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Chapter 3 Overview of the Financial System

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Title: Chapter 3 Overview of the Financial System


1
Chapter 3Overview of the Financial System
2
Purpose of the Financial System
  • Transfer funds from savers to borrowers
  • Savers (lenders) supply the funds, obtaining
    assets that pay future returns.
  • Borrowers demand the funds, issuing liabilities
    that require future returns.

3
Two Parts of Financial System
  • Financial markets directly transfer funds from
    savers to borrowers.
  • Financial intermediaries indirectly transfer the
    funds by acting as go-betweens
  • The ultimate savers lend to financial
    intermediaries, which then lend the funds to the
    ultimate borrowers.

4
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5
Key Services of Financial System
  • Risk-sharing by allowing savers to hold many
    different assets
  • Liquidity i.e. the ease with which an asset can
    be exchanged for money
  • Information about borrowers and returns on
    financial assets

6
Risk-Sharing
  • Risky assets have uncertain returns due to
  • Default
  • Fluctuating asset prices
  • Risk can be reduced by holding a portfolio of
    assets i.e. by diversification.
  • Financial system enables risk to be shifted from
    those less willing to bear it to those more
    willing.

7
Liquidity
  • Liquid assets easily, quickly bought or sold at
    almost equal prices and at little cost
  • Examples of liquid assets currency, deposits,
    Treasury bills, stocks of large companies
  • Example of an illiquid asset houses

8
Information
  • Financial system collects and communicates
    information.
  • It is costly for many individual savers and
    borrowers to do so themselves.

9
Financial Markets
  • Newly issued claims are sold to initial buyers in
    primary markets.
  • Previously issued claims are resold in secondary
    markets.
  • Active secondary markets engender liquidity.

10
Types of Secondary Markets
  • Format
  • Auction markets e.g. NYSE
  • Over-the-counter markets e.g. NASDAQ
  • Settlement
  • Cash markets e.g. stocks, bonds
  • Derivative markets e.g. futures, options

11
Two Types of Claims
  • Debt
  • Equity

12
Debt
  • Principal and interest
  • Maturity date
  • Term to maturity
  • Short-term ? 1 year money market
  • Intermediate-term gt1, lt 10 years
  • Long-term ? 10 years
  • Default

13
Equity
  • Claim to a given share of profits and assets
  • Managers have discretion over how much to
    distribute.
  • Dividend the amount distributed
  • Default debt vs. equity
  • Risk-sharing debt and equity
  • Capital market equity plus intermediate- and
    long-term bonds

14
Financial Intermediaries
  • Collect funds from many savers and transfer the
    funds to many borrowers
  • Provide risk-sharing, liquidity and information
    services

15
Financial Evolution
  • Strong competition
  • Financial innovation
  • Financial integration in US
  • Globalization
  • Recent years
  • Before 1914

16
Reasons for Financial Regulation
  • Prevention of fraud
  • Financial stability
  • Monetary control (silly)
  • Willie Sutton effect

17
Facts for 2006
  • 40 of assets were direct debt and equity
    instruments
  • 60 were liabilities of financial intermediaries
    of which about
  • 27 in bank deposits
  • 49 in pension reserves
  • 19 in mutual funds
  • 5 in insurance reserves
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