Conceptual Overview of Financial Intermediaries and Market

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Conceptual Overview of Financial Intermediaries
and Market

• LECTURE 3

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BEGINNING TERMS

• SAVINGS
• INVESTMENT
• FINANCIAL INSTRUMENTS
• FINANCIAL INTERMEDIATION
• COMMERCIAL BANKS
• INSURANCE COMPANIES
• FINANCIAL MARKETS
• BOND MARKET
• EQUITY MARKET

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BEGINNING TERMS

• SAVINGS
• INVESTMENT
• FINANCIAL INSTRUMENTS
• FINANCIAL INTERMEDIATION
• COMMERCIAL BANKS
• INSURANCE COMPANIES
• FINANCIAL MARKETS
• BOND MARKET
• EQUITY MARKET

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FINANCIAL INTERMEDIATION PROCESS
FINANCIAL INTERMEDIARIES BANKS
BORROWERS/ REAL INVESTORS
LENDERS/ SAVERS
DEPOSITS
PRIMARY SECURITIES
SECONDARY SECURITIES
LOANS
What are the charcteristics of
secondary securities ?
LOAN RATE - DEPOSIT RATE INTEREST

SPREAD
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Direct Finance
COMPANY A SELLS A BOND TO ULTIMATE SAVERS
(LENDERS)
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Balance Sheet Lenders
Balance Sheet Company A
Bond of Company A
Long-term Debt
Issues Financial Instrument -- Bond
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Bond Goes to the Balance Sheet of The Ultimate
Lender
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Investment Banking Function
Balance Sheet Lenders
Balance Sheet Company A
Bond of Company A
Long-term Debt
Issues Financial Instrument -- Bond
Investment Bank
Bond of Company A
Bond of Company A
No Secondary Security is Created
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Indirect Finance
Bond Fund B Purchases Bond of Company A Ultimate
Lenders Hold Shares in Bond Fund B
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Indirect Finance
Balance Sheet Company A
Balance Sheet Lender
Shares of Bond Fund
Long-term Debt
Issues Financial Instrument -- Bond
Balance Sheet Bond Fund
Secondary Security
Bond of Company A
Primary Security
Fund Shares
Issues Financial Instrument -- Bond
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FUNCTIONS PERFORMED BY INTERMEDIARIES

• DENOMINATION INTERMEDIATION
• DEFAULT RISK INTERMEDIATION
• MATURITY INTERMEDIATION
• INFORMATION INTERMEDIATION
• ASYMMETRIC INFORMATION
• ADVERSE SELECTION
• MORAL HAZARD

LOWERING TRANSACTION COSTS
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TRANSFORMATION OF CREDIT FLOW
ULTIMATE HOLDER
DEFICIT UNITS
DEPOSITORY INSTITUTIONS
SECONDARY SECURITIES
PRIMARY SECURITIES
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FINANCIAL MARKETS
Direct Finance
Direct Finance
BORROWERS/ REAL INVESTORS
LENDERS/ SAVERS
FINANCIAL MARKETS
SUPPLY OF BONDS
DEMAND FOR BONDS
INTEREST RATE
( DEMAND FOR FUNDS )
( SUPPLY OF FUNDS )
FINANCIAL INNOVATIONS
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FINANCIAL MARKETS CLASSIFICATIONS

• DEBT MARKETS AND EQUITY MARKETS
• PRIMARY AND SECONDARY MARKETS
• EXCHANGES AND OVER-THE-COUNTER MARKETS
• MONEY AND CAPITAL MARKETS

The ones we talk about most are in red.
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PRIMARY MARKET TRANSACTION
Balance Sheet Lenders
Balance Sheet Company A
Long-term Debt
Issues Financial Instrument -- Bond
Investment Bank
Bond of Company A
Bond of Company A
No Secondary Security Created
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SECONDARY MARKET TRANSACTIONS (But no Secondary
Security)
Balance Sheet Lenders 2
Balance Sheet Lenders 1
- Bond of Company A
Bond of Company A
Buyer (Demander) Of Bonds
- Cash
Cash
Seller (Supplier) Of Bonds
Bond Market
Sale/Purchase to yield an agreed upon interest
rate
Liquidity for the Bond Market
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Over-the Counter Market (OTC)

• Over-the-counter transactions represent the
  buying and selling of securities outside the
  organized stock exchange. Unlike an organized
  stock exchange, the over-the-counter market is
  composed of dealers who negotiate most
  transactions by telephone and computer. For the
  most part, dealers purchase stocks for their own
  account and sell them to customers at a markup
  over wholesale prices. Over-the-counter trading
  represents the single largest securities market
  in the United States today it includes almost
  all U.S. government securities and municipal and
  corporate bonds, as well as most commercial bank
  and insurance company stocks. Today, most
  over-the-counter dealing in the United States is
  done through an extensive computer network,
  called the National Association of Securities
  Dealers Automated Quotations (Nasdaq).

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Exchange Markets

• Stock exchanges are organized markets for the
  trading of stocks and bonds. Such markets were
  originally open to all, but at present only
  members of the owning association may buy and
  sell directly. Members, or stock brokers, buy and
  sell for others, charging commissions for their
  services. A stock may be bought or sold only if
  it is listed on an exchange, and it may not be
  listed unless it meets certain requirements set
  by the exchange's board of governors.

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Definition of Broker

• The broker neither possesses the financial
  instrument sold nor receives the financial
  instrument procured brokers take no market risks
  and transfer no title to financial instruments. A
  broker earns a commission, or brokerage fee, when
  the contract of sale (or purchase) has been made.
  The broker is paid by the party that started the
  negotiation.

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Money Market Instruments

• TREASURY BILLS
• NEGOTIABLE BANK CERTIFICATES OF DEPOSIT
• COMMERCIAL PAPER
• BANKERS ACCEPTANCES
• FEDERAL FUNDS
• REPURCHASE AGREEMENT
• EURODOLLAR

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Treasury Bill

• The U.S. Treasury Bill (T-bill) is a marketable
  bond with maturities of 13 and 26 weeks. The
  minimum purchase is 1,000 and you can purchase
  larger denominations in increments of 1,000. You
  buy the T-bill at a discount and receive the full
  face value of the T-bill when you redeem it at
  maturity. For example, if you paid 980 for a
  1,000 T-bill, you would receive 120 interest at
  maturity. Or you can sell the T-bill before it
  matures and receive the current price of the
  T-bill, which may be more or less than your
  purchase price. Therefore, you can make or lose
  money buying and selling T-Bills before they
  mature.

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Federal Funds

• Funds deposited by commercial banks at Federal
  Reserve Banks. Designed to enable banks
  temporarily short of their reserve requirement to
  borrow reserves from banks having excess
  reserves.

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Negotiable Certificate of Deposit

• A CD with a very large denomination, usually 1
  million or more. These are usually bought by
  institutional investors who are interested in
  low-risk investments. Negotiable certificates of
  deposit are usually in bearer form, and have
  secondary markets that are highly liquid. They
  are sometimes referred to as jumbo CD.

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Commercial Paper

• An unsecured obligation issued by a corporation
  or bank to finance its short-term credit needs,
  such as accounts receivable and inventory.
  Maturities typically range from 2 to 270 days.
  Commercial paper is available in a wide range of
  denominations, can be either discounted or
  interest-bearing, and usually have a limited or
  nonexistent secondary market. Commercial paper is
  usually issued by companies with high credit
  ratings, meaning that the investment is almost
  always relatively low risk.

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Bankers Acceptance

• A short-term credit instrument which is created
  by a non-financial firm and whose payment is
  guaranteed by a bank. Often used in importing and
  exporting, and as a money market fund investment.

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Repurchase Agreement

• A contract in which the seller of securities,
  such as Treasury Bills, agrees to buy them back
  at a specified time and price. This instrument is
  also called a repo or buyback.

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Eurodollar

• An American dollar ( deposits) held by a foreign
  institution outside the U.S., usually a bank in
  Europe, often as a result of payments made to
  overseas companies for merchandise.
• LIBOR (London Interbank Offering Rate) is the
  interest rate that the largest international
  banks charge each other for loans (usually in
  Eurodollars).

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Capital Market Instruments

• STOCKS
• MORTGAGES
• CORPORATE BONDS
• US TREASURY NOTES AND BONDS
• STATE AND LOCAL GOVERNMENT BONDS

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Treasury Notes

• A Treasury note (T-Note) is a marketable bond
  with a maturity of 2, 3, 5, and 10 years. A
  Treasury note pays a fixed rate of interest every
  six months until maturity. At maturity, the U.S.
  Treasury pays back the principal to the bond
  holder.

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Treasury Bonds

• The U.S. Treasury will resume sales of
  fixed-principal Treasury bonds with a 30-year
  bond that will mature in February 2036. Treasury
  will sell 30-year bonds twice a year on a
  schedule it will announce in November 2005.
  Treasury hasn't sold fixed-principal bonds since
  October 2001.
• Treasury bonds pay interest every six months
  until they mature.

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Municipal Bonds

• Bond issued by a state, city, or local
  government. Municipalities issue bonds to raise
  capital for their day-to-day activities and for
  specific projects that they might be undertaking
  (usually pertaining to development of local
  infrastructure such as roads, sewerage, hospitals
  etc). interest on municipal bonds are generally
  exempt from federal tax. In the case that the
  bond is bought by a resident of the state that
  issued the bond, the interest payments are also
  exempt from state tax. Interest payments are
  further exempt from local tax if they are bought
  by residents of the locality that issued the
  bond. Capital gains however are taxable. There
  are two common types of municipal bonds general
  obligation and revenue. General Obligation (GO)
  bonds are unsecured municipal bonds that are
  simply backed by the full faith and credit of the
  municipality. Generally, these bonds have
  maturities of at least 10 years and are paid off
  with funds from taxes or other fees. Revenue
  bonds are used to fund projects that will
  eventually create revenue directly, such as a
  toll road or lease payments for a new building.
  The revenues from the projects are used to pay
  off the bonds.

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Corporate Bonds

• Type of bond issued by a corporation. Corporate
  bonds often pay higher rates than government or
  municipal bonds, because they tend to be riskier.
  The bondholder receives interest payments (yield)
  and the principal, usually 1000, is repaid on a
  fixed maturity date (bonds can mature anywhere
  between 1 to 30 years). Generally, changes in
  interest rates are reflected in bond prices.
  Bonds are considered to be less risky than
  stocks, since the company has to pay off all its
  debts (including bonds) before it handles its
  obligations to stockholders. Corporate bonds have
  a wide range of ratings and yields because the
  financial health of the issuers can vary widely.
  A high-quality blue chip company might have bonds
  carrying an investment-grade rating such as AA
  (with a low yield but a lower risk of default),
  while a startup company might have bonds carrying
  a "junk bond" rating (with a high yield but a
  higher risk of default). Corporate bonds are
  traded on major exchanges and are taxable.

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Corporate Stock

• An instrument that signifies an ownership
  position, or equity, in a corporation, and
  represents a claim on its proportionate share in
  the corporation's assets and profits. However,
  the claim to a companys assets and earnings of
  most stockholders is subordinated to the claim
  that the company's debtors have on its assets and
  earnings. Other names for this financial
  instrument are equities or equity securities or
  corporate stock.

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Mortgages

• A loan to finance the purchase of real estate,
  usually with specified payment periods and
  interest rates. The borrower (mortgagor) gives
  the lender (mortgagee) a lien on the property as
  collateral for the loan.

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INTERNATIONAL CAPITAL MARKET TERMS

• FOREIGN BONDS ARE SOLD IN A FOREIGN COUNTRY AND
  ARE DENOMINATED IN THAT COUNTRYS CURRENCY.
• EXAMPLE IF THE SWEDISH AUTOMAKER VOLVO SELLS
  BONDS IN THE U.S. , DENOMINATED IN U.S. DOLLARS,
  THEY WOULD BE CLASSIFIED AS FOREIGN BONDS.

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INTERNATIONAL CAPITAL MARKET TERMS

• EUROBONDS ARE BONDS DENOMINATED IN A CURRENCY
  OTHER THAN THAT OF THE COUNTRY IN WHICH THEY ARE
  SOLD. A BOND DENOMINATED IN DOLLARS OR YEN THAT
  IS SOLD IN LONDON IS A EUROBOND.

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Competition in the Financial Services Industry

• Many financial service firms exist to satisfy the
  demands of customer. How do savers and borrowers
  choose among them?
• In general, they choose on the basis of the
  risk-sharing, liquidity, and information
  characteristics that best suit their portfolio
  needs.
• Financial institutions develop new products and
  services that represent new arrays of these
  characteristics in order to attract customers.
• These new products and services are what we refer
  to as financial innovations.

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Financial Innovations
Financial Instruments 1
Financial Innovation
Rearrange the Characteristics
Financial Innovation
Financial Instruments 2
Newly Created Financial Instrument
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What are the Characteristics?
Risk-Sharing
Liquidity
Information
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FINANCIAL INTEGRATION

• Financial integration is the way financial
  markets are tied together geographically.
• In the past financial markets were fragmented
  because of the high cost of gathering and
  communicating information. The fragmentation
  created inefficiencies because investment funds
  were not attracted to their highest yield.
• However the increasing ease of communicating
  information has enabled financial markets to
  become much more integrated. We now integrated
  national markets.

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GLOBALIZATION

• In recent years, financial markets realized
  global integration.
• The globalization of financial markets improves
  the ability of the financial system to channel
  savers funds to the most profitable borrowers
  where ever they may be in the entire world.
• The globalization of financial markets has had
  two effects
• First, capital flows across national boundaries
  have helped countries to take advantage of
  productive investment opportunities even if their
  current resources were insufficient.

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GLOBALIZATION

• Second, increasing financial integration around
  the world reduces the cost of allocating savers
  funds to the most profitable uses where ever they
  may exist.

Integrated Global Markets
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OVERVIEWREGULATION OF THE FINANCIAL SYSTEM
Tennessee Department of Financial Institutions
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Basis of Financial Regulation

• CONSTITUTIONAL BASIS
• 
  
• ECONOMIC BASIS
• POLITICAL BASIS

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PURPOSE OF FINANCIAL REGULATIONS

• A. TO PROVIDE FINANCIAL
• INFORMATION TO INVESTORS
• AND CONSUMERS .
• 
  
• B. TO ENSURE THE SOUNDNESS
• OF THE FINANCIAL MARKETS
• AND INSTITUTIONS.

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TYPES OF SOUNDNESS REGULATIONS

• 1. CHARTERING OR ENTRY
• REGULATIONS
• 2. REPORTING AND EXAMINATION
• REQUIREMENTS
• 3. PORTFOLIO COMPOSITION REGULATIONS
• 4. INSURANCE ON DEPOSITS
• 5. LIMITATIONS ON COMPETITION
• 6. PRICING RESTRICTIONS

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TYPES OF SOUNDNESS REGULATIONS

• C. IMPROVED CONTROL OF
• MONETARY POLICY REG. D
• D. ENCOURAGEMENT OF HOME
• OWNERSHIP