Financial Assets, money, Financial transections and Institutions

1. Chapter 2
Financial Assets, Money,
Financial Transactions,
and Financial Institutions

2. The Role of Financial Assets
 The financial system is the mechanism
through which loanable funds reach
borrowers
 Through Operation of the financial markets
 Money exchanged for financial claims in the form
of
-Stock -Bond -Other securities
 Transforms savings into investment
 Economy’s capacity to produce goods & services
increases.

3. The Nature and Characteristics of
Financial Assets
 A financial asset
 A claim against the income or wealth of a
business firm, household, or unit of
government
 Represented usually by a certificate
receipt, computer record file, or other legal
document
 Usually related to the lending of money
 Examples include stocks, bonds,
deposits, and others

4. Characteristics of Financial Assets
 Financial assets are sought after because
they promise future returns to their owners
and serve as a store of value (purchasing
power).
 Financial asset value based on faith that
issuer honors contractual promise to pay

5. Characteristics of Financial Assets
 Financial assets other characteristics
 Do not depreciate like physical goods
 Physical condition or form usually not
relevant in determining market value
 Have little or no value as a commodity
 Cost of transportation and storage is low
 Financial assets are fungible – can easily be
changed in form and substituted for other
assets
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6. Types of Financial Assets
Money
 Financial asset accepted in payment for
purchases of goods and services
 Examples are currency and checking a/c

7. Equities
 Ownership shares in a business firm
 Claims against the firm’s profits
 Claims against proceeds from the sale of its
assets
 Examples are common stock and preferred
stock

8. Types of Financial Assets
Debt Securities
 Priority claim over the holders of equities to
the assets and income of an economic unit
 Can be negotiable or nonnegotiable
 Examples include bonds, notes, accounts
payable, and savings deposits

9. Types of Financial Assets
Derivatives
 Market value tied to or influenced by the
value or return on a financial asset
 Examples include futures contracts,
options, and swaps

10. The Creation Process of Financial
Assets
 Lets take a rudimentary financial
system.
2 Economic units: Household and
Business Firm.
 Financial system is closed. So no
external transaction is possible.
Lets see their financial position in
respective balance sheets.

11. Here Assets represent uses of
funds made by economic units
Liabilities and net worth represent
the accumulated sources of funds
that an economic unit has drawn
upon to acquire the assets it now
holds.

12. The net worth (equity) account
reflects total savings accumulated
overtime by each economic unit.
A balance sheet must always
balance: total assets (accumulated
uses of funds) must equal total
liabilities plus net worth
(accumulated sources of funds).

13. Balance Sheets of Units in a
Simple Financial System

14.  Neither HH or BU has any
outstanding debt or liabilities.
Both are entirely self financed
Both acquired assets by saving not
by borrowing. (internal financing)

15. How Financial Assets Are Created
 Internal financing to acquire assets
 Use current income
 Use accumulated savings
 External financing to acquire assets
 Raise funds by issuing financial liabilities
(debt)
 Raise funds by issuing stock (equities)

16.  BF need a drill press.
 4 alternatives available to it.
1. Pospone purchase of new equipment
2. Sell of some existing asset to raise
fund.
3. Issue stock.
4. Taking loan or debt issue.

17. Unit Balance Sheets Following the
Equipment Purchase and Debt Issuance

18. Unit Balance Sheets Following Equipment
Purchase and Stock Issuance

19. Financial Assets and the Financial System
 All financial assets are recorded as a
liability or claim on some other
economic unit’s balance sheet.
 The act of borrowing or of issuing new
stock simultaneously gives rise to the
creation of an equal volume of financial
assets.

20. 1st: Volume of financial assets for lenders
= Volume of liabilities (claims) issued by
borrowers.
2nd: Total Uses of fund = Total sources of
fund.
Thus, every financial asset in existence
represents the lending or investing of funds
transferred from one economic unit to
another.

21. Financial Assets and the Financial System
 For the balance sheet of any economic unit- HH,
BF or Govt…..
Total assets = Total liabilities + Net Worth
Where
Assets = Real assets + Financial assets
So, RA + FA = TL + Net Worth.
 For the whole economy and financial system,
 Total financial assets = Total liabilities
So, Total Real Asset = Net Worth (ie.
Accumulated Savings)

22. This means that the value of all
buildings, machinery, and other real
asset in existence matches the total
amount of savings carried out by all
businesses, HH and units of Govt.
Thus, society increases its wealth only
by savings and increasing the quantity
of its real assets.

23. Financial Assets and the Financial System
 Society can increase its wealth
 Saving and increasing the quantity of its
real assets
 Real assets enable the economy to
produce more goods and services
 The financial system provides the
essential channel
 Necessary for the creation and exchange
of financial assets
 Exchange is between savers and
borrowers so that real assets can be
acquired

24. Financial System Matters
Strong financial system helps society
 Reducing barriers to external financing
 Lowering cost of capital
 Accelerating economic growth
Nations with more fully developed
financial systems
 Tends to grow faster
 Tends to enjoy a higher standard of living

25. Lending and Borrowing in Financial
System

26. Gurley and Shaw Proposition
 Economists John Gurley and Edward Shaw
pointed out that each business firm,
household, or unit of government active in
the financial system must conform to:
R - E = FA - D
where
R = Current income receipts
E = Expenditures out of current income
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding

27. If current Expenditure (E) exceeds
current receipts (R), we make up
the gap by…
 Reducing holding of financial assets
(- FA)
Issuing debt or stock (+ D) or
Using combination of both.

28. If current receipts (R), exceeds
current Expenditure (E) we make up
the gap by…
 Building up holding of financial assets
(+ FA)
Paying off debt or retiring stock (- D)
or
Using combination of both.

29. Lending and Borrowing in the
Financial System
 So, for any given time period, each
economic unit must fall into one of
three groups:
 Deficit-budget unit (DBU):
E > R, so D > FA (net borrower of funds)
 Surplus-budget unit (SBU):
R > E, so FA > D (net lender of funds)
 Balanced-budget unit (BBU):
R=E, so D=FA (neither net lender nor
borrower)

30. A net lender of funds is really a net
supplier of funds to the financial
system.
He does it by purchasing FA, paying off
debt or retiring stocks.
A net borrower of funds is a net
demander of funds from the FS selling
FA, issuing new debts or selling new
stock.

31. Lending and Borrowing in the
Financial System
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
Households $865.1 $1,411.1 $ - 546.0
Nonfinancial business 599.0 680.5 + 87.5
firms
State and local 80.0 144.0 - 64.0
governments
Federal government - 13.6 634.6 - 648.2
International sector:
foreign investors 1491.9 545.3 + 946.6
and borrowers
Net Acquisitions
of Financial
Assets
Net
Increase in
Liabilities
Net Lender(+)
or Net
Borrower(-)
Major Sectors
of the
Economy
The U.S. Economy in 2006
($ Billions)

32. Lending and Borrowing in the
Financial System
 The global financial system permits
businesses, households, and
governments to adjust their financial
position from that of net borrower
(DBU) to net lender (SBU) and back
again, smoothly and efficiently.

33. What is Money?
 All financial assets are valued in terms
of money, and flows of funds between
lenders and borrowers occur through
the medium of money.
 Money itself is a financial asset,
because all forms of money in use
today are claims against some public
or private institution.

34. The Functions of Money
 Money serves as a standard of
value (or unit of account)
 Money serves as a store of value
 Reserve of future purchasing power
 Value of money can fluctuate with
inflation

35. Money serves as a medium of exchange
 Buyers and sellers no longer need to have
an exact coincidence of wants
 Money is the only perfect liquid asset

36. The Value of Money and Other Financial
Assets and Inflation
 Inflation
 Rise in the average price level of all goods
and services
 Lowers purchasing power of money
 Can damage value of financial contracts
 Deflation
 The opposite of inflation
 Fall in the average price level of all goods
and services

37. The Value of Money and Other Financial
Assets and Inflation
 Inflation is commonly measured
using price indices, such as:
 the Consumer Price Index (CPI),
 the Producer Price Index (PPI), or
 the Gross Domestic Product (GDP)
deflator Index.

38. The Value of Money and Other Financial
Assets and Inflation
 Suppose the U.S. CPI rises from 100 to 125
over a five-year period.
 Over the five-year period, the cost-of-living
index climbed
  ...
25%
or
25
.
0
100
100
125


and the U.S. dollar’s relative purchasing
power fell
.
8
.
0
100
125
1



39. Impact on Purchasing Power
Changes in purchasing power can be
dramatic
 Due to inflation
 Even in the United States
 Provides a warning about measuring value
Need to think in terms of real values
 Purchasing power adjusted
 Nominal values can be misleading

40. The Evolution of Financial
Transactions
 Financial systems change
constantly
 Shifting demands from the public
 Development of new technology
 Changes in laws and regulations
 The ways of carrying out
financial transactions have
evolved

41. In particular, the transfer of funds
from savers to borrowers can be
accomplished in at least three
different ways

42. The Evolution of Financial
Transactions
Direct Finance – Direct lending gives rise
to direct claims against borrowers
Borrowers
(DBUs)
Lenders
(SBUs)
Flow of funds and other financial services
(loans of spending power for an
agreed-upon period of time)
Primary Securities
(stocks, bonds, notes, etc., evidencing
direct claims against borrowers)
 Simple  Difficult to match & risky

43. The Evolution of Financial
Transactions
Semidirect Finance – Direct lending with the
aid of market makers who assist in the sale
of direct claims against borrowers
 Lower search (information) costs
 Risky & matching is still required
Borrowers
(DBUs)
Lenders
(SBUs)
Flow of funds
and other
financial services
(loans of spending
power)
Security
brokers,
dealers, &
investment
bankers
Primary Securities
(direct claims
against
borrowers)
Primary Securities
(direct claims
against
borrowers)
Proceeds of
security sales and other
financial services
(less fees and commissions)

44. Major Financial Institutions

45. The Evolution of Financial
Transactions
Indirect Finance – Financial intermediation of
funds
 Low risk & affordable
Ultimate
borrowers
(DBUs)
Ultimate
lenders
(SBUs)
Flow of funds and other
financial services
(loans of spending power)
Financial intermediaries
(banks, savings and loan associations,
insurance companies, credit unions,
mutual funds, finance companies,
pension funds)
Secondary Securities
(indirect claims against ultimate
borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)
Primary Securities
(direct claims against ultimate
borrowers in the form of loan
contracts, stocks, bonds, notes,
etc.)
Flow of funds and other
financial services
(loans of spending power)

46. Total Financial Assets Held by U.S.
Financial Institutions
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
($ billions at year-end) 1970 1980 1990 2000 2006
Financial intermediaries:
Commercial banks $489 $1,248 $3,340 $6,488 $9,528
S&L assoc. and savings banks 252 794 1,358 1,219 1,829
Life insurance companies 201 464 1,357 3,204 4,479
Private pension funds 110 413 1,629 4,587 4,876
Investment co. (mutual funds) 47 64 602 4,457 6,473
State & local gov’t pension funds 60 198 820 2,290 2,791
Finance companies 63 199 611 1,138 1,300
Property-casualty insurance co. 50 174 534 872 1,280
Money market funds –– 74 498 1,812 2,014
Credit unions 18 72 202 441 703
Mortgage companies –– 16 49 36 32
Real estate investment trusts 4 6 13 62 385
Other financial institutions:
Security brokers and dealers 16 36 262 1,221 2,296

47. Classifying Financial Institutions
 Depository institutions
 Bulk of their loanable funds from deposit
accounts sold to the public
 Commercial banks, savings and loan
associations, savings banks, credit unions
 Contractual institutions
 Funds from offering legal contracts to
protect the saver against risk
 Insurance companies, pension funds
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48. Classifying Financial Institutions
Investment institutions
 Sell shares to the public
 Invest the proceeds in stocks, bonds, and
other assets
 Mutual funds, money market funds, real
estate investment trusts
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49. Portfolio (Financial-Asset)
Decisions by Financial Institutions
 Deciding what financial assets to buy
or sell
 Depends on various asset factors
 Different financial assets relative rate of
return
 Different financial assets risk
 Cost of incoming funds
 Volatility of incoming funds
 Maturity of incoming funds
2-49

50. Portfolio (Financial-Asset)
Decisions by Financial Institutions
Also depends on financial institution
size
 Larger financial institutions tend to have
more diversified sources and uses
 Larger financial institutions also enjoy
economies of scale.
Regulations and competition
2-50

51. The Disintermediation of Funds
 Disintemediation process
 Withdrawal of funds from a financial
intermediary by the ultimate lenders
(SBUs)
 Lending of those funds to ultimate
borrowers (DBUs)
 Disintermediation shifts funds
 Away from indirect finance
 To direct finance or semidirect finance.
2-51

52. The Disintermediation of Funds
Primary Securities
Ultimate
borrowers
(DBUs)
Ultimate
lenders
(SBUs)
Financial
intermediaries
Loanable funds
Financial Disintermediation
2-52

53. The Disintermediation of Funds
Disintermediation is not a foregone
conclusion
Reintermediation
 Reversal of flow of funds
 Back to a “safe haven” of financial
intermediaries
 Interest rates are low or declining
 Or riskiness of financial instruments appear
to be rising
2-53

54. New Forms of Disintermediation
 Initiation by financial intermediaries
 Banks sell off loans
 Difficulty in raising capital
 Initiation by borrowing customers
 Customer learn alternate financing
conduits
 Nonfinancial retail and industrial firms
attempting to draw financial services
customers
 Raise funds in the open market
2-54

55. Bank-Dominated Versus Security-
Dominated Financial Systems
 Bank-dominated financial systems
 Banks and other similar institutions
dominate
 Supply of credit
 Attracting savings
 Common in economies with less
protection of investor rights or less well-
defined rules
2-55

56. Bank-Dominated Versus Security-
Dominated Financial Systems
Security-dominated financial systems
 Traditional intermediaries are less
important
 More borrowers sell securities to the public
 Many economies are gradually moving
toward a more security-dominated financial
system
2-56