The global financial system of money and capital markets performs the important
function of channeling savings into investment. In that process a unique kind
of asset
in the economy—a financial asset—is created. - Financial assets represent claims against the income and assets of
individuals and institutions issuing those claims. There are three major categories
of financial assets—money, debt, and equities. A fourth
instrument, derivatives, is closely related to financial assets, deriving
its value from these assets.
- Money is among the most important of all financial assets in the
economy because it serves as a medium of exchange to facilitate purchases
of goods and services, a standard for valuing all items bought and sold, a
store of value (purchasing power) for the future, and a reserve of liquidity
(immediate spending power). Despite all these advantages, money has a weakness—
susceptibility to inflation (i.e., a rising price level), because its rate
of return is normally so low. In contrast, the financial assets represented
by debt or equity securities, and often by derivatives
as well, carry greater average yields but, unlike money, may incur loss when
converted into immediately spendable funds.
- The creation of financial assets occurs within the financial system through
three different channels—direct, semidirect, or indirect finance. Direct
finance involves the direct exchange of financial assets for money in
which borrowers (deficit-budget units, or DBUs) and lenders (surplus-budget
units or SBUs) meet directly with each other to conduct their business. Semidirect
finance involves the use of a broker or dealer to help bring borrower
and lender together and reduce information costs. Indirect finance
refers to the creation of financial assets by financial intermediaries who
accept primary securities from ultimate borrowers (DBUs) as their principal
earning assets and issue secondary securities to ultimate savers (SBUs)
to raise funds.
- Financial intermediaries (such as banks, pension funds, and insurance
companies) have grown to dominate most financial systems today due to their
greater expertise, efficiency, and capability in diversifying away some of
the risks involved in lending money.
- One of the most serious management problems encountered by some financial
intermediaries is disintermediation—the loss of funds from an
intermediary to direct or semidirect finance. Much of the disintermediation
experienced by modern intermediaries has occurred due to financial innovation.
Borrowers have found new ways to obtain the funds they need without going
through a financial intermediary.
- Finally, financial systems around the world appear to fall into one of two
broad categories—bank-dominated financial systems and security-dominated
financial systems. In bank-dominated systems the majority of financial
assets arise from the banking system. When banks get into trouble the financial
system itself may experience difficulties with risk exposure and slower growth.
In security-dominated financial systems, by contrast, security brokers and
dealers tend to be leaders in the financial system and often provide the greatest
volume of funds to those in need of new capital. Security-dominated financial
systems are heavily dependent upon direct and semidirect finance (i.e., the
open market), while bank-dominated systems tend to rely upon financial intermediaries
(indirect finance) for the raising of funds.
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