Financial institutions, Instruments, and Markets

The Business Environment

The business does not operate in a vacuum but in an environment influenced by various forces, variables, and
systems. In finance, the business environment is dived into international, national, regional, local levels. Regardless of the
nomenclature on the business environmental layers, business is affected by different outside forces.

Political System

Financial
Economic System
System

Socio-Cultural
Technological System
System
Legal
The Business System

The Societal Environment of the Business

The financial system is one of the factors that directly or indirectly affect the financial operation of a business
organization. A system is composed of several parts with interrelated functions. It one part of the system is dysfunctional;
the operation of the whole system is expected to be adversely affected.

The Financial System

The financial system at the societal environment or regional level is principally responsible for the flow of money
or funds from the lender to the borrower. The financial system controls, regulates, and facilitates the saving, borrowing,
lending, and investing activities happening among the different players in the system.

All components of society–households, business, both financial and non-financial, non-profit organizations, the
Church, and the government – exist in the financial environment. This is due to the fact that all of them need finance to
survive. They are called participants in the financial system. Financial institutions encourage people and companies to save
for the future, hedge against risks, and acquire capital for consumption and investment. Households make deposits, borrow,
and invest, so do all the other components mentioned. The central bank of the different countries with their respective
monetary boards defines the rules, regulations, and policies that will affect the country in general and all the members of
society in particular. The banks and the financial institutions existing in society make up the financial environment with the
central bank at the top or at the center of the environment.
 There are six participants or sectors in the financial system. They are:

1. Household or consumers;
2. Financial institutions/intermediaries;
3. Non-financial firms;
4. The government;
5. The central bank; and
6. Foreign participants

Households – household or consumers are generally described as that group receiving income, majority of which typically
come from wages and salaries. Such income is spent on goods and services and part is saved (if there is enough to save).

Financial Institutions/Intermediaries – financial institutions/intermediaries are the firms that bridge the gap between the
surplus units or investors/lenders and the deficit units or borrowers. They channel the funds from the lenders to the
borrowers. They include the depository institutions and the non-depository institutions. Other than being channels, they are,
at times, also lenders and borrowers themselves.

Non-Financial Institutions – the non-financial institutions are the business other than the financial institutions or
intermediaries. They include the trading, manufacturing, extractive industries, construction, genetic industries, and all firms
other than financial ones.

The Government – by government is meant the national, provincial, city, and barangays or towns comprising the
Philippines as a whole.

The Central Bank – Bangko Sentral ng Pilipinas (Central bank of the Philippines) and all other central banks of the
different countries are mandated to assure that their respective countries have a stable and healthy financial system.

Foreign Participants – refer to the participants from the rest of the world–households, governments, financial and non-
financial firms, and central banks. Goods and services and financial instruments/securities are exchanged across national
boundaries, as well as within these boundaries.

Figure 1 illustrates the structure of a typical financial system. This system is highly responsible for the channeling
of funds from the savings of the households or business to the individual and business organizations that need funding
support through financial institutions, financial intermediaries, and financial instruments.

Cash returned Cash payments

Cash
investments
Household  Financial
savings/surplus Institutions
Cash loans
cash
Cash  Financial Borrowers
Markets  Individuals
investments  Business entities
Business
savings/surplus  Financial
cash Instruments
 Cash returned
C a sh re turne d Cash payments

Figure1. Typical Structure of a Financial System

In the Philippine financial system, the government plays an active role in the flow of money in the economy
through the Bangko Sentral ng Pilipinas (BSP). The BSP regulates the operations of financial institutions and financial
intermediaries.

Bangko Sentral ng Pilipinas

Banking Institutions Non-Bank Financial Institutions

Private Government Private Government

Banking Banking
Institutions Institutions
Finance Companies Government Service
Insurance System (GSIS
Land Bank of the
Securities Dealers/Brokers
Commercial Rural & Philippines
Social Security System
Banking Cooperative Thrift Banks
Pawnshops
Institutions Banks Development Bank of
the Philippines
Lending Investors Home Mutual
Ordinary Savings & Development Fund
Commercial Philippine Amanah
Mortgage Funds Managers
Banks Banks Bank

Trust Companies
Private
Universal Development
Banks Banks Insurance Companies

Savings and Etc.

Loan
Associations
Banks

Figure 2. BSP and the Banking Institutions and Non-Bank Financial Institutions

The basic elements of a financial system are as follows:

1. Financial institutions
2. Financial markets
3. Financial instruments
4. Lenders (surplus units) and borrowers (deficit units)

FINANCIAL INSTITUTIONS

People commonly equate financial institutions with banks. However, the term does not simply refer to banks.

Financial institutions are institutions or organizations that provide financial services, among others, in the form of
loan, credit, fund administration, financing, depository, and safekeeping. Financial institutions, therefore, is a broad term
that encompasses all organizations that provide the aforementioned financial services.
 Financial institutions, based on the financial services provided, are generally classified as follows:

1. Depository institutions
2. Financial intermediaries
3. Investment institutions

Depository Institutions – are financial institutions that accept deposits (savings, current, and time deposits) from
individuals and business entities, extend loans to borrowers, transfer funds, and manage funds for investment purposes.

Depository institutions include the following:

1. Banks
2. Savings and loan association
3. Trust companies
4. Credit unions

Banks. Banks are institutions authorized to operate and regulated by the BSP under the General banking Law of 2000.
They accept deposits and bills payments, provide loans, and facilitate the transfer of funds domestically or abroad.

Under BSP Circular No. 271, the major classifications of banks operating in the Philippines are as follows:

a. Universal bank
b. Commercial bank
c. Thrift bank
d. Rural bank
e. Cooperative bank
f. Islamic bank

Universal bank. A universal bank is considered the biggest bank in terms of assets, loan portfolio, and revenue. It has the
widest scope of banking activities authorized by the BSP and usually has the most number of branches nationwide and
abroad. In addition to ordinary banking services, a universal bank may perform the following:

a. Involve in underwriting activities

b. Engage in financial activities of investment houses
c. Invest in equities or non-banking institutions

Commercial bank. It is a type of bank that provides commercial loans and offers investment products in addition to the
regular banking service of accepting deposits. Compared to a universal bank, it has more limited banking services.

Thrift bank. Thrift banks, as defined in Republic Act No. 7906, include savings and mortgage banks, private development
banks, and stock savings, loan associations, and microfinance thrift banks that ate organized under existing laws for the
following purposes:

a. Accumulating and investing the savings of depositors

b. Providing working capital to businesses engaged in agriculture, service, and housing
c. Providing diversified financial services to individuals and small and medium enterprises

Rural bank and cooperative bank. Rural and cooperative banks are organized and operating in rural areas. They are
intended to promote and expand the rural economy by providing the people with basic financial services.

The primary target markets of rural and cooperative banks are farmers who need financial help in the production
and marketing of agricultural products. Rural and cooperative banks are also engaged in micro financing to assist small
individual entrepreneurs.
Islamic bank. The Islamic bank, which has been created and organized under R.A. No. 6848, aims to promote and
accelerate the socio-economic development of the Autonomous Region of Muslim Mindanao by performing banking,
financing, and investment operations and to establish and participate in agricultural, commercial, and industrial ventures
based on the Islamic concept of banking.

All business dealings and activities of the Islamic Bank are subject to the basic principles and rulings of Islamic
Sharia Law.

Savings and Loan Association. A savings and loan association, sometimes referred to as a financing and mortgage loan
company, is a financial institution that is engaged in the business of accumulating the savings of its members and
stockholders, and using such accumulations for loans or investments in securities of productive enterprises.

The unique feature of the financing and mortgage loan company is that the depositors are also member borrowers of the
association. The members are vested with rights to direct the managerial and financial goals of the association. In case the
financing and mortgage loan company is a stock corporation, the members have voting rights and may control the
association’s operation.

Trust Companies. A trust company is a legal business entity, usually a major division of a universal or commercial bank,
that acts as fiduciary agent or trustee on behalf of an individual person or corporate entity for the purpose of management,
administration, and final transfer of property to the beneficiary.

In other words, the trust company acts as the custodian of the property for on behalf of the beneficiary for a fee. It
also performs the following related custodial tasks.

a. Asset management
b. Ownership registration for the beneficiary
c. Stock transfer
d. Custodial arrangement like in court proceedings

A trust company may also be appointed as the administrator of the properties of a decedent when indicated in the
last will and testament. In this case, the trust company is responsible for the distribution of the net estate to the beneficiary
after accounting and paying all debts and taxes.

Credit Unions. A credit union is a financial depository institution that is mainly controlled and operated by its members for
the following purposes:

a. Extending credit to members

b. Offering competitive interest rates
c. Promoting the concept of thrift
d. Providing other types of financial services

Credit unions exist to help and extend financial assistance to members by pooling and accumulating funds form all
the members. The funds amassed from the membership fees shall be made available for borrowing by the members who are
in need. Only those who have accounts with the credit union are considered members and owners.

Financial Intermediaries – a financial intermediary is a type of financial institution that acts as the middleperson between
two parties – the investors and the borrowers. Financial intermediaries raise and accumulate money from investors and
offer the accumulated money to individuals or corporate entities in need of financial assistance.
 The concept of financial intermediaries is very broad. It includes all types of financial institutions that receive
money from one party and offer it to another as financial aid. They include banks, insurance companies, brokerage and
investment houses, broker-dealer, mutual funds, and pension funds.

In the strict technical sense, financial intermediaries do not have depository functions similar to banks and other
institutions though some have wide range of financial services. In this text, financial intermediaries do not include
depository and investment institutions.

Hence, financial intermediaries refer to the following:

a. Mutual funds
b. Pension funds
c. Insurance companies

Mutual Funds. Mutual funds accumulate money by selling shares of stocks or bonds of publicly-listed corporations to
individuals or corporate investors. The funds from the proceeds of the sale are pooled together and channeled to the
borrowers.

The funds accumulated from individual or corporate entities are used to buy stocks, bonds, or other market
instruments. This portfolio of financial securities is managed by a professional fund manager and the investors receive their
fair share of the investment in the form of dividends or stocks price appreciation.

Pension Fund. A pension fund is set up by a business for the purpose of paying the pension requirements of all private-
sector employees who retire form the business organization upon reaching their retirement age.

The pension fund represents the compulsory contributions of the employer or the combined contributions of the
employer and the employees depending on the type of pension plan. This fund, under the administration of the trustee, may
be invested in financial securities like bonds, stocks, treasury shares, or and high-yield investment. The employees who
contribute to the pension fund receive return on their investment in the form of dividends and securities appreciation.

Insurance Companies. An insurance company acts as a financial intermediary by pooling together the proceeds of
insurance policies sold to the public and investing the accumulated funds in high-yield maturing securities from investment
houses. Most of the money accumulated by insurance companies from insurance premiums is lent in either medium-or
long-term loan to companies engaged in commercial real estate.

Insurance companies may offer the following products to the public:

a. Life insurance
b. Health insurance
c. Car insurance
d. Fire insurance
e. Crop insurance
f. Marine insurance
g. Other insurance products

Individuals or corporate entities enter into an agreement with an insurance company as a protection against the
risks inherent to the business or on the life of the individual. In return, the individual or the business pays a premium to the
insurance company in exchange for the expected benefit the company or the individual may receive when the risk happens.

Investment Institutions – an investment institution is a company engaged in buying securities of other companies which
are listed in the stock exchange for investment purposes only. Hence, the buying and selling of financial securities are not
the primary business activities of an investment institution.
 In other words, an investment institution or company simply holds to the securities it acquired from other
companies. Financial securities are held up to the time of their maturity. This financial institution earns income from
holding the securities in the form of interest or dividends.

An investment institution is usually composed of very wealthy investors. The resources of these investors are
pooled together in the institution for the purchase of financial securities of high-grade companies. Mutual funds and
insurance companies likewise pool their financial resources together to form an investment company for investment
purposes only.

FINANCIAL MARKETS

Another element that plays a crucial role in the whole financial system at the national or international level is the
financial market.

Market refers to the place where the sellers and the buyers of goods or services meet. In the market, the major business
happening is the selling-buying activity, in which exchange occurs. The exchange process indicates that the seller and the
buyer agree on the exchange price.

Financial market refers to the place where the selling-buying activity occurs to trade equity securities such as bonds and
stocks, currencies, derivative securities, notes, and mortgages. The selling-buying transaction happening in the financial
market is called trading activity. The kinds of financial transactions and financial securities traded determine the types of
financial market.

The typical market, among others, includes the following:

1. Capital market
2. Money market
3. Primary market
4. Secondary market
5. Public market

Capital Market

The capital market is a financial market where stocks and bonds are issued for medium-and long-term periods.
Stocks are treated as equity securities while bonds are technically considered debt securities. Investors who hold stocks
receive return from the investment in the form of dividends while those who hold bonds earn income in the form of interest.

The concept of medium-and long-term periods is relative. There is no universal rule as or when the financial
securities can be considered medium-or long-term. Hence, the capital stock market treats the securities having a period of
three to five years as medium-term, and those having a period of more than five years as long-term securities.

Large financial transactions happen in the capital market. The volumes of trading can reach millions every day
while the amount involved can be up to billions of pesos for one trading period.

In the Philippines, the capital market is the Philippine Stock Exchange (PSE) created in 1994 from the two defunct
capital markets – the manila Stock Exchange and Makati Stock Exchange.

Money Market

The financial market is classified as money market when the financial securities being traded have a period of
less than one year. This type of financial security is called short-term security. Since short-term securities are not intended
to be held for more than one year, they are also referred to as trading securities.
 In addition to short-term stocks and bonds, money market also trades commercial papers and treasury bills.
Commercial papers and treasury bills have a maturity of less than one year.

The money market, therefore, trades financial securities that are highly liquid or readily marketable. The term
highly liquid or readily marketable implies that there are available sellers and buyers of the financial securities.

The capital market can also be considered money market when it trades financial securities that are short-term,
highly liquid, and readily convertible to cash. The Philippines Stock Exchange is both a capital market and a money market.

Primary Market

The primary market is a financial market where a corporation can issue new shares of stock. Stock corporation
that need fresh capital can raise the required funds by issuing new shares of stock. The primary market facilitates the raising
of the required amount when the investors directly buy the new shares from the issuing corporation.

New shares can be issued only by the corporation from the unissued authorized shares. When the new shares to be
issued are considered large, underwriting companies and investment banks facilitate the sale of the new shares until the
required amount of the issuing corporation has been reached.

Therefore, the trading of financial securities in a primary market happens between the issuing corporation and the
investors or investment banks. The proceeds of the trading go to the issuing corporation.

Secondary Market

The secondary market is a financial market where financial securities are traded between or among investors. In
the secondary market, there is no issuance or new shares from the corporation.

The secondary market, therefore, exists after the corporation has issued new shares to the investors in the primary
market. The issuing corporation is no longer involved in the secondary market. Hence, the proceeds of the trading in the
secondary market go to the seller of the securities.

An investment bank that brings the shares from the issuing corporation directly to the primary market may trade
the financial securities in the secondary market. The primary market becomes a secondary market when the trading of
financial securities is between or among investors already, and not between the issuing company and the investors.

Public Market

A public market is a market in which the financial securities of publicly-listed corporation are traded following a
standardized contract agreement and procedures. Corporation is classified as publicly-listed when its shares are available
for sale to the public. Basically, a public market is an organized financial market.

Trading in the public market immediately starts during the day once the market has been officially opened.
Investors are properly informed of any point the trading time of the current price of the stocks and bonds and other related
information necessary in trading.

FINANCIAL INSTRUMENTS

The third element of the financial system at the regional or national level is the financial instrument. Without it,
financial institutions and financial markets can hardly exist. The financial institutions and financial markets carry out their
activities through the financial instruments.
 Financial instruments refer to contract that give rise to the formation of financial assets of one entity and at the
same time the creation of a financial liability or an equity instrument in another entity.

In all financial instruments, two parties are involved. One party has the contractual right to receive the financial
assets, and the other party has the contractual obligations to pay or deliver the financial assets.

The most common forms of financial instruments are as follows;

1. Cash – on the part of the holder, ash is a financial asset. However, on the part of the government such as
the Bangko Sentral ng Pilipinas, cash is a financial liability.
2. Check – it is a financial asset of the payee, but is considered a financial liability of the drawer or issuer.
3. Loan – it is a financial asset of the lender or creditor and a financial liability of the borrower of the
debtor.
4. Bond – it is a financial asset of the holder or investor but considered a financial liability of the issuing
company.
5. Stock – it is a financial asset of the investor or shareholder but an equity of the issuing company.

Bonds The Business

Business entities may raise the necessary funding requirements to support their investing activities by issuing
bonds. Similarly, the Philippine national government, when it falls short on the collections of taxes and import duties, may
raise the necessary money to support expenditures by issuing or floating bonds either in the local market or abroad.

A bond is a financial instrument that represents a contractual debt of the party issuing the bond. The issuing party
may either be a private business entity or a government. This type of financial instrument is evidenced by a certificate
called bond indenture.

Usually, the issuer makes a promise under oath to pay the specified amount borrowed at a determinable future time
with periodic interest payment at a stated rate until such time that the whole amount borrowed is fully settled. The holder of
the bond, therefore, earns income through interest.

The most common types of bonds are as follows:

1. Term bond
2. Serial bond
3. Secured bond
4. Debenture bond
5. Convertible bond
6. Callable bond

Term Bond. It is a bond that has a single maturity date. The bond can be a single lone bond, or can be composed of several
bonds with the same maturity date.

For example, a corporation has been authorized to issue a P10 million-term bond on March 1, 2018 whish will
mature on March 1, 2028. Investors who acquire the bond on different dates after March 1, 2018 will have the same
payment date which is March 1, 2028.

However, investors are not precluded to cancel or surrender the term bond prior to its maturity date. Hence, an
investor who acquires a bond on September 1, 2019 can surrender the bond any time prior to march 1, 2028.
Serial Bond. A serial bond is a kind of bond that has a series of several maturity dates instead of a single maturity date. For
example, a 10-year serial bond issued on March 1, 2018 may have a series of maturity dates every two years from the date
of issuance.

When the bond is serial, a portion of the total debt obligations is paid out or settled every maturity date. The total
bond obligations, therefore, are reduced gradually as time passes by.

Companies usually issue serial bonds when they feel that the cash raised from the sale of bonds is no longer
necessary as the project is moving towards its completion stage. By gradually cancelling the debt obligation, the financing
charges brought about by interest expense are reduced.

Secured Bond. It is a type of bond that is secured by the issuing company. The security is issued in the form of real
property which serves as collateral in the event of default on the part of the bond issuer.

Two liabilities arise when a bond is issued the first liability is the interest which is payable every interest payment
date indicated in the bond indenture. The second liability is the face value of the bond. Default arises when either the
interest or the principal amount is not paid on the designated payment dates.

A bond is called collateral trust bond when it is secured by the stocks or bonds of other companies. There are
also instances when the issuing company secures the bond by the stream of cash flows expected from the investment
project.

Debenture Bond. A bond is considered debenture bond when it is not supported by any collateral or security as assurance
in times of non-payment or default.

Companies with high credit ratings and the Philippine government issue debenture bonds. Investors who buy
debenture bonds issued by private corporations have a strong belief on the financial capacity of the issuing company based
on the past financial performance shown in its financial statements.

On the other hand, domestic and foreign investors who buy debenture bond issued by the Philippine government in
various stock exchanges worldwide are working on the theory that no government will ever go to a state of bankruptcy. For
them, it is easy for the government to raise money in the form of taxation and other charges.

Convertible Bond. A bond is a debt security. As such, a bondholder is also referred to as a creditor.

A convertible bond is a bond which can be converted into a share of stock in a later date. The option to convert
must be vested in the bondholder and not on the issuing company.

The choice to convert the bond gives preferential right to the bondholder to become a shareholder of the company
instead of being a creditor. Issuing a convertible bond gives the impression that there is some value inherent in the
company.

Callable Bond. Bonds have maturity dates indicated on the face of the indenture. The issuing company is expected to pay
the bondholder on the maturity date. However, the issuing company may call or redeem the bond prior to its maturity date.

The bond is callable when the issuing company has the option to redeem the bond prior to its maturity date. In
most instances, the company pays a higher amount, or technically called at a premium, when the bond is redeemed prior to
its maturity period.

The issuing company redeems the bond prior to its maturity date under the following instances:

a. The company has accumulated enough funds to continue the investment project.
b. The investment project is finished ahead of schedule or at lesser costs.
c. There is a substantial decrease in the interest rate.
 When the current interest rate is significantly lower than the rate appearing on the indenture, the issuing company
usually recalls the bond and reissues another bond at a lower interest rate.

Stocks

Stock is a financial security that signifies ownership of the assets of the corporation. Only stock corporations are
authorized by the Securities and Exchange Commission (SEC) to issue stocks; hence sole proprietorships and partnerships
can never issue shares of stock.

The holders of the shares of stocks as evidenced by the stock certificate are called shareholders or stockholders.
The shareholder has claim on the net assets of the business as owners of the corporation.

The number of shares issued determines the percentage of ownership of the corporation. If the corporation has
10,000 authorized shares issued and outstanding, a holder with 2,500 shares will have 25% ownership on the net assets of
the corporation. This indicates that the holder can control the operation and decision-making of the corporation by 25%/

The two major types of stocks are as follows:

1. Common stock or ordinary shares

2. Preferred stock or preference shares

Common Stock. The common stock or ordinary share is a financial instrument whose holders do not have preference over
each other. The common stockholders have the same rights and privileges in terms of dividend or asset distribution with
other stockholders.

A corporation authorized to issue only one class of stock will issue common stocks. Holders of the common stocks
have the least priority on the income of the corporation during dividend distribution. In addition, the common stockholders
have the least preference on the assets of the corporation at the time of liquidation.

in the event that the income of the corporation is exceptionally good, the common stockholders will benefit most
of the income since the other types of shareholders, including the creditors, have a fixed rate of return. In times of losses,
however, the common shareholders will share the heavy bulk of the losses.

A common stock is a voting stock. One share of stock corresponds to one vote. Hence, a common stockholder with
500 shares has 500 votes. A common stockholder who aspires to practically control the operation of the business should
have more than 50% of the total common stock issued and outstanding.

The rights of the common stockholders include the right to vote during the election of the board of directors, and
the right to subscribe for additional shares to be issued.

Preference Share. The preference share is a kind of stock that is preferred over common stock. These preferences are in
terms of the following:

a. Distribution of earnings or dividend distribution

b. Net assets at the time of liquidation

The privileges of the preference shares outline the distinct difference between common stockholders and
preference stockholders. However, preference shareholders do not have voting rights.

The preference on the distribution of profit means that preference stockholders are paid first of the dividends
accruing to them. It indicates that ordinary shareholders can only share the dividends once all the dividend claims of the
preference shareholders are fully settled.
 However, in most instances, the claim of the preference shareholders on the income is fixed. For example, a
preference share with 10% rate means that the preference share shall receive 10% income on its total preference equity. The
excess shall be provided to the ordinary shareholders.

Similarly, the preference on the net asset means that the equity of the preference shareholders shall be fully settled
at the time of liquidation before settling the claims of the ordinary or common stockholders. Put simply, the equity of the
common stockholders is only settled after fully paying the equity of the preference shareholders. Any amount in excess
after settling the equity claims of the preference shareholders can be given to ordinary shareholders.