Introducing Money and the Financial System

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Introducing Money and theFinancial System
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LESSON
LEARNING OBJECTIVES
After studying this lesson, you should be able to
Identify the key components of the financial
system
1.1
Provide an overview of the financial crisis of
20072009
1.2
Explain the key issues and questions the
financial crisis raises
1.3
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Introducing Money and theFinancial System
1
LESSON

• CAN THE FED RESTORE THE FLOW OF MONEY?
• During the economic crisis that began in 2007,
  the financial system was disrupted as it hadnt
  been since the 1930s.
• Large sections of the U.S. economy were cut off
  from the flow of funds they needed to thrive.
• Some government intervention was necessary to
  pull the economy out of a deep recession.
• During the recession, more than 8 million jobs
  were lost, GM declared bankruptcy, and some Wall
  Street investment houses disappeared.

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1.1
Learning Objective
Identify the key components of the financial
system.
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Key Components of the Financial System
Three major components of the financial system

• Financial assets
• An asset is anything of value owned by a person
  or a firm.
• A financial asset is an asset that represents a
  claim on someone else for a payment.
• Financial institutions
• The Federal Reserve and other financial regulators

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Financial Assets
Economists divide financial assets into those
that are securities and those that arent. A
security is a financial asset that can be bought
and sold in a financial market. Financial
markets are places or channels for buying or
selling stocks, bonds, and other securities.
Key Components of the Financial System
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Financial Assets

• Five key categories of financial assets
• Money
• Stocks
• Bonds
• Foreign exchange
• Securitized loans

Key Components of the Financial System
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Financial Assets
Money
Money Anything that is generally accepted in
payment for goods and services or to pay off
debts.
The money supply is the total quantity of money
in the economy.
Key Components of the Financial System
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Financial Assets
Stocks
Stocks are financial securities that represent
partial ownership of a firm also called equities.
Dividend A payment that a corporation makes to
its shareholders.
Key Components of the Financial System
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Financial Assets
Bonds
Bond A financial security issued by a corporation
or a government that represents a promise to
repay a fixed amount of money.
Interest rate The cost of borrowing funds (or the
payment for lending funds), usually expressed as
a percentage of the amount borrowed.
Key Components of the Financial System
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Financial Assets
Foreign Exchange
To buy foreign goods and services or foreign
assets, a domestic business or a domestic
investor must first exchange domestic currency
for foreign currency.
Foreign exchange Units of foreign currency.
Banks engage in foreign currency transactions on
behalf of investors and business firms.
Key Components of the Financial System
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Financial Assets
Securitized Loans
Before markets for loans were created, it wasnt
possible to sell loans. Loans were financial
assets but not securities. Securitization The
process of converting loans and other financial
assets that are not tradable into securities.
Note that what a saver views as a financial
asset a borrower views as a financial
liability. Financial liability A financial claim
owed by a person or a firm.
Key Components of the Financial System
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Financial Institutions

• The financial system matches savers and borrowers
  through two channels
• Banks and other financial intermediaries
• Financial markets
• Funds flow from lenders to borrowers indirectly
  through financial intermediaries, such as banks,
  or directly through financial markets, such as
  the New York Stock Exchange.

Financial intermediary A financial firm, such as
a bank, that borrows funds from savers and lends
them to borrowers.
Key Components of the Financial System
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Moving Funds Through the Financial System
Figure 1.1
The financial system transfers funds from savers
to borrowers. Borrowers transfer returns back to
savers through the financial system. Savers and
borrowers include domestic and foreign
households, businesses, and governments.
Key Components of the Financial System
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Financial Institutions
Financial Intermediaries
Commercial bank A financial firm that serves as a
financial intermediary by taking in deposits and
using them to make loans. Households rely on
borrowing money from banks to purchase big
ticket items. Firms rely on banks to meet their
short- and long-term needs for credit. Some
financial intermediaries, such as savings and
loans, savings banks, and credit unions, are
legally distinct from banks.
Key Components of the Financial System
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Making the Connection
Pawn Shop Finance What Happens to Small
Businesses When Bank Lending Dries Up?

• Pawn shops typically make small loans at high
  interest rates.
• Before the financial crisis of 2007-2009, banks
  loosened lending requirements. During the crisis,
  defaults by households and firms increased
  dramatically.
• Loan losses during 20072009 were by far the
  largest since the Great Depression of the 1930s.
• Many banks cut small businesses off from credit,
  forcing them to borrow from pawn shops, family,
  or friends to operate.

Key Components of the Financial System
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Making the Connection
Pawn Shop Finance What Happens to Small
Businesses When Bank Lending Dries Up?
Key Components of the Financial System
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Nonbank Financial Intermediaries

• Insurance companies
• Pension funds

Insurance companies collect premiums from
customers then invest the premiums to obtain the
funds necessary to pay claims and other costs.
Pension funds invest contributions from workers
and firms in stocks, bonds, and mortgages to earn
the money necessary to make pension benefit
payments.
Key Components of the Financial System
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Nonbank Financial Intermediaries

• Mutual funds
• Hedge funds
• Investment banks

A mutual fund obtains money by selling shares to
investors and invests the money in a portfolio of
financial assets.
Portfolio A collection of assets, such as stocks
and bonds.
Hedge funds are similar to mutual funds but
typically have no more than 99 wealthy investors
and make riskier investments.
Investment banks concentrate on providing advice
to firms issuing stocks and bonds or considering
mergers with other firms.
Key Components of the Financial System
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Financial Markets
Financial markets are places or channels for
buying and selling stocks, bonds, and other
securities. Today, most securities trading takes
place electronically between dealers linked by
computers and is referred to as
over-the-counter trading.
Primary market A financial market in which
stocks, bonds, and other securities are sold for
the first time.
Secondary market A financial market in which
investors buy and sell existing securities.
Key Components of the Financial System
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Making the Connection
What Do People Do With Their Savings?
Key Components of the Financial System
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The Federal Reserve and Other Financial Regulators

• Federal agencies that regulate the financial
  system
• Securities and Exchange Commission (SEC)
• The Federal Deposit Insurance Corporation (FDIC)
• Office of the Comptroller of the Currency
• The Federal Reserve System (the focus of this
  book)

Key Components of the Financial System
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What Is the Federal Reserve?

• The Federal Reserve is the central bank of the
  United States usually referred to as the Fed.
• Established by Congress in 1913 to deal with
  banking problems.
• Original role Serve as a lender of last resort.

Key Components of the Financial System
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What Does the Federal Reserve Do?

• The Fed is responsible for monetary policy.
  Monetary policy refers to the actions the Federal
  Reserve takes to manage the money supply and
  interest rates to pursue macroeconomic policy
  objectives.
• The Fed is divided into 12 districts (See Figure
  1.2).
• The main policymaking body of the Fed is the
  Federal Open Market Committee (FOMC).
• Chair, Ben Bernanke from 2006 present.
• The FOMC meets eight times per year. During these
  meetings, the Fed decides on a target for the
  federal funds rate.

Federal funds rate The interest rate that banks
charge each other on short-term loans.
Key Components of the Financial System
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The Federal Reserve System
Figure 1.2
The Federal Reserve System is divided into 12
districts, each of which has a District Bank
located in the city shown on the map.
Key Components of the Financial System
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What Does the Financial System Do?
The financial system provides three services to
savers and borrowers risk sharing, liquidity,
and information.
Risk Sharing
Risk is the chance that the value of financial
assets will change relative to what you expect.
Diversification Splitting wealth among many
different assets to reduce risk.
Risk sharing A service the financial system
provides that allows savers to spread and
transfer risk.
Key Components of the Financial System
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Liquidity
Liquidity The ease with which an asset can be
exchanged for money. Financial markets and
intermediaries help make financial assets more
liquid.
Information
Information Facts about borrowers and about
expectations of returns on financial
assets. Financial markets convey information to
both savers and borrowers by determining the
prices of stocks, bonds, and other securities.
Key Components of the Financial System
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1.1
Solved Problem
The Services Provided by Securitized
Loans Briefly discuss the extent to which
securitized loans embody the key services of risk
sharing, liquidity, and information.
Key Components of the Financial System
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1.1
Solved Problem
The Services Provided by Securitized
Loans Solving the Problem

• Step 1 Review the lesson material.
• Step 2 Define securitized loans.
• Non-securitized loans are financial assets but
  not financial securities. Securitized loans are
  loans that have been bundled with other loans and
  resold to investors they are both financial
  assets and financial securities.
• Step 3 Explain whether securitized loans provide
  risk sharing, liquidity, and information.
• When a mortgage is bundled together with other
  mortgage-backed securities, the buyers jointly
  share the risk of a default.
• A securitized loan can be resold and so has a
  secondary market, which makes it liquid.
• When loans are securitized, investors rely on the
  bank or other loan originator to have gathered
  the necessary information.
• So, securitized loans provide all three of these
  key services.

Key Components of the Financial System
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1.2
Learning Objective
Provide an overview of the financial crisis of
20072009.
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Origins of the Financial Crisis
Bubble An unsustainable increase in the price of
a class of assets.

• Overly optimistic expectations, and more
  importantly, changes in the mortgage market for
  made it easier for families to borrow money to
  buy houses.
• Two government-sponsored enterprises (GSEs), the
  Federal National Mortgage Association (Fannie
  Mae) and the Federal Home Loan Mortgage
  Corporation (Freddie Mac), sold bonds to
  investors and used the funds to purchase
  mortgages from banks.
• Investment banks became significant participants
  in the mortgage market, bundling and selling
  mortgage-backed securities.

The Financial Crisis of 20072009
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Origins of the Financial Crisis
Standards for obtaining loans were greatly
loosened. By 2005, many mortgages were being
issued to subprime borrowers with flawed credit
histories. Adjustable-rate mortgages allowed
borrowers to pay a very low interest rate. Both
borrowers and lenders anticipated higher housing
prices, which would reduce the chance of
default. Unfortunately, the decline in housing
prices that began in 2006 led to rising defaults
and a sharp decline in the value of many
mortgage-backed securities.
The Financial Crisis of 20072009
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Origins of the Financial Crisis
The Housing Bubble
Figure 1.3
Panel (a) shows that housing bubble resulted in
rapid increases in both sales of new houses and
housing prices between 2000 and 2005, followed by
sharp decreases in sales and prices from early
2006 through early 2009 and then a slow revival.
Panel (b) shows that home prices followed a
similar pattern to home sales.
The Financial Crisis of 20072009
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The Deepening Crisis and the Response of the Fed
and Treasury

• In October 2008, Congress passed the Troubled
  Asset Relief Program (TARP), under which the
  Treasury provided funds to commercial banks in
  exchange for stock in those banks.
• Many policies of the Fed and Treasury during the
  recession of 20072009 were controversial because
  they involved
• Partial government ownership of financial firms
• Implicit guarantees to large financial firms that
  they would not be allowed to go bankrupt
• Unprecedented intervention in financial markets
• Many feared that the Feds actions might reduce
  its independence.

The Financial Crisis of 20072009
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1.3
Learning Objective
Explain the key issues and questions the
financial crisis raises.
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Key Issues and Questions from the Financial Crisis
Our brief account of the financial crisis raises
a number of questions that we will answer in the
following lessons.
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AN INSIDE LOOK AT POLICY
Fed Ready to Help Economy, but Options Are Limited
Wall Street Journal, Bernanke Prepared to Take
New Steps

• Fed Chairman Ben Bernanke expressed doubts about
  the effectiveness of the actions the Fed usually
  takes to spur the economy, such as lowering the
  discount rate, lowering the federal funds rate,
  or lowering reserve requirements.
• He outlined three other possible options
• Announce the Feds intention to keep short-term
  interest rates low.
• The Fed could lower the interest rate it paid
  banks on required reserves (from 0.25 percent).
• The Fed could buy additional securities with the
  proceeds of maturing mortgage securities.

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AN INSIDE LOOK AT POLICY
The Fed was very aggressive in using its discount
window to pump reserves into the banking system
in 2008 and 2009.