Financial Institutions, Markets, &
Money, 12th Edition
Authors: Kidwell, Blackwell, Whidbee &
Sias
Prepared by:
Kenneth Nolan Daniels
Virginia Commonwealth University
Copyright© 2017 John Wiley & Sons, Inc.
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CHAPTER 1
An Overview of Financial Markets and
Institutions
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The Financial System
Provides for efficient flow of funds from saving to investment by
bringing savers and borrowers together via financial markets and
financial institutions.
The financial system has developed to facilitate the transfer of funds
from those with money to invest to those in need of funds
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The Financial System
The financial system includes:
A mechanism for issuing and selling new securities
A market for the subsequent sale of existing securities, and
A variety of financial intermediaries that stand between suppliers
and users of funds
There are many Financial Institutions in the economy including:
Banks and Thrifts
Life and Property & Casualty Insurers
Pension and Retirement Funds
Mutual Funds
Investment Banks
Brokerage Firms
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The Financial System
The Participants in the Financial System
There are three major groups of players in the financial system:
Households (or individuals)
Business
Government
Each of these groups serves a different role in the financial system and
each of these groups can be either suppliers (Surplus Spending Units,
SSU) or users (Deficit Spending Units, DSU) of funds.
Households influence the economy through wealth, income, savings,
and investment. Household investment is a means of transferring
funds to firms.
Business (Firms) influence the economy by investing in real
production. Firms use funds from income, from the government, and
from household investment. The government is compensated by
means of taxes and real production for the economy. Households are
compensated by means of dividends or capital gains.
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The Financial System
The Participants in the Financial System
Government influences the economy primarily through Fiscal Policy
and Monetary Policy. The government also directly influences
businesses and households in many ways including taxes, subsidies,
regulation.
The financial system provides the mechanism by which funds can be
transferred between these groups and from suppliers (SSUs) to users
of funds (DSUs).
Transfer of Funds
There are two methods of transferring funds from Households to
Business (or between any suppliers and demanders of funds): Direct
investment and indirect investment.
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The Financial System
Transfer of Funds
Direct Investment - Firms (or demanders) raise funds directly
from investors (or suppliers). [This may be accomplished with the
assistance of financial institutions.] Direct markets are “wholesale”
markets. Transactions typically $1 million or more. Institutional
arrangements common.
Indirect Investment - A financial intermediary acquires funds
from savers by issuing new claims on itself, and then lends these
acquired funds.
Indirect and direct investment involve two markets.
The Primary Market is the name given to process of issuing new
securities. This market results in funds going to the firm.
Investment Banks are financial institutions involved in the primary
market. New Equity issues by firms are called initial public offerings
(IPOs). Investment bankers “facilitate the issuance” of new issues of
securities.
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The Financial System
The Secondary Market is the name given to the process of
reselling existing securities.
Securities Brokers are financial institutions involved in the secondary
market. Secondary market trading takes place in many places
including the New York Stock Exchange, Regional Exchanges, and
NASDAQ, among others.
Securities Brokers buy or sell at best possible price for their clients.
Most times securities brokers are dealers and “make markets”
by carrying inventories of securities. Securities Brokers:
buy at “bid price;” sell at “ask price”
“Bid-ask spread” is the dealer’s gross profit.
Investment in firms also involves two markets related to maturity.
The Money Market - Securities with maturities less than one year.
The Capital Market - Securities with maturities greater than one
year.
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Exhibit 1.1 – Transfer of Funds
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Financial Markets and Institutions
CONCEPT QUESTIONS
Why might individuals not want to invest directly?
Why would direct investment without financial intermediaries be
costly for firms?
Financial markets are markets for financial claims, also called
financial instruments or securities.
Financial institutions (also called financial intermediaries) facilitate
flows of funds from savers (SSUs) to borrowers (DSUs).
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Financial Intermediation
Basic Financial Intermediation
raise funds by issuing claims to SSUs (entity with surplus);
use funds to buy claims issued by DSUs (entity with deficit).
Claims can have unmatched characteristics:
SSU has claim against financial intermediary (Bank);
Financial intermediary has claim against DSU.
Ability to resell financial claims makes them
more liquid by giving SSUs choices:
Match maturity of claim to planned investment period;
This will lead to the concept of holding period return.
Buy claim with longer maturity, but sell at end of period; or
This is will lead to the concept of price risk.
Buy claim with shorter maturity, then reinvest.
This will lead to the concept of reinvestment risk.
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Basic Components of Financial System: Markets and Institutions
Financial intermediaries “transform” claims. This transformation
process involves intermediation and Financial intermediaries exist
due to market imperfections from:
Transaction costs
Information costs
Asymmetric information problems:
Adverse selection
Moral hazard – Government bailouts reduce penalty to firms.
Firms anticipate this and assume more risk.
Financial intermediaries lower the cost of financial services as they
pursue profit.
Financial intermediaries perform 5 basic services as they transform
claims.
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Intermediaries lower the cost of financial services as they pursue
profit.
3 sources of comparative advantage:
Economies of scale
Transaction cost control
Risk management expertise
Competition pulls interest rates down
Financing less costly
Projects have higher NPVs
Investment in real assets boosts economy
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Intermediaries perform 5 basic services as they transform
claims.
Denomination Divisibility – pool savings of many
small SSUs into large investments.
Currency Transformation – buy and sell financial
claims denominated in various currencies.
Maturity Flexibility – Offer different ranges of
maturities to both DSUs and SSUs.
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Intermediation Services, cont.
Credit Risk Diversification – Assume credit risks
of DSUs; spread risk over many different types of
DSUs.
Liquidity – Give SSUs and DSUs different choices
about when, to what extent, and for how long to
commit to financial relationships.
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Risks of Financial Institutions
Credit or default risk: risk that a DSU may not
pay as agreed
Interest rate risk: fluctuations in a security's price
or reinvestment income caused by changes in
market interest rates
Liquidity risk: risk that a financial institution may
be unable to disburse required cash outflows, even
if essentially profitable
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Risks of Financial Institutions, cont.
Foreign exchange risk: effect of exchange rate
fluctuations on profit of financial institution
Political risk: risk of government or regulatory
action harmful to interests of financial institution.
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How the Fed Conducts Monetary Policy
The primary concern of the Fed in conducting monetary policy is controlling
expected inflation and sustaining economic growth.
Prior to 1980, the Fed targeted interest rates by increasing and decreasing
reserves in the banking system. When inflation exceeded 10% in the late
1980s, the Fed started targeting the growth in the money supply.
In general, the Fed uses the discount rate and the fed funds rate to signal its
intent to fight inflation. Increasing the fed funds rate to fight inflation and
decreasing the fed funds rate to expand the economy. During the 2007 and
2008 global financial crisis, the Fed kept the federal funds rate as a
significantly low level for an extended period of time.
Large nationwide mortgage lenders such as Countrywide Financial and
Washington Mutual were bought out by large banks with government
encouragement. A series of liquidity crises ensued requiring Federal Reserve
intervention into money market mutual funds, mortgage backed securities and
commercial paper markets. In hindsight lax regulatory oversight of financial
institutions allowed banks and others to take on too much risk. An
overreliance on statistical modeling of risks with flawed inputs also became
apparent.
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Regulation of the Financial System
Protect consumers against industry abuses
Stabilize the financial system
Highlights of the Financial Regulatory
Reform Act of 2010
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Financial Regulation
EXHIBIT 1.6
Highlights of the Dodd Frank Financial Regulatory Reform Act of 2010
Consumer Protection Agency: Created a new independent watchdog with the authority to
protect consumers from hidden fees, abusive terms, and deceptive practices when purchasing
financial services such as credit cards and mortgages. The agency is housed at the Fed and
its dedicated budget is paid by the Fed.
Too big to fail problem: Legislation is designed to end the possibility that tax payers will be
asked to bail out large financial firms whose failure threatens the overall economy: the socalled too big to fail problem. The Fed gained power to impose stricter operating standards;
regulate nonbank financial firms, if necessary; and break up large, complex firms if they
pose a risk to the financial system. Large banks must submit ‘living wills’ to the Fed which
describe how the bank could be liquidated to minimize losses in the event of failure and must
submit to periodic stress tests to ensure the bank could endure poor economic scenarios
Advanced risk warning system: Established the Financial Stability Oversight Council,
which has the sole responsibility for identifying and responding to emerging systemic risks
posed by large, complex financial firms. The council will make recommendations to the Fed
on how to decrease the risk.
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Financial Regulation -Continued
Tougher regulation for large banks: The Federal Reserve now regulates all bank- and
thrift- holding companies with assets over $50 million. Smaller financial institutions, with
assets less than $50 million, will be supervised by other regulators. This move protects the
interest of the nation’s community banks, which serve consumers. For large banks, it means
tougher standards.
Executive compensation: A firm’s shareholders now have a say about executive pay, with
the right to a nonbinding vote on executive compensation.
Better protection for investors: Legislation was spurred by the Madoff scandal, which
revealed that the SEC failed to provide aggressive oversight of the investment industry. New
legislation encourages whistleblowers; creates the Investment Advisory Committee, which
advises the SEC on its regulatory practice; and establishes the Office of Investor Advocate
within the SEC to identify areas where investors have significant problems dealing with the
SEC.
Transparency and accountability financial products: Eliminates the loopholes that allow
risky and abusive practices to continue to be unregulated. Areas that currently need to be
monitored and regulated are over-the-counter derivatives, asset-backed securities, hedge
funds, mortgage brokers, and payday lenders.
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Familiar Forms of Financial Intermediation
Commercial Banking
Insurance
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Commercial Banks
Take deposits and make loans Depositors are SSUs
Borrowers are DSUs.
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Insurance Companies
Issue policies, collect premiums, and invest
in stocks and bonds.
Policyholders are SSUs;
Businesses or governments are DSUs.
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4 Major types of financial intermediaries transform claims to meet
various needs.
Deposit-type or “Depository” Institutions
Contractual Savings Institutions
Investment Funds
“Other” Institutions
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Depository Institutions take deposits and make loans.
Commercial Banks
Thrift Institutions
Savings & Loan Associations
Savings Banks
Credit Unions
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Commercial Banks
Largest single class of financial institution
Issue wide variety of deposit products checking, savings, time deposits
Carry widely diversified portfolios of loans,
leases, government securities
May offer trust or underwriting services
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Thrift Institutions
Closely resemble commercial banks
Focus more on real estate loans, savings deposits,
and time deposits
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Credit Unions: Unique Characteristics
Mutual ownership -“owned” by depositors
or “members”
“Common bond” - members must share
some meaningful common association
Not-for-profit and tax-exempt
Restricted mostly to small consumer loans
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Contractual Institutions bring long-term savers and borrowers
together.
Life Insurance Companies
Casualty Insurance Companies
Pension Funds
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Life Insurance Companies insure against lost income at death.
Policyholders pay premiums, which are
pooled and invested in stocks, bonds, and
mortgages
Investment earnings cover the costs and
reward the risks of the insurance company
Investments are liquidated to pay benefits.
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Casualty Insurance Companies cover property against loss or
damage.
Sources and uses of funds resemble those of
life insurers, but
Casualty claims are not as predictable as
death claims; so
More assets are in short-term, easily
marketable investments
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Pension Funds help workers plan for retirement.
Workers and/or employers make
contributions, which are pooled and
invested in stocks, bonds, and mortgages
Net of administrative costs, investment
earnings are reinvested and compounded
Retirement benefits replace paychecks (at
least partly)
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Investment Funds help small investors share the benefits of large
investments.
Mutual Funds provide intermediated access to
various capital markets
shareholders’ money is pooled and invested in
stocks, bonds, or other securities according to
some objective
Money Market Mutual Funds (“MMMFs”) are
uninsured substitutes for deposit accounts
MMMFs buy money market instruments
wholesale, pay investors interest, and allow
limited check-writing
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“Other” Financial Institutions
Finance Companies—
Make loans but do not take deposits; raise
loanable funds in commercial paper market and
from shareholders
Federal Agencies—
Issue “agency securities” backed by government
and lend at sub-market rates for favored social
purposes
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Exhibit 1.4—Major Financial Intermediaries
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Exhibit 1.5—Major Financial Intermediaries: Sources & Uses of Funds
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Financial Markets - Classifications
Primary and Secondary
Exchange and Over-the-Counter
Public and Private
Futures and Options
Foreign Exchange
International and Domestic
Money and Capital
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Primary and Secondary Markets
Primary markets are where financial claims are
“born”: DSUs receive funds, claims are first
issued.
Secondary markets are where financial claims
“live”—are resold and repriced.
Claims become more liquid because SSUs
can set their own holding periods.
Trading sets prices and yields of widely
held securities.
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Exchanges and Over-the-Counter Markets
Exchanges: physical, relatively exclusive.
Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
New York Stock Exchange
Chicago Board of Trade
OTC Markets: virtual, relatively inclusive.
Decentralized network available to any licensed
dealer willing to buy access and obey rules, for
wide range of securities.
The NASDAQ is a famous OTC market.
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Futures Markets
Spot Markets: immediate pricing, immediate
delivery
Futures or Forward Markets: immediate pricing,
promise of future delivery
“Futures” contracts: standardized as to amounts, forms,
and dates; trade on organized exchanges
“Forward” contracts: individualized between parties
with particular needs
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Options Markets
Rights in underlying securities or commodities—
writer grants owner some exclusive right for some
certain time
Main types of options: Puts (options to sell)
Calls (options to buy)
Options on listed securities and widely held
commodities trade actively on organized
exchanges
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Foreign Exchange Markets
Any currency is convertible to any other at some
exchange rate
“Forex” involves spot, future, forward, and option
markets
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International and Domestic Markets
Help participants diversify both sources and uses
of funds
Examples of major international markets:
Eurodollars—US dollars deposited outside US
Eurobonds—Bonds issued outside US but
denominated in US dollars
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Money and Capital Markets
Money markets: wholesale markets for short-term
debt instruments resembling money itself
Capital markets: where “capital goods” are
permanently financed through long-term financial
instruments
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)
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Money Markets
Help participants adjust liquidity—
DSUs borrow short-term to fund current operations
SSUs lend short-term to avoid holding idle cash
Common characteristics of money market
instruments—
Short maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)
Dealer/OTC more than organized exchange
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Examples of Major Money Market Instruments
Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (“Fed Funds”)
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Exhibit 1.2—Major Money Market Instruments
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Capital Markets
Help participants build wealth
DSUs seek long-term financing for capital projects
SSUs seek highest possible return for given risk
Differences from money markets—
Long maturities (5 to 30 years)
Less liquidity
(secondary markets active but more volatile)
Higher risk in most cases
(with higher potential yield)
Traded “wholesale” and “retail” on organized
exchanges and in OTC markets
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Examples of Major Capital Market Instruments
Common stock
Corporate bonds
Municipal bonds
Mortgages
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Exhibit 1.3—Major Capital Market Instruments
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