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1. Lenders & borrowers

1.1. Learning objectives

After studying this text the learner should / should be able to:

1. Define the financial system.

2. Describe the elements that make up the financial system.

3. Elucidate the allied (non-principal) financial bodies / entities that assist in facilitating the flow of funds and securities in a financial system.

4. Name and define the sectors of the economy that constitute the non-financial lenders and borrowers.

1.2. Introduction

This text is about the fundamentals of the financial system. By "fundamentals" we mean that we attempt to elucidate the system by going back to the basics, and this is best achieved in our view by splitting it up into its components and illuminating each one. The following are the constituents:

• Lenders & borrowers.

• Financial intermediaries.

• Financial instruments.

• Financial markets.

• Money creation.

• Price discovery.

1.3. Defining the financial system

Every scholar on the financial markets has attempted a definition of the financial system. Ours is:

The financial system is a set of arrangements / conventions embracing the lending and borrowing of funds by non-financial economic units and the intermediation of this function by financial intermediaries in order to facilitate the transfer of funds, to create additional money when required, and to create markets in debt and equity instruments (and their derivatives) so that the price and allocation of funds are determined efficiently.

This definition identifies the six essential elements of a financial system:

• First: the lenders and borrowers, i.e. the non-financial economic units that undertake the lending and borrowing process.

• Second: the financial intermediaries, which intermediate the lending and borrowing process, meaning that they interpose themselves between the lenders and borrowers.

• Third: the financial instruments (marketable and non-marketable), which are created to satisfy the needs of the various participants.

• Fourth: the creation of money when required, i.e. the unique money creating ability of banks.

• Fifth: the financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.

• Sixth: price discovery, i.e. the determination or making of the price of equity and the price of money / debt (the rate of interest).

financial system (simplified)

Figure 1: financial system (simplified)

The definition covers the essence of the financial system. In addition to the mentioned elements, there are also allied participants / players / entities in the system, without which the system would not function efficiently. They are:

• First: the brokers and dealers, i.e. the members of exchanges and/or financial intermediaries that facilitate the trade in financial instruments (which we refer to here collectively as broker-dealers).

• Second: the fund managers (portfolio managers), i.e. the corporate entities or departments of financial intermediaries that manage funds on behalf of principals (owners or holders of money).

• Third: the financial exchanges that allow the broker-dealers to facilitate trading in securities, and create the mechanism for clearing and settlement of trades in a risk-minimising manner.

• Fourth: the credit rating agencies, which analyse relevant financial and economic data pertaining to the issuers of securities and assign ratings to the securities reflecting the probability of the issuers meeting their financial obligations (interest and principal).

• Fifth: the financial regulators that regulate and supervise all players in the financial system.

Given the above information, how does one portray the financial system? The answer is that it is not possible to capture all the elements and players in one single illustration. However, we can go pretty far in this regard. A good to start is with the illustration presented in Figure 1.

This illustration portrays the main players in the system: the lenders, borrowers, financial intermediaries, and hints at the two types of borrowing / lending (discussed in detail later). Not observable here are the financial (or securities) markets (OTC or formal - the exchanges) and the broker-dealers. The financial markets may be imagined as being interposed in the flow lines. The broker-dealers of the financial markets, as this generic name indicates, facilitate and operate in these markets as brokers (= match buyers and sellers) and dealers (= act as principals = buy and sell for own account). (We will return to and elucidate this later.)

The addition of the financial exchanges and the broker-dealers maybe depicted as in Figure 2.

financial markets & broker-dealers in financial system

Figure 2: financial markets & broker-dealers in financial system

The remaining elements of, and the other players in, the financial system are the fund managers, the regulators of the financial system, the creation of money and price discovery. The former two we are able to add to the illustration: see Figure 3.

The significant elements of the financial system, creation of money and price discovery, cannot be easily illustrated. The banks, by simply extending new loans (credit) or purchasing new securities on the primary market (also credit, in a different form), create new money.

What is money? It is the amount of bank notes and coins and bank deposits of the non-bank private sector, but overwhelmingly the latter. How is new money (in the form of new deposits) created? By new bank lending; it is the outcome of new bank lending. Often money creation is elucidated by a bank first receiving a new deposit. We will show later that this is not the case; it is misleading because it does not identify where the new deposit springs from.

Many scholars also complicate the money creation process by introducing the (cash) reserve requirement (RR = a ratio of bank deposits to be held with the central bank) and presenting this as the brake on money creation. When a bank makes a new loan a new deposit is created; this requires a topping up of reserves (R), and this is provided by he central bank (d is cussed in more detail later).

(most) elements of the financial system

Figure 3: (most) elements of the financial system

Some scholars believe that a central bank does not have to provide the reserves (R), and that this is a form of money "supply" control. However, in most countries the so-called discount window (= a term used for central bank lending to banks) is always "open" and the central bank happily supplies the additional R. The brake on the system lies not in the amount of R supplied by the central bank, but in the cost of these borrowed R.

The cost of these borrowed R is an interest rate that is set by a committee of central bankers (in most cases), and it is called repo rate, discount rate, base rate, Bank rate (sic), etc. (we call it the key interest rate - KIR). This rate has such a substantial influence on the bank-to-bank interbank rate, the call money rate and other interest rates, that it may be said that the central bank governor "governs" interest rates. The KIR is the genesis of all other interest rates and other financial market pricing.

These two vital elements of the financial system (creation of money and the price of money = part of price discovery) may be depicted simply as in Figure 41. The price discovery process of the equity market will be covered later.

The money creation element of the financial system is a crucial one in terms of the supply of capital / funding when required by economic agents and of course in terms of monetary policy. It is to be noted that this brief elucidation of the money creation process and the role of the KIR is elementary; the real story will be covered in a separate section.

money creation and price of money (interest rates)

Figure 4: money creation and price of money (interest rates)

In fact, each of the elements of the financial system is covered in a separate section. We begin with the first-mentioned element - without which there is no financial system - the non-financial lenders and borrowers.

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