01 Overview of the Financial System

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Banking and Finance

An Overviewof the Financial System


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205/09/2012 Zeller: Banking & Finance

Course Requirements

Course material:

everything presented during the classes

all slides on CooSpace

additional readings

Textbook: Mishkin, F.C.: The Economics of Money, Banking

and Financial Markets, Addison-Wesley 2010 (9thedition)


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Grading Policy

Class Participation (quiz)/ Midterm: 30%

maximum of 25% absence is allowed; otherwise the semester can

not be approved. midterm test contains some multiple-choice and true-false

questions also simple problems to solve and short essays for a totalof 100 points,

Final exam: 45%

the final contains short and long essays, small calculations for atotal of 100 points

a student is required to achieve at least 50%+ (pass) of each partof the assessment in order to receive a pass in aggregate

Semester paper 15%

topics on CooSpace, other topics are to be agreed on

Professors evaluation of class performance 10%


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Function of Financial Markets

Perform the essential function ofchanneling funds from economic

players that have saved surplus funds to those that have a shortage of

funds

Direct finance: borrowers borrow funds directly from lenders in

financial markets by selling them securities.

Promotes economic efficiency by producing an efficient allocation

of capital, which increases production Directly improve the well-being of consumers by allowing them to

time purchases better

Technical intermediaries help in the mutual search process

(broker, dealer, dual trader, underwriter)


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Flows of Funds trough the Financial Markets

Borrowers(spenders, deficit)

Savers

(lenders, sufficit)

Funds

SecuritiesHouseholds

Firms

Government

Foreigners

Households

Firms

GovernmentForeigners

Direct finance,

technical intermediaries

Indirect finance, financial intermediaries

Financial markets


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Direct finance

Borrowers turn directly to lenders offeringdifferent securities, i.e.: IOUs (bonds, stocks, etc.)

Technical intermediaries help in the mutualsearch process broker, dealer, dual trader, underwriter

Three major conflicts: nominal value

maturity

risk, etc.


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Financial Intermediaries

They solve the conflicts of: nominal value, maturity,

risk, etc.

increase the saving and borrowing capacity of the

economy Institutions:

banks,

mutual funds,

pension funds, insurance companies, etc.


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Market types

Trade

Primary markets new issues are traded

Secondary markets previously issued securities aretraded

Institutional structure

Exchanges (concentrated markets)

OTC (over the counter) dealers at different locationstrade for or from their inventories

ATS (alternative trading systems)

Maturity Money market (less than 1 year to maturity)

Capital market (more than 1 year to maturity)


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Types of Money Market Instruments

Treasury bills

Negotiable bank CDs

Commercial papers

Bankers acceptances

Repurchase agreements

Eurodollars

Fed funds


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Principal Money Market Instruments


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Types of Capital Market Instruments

Corporate stocks

Mortgages

Corporate bonds

Government securities (notes, bonds) State/Region/Local government

securities

Consumer and bank commercial loans


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Principal Capital Market Instruments


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The Present Model of Securities Trade

Institutionalinvestor

Private

investorBrokerage

company

Institutionalinvestor

Private

investor

Brokerage

company

InternalizationInternalization

CrossingNetwork

OTC

MultilateralTrading Facility

Dark Pool

Exchange

ATS

Internalization:the client makes an order to his/her brokerage to buy or sell a security which fills the order from

its own inventory of the security. Some exchanges prohibit these trades, and brokerages are required

to report internalization on exchanges that permit it.


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Alternative Trading Systems

Multilateral Trading Facility (or MTF) a multilateral system, operated by an investment firm or a market operator, which

brings together multiple third-party buying and selling interests in financialinstruments in a way that results in a contract in accordance with the provisions of

Title II ofMiFID They can be assimilated to alternative trading exchanges providing

additional pool of liquidity to their members (banks, major mutual funds and large

insurance companies).

Crossing network

matches buy and sell orders electronically for execution without first routing theorder to an exchange or other displayed market, Instead the order is either

anonymously placed into a black box or flagged to other participants of the crossing

network. The advantage of the crossing network is the ability to execute a large

block order without impacting the public quote.

Dark pools of liquidity

are crossing networks that provide liquidity that is not displayed on order books.This is useful for traders who wish to move large numbers of shares without

revealing themselves to the open market.
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2004:145:0001:0044:EN:PDFhttp://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2004:145:0001:0044:EN:PDF


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Market Share of MTFs in Stock Trade

0,00%

5,00%

10,00%

15,00%

20,00%

25,00%

2008.

jan.

febr.

r.

pr.

mj.

jn.

jl.

aug.

szept.

okt.

nov.

dec.

2009.

jan.

febr.

r.

pr.

j.

jn.

jl.

aug.

szept.

okt.

nov.

dec.

2010.

jan

feb.

Forrs: FESE

Chi-X(2007. March)

Turquoise(2008. Aug)

BATS

(2008. Oct)

NASDAQ OMX Europe(2008. Sept.)

Burgundy

(2009. May)

QUOTE MTF(2009. Sept)

Equiduct-Berliner (2009.

March)

NYSE ArcaEurope

(2009. mrc.)


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The Structure of Capital Market (January 2010)

Deutsche Boerse

10%

Markit BOAT21%

LSE Group

18%

Euronext

17%

CHI-X9%

Spanish

Exchanges

7%

SIX Swiss

5%

Nasdaq OMX

Nordic

4%

BATS Europe

2%

Turquoise

2%

Other

5%

Forrs: Reuters

M i G f Fi i l I t t 1


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Main Groups of Financial Instruments 1.

Right

Debt - temporary, should be repaid (bond) Equity - permanent, not refunded (stock)

Right limiting the trade of a product (bill of lading, warehouse

warrant, etc)

Right or obligation to buy or sell (option, future)

Reparation certificate (a special Hungarian instrument)

Transferability

Registered: given owner, endorsement on the back or on anattached form

Bearer entitled: simple sale Negotiable: endorsed drafts, universal obligation


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Physical character Materialized: printed, preserved by the owners, physically

transferred when traded Immobilized: printed, deposited at a central place, deposit

certificates

Immaterialized: not printed; bookkeeping entry or electronic sign;transfer between security accounts

Maturity Varies country by country, no consent

Short term: less than 1 year to maturity (consensus),

Medium term: 1-10 years to maturity

Long term: 5 - 30 years

Conditional (console): matures with an event (life insurance) Without maturity: provides the service till the issuer exists

(stock)

i G f i i l 3


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Returns Interest bearing securities

permanent: fix interest from the issue to the maturity flexible

changing by a given schedule (increases 1 % yearly)

pegged to a well measurable economic phenomenon (inflation, prime rate, exchangerate, etc.)

convertible bond (a bond convertible to stock)

Discount papers: issued under and redeemed at the face value

Dividend bearing securities: shares Issuer

Government: federal, state, regional, municipal (local)

Special institutions issue special securities: banks - CDs,

mutual funds - mutual fund shares

warehouses - warehouse warrants mortgage institutions - mortgage bonds

Companies: bonds, stocks,commercial papers...

Anyone: check, drafts...


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Main International Instruments of Financial Markets

Foreign Bonds:

sold in a foreign country and denominated in that country

scurrency

Eurobond:

bond denominated in a currency other than that of the country

in which it is sold

Eurocurrencies:

foreign currencies deposited in banks outside the home country

Eurodollars: U.S. dollars deposited in foreign banks outside the

U.S. or in foreign branches of U.S. banks

World Stock Markets

Help finance governments also

F i f Fi i l I di I i i


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Function of Financial Intermediary Institutions

Institutions:

banks, mutual funds, pension funds, insurance companies,

Reduce the exposure of investors to risk Risk Sharing (Asset Transformation)

Diversification

Deal with asymmetric information problems

(before the transaction) Adverse Selection: try to avoid selectingthe risky borrower.

Gather information about potential borrower.

(after the transaction) Moral Hazard: ensure borrower will notengage in activities that will prevent him/her to repay the loan.

Sign a contract with restrictive covenants.

Conclusion:

Financial intermediaries allow small savers and borrowers tobenefit from the existence of financial markets.

T A d Li bili i f Fi I di i


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Types, Assets and Liabilities of Fin. Intermediaries

Fi i l I t di i d V l f Th i A t


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Financial Intermediaries and Value of Their Assets

R l ti f th Fi i l S t


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Regulation of the Financial System

To increase the information available to investors:

Reduce adverse selection and moral hazard problems

Reduce insider trading (SEC)

To ensure the soundness of financial intermediaries:

Restrictions on entry (chartering process).

Disclosure of information. Restrictions on Assets and Activities (control holding of

risky assets).

Deposit Insurance (avoid bank runs).

Limits on Competition (mostly in the past):

Branching

Restrictions on Interest Rates

P i i l R l t A i f th U S S t


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Principal Regulatory Agencies of the U.S. System

01 Overview of the Financial System

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