mb2 an overview of the financial system

Money and Banking ECO 324 2-1

Chapter 2: An Overview of the Financial System

• In this chapter we will analyze how financial markets function.

• We will study the: structure of financial markets main financial market instruments types of financial intermediaries

• It will also cover the key concept of asymmetric markets


Function of Financial Markets

• The main components of the financial system are: Financial markets (bonds, stocks, foreign exchange) Financial intermediaries which include banks, investment funds, pension

funds, insurance companies, leasing companies…. Lenders/savers and borrowers/spenders

• Lenders/savers are those with excess funds. Households are the main source of funds in the category of lenders/savers

• In some cases and during certain periods of time businesses, governments can also have excess funds. (Sovereign Wealth Funds are lenders, for example).

• Lenders/savers like to put their excess funds in a safe place and, if possible, they would like to earn some interest on those funds.

• Suppose you had €1,000, what would you do with the it?


Function of Financial Markets (cont)

• Borrowers/spenders are businesses and governments, especially the federal governments and also households

• Though both groups figure on both sides of the lending-borrowing account, households are the primary lenders and businesses and governments the primary borrowers.

• Financial markets perform the essential function of channeling funds from lenders to borrowers

• They are a necessary ingredient to economic efficiency.

• And as we have seen recently, poorly functioning financial markets lead to economic paralysis

• To further explain the function of financial markets, we will introduce two more terms:

Direct finance or when borrowers are in direct contact with lenders

And indirect finance or when a financial intermediary puts the two sides together.


Function of Financial Markets (cont)


Structure of Financial Markets:Debt and Equity Markets• Borrowers/spenders can obtain funds in a financial market by two ways:

debt and equity

• The most common method is the debt instrument such as a bond or mortgage

• An agreement where the borrower pays the holder of the instrument regular amounts (interest and principal payments) until a specified date (the maturity date)

• The maturity of a debt instrument is number of years until the instrument’s expiration date.

A short-term instrument is less than 1 year A long-term instrument is 10 years or longer 1-10 years is considered an intermediate term


Debt and Equity Markets (cont.)

• The second method of raising funds is through issuing equities such as common stock

• Owning stock means you own a portion of the company

• If you have 1 share of a company that has 100 shares you own 1/100 of the company.

• The share also gives you the right to vote on issues important to the company and to elect its directors

• Equities often make periodic payment to their holders in the form of dividends

• Equities are considered long-term securities because they have no maturity date.


Debt and Equity Markets (cont.)

• The main disadvantage of owning a company’s equity rather than its debt is that an equity holder is a residual claimant: the company must pay all its debt holders before paying equity holders

• The main advantage is equity holders benefit directly in profit increases (debt payments are normally fixed)

• In other words, as profits increase dividends increase and there is not upper limit to the increase in profit and dividends

• There is, however, the risk is that if profits go down the debt holders get paid first. Any funds left over will be distributed to shareholders

• Even if we are more aware of equity markets, the debt market is much larger than the equity market.

2008 value of debt instruments = $35 trillion 2008 value of equity = $20 trillion


Structure of Financial Markets:Primary and Secondary Markets• Primary markets are where new securities (both debt and equities) are

issued

• Secondary markets are where previously issued securities are traded.

• Primary markets are not as well-known as secondary markets because the issuing is often not public.

Perhaps some students may have heard that the EDF, a French electricity company, raised several billion Euros in a recent bond issue.

The issue was on the primary market. An important financial intermediary in the primary market is the

investment bank. They assist in the sale of securities in primary markets If the investment bank guarantees a price for the security which it is

selling, we say the bank is underwriting the security.


Primary and Secondary Markets (cont)

• If an investor who bought one of the EDF bonds were to later sell the bond, that sale would occur on the secondary market.

• The most well-known secondary markets are the NYSE, the NASDAQ or the Euronext.

• When you are listening to the radio or watching news and you hear that the stock market is up or down several percent, it is the secondary market.

• Other examples of secondary markets are the foreign exchange markets, futures markets, and option markets.

• Two terms necessary to understand secondary markets are: Brokers who are paid a commission for matching buyers and sellers of

securities without ever taking ownership of the securities And dealers who buy and then sell the securities.


Primary and Secondary Markets (cont)

• When an individual buys a security on the secondary market, the person who sold the security receives the funds.

• If you sell a share of Apple on the stock market, the proceeds go to you and not to Apple.

• Apple acquires funds only when it issues a share on the primary market.• If the CEO of Apple were to sell his shares, he sells them on the

secondary market and receives the funds. If Apple corporation sells shares, then it is acting in the primary market.

• Do companies care what happens in the secondary market?• Secondary markets make it easier to buy and sell securities or in other

words they provide liquidity.• Increased liquidity makes them more desirable and then easier to sell on

the primary market.• The secondary market also provides the key role of determining price. • A high price for the security in the secondary market, means that the

company can ask an equivalent price in the primary market.• (Company directors are sometimes accused of boosting secondary

market prices so that their bonus often paid in stock options increases in value.)


Structure of Financial Markets (cont)

• Secondary markets are organized into:

regulated exchanges such as NYSE or NASDAQ

unregulated exchanges called OTC for Over the Counter

• The US government bond market which has more trading volume than the NYSE is organized as OTC

• Other financial markets include the Money and Capital Markets Money markets deal in short-term debt instruments Capital markets deal in longer-term debt and

equity instruments


Financial Market Instruments• To complete our understanding of how financial markets perform, we

need to examine the securities traded in the markets.• We have already seen bonds and equities, these are traded on capital

markets• But before tackling capital markets, we will look at money markets.


Financial Market Instruments:Money Markets• US Treasury Bills.

Short-term debt instruments of the US government issued in 1-, 3-, and 6-month maturities.

They pay a set amount at maturity and pay no interest. They are the most liquid of the money market instruments because they are

the most actively traded. They are also thought to be the safest of all money market instruments

because there is almost no possibility of default. Treasury bills are mostly held by banks

• Negotiated bank certificates of deposits or CD is a debt instrument sold by banks to depositors that pays interest and at maturity pays back the original purchase price.

It is short-term funding for the bank. Lenders (depositors) like CDs because they provide interest where checking

accounts in most cases do not.


Financial Market Instruments(cont)

• Commercial paper is a short-term debt instrument (1 week or several months) issued by large banks and well-known corporations, such as Microsoft or General Electric. The commercial paper market has grown rapidly in the period 1985-2008.

• Banker’s acceptances are created in the course of carrying out international trade and have been in use for hundreds of years.

It is a draft or a promise of payment similar to a check issued by a firm and guaranteed for a fee by the ban that stamps it “accepted”.

The firm issuing the instrument is required to place the funds into its account to cover the draft.

The advantage is that the draft is more likely to be accepted when purchasing goods from abroad.

These “accepted” drafts can be resold in a secondary market.


Money Markets (cont)

• Repurchase agreements also called repos Another short-term debt instrument which is not well-known outside of

banking circles A large corporation such as Microsoft may have some idle cash in its bank

account, say $1 million Microsoft can use the $1 million to purchase Treasury Bills from the bank The bank will agree to buy back the Treasury Bills one week later at a slightly

higher price Microsoft earns a interest slightly higher interest than its bank account and

the Treasury Bills are a guarantee if the bank were to default The bank obtains short-term liquidity which it will use in its operations.


Money Markets (cont)

• Federal (Fed) Funds These instruments are typically overnight loans between banks of their

deposits at the Federal Reserve The term is confusing because they are not loans from the Fed They are inter-bank loans which are sometimes used to meet regulatory

requirements on reserves. If a bank saw that its reserves were too low, it could borrow the funds from

another bank who would use the Fed’s wire transfer system The market is very sensitive to credit needs by banks, so the interest rate on

these loans called the federal funds rate is a closely watched indicator of credit market conditions

• For the latest data on Money Market rates see the Wall Street Journal website: http://wsj.com/mdc/public/page/2_3020-moneyrate.html

http://wsj.com/mdc/public/page/2_3020-moneyrate.html


Financial Market Instruments:Capital Markets• Capital markets instruments are securities with maturities greater than

one year

• Stocks are the largest of these instruments. At $17 trillion in the end of 2010, they are the largest instrument on the capital

markets. Again students should not confuse this figure with stock issues which are less

than 1% of that amount. Individuals own about half the value of stocks, the other half is held by

pension funds, mutual funds and insurance companies.

• Mortgages are loans by households or firms where the structure or land serves as collateral for the loans. Residential housing loans are by a large amount the largest of these types of loans


Capital Markets (cont)

• Corporate bonds are long-term bonds issued by corporations as the name suggests. The typical corporate bond pays interest twice a year and then the face value when the bond matures. Some corporate bonds are convertible or have an additional feature where they can be converted to shares.

• US Government Securities are long-term debt issued by the US government to finance the federal deficit. They are the most liquid security traded on the capital markets.

• US Agency Securities are long-term debt issued by US agencies such as housing. Many are guaranteed by the government.

• State and Local Government Bonds also called municipal bonds re long-term debt issued by these governments for schools, roads and other large scale programs. Many of these bonds are tax-exempt.

• Commercial and Bank Commercial Loans are loans to individuals and businesses.



• US Agency Securities are long-term debt issued by US agencies such as housing. Many are guaranteed by the government.

• State and Local Government Bonds also called municipal bonds re long-term debt issued by these governments for schools, roads and other large scale programs. Many of these bonds are tax-exempt.

• Commercial and Bank Commercial Loans are loans to individuals and businesses.

• For the latest capital markets data, see the WSJ site: http://wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3020

http://wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3020

http://wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3020


• Capital markets instruments are equity and debt with maturities greater than 1 year



Internationalization of Financial Markets

• Foreign Bonds are sold in a foreign country and denominated in that country’s currency

If the German automaker Porche sells a bond in the US market denominated in dollars it is considered a foreign bond

A large percentage of US railroads built in the 19th century were financed by sales of foreign bonds in Britain

• A recent innovation is the Eurobond, a bond denominated in a currency other than that of the country in which it is sold

A bond denominated in US dollars sold in London is a Eurobond 80% of new issues in the international bond market are Eurobonds

• A variant of the Eurobond is Eurocurrencies and Eurodollars Eurocurrencies are currencies deposited in banks outside the home

country One of the largest Eurocurrencies is Eurodollars, or dollars deposited

outside of the US

• Note: Eurobonds, Eurodollars have nothing to do with the Euro


Function of Financial Intermediaries

• Funds can move from lenders to borrowers via indirect finance involving financial intermediaries

• Financial intermediaries borrow funds from lenders/savers and then provide funds to borrowers/spenders

• A bank may acquire funds by issuing a liability to the public in the form of saving deposits and then loan to others for a housing loan

• The process of using indirect finance via financial intermediaries is called financial intermediation

• Financial intermediaries are the largest source of funding for companies and governments.


Function of Financial Intermediaries (cont)

• Why do intermediaries exist? Transaction costs, risk and asymmetric information

• Lower transaction costs Because of economies of scale earned through trading large amounts

frequently financial intermediaries have a lower trading costs than individual investors

Intermediaries also provide lenders with ways to invest while still maintaining a minimum of liquidity, a CD is a good example.

• Reduce Risk Financial intermediaries will sell an asset whose risk profile suits lenders. The intermediary will then through expertise and benefiting from lower

transaction costs use the funds to invest in risky assets. Risky assets can be diversified long-term assets, for example. The intermediary benefits from the difference in interest rates which is called

the spread.



• Asymmetric Information• In financial markets, one party often does not know enough about the

other party to make accurate decisions.• This inequality is called asymmetric information.• For example, a borrower who takes out a loan generally knows more a

but the risk and returns of an investment than the lender.• Asymmetric information creates problems because of two fronts:

• Adverse Selection occurs before the transaction. • Those borrowers who need funds the most are the ones most

desperately looking for funds. • In other words, the riskier borrowers are the ones willing to accept high

interest costs to receive funds. • If you knowledge of the situation were “symmetric”, then you would know

which borrowers were high credit risks and which were acceptable risks.• Because of adverse selection, you may choose to lender to neither of the

candidates.



• Moral Hazard occurs after the transaction.• It is the risk (hazard) that the borrower might engage in activities that are

undesirable (immoral) from the lender’s point of view.• Because lenders are less informed (again the information is not

symmetric) on the intentions of the borrower it is a moral hazard.• Suppose you lend $1,000 to an uncle for the purchase of a computer for

his new business.• Your uncle takes the funds and heads to the race track because he is

sure that he can obtain high returns.• If you knew his intentions your would not lend the money.



• Because of asymmetric information and the two problems of adverse selection and moral hazard, individual or small investors are reluctant to invest.

• On the other hand, financial intermediaries have an expertise and through volume the financial means to research

investment projects reducing adverse selection and monitor their progress reducing moral hazard.

• We will analyze in later chapters the theory of asymmetric information and its influence on financial markets.

• We will see for example, that because US markets are characterized by a high-level of transparency, that US investors have a relatively high share of direct finance.

• In other words, US investors benefit from more symmetric information and can afford to invest directly rather than having to go through financial intermediaries.


Types of Financial Intermediaries


Types of Financial Intermediaries (cont)

• The table on the previous slide shows the sources and uses of funds of different types of financial intermediaries.

• Depository institutions are financial intermediaries whose main source of funds is deposits an important component of money supply.

• They comprise:• Commercial banks which number 7,500 in the US and are therefore, the

largest group. They provide checking accounts, savings deposits, and time deposits. Their loan portfolios are diversified.

• Savings and Loans and Mutual Banks have the same profile of source of funds as savings banks, but tend to be smaller and have a less-diversified loan portfolio. They are often focused on residential mortgages.

• Credit Unions are similar to the above two. They are the smallest in size but number 8,900. They are often institutions organized around a group such as union members or employees of a particular firm.



• An investment bank despite its name, is not a bank or a financial intermediary in the ordinary sense.

• They do not take deposits nor lend them out.• An investment bank advises companies on security issues and will

underwrite their issues• They often have a proprietary trading desk and will make temporary

loans to companies for short-term uses such as M&A.• Because they are not depositary institutions, they are not subject to

banking regulation.• They are, however, subject to exchange regulations as any participant is

in the security markets.


Regulation of the Financial System

• Given the recent upheaval in the financial system, students may be surprise to hear that the financial industry is one of the most heavily regulated industries.

• The main goal is to increase available information and insure soundness of the system.

• In a later chapter we will analyze the regulatory agencies and attempt an explanation of the current turmoil in the markets.


Questions and problems

1. Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft?The share is an asset to the owner because it entitles the owner to a share of the earnings and assets. It is a liability to Microsoft because it is a claim on its earnings and assets by the owner of the share

2. If you own a share in a company, Google for example, your potential profits are unlimited. Explain whether this is true or false. Would the profits be unlimited if you owned Google bonds?

Share holders have potentially unlimited profits (via dividends). Bond holders can earn only the bond interest rate. The two financial instruments do not have the same risk.



3. If you expect a company to go bankrupt next year, which would you rather hold, bonds or equities issued by the company?You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.

4. When you are buying or selling a stock, are you acting in the primary or secondary market? Explain the difference between the markets.

Primary markets are where new securities are issued Secondary markets are where previously issued securities are traded. New York stock exchange and the NASDAQ are secondary markets

5. If you buy a used Renault car is it the primary or secondary market for cars?

Secondary



5. What is the difference between money markets and capital markets?

Money markets are short term lending and borrowing mostly between financial institutions. The capital markets are long term lending and borrowing and include stocks and bonds.

6. US Treasury Bills are traded on which market?

Money markets. The are securities of less than one year.

7. What is commercial paper? And how is it different from a corporate bond?

Commercial paper is short term borrowing by banks and corporations. A corporate bond is long term borrowings.



8. Suppose you are at a family dinner and a rich uncle who has heard that you are taking a course in money and banking, turns to you and asks “What are Federal (Fed) Funds?”. To show your parents that you listen at school, your answer is :

These instruments are typically overnight loans between banks of their deposits at the Federal Reserve. The term is confusing because they are not loans from the Fed. They are inter-bank loans which are sometimes used to meet regulatory requirements on reserves.



9. Why do financial intermediaries exist?

lower transaction costs (higher volumes)

lower risk through portfolio management

developed expertise in handling asymmetric information

10. How does adverse risk selection problem explain why you are more likely to make a loan to a family member than to a stranger?

There is less asymmetric information with a family member than with a stranger because you know your family member better. Adverse selection is that borrowers are people looking for money and therefore have higher risk than people with money.


Questions and problems11. Explain the difference between a commercial bank and an investment

bank.

An investment bank is not really even a bank. It does not have deposits as commercial banks do. Investment banks provide advisory services to companies and governments mainly for the issue of securities and for major transactions. They may provide short-term loans for specific deals. They are not subject to banking regulations as deposit institutions are.

mb2 an overview of the financial system

Documents

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financial markets function

financial markets bonds

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financial intermediary

financial systemin

excess funds

investment funds