An Overview of the Financial System

Lecture Chapter 2

Learning Objectives • This chapter presents an overview of financial markets

and institutions.• Compare and contrast direct and indirect finance.• Identify the structure and components of financial markets.• List and describe the different types of financial market

instruments.• Summarize the roles of transaction costs, risk sharing, and

information costs as they relate to financial intermediaries.• List and describe the different types of financial

intermediaries.

Function of Financial Markets

• Performs the essential function of channeling 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

Function of Financial Markets

• 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

Types of Financial Instruments

• Securities: pieces of paper that give the owner a claim on the issuer’s assets or future payment.

- Simple contracts - Negotiable (can be resold, traded) - Used in both direct and indirect finance

• Loans: – Contracts that are more complicated than securities. – Usually non-negotiable. Have collateral requirements

and covenants. – Used almost exclusively indirect finance.

Types of Finance

1. Direct Finance• Borrowers borrow directly from lenders in financial

markets by selling financial instruments (securities)which are claims on the borrower’s future income or assets

2. Indirect Finance• Borrowers borrow indirectly from lenders via

financial intermediaries that issue financial instruments which are claims on the borrower’s future income or assets

World Without Financial Intermediaries

2-7

Lender – Saver(Households…)

Borrower - spender(Businesses…) Cash

Equity and Debt Securities

In this world (all direct finance) - the flow of funds from savers to borrowers is likely to be low:

• As a lender, how do you know you will get your money back (problem of adverse selection)

• As a lender, how do you know the borrower will use funds as stated? (problem of moral hazard)

• Screening and monitoring is a hassle. Prefer to leave the screening and monitoring to others.

• Lack of liquidity.

World With Financial Intermediaries (FI)

2-8

Lender – Saver(Households….)

Borrower – spenderBusinesses….)

Cash Debt and Equity

FI Broker

FI Asset Transformer

Deposits and Insurance policies

Here we have both direct and indirect finance.

depositsLoans Insurance Policies

BondsStocks

Retirement Plans

Stocks SharesBondsStocks

Commercial paperT-Bills

Shares/ “deposits”

Commercial Banks Insurance Companies

Pension Funds Mutual Funds

Money Market Mutual Funds

Mishkin’s Representation: Function of Financial Markets

Assets

Something of value that you

own

Something you owe.

Indirect Finance Involves Asset Transformation

Liabilities and Net Worth

Net Worth = Assets - Liabilities

Assets

Financial Intermediary - Commercial Bank

– Cash (vault cash)

– Deposits at Fed (Reserves)– Mortgages – Commercial Loans– US Gov’t bonds

–Demand Deposits–Time Deposits–Debt (Borrowing)–Equity Capital(Bank Capital)

Liabilities and Net Worth

Asset Transformation – Banks issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics.

Also, referred to as maturity Transformation – Bank liabilities are short-term, assets are long-term.

Assets

Financial Intermediary - Insurance Company

– Cash

- Mortgages– Corporate Bonds– US Gov’t bonds– Equity (Google Stock

– Insurance Policies (contingent liability)

– Equity Capital

Liabilities and Net Worth

Asset Transformation – Insurance companies issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics

Examples of Direct Finance:

– Initial Public Offering of a stock

– Ford Motor sells bonds to the public

– GE issues commercial paper to public to fund its payroll

– Bowie Bonds

Structure of Financial Markets

1. Debt Markets─ Short-Term (maturity < 1 year)─ Long-Term (maturity > 10 year)─ Intermediate term (maturity in-between)─ Represented $52.4 trillion at the end of 2009.

2. Equity Markets─ Pay dividends, in theory forever─ Represents an ownership claim in the firm─ Total value of all U.S. equity was $20.5 trillion at

the end of 2009.

Structure of Financial Markets

1. Primary Market─ New security issues sold to initial buyers─ Typically involves an investment bank that

underwrites the offering

2. Secondary Market─ Previously issued securities are bought

and sold─ Examples include the NYSE and Nasdaq─ Involves both brokers and dealers (do you know

the difference?)

Structure of Financial Markets: Secondary Markets

Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:

Provides liquidity, making it easy to buy and sell the securities of the companies

Establish a price for the securities

Structure of Financial Markets: Secondary Markets

We can further classify secondary markets as follows:

1. Exchanges─ Trades conducted in central locations - Auction (e.g.,

New York Stock Exchange, CBT)

2. Over-the-Counter Markets─ Dealers at different locations buy and sell─ Best example is the market for Treasury Securities

Classifications of Financial Markets

We can also further classify markets by the maturity of the securities:

1. Money Market: Short-Term (maturity < 1 year)

2. Capital Market: Long-Term (maturity > 1 year)

Principal Money Market Instruments: Short-term debt instruments with maturity < 1 year

http://research.stlouisfed.org/fred2/graph/?id=COMPOUT

Principal Capital Market Instruments Maturity > 1 year

Internationalization of Financial Markets

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

• 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

Financial Intermediaries - Indirect Finance

This is actually the primary means of moving funds from lenders to borrowers.

More important source of finance than securities markets (such as stocks and bonds)

Why? ─ Transaction costs, information costs (asymmetric

information), risk sharing and liquidity.

Copyright © 2007 Pearson Addison-Wesley. All rights

reserved.

Sources of External Finance for Nonfinancial BusinessesFrom Chapter 8

Transaction Cost - Direct Finance is Expensive

• Legal Costs: Loans and securities are legal contracts which must be written carefully to be enforced. Loans are more complicated – covenants and collateral.

• Regulatory costs: Securities. SEC filing requirements. Must file registration statement, prospectus, periodic financial statements.

• Sales Costs: Cost of matching buyers and sellers - Primary Markets: Investment bankers market to potential buyers and guarantee a minimum initial price for a fee.

Financial Intermediaries Reduce Transactions Costs

1. Financial intermediaries make profits by reducing transactions costs

2. Reduce transaction costs by developing expertise (screening and monitoring) and taking advantage of economies of scale

Financial Intermediaries - Economies of Scale

• Most transaction costs associated with a financial transaction are fixed costs

• Independent of size of transactions and number of transactions.

- Legal cost for a $100,000 loan similar to $1,000,000 loan. - Repeated transactions => spread the cost over a large number of loans (e.g. spread $10,000 legal cost over 2,000 loans = $5.00 per loan)

Banks provide liquidity services - services that make it easier for customers to conduct transactions Banks provide depositors with checking accounts

that enable them to pay their bills easily

Depositors can earn interest on checking and savings accounts and convert them into goods and services whenever necessary

Financial Intermediaries - liquidity

Financial Intermediaries – reduce risk

reduce the exposure of investors to risk, through risk sharing

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

─ This process is referred to as asset transformation, risky assets are turned into safer assets for investors

Financial Intermediaries – reduce risk

Allow individuals and businesses to diversify their asset holdings.

Low transaction costs allow FIs to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals (mutual funds).

Financial Intermediaries: Indirect Finance

Information cost - asymmetric information.

─ One party lacks crucial information about another party, impacting decision-making.

─ adverse selection and moral hazard.

Function of FinancialIntermediaries: Indirect Finance

Adverse Selection

1. Before transaction occurs

2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan

3. Similar problems occur with insurance where unhealthy people want their known medical problems covered

Moral Hazard

1. After transaction occurs

2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back

3. Again, with insurance, people may engage in risky activities only after being insured

Asymmetric Information: Adverse Selection and Moral Hazard

Types of Financial Intermediaries

Types of Financial Intermediaries

Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts.

Commercial banks (around 7,000)─ Raise funds primarily by issuing checkable, savings, and time

deposits which are used to make commercial, consumer and mortgage loans

─ Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios

Types of Financial Intermediaries

Thrifts: S&Ls & Mutual Savings Banks (1,300) and Credit Unions (9,500)─ Raise funds primarily by issuing savings, time, and checkable

deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings Banks

─ Mutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company’s workers

Contractual Savings Institutions (CSIs) CSIs acquire funds from clients at periodic intervals on a

contractual basis and have fairly predictable future payout requirements.─ Life Insurance Companies receive funds from policy premiums, can

invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis

─ Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict

─ Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities

Types of Financial Intermediaries Investment Intermediaries

Finance Companies sell commercial paper (a short-term debt instrument), and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations

Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds

Types of Financial Intermediaries

Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments

Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.

Regulatory Agencies

Regulatory Agencies (cont.)

Regulation of Financial Markets

Main Reasons for Regulation

1. Increase Information to Investors

2. Ensure the Soundness of Financial Intermediaries

Regulation of the Financial Markets

• Ensure the soundness of financial intermediaries:– Restrictions on entry (chartering process).

– Disclosure of information (SEC)

– Restrictions on Assets and Activities (control holding of risky assets).

– Deposit Insurance (avoid bank runs).

– In the past, regulation placed limits on competition • Restrictions on bank branches

• Restrictions on Interest Rates

Classifying Financial Instruments

1. Type of claim - Equity (Common Stock): Gives owner a share of

the firm’s assets and profits. Also have voting rights. Debt (loans, bonds, commercial paper): Entitles owner to specific payments on specific dates. If firm fails, get paid before equity holders. Equity holders have a residual claim.

2. Length of the claim - maturity: Money Market or Capital Market. Equity does not mature.

Classifying Financial Instruments

3. Risk: degree of uncertainty as to payment.

Equity generally has the highest risk. Next is various

grades of debt, then unsecured debt such as consumer

loans. Safest: treasury bills and insured bank deposits

4. Liquidity: How quickly converted into medium

of exchange (money).

Demand deposits, followed by savings deposits, treasury securities.

Classifying Financial Instruments

5. Expected Returns. As shown on the next slide, returns are typically higher for riskier, less liquid and longer-maturity assets.

Highest risk: Equities, followed by various grades of debt.

Lowest risk: Treasury bills, demand deposits.

Risk and Return by Asset Class - Ibbotson Associates

11.89.82009

16.611.92009

2009

The Ibbotson Chart• Returns are at 5 % increments.

• Most risk - Equity ( small cap). Low, spread-out “skylines”.

• Least Risk - Treasury bills. Narrow skyline.

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