Economic system relies heavily on financial resources and transactions, and economic efficiency rests
in part on efficient financial markets.

Financial markets consist of agents, brokers, institutions, and intermediaries transacting purchases
and sales of securities. The many persons and institutions operating in the financial markets are linked
by contracts, communications networks which form an externally visible financial structure, laws, and
friendships. The financial market is divided between investors and financial institutions.

The term financial institution is a broad phrase referring to organizations which act as agents, brokers,
and intermediaries in financial transactions. Agents and brokers contract on behalf of others;
intermediaries sell for their own account. Financial intermediaries purchase securities for their own
account and sell their own liabilities and common stock. For example, a stockbroker buys and sells
stocks for us as our agent, but a savings and loan borrows our money (savings account) and lends it to
others (mortgage loan). The stockbroker is classified as an agent and broker, and savings and loan is
called a financial intermediary. Brokers and savings and loans, like all financial institutions, buy and
sell securities, but they are classified separately, because the primary activity of brokers is buying and
selling rather than buying and holding an investment portfolio. Financial institutions are classified
according to their primary activity, although they frequently engage in overlapping activities. The
classification of financial market participants is outlined in Figure 1.

Financial markets provide our specialized, interdependent economy with many financial services,
including time preference, distribution of risk, diversification of risk, transactions economy,
transmutation of contractual arrangements, and financial management.

Time Preference

Time preference refers to the value of money spent now relative to money available for spending in
the future. Businesses are frequently making decisions among short-term and long-term uses of funds,
and business executives must judge between outlays which provide a return in the near term and those
which pay off many years from now. They must decide upon commitments requiring funds now and
those requiring funds later, by allocating not only funds that they expect to receive currently, but also
those that they expect to receive in the future.

The money and capital markets price funds so that businesses and governments can make rational
economic allocations of capital. The price of capital is set in a competitive marketplace by supply and
demand forces. The market price of capital is compared by businesses to the expected returns in
proposed capital expenditures. Businesses allocate their capital to real investments whose return is at
above the cost of capital. Long-term investments are compared to short-term investments using the
financial-market-determined cost of capital. Consequently, the allocation of capital between short-and
long-term investments depends on the free play of supply and demand in an open market.

Like businesspersons, consumers may decide upon a time pattern for expenditures that does not
necessarily coincide with their current or expected income flows. Financial markets allow us to
implement time adjustments in the payments for goods. Without them, there would be no opportunity
to earn interest on savings, and expenditures would be limited to current receipts and cash. Savings
allows many consumers to postpone consumption and to receive returns from investments.
    Risk Distribution

    The financial markets distribute economic risks. Employment and investment risks are separated by
    the creation and distribution of financial securities. On a larger scale, the money and capital markets
    transfer the massive risks from people actually performing the work (employment risks) to savers
    who accept the risk of an uncertain return. The chance of failure for a 100 million € mobile phones
    manufacturer may be divided among thousands of investors living and working all over the world. If
    the mobile phones business fails, each investor loses only part of his or her wealth and may continue
    to receive income from other investments and employment.

    Figure 1 Classification of participants in the financial markets

    Participants                                                   Classification

    Commercial Banks
    Savings Banks
    Savings and Loans
    Credit Unions
    Finance Companies                              Financial                         Financial
    Life Insurance Companies                    Intermediaries           Financial Institutions
    Pension Funds                                                        Institutions
    Investment Companies
    Real Estate Investment Funds
    Mortgage Bankers                         Securities
                                             Agents andMarket
    Investment Bankers                          Institutions
    Securities Dealers and Brokers
    Clearing Houses
    Stock Exchanges
    People who own stocks, bonds,
    and other securities

    People who borrow money with
    mortgages, installment loans,                             Investors and Borrowers
    and other instruments

    Businesses (Non financial)


    Diversification of risk

    In addition to permitting individuals to separate employment and investment risks, the financial
    markets allow individuals to diversify among investments. Diversification means combining
    securities with different attributes into a portfolio. Ordinarily, a diversified portfolio of financial
    claims is less risky than a portfolio consisting of one or at most a handful of similar securities. Total
    risk is reduced because losses in some investments are offset by gains in others. The benefits of
    diversification are possible due to the existence of large, diversified financial markets where investors
    may buy and sell securities with minimum transactions cost, regulatory interference, and so forth.

Functions of Financial Intermediaries

Financial markets facilitate the movement of funds from those who save money to those who invest
money in capital assets. Savings are distributed among investments and expenditures through
securities traded in the financial markets. Financial institutions facilitate and improve the distribution
of funds, money, and capital in several respects:

    1.   Payments mechanism
    2.   Security trading
    3.   Transmutation
    4.   Risk diversification
    5.   Portfolio management

All of these functions are important to an efficient financial system, and managers are improving
execution capability through improved electronic communication, computer processing, and
institutional design. Note that these functions are characteristic of agents. Financial intermediaries are
special types of agents that collect information about economic entities, evaluate financial
information, and package financial claims.

The financial intermediary, by purchasing primary securities and issuing secondary securities adds
choices to borrowers and lenders. Issues of financial intermediaries are termed secondary securities.
The process of changing the terms of money bought and sold by financial intermediaries is termed
transmutation. For example, savings and loan associations obtain money with short-term, small-
balance savings deposits to make 20- to- 30 year mortgage loans in amounts usually exceeding
10,000 €. Timing and amount are usually changed through transmutation, with alterations limited
only by the creativity of the financial institution and the acceptance of its customers.

Financial institutions also act as portfolio managers and advisers over most of the primary
securities owned by investors. The private financial sector manages most of the home
mortgages, commercial mortgages, consumer loans, state and local government securities,
and business loans. In addition, nearly one-fourth of outstanding common stocks are
managed by investment companies, and a large portion of the remaining shares of stock are
invested with the advice of trust institutions. The most important reasons for obtaining
institutional management are:
         convenience,
          protection against fraud,
          quality of investment selection, and
          a low transaction cost.
Financial institutions provide a convenient place where savers can safely invest excess money and
consumers can easily borrow funds. Investments are protected against unscrupulous borrowers by the
institution’s qualified loan officers and a bevy of collectors and attorneys. Well-trained investment
analysts and loan officers seek good investment opportunities and screen prospective securities so as
to obtain the best yield available for the risk level that suits the investor’s preferences.

Income tax differentials among individuals and businesses are mitigated by intermediaries which
transfer tax deductions from low-to high-income taxpayers and provide tax-free services in place of
taxable interest. For example, pension funds owe their existence to tax differentials. Income invested
in and earned by pension funds is not taxed until retirement when rates are generally lower than
before retirement. Commercial banks reward depositors with “free services”, which are nontaxable,
rather than pay interest, which is taxable. The depositors receive nontaxable benefits such as checking

    accounts, traveler’s checks, and low-rate loans in return for the use of their money. Leasing
    intermediaries, a type of finance company, pass depreciation tax shields from equipment users in low-
    tax brackets to equipment owners in high-tax brackets. The depreciation expense reduces income
    taxes more for high-than for low-tax-bracket owners.


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