Chapter 2 An Overview of the Financial System

Chapter 2 An Overview of the Financial System

Chapter 2 An Overview of the Financial System Introduction Look at three components of the financial system: 1. Financial Instruments (or securities) Stocks, bonds, loans and insurance (these are contracts). What is their role in our economy? 2. Financial Markets New York Stock Exchange, Nasdaq, etc. Where investors trade financial instruments. 3. Financial Institutions Why they exist and what they do. Introduction Direct Finance: Borrowers sell securities directly to lenders (savers) in the financial markets.

Direct finance provides financing for governments and corporations. Indirect Finance: An intermediary (financial institution) stands between lender and borrower. For example, you get a loan from a bank or finance company to buy a car. The bank is a financial intermediary (FI) World Without Financial Intermediaries (FI) Lender Saver (Households) Equity and Debt Securities Cash Borrower - spender (Businesses) In this world (all direct finance) the flow of funds from

savers to borrowers is likely to be low: As a lender, how do you know you will get your money back? (problem of adverse selection) As a lender, how do you know the borrower will use funds as stated? (problem of moral hazard) Borrowers must be screened and monitored and this is a hassle. Prefer to leave the screening and monitoring to others. Also, there is a lack of liquidity why? 2-4 World With Financial Intermediaries (FI) Financial Intermediary Lender Saver (Households.) Cash FI - Broker FI - Asset Transformer

Borrower spender Businesses.) Debt and Equity Deposits and Insurance policies Here we have both direct and indirect finance. 2-5 Mishkins Example - Flows of Funds Through the Financial System Basic Balance Sheet Assets Something of value that you own Liabilities and Net Worth

Something you owe. Net Worth = Assets - Liabilities Financial Intermediary - Commercial Bank Assets (Uses of Funds) - Cash (vault cash) Deposits at Fed (Reserves) Mortgages Commercial Loans US Govt bonds Liabilities and Net Worth (Sources of Funds)

Demand Deposits Time Deposits Debt (Borrow) Equity Capital (Bank Capital) Asset Transformation Banks issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics. Also, referred to as maturity Transformation Bank liabilities are short-term and their assets are long-term. Financial Intermediary - Investment Bank Assets (Uses of Funds) - Stocks

US Govt bonds Corporate bonds MBS Bunch of other stuff Liabilities and Net Worth (Sources of Funds) - Issue Debt (Borrow) - Equity Capital Financial Intermediary - Insurance Company Assets - Cash - Mortgages - Corporate Bonds - US Govt bonds - Equity (Stocks) Liabilities and Net Worth Insurance Policies (Promise, contingent liability) Equity Capital

Asset Transformation Insurance companies issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics Examples of Direct Finance Initial Public Offering of a stock. Ford Motor sells bonds to the public. GE issues commercial paper to public to fund its payroll. Key point the lender has a direct claim on the borrower Financial Instrument Financial Instrument: Legal obligation of one party to transfer something of value (usually money) to another party at some specified date, under specified conditions. Trade value for a promise. obligate one party (person, company, or government) to transfer something to another party. specify payment will be made at some future date. specify conditions under which a payment will be

made. The enforceability of the obligation is important. We can organize financial instruments by how they are used stores of value or transfer risk Instruments used as stores of value: 1. Bank loans Borrower obtains funds from a lender to be repaid in the future. 2. Bonds A form of a loan issued by a corporation or government. Bought and sold in financial markets. Financial Instruments used as stores of value: 3.Home mortgages Home buyers usually need to borrow using the home as collateral for the loan.

A specific asset the borrower pledges to protect the lenders interests. 4.Stocks (Equity) The holder owns a small piece of the firm and entitled to part of its profits: retained or paid out in dividend. Firms sell stocks to raise money. Primarily used as a stores of wealth. Financial Instruments used as stores of value: 5.Asset-backed securities Buyers share in the payments arising from specific assets, such as home mortgages, car loans, student loans. A Mortgage Backed Security(MBS) is an asset-back security that bundles a large number of mortgages together into a pool in which shares are sold. Financial Instruments used to transfer risk: 1. Insurance contracts.

Primary purpose is to assure that payments will be made under particular circumstances. 2. Futures Option and Swap Contracts. Characteristics of Financial Instruments Can be simple contracts or very complex. Complexity is costly. Individuals do not want to bear these costs let someone else (a financial intermediary) do it. Bank loans can be very complex Standardization of financial instruments overcomes potential costs of complexity. US Govt bond is an example of a simple contact. Financial instruments are designed to handle the problem of asymmetric information. Borrowers have some information they dont disclose to lenders. Financial Markets Places where financial instruments are bought and

sold. Three benefits: 1. Provide market liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low. 2. Provide information: Pool and communication information about issuers of financial instruments. 3. Provide risk sharing: Provide a place to buy and sell risk. The Structure of Financial Markets 1. Primary or secondary markets - distinguish between markets where new financial instruments are sold and markets where previously issued instruments are resold or traded. 2. Centralized or not - Categorize by the way financial instruments are traded.

3. Type of instrument Primary versus Secondary Markets A primary market is one in which a borrower obtains funds from a lender by selling newly issued securities. Occurs out of the publics view. An investment bank determines the price, purchases the securities, and resells to clients. This process is called underwriting and is usually very profitable. Primary versus Secondary Markets Secondary markets are where people can buy and sell existing (previously issued) securities. Buy a share of Netflix stock not from the company, but from another investor in a secondary market. These are the prices we hear about in the news. Secondary Markets Two important functions: Provides liquidity, making it easy to buy and sell the

securities of the companies Establish a price for the securities and thus provides information regarding well a firm is doing 2012 Pearson Prentice Hall. All rights reserved. 2-22 Type of Financial Markets Debt markets are markets for loans, mortgages, and bonds. Equity markets are the markets for stocks. Derivative markets are the markets where investors trade instruments like futures, options, and swaps. Markets and Maturity Debt instruments categorized by the loans maturity Repaid in less than a year called a money market instrument traded in money markets. Maturity of more than a year called a capital market

instrument traded in capital market. Equity does not mature. It is a capital market instrument. Financial Market Instruments (1 of 2) Table 1 Principal Money Market Instruments Amount ($ billions, end of year) Type of Instrument 1990 2000 2010 2016 U.S. Treasury bills 527

647 1,767 1,816 Negotiable bank certificates of deposit (large denominations) 547 1,053 1,923 1,727 Commercial paper 558 1,602

1,058 885 Federal funds and security repurchase agreements 372 1,197 3,598 3,778 Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov Financial Market Instruments (2 of 2) Table 2 Principal Capital Market Instruments Amount ($ billions, end of year) Type of Instrument

1990 2000 2010 2016 Corporate stocks (market value) 3,530 17,628 23,567 38,685 Residential mortgages 2,676

5,205 10,446 10,283 Corporate bonds 1,703 4,991 10,337 12,008 U.S. government securities (marketable long-term) 2,340

3,171 7,405 12,064 U.S. government agency securities 1,446 4,345 7,598 8,531 State and local government bonds 957 1,139

2,961 3,030 Bank commercial loans 818 1,497 2,001 3,360 Consumer loans 811 1,728 2,647

3,765 Commercial and farm mortgages 838 1,276 2,450 2,850 Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov Characteristics of a Well-Run Financial Market Keep transaction costs low. Information communicated must be accurate and widely available. Borrower promises to pay lenders must be credible. Lenders must be able to enforce their right of repayment quickly and at low cost.

Characteristics of a Well-Run Financial Market Because of these criteria, the government is an essential part of financial markets - they enforce the rules of the game. countries with better investor protections have bigger and deeper financial markets. The Role of Financial Institutions reduce transaction costs by specializing in the issuance of standardized securities. reduce the information costs of screening and monitoring borrowers. Provide liquidity - savers have ready access to their funds checking account deposit. The Structure of the Financial Industry Two broad categories of financial intermediaries: Depository institutions, Take deposits and make loans Commercial banks, S&Ls and credit unions. Non-depository institutions.

Insurance companies, securities firms, mutual fund companies, finance companies, and pension funds. The Structure of the Financial Industry 1. Depository institutions take deposits and make loans. 2. Insurance companies accept premiums, which they invest, in return for promising compensation to policy holders under certain events (contingent liability). 3. Pension funds invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers. The Structure of the Financial Industry 4. Securities firms include brokers, investment banks, underwriters, mutual fund companies private equity firms, and venture capital firms. Brokers and investment banks issue stocks and bonds for corporate customers, trade them, and advise customers. Mutual-fund companies pool the resources of individuals and companies and invest them in portfolios - passive investing.

Hedge funds do the same for small groups of wealthy investors. The Structure of the Financial Industry 4. Cont. Private equity and venture capital firms also serve wealthy investors by acquiring controlling stakes in a few firms and manage them actively. 5. Finance companies raise funds directly in the financial markets in order to make loans to individuals and firms. Finance companies tend to specialize in particular types of loans, such as consumer, automobile, or business equipment. Types of Financial Intermediaries (1 of 5) Table 3 Primary Assets and Liabilities of Financial Intermediaries Primary Liabilities (Sources of Funds) Primary Assets (Uses of Funds)

Depository institutions (banks and credit unions) Blank Blank Commercial banks Deposits Business and consumer loans, mortgages, U.S. government securities, and municipal bonds Savings and loan associations Deposits Mortgages

Mutual savings banks Deposits Mortgages Credit unions Deposits Consumer loans Type of Intermediary Types of Financial Intermediaries (2 of 5) [Table 3 Continued] Primary Liabilities (Sources of Funds) Primary Assets (Uses of Funds) Contractual savings

institutions Blank Blank Life insurance companies Premiums from policies Corporate bonds and mortgages Fire and casualty insurance companies Premiums from policies Municipal bonds, corporate bonds and stock, and U.S. government securities Pension funds, government

retirement funds Employer and employee contributions Corporate bonds and stock Type of Intermediary Types of Financial Intermediaries (3 of 5) [Table 3 Continued] Type of Intermediary Primary Liabilities (Sources of Funds) Primary Assets (Uses of Funds) Investment intermediaries Blank

Blank Finance companies Commercial paper, stocks, bonds Consumer and business loans Mutual funds Shares Stocks, bonds Money market mutual funds Shares Money market instruments Hedge funds

Partnership participation Stocks, bonds, loans, foreign currencies, and many other assets Commercial Banks Loans deposits Pension Funds Stocks Retirement Plans Finance Companies Auto Loans Consumer Loans Commercial paper

ABCP Bank Loans Insurance Companies Bonds Stocks Insurance Policies Mutual Funds Bonds Stocks Shares Money Market Mutual Funds Commercial paper T-Bills

Shares/ deposits Types of Financial Intermediaries (4 of 5) Table 4 Primary Financial Intermediaries and Value of Their Assets Value of Assets ($ billions, end of year) Type of Intermediary Depository institutions (banks/credit unions) Commercial banks, savings and loans, and mutual savings banks 1990 Blank 2000 Blank 2010

Blank 2016 Blank 4,744 7,687 12,821 16,834 217 441 876 1,238

Contractual savings institutions Blank Blank Blank Blank Life insurance companies 1,367 3,136 5,168 6,764 533

866 1,361 1,908 1,619 4,423 6,614 9,099 820 2,290 4,779 6,103

Credit unions Fire and casualty insurance companies Pension funds (private) State and local government retirement funds Types of Financial Intermediaries (5 of 5) [Table 4 Continued] Value of Assets ($ billions, end of year) Type of Intermediary Investment intermediaries 1990 Blank 2000 Blank

2010 Blank 2016 Blank Finance companies 612 1,140 1,589 1,385 Mutual funds 608

4,435 7,873 13,616 Money market mutual funds 493 1,812 2,755 2,728 Source: Federal Reserve Flow of Funds Accounts; https://www.federalreserve.gov/releases/z1/current/data.htm, Tables L110, L114, L115, L116, L118, L120, L121, L122, L127.

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