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• Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets
• Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets
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Figure 2.1 Flow of Funds Through the Financial System
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• Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy, as well as economic security for everyone as a whole
• Financial markets also improve the lot of individual participants by providing investment returns to lender-savers and profit and/or use opportunities to borrower-spenders
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There are two ways a firm or an individual can obtain funds in a financial markets.
1. Debt Markets (debt instruments such as bonds)
– Short-Term (maturity < 1 year) – Money markets
– Intermediate-term (1 year<maturity<10 years) Capital markets
– Long-Term (maturity > 10 year) Capital Markets
2. Equity Markets
– Common Stock (which pays dividends, no maturity date)
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• Debt instruments
– Buyers of debt instruments are suppliers (of capital) to the firm, not owners of the firm
– Debt instruments have a finite life or maturity date
– Advantage is that the debt instrument is a contractual promise to pay with legal rights to enforce repayment
– Disadvantage is that return/profit is fixed or limited
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• Equity instruments (common stock is most prevalent equity instrument)
– Buyers of common stock are owners of the firm
– Common stock has no finite life or maturity date
– Advantage of common stock is potential high income since return is not fixed or limited
– Disadvantage is that debt payments must be made before equity payments can be made
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1. Debt Markets
– Although less well-known by the average person, debt markets in U.S. are much larger in total dollars than equity markets due to greater number of participant classes (households, businesses, government, and foreigners) and size of individual participants (businesses, and government)
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2. Equity Markets
– Although U.S. markets are highly efficient, the world’s largest, and more familiar to the average person, they are far smaller than the U.S. debt markets largely due to the fact that the only applicable participants are businesses
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– New issues of a security such as a bond or a stock are sold to initial buyers
– Securities previously issued are bought and sold
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Secondary markets can be organized in two ways .
Exchanges
– Trades conducted in central locations
(e.g., New York Stock Exchange, London)
Over-the-Counter Markets
– Dealers at different locations buy and sell
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NYSE home page http://www.nyse.com

•
– Foreign bonds
– Eurobonds (now larger than U.S. corporate bond market)
•
– U.S. stock markets are no longer always the largest —at one point, Japan's was larger
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•
1. Engage in process of indirect finance
2. More important source of finance than securities markets
3. Needed because of transactions costs and asymmetric information
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•
1. Financial intermediaries make profits by reducing transactions costs
2. Reduce transactions costs by developing expertise and taking advantage of economies of scale
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• 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
1.
Banks provide depositors with checking accounts that enable them to pay their bills easily
2.
Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary
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• Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing
– FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party
– This process is referred to as asset transformation , because in a sense risky assets are turned into safer assets for investors
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Central Bank of the Philippines
Commercial
Banks
Thrift
Banks
Savings &
Mortgage
Banks
Non-bank Thrift
Institutions
Specialized
Government
Banks
Non-Stock
Savings &
Loan Assns.
Development
Bank of the
Philippines
Private
Development
Banks
Stock Savings and Loan
Associations
Mutual Bldg. and Loan
Associations
Land Bank of the
Philippines
Philippine
Export-Import
Agency
NOTE: Insurance Companies are under the supervision of the Insurance Commission
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Rural
Banks
Financing
Companies
Fund Managers
Lending
Investors
Money Brokers
Non-bank
Financial
Intermediaries
Investment
Houses
Investment
Companies
Securities
Dealers/
Brokers
Pawnshops

Bank Negara Malaysia
Banking Institutions
Islamic Banks
Finance Companies
Discount Houses
Financial Markets
Commercial Banks
Labuan Int’l. Offshore
Financial Centre
Merchant Banks
Money & Foreign
Exchange
Foreign Bank Rep.
Offices Malaysian Gov’t.
Securities
Securities Commission
• Private Debt Securities
• Options & Futures Exchange
• Stock Exchanges
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Non-bank Financial
Intermediaries
DFIs
Insurance Companies
Leasing Companies
Factoring Companies
Savings Institutions Venture
Capital Cos.
Credit Token Cos.
Provident/Pension Funds
Unit Trust Property
Trusts
Housing Credit Inst.
Gov’t. Housing Division
Cagamas Berhad
Pilgrims Fund
Credit Guarantee Corp.
MECIB

Ministry of Finance
Commercial
Banks
International
Banking
Facilities
(IBFs)
Central
Bank of Thailand
Finance
Companies
Finance
Securities
Companies
Credit
Companies
Asset
Management
Companies
Government
Specialized
Financial
Institutions
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All Financial Institutions
All-India Financial
Institutions
State Level Institutions Other Institutions
All India Development
Banks IDBI, SIDBI, IIBI,
IFCI
Specialized Financial
Institutions EXIM Bank,
IVCF, ICICI Venture,
TFCI, IDFC
Investment Institutions
UTI, LIC, GIC & its erstwhile four subsidiaries
Refinance Institutions
NABARD, NHB
*
* *
SFCs SIDCs ECGC DICGC
*
Regulatory & supervisory domain of the Reserve Bank of India
(Central Bank)
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CENTRAL BANK
BANKING INSTITUTIONS
NON-BANKING FINANCIAL
INSTITUTIONS
THE BANK OF KOREA
COMMERCIAL BANKS
SPECIALIZED BANKS
NON-BANK DEPOSITORY INSTITUTIONS
INSURANCE INSTITUTIONS
SECURITIES INSTITUTIONS
OTHER INSTITUTIONS
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Central Bank (Bank of Japan)
Private Financial
Institutions
Ordinary Banks (231)
Trust Banks (33)
Long-term Credit
Banks (3)
Credit Associations
(412)
Credit Cooperatives
(363)
Insurance Companies
(77)
Agricultural &
Fishery
Cooperatives
(3,580)
Securities Companies
(265)
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Policy-based Financial
Institutions
Development Banks (2) Government Finance (9)

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Life Insurance Companies
1.
Regulated by states, not federal government, as no widespread failures
2.
Hold illiquid long-term assets, as death rates predictable: mortgages
3.
Since 1970s, restructure to become also managers of pension funds
4.
Recently, OCC encourages banks to enter the insurance field
Property & Casualty Insurance Companies
1.
Losses from fire, theft, auto-accident, negligence, natural disaster
2.
Regulated by states
3.
Hold more liquid assets: 50% US Government securities
4.
Reinsurance : a portion of the risk is allocated to another insurance company in exchange for a portion of the premium,
Lloyd’s association of insurers
Insurance Management : adverse selection (1.-2.) and moral hazard (3.-8.)
1.
Screening : (medical) evaluation; similar to credit score in lending
2.
Risk-based premiums : young males more likely to have auto-accidents
3.
Restrictive provisions : helmets when renting motor scooters; covenants
4.
Prevention of fraud : claim when restrictive provisions not complied with
5.
Cancellation of insurance : a driver gets too many speeding tickets
6.
Deductible : a fixed amount by which the insured’s loss is reduced
7.
Coinsurance : 80% of medical bills covered by insurer, 20% by insured
8.
Limits on amounts of insurance : cannot insure a car more than its value
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Pension Funds: ensure income payments on retirement
1.
Rapid growth: contributions tax-deductible for both employers and employees
2.
Bigger role in stock market: payments predictable => buy LT securities
3.
Problem of underfunding: contributions and earnings less than benefits
4.
Private
– regulated by Department of Labor
– insured by the Pension Benefit Guarantee Corporation (Penny Benny) under the Employment Retirement Income Security Act (ERISA) of 1974
5.
Public
A.
Social Security
– since 1935, covers all individuals employed in the private sector
– “pay as you go”  benefits paid out of current contributions => underfunding
B.
State and local pension plans
Mutual Funds: pool resources of many small investors selling them shares
1.
Regulated by SEC
2.
Open-end vs. closed-end: shares can be redeemed at a price tied to the asset value of the fund or not
3.
Load vs. no-load: commission paid to selling broker or not
4.
Money market mutual funds: shares function as checkable deposits
5.
Hedge funds: 1998, near collapse of Long-Term Capital Management
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Finance Companies: borrow in large amounts to lend in small amounts
– Minimal regulation by states
– Rapid growth
– Three types
1.
Sales finance companies: loans to buy items from a particular company
2.
Consumer finance companies: loans for furniture, home improvements
3.
Business finance companies
– factoring : form of specialised credit by making loans and purchasing accounts receivable (bills owed to the firm) at a discount
– leasing : railroad cars, jet planes, computers
Government Financial Intermediation
1.
Federal credit agencies: mostly, helping residential housing and agriculture
2.
Government guarantees to private loans: moral hazard problem
Securities Market Institutions: all are regulated by SEC
1.
Investment bank(er)s : primary markets, initial public offerings (IPOs) vs seasoned issues, underwriters guarantee a price and sell to the public
2.
Securities brokers ( agents for investors), dealers (hold inventories of securities and trade on their own account ) and specialists: secondary markets
3.
Brokerage firms: investment bank(er)’s, broker’s and dealer’s activities
4.
Organised exchanges (NYSE, AMEX) vs OTC markets (NASDAQ)
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• A trust institution : a legal entity that can hold and manage assets for one or more beneficiaries over time
– Grantor is the creator of the trust
– Trustee is the manager of the trust
– Beneficiaries receive the benefits of the trust
• Business trusts historically were formed among firms in the same industry to avoid competition and gain monopoly power
– The Sherman Antitrust Act of 1890 in US and other legislation struck down such anti-competitive behavior
– Today holding companies (ownership of affiliated firms) and consortiums
(association or partnership of financial institutions but no cross ownership) have replaced trusts as a common form of business organisation
• Trust institutions now handle employee benefit programmes, personal trusts and estates, and corporate trusts
– Real estate investment trusts (REITs) is a trust that purchases real estate and offers shares of ownership to investors
– Trust companies can be within or outside a bank for purposes of estate planning to distribute assets of an individual after death and reduce taxes for beneficiaries: US federal estate tax rates range from 37% to 55%!
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• 1933 : Glass-Steagall Act , which was part of the 1933 Banking Act ,
separated commercial banking from investment banking
• 1987 : the Federal Reserve reinterpreted this Act to mean that bank holding companies could own nonbank securities subsidiaries if approved by the
Fed
• 1999 : the Financial Services Modernization (Gramm-Leach-Bliley) Act dropped barriers under Glass-Steagall : now financial (
 bank ) holding companies can offer securities and insurance services
• Some related financial innovations
– Sweep accounts (at banks or nonbanks) for temporary transfer of funds from non-interest bearing accounts into an investment account earning higher yields
– Private banking provides custom-tailored services to high net worth individuals: wealth management (tax optimisation), art banking
(jewellery)
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