chapter-1-banking-introduction.power point

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An Overview of the Financial
System
Chapter 1

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1. An Overview of the Financial System
• 1. Introduction to Financial Markets and Institutions
– At any point in time in an economy, there are individuals or
organizations with excess amounts of funds, and others with a
lack of funds they need for example to consume or to invest.
• Exchange between these two groups of agents is settled in
financial markets
• The first group is commonly referred to as lenders, the second
group is commonly referred to as the borrowers of funds.

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– We will start our discussion of financial and money markets with
some basic definitions:
• 1. There exist two different forms of exchange in financial markets.
The first one is direct finance, in which lenders and borrowers meet
directly to exchange securities.
• Securities are claims on the borrower’s future income or
assets. Common examples are stock, bonds or foreign exchange

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• 1. Introduction to Financial Markets and
Institutions
– Basic definitions:
• The second type of financial trade occurs with the help of
financial intermediaries and is known as indirect finance.
• In this scenario borrowers and lenders never meet directly, but
borrowers provide funds to a financial intermediary such as
a bank and those intermediaries independently pass these
funds on to lenders.

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• 2. Financial markets are split into debt and equity markets.
• Debt titles are the most commonly traded security. In these arrangements,
the issuer of the title (borrower) earns some initial amount of money
(such as the price of a bond) and the holder (lender) subsequently receives a
fixed amount of payments over a specified period of time, known as
the maturity of a debt title.
• Debt titles can be issued on short term (maturity < 1 yr.), long term
(maturity >10 yrs.) and intermediate terms (1 yr. < maturity < 10 yrs.).
• The holder of a debt title does not achieve ownership of the borrower’s
enterprise.
• Common debt titles are bonds or mortgages.

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• Equity titles are somewhat different from bonds. The most common equity
title is (common) stock.
• First and foremost, an equity instruments makes its buyer (lender) an owner
of the borrower’s enterprise.
• Formally this entitles the holder of an equity instrument to earn a share of
the borrower’s enterprise’s income, but only some firms actually pay
(more or less) periodic payments to their equity holders known as dividends.
Often these titles, thus, are held primarily to be sold and resold.
• Equity titles do not expire and their maturity is, thus, infinite. Hence
they are considered long term securities.

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• 3. Markets are divided into primary and secondary markets
• Primary markets are markets in which financial instruments are
newly issued by borrowers.
• Secondary markets are markets in which financial instruments
already in existence are traded among lenders.
• Secondary markets can be organized as exchanges, in which titles
are traded in a central location, such as a stock exchange, or
alternatively as over-the-counter markets in which titles are sold
in several locations.

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Institutions
• 4. Finally, we make a distinction between money and capital
markets.
– Money markets are markets in which only short term debt
titles are traded.
– Capital markets are markets in which longer term debt and
equity instruments are traded.

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– Principal Money Market Instruments (maturity < 1 yr.)
Source: Miskin

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– Principal Capital Market Instruments (maturity > 1yr.)
Source: Miskin

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– Most commonly you will encounter:
• Corporate stocks are privately issued equity instruments, which
have a maturity of infinity by definition and, thus, are classified as
capital market instruments
• Corporate bonds are private debt instruments which have a certain
specified maturity. They tend to be long-run instruments and are,
hence, capital market instruments
• The short-run equivalent to corporate bonds are commercial
papers which are issued to satisfy short-run cash needs of private
enterprises.

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– Most commonly you will encounter:
• On the government side, the most commonly used long-run debt
instruments are Treasury Bonds or T-Bonds. Their maturity
exceeds ten years.
• Short-run liquidity needs are satisfied by the issuance of Treasury
Bills or T-Bills, which are short-run debt titles with a maturity of less
than one year.

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Institutions
• An Overview:
• Financial markets can be categorized as follows:
Direct vs. Indirect Finance
Debt vs. Equity Markets
Primary vs. Secondary Markets
Money vs. Capital Markets

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• 2. Functions of Financial Markets
– Borrowing and Lending
• Financial markets channel funds from households, firms,
governments and foreigners that have saved surplus funds to
those who encounter a shortage of funds (for purposes of
consumption and investment)
– Price Determination
• Financial markets determine the prices of financial assets. The
secondary market herein plays an important role in
determining the prices for newly issued assets

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– Coordination and Provision of Information
• The exchange of funds is characterized by a high amount of
incomplete and asymmetric information. Financial markets
collect and provide much information to facilitate this
exchange.
– Risk Sharing
• Trade in financial markets is partly motivated by the transfer
of risk from lenders to borrowers who use the obtained funds
to invest

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– Liquidity
• The existence of financial markets enables the owners of
assets to buy and resell these assets. Generally this leads to
an increase in the liquidity of these financial instruments
– Efficiency
• The facilitation of financial transactions through financial
markets lead to a decrease in informational cost and
transaction costs, which from an economic point of view leads
to an increase in efficiency.

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• 3. Financial Institutions and their Functions
– Any classification of financial institutions is ultimately somewhat
arbitrary, since financial markets are subject to high dynamics
and frequent innovation. Thus, we roughly use four categories:
• Brokers
• Dealers
• Investment banks
• Financial intermediaries
Engage in trade in securities
(direct finance)
Engage in financial asset
transformation (indirect
finance)

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– Brokers are agents who match buyers with sellers for a desired
transaction.
• A broker does not take position in the assets she/he trades (i.e.
does not maintain inventories of those assets)
• Brokers charge commissions on buyers and/or sellers using their
services
• Examples: Real estate brokers, stock brokers

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– Like brokers, dealers match sellers and buyers of financial assets.
• Dealers, however, take position in they assets their trading.
• As opposed to charging commission, dealers obtain their profits from
buying assets at low prices and selling them at high prices.
• A dealer’s profit margin, the so-called bid-ask spread is the
difference between the price at which a dealer offers to sell an asset
(the asked price) and the price at which a dealer offers to buy an
asset (the bid price)
• Examples: Dealers in U.S. government bonds, Nasdaq stock dealers

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– Investment Banks
• Investment banks assist in the initial sale of newly issued
securities (e.g. IPOs)
• Investment banks are involved in a variety of services for their
customers, such as advice, sales assistance and underwriting of
issuances
• Examples: Morgan-Stanley, Merill Lynch, Goldman Sachs, ...

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– Financial Intermediaries
• Financial intermediaries match sellers and buyers indirectly through
the process of financial asset transformation.
• As opposed to three above mentioned institutions. they buy a
specific kind of asset from borrowers –usually a long term loan
contract – and sell a different financial asset to savers –usually
some sort of highly-liquid short-run claim.

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• Although securities markets receive a lot of media attention,
financial intermediaries are still the primary source of
funding for businesses.
• Even in the United States and Canada, enterprises tend to
obtain funds through financial intermediaries rather
than through securities markets.
• Other than historic reasons, this prevalence results from a
variety of factors.

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• First, financial intermediaries lower transaction costs for
borrowers and lenders (economies of scale, professional
experience,...)
• Since transaction costs are reduced, financial intermediaries are able
to provide customers with additional liquidity services, such as
checking accounts which can be used as methods of payment
or deposits which can be liquidated any time while still bearing some
interest.

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• Second, financial intermediaries can reduce an investor’s
exposure to risk through risk sharing.
• Through the process of asset transformation not only maturities, but
also the risk of an asset can change: A financial intermediary uses
funds it acquires (e.g. through deposits) and often turns them into a
more risky asset (e.g. a larger loan). The risk then is spread out
between various borrowers and the financial intermediary itself.
• The process of risk sharing is further augmented through
diversification of assets (portfolio-choice), which involves
spreading out funds over a portfolio of assets with different
types of risk.

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• Third, financial intermediaries are important in the production of
information. They help reduce informational asymmetries about
some unobservable quality of the borrower for example through
screening, monitoring or rating of borrowers.
• Two problems are usually connected to informational asymmetries:
– Adverse selection (preceding a transaction), e.g. selection of “bad”
debtor
– Moral hazard (succeeding a transaction), e.g. undesirable activities by
the debtor

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• Finally, some financial intermediaries specialize on services such
as management of payments for their customers or insurance
contracts against loss of supplied funds.
• Through all of these channels financial intermediaries increase
market efficiency from an economic point of view.

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• There are roughly three classes of financial intermediaries:
– Depository institutions accept deposits from savers and transform
them into loans (Commercial banks, savings and loan associations,
mutual savings banks and credit unions)
– Contractual savings institutions acquire funds at periodic intervals
on a contractual basis (insurance and pension funds)
– Investment intermediaries serve different forms of finance. They
include finance companies, mutual funds and money market
mutual funds.

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• 4. Financial regulation
– Why regulate financial markets?
• Financial markets are among the most regulated markets in
modern economies.
• The first reason for this extensive regulation is to increase the
information available to investors (and, thus, to protect them).
• The second reason is to ensure the soundness of the financial
system.

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– 1. Increasing information available to investors
• As mentioned above, asymmetric information can cause severe
problems in financial markets (Risk behavior, insider trades,....)
• Certain regulations are supposed to prohibit agents with superior
information from exploiting less informed agents.
• In the U.S. the stock-market crash of 1929 led to the
establishment of the Securities and Exchange Commission
(SEC), which requires companies involved in the issuance of
securities to disclose certain information relevant to their
stockholders. The SEC further prohibits insider trades.

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– 2. Ensuring the soundness of financial intermediaries
• Even more devastating consequences from asymmetric information
manifest themselves in collapses of the entire financial system –
so called financial panics.
• Financial panics occur if providers of funds on a large scale
withdraw their funds in a brief period of time from the
financial system leading to a collapse of the system. These panics
can produce enormous damage to an economy.
• Examples of some recent panics are the crises in the Asian Tiger
states, Argentina or Russia. The United States, while spared for most
of the second half of 20th century, has a long tradition of financial
crises throughout the 19th century up to the Great Depression.

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– Overview of financial regulations in the United States
• 1. Restrictions to entry:
– State banking and insurance commissions and the Office of the
Comptroller of the Currency have set high standards for
market entry as a financial intermediary.
– Generally the state or federal government grants a charter to
new financial intermediaries subject to strict criteria such
as volume of initial funds, etc.

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• 2. Disclosure
– Generally financial intermediaries have to follow strict rules for
bookkeeping
– Books are subject to periodic inspection and certain
information must be made public.

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• 3. Restrictions on Assets and Activities
– Financial intermediaries are restricted from holding certain
risky assets (e.g. Commercial banks are not allowed to hold
common stock)
– Unlike in many European countries legislation in the U.S.
separated commercial banking from securities trade
from 1933 to 1999

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• 4. Deposit insurance
– If a financial intermediary fails, the central government (or
sometimes a private conglomerate of banks) can insure the
deposits of lenders
– In the U.S. deposit insurance of commercial banks is granted
mainly through the Federal Deposit Insurance Corporation
(FDIC), which was created after the severe banking crisis of the
Great Depression in 1930-1933

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• 5. Limits to Competition
– An argument of politics rather than economics is that overly hard
competition in the banking sector increases the risk of bank
failure. This belief has (especially in the past) led to some
restrictions in the commercial banking sectors
– In the U.S. private banks e.g. were prohibited to open
branches in different states
– The empirical evidence for the benefits of limiting
competition is weak and from an economic point of view it
appears more as an obstacle to risk diversification rather
than a useful regulation

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• 6. Restriction of interest rates
– The experience of the Great Depression in the U.S. has led to
the widespread belief that interest rate competition paid on
deposits might facilitate bank failure and to strong
regulation of interest rates on bank deposits
– Unlike most other developed economies, banks in the U.S. were
prohibited from paying any interest on deposits from
1933. Under what is known as Regulation Q, the Federal
Reserve System had the power to set the maximum interest
rates payable on savings deposits until 1986.

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