1 Overview of Financial Markets

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1February 17th , 2011

Financial Marketsand Institutions :An Overview


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Objectives1. Explain the functions of financial markets2. Explain the types and categories of financial

markets that facilitate the flow of funds

3. Explain the internationalization of financial markets

4. Explain the functions of financial intermediaries5. Describe the main types of financial intermediaries

that facilitate transactions


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Topics include: Function of Financial Markets

Structure of Financial Markets

Internationalization of Financial Markets

Function of Financial Intermediaries Financial Intermediaries

Regulation of the Financial System

Topics


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1. Channels funds from savers toinvestors, thereby promoting economicefficiency.

2. Affects personal wealth and behaviorof business firms.

Well functioning financial markets, suchas the bond market, stock market, andforeign exchange market, are keyfactors in producing high economic

growth

Why Study Financial Markets?


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1. Central Banks and the Conduct of Monetary Policy The role of the Fed and foreign counterparts

2. Structure of the Financial System Helps get funds from savers to investors

3. Banks and Other Financial Institutions Includes the role of insurance companies, mutual funds,

pension funds, etc.

4. Financial Innovation

Focusing on the improvements in technology and itsimpact on how financial products are delivered

5. Managing Risk in Financial Institutions Focusing on risk management in the financial

institution.

Why Study Financial Institutions?


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Overview of Financial Markets (Madura,2010)

Financial markets provide for financialintermediation--financial savings (Surplus Units) toinvestment (Deficit Units)

Financial markets provide payments system Financial markets provide means to manage risk

Financial Market: a market in which financial

assets (securities) such as stocks and bonds

can be purchased or sold


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Money versus Capital Markets

Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

Broad Classifications of Financial Markets(Madura, 2010)


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Money vs. Capital Markets

Money Short-Term, < 1 Year

High Quality Issuers

Debt Only

Primary Market Focus

Liquidity Market--LowReturns

Capital Long-Term, >1Yr

Range of Issuer Quality

Debt and Equity

Secondary Market Focus

Financing Investment--Higher Returns

Classifications of Financial Markets


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Primary vs. Secondary Markets

PRIMARY

New Issue of Securities

Exchange of Funds forFinancial Claim

Funds for Borrower; an

IOU for Lender

SECONDARY

Trading Previously IssuedSecurities

No New Funds for Issuer

Provides Liquidity for

Seller



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Organized vs. Over-the-Counter Markets

Organized

Visible Marketplace

Members Trade

Securities Listed

New York StockExchange

OTC

Wired Network ofDealers

No Central, PhysicalLocation

All Securities Tradedoff the Exchanges



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Allows transfers of funds from person or businesswithout investment opportunities (i.e., Lender-Savers) to one who has them (i.e., Borrower-Spenders)

Improves economic efficiency

Functions of Financial Markets

Direct Finance : Borrowers borrow directly from lenders infinancial markets by selling financial instruments which

are claims on the borrowers future income or assetsIndirect Finance : Borrowers borrow indirectly from lendersvia financial intermediaries (established to source bothloanable funds and loan opportunities) by issuingfinancial instruments which are claims on the borrowers

future income or assets

Segments of Financial Markets


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Figure 1 Flow of Funds Through the Financial System

Functions of Financial Markets


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Internationalization of Financial Markets

International Bond Market Foreign bonds

Eurobonds (now larger than U.S. corporate bond market)

World Stock Markets

U.S. stock markets are no longer always the largestatone point, Japan's was larger


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Function of Financial Intermediaries (FIs)

Financial Intermediaries1. Engage in process of indirect finance

2. More important source of finance than securitiesmarkets

3. Needed because of transactions costs andasymmetric information

Transactions Costs

1. Financial intermediaries make profits by reducingtransactions costs

2. Reduce transactions costs by developing expertiseand taking advantage of economies of scale


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Function of Financial Intermediaries (cont.) A financial intermediarys low transaction costs mean

that it can provide its customers with liquidityservices, services that make it easier for customers toconduct transactions

1. Banks provide depositors with checking accounts that enable

them to pay their bills easily2. Depositors can earn interest on checking and savings

accounts and yet still convert them into goods and serviceswhenever necessary

Another benefit made possible by the FIs low transaction

costs is that they can help reduce the exposure ofinvestors to risk, through a process known as risksharing

FIs create and sell assets with lesser risk to oneparty in order to buy assets with greater risk from another party

This process is referred to as asset transformation, because in a


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Copyright 2006 PearsonAddison-Wesley. All rights

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Financial Intermediaries


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Copyright 2006 PearsonAddison-Wesley. All rights

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Size of Financial Intermediaries


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Types of Financial Intermediaries Depository Institutions (Banks)

Commercial banks

Savings & Loan Associations (S&Ls)

Mutual Savings Banks

Contractual Savings Institutions (Non Depository) Life insurance companies Fire & casualty insurance companies

Pension funds, government retirement funds

Investment Intermediaries

Finance companies Mutual funds

Money market mutual funds


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Depository Institutions (Banks) Commercial banks

Raise funds primarily by issuing checkable, savings, andtime deposits which are used to make commercial,consumer and mortgage loans

Collectively, these banks comprise the largest financialintermediary and have the most diversified asset portfolios

S&Ls, Mutual Savings Banks and Credit Unions Raise funds primarily by issuing savings, time, and

checkable deposits which are most often used to makemortgage and consumer loans, with commercial loans alsobecoming more prevalent at S&Ls and Mutual Savings

Banks Mutual savings banks and credit unions issue deposits asshares and are owned collectively by their depositors, mostof which at credit unions belong to a particular group, e.g., acompanys workers


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Contractual Savings Institutions (CSIs) All CSIs acquire funds from clients at periodic

intervals on a contractual basis and have fairlypredictable future payout requirements. Life Insurance Companies receive funds from policy

premiums, can invest in less liquid corporate securities andmortgages,

since actual benefit pay outs are close to those predicted byactuarial analysis Fire and Casualty Insurance Companies receive funds

from policy premiums, must invest most in liquid governmentand corporate securities, since loss events are harder topredict

Pension and Government Retirement Funds hosted bycorporations and state and local governments acquire fundsthrough employee and employer payroll contributions, investin corporate securities, and provide retirement income via

annuities


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Investment Intermediaries Finance Companies sell commercial paper (a

short-term debt instrument) and issue bonds andstocks to raise funds to lend to consumers to buydurable goods, and to small businesses foroperations

Mutual Funds acquire funds by selling shares toindividual investors (many of whose shares areheld in retirement accounts) and use theproceeds to purchase large, diversified portfoliosof stocks and bonds

Money MarketMutual Funds acquire funds byselling checkable deposit-like shares to individualinvestors and use the proceeds to purchasehighly liquid and safe short-term money marketinstruments


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Regulation of Financial Markets

Three Main Reasons for Regulation1. Increase Information to Investors

2. Ensure the Soundness of Financial Intermediaries

3. Improve Monetary Control


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Regulation Reason:

Increase Investor Information

Asymmetric information in financial markets means that

investors may be subject to adverse selection and moralhazard problems that may hinder the efficient operationof financial markets and may also keep investors awayfrom financial markets

The Securities and Exchange Commission (SEC)requires corporations issuing securities to disclosecertain information about their sales, assets, andearnings to the public and restricts trading by the largeststockholders (known as insiders) in the corporation

Such government regulation can reduce adverseselection and moral hazard problems in financial marketsand increase their efficiency by increasing the amount ofinformation available to investors


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Regulation Reason: Ensure Soundnessof Financial Intermediaries Because providers of funds to financial

intermediaries may not be able to assesswhether the institutions holding their funds aresound or not, if they have doubts about theoverall health of financial intermediaries, theymay want to pull their funds out of both soundand unsound institutions, with the possibleoutcome of a financial panic that produces largelosses for the public and causes serious damage

to the economy


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Regulation: Restriction on Entry

Restrictions on Entry Regulators have created very tight regulations as to

who is allowed to set up a financial intermediary

Individuals or groups that want to establish a

financial intermediary, such as a bank or an insurancecompany, must obtain a charter from the state or thefederal government

Only if they are upstanding citizens with impeccablecredentials and a large amount of initial funds will theybe given a charter.


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Regulation: Disclosure

Disclosure Requirements There are stringent reporting requirements for

financial intermediaries Their bookkeeping must follow certain strict principles,

Their books are subject to periodic inspection,

They must make certain information available tothe public.


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Regulation: Restriction on Assets andActivities

There are restrictions on what financialintermediaries are allowed to do and what assetsthey can hold

Before you put your funds into a bank or some other

such institution, you would want to know that yourfunds are safe and that the bank or other financialintermediary will be able to meet its obligations toyou

One way of doing this is to restrict the financialintermediary from engaging in certain risky activities

Another way is to restrict financial intermediaries fromholding certain risky assets, or at least from holding a

greater quantity of these risky assets than is prudent


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Regulation: Deposit Insurance

The government can insure people providingfunds to a financial intermediary from anyfinancial loss if the financial intermediary shouldfail

The Federal Deposit Insurance Corporation(FDIC), insures each depositor at a commercialbank or mutual savings bank up to a loss of$100,000 per account


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Regulation: Past Limits on Competition

Although the evidence that unbridled competitionamong financial intermediaries promotes failuresthat will harm the public is extremely weak, it hasnot stopped the state and federal governments

from imposing many restrictive regulations In the past, banks were not allowed to open up

branches in other states, and in some states

banks were restricted from openingadditional locations


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Regulation: Past Restrictions on InterestRates Competition has also been inhibited by

regulations that impose restrictions on interestrates that can be paid on deposits

These regulations were instituted because of the

widespread belief that unrestricted interest-ratecompetition helped encourage bank failuresduring the Great Depression

Later evidence does not seem to support this

view, and restrictions on interest rates havebeen abolished


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Regulation: Past Restrictionson Interest Rates Competition has also been inhibited by

regulations that impose restrictions on interestrates that can be paid on deposits

These regulations were instituted because of the

widespread belief that unrestricted interest-ratecompetition helped encourage bank failuresduring the Great Depression

Later evidence does not seem to support this

view, and restrictions on interest rates havebeen abolished


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Regulation Reason: Improve MonetaryControl Because banks play a very important role in determining

the supply of money (which in turn affects many aspectsof the economy), much regulation of these financialintermediaries is intended to improve control over themoney supply

One such regulation is reserve requirements, whichmake it obligatory for all depository institutions to keep acertain fraction of their deposits in accounts with theFederal Reserve System (the Fed), the central bank inthe United States

Reserve requirements help the Fed exercise moreprecise control over the money supply


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Financial Regulation Abroad

Those countries with similar economic systemsalso implement financial regulation consistentwith the U.S. model: Japan, Canada, andWestern Europe

Financial reporting for corporations is required Financial intermediaries are heavily regulated

However, U.S. banks are more regulated along

dimensions of branching and services than theirforeign counterparts.


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Summary

Thank You

REFERENCE

Frederic S. Mishkin and Stanley G. Eakins (2006),Financial Markets + Institutions, 5ed, Addison-Wesley, Boston, MA. (MEA)

Jeff Madura (2006), Financial Institutions and Markets,7ed, Thomson South-Western, Mason, OH. (JEM)

1 Overview of Financial Markets

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