Economics 370 Money and Banking

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Economics 370Money and Banking

• Instructor
• Ryan Herzog

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Daily Overview

• Articles/Paper
• CNNMoney.com
• Economist.com
• Chapter 2 An Overview of the Financial System

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Function of Financial Markets

• Perform the essential function of channeling
  funds from economic players that have saved
  surplus funds to those that have a shortage of
  funds
• Promotes economic efficiency by producing an
  efficient allocation of capital, which increases
  production
• Directly improve the well-being of consumers by
  allowing them to time purchases better

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Financial System
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Direct Finance

• Financial Markets
• Borrowers borrow directly from lenders by issuing
  financial instruments
• Claims on future income/assets
• Assets for lender
• Liability for the seller
• Repayment promises
• Allow individuals to come together and improve
  efficiency
• Allow many individuals to make investments that
  otherwise are not available (education, housing,
  )

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Structure of Financial Markets

• Debt and Equity Markets
• Primary and Secondary Markets
• Where debt and equity securities are sold and
  traded
• Investment Banks underwrite securities in primary
  markets
• Brokers and dealers work in secondary markets
• Exchanges and Over-the-Counter (OTC) Markets
• Types of secondary markets
• Money and Capital Markets
• Money markets deal in short-term debt instruments
• Capital markets deal in longer-term debt and
  equity instruments

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Debt Markets

• Entities use financial markets by issuing debt,
  usually through a bond or mortgage
• Specify a fixed payment amount and the number of
  payments to the lender until maturity.
• Maturity number of years until the instruments
  expiration date
• Short-term less than one year
• Long-term greater than ten years
• Intermediate-term between one and ten years

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Equity Markets

• Equities
• Claims to share in the net income and assets of a
  business
• Make periodic payments to their holders
  (dividends)
• Considered long-term because they do not have a
  maturity date

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Debt vs. Equities

• An equity holder is an residual claimant
• Corporations must pay all their debt holders
  before they pay their equity holders
• But equity holders benefit directly from an
  increase in the corporations profitability

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Primary Markets

• A financial market in which new issues of a
  security are sold to initial buyers from a
  corporation or government agency
• Often times this takes place behind close doors
  usually assisted by an investment bank
• The investment bank underwrites the securities,
  i.e. they guarantee a price for the corporations
  securities and then sells them to the public via
  the secondary markets

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Secondary Markets

• Common secondary equity markets are the NASDAQ
  and Dow Jones
• Previously issued stocks are traded
• Other examples of secondary markets are the bond,
  foreign exchange, futures, and options markets
• Brokers are agents of investors who match buyers
  with sellers of securities
• Dealers link buyers and sellers by buying and
  selling securities at a stated price

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Secondary Market

• When a transaction occurs
• The buyer of the instruments pays money to the
  seller, but the initial issuer acquires no new
  funds
• Make financial instruments more liquid
• Determine the price of the instrument (via supply
  and demand)
• As the price increases in the secondary market,
  the issuer will receive a higher price on new
  securities issued in the primary market

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Secondary Markets

• Secondary markets can be organized in two ways
• Exchange market buyers and sellers meet in one
  central location to conduct trades
• New York Stock Exchange, American Stock Exchange,
  Chicago Board of Trade
• Over-the-counter market dealers at different
  locations have an inventory of securities
• U.S. Government Bond Market, CDs, federal funds,
  bankers acceptances, and foreign exchange

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Markets and Maturity

• Money Market
• A financial market in which short-term debt
  instruments are traded
• More widely traded, more liquid
• Used when entities have surplus funds for a short
  time
• Capital Market
• Is the market in which longer-term debt and
  equity instruments are traded
• Financial institutions (insurance companies and
  pension funds)

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Money Market Instruments

• United States Treasury Bills
• 1, 3, and 6 month maturities
• Pay a set amount at maturity, no interest
  payment, but are sold at a discount (Saving Bond)
• Negotiable Bank Certificates of Deposit
• Debt instrument sold by banks to depositors
• Commercial Paper
• Short-term debt issued by large banks and
  well-known corporations

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Money Market Instruments cont.

• Bankers Acceptance
• Is a bank draft, similar to a check, issued by a
  firm, payable at some future date, and guaranteed
  for a fee by the bank that stamps it accepted
• Allows firms to purchase goods abroad, the funds
  are guaranteed even if the corporation goes
  bankrupt
• Federal Funds
• Typically overnight loans made by banks to other
  banks
• Usually occurs when a bank falls below its
  required reserve amount

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Money Market Instruments cont.

• Repurchase Agreements (repos)
• Short-term loans, less than two week maturity
• A large firm may have excess funds it wants to
  lend for a week. The firm will buy treasury
  bills from the bank with an agreement that the
  bank will repurchase the t-bills in one weeks
  time.
• The firm gets a small interest payment and the
  bank gets the use of the firms funds

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Capital Market Instruments

• Stocks
• Equity claims on the net income and assets of a
  corporation
• Mortgages
• Loans to households or firms to purchase housing,
  land, or other real estate structures
• The structural/land serves as collateral
• Corporate Bonds
• Long-term bonds issued by corporations with
  strong credit ratings
• Sends an interest payments twice a year and pays
  off the face value of the bond at maturity

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Capital Market Instruments

• U.S. Government Securities
• Long-term debt instruments issued by the U.S.
  Treasury to finance the government deficit
• U.S. Government Agency Securities
• Long-term bonds used to finance capital
• State and Local Government Bonds
• Municipal bonds, long-term debt issued by state
  and local governments. Interest payments are tax
  free.
• Consumer and Bank Commercial Loans

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Internationalization of Financial Markets

• Foreign Bondssold in a foreign country and
  denominated in that countrys currency
• U.S. bonds sold in Europe and denominated in
  Euros
• Eurobondbond denominated in a currency other
  than that of the country in which it is sold
• U.S. bonds sold in Europe and denominated in
  Dollars
• Eurocurrenciesforeign currencies deposited in
  banks outside the home country
• EurodollarsU.S. dollars deposited in foreign
  banks outside the U.S. or in foreign branches of
  U.S. banks
• World Stock Markets

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Function of Financial Intermediaries Indirect
Finance

• Lower transaction costs
• Reduce Risk
• Asymmetric Information

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Indirect Finance

• Financial Intermediation
• Primary route for moving funds from lenders to
  borrowers
• Firms rely on financial intermediaries much more
  so than the securities markets
• True for the U.S. and most other developed
  countries

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Financial Intermediaries

• Have lower transaction costs
• Allows small lenders and borrowers to enter the
  market
• Very costly to write a loan contract
• Economies of scales
• Financial intermediaries write many loans, the
  average cost of doing so is much small than one
  individual writing one loan
• Liquidity Services
• Banks offer checking and savings accounts which
  all customers to earn interest on their savings,
  but also have access to their money to purchase
  goods and services

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Financial Intermediaries cont.

• Risk Sharing
• Financial Intermediaries create and sell assets
  with less risk that customers are more
  comfortable with
• Banks offer less risky assets (CDs, Money Market
  Accounts) and use these funds to purchase riskier
  securities
• Allow investors to diversify their portfolio and
  lower risk

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Financial Intermediaries cont.

• Asymmetric Information
• One party does not know everything about the
  other party
• Adverse Selection
• Occurs before the transaction takes place
• Borrowers who are the most likely to produce an
  undesirable outcome are the ones most actively
  seeking the loan
• Borrowers with a lot to gain and a little to lose
  are most likely to take out loans at a high
  interest rate

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Financial Intermediaries cont.

• Moral Hazard
• Occurs after the transaction takes place
• The risk that the borrower might engage in
  activities that are undesirable from the lenders
  point of view, i.e. it will be less likely the
  loan is paid back
• The borrower uses the money for purposes other
  than agreed upon

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Financial Intermediaries

• Allows small savers the ability to provide funds
  to the financial markets
• Financial intermediaries are more successful than
  individuals on earning returns because they can
  screen out bad credit risks from good ones
• They are able to reduce the risks incurred from
  moral hazard

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Types of Intermediaries

• Depository institutions (banks)
• Contractual savings institutions
• Investment intermediaries

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Depository Institutions

• Commercial Banks
• Raise funds via checking and saving deposits
• Make commercial, consumer, and mortgage loans and
  buy U.S. securities
• Savings and Loan Associations and Mutual Savings
  Banks
• Raise funds via checking, time, and saving
  deposit.
• Initially, constrained to just mortgage loans,
  but now very similar to banks
• Credit Unions
• Smaller than banks and organized around a
  particular group

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Contractual Savings Institutions

• Life Insurance Companies
• Acquire funds through premiums by selling
  annuities once the individual is retired
• Buy corporate bonds, mortgages, and some
  restricted stocks
• Fire and Casualty Insurance Companies
• Similar to life insurance companies, but
  experience a greater probability of losses
• Pension Funds and Government Retirement Funds
• Acquire funds through employee and employer
  contributions
• Purchase corporate bonds and stocks

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Investment Intermediaries

• Finance Companies
• Sell commercial paper and issue stocks and bonds
• Make loans to consumers
• Mutual Funds
• Sell shares to individuals and use the funds to
  purchase diversified portfolios of stocks and
  bonds
• Money Market Mutual Funds
• Sell shares to purchase money market instruments,
  interest is paid to shareholders, and
  shareholders can write checks against their
  holdings
• Investment Banks
• Advises corporations on the type of securities to
  issue and purchases them at a predetermined price
• Also participate in mergers and acquisitions

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Regulation of the Financial System

• To increase the information available to
  investors
• Reduce adverse selection and moral hazard
  problems
• Reduce insider trading
• To ensure the soundness of financial
  intermediaries
• Restrictions on entry
• Disclosure
• Restrictions on Assets and Activities
• Deposit Insurance
• Limits on Competition
• Restrictions on Interest Rates

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