Introduction to the Financial System What is financial system? A financial system consist of institutional units and markets that interact, typically in a complex manner, for the purpose of mobilizing funds for investment, and providing facilities, including payment system, for financing of commercial activity. The collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world. The role of financial institutions within the system is primarily to intermediate between those that provide the funds and those that need the funds, and typically involves transforming and managing risk. Financial markets provide a forum within which financial claims can be traded under established rules of conduct, and can facilitate the management and transformation risk. They also play important role in identifying market prices (price discovery). (IMF(http//:IMF.ORG., Nov.2004) Its primary task is to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the global economy can grow and increase the standard of living enjoyed by its citizens.

Circular Flow of Income, Payments, and Production in the Global Economic System Flow of productive services The basic function of the economic system is to allocate scarce resources – land, labor, management skill, and capital – to produce the goods and services needed by society. Flow of expenditures for consumption & taxes Flow of incomes Flow of production of goods & services Producing units (mainly business firms and governments) Consuming units (mainly households) The global economy generates a flow of production in return for a flow of payments. The circular flow of production and income is interdependent and never ending.

The Role of Markets in the Global Economic System Most economies around the world rely principally upon markets to carry out the complex task of allocating scarce resources. The marketplace is dynamic. It determines what goods and services will be produced and in what quantities through their prices. Markets also distribute income by rewarding superior producers with increased profits, higher wages, and other economic benefits. There are essentially three types of markets within the global economic system. The factor markets allocate factors of production (land, labor, skills, capital) and distribute income (wages, rent) to the owners of productive resources. Consuming units use most of their income from factor markets to purchase goods and services in the product markets. The financial markets channel savings to those individuals and institutions needing more funds for spending that are provided by their current incomes.

Types of Markets Product markets Financial markets Factor markets Flow of production Product markets Goods and services Flow of payments Flow of payments for consumption and taxes Flow of funds (savings) Flow of financial services, income, and financial claims Financial markets Consuming units (mainly households) Producing units (mainly business firms and governments) Factor markets Productive services Flow of incomes

Transfer of funds in the financial system Market Returns Returns Funds Funds Government Involvement Households Firms Government Households Firms Government Savers Borrowers Funds Financial Intermediaries Funds Returns Returns Infrastructure and Environtment Source: Hubbard (2005)

The role of financial system Risk Sharing Information Financial System Financial Market Intermediaries Liquidity Funds Returns Firms Governments Households Borrowers Savers Issues: The Law of large number Pooled Information Free Riding Issues: Asymmetric information Moral Hazard Adverse Selection Source: Hubbard (2005)

The Global Financial System: Channel for Savings and Investment Demanders of funds (mainly business firms and governments) Flow of loanable funds (savings) Suppliers of funds (mainly households) Flow of financial services, incomes, and financial claims Nature of savings Households: current income – tax payments – consumption expenditures Businesses: retained earnings Governments: current revenues – expenditures Nature of investment Households: purchase of a home Businesses: expenditures on capital goods and inventories Governments: building/maintaining public facilities The financial markets enable the exchange of current income for future income and the transformation of savings into investment so that production, employment, and income can grow, and living standards can improve. The suppliers of funds to the financial system expect not only to recover their original funds but also to earn additional income as a reward for waiting and assuming risk.

Functions Performed by the Global Financial System and the Financial Markets Savings function. The global system of financial markets and institutions provides a conduit for the public’s savings. Wealth function. The financial instruments sold in the money and capital markets provide an excellent way to store wealth. Liquidity function. Financial markets provide liquidity for savers who hold financial instruments but are in need of money. Credit function. Global financial markets furnish credit to finance consumption and investment spending. Payments function. The global financial system provides a mechanism for making payments for goods and services, in the form of currency, checking accounts, debit cards, credit cards, digital cash, etc. Risk protection function. The financial markets offer protection against life, health, property, and income risks, by permitting individuals and institutions to engage in both risk-sharing and risk reduction. Policy function. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation.

Financial Intermediaries Saving and Loan Products other fee based products Commercial Banks Securities Companies (Investment Banks) Brokerage, Trading and securities transaction, Underwriting, investment management (including mutual fund), asset management, financial advisory Life Insurance General insurance Reinsurance Insurance Defined Benefit and Defined Contribution Pension Fund Leasing, Consumer Financing, credit cards, and Factoring Multifinance SME Financing, personal financing Microfinance Personal Financing Pawn Shop Source: Chatterji (2001)

Types of financial markets Money market vs Capital market Primary vs secondary markets. (Financial capital is raised when new securities are sold in the primary markets. Security trading in the secondary markets then provides liquidity for the investors) Open vs Negotiated markets (In open markets, financial instruments are sold to the highest bidder, and they can be traded as often as is desirable before they mature.In negotiated markets, the instruments are sold to one or a few buyers under private contract.) Spot vs Futures, Forward, and Option markets (In the spot market, assets are traded for immediate delivery (usually within one or two business days). A futures or forward market is designed to trade contracts calling for the future delivery of financial instruments. Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time to be traded Organized vs Over-the-counter markets Stock vs debt (fixed income) markets Foreign exchange markets International vs domestic markets

Financial market instruments Capital market instruments - long-term maturity (more than 1 year) - corporate stock - corporate bonds - government bonds - municipal bonds - eurobonds - mortgages Money market instruments – short-term maturity (less than 1year) - treasury bills (T-Bills) - negotiable certificate of deposits (NCDs) - bankers’ acceptance - commercial paper - federal funds - eurocurrencies - Sertifikat Bank Indonesia

Factors Tying All Financial Markets Together Credit, the common commodity. The shifting of borrowers among markets helps to weld the financial system together and to balance the costs of credit in the different markets. Speculation and arbitrage. Speculators who gamble on their market forecasts and arbitrageurs who watch for profitable arbitrage opportunities help to level out prices and maintain price consistency among the markets. Perfect and efficient markets. There is some research evidence suggesting that financial markets are closely tied to one another due to their near perfection and efficiency. Financial markets in the real world. In the real world however, market imperfection and information asymmetry exist.

Types of Financial Intermediaries in the US

Sistem Keuangan di Indonesia Otoritas Moneter Bank Indonesia Sistem Moneter Bank Umum Perbankan BPR Sistem Keuangan Modal Ventura Leasing Di luar Sistem Moneter Lembaga Pembiayaan Factoring Kartu Kredit Pembiayaan Konsumen Asuransi Dana Pensiun Pasar Modal Lembaga Lainnya Pefindo Pegadaian Pialang Pasar Uang Kantor Pos

Ratio of Assets of Financial Intermediaries to GDP of several countries   Indonesia Malaysia Thailand Singapore Assets US$ billion % of GDP US$ billion Commercial banks 138 56% 166 160% 172 115% 213 233% Insurance firms 10 4% 20 20% 5 3% 46 50% Mutual funds 8 21 18 12% Pension funds 4 2% 58 7 5% 60 66% Stock market capitalization 55 22% 168 162% 119 79% 148 Funds raised through capital market 7% n/a GDP 247 104 150 91 Exchange rate 8.441 39,7 1,7 Source: Srinivas, PS (2004)

Structure of Assests of Nonbank Financial Institutions in Indonesia   2001 2002 2003 Investasi Amount % Pension Funds - Bank deposits 23 69 28 27 57 - SBI 1 - Shares 2 5 4 - Corporate bonds 3 10 12 9 19 - Government bonds - Direct investment 7 - Land & Buildings 6 - Mutual funds - Others Total 34 100 40 47 Insurance 31 59 37 58 35 44 - Bonds 16 21 11 8 53 64 80 Source: Srinivas, P.S. (2004)

Banks’ dominance of Indonesia’s Financial System Keterangan Tahun 2001 Tahun 2002 Tahun 2003 Asset Kontribusi Bank Umum 1,099.7 88.0% 1,112.2 86.4% 1,213.5 85.1% Bank Perkreditan Rakyat 4.7 0.4% 6.4 0.5% 9.1 0.6% Perusahaan Asuransi 64.8 5.2% 77.6 6.0% 94.1 6.6% Dana Pensiun 34.9 2.8% 41.2 3.2% 49.4 3.5% Perusahaan Pembiayaan 37.3 3.0% 39.9 3.1% 47.2 3.3% Perusahaan Sekuritas 6.7 7.8 10.0 0.7% Pegadaian 1.8 0.1% 2.4 0.2% 2.7 Total 1.249,9 100% 1.287,5 1.426,0 Source : BI, MoF.