Overview of the Financial System
CHAPTER 2
FEDERICA IELASI
Agenda
• We examine the role and the structure of the
financial system in an advanced economy.
• We study the effects of financial markets and
institutions on the economy, and look at their
general structure and operations.
• Topics include:
–
–
–
–
–
Function of Financial Markets
Structure of Financial Markets
Function of Financial Intermediaries
Financial Intermediaries
Regulation of the Financial System
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Function of Financial Markets
• Channel funds from person or business
without investment opportunities (i.e.,
“Lender-Savers” – surplus agents) to one
who has them (i.e., “Borrower-Spenders” –
deficit agents)
• Surplus agents have funds that they wish to
invest; deficit agents do not have sufficient
current funds themselves and need to
borrow money
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Financial Markets Funds Transferees
Lender-Savers
Borrower-Spenders
1. Households
1. Firms
2. Firms
2. Government
3. Government
3. Households
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Financial Markets Funds
Transferees
• You have a business…
• You need money…
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Segments of Financial Markets
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Segments of Financial Markets
1. Direct Finance (bottom route)
• Borrowers borrow directly from lenders in financial markets
by selling financial instruments (securities) which are
claims on the borrower’s future income or assets.
Securities are assets for the person who buys them but
they are liabilities for the individual or firm that sells (issues)
them.
2. Indirect Finance (top route)
• Borrowers borrow indirectly from lenders via financial
intermediaries. A financial intermediary stands between the
lender and the borrower and helps transfer funds from one
to the other.
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Segments of Financial Markets
• A financial intermediary borrows funds from
savers (for example a bank might acquire
funds by issuing a liability in the form of
saving deposits) and lends money to deficit
agents…
– …by making a loan
– …by buying a bond in the financial market
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Importance of Financial Markets
• Financial markets are critical for producing
an efficient allocation of capital, allowing
funds to move from people who lack
productive investment opportunities to
people who have them.
• Financial markets also improve the wellbeing of consumers, allowing them to time
their purchases better.
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Importance of Financial Markets
• When financial markets break down during
financial crises, as they have in Mexico,
East Asia and Argentina in recent years,
severe economic hardship results, which
can even lead to dangerous political
instability.
• Financial markets break downs led to
economic instability and led to widespread
social problems.
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Structure of Financial Markets
It helps to define financial markets along a
variety of dimensions (not necessarily
mutually exclusive). For starters, …
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Structure of Financial Markets
• Debt markets
• Equity markets
•
•
Equities: claims to share in the net
income and the assets of a business
•
Equities often make periodic payments
(dividends) to their holders and are
considered long-term securities
•
Equity holder is a residual claimant (the
corporation must pay all its debt
holders before it pays its equity
holders)
•
Equity holders benefit directly from any
increases in the corporation’s
profitability or asset value
•
Debt instrument (bond): contractual
agreement by the borrower to pay
the holder of the instrument fixed
amounts at regular intervals
(interest and principal payment)
until a specified date (the maturity
date)
The payments for debt holders are
fixed
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Structure of Financial Markets
1. Primary Market
– New security issues sold to initial buyers
– Typically involves an investment bank
2. Secondary Market
– Securities previously issued are bought
and sold
– Examples include the NYSE and Nasdaq
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Structure of Financial Markets
Even though firms don’t get any money,
per se, from the secondary market, it
serves two important functions:
• Provide liquidity, making it easy to buy
and sell the securities of the companies
• Establish a price for the securities
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Structure of Financial Markets
We can further classify secondary markets as
follows:
1. Exchanges
–
Trade conducted in central locations
(e.g., New York Stock Exchange)
2. Over-The-Counter Markets
–
Dealers at different locations who have an inventory
of securities are ready to buy and sell securities
OTC to anyone who comes to them and is willing to
accept their price
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NYSE home page
http://www.nyse.com
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Classifications of Financial Markets
We can also further classify markets by
the maturity of the securities:
1. Money Market: Short-Term (maturity < 1
year)
2. Capital Market : Long-Term (maturity > 1
year) plus equities
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Classifications of Financial Markets
National and international market
• International Bond Market
– Foreign bonds
• Denominated in a foreign currency
• Targeted at a foreign market
– Eurobonds
• Denominated in one currency, but sold in a different market
• Example: a bond denominated in U.S. dollars sold in London
• Over 80% of new issues in the international bond market are
Eurobonds.
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Classifications of Financial Markets
• A variant of the Eurobond is Eurocurrencies
• Eurocurrency Market
– Foreign currency deposited outside of home country
– Eurodollars are U.S. dollars deposited, say, London.
The € can cause confusion with these terms…
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Classifications of Financial Markets
A bond denominated in euros is called a
Eurobond only if it is sold outside the
countries that have adopted the euro.
Eurodollars have nothing to do with euros,
but are U.S. dollars deposited in banks
outside the United States.
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Key terms
Italian
English
Risparmio
Emettere un titolo
Negoziare un titolo
Possedere un titolo
Concedere un finanziamento
Ottenere un finanziamento
Rimborsare un prestito
Azionista
Azione
Obbligazione
Borsa
Obbligazionista
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Key terms
Italian
English
Risparmio
Saving
Emettere un titolo
To issue a security
Negoziare un titolo
To trade a security
Possedere un titolo
To hold a security
Concedere un finanziamento
To lend funds
Ottenere un finanziamento
To borrow funds
Rimborsare un prestito
To pay back a loan
Azionista
Shareholder / stockholder / equity holder
Borsa
Stock Exchange
Obbligazionista
Bondholder / Debt holder
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Key terms
English
Italian
Maturity
Bond
Common stock
Asset
Liability
Security
Mortgage
Bank supervision
Disclosure
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Key terms
English
Italian
Maturity
Scadenza
Bond
Obbligazione
Common stock
Azione ordinaria
Asset
Attività
Liability
Passività
Security
Titolo
Mortgage
Mutuo
Bank supervision
Vigilanza bancaria
Disclosure
Trasparenza
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