Finance: Capital Markets, Financial Management, and Investment Management

CHAPTER 4

The Financial System

It is through a country’s financial system that entities with funds allocate those funds to those who have potentially more productive ways to deploy those funds, potentially leading to faster growth for a country’s economy. A financial system makes possible a more efficient transfer of funds is by overcoming the information asymmetry problem between those with funds to invest and those needing funds. In general, information asymmetry means that one party to a transaction has more or superior information than the other party, resulting in an imbalance of power in a transaction.⁶ In terms of a financial system, information asymmetry can lead to an inefficient allocation of financial resources. In Chapter 9, we look further at the problem of information asymmetry within the context of the principal-agent problem in financial management.

As explained in Chapter 1, the financial system has three components: (1) financial markets, (2) financial intermediaries, and (3) regulators of financial actitivies. In this chapter, we look at each of these components and the motivation for their existence. In addition, as noted by Neave (2009), the financial system includes internally provided financing, which we cover in Chapter 9’s discussion of dividend decision. We begin with a discussion of financial assets.

FINANCIAL ASSETS/FINANCIAL INSTRUMENTS

An asset is defined as any resource that is expected to provide future benefits and, hence, has economic value. ...