The financial systeм

Nature

A financial system is composed of institutions and markets which fulfil a variety of economic functions. Central to all is arranging or facilitating the lending of funds from one economic agent to another. Most other financial services are ancillary to, or derived from, this one. The lending of funds from one economic agent to another - from lender to borrower - can be ac­complished in many different ways; but all can be classified into just two distinct approaches.

Firstly, the lender can lend direct to the borrower, albeit perhaps with the assistance of brokers who act in an agency capacity. This is what happens when a person subscribes to a new issue of government stock, deposits money with a local authority or buys a share in a public company. In each case, the person is lending direct to the borrower and is incurring all the risks that such lending involves. This may be called direct finance.

The second approach, which may be called indirect finance, involves a financial intermediary standing between borrower and lender. The lender lends his funds to the intermediary, e.g. a bank or a building society. The intermediary collects the funds from many lenders and decides to whom it will lend. Borrowers approach the intermediary and, if creditworthy, they receive loans. There is no direct contract between lender and borrower. Each deals with the intermediary, each has his contact with the intermedi­ary; instead of one transaction, there are two.

This form of finance seems at first sight to be more roundabout, and to involve the use of more real resources of capital and labour than direct finance. But financial intermediaries are numerous and indirect finance more common than direct finance. What, then, are its advantages? They are many, and they derive from the ability of financial institutions to use their size and expertise to transform financial claims, so that they can offer savers a wider choice of assets than ultimate borrowers are able to do. At the same time, they can offer borrowers a more varied choice of credit terms than ultimate lenders are able to do.

Such a bank accepts deposits of all sizes and on a variety of terms. In the United Kingdom, the largest banks each have many millions of individual deposits, which in the aggregate sum to more than £50bn. They know that, every day, many depositors will withdraw money, but that many others will make new deposits. The law of averages, in normal circumstances, ensures that the total sum of money deposited does not vary greatly. In consequence, banks can allow depositors the freedom to withdraw funds at little or no notice, whilst at the same time making loans to borrowers which last for many years. The banks are said to engage in maturity transformation, that is, they borrow short and lend long. It is not only banks that do this. Building Societies lend money on mortgages for periods up to thirty years, whilst still allowing most depositors to withdraw funds on demand or at short notice.

I. Key terms:

Borrower	- позичальник – legal entity that attracts borrowed money through loaning or issuing securities
Lender	- кредитор – legal entity that stands ready to lend money for a certain period of time and commission
Fund	- фонд, запас, кошти; ощадна або інвестиційна установа – a reserve of money or investments held for a specific purpose, e.g. to provide a source of pensions or to sell as units (unit trust, etc.)
Broker	- брокер – an intermediary between a buyer and a seller in a highly organized market, e.g. a stockbroker, a commodity broker or a market operator working on their own account, such as insurance broker, pawnbroker or bill broker.
Transaction	- - ділова операція – conducting through business with somebody; buying and selling of financial instruments.
Default	- - невиконання зобов’язань несплата – usually a failure to make payments or repayments of interest or principal on the due date.
Bad debts	- безнадійні борги – debts that are not likely to be repaid (the reserves are made to redeem them).
Mortgage	- застава, іпотечний кредит – a legal agreement conveying conditional ownership of assets as security for a loan and becoming void when the debt is repaid.

II. Answer the following questions:

1. What is the central economic function of a financial system?

2. What are the two distinct approaches to the classification of the main economic function?

3. Compare direct and indirect finance. What are the advantages and disadvantages of them.

4. What is the main function of the general-purpose bank?

5. What is “maturity transformation”?

6. Are only banks engaged in “maturity transformation”?

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