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[Frederic s. mishkin,_stanley_eakins]_financial_ma(bookos.org)
[Frederic s. mishkin,_stanley_eakins]_financial_ma(bookos.org)
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  • 1. Financial Marketsand InstitutionsSEVENTH EDITION
  • 2. The Prentice Hall Series in FinanceAlexander/Sharpe/Bailey Geisst Megginson Fundamentals of Investments Investment Banking in the Financial Corporate Finance Theory SystemAndersen Melvin Global Derivatives: A Strategic Risk Gitman International Money and Finance Management Perspective Principles of Managerial Finance* Principles of Managerial Finance–– Mishkin/EakinsBear/Moldonado-Bear Brief Edition* Financial Markets and Institutions Free Markets, Finance, Ethics, and Law Gitman/Joehnk MoffettBerk/DeMarzo Fundamentals of Investing* Cases in International Finance Corporate Finance* Corporate Finance: The Core* Gitman/Madura Moffett/Stonehill/Eiteman Introduction to Finance Fundamentals of Multinational FinanceBierman/Smidt The Capital Budgeting Decision: Guthrie/Lemon Nofsinger Economic Analysis of Investment Projects Mathematics of Interest Rates and Finance Psychology of InvestingBodie/Merton/Cleeton Haugen Ogden/Jen/O’Connor Financial Economics The Inefficient Stock Market: What Pays Advanced Corporate Finance Off and WhyClick/Coval Modern Investment Theory Pennacchi The Theory and Practice of International The New Finance: Overreaction, Theory of Asset Pricing Financial Management Complexity, and Uniqueness RejdaCopeland/Weston/Shastri Holden Principles of Risk Management and Financial Theory and Corporate Policy Excel Modeling and Estimation in the Insurance Fundamentals of Corporate Finance SchoenebeckCornwall/Vang/Hartman Excel Modeling and Estimation in the Entrepreneurial Financial Management Interpreting and Analyzing Financial Fundamentals of Investments Statements Excel Modeling and Estimation inCox/Rubinstein Investments Scott/ Martin/ Petty/Keown/Thatcher Options Markets Excel Modeling and Estimation in Cases in FinanceDorfman Corporate Finance Introduction to Risk Management and Seiler Insurance Hughes/MacDonald Performing Financial Studies: A International Banking: Text and Cases Methodological CookbookDietrich Financial Services and Financial Hull Shapiro Fundamentals of Futures and Options Capital Budgeting and Investment Institutions: Value Creation in Theory and Practice Markets Analysis Options, Futures, and Other DerivativesDufey/Giddy Risk Management and Financial Sharpe/Alexander/Bailey Cases in International Finance Institutions InvestmentsEakins Keown Solnik/McLeavey Finance in .learn Personal Finance: Turning Money into Global Investments WealthEiteman/Stonehill/Moffett Stretcher/Michael Multinational Business Finance Keown/Martin/Petty/Scott Cases in Financial Management Financial Management: Principles andEmery/Finnerty/Stowe Applications Titman/Martin Corporate Financial Management Foundations of Finance: The Logic and Valuation: The Art and Science of Practice of Financial Management Corporate Investment DecisionsFabozzi Bond Markets, Analysis and Strategies Kim/Nofsinger Trivoli Corporate Governance Personal Portfolio Management:Fabozzi/Modigliani Fundamentals and Strategies Capital Markets: Institutions and Levy/Post Instruments Investments Van Horne Financial Management and PolicyFabozzi/Modigliani/Jones/Ferri May/May/Andrew Financial Market Rates and Flows Foundations of Financial Markets and Effective Writing: A Handbook for Finance Institutions People Van Horne/Wachowicz Fundamentals of Financial ManagementFinkler Madura Financial Management for Public, Health, Personal Finance Vaughn and Not-for-Profit Organizations Financial Planning for the Entrepreneur MarthinsenFrancis/Ibbotson Risk Takers: Uses and Abuses of Financial Weston/Mitchel/Mulherin Investments: A Global Perspective Derivatives Takeovers, Restructuring, and Corporate GovernanceFraser/Ormiston McDonald Understanding Financial Statements Derivatives Markets Winger/Frasca Fundamentals of Derivatives Markets Personal Fikance *denotes titles Log onto www.myfinancelab.com to learn more
  • 3. Financial Marketsand InstitutionsSEVENTH EDITIONFrederic S. MishkinGraduate School of Business, Columbia UniversityStanley G. EakinsEast Carolina University Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
  • 4. Editorial Director: Sally Yagan Cover Designer: Jonathan BoylanEditor in Chief: Donna Battista Cover Images: © Dorling Kindersley;Acquisitions Editor: Noel Kamm Seibert Petrol/Westend61 GmbH/Alamy; KevinEditorial Project Manager: Melissa Pellerano Foy/Alamy; JLImages/Alamy; MartinDirector of Marketing: Patrice Jones Preston/Shutterstock Images; paokun/ShutterstockFull-Service Project Management/Composition: Images; Tupungato/Shutterstock Images; GEX Publishing Services HenryHo/Shutterstock ImagesManaging Editor: Nancy Fenton Media Producer: Nicole SackinSenior Production Project Manager: Nancy Freihofer Supplements Editor: Alison EudsenText Permissions Project Supervisor: Michael Joyce Printer/Binder: R.R. Donnelley, WillardPermissions Researcher: Jill Dougan Cover Printer: Lehigh PhoenixSenior Manufacturing Buyer: Carol Melville Text Font: 10/12 ITCCentury LightText Designer: GEX Publishing ServicesCredits and acknowledgments borrowed from other sources and reproduced, with permission, in this text-book appear on appropriate page within text.Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U.S.A. and othercountries. Screen shots and icons reprinted with permission from the Microsoft Corporation. This book is notsponsored or endorsed by or affiliated with the Microsoft Corporation.Copyright © 2012, 2009, 2006 Pearson Education, Inc. All rights reserved. Manufactured in the United Statesof America. This publication is protected by Copyright, and permission should be obtained from the publisherprior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means,electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from thiswork, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www.pearsoned.com/legal/permission.htmMany of the designations by manufacturers and sellers to distinguish their products are claimed as trade-marks. Where those designations appear in this book, and the publisher was aware of a trademark claim, thedesignations have been printed in initial caps or all caps.Library of Congress Cataloging-in-Publication DataMishkin, Frederic S. Financial markets and institutions / Frederic S. Mishkin, Stanley G.Eakins. -- 7th ed. p. cm. -- (The Prentice Hall series in finance) Includes index. ISBN 978-0-13-213683-9 (0-13-213683-x) 1. Financial institutions--United States. 2. Money--United States. 3.Money market--United States. 4. Banks and banking--United States. I.Eakins, Stanley G. II. Title. III. Series. HG181.M558 2012 332.10973--dc22201004849010 9 8 7 6 5 4 3 2 1 ISBN 10: 0-13-213683-X ISBN 13: 978-0-13-213683-9
  • 5. To My Dad —F. S. M.To My Wife, Laurie —S. G. E.
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  • 7. Contents in Brief Contents in Detail ix Contents on the Web xxvii Preface xxix About the Authors xxxix PART ONE INTRODUCTION 1 1 Why Study Financial Markets and Institutions? 1 2 Overview of the Financial System 15 PART TWO FUNDAMENTALS OF FINANCIAL MARKETS 36 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 36 4 Why Do Interest Rates Change? 64 5 How Do Risk and Term Structure Affect Interest Rates? 89 6 Are Financial Markets Efficient? 116PART THREE FUNDAMENTALS OF FINANCIAL INSTITUTIONS 134 7 Why Do Financial Institutions Exist? 134 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy? 163PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 191 9 Central Banks and the Federal Reserve System 191 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 214 PART FIVE FINANCIAL MARKETS 254 11 The Money Markets 254 12 The Bond Market 279 13 The Stock Market 302 14 The Mortgage Markets 323 15 The Foreign Exchange Market 344 16 The International Financial System 374 PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY 398 17 Banking and the Management of Financial Institutions 398 18 Financial Regulation 425 19 Banking Industry: Structure and Competition 454 20 The Mutual Fund Industry 489 21 Insurance Companies and Pension Funds 513 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 543 vii
  • 8. viii Contents in Brief PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS 568 23 Risk Management in Financial Institutions 568 24 Hedging with Financial Derivatives 590 Glossary G-1 Index I-1 CHAPTERS ON THE WEB 25 Savings Associations and Credit Unions 26 Finance Companies
  • 9. Contents in Detail Contents on the Web xxvii Preface xxix About the Authors xxxixPART ONE INTRODUCTIONChapter 1 Why Study Financial Markets and Institutions? 1 Preview 1 Why Study Financial Markets? 2 Debt Markets and Interest Rates 2 The Stock Market 3 The Foreign Exchange Market 4 Why Study Financial Institutions? 6 Structure of the Financial System 6 Financial Crises 6 Central Banks and the Conduct of Monetary Policy 6 The International Financial System 7 Banks and Other Financial Institutions 7 Financial Innovation 7 Managing Risk in Financial Institutions 7 Applied Managerial Perspective 8 How We Will Study Financial Markets and Institutions 8 Exploring the Web 9 Collecting and Graphing Data 9 Web Exercise 10 Concluding Remarks 12 Summary 12 Key Terms 13 Questions 13 Quantitative Problems 14 Web Exercises 14Chapter 2 Overview of the Financial System 15 Preview 15 Function of Financial Markets 16 Structure of Financial Markets 18 Debt and Equity Markets 18 Primary and Secondary Markets 18 Exchanges and Over-the-Counter Markets 19 Money and Capital Markets 20 ix
  • 10. x Contents in Detail Internationalization of Financial Markets 20 International Bond Market, Eurobonds, and Eurocurrencies 20 ■ GLOBAL Are U.S. Capital Markets Losing Their Edge? 21 World Stock Markets 22 Function of Financial Intermediaries: Indirect Finance 22 Transaction Costs 22 ■ FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes 23 ■ GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 24 Risk Sharing 25 Asymmetric Information: Adverse Selection and Moral Hazard 25 Types of Financial Intermediaries 27 Depository Institutions 28 Contractual Savings Institutions 29 Investment Intermediaries 29 Regulation of the Financial System 30 Increasing Information Available to Investors 30 Ensuring the Soundness of Financial Intermediaries 32 Financial Regulation Abroad 33 Summary 33 Key Terms 34 Questions 34 Web Exercises 35 PART TWO FUNDAMENTALS OF FINANCIAL MARKETS Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 36 Preview 36 Measuring Interest Rates 37 Present Value 37 Four Types of Credit Market Instruments 39 Yield to Maturity 40 ■ GLOBAL Negative T-Bill Rates? It Can Happen 47 The Distinction Between Real and Nominal Interest Rates 48 The Distinction Between Interest Rates and Returns 50 ■ MINI-CASE With TIPS, Real Interest Rates Have Become Observable in the United States 51 Maturity and the Volatility of Bond Returns: Interest-Rate Risk 53 Reinvestment Risk 54 ■ MINI-CASE Helping Investors Select Desired Interest-Rate Risk 54 Summary 55 ■ THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk 55 Calculating Duration 56 Duration and Interest-Rate Risk 60 Summary 61 Key Terms 62 Questions 62
  • 11. Contents in Detail xi Quantitative Problems 62 Web Exercises 63Chapter 4 Why Do Interest Rates Change? 64 Preview 64 Determinants of Asset Demand 64 Wealth 65 Expected Returns 65 Risk 66 Liquidity 67 Summary 68 Supply and Demand in the Bond Market 68 Demand Curve 69 Supply Curve 69 Market Equilibrium 70 Supply-and-Demand Analysis 71 Changes in Equilibrium Interest Rates 72 Shifts in the Demand for Bonds 72 Shifts in the Supply of Bonds 75 ■ CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect 78 ■ CASE Changes in the Interest Rate Due to a Business Cycle Expansion 79 ■ CASE Explaining Low Japanese Interest Rates 81 ■ CASE Reading the Wall Street Journal “Credit Markets” Column 82 ■ FOLLOWING THE FINANCIAL NEWS The “Credit Markets” Column 83 ■ THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts 84 ■ FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates 85 Summary 85 Key Terms 86 Questions 86 Quantitative Problems 87 Web Exercises 87 Web Appendices 88Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 89 Preview 89 Risk Structure of Interest Rates 89 Default Risk 90 ■ CASE The Subprime Collapse and the Baa-Treasury Spread 93 Liquidity 93 Income Tax Considerations 94 Summary 95 ■ CASE Effects of the Bush Tax Cut and Its Possible Repeal on Bond Interest Rates 96 Term Structure of Interest Rates 96 ■ FOLLOWING THE FINANCIAL NEWS Yield Curves 97 Expectations Theory 98 Market Segmentation Theory 102 Liquidity Premium Theory 103
  • 12. xii Contents in Detail Evidence on the Term Structure 106 Summary 107 ■ MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 108 ■ CASE Interpreting Yield Curves, 1980–2010 108 ■ THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates 110 Summary 112 Key Terms 113 Questions 113 Quantitative Problems 114 Web Exercises 115 Chapter 6 Are Financial Markets Efficient? 116 Preview 116 The Efficient Market Hypothesis 117 Rationale Behind the Hypothesis 119 Stronger Version of the Efficient Market Hypothesis 120 Evidence on the Efficient Market Hypothesis 120 Evidence in Favor of Market Efficiency 120 ■ MINI-CASE An Exception That Proves the Rule: Ivan Boesky 122 ■ CASE Should Foreign Exchange Rates Follow a Random Walk? 124 Evidence Against Market Efficiency 124 Overview of the Evidence on the Efficient Market Hypothesis 126 ■ THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 127 How Valuable Are Published Reports by Investment Advisers? 127 ■ MINI-CASE Should You Hire an Ape as Your Investment Adviser? 127 Should You Be Skeptical of Hot Tips? 128 Do Stock Prices Always Rise When There Is Good News? 128 Efficient Markets Prescription for the Investor 129 ■ CASE What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis? 130 Behavioral Finance 131 Summary 132 Key Terms 132 Questions 132 Quantitative Problems 133 Web Exercises 133 PART THREE FUNDAMENTALS OF FINANCIAL INSTITUTIONS Chapter 7 Why Do Financial Institutions Exist? 134 Preview 134 Basic Facts About Financial Structure Throughout the World 134 Transaction Costs 138 How Transaction Costs Influence Financial Structure 138 How Financial Intermediaries Reduce Transaction Costs 138 Asymmetric Information: Adverse Selection and Moral Hazard 139
  • 13. Contents in Detail xiii The Lemons Problem: How Adverse Selection Influences Financial Structure 140 Lemons in the Stock and Bond Markets 140 Tools to Help Solve Adverse Selection Problems 141 ■ MINI-CASE The Enron Implosion 143 How Moral Hazard Affects the Choice Between Debt and Equity Contracts 145 Moral Hazard in Equity Contracts: The Principal–Agent Problem 145 Tools to Help Solve the Principal–Agent Problem 146 How Moral Hazard Influences Financial Structure in Debt Markets 148 Tools to Help Solve Moral Hazard in Debt Contracts 149 Summary 151 ■ CASE Financial Development and Economic Growth 152 ■ MINI-CASE Should We Kill All the Lawyers? 153 ■ CASE Is China a Counter-Example to the Importance of Financial Development? 154 Conflicts of Interest 154 What Are Conflicts of Interest and Why Do We Care? 155 Why Do Conflicts of Interest Arise? 155 ■ MINI-CASE The Demise of Arthur Andersen 157 ■ MINI-CASE Credit Rating Agencies and the 2007–2009 Financial Crisis 158 What Has Been Done to Remedy Conflicts of Interest? 158 ■ MINI-CASE Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets? 160 Summary 160 Key Terms 161 Questions 161 Quantitative Problems 162 Web Exercises 162Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy? 163 Preview 163 Asymmetric Information and Financial Crises 164 Agency Theory and the Definition of a Financial Crisis 164 Dynamics of Financial Crises in Advanced Economies 164 Stage One: Initiation of Financial Crisis 164 Stage Two: Banking Crisis 167 Stage Three: Debt Deflation 168 ■ CASE The Mother of All Financial Crises: The Great Depression 169 ■ CASE The 2007–2009 Financial Crisis 171 Causes of the 2007–2009 Financial Crisis 171 Effects of the 2007–2009 Financial Crisis 172 ■ INSIDE THE FED Was the Fed to Blame for the Housing Price Bubble? 174 ■ GLOBAL Ireland and the 2007–2009 Financial Crisis 177 Height of the 2007–2009 Financial Crisis and the Decline of Aggregate Demand 178 Dynamics of Financial Crises in Emerging Market Economies 178 Stage One: Initiation of Financial Crisis 178 Stage Two: Currency Crisis 181 Stage Three: Full-Fledged Financial Crisis 182
  • 14. xiv Contents in Detail ■ CASE Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 184 ■ GLOBAL The Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis 185 Summary 188 Key Terms 189 Questions 189 Web Exercises 190 Web References 190 PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY Chapter 9 Central Banks and the Federal Reserve System 191 Preview 191 Origins of the Federal Reserve System 192 ■ INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System 192 Structure of the Federal Reserve System 193 Federal Reserve Banks 194 ■ INSIDE THE FED The Special Role of the Federal Reserve Bank of New York 195 Member Banks 196 Board of Governors of the Federal Reserve System 197 ■ INSIDE THE FED The Role of the Research Staff 198 Federal Open Market Committee (FOMC) 198 The FOMC Meeting 199 ■ INSIDE THE FED Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? 200 Why the Chairman of the Board of Governors Really Runs the Show 200 ■ INSIDE THE FED How Bernanke’s Style Differs from Greenspan’s 201 How Independent Is the Fed? 202 Structure and Independence of the European Central Bank 203 Differences Between the European System of Central Banks and the Federal Reserve System 204 Governing Council 204 How Independent Is the ECB? 205 Structure and Independence of Other Foreign Central Banks 206 Bank of Canada 206 Bank of England 206 Bank of Japan 207 The Trend Toward Greater Independence 207 Explaining Central Bank Behavior 207 Should the Fed Be Independent? 208 The Case for Independence 208 ■ INSIDE THE FED The Evolution of the Fed’s Communication Strategy 209 The Case Against Independence 210 Central Bank Independence and Macroeconomic Performance Throughout the World 211
  • 15. Contents in Detail xv Summary 212 Key Terms 212 Questions and Problems 212 Web Exercises 213Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 214 Preview 214 The Federal Reserve’s Balance Sheet 214 Liabilities 215 Assets 216 Open Market Operations 216 Discount Lending 217 The Market for Reserves and the Federal Funds Rate 217 Demand and Supply in the Market for Reserves 218 How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate 219 ■ INSIDE THE FED Why Does the Fed Need to Pay Interest on Reserves? 220 ■ CASE How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate 223 Tools of Monetary Policy 224 Open Market Operations 224 A Day at the Trading Desk 225 Discount Policy 226 Operation of the Discount Window 226 Lender of Last Resort 227 Reserve Requirements 228 ■ INSIDE THE FED Federal Reserve Lender-of-Last-Resort Facilities During the 2007–2009 Financial Crisis 229 Monetary Policy Tools of the European Central Bank 230 Open Market Operations 231 Lending to Banks 231 Reserve Requirements 231 The Price Stability Goal and the Nominal Anchor 232 The Role of a Nominal Anchor 232 The Time-Inconsistency Problem 232 Other Goals of Monetary Policy 233 High Employment 233 Economic Growth 234 Stability of Financial Markets 234 Interest-Rate Stability 234 Stability in Foreign Exchange Markets 235 Should Price Stability Be the Primary Goal of Monetary Policy? 235 Hierarchical vs. Dual Mandates 235 Price Stability as the Primary, Long-Run Goal of Monetary Policy 236 Inflation Targeting 237 Inflation Targeting in New Zealand, Canada, and the United Kingdom 237 Advantages of Inflation Targeting 238
  • 16. xvi Contents in Detail ■ GLOBAL The European Central Bank’s Monetary Policy Strategy 240 Disadvantages of Inflation Targeting 240 ■ INSIDE THE FED Chairman Bernanke and Inflation Targeting 242 Central Banks’ Response to Asset-Price Bubbles: Lessons from the 2007–2009 Financial Crisis 243 Two Types of Asset-Price Bubbles 243 Should Central Banks Respond to Bubbles? 244 Should Monetary Policy Try to Prick Asset-Price Bubbles? 244 Are Other Types of Policy Responses Appropriate? 245 Tactics: Choosing the Policy Instrument 246 Criteria for Choosing the Policy Instrument 248 ■ THE PRACTICING MANAGER Using a Fed Watcher 249 Summary 250 Key Terms 251 Questions 251 Quantitative Problems 252 Web Exercises 252 Web Appendices 253 PART FIVE FINANCIAL MARKETS Chapter 11 The Money Markets 254 Preview 254 The Money Markets Defined 255 Why Do We Need the Money Markets? 255 Money Market Cost Advantages 256 The Purpose of the Money Markets 257 Who Participates in the Money Markets? 258 U.S. Treasury Department 258 Federal Reserve System 258 Commercial Banks 258 Businesses 259 Investment and Securities Firms 260 Individuals 260 Money Market Instruments 260 Treasury Bills 261 ■ CASE Discounting the Price of Treasury Securities to Pay the Interest 261 ■ MINI-CASE Treasury Bill Auctions Go Haywire 264 Federal Funds 264 Repurchase Agreements 266 Negotiable Certificates of Deposit 267 Commercial Paper 268 Banker’s Acceptances 271 Eurodollars 271 ■ GLOBAL Ironic Birth of the Eurodollar Market 272 Comparing Money Market Securities 273 Interest Rates 273
  • 17. Contents in Detail xvii Liquidity 274 How Money Market Securities Are Valued 274 ■ FOLLOWING THE FINANCIAL NEWS Money Market Rates 274 Summary 276 Key Terms 277 Questions 277 Quantitative Problems 277 Web Exercises 278Chapter 12 The Bond Market 279 Preview 279 Purpose of the Capital Market 279 Capital Market Participants 280 Capital Market Trading 280 Types of Bonds 281 Treasury Notes and Bonds 282 Treasury Bond Interest Rates 282 Treasury Inflation-Protected Securities (TIPS) 282 Treasury STRIPS 283 Agency Bonds 284 ■ CASE The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac 284 Municipal Bonds 286 Risk in the Municipal Bond Market 288 Corporate Bonds 288 Characteristics of Corporate Bonds 289 Types of Corporate Bonds 290 Financial Guarantees for Bonds 293 Current Yield Calculation 294 Current Yield 294 Finding the Value of Coupon Bonds 295 Finding the Price of Semiannual Bonds 296 Investing in Bonds 298 Summary 299 Key Terms 300 Questions 300 Quantitative Problems 300 Web Exercises 301Chapter 13 The Stock Market 302 Preview 302 Investing in Stocks 302 Common Stock vs. Preferred Stock 303 How Stocks Are Sold 304 Computing the Price of Common Stock 307 The One-Period Valuation Model 308 The Generalized Dividend Valuation Model 309
  • 18. xviii Contents in Detail The Gordon Growth Model 309 Price Earnings Valuation Method 311 How the Market Sets Security Prices 311 Errors in Valuation 313 Problems with Estimating Growth 313 Problems with Estimating Risk 314 Problems with Forecasting Dividends 314 ■ CASE The 2007–2009 Financial Crisis and the Stock Market 314 ■ CASE The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market 315 Stock Market Indexes 316 ■ MINI-CASE History of the Dow Jones Industrial Average 318 Buying Foreign Stocks 318 Regulation of the Stock Market 319 The Securities and Exchange Commission 319 Summary 320 Key Terms 320 Questions 321 Quantitative Problems 321 Web Exercises 322 Chapter 14 The Mortgage Markets 323 Preview 323 What Are Mortgages? 324 Characteristics of the Residential Mortgage 325 Mortgage Interest Rates 325 ■ CASE The Discount Point Decision 326 Loan Terms 327 Mortgage Loan Amortization 329 Types of Mortgage Loans 330 Insured and Conventional Mortgages 330 Fixed- and Adjustable-Rate Mortgages 330 Other Types of Mortgages 331 Mortgage-Lending Institutions 333 Loan Servicing 334 ■ E-FINANCE Borrowers Shop the Web for Mortgages 335 Secondary Mortgage Market 335 Securitization of Mortgages 336 What Is a Mortgage-Backed Security? 336 Types of Pass-Through Securities 337 Subprime Mortgages and CDOs 338 The Real Estate Bubble 339 Summary 340 Key Terms 340 Questions 341 Quantitative Problems 341 Web Exercises 343
  • 19. Contents in Detail xix Chapter 15 The Foreign Exchange Market 344 Preview 344 Foreign Exchange Market 345 What Are Foreign Exchange Rates? 346 Why Are Exchange Rates Important? 346 ■ FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates 347 How Is Foreign Exchange Traded? 348 Exchange Rates in the Long Run 348 Law of One Price 348 Theory of Purchasing Power Parity 349 Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates 350 Factors That Affect Exchange Rates in the Long Run 351 Exchange Rates in the Short Run: A Supply and Demand Analysis 352 Supply Curve for Domestic Assets 353 Demand Curve for Domestic Assets 353 Equilibrium in the Foreign Exchange Market 354 Explaining Changes in Exchange Rates 355 Shifts in the Demand for Domestic Assets 355 Recap: Factors That Change the Exchange Rate 358 ■ CASE Changes in the Equilibrium Exchange Rate: An Example 360 ■ CASE Why Are Exchange Rates So Volatile? 362 ■ CASE The Dollar and Interest Rates 362 ■ CASE The Subprime Crisis and the Dollar 364 ■ CASE Reading the Wall Street Journal: The “Currency Trading” Column 365 ■ FOLLOWING THE FINANCIAL NEWS The “Currency Trading” Column 366 ■ THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts 366 Summary 367 Key Terms 368 Questions 368 Quantitative Problems 368 Web Exercises 369Chapter 15 Appendix The Interest Parity Condition 370 Comparing Expected Returns on Domestic and Foreign Assets 370 Interest Parity Condition 372 Chapter 16 The International Financial System 374 Preview 374 Intervention in the Foreign Exchange Market 374 Foreign Exchange Intervention and the Money Supply 374 ■ INSIDE THE FED A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk 376 Unsterilized Intervention 377 Sterilized Intervention 377 Balance of Payments 379 ■ GLOBAL Why the Large U.S. Current Account Deficit Worries Economists 380
  • 20. xx Contents in Detail Exchange Rate Regimes in the International Financial System 380 Fixed Exchange Rate Regimes 381 How a Fixed Exchange Rate Regime Works 381 ■ GLOBAL The Euro’s Challenge to the Dollar 383 ■ GLOBAL Argentina’s Currency Board 384 ■ GLOBAL Dollarization 385 ■ CASE The Foreign Exchange Crisis of September 1992 386 ■ THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis 387 ■ CASE Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 388 ■ CASE How Did China Accumulate Over $2 Trillion of International Reserves? 389 Managed Float 390 Capital Controls 391 Controls on Capital Outflows 391 Controls on Capital Inflows 391 The Role of the IMF 392 Should the IMF Be an International Lender of Last Resort? 392 How Should the IMF Operate? 393 Summary 395 Key Terms 395 Questions 396 Quantitative Problems 396 Web Exercises 397 Web Appendices 397 PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY Chapter 17 Banking and the Management of Financial Institutions 398 Preview 398 The Bank Balance Sheet 399 Liabilities 399 Assets 401 Basic Banking 403 General Principles of Bank Management 405 Liquidity Management and the Role of Reserves 406 Asset Management 408 Liability Management 409 Capital Adequacy Management 410 ■ THE PRACTICING MANAGER Strategies for Managing Bank Capital 412 ■ CASE How a Capital Crunch Caused a Credit Crunch in 2008 413 Off-Balance-Sheet Activities 414 Loan Sales 414 Generation of Fee Income 414 Trading Activities and Risk Management Techniques 415 ■ CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, and Societé Generale: Rogue Traders and the Principal–Agent Problem 416 Measuring Bank Performance 417 Bank’s Income Statement 417
  • 21. Contents in Detail xxi Measures of Bank Performance 419 Recent Trends in Bank Performance Measures 420 Summary 422 Key Terms 422 Questions 422 Quantitative Problems 423 Web Exercises 424Chapter 18 Financial Regulation 425 Preview 425 Asymmetric Information and Financial Regulation 425 Government Safety Net 425 ■ GLOBAL The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 427 Restrictions on Asset Holdings 430 Capital Requirements 430 Prompt Corrective Action 431 ■ GLOBAL Whither the Basel Accord? 432 Financial Supervision: Chartering and Examination 433 Assessment of Risk Management 434 Disclosure Requirements 435 Consumer Protection 436 Restrictions on Competition 436 ■ MINI-CASE Mark-to-Market Accounting and the 2007–2009 Financial Crisis 437 ■ MINI-CASE The 2007–2009 Financial Crisis and Consumer Protection Regulation 438 Summary 438 ■ E-FINANCE Electronic Banking: New Challenges for Bank Regulation 439 ■ GLOBAL International Financial Regulation 440 The 1980s Savings and Loan and Banking Crisis 443 Federal Deposit Insurance Corporation Improvement Act of 1991 444 Banking Crises Throughout the World in Recent Years 445 “Déjà Vu All Over Again” 447 The Dodd-Frank Bill and Future Regulation 448 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 448 Future Regulation 449 Summary 451 Key Terms 451 Questions 451 Quantitative Problems 452 Web Exercises 453 Web Appendices 453Chapter 19 Banking Industry: Structure and Competition 454 Preview 454 Historical Development of the Banking System 454 Multiple Regulatory Agencies 456
  • 22. xxii Contents in Detail Financial Innovation and the Growth of the Shadow Banking System 457 Responses to Changes in Demand Conditions: Interest Rate Volatility 458 Responses to Changes in Supply Conditions: Information Technology 459 ■ E-FINANCE Will “Clicks” Dominate “Bricks” in the Banking Industry? 461 ■ E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking? 462 ■ E-FINANCE Are We Headed for a Cashless Society? 463 Avoidance of Existing Regulations 465 ■ MINI-CASE Bruce Bent and the Money Market Mutual Fund Panic of 2008 467 ■ THE PRACTICING MANAGER Profiting from a New Financial Product: A Case Study of Treasury Strips 467 Financial Innovation and the Decline of Traditional Banking 469 Structure of the U.S. Commercial Banking Industry 473 Restrictions on Branching 474 Response to Branching Restrictions 474 Bank Consolidation and Nationwide Banking 475 ■ E-FINANCE Information Technology and Bank Consolidation 477 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 477 What Will the Structure of the U.S. Banking Industry Look Like in the Future? 478 Are Bank Consolidation and Nationwide Banking Good Things? 478 Separation of the Banking and Other Financial Service Industries 479 Erosion of Glass-Steagall 480 The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall 480 Implications for Financial Consolidation 480 Separation of Banking and Other Financial Services Industries Throughout the World 481 ■ MINI-CASE The 2007-2009 Financial Crisis and the Demise of Large, Free-Standing Investment Banks 481 Thrift Industry: Regulation and Structure 482 Savings and Loan Associations 482 Mutual Savings Banks 483 Credit Unions 483 International Banking 483 Eurodollar Market 484 Structure of U.S. Banking Overseas 485 Foreign Banks in the United States 485 Summary 486 Key Terms 487 Questions 487 Web Exercises 488 Chapter 20 The Mutual Fund Industry 489 Preview 489 The Growth of Mutual Funds 489 The First Mutual Funds 490 Benefits of Mutual Funds 490 Ownership of Mutual Funds 491
  • 23. Contents in Detail xxiii Mutual Fund Structure 494 Open- Versus Closed-End Funds 494 Organizational Structure 494 ■ CASE Calculating a Mutual Fund’s Net Asset Value 495 Investment Objective Classes 497 Equity Funds 497 Bond Funds 498 Hybrid Funds 498 Money Market Funds 499 Index Funds 500 Fee Structure of Investment Funds 501 Regulation of Mutual Funds 502 Hedge Funds 503 ■ MINI-CASE The Long Term Capital Debacle 505 Conflicts of Interest in the Mutual Fund Industry 506 ■ CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring Ethical Standards 507 Sources of Conflicts of Interest 506 Mutual Fund Abuses 507 ■ CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread 509 Government Response to Abuses 509 Summary 510 Key Terms 510 Questions 511 Quantitative Problems 511 Web Exercises 512Chapter 21 Insurance Companies and Pension Funds 513 Preview 513 Insurance Companies 514 Fundamentals of Insurance 515 Adverse Selection and Moral Hazard in Insurance 515 Selling Insurance 516 ■ MINI-CASE Insurance Agent: The Customer’s Ally 517 Growth and Organization of Insurance Companies 517 Types of Insurance 518 Life Insurance 518 Health Insurance 522 Property and Casualty Insurance 524 Insurance Regulation 525 ■ CONFLICTS OF INTEREST Insurance Behemoth Charged with Conflicts of Interest Violations 526 ■ THE PRACTICING MANAGER Insurance Management 526 Screening 527 Risk-Based Premium 527 Restrictive Provisions 528 Prevention of Fraud 528
  • 24. xxiv Contents in Detail Cancellation of Insurance 528 Deductibles 528 Coinsurance 529 Limits on the Amount of Insurance 529 Summary 529 Credit Default Swaps 529 ■ CONFLICTS OF INTEREST The AIG Blowup 530 Pensions 531 ■ CONFLICTS OF INTEREST The Subprime Financial Crisis and the Monoline Insurers 531 Types of Pensions 532 Defined-Benefit Pension Plans 532 Defined-Contribution Pension Plans 532 Private and Public Pension Plans 533 ■ MINI-CASE Power to the Pensions 534 Regulation of Pension Plans 537 Employee Retirement Income Security Act 537 Individual Retirement Plans 539 The Future of Pension Funds 540 Summary 540 Key Terms 541 Questions 541 Quantitative Problems 541 Web Exercises 542 Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 543 Preview 543 Investment Banks 544 Background 544 Underwriting Stocks and Bonds 545 ■ FOLLOWING THE FINANCIAL NEWS New Securities Issues 548 Equity Sales 550 Mergers and Acquisitions 551 Securities Brokers and Dealers 552 Brokerage Services 553 Securities Dealers 555 ■ MINI-CASE Example of Using the Limit-Order Book 556 Regulation of Securities Firms 556 Relationship Between Securities Firms and Commercial Banks 558 Private Equity Investment 558 Venture Capital Firms 558 Private Equity Buyouts 562 Advantages to Private Equity Buyouts 563 ■ E-FINANCE Venture Capitalists Lose Focus with Internet Companies 563 Life Cycle of the Private Equity Buyout 564
  • 25. Contents in Detail xxv Summary 564 Key Terms 565 Questions 565 Quantitative Problems 566 Web Exercises 567PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS Chapter 23 Risk Management in Financial Institutions 568 Preview 568 Managing Credit Risk 569 Screening and Monitoring 569 Long-Term Customer Relationships 570 Loan Commitments 571 Collateral 571 Compensating Balances 572 Credit Rationing 572 Managing Interest-Rate Risk 573 Income Gap Analysis 574 Duration Gap Analysis 576 Example of a Nonbanking Financial Institution 581 Some Problems with Income Gap and Duration Gap Analyses 582 ■ THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk 584 Summary 585 Key Terms 586 Questions 586 Quantitative Problems 586 Web Exercises 589 Chapter 24 Hedging with Financial Derivatives 590 Preview 590 Hedging 590 Forward Markets 591 Interest-Rate Forward Contracts 591 ■ THE PRACTICING MANAGER Hedging Interest-Rate Risk with Forward Contracts 591 Pros and Cons of Forward Contracts 592 Financial Futures Markets 593 Financial Futures Contracts 593 ■ FOLLOWING THE FINANCIAL NEWS Financial Futures 594 ■ THE PRACTICING MANAGER Hedging with Financial Futures 595 Organization of Trading in Financial Futures Markets 597 Globalization of Financial Futures Markets 597 Explaining the Success of Futures Markets 598 ■ MINI-CASE The Hunt Brothers and the Silver Crash 600 ■ THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts 601
  • 26. xxvi Contents in Detail Hedging Foreign Exchange Risk with Forward Contracts 601 Hedging Foreign Exchange Risk with Futures Contracts 602 Stock Index Futures 603 Stock Index Futures Contracts 603 ■ MINI-CASE Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987? 603 ■ FOLLOWING THE FINANCIAL NEWS Stock Index Futures 604 ■ THE PRACTICING MANAGER Hedging with Stock Index Futures 605 Options 606 Option Contracts 606 Profits and Losses on Option and Futures Contracts 607 Factors Affecting the Prices of Option Premiums 610 Summary 611 ■ THE PRACTICING MANAGER Hedging with Futures Options 613 Interest-Rate Swaps 613 Interest-Rate Swap Contracts 613 ■ THE PRACTICING MANAGER Hedging with Interest-Rate Swaps 613 Advantages of Interest-Rate Swaps 615 Disadvantages of Interest-Rate Swaps 615 Financial Intermediaries in Interest-Rate Swaps 616 Credit Derivatives 616 Credit Options 616 Credit Swaps 617 Credit-Linked Notes 617 ■ CASE Lessons from the Subprime Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? 618 Summary 619 Key Terms 620 Questions 620 Quantitative Problems 620 Web Exercises 623 Web Appendices 623 Glossary G-1 Index I-1
  • 27. Contents on the Web The following updated chapters and appendices are available on our Companion Website at www.pearsonhighered.com/mishkin_eakins.Chapter 25 Savings Associations and Credit Unions Preview Mutual Savings Banks Savings and Loan Associations Mutual Savings Banks and Savings and Loans Compared Savings and Loans in Trouble: The Thrift Crisis Later Stages of the Crisis: Regulatory Forbearance Competitive Equality in Banking Act of 1987 Political Economy of the Savings and Loan Crisis Principal–Agent Problem for Regulators and Politicians ■ CASE Principal–Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal Savings and Loan Bailout: Financial Institutions Reform, Recovery, and Enforcement Act of 1989 The Savings and Loan Industry Today Number of Institutions S&L Size S&L Assets S&L Liabilities and Net Worth Capital Profitability and Health The Future of the Savings and Loan Industry Credit Unions History and Organization Sources of Funds Uses of Funds Advantages and Disadvantages of Credit Unions The Future of Credit Unions Summary Key Terms Questions Web ExercisesChapter 26 Finance Companies History of Finance Companies I Purpose of Finance Companies Risk in Finance Companies xxvii
  • 28. xxviii Contents on the Web Types of Finance Companies Business (Commercial) Finance Companies Consumer Finance Companies Sales Finance Companies Regulation of Finance Companies Finance Company Balance Sheet Assets Liabilities Income Finance Company Growth Summary Key Terms Questions Web Exercises CHAPTER APPENDICES Chapter 4 Appendix 1: Models of Asset Pricing Chapter 4 Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Chapter 4 Appendix 3: Loanable Funds Framework Chapter 4 Appendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework Chapter 10 Appendix: The Fed’s Balance Sheet and the Monetary Base Chapter 16 Appendix: Balance of Payments Chapter 18 Appendix 1: Evaluating FDICIA and Other Proposed Reforms of the Banking Regulatory System Chapter 18 Appendix 2: Banking Crises Throughout the World Chapter 24 Appendix: More on Hedging with Financial Derivatives
  • 29. PrefaceA Note from Frederic Mishkin When I took leave from Columbia University in September 2006 to take a position as a member (governor) of the Board of Governors of the Federal Reserve System, I never imagined how exciting—and stressful—the job was likely to be. How was I to know that, as Alan Greenspan put it, the world economy would be hit by a “once- in-a-century credit tsunami,” the global financial crisis of 2007–2009. When I returned to Columbia in September 2008, the financial crisis had reached a particularly viru- lent stage, with credit markets completely frozen and some of our largest financial institutions in very deep trouble. The global financial crisis, which has been the worst financial crisis the world has experienced since the Great Depression, has completely changed the nature of financial markets and institutions. Given what has happened, the seventh edition of Financial Markets and Institutions not only ended up being the most extensive revision that my co-author and I have ever done, but I believe it is also the most exciting. I hope that students reading this book will have as much fun learning from it as we have had in writing it. December 2010What’s New in the Seventh Edition In addition to the expected updating of all data through 2010 whenever possible, there is major new material in every part of the text. The Global Financial Crisis The global financial crisis of 2007–2009 has led to a series of events that have com- pletely changed the structure of the financial system and the way central banks oper- ate. This has required a rewriting of almost the entire textbook, including a new chapter, a rewrite of one whole chapter, and addition of many new sections, appli- cations, and boxes throughout the rest of the book. xxix
  • 30. xxx Preface New Chapter 8: “Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?” With the coming of the subprime financial crisis, a financial markets and institutions textbook would not be complete without an extensive analysis of financial crises like the recent one. Using an economic analysis of the effects of asymmetric information on financial markets and the economy, this new chapter greatly expands on the dis- cussion of financial crises that was in the previous edition to see why financial crises occur and why they have such devastating effects on the economy. This analysis is used to explain the course of events in a number of past financial crises throughout the world, with a particular focus on explaining the recent financial crisis. Because the recent events in the financial crisis have been so dramatic, the material in this chap- ter is very exciting for students. Indeed, when teaching this chapter after I returned to Columbia, the students were the most engaged with this material than anything else I have taught in my entire career of over 30 years of teaching. Reordering of Part 6, “Financial Institutions,” and Rewrite of Chapter 18, “The Economic Analysis of Financial Regulation” In past editions, the chapter on the structure of the banking industry was followed by the chapter on banking regulation. This ordering no longer makes sense in the aftermath of the recent financial crisis, because nonbank financial institutions, such as investment banks, have for the most part disappeared as free-standing institutions and are now part of banking organizations. To reflect the new financial world that we have entered, we should first discuss the financial industry as a whole and then look at the specifics of how the now more broadly based banking industry is structured. To do this, we have moved the chap- ter on regulation to come before the chapter on the structure of the banking indus- try and have rewritten it to focus less on bank regulation and more on regulation of the overall financial system. Compelling New Material on the 2007–2009 Financial Crisis Throughout the Text The recent financial crisis has had such far-reaching effects on the field of financial markets and institutions that almost every chapter has required changes to reflect what has happened. A large amount of substantive new material on the impact of the financial crisis has also been added throughout the book, including: • A new “Case” on the subprime collapse and the Baa-Treasury spread (Chapter 5) • A new “Mini-Case” on credit-rating agencies and the 2007–2009 financial cri- sis (Chapter 7) • A new “Inside the Fed” box on Federal Reserve lender-of-last-resort facili- ties during the 2007–2009 financial crisis (Chapter 10) • A new section on lessons from the financial crisis as to how central banks should respond to asset price bubbles (Chapter 10)
  • 31. Preface xxxi • A new section on the role of asset-backed commercial paper in the financial crisis (Chapter 11) • A new section on the subprime financial crisis and the bailout of Fannie Mae and Freddie Mac (Chapter 12) • A new section on credit default swaps and their role in the financial crisis (Chapter 12) • A new section on the subprime financial crisis and the stock market (Chapter 13) • An expanded coverage of mortgage pass-through securities that relates col- lateralized mortgage obligations to subprime mortgages and to the financial crisis (Chapter 14) • A new section on the real estate bubble (Chapter 14) • A new “Case” on the financial crisis and the dollar (Chapter 15) • A new “Case” on how a capital crunch caused a credit crunch in 2008 (Chapter 17) • A new section on the Dodd-Frank bill and future regulation (Chapter 18) • A new “Mini-Case” on mark-to-market accounting and the financial crisis (Chapter 18) • A new “Mini-Case” on the financial crisis and consumer protection regula- tion (Chapter 18) • A new “Mini-Case” on the money market mutual fund panic of 2008 (Chapter 19) • A new “Mini-Case” on the demise of large, free-standing investment banks (Chapter 19) • A new section on the impact of credit default swaps on the insurance indus- try and the bailout of AIG (Chapter 21) • A new “Case” on lessons from the subprime financial crisis: when are finan- cial derivatives likely to be a worldwide time bomb (Chapter 24)Additional New MaterialThere have also been changes in financial markets and institutions in recent yearsthat have not been directly related to the recent financial crisis, and I have added thefollowing material to keep the text current: • A new section on the positive role that lawyers play in our financial system, entitled “Should We Kill All the Lawyers?” (Chapter 7) • A new “Inside the Fed” box on how Bernanke’s style differs from Greenspan’s (Chapter 9) • A new “Inside the Fed” box on the evolution of the Fed’s communication strategy (Chapter 9) • A new “Case” on how the Federal Reserve’s operating procedure limits fluctuations in the federal funds rate (Chapter10) • A new “Inside the Fed” box on why the Fed pays interest on reserves (Chapter 10) • An update on the “Inside the Fed” box on Chairman Bernanke and inflation targeting (Chapter 10) • A rewritten section on financial innovation and the growth of the “shadow banking system” (Chapter 19)
  • 32. xxxii Preface Further Simplification of the Supply-and- Demand Analysis of the Foreign Exchange Market The chapter on the determination of exchange rates has always been challenging for some students. In the sixth edition, we moved the analysis closer to a more tra- ditional supply-and-demand analysis to make it more intuitive for students. Although this change has been very well received by instructors, we felt that the model of exchange rate determination could be made even easier for the students if we rele- gated the calculation comparing expected returns and interest parity to an appen- dix. Doing so in the seventh edition simplifies the discussion appreciably and should make the analysis of exchange rate determination much more accessible to students. Improved Exposition and Organization Helpful comments from reviewers prompted us to improve the exposition through- out the book. Reviewers convinced us that the discussion of conflicts of interest in the financial services industry could be shortened, and this material has now been moved to Chapter 7. Reviewers also convinced us that because saving institutions and credit unions are now just another part of the banking industry, we have com- bined the material on these institutions with material on the commercial banking industry into one chapter. Because some instructors might want to discuss saving institutions and credit unions in more detail, we continue to have a separate chap- ter on these institutions available on the web. Appendices on the Web The Website for this book, www.pearsonhighered.com/mishkin_eakins, has allowed us to retain and add new material for the book by posting content online. The appen- dices include: Chapter 4: Models of Asset Pricing Chapter 4: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Chapter 4: Loanable Funds Framework Chapter 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework Chapter 10: The Fed’s Balance Sheet and the Monetary Base Chapter 16: Balance of Payments Chapter 18: Evaluating FDICIA and Other Proposed Reforms of the Bank Regulatory System Chapter 18: Banking Crises Throughout the World Chapter 24: More on Hedging with Financial Derivatives Instructors can either use these appendices in class to supplement the material in the textbook, or recommend them to students who want to expand their knowl- edge of the financial markets and institutions field.
  • 33. Preface xxxiiiHallmarks Although this text has undergone a major revision, it retains the basic hallmarks that make it the best-selling textbook on financial markets and institutions. The seventh edition of Financial Markets and Institutions is a practical introduction to the workings of today’s financial markets and institutions. Moving beyond the descrip- tions and definitions provided by other textbooks in the field, Financial Markets and Institutions encourages students to understand the connection between the theoretical concepts and their real-world applications. By enhancing students’ ana- lytical abilities and concrete problem-solving skills, this textbook prepares students for successful careers in the financial services industry or successful interactions with financial institutions, whatever their jobs. To prepare students for their future careers, Financial Markets and Institutions provides the following features: • A unifying analytic framework that uses a few basic principles to organize students’ thinking. These principles include: Asymmetric information (agency) problems Conflicts of interest Transaction costs Supply and demand Asset market equilibrium Efficient markets Measurement and management of risk • “The Practicing Manager” sections include nearly 20 hands-on applications that emphasize the financial practitioner’s approach to financial markets and institutions. • A careful step-by-step development of models enables students to master the material more easily. • A high degree of flexibility allows professors to teach the course in the man- ner they prefer. • International perspectives are completely integrated throughout the text. • “Following the Financial News” and “Case: Reading the Wall Street Journal,” are features that encourage the reading of a financial newspaper. • Numerous cases increase students’ interest by applying theory to real-world data and examples. • The text focuses on the impact of electronic (computer and telecommunica- tions) technology on the financial system. The text makes extensive use of the Internet with Web exercises, Web sources for charts and tables, and Web refer- ences in the margins. It also features special “E-Finance” boxes that explain how changes in technology have affected financial markets and institutions.
  • 34. xxxiv Preface Flexibility There are as many ways to teach financial markets and institutions as there are instructors. Thus, there is a great need to make a textbook flexible in order to sat- isfy the diverse needs of instructors, and that has been a primary objective in writ- ing this book. This textbook achieves this flexibility in the following ways: • Core chapters provide the basic analysis used throughout the book, and other chapters or sections of chapters can be assigned or omitted according to instructor preferences. For example, Chapter 2 introduces the financial system and basic concepts such as transaction costs, adverse selection, and moral hazard. After covering Chapter 2, an instructor can decide to teach a more detailed treatment of financial structure and financial crises using chapters in Part 3 of the text, or cover specific chapters on financial mar- kets or financial institutions in Parts 4 or 5 of the text, or the instructor can skip these chapters and take any of a number of different paths. • The approach to internationalizing the text using separate, marked interna- tional sections within chapters and separate chapters on the foreign exchange market and the international monetary system is comprehensive yet flexible. Although many instructors will teach all the international mate- rial, others will choose not to. Instructors who want less emphasis on inter- national topics can easily skip Chapter 15 (on the foreign exchange market) and Chapter 16 (on the international financial system). • “The Practicing Manager” applications, as well as Part 7 on the management of financial institutions, are self-contained and so can be skipped without loss of continuity. Thus, an instructor wishing to teach a less managerially oriented course, who might want to focus more on public policy issues, will have no trouble doing so. Alternatively, Part 7 can be taught earlier in the course, immediately after Chapter 17 on bank management. The course outlines listed next for a semester teaching schedule illustrate how this book can be used for courses with a different emphasis. More detailed infor- mation about how the text can offer flexibility in your course is available in the Instructor’s Manual. Financial markets and institutions emphasis: Chapters 1–5, 7–8, 11–13, 17–19 , and a choice of five other text chapters Financial markets and institutions with international emphasis: Chapters 1–5, 7–8, 11–13, 15–19, and a choice of three other text chapters Managerial emphasis: Chapters 1–5, 17–19, 23–24, and a choice of eight other text chapters Public policy emphasis: Chapters 1–5, 7–10, 17–18, and a choice of seven other text chapters Making It Easier to Teach Financial Markets and Institutions The demands for good teaching at business schools have increased dramatically in recent years. To meet these demands, we have provided the instructor with sup- plementary materials, unavailable with any competing textbook, that should make teaching the course substantially easier.
  • 35. Preface xxxv The Instructor’s Manual includes chapter outlines, overviews, teaching tips, and answers to the end-of-chapters questions and quantitative problems. We are also pleased to offer over 1,000 PowerPoint slides. These slides are comprehensive and outline all the major points covered in the text. They have been successfully class tested by the authors and should make it much easier for other instructors to pre- pare their own PowerPoint slides or lecture notes. This edition of the book comes with a powerful teaching tool: an Instructor’s Resource Center online offering the Instructor’s Manual, PowerPoint presentations, and Computerized Test Bank files. Using these supplements, all available via the Instructor’s Resource Center online at www.pearsonhighered.com/irc, instructors can prepare student handouts such as solutions to problem sets made up of end-of-chapter problems. We have used hand- outs of this type in our classes and have found them to be very effective. To facili- tate classroom presentation even further, the PowerPoint presentations include all the book’s figures and tables in full color, as well as all the lecture notes; all are fully customizable. The Computerized Test Bank software (TestGen-EQ with QuizMaster-EQ for Windows and Macintosh) is a valuable test preparation tool that allows professors to view, edit, and add questions. Instructors have our permission and are encouraged to reproduce all of the materials on the Instructor’s Resource Center online and use them as they see fit in class.Pedagogical Aids A textbook must be a solid motivational tool. To this end, we have incorporated a wide variety of pedagogical features. 1. Chapter Previews at the beginning of each chapter tell students where the chapter is heading, why specific topics are important, and how they relate to other topics in the book. 2. Cases demonstrate how the analysis in the book can be used to explain many important real-world situations. A special set of cases called “Case: Reading the Wall Street Journal” shows students how to read daily columns in this leading financial newspaper. 3. “The Practicing Manager” is a set of special cases that introduce students to real-world problems that managers of financial institutions have to solve. 4. Numerical Examples guide students through solutions to financial problems using formulas, time lines, and calculator key strokes. 5. “Following the Financial News” boxes introduce students to relevant news articles and data that are reported daily in the Wall Street Journal and other financial news sources and explain how to read them. 6. “Inside the Fed” boxes give students a feel for what is important in the operation and structure of the Federal Reserve System. 7. “Global” boxes include interesting material with an international focus. 8. “E-Finance” boxes relate how changes in technology have affected finan- cial markets and institutions. 9. “Conflicts of Interest” boxes outline conflicts of interest in different finan- cial service industries. 10. “Mini-Case” boxes highlight dramatic historical episodes or apply the theory to the data.
  • 36. xxxvi Preface 11. Summary Tables are useful study aids for reviewing material. 12. Key Statements are important points that are set in boldface type so that students can easily find them for later reference. 13. Graphs with captions, numbering over 60, help students understand the interrelationship of the variables plotted and the principles of analysis. 14. Summaries at the end of each chapter list the chapter’s main points. 15. Key Terms are important words or phrases that appear in boldface type when they are defined for the first time and are listed at the end of each chapter. 16. End-of-Chapter Questions help students learn the subject matter by apply- ing economic concepts, and feature a special class of questions that students find particularly relevant, titled “Predicting the Future.” 17. End-of-Chapter Quantitative Problems, numbering over 250, help stu- dents to develop their quantitative skills. 18. Web Exercises encourage students to collect information from online sources or use online resources to enhance their learning experience. 19. Web Sources report the URL source of the data used to create the many tables and charts. 20. Marginal Web References point the student to Websites that provide infor- mation or data that supplement the text material. 21. Glossary at the back of the book defines all the key terms. 22. Full Solutions to the Questions and Quantitative Problems appear in the Instructor’s Manual and on the Instructor’s Resource Center online at www.pearsonhighered.com/irc. Professors have the flexibility to share the solutions with their students as they see fit. Supplementary Materials The seventh edition of Financial Markets and Institutions includes the most com- prehensive program of supplementary materials of any textbook in its field. These items are available to qualified domestic adopters but in some cases may not be avail- able to international adopters. These include the following items: For the Professor Materials for the professor may be accessed at the Instructor’s Resource Center online, located at www.pearsonhighered.com/irc. 1. Instructor’s Manual: This manual, prepared by the authors, includes chap- ter outlines, overviews, teaching tips, and complete solutions to questions and problems in the text. 2. PowerPoint: Prepared by John Banko (University of Florida). The presen- tation, which contains lecture notes and the complete set of figures and tables from the textbook, contains more than 1,000 slides that comprehensively out- line the major points covered in the text. 3. Test Item File: Updated and revised for the seventh edition, the Test Item File comprises over 2,500 multiple-choice, true-false, and essay questions. All of the questions from the Test Item File are available in computerized for- mat for use in the TestGen software. The TestGen software is available for both Windows and Macintosh systems.
  • 37. Preface xxxvii 4. Mishkin-Eakins Companion Website (located at http://www .pearsonhighered.com/mishkin_eakins) features Web chapters on sav- ing associations and credit unions and another on finance companies, Web appendices, animated figures, and links to relevant data sources and Federal Reserve Websites. For the Student 1. Study Guide: Updated and revised for the seventh edition, the Study Guide offers chapter summaries, exercises, self-tests, and answers to the exercises and self-tests. 2. Readings in Financial Markets and Institutions, edited by James W. Eaton of Bridgewater College and Frederic S. Mishkin. Updated annually, with numerous new articles each year, this valuable resource is available online at the book’s Website (www.pearsonhighered.com/mishkin_eakins). 3. Mishkin-Eakins Companion Website (located at www.pearsonhighered .com/mishkin_eakins) includes Web chapters on saving associations and credit unions and another on finance companies, Web appendices, animated figures, glossary flash cards, Web exercises, and links from the textbook. Acknowledgments As always in so large a project, there are many people to thank. Our special grati- tude goes to Bruce Kaplan, former economics editor at HarperCollins; Donna Battista, my former finance editor; Noel Kamm Seibert, my current finance editor at Prentice Hall; and Jane Tufts and Amy Fleischer, our former development editors. We also have been assisted by comments from my colleagues at Columbia and from my students. In addition, we have been guided in this edition and its predecessors by the thoughtful comments of outside reviewers and correspondents. Their feedback has made this a better book. In particular, we thank:Ibrahim J. Affanen, Indiana University of Pennsylvania Yea-Mow Chen, San Francisco State UniversitySenay Agca, George Washington University N.K. Chidambaran, Tulane UniversityAigbe Akhigbe, University of Akron Wan-Jiun Paul Chiou, Shippensburg UniversityRonald Anderson, University of Nevada–Las Vegas Jeffrey A. Clark, Florida State UniversityBala G. Arshanapalli, Indiana University Northwest Robert Bruce Cochran, San Jose State UniversityChristopher Bain, Ohio State University William Colclough, University of Wisconsin–La CrosseJames C. Baker, Kent State University Elizabeth Cooperman, University of BaltimoreJohn Banko, University Central Florida Carl Davison, Mississippi State UniversityMounther H. Barakat, University of Houston Clear Lake Erik Devos, Ohio University at SUNY BinghamtonJoel Barber, Florida International University Alan Durell, Dartmouth CollegeThomas M. Barnes, Alfred University Franklin R. Edwards, Columbia UniversityMarco Bassetto, Northwestern University Marty Eichenbaum, Northwestern UniversityDallas R. Blevins, University of Montevallo Elyas Elyasiani, Temple UniversityMatej Blusko, University of Georgia Edward C. Erickson, California State University, StanislausPaul J. Bolster, Northeastern University Kenneth Fah, Ohio Dominican CollegeLowell Boudreaux, Texas A&M University Galveston J. Howard Finch, Florida Gulf Coast UniversityDeanne Butchey, Florida International University E. Bruce Fredrikson, Syracuse UniversityMitch Charklewicz, Central Connecticut State University James Gatti, University of Vermont
  • 38. xxxviii PrefacePaul Girma, SUNY–New Paltz Joseph S. Mascia, Adelphi UniversitySusan Glanz, St. John’s University Khalid Metabdin, College of St. RoseGary Gray, Pennsylvania State University David Milton, Bentley CollegeWei Guan, University of South Florida - St. Petersburg A. H. Moini, University of Wisconsin–WhitewaterCharles Guez, University of Houston Russell Morris, Johns Hopkins UniversityBeverly L. Hadaway, University of Texas Chee Ng, Fairleigh Dickinson UniversityJohn A. Halloran, University of Notre Dame Srinivas Nippani, Texas A&M CommerceBillie J. Hamilton, East Carolina University Terry Nixon, Indiana UniversityJohn H. Hand, Auburn University William E. O’Connell, Jr., The College of William and MaryJeffery Heinfeldt, Ohio Northern University Masao Ogaki, Ohio State UniversityDon P. Holdren, Marshall University Evren Ors, Southern Illinois UniversityAdora Holstein, Robert Morris College Coleen C. Pantalone, Northeastern UniversitySylvia C. Hudgins, Old Dominion University Scott Pardee, University of ChicagoJerry G. Hunt, East Carolina University James Peters, Fairleigh Dickinson UniversityBoulis Ibrahim, Heroit-Watt University Fred Puritz, SUNY–OneontaWilliam E. Jackson, University of North Carolina–Chapel Hill Mahmud Rahman, Eastern Michigan UniversityJoe James, Sam Houston State University Anoop Rai, Hofstra UniversityMelvin H. Jameson, University of Nevada–Las Vegas Mitchell Ratner, Rider UniversityKurt Jessewein, Texas A&M International University David Reps, Pace University–WestchesterJack Jordan, Seton Hall University Terry Richardson, Bowling Green UniversityTejendra Kalia, Worcester State College Jack Rubens, Bryant CollegeTaeho Kim, Thunderbird: The American Graduate Charles B. Ruscher, James Madison UniversitySchool of International Management William Sackley, University of Southern MississippiTaewon Kim, California State University, Los Angeles Kevin Salyer, University of California–DavisElinda Kiss, University of Maryland Siamack Shojai, Manhattan CollegeGlen A. Larsen, Jr., University of Tulsa Donald Smith, Boston UniversityJames E. Larsen, Wright State University Sonya Williams Stanton, Ohio State UniversityRick LeCompte, Wichita State University Michael Sullivan, Florida International UniversityBaeyong Lee, Fayetteville State University Rick Swasey, Northeastern UniversityBoyden E. Lee, New Mexico State University Anjan Thackor, University of MichiganAdam Lei, Midwestern State University Janet M. Todd, University of DelawareKartono Liano, Mississippi State University James Tripp, Western Illinois UniversityJohn Litvan, Southwest Missouri State Carlos Ulibarri, Washington State UniversityRichard A. Lord, Georgia College Emre Unlu, University of Nebraska - LincolnRobert L. Losey, American University John Wagster, Wayne State UniversityAnthony Loviscek, Seton Hall University Bruce Watson, Wellesley CollegeJames Lynch, Robert Morris College David A. Whidbee, California State University–SacramentoJudy E. Maese, New Mexico State University Arthur J. Wilson, George Washington UniversityWilliam Mahnic, Case Western Reserve University Shee Q. Wong, University of Minnesota–DuluthInayat Mangla, Western Michigan University Criss G. Woodruff, Radford UniversityWilliam Marcum, Wake Forest University Tong Yu, University of Rhode IslandDavid A. Martin, Albright College Dave Zalewski, Providence CollegeLanny Martindale, Texas A&M University Finally, I want to thank my wife, Sally, my son, Matthew, and my daughter, Laura, who provide me with a warm and happy environment that enables me to do my work, and my father, Sydney, now deceased, who a long time ago put me on the path that led to this book. Frederic S. Mishkin I would like to thank Rick Mishkin for his excellent comments on my contributions. By working with Rick on this text, not only have I gained greater skill as a writer, but I have also gained a friend. I would also like to thank my wife, Laurie, for patiently read- ing each draft of this manuscript and for helping make this my best work. Through the years, her help and support have made this aspect of my career possible. Stanley G. Eakins
  • 39. About the Authors Frederic S. Mishkin is the Alfred University Press, 2006); Inflation Targeting: Lessons from the Lerner Professor of Banking and International Experience (Princeton University Press, 1999); Financial Institutions at the Graduate Money, Interest Rates, and Inflation (Edward Elgar, 1993); and School of Business, Columbia A Rational Expectations Approach to Macroeconometrics: University. From September 2006 to Testing Policy Ineffectiveness and Efficient Markets Models August 2008, he was a member (gov- (University of Chicago Press, 1983). In addition, he has published ernor) of the Board of Governors of more than 200 articles in such journals as American Economic the Federal Reserve System. Review, Journal of Political Economy, Econometrica, Quarterly He is also a research associate Journal of Economics, Journal of Finance, Journal of Applied at the National Bureau of Economic Econometrics, Journal of Economic Perspectives, and Journal Research and past president of of Money Credit and Banking. the Eastern Economics Association. Professor Mishkin has served on the editorial board of the Since receiving his Ph.D. from American Economic Review and has been an associate editor at the Massachusetts Institute of the Journal of Business and Economic Statistics and Journal ofTechnology in 1976, he has taught at the University of Chicago, Applied Econometrics; he also served as the editor of the FederalNorthwestern University, Princeton University, and Columbia Reserve Bank of New York’s Economic Policy Review. He is cur-University. He has also received an honorary professorship from rently an associate editor (member of the editorial board) at fivethe People’s (Renmin) University of China. From 1994 to 1997, academic journals, including Journal of International Money andhe was executive vice president and director of research at Finance; International Finance; Finance India; Emergingthe Federal Reserve Bank of New York and an associate econ- Markets, Finance and Trade; and Review of Developmentomist of the Federal Open Market Committee of the Federal Finance. He has been a consultant to the Board of Governors ofReserve System. the Federal Reserve System, the World Bank and the International Professor Mishkin’s research focuses on monetary policy and Monetary Fund, as well as to many central banks throughout theits impact on financial markets and the aggregate economy. He is world. He was also a member of the International Advisory Boardthe author of more than twenty books, including Macroeconomics: to the Financial Supervisory Service of South Korea and an adviserPolicy and Practice (Addison-Wesley, 2012); The Economics of to the Institute for Monetary and Economic Research at the BankMoney, Banking and Financial Markets, Ninth Edition (Addison- of Korea. Professor Mishkin has also served as a senior fellow at theWesley, 2010); Monetary Policy Strategy (MIT Press, 2007); The Federal Deposit Insurance Corporation’s Center for BankingNext Great Globalization: How Disadvantaged Nations Can Research, and as an academic consultant to and member of theHarness Their Financial Systems to Get Rich (Princeton Economic Advisory Panel of the Federal Reserve Bank of New York. Stanley G. Eakins has notable Professor Eakins received his Ph.D. from Arizona State experience as a financial practi- University. He is the Associate Dean for the College of Business tioner, serving as vice president and at East Carolina University. His research is focused primarily on comptroller at the First National the role of institutions in corporate control and how they influence Bank of Fairbanks and as a com- investment practices. He is also interested in integrating multi- mercial and real estate loan officer. media tools into the learning environment and has received grants A founder of the Denali Title and from East Carolina University in support of this work. Escrow Agency, a title insurance A contributor to journals such as the Quarterly Journal of company in Fairbanks, Alaska, he Business and Economics, the Journal of Financial Research, and also ran the operations side of a bank the International Review of Financial Analysis, Professor Eakins and was the chief finance officer for is also the author of Finance, 3rd edition (Addison-Wesley, 2008). a multimillion-dollar construction and development company. xxxix
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  • 41. PA R T O N E I N T R O D U C T I O N CHAPTER 1 Why Study Financial Markets and Institutions? Preview On the evening news you have just heard that the bond market has been booming. Does this mean that interest rates will fall so that it is easier for you to finance the purchase of a new computer system for your small retail busi- ness? Will the economy improve in the future so that it is a good time to build a new building or add to the one you are in? Should you try to raise funds by issuing stocks or bonds, or instead go to the bank for a loan? If you import goods from abroad, should you be concerned that they will become more expensive? This book provides answers to these questions by examining how financial markets (such as those for bonds, stocks, and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other institutions) work. Financial markets and institutions not only affect your everyday life but also involve huge flows of funds—trillions of dollars—throughout our economy, which in turn affect business profits, the production of goods and services, and even the economic well-being of countries other than the United States. What happens to financial markets and institutions is of great concern to politicians and can even have a major impact on elections. The study of financial markets and institutions will reward you with an understanding of many exciting issues. In this chapter we provide a road map of the book by outlining these exciting issues and exploring why they are worth studying. 1
  • 42. 2 Part 1 Introduction Why Study Financial Markets? Parts 2 and 5 of this book focus on financial markets, markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial markets, such as bond and stock markets, are crucial to pro- moting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. Indeed, well-functioning financial mar- kets are a key factor in producing high economic growth, and poorly performing finan- cial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth, the behav- ior of businesses and consumers, and the cyclical performance of the economy. Debt Markets and Interest Rates A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to owner- ship). A bond is a debt security that promises to make payments periodically for a specified period of time.1 Debt markets, also often referred to generically as the bond market, are especially important to economic activity because they enable cor- porations and governments to borrow in order to finance their activities; the bond market is also where interest rates are determined. An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a per- centage of the rental of $100 per year). There are many interest rates in the econ- omy—mortgage interest rates, car loan rates, and interest rates on many different types of bonds. GO ONLINE Interest rates are important on a number of levels. On a personal level, high inter-http://www.federalreserve est rates could deter you from buying a house or a car because the cost of financ-.gov/econresdata/releases/ ing it would be high. Conversely, high interest rates could encourage you to savestatisticsdata.htm because you can earn more interest income by putting aside some of your earningsAccess daily, weekly,monthly, quarterly, and as savings. On a more general level, interest rates have an impact on the overall healthannual releases and of the economy because they affect not only consumers’ willingness to spend orhistorical data for selected save but also businesses’ investment decisions. High interest rates, for example, mightinterest rates, foreign cause a corporation to postpone building a new plant that would provide more jobs.exchange rates, and so on. Because changes in interest rates have important effects on individuals, finan- cial institutions, businesses, and the overall economy, it is important to explain fluc- tuations in interest rates that have been substantial over the past 20 years. For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981. This interest rate fell to 3% in late 1992 and 1993, and then rose to above 5% in the mid to late 1990s. It then fell below 1% in 2004, rose to 5% by 2007, only to fall to zero in 2008 where it remained close to that level into 2010. Because different interest rates have a tendency to move in unison, economists frequently lump interest rates together and refer to “the” interest rate. As Figure 1.1 shows, however, interest rates on several types of bonds can differ substantially. The interest rate on three-month Treasury bills, for example, fluctuates more than the other interest rates and is lower, on average. The interest rate on Baa (medium- quality) corporate bonds is higher, on average, than the other interest rates, and 1 The definition of bond used throughout this book is the broad one in common use by academics, which covers both short- and long-term debt instruments. However, some practitioners in financial markets use the word bond to describe only specific long-term debt instruments such as corporate bonds or U.S. Treasury bonds.
  • 43. Chapter 1 Why Study Financial Markets and Institutions? 3 Interest Rate (%) 20 15 Corporate Baa Bonds 10 U.S. Government Long-Term Bonds 5 Three-Month Treasury Bills 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 FIGURE 1.1 Interest Rates on Selected Bonds, 1950–2010 Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm. the spread between it and the other rates became larger in the 1970s, narrowed in the 1990s and particularly in the middle 2000s, only to surge to extremely high lev- els during the financial crisis of 2007–2009 before narrowing again. In Chapters 2, 11, 12, and 14 we study the role of debt markets in the economy, and in Chapters 3 through 5 we examine what an interest rate is, how the common movements in interest rates come about, and why the interest rates on different bonds vary. The Stock Market GO ONLINE A common stock (typically just called a stock) represents a share of ownership inhttp://stockcharts.com/ a corporation. It is a security that is a claim on the earnings and assets of the corpo-charts/historical/ ration. Issuing stock and selling it to the public is a way for corporations to raise fundsAccess historical charts of to finance their activities. The stock market, in which claims on the earnings of cor-various stock indexes overdiffering time periods. porations (shares of stock) are traded, is the most widely followed financial market in almost every country that has one; that’s why it is often called simply “the market.” A big swing in the prices of shares in the stock market is always a major story on the evening news. People often speculate on where the market is heading and get very excited when they can brag about their latest “big killing,” but they become depressed when they suffer a big loss. The attention the market receives can probably be best explained by one simple fact: It is a place where people can get rich—or poor—quickly. As Figure 1.2 indicates, stock prices are extremely volatile. After the market rose in the 1980s, on “Black Monday,” October 19, 1987, it experienced the worst one- day drop in its entire history, with the Dow Jones Industrial Average (DJIA) falling by 22%. From then until 2000, the stock market experienced one of the great bull markets in its history, with the Dow climbing to a peak of over 11,000. With the col- lapse of the high-tech bubble in 2000, the stock market fell sharply, dropping by over 30% by late 2002. It then recovered again, reaching the 14,000 level in 2007, only to fall by over 50% of its value to a low below 7,000 in 2009. These considerable
  • 44. 4 Part 1 Introduction Dow Jones Industrial Average 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 FIGURE 1.2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2010 Source: Dow Jones Indexes: http://finance.yahoo.com/?u. fluctuations in stock prices affect the size of people’s wealth and as a result may affect their willingness to spend. The stock market is also an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by sell- ing newly issued stock to finance investment spending. A higher price for a firm’s shares means that it can raise a larger amount of funds, which can be used to buy production facilities and equipment. In Chapter 2 we examine the role that the stock market plays in the financial sys- tem, and we return to the issue of how stock prices behave and respond to infor- mation in the marketplace in Chapters 6 and 13. The Foreign Exchange Market For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin (say, dollars) into the currency of the coun- try they are going to (say, euros). The foreign exchange market is where this
  • 45. Chapter 1 Why Study Financial Markets and Institutions? 5 conversion takes place, so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, the price of one country’s currency in terms of another’s, is determined. Figure 1.3 shows the exchange rate for the U.S. dollar from 1970 to 2010 (mea- sured as the value of the U.S. dollar in terms of a basket of major foreign curren- cies). The fluctuations in prices in this market have also been substantial: The dollar’s value weakened considerably from 1971 to 1973, rose slightly until 1976, and then reached a low point in the 1978–1980 period. From 1980 to early 1985, the dollar’s value appreciated dramatically, and then declined again, reaching another low in 1995. The dollar appreciated from 1995 to 2000, only to depreciate thereafter until it recovered some of its value starting in 2008. What have these fluctuations in the exchange rate meant to the American pub- lic and businesses? A change in the exchange rate has a direct effect on American con- sumers because it affects the cost of imports. In 2001, when the euro was worth around 85 cents, 100 euros of European goods (say, French wine) cost $85. When the dol- lar subsequently weakened, raising the cost of a euro to $1.50, the same 100 euros of wine now cost $150. Thus, a weaker dollar leads to more expensive foreign goods, makes vacationing abroad more expensive, and raises the cost of indulging your desire for imported delicacies. When the value of the dollar drops, Americans decrease their purchases of foreign goods and increase their consumption of domes- tic goods (such as travel in the United States or American-made wine). Conversely, a strong dollar means that U.S. goods exported abroad will cost more in foreign countries, and hence foreigners will buy fewer of them. Exports of steel, for example, declined sharply when the dollar strengthened in the 1980–1985 and 1995–2001 periods. A strong dollar benefited American consumers by making for- eign goods cheaper but hurt American businesses and eliminated some jobs by cut- ting both domestic and foreign sales of their products. The decline in the value of the dollar from 1985 to 1995 and 2001 to 2007 had the opposite effect: It made foreign goods more expensive, but made American businesses more competitive. Fluctuations in the foreign exchange markets thus have major consequences for the American economy. In Chapter 15 we study how exchange rates are determined in the foreign exchange market, in which dollars are bought and sold for foreign currencies. Index(March 1973 = 100) 150 135 120 105 90 75 1970 1975 1980 1985 1990 1995 2000 2005 FIGURE 1.3 Exchange Rate of the U.S. Dollar, 1970–2010Source: www.federalreserve.gov/releases/H10/summary/indexbc_m.txt.
  • 46. 6 Part 1 Introduction Why Study Financial Institutions? The second major focus of this book is financial institutions. Financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment oppor- tunities. They thus play a crucial role in improving the efficiency of the economy. Structure of the Financial System The financial system is complex, comprising many different types of private-sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks—all of which are heavily regulated by the govern- ment. If you wanted to make a loan to IBM or General Motors, for example, you would not go directly to the president of the company and offer a loan. Instead, you would lend to such companies indirectly through financial intermediaries, institutions such as commercial banks, savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies that borrow funds from people who have saved and in turn make loans to others. Why are financial intermediaries so crucial to well-functioning financial markets? Why do they give credit to one party but not to another? Why do they usually write complicated legal documents when they extend loans? Why are they the most heav- ily regulated businesses in the economy? We answer these questions by developing a coherent framework for analyz- ing financial structure both in the United States and in the rest of the world in Chapter 7. Financial Crises At times, the financial system seizes up and produces financial crises, major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises have been a feature of capitalist economies for hundreds of years and are typically followed by the worst business cycle downturns. From 2007 to 2009, the U.S. economy was hit by the worst financial crisis since the Great Depression. Defaults in subprime residential mortgages led to major losses in financial institutions, producing not only numerous bank failures, but also leading to the demise of Bear Stearns and Lehman Brothers, two of the largest investment banks in the United States. Why these crises occur and why they do so much damage to the economy is discussed in Chapter 8. Central Banks and the Conduct of Monetary Policy GO ONLINE The most important financial institution in the financial system is the central bank,www.federalreserve.gov the government agency responsible for the conduct of monetary policy, which inAccess general the United States is the Federal Reserve System (also called simply the Fed).information as well as Monetary policy involves the management of interest rates and the quantity ofmonetary policy, bankingsystem, research, and money, also referred to as the money supply (defined as anything that is gener-economic data of the ally accepted in payment for goods and services or in the repayment of debt).Federal Reserve. Because monetary policy affects interest rates, inflation, and business cycles, all of
  • 47. Chapter 1 Why Study Financial Markets and Institutions? 7which have a major impact on financial markets and institutions, we study how mon-etary policy is conducted by central banks in both the United States and abroad inChapters 9 and 10.The International Financial SystemThe tremendous increase in capital flows between countries means that the inter-national financial system has a growing impact on domestic economies. Whether acountry fixes its exchange rate to that of another is an important determinant ofhow monetary policy is conducted. Whether there are capital controls that restrictmobility of capital across national borders has a large effect on domestic financialsystems and the performance of the economy. What role international financial insti-tutions such as the International Monetary Fund should play in the international finan-cial system is very controversial. All of these issues are explored in Chapter 16.Banks and Other Financial InstitutionsBanks are financial institutions that accept deposits and make loans. Included underthe term banks are firms such as commercial banks, savings and loan associations,mutual savings banks, and credit unions. Banks are the financial intermediaries thatthe average person interacts with most frequently. A person who needs a loan to buya house or a car usually obtains it from a local bank. Most Americans keep a largeproportion of their financial wealth in banks in the form of checking accounts, sav-ings accounts, or other types of bank deposits. Because banks are the largest finan-cial intermediaries in our economy, they deserve careful study. However, banks are notthe only important financial institutions. Indeed, in recent years, other financial insti-tutions such as insurance companies, finance companies, pension funds, mutual funds,and investment banks have been growing at the expense of banks, and so we need tostudy them as well. We study banks and all these other institutions in Parts 6 and 7.Financial InnovationIn the good old days, when you took cash out of the bank or wanted to check youraccount balance, you got to say hello to a friendly human. Nowadays, you are more likelyto interact with an automatic teller machine (ATM) when withdrawing cash, and touse your home computer to check your account balance. To see why these options havedeveloped, we study why and how financial innovation takes place in Chapter 19, withparticular emphasis on how the dramatic improvements in information technology haveled to new means of delivering financial services electronically, in what has becomeknown as e-finance. We also study financial innovation because it shows us how cre-ative thinking on the part of financial institutions can lead to higher profits. By seeinghow and why financial institutions have been creative in the past, we obtain a bettergrasp of how they may be creative in the future. This knowledge provides us with use-ful clues about how the financial system may change over time and will help keep ourunderstanding about banks and other financial institutions from becoming obsolete.Managing Risk in Financial InstitutionsIn recent years, the economic environment has become an increasingly risky place.Interest rates have fluctuated wildly, stock markets have crashed both here andabroad, speculative crises have occurred in the foreign exchange markets, and failures
  • 48. 8 Part 1 Introduction of financial institutions have reached levels unprecedented since the Great Depression. To avoid wild swings in profitability (and even possibly failure) result- ing from this environment, financial institutions must be concerned with how to cope with increased risk. We look at techniques that these institutions use when they engage in risk management in Chapter 23. Then in Chapter 24, we look at how these institutions make use of new financial instruments, such as financial futures, options, and swaps, to manage risk. Applied Managerial Perspective Another reason for studying financial institutions is that they are among the largest employers in the country and frequently pay very high salaries. Hence, some of you have a very practical reason for studying financial institutions: It may help you get a good job in the financial sector. Even if your interests lie elsewhere, you should still care about how financial institutions are run because there will be many times in your life, as an individual, an employee, or the owner of a business, when you will inter- act with these institutions. Knowing how financial institutions are managed may help you get a better deal when you need to borrow from them or if you decide to sup- ply them with funds. This book emphasizes an applied managerial perspective in teaching you about financial markets and institutions by including special case applications headed “The Practicing Manager.” These cases introduce you to the real-world problems that man- agers of financial institutions commonly face and need to solve in their day-to-day jobs. For example, how does the manager of a financial institution come up with a new financial product that will be profitable? How does a manager of a financial insti- tution manage the risk that the institution faces from fluctuations in interest rates, stock prices, or foreign exchange rates? Should a manager hire an expert on Federal Reserve policy making, referred to as a “Fed watcher,” to help the institution dis- cern where monetary policy might be going in the future? Not only do “The Practicing Manager” cases, which answer these questions and others like them, provide you with some special analytic tools that you will need if you make your career at a financial institution, but they also give you a feel for what a job as the manager of a financial institution is all about. How We Will Study Financial Markets and Institutions Instead of focusing on a mass of dull facts that will soon become obsolete, this text- book emphasizes a unifying, analytic framework for studying financial markets and institutions. This framework uses a few basic concepts to help organize your think- ing about the determination of asset prices, the structure of financial markets, bank management, and the role of monetary policy in the economy. The basic concepts are equilibrium, basic supply and demand analysis to explain behavior in financial mar- kets, the search for profits, and an approach to financial structure based on trans- action costs and asymmetric information. The unifying framework used in this book will keep your knowledge from becom- ing obsolete and make the material more interesting. It will enable you to learn what really matters without having to memorize material that you will forget soon after the final exam. This framework will also provide you with the tools needed to under- stand trends in the financial marketplace and in variables such as interest rates and exchange rates.
  • 49. Chapter 1 Why Study Financial Markets and Institutions? 9 To help you understand and apply the unifying analytic framework, simple mod-els are constructed in which the variables held constant are carefully delineated, eachstep in the derivation of the model is clearly and carefully laid out, and the modelsare then used to explain various phenomena by focusing on changes in one variableat a time, holding all other variables constant. To reinforce the models’ usefulness, this text also emphasizes the interactionof theoretical analysis and empirical data in order to expose you to real-life eventsand data. To make the study of financial markets and institutions even more rele-vant and to help you learn the material, the book contains, besides “The PracticingManager” cases, numerous additional cases and mini-cases that demonstrate how youcan use the analysis in the book to explain many real-world situations. To function better in the real world outside the classroom, you must have thetools to follow the financial news that appears in leading financial publications. Tohelp and encourage you to read the financial section of the newspaper, this book con-tains two special features. The first is a set of special boxed inserts titled “Followingthe Financial News” that contain actual columns and data from the Wall StreetJournal (subscription required on the Web at http://online.wsj.com/home-page) or thatare found in other financial publications or Web sites that appear daily or periodically.These boxes give you the detailed information and definitions you need to evaluatethe data being presented. The second feature is a set of special case applications titled“Reading the Wall Street Journal” that expand on the “Following the FinancialNews” boxes. These cases show you how you can use the analytic framework in thebook directly to make sense of the daily columns in the United States’ leading finan-cial newspaper. In addition to these cases, this book also contains nearly 400 end-of-chapter problems that ask you to apply the analytic concepts you have learnedto other real-world issues. Particularly relevant is a special class of problems headed“Predicting the Future.” These questions give you an opportunity to review and applymany of the important financial concepts and tools presented throughout the book.Exploring the WebThe World Wide Web has become an extremely valuable and convenient resourcefor financial research. We emphasize the importance of this tool in several ways. First,wherever we use the Web to find information to build the charts and tables thatappear throughout the text, we include the source site’s URL. These sites often con-tain additional information and are updated frequently. Second, we have added Webexercises to the end of each chapter. These exercises prompt you to visit sites relatedto the chapter and to work with real-time data and information. We have also addedWeb references to the end of each chapter that list the URLs of sites related to thematerial being discussed. Visit these sites to further explore a topic you find of par-ticular interest. Web site URLs are subject to frequent change. We have tried to selectstable sites, but we realize that even government URLs change. The publisher’s Website (www.pearsonhighered.com/mishkin_eakins) will maintain an updated list of cur-rent URLs for your reference.Collecting and Graphing DataThe following Web exercise is especially important because it demonstrates how toexport data from a Web site into Microsoft Excel for further analysis. We suggestyou work through this problem on your own so that you will be able to perform thisactivity when prompted in subsequent Web exercises.
  • 50. 10 Part 1 Introduction Web Exercise You have been hired by Risky Ventures, Inc., as a consultant to help the company ana- lyze interest-rate trends. Your employers are initially interested in determining the historical relationship between long- and short-term interest rates. The biggest task you must immediately undertake is collecting market interest-rate data. You know the best source of this information is the Web. 1. You decide that your best indicator of long-term interest rates is the 10-year U.S. Treasury note. Your first task is to gather historical data. Go to www.federalreserve.gov/releases/H15. The site should look like Figure 1.4. At the top, click HISTORICAL DATA. Now scroll down to “Treasury Constant Maturities,” and click on the ANNUAL TAG to the right of the “10 Year category.” FIGURE 1.4 Federal Reserve Web Site for Selected Interest Rates Source: www.federalreserve.gov.
  • 51. Chapter 1 Why Study Financial Markets and Institutions? 112. Now that you have located an accurate source of historical interest-rate data, the next step is getting it onto a spreadsheet. Excel will let you convert text data into columns. Begin by highlighting the two columns of data (the year and rate). Right-click and choose COPY. Now open Excel and put the cursor in a cell. Click PASTE. Now choose data from the menu bar and click TEXT TO COLUMNS. Follow the wizard (Figure 1.5), checking the fixed-width option. The list of interest rates should now have the year in one column and the inter- est rate in the next column. Label your columns. Repeat the preceding steps to collect the one-year interest rate series. Put it in the column next to the 10-year series. Be sure to line up the years correctly and delete any years that are not included in both series.3. You now want to analyze the interest rates by graphing them. Highlight the two columns of interest-rate data you just created in Excel. Click on the CHART WIZARD ICON on the toolbar (or INSERT/CHART). Select the Scatter chart type, and choose any type of scatter chart subtype that connects the dots. Let the Excel wizard take you through the steps of completing the graph. (See Figure 1.6.) FIGURE 1.5 Excel Spreadsheet with Interest-Rate Data Source: Used with permission from Microsoft
  • 52. 12 Part 1 Introduction FIGURE 1.6 Excel Graph of Interest-Data Source: Used with permission from Microsoft Concluding Remarks The field of financial markets and institutions is an exciting one. Not only will you develop skills that will be valuable in your career, but you will also gain a clearer understanding of events in financial markets and institutions you frequently hear about in the news media. This book will introduce you to many of the controver- sies that are hotly debated in the current political arena. SUMMARY 1. Activities in financial markets have direct effects on market (because fluctuations in the foreign exchange individuals’ wealth, the behavior of businesses, and the rate have major consequences for the U.S. economy). efficiency of our economy. Three financial markets 2. Because monetary policy affects interest rates, infla- deserve particular attention: the bond market (where tion, and business cycles, all of which have an impor- interest rates are determined), the stock market tant impact on financial markets and institutions, we (which has a major effect on people’s wealth and on need to understand how monetary policy is conducted firms’ investment decisions), and the foreign exchange by central banks in the United States and abroad.
  • 53. Chapter 1 Why Study Financial Markets and Institutions? 13 3. Banks and other financial institutions channel funds analytic tools that are useful if you choose a career from people who might not put them to productive with a financial institution but also give you a feel for use to people who can do so and thus play a crucial what a job as the manager of a financial institution role in improving the efficiency of the economy. is all about. 4. Understanding how financial institutions are managed 5. This textbook emphasizes an analytic way of thinking is important because there will be many times in your by developing a unifying framework for the study of life, as an individual, an employee, or the owner of a financial markets and institutions using a few basic business, when you will interact with them. “The principles. This textbook also focuses on the inter- Practicing Manager” cases not only provide special action of theoretical analysis and empirical data. KEY TERMSasset, p. 2 Federal Reserve System (the Fed), foreign exchange rate, p. 5banks, p. 7 p. 6 interest rate, p. 2bond, p. 2 financial crises, p. 6 monetary policy, p. 6central bank, p. 6 financial intermediaries, p. 6 money (money supply), p. 6common stock (stock), p. 3 financial markets, p. 2 security, p. 2e-finance, p. 7 foreign exchange market, p. 4 QUESTIONS 1. Why are financial markets important to the health of 9. How can changes in foreign exchange rates affect the the economy? profitability of financial institutions? 2. When interest rates rise, how might businesses and 10. Looking at Figure 1.3, in what years would you have consumers change their economic behavior? chosen to visit the Grand Canyon in Arizona rather 3. How can a change in interest rates affect the prof- than the Tower of London? itability of financial institutions? 11. What is the basic activity of banks? 4. Is everybody worse off when interest rates rise? 12. What are the other important financial intermediaries 5. What effect might a fall in stock prices have on busi- in the economy besides banks? ness investment? 13. Can you think of any financial innovation in the past 6. What effect might a rise in stock prices have on con- 10 years that has affected you personally? Has it made sumers’ decisions to spend? you better or worse off? In what way? 7. How does a decline in the value of the pound ster- 14. What types of risks do financial institutions face? ling affect British consumers? 15. Why do managers of financial institutions care so 8. How does an increase in the value of the pound ster- much about the activities of the Federal Reserve ling affect American businesses? System?
  • 54. 14 Part 1 Introduction Q U A N T I TAT I V E P R O B L E M S 1. The following table lists foreign exchange rates Which day would have been the best day to convert between U.S. dollars and British pounds (GBP) dur- $200 into British pounds? Which day would have been ing April. the worst day? What would be the difference in pounds? Date U.S. Dollars per GBP 4/1 1.9564 4/4 1.9293 4/5 1.914 4/6 1.9374 4/7 1.961 4/8 1.8925 4/11 1.8822 4/12 1.8558 4/13 1.796 4/14 1.7902 4/15 1.7785 4/18 1.7504 4/19 1.7255 4/20 1.6914 4/21 1.672 4/22 1.6684 4/25 1.6674 4/26 1.6857 4/27 1.6925 4/28 1.7201 4/29 1.7512 WEB EXERCISESWorking with Financial Market Data 2. In Web Exercise 1 you collected and graphed the Dow Jones Industrial Average. This same site reports fore- 1. In this exercise we will practice collecting data from cast values of the DJIA. Go to www.forecasts.org/ the Web and graphing it using Excel. Use the exam- data/index.htm. Click the Dow Jones Industrials link ple on pages 10–12 as a guide. Go to www.forecasts under “6 Month Forecasts” in the far-left column. .org/data/index.htm, click on “Data” at the top of the page, click on “Stock Index Data,” and choose the a. What is the Dow forecast to be in six months? “U.S. Stock Indices—Monthly” option. Finally, choose b. What percentage increase is forecast for the next the “Dow Jones Industrial Average” option. six months? a. Using the method presented in this chapter, move the data into an Excel spreadsheet. b. Using the data from step a, prepare a chart. Use the Chart Wizard to properly label your axes.
  • 55. CHAPTER 2Overview of theFinancial SystemPreviewSuppose that you want to start a business that manufactures a recently inventedlow-cost robot that cleans the house (even does windows), mows the lawn, andwashes the car, but you have no funds to put this wonderful invention into pro-duction. Walter has plenty of savings that he has inherited. If you and Waltercould get together so that he could provide you with the funds, your company’srobot would see the light of day, and you, Walter, and the economy would allbe better off: Walter could earn a high return on his investment, you would getrich from producing the robot, and we would have cleaner houses, shinier cars,and more beautiful lawns. Financial markets (bond and stock markets) and financial intermediaries(banks, insurance companies, pension funds) have the basic function of gettingpeople such as you and Walter together by moving funds from those who havea surplus of funds (Walter) to those who have a shortage of funds (you). Morerealistically, when Apple invents a better iPod, it may need funds to bring it tomarket. Similarly, when a local government needs to build a road or a school, itmay need more funds than local property taxes provide. Well-functioning finan-cial markets and financial intermediaries are crucial to our economic health. To study the effects of financial markets and financial intermediaries on theeconomy, we need to acquire an understanding of their general structure andoperation. In this chapter we learn about the major financial intermediaries andthe instruments that are traded in financial markets. This chapter offers a preliminary overview of the fascinating study of finan-cial markets and institutions. We will return to a more detailed treatment ofthe regulation, structure, and evolution of financial markets and institutions inParts 3 through 7. 15
  • 56. 16 Part 1 Introduction Function of Financial Markets Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. This function is shown schematically in Figure 2.1. Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow funds to finance their spending, the borrower-spenders, are at the right. The principal lender-savers are households, but business enterprises and the government (particularly state and local government), as well as foreigners and their governments, sometimes also find themselves with excess funds and so lend them out. The most important borrower-spenders are businesses and the government (particularly the federal government), but households and foreigners also borrow to finance their purchases of cars, furniture, and houses. The arrows show that funds flow from lender-savers to borrower-spenders via two routes. In direct finance (the route at the bottom of Figure 2.1), borrowers borrow funds directly from lenders in financial markets by selling them securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them, but they are liabilities (IOUs or debts) for the individual or firm that sells (issues) them. For example, if General Motors needs to borrow funds to pay for a new factory to man- ufacture electric cars, it might borrow the funds from savers by selling them a bond, a debt security that promises to make payments periodically for a specified period INDIRECT FINANCE FUNDS Financial FUNDS Intermediaries FUNDS Lender-Savers Borrower-Spenders 1. Households 1. Business firms Financial 2. Business firms FUNDS FUNDS 2. Government Markets 3. Government 3. Households 4. Foreigners 4. Foreigners DIRECT FINANCE FIGURE 2.1 Flows of Funds Through the Financial System
  • 57. Chapter 2 Overview of the Financial System 17of time, or a stock, a security that entitles the owner to a share of the company’sprofits and assets. Why is this channeling of funds from savers to spenders so important to theeconomy? The answer is that the people who save are frequently not the same peo-ple who have profitable investment opportunities available to them, the entrepre-neurs. Let’s first think about this on a personal level. Suppose that you have saved$1,000 this year, but no borrowing or lending is possible because there are no finan-cial markets. If you do not have an investment opportunity that will permit youto earn income with your savings, you will just hold on to the $1,000 and will earnno interest. However, Carl the carpenter has a productive use for your $1,000: Hecan use it to purchase a new tool that will shorten the time it takes him to build ahouse, thereby earning an extra $200 per year. If you could get in touch with Carl,you could lend him the $1,000 at a rental fee (interest) of $100 per year, and bothof you would be better off. You would earn $100 per year on your $1,000, insteadof the zero amount that you would earn otherwise, while Carl would earn $100 moreincome per year (the $200 extra earnings per year minus the $100 rental fee forthe use of the funds). In the absence of financial markets, you and Carl the carpenter might never gettogether. You would both be stuck with the status quo, and both of you would beworse off. Without financial markets, it is hard to transfer funds from a person whohas no investment opportunities to one who has them. Financial markets are thusessential to promoting economic efficiency. The existence of financial markets is beneficial even if someone borrows for apurpose other than increasing production in a business. Say that you are recentlymarried, have a good job, and want to buy a house. You earn a good salary, butbecause you have just started to work, you have not saved much. Over time, youwould have no problem saving enough to buy the house of your dreams, but by thenyou would be too old to get full enjoyment from it. Without financial markets, you arestuck; you cannot buy the house and must continue to live in your tiny apartment. If a financial market were set up so that people who had built up savings couldlend you the funds to buy the house, you would be more than happy to pay them someinterest so that you could own a home while you are still young enough to enjoy it.Then, over time, you would pay back your loan. If this loan could occur, you wouldbe better off, as would the persons who made you the loan. They would now earnsome interest, whereas they would not if the financial market did not exist. Now we can see why financial markets have such an important function in theeconomy. They allow funds to move from people who lack productive investmentopportunities to people who have such opportunities. Financial markets are criticalfor producing an efficient allocation of capital (wealth, either financial or physical,that is employed to produce more wealth), which contributes to higher productionand efficiency for the overall economy. Indeed, as we will explore in Chapter 8,when financial markets break down during financial crises, as they did during therecent global financial crisis, severe economic hardship results, which can even leadto dangerous political instability. Well-functioning financial markets also directly improve the well-being of con-sumers by allowing them to time their purchases better. They provide funds to youngpeople to buy what they need and can eventually afford without forcing them towait until they have saved up the entire purchase price. Financial markets that areoperating efficiently improve the economic welfare of everyone in the society.
  • 58. 18 Part 1 Introduction Structure of Financial Markets Now that we understand the basic function of financial markets, let’s look at their structure. The following descriptions of several categorizations of financial markets illustrate the essential features of these markets. Debt and Equity Markets A firm or an individual can obtain funds in a financial market in two ways. The most common method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of years (term) until 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 10 years or longer. Debt instruments with a maturity between one and 10 years are said to be intermediate-term. The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of a business. If you own one share of common stock in a company that has issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no matu- rity date. In addition, owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors. The main disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equi- ties is that equity holders benefit directly from any increases in the corporation’s prof- itability or asset value because equities confer ownership rights on the equity holders. Debt holders do not share in this benefit, because their dollar payments are fixed. We examine the pros and cons of debt versus equity instruments in more detail in Chapter 7, which provides an economic analysis of financial structure. The total value of equities in the United States has typically fluctuated between $4 trillion and $20 trillion since the early 1990s, depending on the prices of shares. Although the average person is more aware of the stock market than any other finan- cial market, the size of the debt market is often substantially larger than the size of the equities market: At the end of 2009, the value of debt instruments was $52.4 trillion, while the value of equities was $20.5 trillion. Primary and Secondary Markets A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency GO ONLINE borrowing the funds. A secondary market is a financial market in which securi-www.nyse.com ties that have been previously issued can be resold.Access the New York StockExchange. Find listed The primary markets for securities are not well known to the public becausecompanies, quotes, the selling of securities to initial buyers often takes place behind closed doors. Ancompany historical data, important financial institution that assists in the initial sale of securities in the pri-real-time market indices, mary market is the investment bank. It does this by underwriting securities: Itand more. guarantees a price for a corporation’s securities and then sells them to the public.
  • 59. Chapter 2 Overview of the Financial System 19 The New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation System), in which previously issued stocks are traded, are the best-known examples of secondary markets, although the bond markets, in which previously issued bonds of major corporations and the U.S. government are bought and sold, actually have a larger trading volume. Other examples of secondary markets are foreign exchange markets, futures markets, and options markets. Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices. When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corpo- ration that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve two important functions. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the finan- cial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the pri- mary market. Second, they determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary mar- ket will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security’s price in the secondary market, the higher the price that the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Conditions in the secondary market are therefore the most relevant to corporations issuing securities. It is for this reason that books like this one, which deal with financial markets, focus on the behavior of secondary markets rather than primary markets. Exchanges and Over-the-Counter Markets GO ONLINE Secondary markets can be organized in two ways. One method is to organizewww.nasdaq.com exchanges, where buyers and sellers of securities (or their agents or brokers) meetAccess detailed market in one central location to conduct trades. The New York and American Stockand security information Exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn,for the NASDAQ OTCstock exchange. silver, and other raw materials) are examples of organized exchanges. 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. Because over- the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a mar- ket with an organized exchange. Many common stocks are traded over the counter, although a majority of the largest corporations have their shares traded at organized stock exchanges. The U.S. government bond market, with a larger trading volume than the New York Stock Exchange, by contrast, is set up as an over-the-counter market. Forty or so dealers establish a “market” in these securities by standing ready to buy and sell U.S. gov- ernment bonds. Other over-the-counter markets include those that trade other types of financial instruments such as negotiable certificates of deposit, federal funds, banker’s acceptances, and foreign exchange.
  • 60. 20 Part 1 Introduction Money and Capital Markets Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each market. The money market is a financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded; the capital market is the market in which longer- term debt (generally with original maturity of one year or greater) and equity instru- ments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. In addition, as we will see in Chapter 3, short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily. Capital market securities, such as stocks and long-term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future. Internationalization of Financial Markets The growing internationalization of financial markets has become an important trend. Before the 1980s, U.S. financial markets were much larger than financial markets outside the United States, but in recent years the dominance of U.S. mar- kets has been disappearing. (See the Global box, “Are U.S. Capital Markets Losing Their Edge?”) The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled foreign markets to expand their activities. American corporations and banks are now more likely to tap international capital markets to raise needed funds, and American investors often seek investment opportunities abroad. Similarly, foreign corpora- tions and banks raise funds from Americans, and foreigners have become impor- tant investors in the United States. A look at international bond markets and world stock markets will give us a picture of how this globalization of financial markets is taking place. 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. For example, if the German automaker Porsche sells a bond in the United States denominated in U.S. dollars, it is classified as a foreign bond. Foreign bonds have been an important instrument in the international capital mar- ket for centuries. In fact, a large percentage of U.S. railroads built in the nineteenth century were financed by sales of foreign bonds in Britain. A more recent innovation in the international bond market is the Eurobond, a bond denominated in a currency other than that of the country in which it is sold— for example, a bond denominated in U.S. dollars sold in London. Currently, over 80% of the new issues in the international bond market are Eurobonds, and the market for these securities has grown very rapidly. As a result, the Eurobond mar- ket is now larger than the U.S. corporate bond market.
  • 61. Chapter 2 Overview of the Financial System 21 GLOBAL Are U.S. Capital Markets Losing Their Edge?Over the past few decades the United States lost its securities issuers to greater risks of lawsuits. Manyinternational dominance in a number of manufactur- people see burdensome financial regulation as theing industries, including automobiles and consumer main cause, however, and point specifically to theelectronics, as other countries became more competi- Sarbanes-Oxley Act of 2002. Congress passed thistive in global markets. Recent evidence suggests that act after a number of accounting scandals involvingfinancial markets now are undergoing a similar trend: U.S. corporations and the accounting firms thatJust as Ford and General Motors have lost global audited them came to light. Sarbanes-Oxley aims tomarket share to Toyota and Honda, U.S. stock and strengthen the integrity of the auditing process and thebond markets recently have seen their share of sales quality of information provided in corporate financialof newly issued corporate securities slip. By 2006 the statements. The costs to corporations of complying withLondon and Hong Kong stock exchanges each han- the new rules and procedures are high, especially fordled a larger share of initial public offerings (IPOs) of smaller firms, but largely avoidable if firms choose tostock than did the New York Stock Exchange, which issue their securities in financial markets outside thehad been by far the dominant exchange in terms of United States. For this reason, there is much supportIPO value just three years before. Likewise, the por- for revising Sarbanes-Oxley to lessen its alleged harm-tion of new corporate bonds issued worldwide that ful effects and induce more securities issuers back toare initially sold in U.S. capital markets has fallen United States financial markets. However, there is notbelow the share sold in European debt markets in conclusive evidence to support the view that Sarbanes-each of the past two years.* Oxley is the main cause of the relative decline of U.S. Why do corporations that issue new securities to financial markets and therefore in need of reform.raise capital now conduct more of this business in Discussion of the relative decline of U.S. financialfinancial markets in Europe and Asia? Among the fac- markets and debate about the factors that are con-tors contributing to this trend are quicker adoption of tributing to it likely will continue. Chapter 7 providestechnological innovation by foreign financial markets, more detail on the Sarbanes-Oxley Act and its effectstighter immigration controls in the United States follow- on the U.S. financial system.ing the terrorist attacks in 2001, and perceptions thatlisting on American exchanges will expose foreign *“Down on the Street,” Economist, November 25, 2006, pp. 69–71. A variant of the Eurobond is Eurocurrencies, which are foreign currencies deposited in banks outside the home country. The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks. Because these short- term deposits earn interest, they are similar to short-term Eurobonds. American banks borrow Eurodollar deposits from other banks or from their own foreign branches, and Eurodollars are now an important source of funds for American banks. Note that the euro, the currency used by countries in the European Monetary System, can create some confusion about the terms Eurobond, Eurocurrencies, and Eurodollars. A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with euros, but are instead U.S. dollars deposited in banks outside the United States.
  • 62. 22 Part 1 Introduction World Stock Markets GO ONLINE Until recently, the U.S. stock market was by far the largest in the world, but foreign stockhttp://stockcharts.com/ markets have been growing in importance, with the United States not always being num-def/servlet/Favorites ber one. The increased interest in foreign stocks has prompted the development in.CServlet?obj=msummary& the United States of mutual funds that specialize in trading in foreign stock markets.cmd=show&disp=SXAThis site contains historical American investors now pay attention not only to the Dow Jones Industrial Averagestock market index charts but also to stock price indexes for foreign stock markets such as the Nikkei 300 Averagefor many countries around (Tokyo) and the Financial Times Stock Exchange (FTSE) 100-Share Index (London).the world. The internationalization of financial markets is having profound effects on the United States. Foreigners, particularly Japanese investors, are not only providing GO ONLINE funds to corporations in the United States but also are helping finance the federalhttp://quote.yahoo government. Without these foreign funds, the U.S. economy would have grown far.com/m2?u less rapidly in the last 20 years. The internationalization of financial markets is alsoAccess major world stockindexes, with charts, news, leading the way to a more integrated world economy in which flows of goods and tech-and components. nology between countries are more commonplace. In later chapters, we will encounter many examples of the important roles that international factors play in our economy (see the Following the Financial News box). Function of Financial Intermediaries: Indirect Finance As shown in Figure 2.1 (p. 16), funds also 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 borrower-spenders and helps trans- fer funds from one to the other. A financial intermediary does this by borrowing funds from the lender-savers and then using these funds to make loans to borrower- spenders. For example, a bank might acquire funds by issuing a liability to the pub- lic (an asset for the public) in the form of savings deposits. It might then use the funds to acquire an asset by making a loan to General Motors or by buying a U.S. Treasury bond in the financial market. The ultimate result is that funds have been transferred from the public (the lender-savers) to GM or the U.S. Treasury (the borrower- spender) with the help of the financial intermediary (the bank). The process of indirect finance using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers. Indeed, although the media focus much of their attention on securities markets, particularly the stock market, financial intermediaries are a far more important source of financing for corporations than securities markets are. This is true not only for the United States but also for other industrialized countries (see the Global box on p. 24). Why are financial intermediaries and indirect finance so important in finan- cial markets? To answer this question, we need to understand the role of transac- tion costs, risk sharing, and information costs in financial markets. 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. As we have seen, Carl the carpenter needs $1,000 for his new tool, and you know that it is an excellent investment opportunity. You have the cash and would like to lend him the money, but to protect your investment, you have to hire a lawyer to write up the loan con- tract that specifies how much interest Carl will pay you, when he will make these interest payments, and when he will repay you the $1,000. Obtaining the contract
  • 63. Chapter 2 Overview of the Financial System 23 FOLLOWING THE FINANCIAL NEWS Foreign Stock Market IndexesForeign stock market indexes are published daily in the Wall Street Journal in the “Money and Investing”section of the paper. The first two columns identify the region/country and the market index; for example, the colored entry is forthe DAX index for Germany. The third column, “CLOSE,” gives the closing value of the index, which was5988.67 for the DAX on May 20, 2010. The “NET CHG” column indicates the change in the index from theprevious trading day, –167.26, and the “% CHG” column indicates the percentage change in the index,–2.72. The next column indicates the year-to-date percentage change of the index (0.5%).Source: Wall Street Journal, May 20, 2010, p. C2. THE WALL STREET JOURNAL. Copyright 2010 by DOW JONES & COMPANY, INC.Reproduced with permission of DOW JONES & COMPANY, INC. via Copyright Clearance Center.
  • 64. 24 Part 1 Introduction GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Patterns of financing corporations differ across coun- the share of corporate financing by financial interme- tries, but one key fact emerges: Studies of the major diaries has been declining relative to the use of secu- developed countries, including the United States, rities markets. Canada, the United Kingdom, Japan, Italy, Although the dominance of financial intermedi- Germany, and France, show that when businesses aries over securities markets is clear in all countries, go looking for funds to finance their activities, they the relative importance of bond versus stock markets usually obtain them indirectly through financial inter- differs widely across countries. In the United States, mediaries and not directly from securities markets.* the bond market is far more important as a source of Even in the United States and Canada, which have corporate finance: On average, the amount of new the most developed securities markets in the world, financing raised using bonds is 10 times the amount loans from financial intermediaries are far more raised using stocks. By contrast, countries such as important for corporate finance than securities mar- France and Italy make more use of equities markets kets are. The countries that have made the least use than of the bond market to raise capital. of securities markets are Germany and Japan; in these two countries, financing from financial interme- diaries has been almost 10 times greater than that *See, for example, Colin Mayer, “Financial Systems, Corporate Finance, and Economic Development,” in Asymmetric Information, from securities markets. However, after the deregula- Corporate Finance, and Investment, ed. R. Glenn Hubbard tion of Japanese securities markets in recent years, (Chicago: University of Chicago Press, 1990), pp. 307–332. will cost you $500. When you figure in this transaction cost for making the loan, you realize that you can’t earn enough from the deal (you spend $500 to make per- haps $100) and reluctantly tell Carl that he will have to look elsewhere. This example illustrates that small savers like you or potential borrowers like Carl might be frozen out of financial markets and thus be unable to benefit from them. Can anyone come to the rescue? Financial intermediaries can. Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale, the reduction in transaction costs per dollar of trans- actions as the size (scale) of transactions increases. For example, a bank knows how to find a good lawyer to produce an airtight loan contract, and this contract can be used over and over again in its loan transactions, thus lowering the legal cost per transaction. Instead of a loan contract (which may not be all that well written) costing $500, a bank can hire a topflight lawyer for $5,000 to draw up an airtight loan contract that can be used for 2,000 loans at a cost of $2.50 per loan. At a cost of $2.50 per loan, it now becomes profitable for the financial intermediary to lend Carl the $1,000. Because financial intermediaries are able to reduce transaction costs substan- tially, they make it possible for you to provide funds indirectly to people like Carl with productive investment opportunities. In addition, a financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. For example, banks provide depositors with checking accounts that enable them to pay their bills easily. In addition, depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary.
  • 65. Chapter 2 Overview of the Financial System 25Risk SharingAnother benefit made possible by the low transaction costs of financial institutionsis that they can help reduce the exposure of investors to risk—that is, uncertaintyabout the returns investors will earn on assets. Financial intermediaries do thisthrough the process known as risk sharing: They create and sell assets with riskcharacteristics that people are comfortable with, and the intermediaries then use thefunds they acquire by selling these assets to purchase other assets that may havefar more risk. Low transaction costs allow financial intermediaries to share risk at lowcost, enabling them to earn a profit on the spread between the returns they earnon risky assets and the payments they make on the assets they have sold. This processof risk sharing is also sometimes referred to as asset transformation, because ina sense, risky assets are turned into safer assets for investors. Financial intermediaries also promote risk sharing by helping individuals to diver-sify and thereby lower the amount of risk to which they are exposed. Diversificationentails investing in a collection (portfolio) of assets whose returns do not alwaysmove together, with the result that overall risk is lower than for individual assets.(Diversification is just another name for the old adage, “You shouldn’t put all youreggs in one basket.”) Low transaction costs allow financial intermediaries to do thisby pooling a collection of assets into a new asset and then selling it to individuals.Asymmetric Information: Adverse Selectionand Moral HazardThe presence of transaction costs in financial markets explains, in part, why finan-cial intermediaries and indirect finance play such an important role in financial mar-kets. An additional reason is that in financial markets, one party often does notknow enough about the other party to make accurate decisions. This inequality iscalled asymmetric information. For example, a borrower who takes out a loan usu-ally has better information about the potential returns and risks associated with theinvestment projects for which the funds are earmarked than the lender does. Lack ofinformation creates problems in the financial system on two fronts: before the trans-action is entered into and after.1 Adverse selection is the problem created by asymmetric information beforethe transaction occurs. Adverse selection in financial markets occurs when thepotential borrowers who are the most likely to produce an undesirable (adverse)outcome—the bad credit risks—are the ones who most actively seek out a loan andare thus most likely to be selected. Because adverse selection makes it more likelythat loans might be made to bad credit risks, lenders may decide not to make anyloans even though there are good credit risks in the marketplace. To understand why adverse selection occurs, suppose that you have two auntsto whom you might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a con-servative type who borrows only when she has an investment she is quite sure willpay off. Aunt Sheila, by contrast, is an inveterate gambler who has just come acrossa get-rich-quick scheme that will make her a millionaire if she can just borrow $1,000to invest in it. Unfortunately, as with most get-rich-quick schemes, there is a highprobability that the investment won’t pay off and that Aunt Sheila will lose the $1,000. 1 Asymmetric information and the adverse selection and moral hazard concepts are also crucial prob-lems for the insurance industry.
  • 66. 26 Part 1 Introduction Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila, of course, because she has so much to gain if the investment pays off. You, however, would not want to make a loan to her because there is a high probability that her investment will turn sour and she will be unable to pay you back. If you knew both your aunts very well—that is, if your information were not asymmetric—you wouldn’t have a problem, because you would know that Aunt Sheila is a bad risk and so you would not lend to her. Suppose, though, that you don’t know your aunts well. You are more likely to lend to Aunt Sheila than to Aunt Louise because Aunt Sheila would be hounding you for the loan. Because of the possibility of adverse selection, you might decide not to lend to either of your aunts, even though there are times when Aunt Louise, who is an excellent credit risk, might need a loan for a worthwhile investment. Moral hazard is the problem created by asymmetric information after the trans- action occurs. Moral hazard in financial markets is the risk (hazard) that the bor- rower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. As an example of moral hazard, suppose that you made a $1,000 loan to another relative, Uncle Melvin, who needs the money to purchase a computer so he can set up a business typing students’ term papers. Once you have made the loan, however, Uncle Melvin is more likely to slip off to the track and play the horses. If he bets on a 20-to-1 long shot and wins with your money, he is able to pay you back your $1,000 and live high off the hog with the remaining $19,000. But if he loses, as is likely, you don’t get paid back, and all he has lost is his reputation as a reliable, upstanding uncle. Uncle Melvin therefore has an incentive to go to the track because his gains ($19,000) if he bets correctly are much greater than the cost to him (his reputation) if he bets incorrectly. If you knew what Uncle Melvin was up to, you would prevent him from going to the track, and he would not be able to increase the moral hazard. However, because it is hard for you to keep informed about his whereabouts—that is, because information is asymmetric—there is a good chance that Uncle Melvin will go to the track and you will not get paid back. The risk of moral hazard might therefore dis- courage you from making the $1,000 loan to Uncle Melvin, even if you were sure that you would be paid back if he used it to set up his business. Another way of describing the moral hazard problem is that it leads to conflicts of interest, in which one party in a financial contract has incentives to act in its own interest rather than in the interests of the other party. Indeed, this is exactly what happens if your Uncle Melvin is tempted to go to the track and gamble at your expense. The problems created by adverse selection and moral hazard are an important impediment to well-functioning financial markets. Again, financial intermediaries can alleviate these problems. With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary—say, the Honest John Bank—which in turn lends the funds out either by making loans or by buy- ing securities such as stocks or bonds. Successful financial intermediaries have higher earnings on their investments than small savers, because they are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services and still earn a profit.
  • 67. Chapter 2 Overview of the Financial System 27 As we have seen, financial intermediaries play an important role in the econ- omy because they provide liquidity services, promote risk sharing, and solve infor- mation problems, thereby allowing small savers and borrowers to benefit from the existence of financial markets. The success of financial intermediaries in perform- ing this role is evidenced by the fact that most Americans invest their savings with them and obtain loans from them. Financial intermediaries play a key role in improv- ing economic efficiency because they help financial markets channel funds from lender-savers to people with productive investment opportunities. Without a well- functioning set of financial intermediaries, it is very hard for an economy to reach its full potential. We will explore further the role of financial intermediaries in the economy in Parts 5 and 6.Types of Financial Intermediaries We have seen why financial intermediaries play such an important role in the econ- omy. Now we look at the principal financial intermediaries themselves and how they perform the intermediation function. They fall into three categories: depository insti- tutions (banks), contractual savings institutions, and investment intermediaries. Table 2.1 provides a guide to the discussion of the financial intermediaries that fit into these three categories by describing their primary liabilities (sources of funds) TA B L E 2 . 1 Primary Assets and Liabilities of Financial Intermediaries Primary Liabilities Type of Intermediary (Sources of Funds) Primary Assets (Uses of Funds) Depository institutions (banks) Commercial banks Deposits Business and consumer loans, mortgages, U.S. government securities, and municipal bonds Savings and loan Deposits Mortgages associations Mutual savings banks Deposits Mortgages Credit unions Deposits Consumer loans Contractual savings institutions Life insurance companies Premiums from policies Corporate bonds and mortgages Fire and casualty insur- Premiums from policies Municipal bonds, corporate ance companies bonds and stock, U.S. govern- ment securities Pension funds, govern- Employer and employee Corporate bonds and stock ment retirement funds contributions Investment intermediaries Finance companies Commercial paper, Consumer and business loans