Chapter 2
An Overview of the Financial System
Financial markets and financial intermediaries have the basic function of moving funds from those who have a surplus of funds to those who have a shortage of funds.
Well-functioning financial markets and financial intermediaries are needed to improve economic well-being and efficiency.
This chapter presents the major financial intermediaries and the instruments that are traded in financial markets as well as how these markets are regulated
Function of Financial Markets
Figure 1 Flows of Funds Through the Financial System
INDIRECT FINANCE
Financial
Intermediaries
Funds
Financial
Markets
DIRECT FINANCE
Funds
Lender-Savers
firms
Funds
Borrower-Spenders
firms
Funds
Funds
1. Financial markets perform the essential economic function of channeling funds between lenders and borrowers.
2. The principal lender-savers are households, but businesses and the government as well as foreigners are also lenders.
3. The principal borrowers-spenders are businesses and the government, but households and foreigners also borrow to finance their spending.
4. Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments).
5. Securities are assets for the persons who buys them but liabilities for the individual or firm that sells them.
Structure of Financial Markets
1. Debts and Equity Markets
(1) A firm can obtain funds in a financial market in two ways. One is to issue a debt instrument, such as a bond or a mortgage. This contractual agreement promises to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date.
(2) The maturity of a debt instrument is the time to that instrument’s expiration date. A debt instrument is short term if its maturity is less than a year and long term if its maturity is ten years or longer. The debt instrument with a maturity between one and ten years are intermediate term.
(3) The second method of raising funds is by issuing equities, such as common stocks, which are claims to share in the net income and the assets of a business. Equities usually make periodic payments (dividends) to their holders and are considered long term securities.
(4)The main disadvantage of owning a corporation’s equities is that the holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders.
(5) The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders.
2. Primary and secondary markets
(1) A primary market is a financial market in which new issues of a security are sold to initial buyers by the corporation or government agency borrowing the funds.
(2) A secondary market is a financial market in which securities that have been previously issued can be resold.
(3) An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public.
(4) Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of investors who match buyers and sellers of securities. Dealers link buyers and sellers by buying and selling securities at stated prices.
(5) Secondary markets serve two important functions. First, they make the financial instruments more liquid, and therefore more desirable and easier for the issuing firm to sell in the primary market. Second, they determine the price of the security that the issuing firm will receive for a new security in the primary market.
3. Exchanges and Over-the-Counter Markets
(1) Secondary markets can be organized in two ways. One is to organize exchanges, where buyers and sellers of securities meet in one central location to conduct trades.
(2) The other method of organizing a secondary market is to have an over-the-counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices.
(3) The US government bond market is set up as an over-the-counter market. Others that are traded in this way are negotiable certificates of deposit, federal funds, bankers’ acceptances, and foreign exchange.
4. Money and Capital markets
(1) Another way of distinguishing between markets is on the bases of the maturity of the securities traded in each market. The money market is a financial market in which only short term debt instruments (less than one year) are traded. The capital market is the market in which longer-term debt ( one year or greater) and equity instruments are traded.
(2) Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. Money market securities have smaller fluctuations in prices than longer-term securities, making them safer investments.
Financial Market Instruments
1. Money market Instruments
Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments.
Treasury bills
These short term debt instruments of the government are issued in 3-, 6-, and 12-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount. They are the most liquid and the safest of all money market instruments because they are the most actively traded and there is no possibility of default.
Negotiable Bank Certificates of Deposit
A CD is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original price. In 1961, Citibank introduced the first negotiable CD in large denominations that could be resold in a secondary market.
Commercial Paper
It is a short term debt instrument issued by large banks and well-known corporations. Corporations engage in direct finance by issuing commercial papers.
Banker’s Acceptances
It is a bank draft issued by a firm, payable at some future date, and guaranteed for a fee by the bank. The issuing firm is required to deposit the required funds into its account to cover the draft. These accepted drafts are often resold in a secondary market at a discount.
Repurchase Agreements
Repurchase agreements (Repos) are effectively short-term loans (with a maturity less than two weeks) in which treasury bills serve as collateral. The most important lenders in this market are large corporations.
Federal Funds
They are typically overnight loans between banks of their deposits at the Federal Reserve. The market is very sensitive to the credit needs of the banks. The interest rate on these loans is called the federal funds rate, which is closely watched barometer of the tightness of credit market conditions and the stance of monetary policy.
2. Capital Market Instruments
Capital market instruments are debt and equity instruments with maturities of greater than one year.
Stocks
stocks are equity claims on the net income and assets of a corporation.
Mortgages
Mortgages are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans. An important development in the residential mortgage market in recent years is the mortgage-backed security.
Corporate Bonds
These are long-term bonds issued by corporations with very strong credit ratings. It sends an interest payment twice a year and pays off the face value when the bond matures.
Convertible bonds have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date.
Government Securities
These long-term debt instruments are issued by the Treasury to finance the deficits of the federal government. They are the most liquid security traded in the capital market.
Government Agency Securities
These are long-term bonds issued by various government agencies. Many of these are guaranteed by the federal government.
State and Local Government Bonds
Municipal bonds are long-term debt instruments issued by state and local governments. Their interest payments are exempt from federal income tax and generally from state taxes in the issuing state.
Consumer and Bank Commercial Loans
these are loans to consumers and businesses made principally by banks or finance companies. They are the least liquid of the capital market instruments.
Internationalization of Financial Markets
International Bond market, Eurobonds, and Eurocurrencies
The traditional instruments in the international bond market are known as foreign bonds. Foreign bonds are sold in a foreign country and are denominated in that country’s currency. Eurobond is a bond denominated in a currency other than that of the country in which it is sold.
Eurocurrencies and Eurodollars
Eurocurrencies are foreign currencies deposited in banks outside the home country.
Eurodollars are . dollars deposited in foreign banks outside the United States.
World Stock Markets
Globalization increases the interactions among major stock markets in the world.
Function of Financial Intermediaries
Funds can move from lenders to borrowers by a second route, called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrows-spenders and helps transfer funds from one to the other.
The process of indirect finance using financial intermediaries, called financial intermediation is the primary route for moving funds from lenders to borrowers.
Why are financial intermediaries and indirect finance so important in financial markets?
The role of transaction costs and information costs in financial markets.
1. Transaction Costs
Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend.
Financial intermediaries can substantially reduce transaction costs by developed expertise in lowering them and by taking advantage of economies of scale, the reduction in transaction costs per dollar of transactions as the size of transactions increases.
2. Asymmetric Information: Adverse Selection and Moral Hazard
In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. Asymmetric information can create two problems: Adverse selection and moral hazard.
Adverse selection is the problem before the transaction occurs. It occurs in financial markets when the potential borrowers who are the most likely to produce an adverse outcome are the ones who most actively seek out a loan and are thus most likely to be selected.
Moral hazard is the problem after the transaction occurs. Moral hazard in financial markets is the risk that the borrower might engage in activities that are undesirable from the lenders’ point of view.
Financial intermediaries can alleviate the adverse selection and moral hazard problems.
Successful financial intermediaries are better equipped to screen out good from bad credit risks, thereby reducing losses due to adverse selection.
Financial intermediaries develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard.
Financial Intermediaries
They fall into three categories: depository institutions (banks), contractual saving institutions, and investment intermediaries.
1. Depository Institutions
Depository institutions are financial intermediaries that accept deposits from individuals and institutions and make loans.
They are involved in the creation of deposits, an important component of the money supply.
Commercial Banks
They raise funds primarily by issuing checkable deposits, savings deposits, and time deposits. They use these funds to make commercial, consumer, and mortgage loans and buy government securities.
Savings and Loan Associations
(S&Ls) obtain funds primarily through savings deposits (shares) and time and checkable deposits. The acquired funds have traditionally been used to make mortgage loans.
Now the distinction between savings and loans and commercial banks has blurred.
Mutual Savings Banks
They raise funds by accepting deposits and use them to make mortgage loans.
The depositors own the bank.
They are similar to savings and loans.
They now can issue checkable deposits and make loans other than mortgages.
Credit Unions
They are very small cooperative lending institutions organized around a particular group.
They acquire funds from deposits called shares and primarily make consumer loans.
They can now issue checkable deposits and make mortgage loans.
2. Contractual Savings Institutions
They are financial intermediaries, such as insurance companies and pension funds, that acquire funds at periodic intervals on a contractual basis. The liquidity of assets is not as important as it is for depository institutions. They tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages.
Life Insurance Companies
they insure people against financial hazards following a death and sell annuities. They acquire funds from the premiums that people pay to keep their policies in force and use them to buy corporate bonds, stocks, and mortgages.
Fire and Casualty Insurance Companies
They insure their policyholders against loss from theft, fire, and accidents. They receive funds through premiums for their policies, and use funds to buy more liquid assets than life insurance companies, mostly municipal bonds.
Pension Funds and Government Retirement Funds
private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and employees. The largest asset holdings of pension funds are corporate bonds and stocks.
3. Investment Intermediaries
they includes finance companies, mutual funds, and money market mutual funds.
Finance Companies
they raise funds by selling commercial paper and by issuing stocks and bonds. They lend these funds to consumers and to small businesses.
Some finance companies are organized by a parent corporation to help sell its products.
Mutual Funds
They acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds.
They can take advantage of lower transaction costs.
Money Market Mutual Funds
They have the characteristics of a mutual fund but also function to some extent as a depository institution by offering deposit-type accounts.
They sell shares to acquire funds that are used to buy money market instruments that are safe and liquid.
They function like checking account deposits that pay interest, but with some restrictions on the checking-writing privilege.
Regulation of the Financial System
1. Increasing information available to investors
Government regulation can reduce adverse selection and moral hazard problems in financial markets by increasing the amount of information available to investors.
2. Ensuring the soundness of financial intermediaries
To protect the public and the economy from financial panics, the government has implemented six types of regulations:
(1) Restrictions on entry: regulations governing who is allowed to
set up a financial intermediary.
(2) Disclosure: There are stringent reporting requirements for financial
intermediaries.
(3) Restrictions on assets and activities: Restrictions on what financial intermediaries are allowed
to do and what assets they can hold.
(4) Deposit insurance: The government can insure people providing funds to a financial intermediary from any financial loss if the financial intermediary should fail. (5) Limits on competition: government often declared that unbridled competition among financial intermediaries promotes failures that harm the public. (6) Restrictions on interest rate: competition has also been inhibited by regulations that impose restrictions on interest rate that can be paid on deposits.
3. Improving control of monetary policy
Banks play an important role in determining the supply of money, much regulation is intended to improve control over the money supply, such as reserve requirements and deposit insurance regulation.
Financial regulation abroad
The major differences between financial regulation in the . and abroad relate to bank regulation. In the past, the United States was the only industrialized country to subject banks to restrictions on branching. . Banks are also the most restricted in the range of assets they may hold.
