Financial Markets & Institutions
Professor Vinh Nguyen
Faculty of Business and Economics
The University of Hong Kong
Instructor's Info
1. Contact details
• Email: nguyenvq@hku.hk
• Office hours: Tue 9:00 AM‐12:00 PM
2. About myself
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Native of Vietnam
HKU (Aug 2017‐ present)
Boston College - Finance PhD (2012- 2017)
Northeastern University - MBA (2005‐2007)
The Course
1. Course objective:
• Overview of major financial markets and financial institutions.
• Understanding and applications of the basic concepts in banking
and finance
2. Course website
• Moodle: All announcements, classroom presentation materials,
assignments, and course updates
3. Textbook
• Financial Markets and Institutions, by Frederic S. Mishkin and
Stanley G. Eakins (ME), 9th edition, Pearson Education
Performance Evaluation
• Tutorial
10%
• Project
30%
• In‐term Examination
60%
4
Performance Evaluation
1. Tutorial performance
2. Project
• Board range of topics related to banking and finance
• A write‐up of up to 8 pages of texts and 3 pages of graphs
and exhibits
• Team of 4 and Peer Evaluation
3. In‐term examination
• Take home exam on April 24-25, 2023
• 40% MCQs and 60% short‐answer questions
5
Capital Flows in an Economy
The financial system is critical for producing an efficient capital
allocation in an economy.
• Investments ‐ Efficient capital allocation allows funds to move from
savers (entities with a surplus of funds) to investors (entities with a
deficit of funds).
• Consumption ‐ The flows of capital improve the well‐being of
consumers by allowing them to time their purchases better.
Capital Flows in an Economy
Lender‐Savers
1. Households
2. Business firms
3. Government
4. Foreigners
Borrower‐Investors
1. Business firms
2. Government
3. Households
4. Foreigners
Capital Flows in an Economy
• A real asset is an entity that generates a flow of goods or services
over time (e.g. land, people, factories, inventions, business plans,
goodwill with consumers, reputation)
• A financial asset is a legal contract that gives its owner a claim to
payments, usually generated by a real asset. (currencies, stocks,
bonds, bank deposits, bank loans, options, futures, etc.)
Capital Flows in an Economy
Example of Financial Assets:
• Modern currencies are fiat money. Fiat money does not have
intrinsic value but and has value only because its issuer (usually a
government) maintains its value and because exchanging parties
agree on its value.
9
Capital Flows in an Economy
1
Capital Flows in an Economy
(Bank Finance vs. Non-Bank Finance)
Instead of savers lending/investing directly with borrowers, a
financial intermediary (such as a commercial bank) makes the
lending decisions:
• The intermediary obtains funds from savers
• The intermediary then makes loans/investments with borrowers
Structure of Financial Markets
1. Debt Markets
• Short‐Term (maturity < 1 year)
• Long‐Term (maturity > 10 year)
• Intermediate term (maturity in‐between)
• Represented over $100 trillion.
2. Equity Markets
• Pay dividends, in theory forever
• Represents an ownership claim in the firm
• Total value of all U.S. equity is around $34 trillion.
Structure of Financial Markets
1. Primary Market
• New security issues sold to initial buyers
• Typically involves an investment bank that underwrites the
offering
2. Secondary Market
• Securities previously issued are bought
and sold
• Examples include the NYSE and Nasdaq
• Involves both brokers and dealers
Structure of Financial Markets
Even though firms do not receive any money, per se, from the
secondary market, the market serves two important functions:
• Providing liquidity ‐ making it easy to buy and sell the securities
of the companies
• Establishing a price for the securities (useful for company
valuation)
Structure of Financial Markets
We can further classify secondary markets as follows:
1. Exchanges
• Trades conducted in central locations (e.g., New York Stock Exchange, CBT)
2. Over‐the‐Counter Markets
• Dealers at different locations buy and sell
• Best example is the market for Treasury Securities
Classifications of Financial Markets
We can also classify markets by the maturity of the
securities:
1. Money Market: Short‐Term
(maturity < 1 year)
2. Capital Market: Long‐Term
(maturity > 1 year) plus equities (no maturity)
Internationalization of
Financial Markets
The internationalization of markets is an important trend. The U.S. no
longer dominates the world stage.
International Bond Market & Eurobonds
1. Foreign bonds
• Denominated in a foreign currency
• Targeted at a foreign market
2. Eurobonds
• Denominated in one currency (US$), but sold in a different market (London)
• Now larger than U.S. corporate bond market
• Over 80% of new bonds are Eurobonds
Internationalization of
Financial Markets
3. Eurocurrency Market
• Foreign currencies deposited outside of home country
• Eurodollars are U.S. dollars deposited, say, London.
• Gives U.S. borrows an alternative source for dollars.
4. World Stock Markets
• U.S. stock markets are no longer always the largest—at one point
in the 1990s, Japan’s was larger
Functions of the Financial System
Financial Intermediaries perform 3 functions in an
economy:
• Generate liquidity
• Improve risk sharing
• Lessen the problem of asymmetric information
Functions of the Financial System
The main competitive advantage of a financial intermediary
is (lower) transaction costs.
• Financial intermediaries make profits by reducing transactions
costs
• Financial intermediaries reduce transactions costs by
developing expertise and taking advantage of economies of
scale
Functions of the Financial System
Low transaction costs enable the intermediaries to perform 3
functions in an economy:
1. Financial intermediaries provide an economy with liquidity
services.
• Banks provide depositors with checking accounts that enable them to pay their bills
easily
• Depositors can earn interest on checking and savings accounts and yet still convert
them into goods and services whenever necessary
• Banks provide credit cards for consumers and lines of credits for corporations.
• Banks stand ready to buy and sell securities with other entities in the economy
Functions of the Financial System
Two liquidity definitions:
Market Liquidity is an attribute of an asset reflecting the
cost of trading the asset.
 Funding liquidity is the ability of an entity to come up with
cash on short notice.
Functions of the Financial System
Market Liquidity is an attribute of an asset reflecting the
cost of trading the asset. An asset with high market liquidity
generally has the following characteristics:
 Standardized
 Value is well understood by all
 Many potential buyers and sellers
Functions of the Financial System
Rank the following assets by their liquidity:
• Share of IBM
• Bond issued by IBM
• Loan from Citibank to a small business
• Your car
• Your house
Functions of the Financial System
Funding Liquidity ‐ the ability of an entity to come up with cash
on short notice.
• Holding liquid assets
• Easily borrow on short notice
But some firms without a lot of highly liquid assets may still have a high
degree of funding liquidity. Why?
• Credit lines with banks
• Trade credit with suppliers
• Access to the debt/equity markets
Functions of the Financial System
• Studies show that firms in the U.S., Canada, the U.K., and
other developed nations usually obtain funds from financial
intermediaries, not directly from capital markets.
• In Germany and Japan, financing from financial intermediaries
exceeds capital market financing 10‐fold.
• However, the relative use of bonds versus equity does differ by
country.
Functions of the Financial System
2. Financial intermediaries provide an economy with better risk
sharing:
• Many risks that have very high costs but low likelihood of
occurring (hurricanes, early death, collapse of the WTC, etc.)
• Financial intermediaries 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
Functions of the Financial System
• Question: How does the financial system allow agents to share
these risks?
Functions of the Financial System
• Financial intermediaries also help by providing the means
for individuals and businesses to diversify their asset
holdings.
• Low transaction costs allow the intermediaries to buy a
range of assets, pool them, and then sell rights to the
diversified pool to individuals.
Functions of the Financial System
3. Financial intermediaries exist is to reduce the impact
of asymmetric information.
• One party lacks crucial information about another party, impacting
decision‐making.
• We usually discuss this problem along two fronts: adverse selection
and moral hazard.
Functions of the Financial System
Adverse Selection
• Occurs when one party in a transaction has better
information than the other party
• Before transaction occurs
Functions of the Financial System
Example: Lemons Problem in Used Cars
1. There are 10 used cars on the market. Each car is worth $100,
$200,…, $1,000, respectively.
2. As a buyer, if you cannot distinguish between “good” and
“bad” (lemons) used cars, how much are you willing to pay for
a car randomly selected from the above market?
3. As a seller, you know the true value of your car,
• What do you do if your car is worth $1,000?
• What do you do if your car is worth $100?
Functions of the Financial System
Example: Lemons Problem in Used Cars
Result: Good cars won’t be sold, and the used car market will
function inefficiently.
What helps us avoid this problem with used cars?
Functions of the Financial System
Examples of adverse selection problems in the financial
market:
• Subprime borrowers are more likely to take loans and default.
• Riskier clients are more willing to buy insurance.
How do financial firms help solve adverse selection problems
in the insurance, lending, and securities trading?
Functions of the Financial System
Moral Hazard
• After transaction occurs
• Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that the loan won’t
be paid back.
Functions of the Financial System
1. What is the moral hazard problem that occurs when you
buy rental car insurance?
2. What about when you borrow money?
3. How do financial institutions deal with the problem?
Economies of Scope and
Conflicts of Interest
• The intermediaries are able to lower the production cost of information
by using the information for multiple services: bank accounts, loans, auto
insurance, retirement savings, etc. This is called economies of scope.
• But, providing multiple services may lead to conflicts of interest, perhaps
causing one area of an intermediary to hide or conceal information from
another area (or the economy as a whole). This may actually make
financial markets less efficient!
Bank Finance
38
Bank Finance
Traditional (US in 1980) Financial System (Financial Assets)
Securities Markets: Bonds, Commercial Paper (non‐financial), Public Equity
Derivatives Markets: Commodity Futures, Stock options
39
Bank Finance
Modern Financial System (Financial Assets)
Securities Markets: Bonds, Commercial Paper (non‐financial), Public Equity, Mortgage‐backed
Securities & Asset‐backed Securities, CDOs, CLOs, ETFs, etc.
Derivatives Markets: Commodity & Financial Futures, Interest rate and Credit Default Swaps,
Options
40
Institutions in a Financial System
(Bank Finance)
1. Depository Institutions:
Creating financial assets (bank deposits, loans)
• Enhancing liquidity (asset transformation)
• And risk management (diversification of the loan portfolio, holding
capital, trading)
2. Commercial Banks
• Raise funds primarily by issuing checkable, savings, and time deposits
which are used to make commercial, consumer and mortgage loans
• Collectively, these banks comprise the largest financial intermediary
and have the most diversified asset portfolios
Institutions in a Financial System
(Non‐Bank Finance)
4. Finance companies are very much like depository
institutions, with two key differences:
• Their liabilities are composed of commercial paper and
other debt securities rather than deposits;
• They are very lightly regulated
5. Venture capital/Private Equity firms are the least
regulated
Institutions in a Financial System
(Non-Bank Finance)
6. Contractual Savings Institutions (CSIs) acquire funds from
clients at periodic intervals on a contractual basis and have
fairly predictable future payout requirements.
• Life Insurance Companies receive funds from policy premiums, can
invest in less liquid corporate securities and mortgages, since actual
benefit pay outs are close to those predicted by actuarial analysis
• Fire and Casualty Insurance Companies receive funds from policy
premiums, must invest most in liquid government and corporate
securities, since loss events are harder to predict
• Pension and Government Retirement Funds hosted by corporations
and local governments acquire funds through employee and
employer contributions, invest in corporate securities, and provide
retirement income via annuities
Institutions in a Financial System
(Non‐Bank Finance)
7. Mutual Funds acquire funds by selling shares to individual investors
(many of whose shares are held in retirement accounts) and use the
proceeds to purchase large, diversified portfolios of stocks and bonds.
8. Money Market Mutual Funds acquire funds by selling checkable
deposit‐like shares to individual investors and use the proceeds to
purchase highly liquid and safe short‐term money market
instruments.
9. Hedge Funds pooled investment vehicles like mutual funds but they
are very lightly regulated. Hedge funds usually raise funds from
wealthy investors and also from pension funds, University
endowments and state funds.
Institutions in a Financial System
(Non‐Bank Finance)
10.Fannie/Freddie support the provision of mortgage credit by buying
and/or guaranteeing mortgages.
11.Securities firms & Investment Banks advise companies on securities
to issue, underwriting security offerings, offer M&A assistance, and
act as dealers in security markets.
Regulatory Agencies
Regulation of Financial Markets
Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial Intermediaries
Regulation Reason:
Increase Investor Information
• Asymmetric information  Market Breakdown. See “The Market for
Lemons”
• The Federal Reserve (the central bank in other countries) oversees the
banking system with strict reporting and disclosure requirements.
• The Securities and Exchange Commission (SEC) requires corporations
issuing securities to disclose certain information about their sales, assets,
and earnings to the public and restricts trading by the largest stockholders
(known as insiders) in the corporation.
Regulation Reason:
Increase Investor Information
• Government regulation can reduce adverse selection and moral hazard
problems in financial markets and increase their efficiency by increasing
the amount of information available to investors. Indeed, the SEC has been
particularly active recently in pursuing illegal insider trading.
Regulation Reason: Ensure
Soundness of the Financial System
• Providers of funds (depositors, like you) to institutions in the
financial system may not be able to assess whether the institutions
holding their funds are sound or not.
• If they have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of both sound
and unsound institutions, which can lead to a financial panic.
• Such panics produces large losses for the public and causes serious
damage to the economy.
Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)
To protect the public and the economy from financial panics, the
government has implemented six types of regulations:
• Restrictions on Entry
• Disclosure
• Restrictions on Assets and Activities
• Deposit Insurance
• Limits on Competition
• Restrictions on Interest Rates