There key components of the financial system

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Key Components of the Financial System
1. Financial assets
2. Financial institutions
3. The Federal Reserve and other financial regulators

Financial Assets 

An asset is anything of value owned by a person or a firm. A financial asset is a financial claim, which means that if you own a financial asset, you have a claim on someone else to pay you money. For instance, a bank checking account is a financial asset because it represents a claim you have against a bank to pay you an amount of money equal to the dollar value of your account. Economists divide financial assets into those that are securities and those that aren’t. A security is tradable, which means that it can be bought and sold in a financial market. Financial markets are places or channels for buying and selling stocks, bonds, and other securities, such as the New York Stock Exchange. If you own a share of stock in Apple or Google, you own a security because you can sell that share in the stock market. If you have a checking account at Citibank or Wells Fargo, you can’t sell it. So, your checking account is an asset but not a security. In this book, we will discuss many financial assets, but the following are five keycategories of assets:

1. Money
2. Stocks
3. Bonds
4. Foreign exchange
5. Securitized loans
We now briefly discuss these five key assets. 

Money Although we typically think of “money” as coins and paper currency, even the narrowest government definition of money includes funds in checking accounts. In fact, economists have a very general definition of money: Money is anything that people are willing to accept in payment for goods and services or to pay off debts.   money plays an important role in the economy, and there is some debate concerning the best way to measure it.

Stocks

 Stocks, also called equities, are financial securities that represent partial ownership of a corporation.When you buy a share of Microsoft stock, you become a Microsoft shareholder, and you own part of Microsoft, although only a tiny part because Microsoft has issued millions of shares of stock. When Microsoft sells additional stock, it is doing the same thing that the owner of a small firm does when she takes on a partner: increasing the funds available to the firm, its financial capital, in exchange for increasing the number of the firm’s owners. As an owner of a share of stock in a corporation, you have a legal claim to a share of the corporation’s assets and to a share of its profits, if there are any. Firms keep some of their profits as retained earnings and pay the remainder to shareholders in the form of dividends, which are payments corporations typically make every quarter.

Bonds 

When you buy a bond issued by a corporation or a government, you are lending the corporation or the government a fixed amount of money. The interest rate is the costof borrowing funds (or the payment for lending funds), usually expressed as a percentage of the amount borrowed. For instance, if you borrow $1,000 from a friend and pay him back $1,100 a year later, the interest rate on the loan was $100/$1,000 = 0.10, or 10%. Bonds typically pay interest in fixed dollar amounts called coupons. When a bond matures, the seller of the bond repays the principal. For example, if you buy a $1,000 bond issued by IBM that has a coupon of $65 per year and a maturity of 30 years, IBM will pay you $65 per year for the next 30 years, at the end of which IBM will pay you the $1,000 principal. A bond that matures in one year or less is a short-term bond. A bond that matures in more than one year is a long-term bond. Bonds can be bought and sold in financial markets, so, like stocks, bonds are securities.

Foreign Exchange 

Many goods and services purchased in a country are produced outside that country. Similarly, many investors buy financial assets issued by foreign governments and firms. To buy foreign goods and services or foreign assets, a domestic business or a domestic investor must first exchange domestic currency for foreign currency. For example, consumer electronics giant Best Buy exchanges U.S. dollars for  Japanese yen when importing Sony televisions. Foreign exchange refers to units of foreign currency. The most important buyers and sellers of foreign exchange are large banks. Banks engage in foreign currency transactions on behalf of investors who want to buy foreign financial assets. Banks also engage in foreign currency transactions on behalf of firms that want to import or export goods and services or to invest in physical assets, such as factories, in foreign countries.

Securitized Loans

  If you lack the money to pay the full price of a car or house in cash, you can apply for a loan at a bank. Similarly, if a developer wants to build a new office building or shopping mall, the developer can also take out a loan with a bank. Until about 30 years ago, banks made loans with the intention of making profits by collecting interest payments on a loan until the loan was paid off. It wasn’t possible to sell most loans in financial markets, so loans were financial assets but not securities.  Loans that banks could sell on financial markets became securities, so the process of converting loans into securities is known as securitization.

To take one example, a bank might grant a mortgage, which is a loan a borrower uses to buy a home, and sell it to a government-sponsored enterprise or a financial firm that will bundle the mortgage together with similar mortgages granted by other banks. This bundle of mortgages will form the basis of a new security called a mortgage-backed security that will function like a bond. Just as an investor can buy a bond from IBM, the investor can buy a mortgage-backed security from the government agency or financial firm. The banks that grants, or originates, the original mortgages will still collect the interest paid by the borrowers and send those interest payments on to the government agency or financial firm to distribute to the investors who have bought the mortgage-backed security. The bank will receive fees for originating the loan and for collecting the loan payments from borrowers and distributing them to lenders.
 

Note that what a saver views as a financial asset a borrower views as a financial liability. A financial liability is a financial claim owed by a person or a firm. For example, if you take out a car loan from a bank, the loan is an asset from the viewpoint of the bank because it represents a promise by you to make a certain payment to the bank every month until the loan is paid off. But the loan is a liability to you, the borrower, because you owe the bank the payments specified in the loan.


Financial Institutions
The financial system matches savers and borrowers through two channels: (1) Banks and other financial intermediaries and (2) financial markets. These two channels are distinguished by how funds flow from savers, or lenders, to borrowers and by the financial institutions involved.1 Funds flow from lenders to borrowers indirectly through financial intermediaries, such as banks, or directly through financial markets, such as the New York Stock Exchange.
 

If you get a loan from a bank to buy a car, economists refer to this flow of funds as indirect finance. The flow is indirect because the funds the bank lends you come from people who have put money in checking or savings deposits in the bank; in that sense, the bank is not lending its own funds directly to you. On the other hand, if you buy stock that a firm has just issued, the flow of funds is direct finance because the funds are flowing directly from you to the firm. Savers and borrowers can be households, firms, or governments, both domestic and foreign. Figure 1.1 shows that the financial system channels funds from savers to borrowers, and channels returns back to savers, both directly and indirectly. Savers receive their returns in various forms, including dividend payments on stock, coupon payments on bonds, and interest payments on loans

Figure 1.1

Financial Intermediaries Commercial banks are the most important financial intermediaries. Commercial banks play a key role in the financial system by taking in deposits from households and firms and investing most of those deposits, either by making loans to households and firms or by buying securities, such as government bonds or securitized loans. Most households rely on borrowing money from banks when they purchase “big-ticket items,” such as cars or homes. Similarly, many firms rely on bank loans to meet their short-term needs for credit, such as funds to pay for inventories or to meet their payrolls. Many firms rely on bank loans to bridge the gap between the time they must pay for inventories or meet their payrolls and when they receive revenues from the sales of goods and services. Some firms also rely on bank loans to meet their long-term credit needs, such as funds they require to physically expand the firm.

The Federal Reserve and Other Financial Regulators
During the financial crisis of 2007–2009, many people looked around at failing banks, the frozen markets for some financial assets, and plummeting stock prices and asked: “Who’s in charge here? Who runs the financial system?” In a sense, these are unusual questions to ask because the point of a market system is that no one individual or group is in charge. Consumers decide which goods and services they value the most, and firms compete to offer those goods and services at the lowest price. Few people think to ask: “Who’s in charge of the frozen pizza market?” or “Who’s in charge of the breakfast cereal market?” In most markets, the government plays a very limited role in deciding what gets produced, how it gets produced, what prices firms charge, or how firms operate. But policymakers in the United States and most other countries view the financial system as different from the markets for most goods and services. It is different because, when left largely alone, the financial system has experienced periods of instability that have led to economic recessions. The federal government of the United States has several agencies that are devoted to regulating the financial system, including these:
● The Securities and Exchange Commission (SEC), which regulates financial markets
● The Federal Deposit Insurance Corporation (FDIC), which insures deposits in banks
● The Office of the Comptroller of the Currency, which regulates federally chartered banks
● The Federal Reserve System, which is the central bank of the United States

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