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An Overview of the Financial System

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Title: An Overview of the Financial System


1
An Overview of the Financial System
Chapter 1
2
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.

3
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

4
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.

5
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.

6
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.

7
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.

8
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.

9
1. An Overview of the Financial System
  • 1. Introduction to Financial Markets and
    Institutions
  • Principal Money Market Instruments (maturity lt 1
    yr.)

Source Miskin
10
1. An Overview of the Financial System
  • 1. Introduction to Financial Markets and
    Institutions
  • Principal Capital Market Instruments (maturity gt
    1yr.)

Source Miskin
11
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.

12
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.

13
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
14
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

15
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

16
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.

17
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)
18
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

19
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

20
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, ...

21
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.

22
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.

23
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.

24
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.

25
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

26
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.

27
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.

28
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.

29
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.

30
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.

31
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.

32
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.

33
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

34
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

35
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

36
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.
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