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. 1 CHAPTER 1 An Overview of Financial Markets and Institutions Copyright© 2017 John Wiley & Sons, Inc. 2 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 Copyright© 2017 John Wiley & Sons, Inc. . 3 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 Copyright© 2017 John Wiley & Sons, Inc. 4 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. Copyright© 2017 John Wiley & Sons, Inc. 5 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. Copyright© 2017 John Wiley & Sons, Inc. 6 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. Copyright© 2017 John Wiley & Sons, Inc. 7 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. Copyright© 2017 John Wiley & Sons, Inc. 8 Exhibit 1.1 – Transfer of Funds Copyright© 2017 John Wiley & Sons, Inc. 9 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). Copyright© 2017 John Wiley & Sons, Inc. 10 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. Copyright© 2017 John Wiley & Sons, Inc. 11 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. Copyright© 2017 John Wiley & Sons, Inc. 12 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 Copyright© 2017 John Wiley & Sons, Inc. 13 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. Copyright© 2017 John Wiley & Sons, Inc. 14 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. Copyright© 2017 John Wiley & Sons, Inc. 15 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 Copyright© 2017 John Wiley & Sons, Inc. 16 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. Copyright© 2017 John Wiley & Sons, Inc. 17 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. Copyright© 2017 John Wiley & Sons, Inc. 18 Regulation of the Financial System Protect consumers against industry abuses Stabilize the financial system Highlights of the Financial Regulatory Reform Act of 2010 Copyright© 2017 John Wiley & Sons, Inc. 19 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. Copyright© 2017 John Wiley & Sons, Inc. 20 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. Copyright© 2017 John Wiley & Sons, Inc. 21 Familiar Forms of Financial Intermediation Commercial Banking Insurance Copyright© 2017 John Wiley & Sons, Inc. 22 Commercial Banks Take deposits and make loans Depositors are SSUs Borrowers are DSUs. Copyright© 2017 John Wiley & Sons, Inc. 23 Insurance Companies Issue policies, collect premiums, and invest in stocks and bonds. Policyholders are SSUs; Businesses or governments are DSUs. Copyright© 2017 John Wiley & Sons, Inc. 24 4 Major types of financial intermediaries transform claims to meet various needs. Deposit-type or “Depository” Institutions Contractual Savings Institutions Investment Funds “Other” Institutions Copyright© 2017 John Wiley & Sons, Inc. 25 Depository Institutions take deposits and make loans. Commercial Banks Thrift Institutions Savings & Loan Associations Savings Banks Credit Unions Copyright© 2017 John Wiley & Sons, Inc. 26 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 Copyright© 2017 John Wiley & Sons, Inc. 27 Thrift Institutions Closely resemble commercial banks Focus more on real estate loans, savings deposits, and time deposits Copyright© 2017 John Wiley & Sons, Inc. 28 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 Copyright© 2017 John Wiley & Sons, Inc. 29 Contractual Institutions bring long-term savers and borrowers together. Life Insurance Companies Casualty Insurance Companies Pension Funds Copyright© 2017 John Wiley & Sons, Inc. 30 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. Copyright© 2017 John Wiley & Sons, Inc. 31 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 Copyright© 2017 John Wiley & Sons, Inc. 32 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) Copyright© 2017 John Wiley & Sons, Inc. 33 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 Copyright© 2017 John Wiley & Sons, Inc. 34 “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 Copyright© 2017 John Wiley & Sons, Inc. 35 Exhibit 1.4—Major Financial Intermediaries Copyright© 2017 John Wiley & Sons, Inc. 36 Exhibit 1.5—Major Financial Intermediaries: Sources & Uses of Funds 37 Copyright© 2017 John Wiley & Sons, Inc. 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 Copyright© 2017 John Wiley & Sons, Inc. 38 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. Copyright© 2017 John Wiley & Sons, Inc. 39 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. Copyright© 2017 John Wiley & Sons, Inc. 40 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 Copyright© 2017 John Wiley & Sons, Inc. 41 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 Copyright© 2017 John Wiley & Sons, Inc. 42 Foreign Exchange Markets Any currency is convertible to any other at some exchange rate “Forex” involves spot, future, forward, and option markets Copyright© 2017 John Wiley & Sons, Inc. 43 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 Copyright© 2017 John Wiley & Sons, Inc. 44 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.) Copyright© 2017 John Wiley & Sons, Inc. 45 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 Copyright© 2017 John Wiley & Sons, Inc. 46 Examples of Major Money Market Instruments Treasury Bills Negotiable Certificates of Deposit Commercial Paper Federal Funds (“Fed Funds”) Copyright© 2017 John Wiley & Sons, Inc. 47 Exhibit 1.2—Major Money Market Instruments Copyright© 2017 John Wiley & Sons, Inc. 48 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 Copyright© 2017 John Wiley & Sons, Inc. 49 Examples of Major Capital Market Instruments Common stock Corporate bonds Municipal bonds Mortgages Copyright© 2017 John Wiley & Sons, Inc. 50 Exhibit 1.3—Major Capital Market Instruments Copyright© 2017 John Wiley & Sons, Inc. 51