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Financial Sector Legal and Regulatory Toolkit : Part One: Introduction and Overview : I. The Financial Sector: An Overview
A. The Role of the Financial SectorIn general terms, a financial system is comprised of the interactions between the supply of and demand for financial resources. At the most basic level, a financial system should serve to balance these elements. The supply of finance results from the existence of lenders, savers, or investors with financial assets in excess of their current requirements. Lenders, savers, and investors take a variety of forms, including individuals, firms and governments. Demand for funds comes from borrowers or spenders who require additional financial resources. Borrowers and spenders include individuals, firms, governments and international financial institutions (IFIs). In allocating financial resources, the financial sector serves as a transmission mechanism by transferring supply to meet demand on the basis of price. There are two main forms of transmission mechanisms: direct finance and indirect finance. Direct finance occurs through both direct investment and financial markets (though usually with the assistance of various types of financial intermediaries). Direct finance is most familiar in the context of securities exchanges (Macey & Kanda, 1990), which may be defined as "a body that provides a centralized forum in which securities trades are undertaken." An exchange provides the means by which the market prices of securities can be openly established and through which price information can be produced and disseminated to users of the market. On the other hand, an over-the-counter (OTC) market refers to trading done off the floor of an organized exchange. Technology has blurred the distinction between exchanges and OTC markets. While historically, observers have often viewed securities exchanges as philanthropic institutions organized to act in the public interest, this is not in fact the case. Instead, exchanges are self-interested economic organizations which supply services to companies listing their securities in exchange for fees, which typically come in the form of an initial listing fee and an annual fee and to investors wishing to buy or sell securities, once again for fees. Firms are not required to have their securities listed on an exchange, but do so for their own interests. Markets can also be classified as primary and secondary markets. Primary markets are markets in which assets are first offered to investors (e.g., an initial public offering or IPO), while secondary markets encompass trading of assets between investors (e.g., buying and selling company securities listed on an exchange or OTC). Indirect finance involves financial intermediation of some form, which steps in to assist in matching supply and demand. The major types of intermediaries include banks, insurance companies, pension funds, investment institutions such as unit trusts, mutual funds or hedge funds, investment banks or merchant banks, and IFIs. Generally speaking, intermediaries can be characterized as deposit institutions (banks), contractual savings/risk protection institutions, or investment institutions. Indirect finance arises because financial markets are not perfect markets. Their imperfections arise from three main sources: transaction costs, asymmetric information and irrational behavior. Asymmetric information also results in adverse selection and moral hazard. Office of the General Counsel
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