2. OVERVIEW OF THE U.S. FINANCIAL SYSTEM
This chapter explains how financial markets link the savers to the borrowers. Savers can use
two separate channels to lend to borrowers. First, the savers could deposit their funds into a
financial institution that in turn, lends to the borrowers. Second, savers could lend directly to the
borrowers by directly investing in financial securities. Thus, these two channels create a variety
of financial markets, such as the spot and derivative markets, and primary and secondary
markets. Furthermore, we examine the impact of financial innovation and government
regulation of the financial markets. Finally, we define the common financial instruments at the
end of the chapter that we will use for the rest of the book.
The U.S. banking system evolved into a complex system. As the United States was forming,
the public and the government distrusted large, powerful banks. Consequently, the government
passed laws that heavily regulated the banking system, enlarging the number of U.S. banks and
shrinking the banks’ asset size. Moreover, the United States created two layers of commercial
banks: national and state banks. Several government agencies at the federal and/or state level
regulate these banks. Consequently, banks have used ingenious methods and innovations to
circumvent governments’ regulations.
Financial Intermediation
A financial system transfers funds from savers to borrowers. Savers and borrowers can be
anyone. Some households, businesses, and governments are net savers because they spend less
than their income, and they become the source of loans while other households, businesses, and
governments are net borrowers. They spend more than their incomes. For example, many
college students are net borrowers. Students’ incomes are usually lower than their yearly
expenses, and they use student loans to pay for the difference. After graduation, the students
enter the workforce, and they start repaying their student loans. As their incomes continually
rise over time, the former students repay their loans and become net savers, saving funds for
retirement. Using another example, many local and state governments have laws, requiring them
to balance their budgets. This fiscal responsibility forces many local and state governments in
the United States to be net savers while the U.S. federal government has been a net borrower for
the last 50 years.
Transfer of funds from savers to borrowers is vital to an economy. If the borrowers invest
the funds by purchasing machines and equipment, the borrowers can produce more goods and
services. When businesses produce more goods and services, subsequently, the economy grows,
and a growing economy creates jobs and rising incomes. As consumers experience rising
incomes, they buy more goods and services, increasing the living standards. Beauty in the U.S.
financial system is the financial institutions can collect and concentrate the meager savings of
many people and then lend to a large company. For instance, 10,000 savers who have $200 in
their savings accounts could allow a financial institution to grant a business loan for $2 million.