Understanding the Financial System and its Components

Posted on Dec 16, 2024 in Economy

The Financial System: Structure and Key Components

The financial system is composed of a set of intermediaries that channel resources towards financing private consumption, business investment, and public spending.

1. Funds or Financial Assets

These products provide a means of maintaining wealth for those who possess them (assets) and a debt for those who owe (liabilities). They differ by:

  • 1.1. Liquidity: Measures the ease and certainty of realizing the assets in the short term without incurring losses.
  • 1.2. Risk: Probability that the debtor will not pay.
  • 1.3. Performance: An asset’s capacity to produce interest.

2. Financial Intermediaries

These are institutions that specialize in mediation between savers and investors. There are two main types:

  • 2.1. Banking: Offer checking or savings accounts, and their financial products are accepted as a means of payment.
  • 2.2. Non-bank: Insurers cannot offer financial products that are considered money.

State Functions in the Bank of Spain

  • 1. Hold and manage foreign reserves and precious metals that are not transferable to the ECB.
  • 2. Promote the stability of international payment systems.
  • 3. Circulate coins.
  • 4. Act as the financial agent of public debt.
  • 5. Monitor the performance of credit institutions.

Difference Between Private Banking and Savings Banks

  • 1. Private Banking: Provides financing to operators, maintaining a portion of their funds in cash to cover possible withdrawals, with funding given on a loan basis.
  • 2. Savings Banks: Cannot raise funds by issuing equity securities and receive beneficial tax treatment. They also perform charitable activities.

Non-bank Financial Intermediaries

  • 1. Instituto de Crédito Oficial (ICO): Subsidizes economic sectors and funds infrastructure projects facing difficulties.
  • 2. Insurance Companies: Issue insurance policies.
  • 3. Pension Funds: Mutual funds that complement the state retirement pension paid by social security.
  • 4. Leasing Companies: A financing system whereby a company can incorporate a capital asset in exchange for a periodic lease payment.
  • 5. Factoring Companies: Involves the sale of all rights represented by receivable invoices.
  • 6. Brokerages in the Money Market: Manage highly liquid assets in the stock market.
  • 7. Stock Market: Civil partnerships serving the public, facilitating the negotiation of securities in a competitive manner.

The most important securities are:

  • Fixed Income: Securities with a fixed return agreed upon beforehand.
  • Equities: Shares.

Stock Market Index

An indicator of market behavior as a function of the contributions of the most representative securities.

Equity Market

  • 1. Primary Market: Assets are created, and savings are channeled into investment.
  • 2. Secondary Market: This is where shares acquired in the primary market are sold without affecting the company.

Business Financing

  • 1. Own:
    • 1.1. Contributions from Owners: When buying company shares, resources are contributed.
    • 1.2. Reserves: Profits that are not distributed and remain in the company as self-financing.
  • 2. External:
    • 2.1. Trade Credit: Automatic financing that occurs when a company makes purchases on credit from its suppliers.
    • 2.2. Loans: Involve interest that is repaid with the company’s profits.
    • 2.3. Bonds: Loans to individuals by issuing bonds.

Shares vs. Bonds

  • Shares: Entitle the purchaser to a dividend, a share of ownership proportional to the assets held, and represent self-financing.
  • Bonds: Involve interest; the purchaser makes a loan to the company with the right to have the borrowed amount returned, representing external financing.