that corporation, and represents a claim on its assets and its profits. The shares in a company are referred to collectively as its "stock" or its "equity". The term "equity" is also used to mean the value of the firm after all its debts and other obligations have been paid. Except for "non-voting shares" the possession of a share carries the right to vote on matters raised at its general meetings. Holders of "preference shares" are entitled to a specified form of preferential treatment compared with holders of "ordinary shares" - sometimes a guaranteed dividend, sometimes a guaranteed repayment if the company were liquidated. The "par value" of a share sometimes denotes the amount due on liquidation to the holder of a preference share, and it is unrelated to the share's market value.

Derivatives

A derivative is financial instrument whose value depends upon the value of another instrument. The principal categories of derivative are "forward contracts", "futures", "options", and "swaps". A forward contract is an agreement to buy or sell a specified quantity of an asset on a specified date, at a specified price. An option is an agreement that gives the holder the right, but not the obligation, to buy ("call option") or sell ("put option") an asset, on or before a specified date . A swap is an agreement to exchange a series of cashflows from one asset with a series of cashflows from another asset. Swaps are widely used as credit risk transfers (see below). Some derivatives are used to create leverage, as a means of speculation, or for hedging against risk.

Mortgages

A mortgage is a loan secured on property - usually real estate, although ships and aircraft are commonly mortgaged. A mortgage may be used to help finance the purchase of the property or to obtain money for other purposes.
Mortgage interest payments may be fixed or may be varied by the provider of the loan - usually in response to changes in the general level of interest rates. The term "adjustable rate mortgage" (ARM) is used in the United States to denote a mortgage for which the interest rate payable is related to a published index, and a "hybrid mortgage" is one in which the interest rate is fixed for a period, and then varied. "Subprime mortgages" are designed for the use of borrowers with low credit ratings (typically below a FICO rating of 620 in the United States). They are offered at higher interest rates than for other mortgages, but may provide for reduced payments in their early years.
If the market value of the property that is mortgaged falls below the amount of the loan, the borrower is said to have "negative equity" in the property and thus to cease benefiting from the mortgage agreement.
Failure to make the agreed payments is termed "default" and usually entitles the provider of the loan to "repossess" the property.
A mortgage loan may be financed by its provider by selling claims to its repayments - a procedure known as "securitisation".

Structured finance

The term "structured finance" refers to assets created by "securitising" cash flows such as debt repayments by converting them into marketable securities that are structured according to their maturity and risk rating, and among which priorities concerning payments and liabilities for losses are stipulated in "waterfall clauses" . The cash flows that are securitised may be income from corporate bonds, in which case the assets that are created are termed "collateralised debt obligations (CDOs)" or "asset-backed securities (ABSs)", or they may be mortgage repayments, in which case the assets are termed "collateralised mortgage obligations (CMOs)". CMOs are normally segregated into "tranches", each with its own maturity date and risk rating.

Credit risk transfer

A "credit default swap" (CDS), enables a "protection buyer" to transfer the credit risk from holding a security to a "protection seller" in return for an annual percentage charge, known as the "CDS spread", that is determined by the credit rating of the protected security. Credit default swaps can be combined to create a "synthetic CDO," in which credit losses are allocated to tranches according to stated priority rules. A "total return swap" transfers market risk as well as credit risk. Another form of risk transfer is a bank guarantee which is an undertaking to pay compensation if there is a specified form of default by a third party.

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Participants

Financial intermediaries

Banks

"Commercial banks" accept payments from depositors and lend money to personal and commercial borrowers. In addition to the money they get from depositors, they can get short-term loans from their central bank's "discount window", or from the money market. They make profits by charging higher interest rates to their borrowers than they pay to their lenders - a difference that is known as their "spread".

The banks that lend money to borrowers but do not accept deposits from the public, include "wholesale banks" that deal with other banks or financial companies; "investment banks", (also known as "merchant banks") that raise money for companies by finding buyers for their equity and bonds; and "universal banks" that combine all of those activities. Other institutions that lend money to personal or commercial borrowers are referred to collectively as the "shadow banking system".

The practice of retaining only a fraction of the money deposited with it as a "reserve" and lending out the rest is known as "fractional reserve banking", and it enables the bank to participate in the process of money creation.

Asset managers

A hedge fund is a pooled investment vehicle that is privately managed and is not widely available to the public. Being free of the regulations that govern the conduct of other financial intermediaries, hedge funds tend to adopt unconventional strategy, and many of them make extensive use of leverage and derivatives, and of short and long selling. Their strategies are very diverse but Harry Kat has suggested a broad categorisation . According to Harry Kat, "global funds" take advantage of perceived anomalies in currency markets, or of expected developments in emerging markets; "event-driven funds" seek to profit from company developments such as mergers and acquisitions and risks of insolvency; and "market-neutral funds" make use of hedging tactics to reduce market risks while seeking to profit from pricing anomalies in markets for equities, derivatives and other securities.

Markets

Trading in the different categories of instrument takes place in different types of market. "Primary markets" for pensions and insurance policies take the form of one-to-one "over-the-counter" (OTC) transactions with their suppliers, and there is seldom any further trading because those instruments are considered to be "non-negotiable". The primary markets in stocks and shares and bonds usually start with an "initial public offering" (IPO) in which the issuers deal directly with professional traders, and through them with the public. Subsequent trading in those instruments can take place, either as over-the-counter deals between dealers and individual customers, or in "auction markets" in which numbers of holders trade with each other, or in "dealers markets" in which numbers of holders trade with dealers.

International institutions

The International Monetary Fund was set up in 1944, mainly to provide loans to member governments in support of policies to deal with balance of payments problems. In recent years it has also devoted its resources to the strengthening of the international financial system and relieving financial crises. It also advises member governments about their economic problems and, when necessary, it grants loans to help resolve them.
The World Bank provides low-interest loans, interest-free credit and grants to developing countries, finances selected private sector projects,. guarantees foreign investors against non-commercial risks and settles disputes between foreign investors and host countries.
The Bank for International Settlements serves as the central banks’ bank and provides a forum to promote discussion and policy analysis among central bank governors and senior executives. Its committees include the Basel Committee on Banking Supervision and the Committee on the Global Financial System.

Reform of the system

In preparation for a meeting of the world leaders in November 2008, an ebook was published by an international group of twenty leading financial economists. They agreed on the need to augment IMF resources and to strengthen existing arrangements for global governance. Several of them also argued for new approaches to the regulation of large cross-border financial institutions.

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