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The Financial System

Chapter 17

Learning Goals

Outline the structure and importance of the financial system.

List the various types of securities.

Define financial market, and distinguish between primary and secondary financial markets.

Describe the characteristics of the major stock exchanges.

Discuss the organization and functioning of financial institutions.

Explain the functions of the Federal Reserve System and the tools it uses to control the supply of money and credit.

Evaluate the major features of regulations and laws affecting the financial system.

Describe the global financial system.

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The Financial

System

The financial system is the process by which money

flows from savers to users.

Understanding the

Financial System

• Financial System

– Savers

– Users

– Financial Institutions

– Financial Markets

• Savings is a function of many variables.

• Funds can be transferred between users and savers directly or indirectly.

Types of

Securities

• Securities– Financial instruments– Obligations on the part of the issuer

• Businesses and Governments

– Provide rate of return to purchasers

• Money Market Instruments

• Bonds

• Stock

Money Market

Instruments

• Short-term Debt Securities– Issued by governments, financial institutions

and corporations

• Investors are paid interest for the use of their funds.

• Generally low-risk

• U.S. Treasury bills, commercial paper, and bank certificates of deposit

Bonds

• Government Bonds– Bonds sold by the U.S. Department of the

Treasury.

• Municipal Bonds– Bonds issued by state or local governments

• Revenue bonds are used toward a project that will produce revenue, General Obligation Bonds are not.

Bond Ratings

• Price is determined by risk and interest rate.

• Several firms rate bonds– Standard & Poor’s (S&P)– Moody’s

• Investment-grade

• Speculative/Junk

Stocks

• Common stock – ownership claims in corporations.– Vote on major company decisions– Cash dividends– Price appreciation

• Preferred stock – stockholders with preference in the payment of dividends.

Convertible

Securities

Stockholder has the right to exchange the

bond or preferred stock for a fixed

number of shares of common stock.

Financial

Markets

• Primary Market – firms and governments issue securities and sell them initially to the public.– When a firm offers a stock for sale to the

general public for the first time.

• Secondary Market – collection of financial markets in which previously issued securities are traded among investors.

Understanding

Stock Markets

Stock market (exchange) – market in which common stocks are traded, such as the New York Stock Exchange.

Stock Exchanges

• The New York Stock Exchange – the Big Board is the most famous and one of the oldest stock markets in the world. More than 3,000 stocks are listed on NYSE.

• The Nasdaq Stock Market – the second largest stock market. Over 5,000 companies have their stocks listed on Nasdaq but many are smaller firms.

• Other U.S. Stock Markets– The American Stock Exchange/AMEX– Regional Stock Exchanges– Foreign Markets

ECNs and The

Future of Stock

Markets

• ECNs – electronic communication networks– The 4th Market– Buyers and sellers meet in a virtual market

and exchange with one another– Take place on INET or Archipelago

• INET and Archipelago have been purchased by Nasdaq and NYSE

Investor

Participation in the

Stock Markets

• Investors use brokerage firms, they:1) Establish an account2) Enter orders3) Trade stock

• The brokerage firm executes the trade on behalf of the investor, charging a fee for the order

– Market Order– Limit Order

Financial

Institutions

Commercial Banks

Savings Banks and Credit Unions

Non-depository Institutions

Electronic

Banking

An increasing amount of funds move through electronic funds transfer (EFTs).

Millions of businesses and consumers now pay bills and receive payments electronically.

Most employees directly deposit employee paychecks.

Social security and other federal payments are made each year electronically.

Automated Teller Machines (ATMs) continue to grow in popularity.

More than 1/3 of American households use some online banking.

Federal Deposit

Insurance

• Enacted by the Banking Act of 1933

• Restore public confidence in the banking system

• Before deposit insurance, runs were common as people rushed to withdraw their money from the bank

• Deposit insurance shifts the risk of bank failures from individuals to the FDIC

Savings Banks and

Credit Unions

• Offer a variety of consumer services

• 85% of their loans are real estate loans

• Credit unions are cooperative financial institutions that are owned by depositors/members.

• Credit unions are created to serve consumers.

– Insured by National Credit Union Administration (NCUA) which functions the same as the FDIC

Non Depository

Financial

Institutions

Insurance Companies

Pension Funds

Finance Companies

Insurance Companies

Pension Funds

Finance Companies

The Role of the

Federal Reserve

• Created In 1913

• Central bank of the United States

• Regulate commercial banks

• Perform banking-related activities for the U.S. Department of Treasury

• Providing services for banks

• Setting monetary policy

Organization of the

Federal Reserve

• 12 Federal reserve districts– Own federal reserve bank

• District banks are run by a nine-member board of directors.

• The board of governors is the governing body.• Politically independent• Federal Open Markets Committee (FOMC)

sets most policies concerning monetary policy and interest rates.

Check Clearing

and the Fed

• Americans still write billions of paper checks.

• The process by which funds are transferred from the check writer to receiver

• The multiple-step process is managed and cleared by the FED.

• The Check Clearing for the 21st Century Act is making this process more electronic.

Monetary Policy

• Supply of money and credit

• Measures of the money supply: M1 & M2

• The FED requires banks to maintain reserves.

• Set the discount rate

• Open Market Operations

M1 & M2

Graphic

Regulation of the

Financial System

• Bank Regulation

• Government Regulation of the Financial Markets

• Industry Self-Regulation– Rules of conduct by professional

organizations like National Association of Securities Dealers

– Market Surveillance

The Financial System:

A Global

Perspective

• The financial system is more connected.

• Financial institutions are more global.

• Only 3 of the 30 largest banks in the world are US institutions.

• Most nations have a central bank.