An Overview of the Financial System

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An Overview of the Financial System
Chapter 1
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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• At any point in time in an economy, there are
  individuals or organizations with excess amounts
  of funds, and others with a lack of funds they
  need for example to consume or to invest.
• Exchange between these two groups of agents is
  settled in financial markets
• The first group is commonly referred to as
  lenders, the second group is commonly referred to
  as the borrowers of funds.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• We will start our discussion of financial and
  money markets with some basic definitions
• 1. There exist two different forms of exchange in
  financial markets. The first one is direct
  finance, in which lenders and borrowers meet
  directly to exchange securities.
• Securities are claims on the borrowers future
  income or assets. Common examples are stock,
  bonds or foreign exchange

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Basic definitions
• The second type of financial trade occurs with
  the help of financial intermediaries and is known
  as indirect finance.
• In this scenario borrowers and lenders never meet
  directly, but borrowers provide funds to a
  financial intermediary such as a bank and those
  intermediaries independently pass these funds on
  to lenders.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Basic definitions
• 2. Financial markets are split into debt and
  equity markets.
• Debt titles are the most commonly traded
  security. In these arrangements, the issuer of
  the title (borrower) earns some initial amount of
  money (such as the price of a bond) and the
  holder (lender) subsequently receives a fixed
  amount of payments over a specified period of
  time, known as the maturity of a debt title.
• Debt titles can be issued on short term (maturity
  lt 1 yr.), long term (maturity gt10 yrs.) and
  intermediate terms (1 yr. lt maturity lt 10 yrs.).
• The holder of a debt title does not achieve
  ownership of the borrowers enterprise.
• Common debt titles are bonds or mortgages.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Basic definitions
• Equity titles are somewhat different from bonds.
  The most common equity title is (common) stock.
• First and foremost, an equity instruments makes
  its buyer (lender) an owner of the borrowers
  enterprise.
• Formally this entitles the holder of an equity
  instrument to earn a share of the borrowers
  enterprises income, but only some firms actually
  pay (more or less) periodic payments to their
  equity holders known as dividends. Often these
  titles, thus, are held primarily to be sold and
  resold.
• Equity titles do not expire and their maturity
  is, thus, infinite. Hence they are considered
  long term securities.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Basic definitions
• 3. Markets are divided into primary and secondary
  markets
• Primary markets are markets in which financial
  instruments are newly issued by borrowers.
• Secondary markets are markets in which financial
  instruments already in existence are traded among
  lenders.
• Secondary markets can be organized as exchanges,
  in which titles are traded in a central location,
  such as a stock exchange, or alternatively as
  over-the-counter markets in which titles are sold
  in several locations.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Basic definitions
• 4. Finally, we make a distinction between money
  and capital markets.
• Money markets are markets in which only short
  term debt titles are traded.
• Capital markets are markets in which longer term
  debt and equity instruments are traded.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Principal Money Market Instruments (maturity lt 1
  yr.)

Source Miskin
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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Principal Capital Market Instruments (maturity gt
  1yr.)

Source Miskin
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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Most commonly you will encounter
• Corporate stocks are privately issued equity
  instruments, which have a maturity of infinity by
  definition and, thus, are classified as capital
  market instruments
• Corporate bonds are private debt instruments
  which have a certain specified maturity. They
  tend to be long-run instruments and are, hence,
  capital market instruments
• The short-run equivalent to corporate bonds are
  commercial papers which are issued to satisfy
  short-run cash needs of private enterprises.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Most commonly you will encounter
• On the government side, the most commonly used
  long-run debt instruments are Treasury Bonds or
  T-Bonds. Their maturity exceeds ten years.
• Short-run liquidity needs are satisfied by the
  issuance of Treasury Bills or T-Bills, which are
  short-run debt titles with a maturity of less
  than one year.

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1. An Overview of the Financial System

• 1. Introduction to Financial Markets and
  Institutions
• Basic definitions
• An Overview
• Financial markets can be categorized as follows

Direct vs.
Indirect FinanceDebt vs. Equity
MarketsPrimary vs. Secondary
MarketsMoney vs. Capital
Markets
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1. An Overview of the Financial System

• 2. Functions of Financial Markets
• Borrowing and Lending
• Financial markets channel funds from households,
  firms, governments and foreigners that have saved
  surplus funds to those who encounter a shortage
  of funds (for purposes of consumption and
  investment)
• Price Determination
• Financial markets determine the prices of
  financial assets. The secondary market herein
  plays an important role in determining the prices
  for newly issued assets

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1. An Overview of the Financial System

• 2. Functions of Financial Markets
• Coordination and Provision of Information
• The exchange of funds is characterized by a high
  amount of incomplete and asymmetric information.
  Financial markets collect and provide much
  information to facilitate this exchange.
• Risk Sharing
• Trade in financial markets is partly motivated by
  the transfer of risk from lenders to borrowers
  who use the obtained funds to invest

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1. An Overview of the Financial System

• 2. Functions of Financial Markets
• Liquidity
• The existence of financial markets enables the
  owners of assets to buy and resell these assets.
  Generally this leads to an increase in the
  liquidity of these financial instruments
• Efficiency
• The facilitation of financial transactions
  through financial markets lead to a decrease in
  informational cost and transaction costs, which
  from an economic point of view leads to an
  increase in efficiency.

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Any classification of financial institutions is
  ultimately somewhat arbitrary, since financial
  markets are subject to high dynamics and frequent
  innovation. Thus, we roughly use four categories
• Brokers
• Dealers
• Investment banks
• Financial intermediaries

Engage in trade in securities (direct finance)
Engage in financial asset transformation
(indirect finance)
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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Brokers are agents who match buyers with sellers
  for a desired transaction.
• A broker does not take position in the assets
  she/he trades (i.e. does not maintain inventories
  of those assets)
• Brokers charge commissions on buyers and/or
  sellers using their services
• Examples Real estate brokers, stock brokers

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Like brokers, dealers match sellers and buyers of
  financial assets.
• Dealers, however, take position in they assets
  their trading.
• As opposed to charging commission, dealers obtain
  their profits from buying assets at low prices
  and selling them at high prices.
• A dealers profit margin, the so-called bid-ask
  spread is the difference between the price at
  which a dealer offers to sell an asset (the asked
  price) and the price at which a dealer offers to
  buy an asset (the bid price)
• Examples Dealers in U.S. government bonds,
  Nasdaq stock dealers

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Investment Banks
• Investment banks assist in the initial sale of
  newly issued securities (e.g. IPOs)
• Investment banks are involved in a variety of
  services for their customers, such as advice,
  sales assistance and underwriting of issuances
• Examples Morgan-Stanley, Merill Lynch, Goldman
  Sachs, ...

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• Financial intermediaries match sellers and buyers
  indirectly through the process of financial asset
  transformation.
• As opposed to three above mentioned institutions.
  they buy a specific kind of asset from borrowers
  usually a long term loan contract and sell a
  different financial asset to savers usually some
  sort of highly-liquid short-run claim.

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• Although securities markets receive a lot of
  media attention, financial intermediaries are
  still the primary source of funding for
  businesses.
• Even in the United States and Canada, enterprises
  tend to obtain funds through financial
  intermediaries rather than through securities
  markets.
• Other than historic reasons, this prevalence
  results from a variety of factors.

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• First, financial intermediaries lower transaction
  costs for borrowers and lenders (economies of
  scale, professional experience,...)
• Since transaction costs are reduced, financial
  intermediaries are able to provide customers with
  additional liquidity services, such as checking
  accounts which can be used as methods of payment
  or deposits which can be liquidated any time
  while still bearing some interest.

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• Second, financial intermediaries can reduce an
  investors exposure to risk through risk sharing.
• Through the process of asset transformation not
  only maturities, but also the risk of an asset
  can change A financial intermediary uses funds
  it acquires (e.g. through deposits) and often
  turns them into a more risky asset (e.g. a larger
  loan). The risk then is spread out between
  various borrowers and the financial intermediary
  itself.
• The process of risk sharing is further augmented
  through diversification of assets
  (portfolio-choice), which involves spreading out
  funds over a portfolio of assets with different
  types of risk.

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• Third, financial intermediaries are important in
  the production of information. They help reduce
  informational asymmetries about some unobservable
  quality of the borrower for example through
  screening, monitoring or rating of borrowers.
• Two problems are usually connected to
  informational asymmetries
• Adverse selection (preceding a transaction), e.g.
  selection of bad debtor
• Moral hazard (succeeding a transaction), e.g.
  undesirable activities by the debtor

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• Finally, some financial intermediaries specialize
  on services such as management of payments for
  their customers or insurance contracts against
  loss of supplied funds.
• Through all of these channels financial
  intermediaries increase market efficiency from an
  economic point of view.

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1. An Overview of the Financial System

• 3. Financial Institutions and their Functions
• Financial Intermediaries
• There are roughly three classes of financial
  intermediaries
• Depository institutions accept deposits from
  savers and transform them into loans (Commercial
  banks, savings and loan associations, mutual
  savings banks and credit unions)
• Contractual savings institutions acquire funds at
  periodic intervals on a contractual basis
  (insurance and pension funds)
• Investment intermediaries serve different forms
  of finance. They include finance companies,
  mutual funds and money market mutual funds.

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1. An Overview of the Financial System

• 4. Financial regulation
• Why regulate financial markets?
• Financial markets are among the most regulated
  markets in modern economies.
• The first reason for this extensive regulation is
  to increase the information available to
  investors (and, thus, to protect them).
• The second reason is to ensure the soundness of
  the financial system.

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1. An Overview of the Financial System

• 4. Financial regulation
• 1. Increasing information available to investors
• As mentioned above, asymmetric information can
  cause severe problems in financial markets (Risk
  behavior, insider trades,....)
• Certain regulations are supposed to prohibit
  agents with superior information from exploiting
  less informed agents.
• In the U.S. the stock-market crash of 1929 led to
  the establishment of the Securities and Exchange
  Commission (SEC), which requires companies
  involved in the issuance of securities to
  disclose certain information relevant to their
  stockholders. The SEC further prohibits insider
  trades.

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1. An Overview of the Financial System

• 4. Financial regulation
• 2. Ensuring the soundness of financial
  intermediaries
• Even more devastating consequences from
  asymmetric information manifest themselves in
  collapses of the entire financial system so
  called financial panics.
• Financial panics occur if providers of funds on a
  large scale withdraw their funds in a brief
  period of time from the financial system leading
  to a collapse of the system. These panics can
  produce enormous damage to an economy.
• Examples of some recent panics are the crises in
  the Asian Tiger states, Argentina or Russia. The
  United States, while spared for most of the
  second half of 20th century, has a long tradition
  of financial crises throughout the 19th century
  up to the Great Depression.

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1. An Overview of the Financial System

• 4. Financial regulation
• Overview of financial regulations in the United
  States
• 1. Restrictions to entry
• State banking and insurance commissions and the
  Office of the Comptroller of the Currency have
  set high standards for market entry as a
  financial intermediary.
• Generally the state or federal government grants
  a charter to new financial intermediaries subject
  to strict criteria such as volume of initial
  funds, etc.

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1. An Overview of the Financial System

• 4. Financial regulation
• Overview of financial regulations in the United
  States
• 2. Disclosure
• Generally financial intermediaries have to follow
  strict rules for bookkeeping
• Books are subject to periodic inspection and
  certain information must be made public.

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1. An Overview of the Financial System

• 4. Financial regulation
• Overview of financial regulations in the United
  States
• 3. Restrictions on Assets and Activities
• Financial intermediaries are restricted from
  holding certain risky assets (e.g. Commercial
  banks are not allowed to hold common stock)
• Unlike in many European countries legislation in
  the U.S. separated commercial banking from
  securities trade from 1933 to 1999

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1. An Overview of the Financial System

• 4. Financial regulation
• Overview of financial regulations in the United
  States
• 4. Deposit insurance
• If a financial intermediary fails, the central
  government (or sometimes a private conglomerate
  of banks) can insure the deposits of lenders
• In the U.S. deposit insurance of commercial banks
  is granted mainly through the Federal Deposit
  Insurance Corporation (FDIC), which was created
  after the severe banking crisis of the Great
  Depression in 1930-1933

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1. An Overview of the Financial System

• 4. Financial regulation
• Overview of financial regulations in the United
  States
• 5. Limits to Competition
• An argument of politics rather than economics is
  that overly hard competition in the banking
  sector increases the risk of bank failure. This
  belief has (especially in the past) led to some
  restrictions in the commercial banking sectors
• In the U.S. private banks e.g. were prohibited to
  open branches in different states
• The empirical evidence for the benefits of
  limiting competition is weak and from an economic
  point of view it appears more as an obstacle to
  risk diversification rather than a useful
  regulation

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1. An Overview of the Financial System

• 4. Financial regulation
• Overview of financial regulations in the United
  States
• 6. Restriction of interest rates
• The experience of the Great Depression in the
  U.S. has led to the widespread belief that
  interest rate competition paid on deposits might
  facilitate bank failure and to strong regulation
  of interest rates on bank deposits
• Unlike most other developed economies, banks in
  the U.S. were prohibited from paying any interest
  on deposits from 1933. Under what is known as
  Regulation Q, the Federal Reserve System had the
  power to set the maximum interest rates payable
  on savings deposits until 1986.