Chapter 2
An Overview
of the Financial
System
Function of Financial Markets
• Perform the essential function of channeling
funds from economic players that have
saved surplus funds to those that have a
shortage of funds
• Promotes economic efficiency by producing
an efficient allocation of capital, which
increases production
• Directly improve the well-being of consumers
by allowing them to time purchases better
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Direct finance and Indirect finance
• Direct finance – funds are directly
transferred from lenders to borrowers
• Indirect finance – financial intermediaries
receive funds from savers and lend them
to borrowers
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Securities are assets for the holder and
liabilities for the issuer
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1.Allows transfers of funds from person or business without investment
opportunities to one who has them
2. Improves economic efficiency
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Structure of Financial Markets
• Debt and Equity Markets
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Debt instruments – contractual obligation to pay the holder
fixed payments at specified dates (e.g., mortgages, bonds,
car loans, student loans)
Short-term debt instruments have a maturity of less than one
year
Intermediate-term debt instruments have a maturity between
1 and 10 years
Long-term debt instruments have a maturity of ten or more
years
Equity – sale of ownership share (owners are residual
claimants).
Owners of stock may receive dividends
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Structure of Financial Markets
• Primary and Secondary Markets
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Primary market = financial market in which newly
issued securities are sold.
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Secondary market = financial market in which
previously owned securities are sold.
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Investment Banks underwrite securities in primary
markets
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Brokers and dealers work in secondary markets
• Broker – match buyers and sellers
• Dealers – buy and sell securities
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Structure of Financial Markets
• Roles of Secondary Markets
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Increase liquidity of financial assets
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Determine security prices that help determine the
price of securities in primary markets
• Exchanges and Over-the-Counter (OTC)
Markets
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Exchange – buyers and sellers meet in one central
location (e.g., NYSE or Chicago Board of Trade)
Over-the-counter market – transactions take place
in multiple locations through dealers
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Structure of Financial Markets
• Money and Capital Markets
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Money markets deal in short-term debt
instruments
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Capital markets deal in intermediate and
longer-term debt and
equity instruments
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Financial Market Instruments
• Money Market Instruments
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US treasury bills: 1-, 3-, 6-month maturities, discounted; no
default risk
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Negotiable bank certificates of deposit (NCD): transferable in
the secondary markets, large denominations
Commercial paper (CP): issued by large banks or well-known
corporations, growing fast, direct finance; largest instrument
Banker’s Acceptances: can be resold in the secondary
markets, use abroad in international trade
Repurchase Agreements (repos): treasury bills are used to
serve as collateral, <2 weeks
Federal (Fed) funds: overnight loan b/w banks of their deposits
at Fed
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Financial Market Instruments
• Capital Market Instruments
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Stocks: largest instruments, hold by individuals (1/2),
pensions, mutual funds, and insurance companies
Mortgages: 3 government agencies, FNMA (Fannie Mae),
GNMA (Ginnie Mae), FHLMC (Freddie Mac)
Corporate bonds: convertible or non-convertible
US government securities: issued by US Treasury, most
liquid security
US government agency securities: issued by other US gov’t
agencies, e.g., FNMA, GNMA…
State and local government bonds: also called municipal
bonds, interest-exemption
Consumer and bank commercial loans
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Internationalization of Financial Markets
• Foreign Bonds—sold in a foreign country and denominated
in that country’s currency
• Foreign bonds may be used to avoid exchange-rate risk
• Eurobond—bond denominated in a currency other than that
of the country in which it is sold
• Eurocurrencies—foreign currencies deposited in banks
outside the home country
 Eurodollars—U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets
 London, Tokyo and other foreign stock exchanges have
grown in importance
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Function of Financial Intermediaries:
Indirect Finance
• Lower transaction costs
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Economies of scale
Liquidity services
• Reduce Risk
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Risk Sharing (Asset Transformation)
Diversification
• Asymmetric Information
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Adverse Selection (before the transaction)—more
likely to select risky borrower
Moral Hazard (after the transaction)—less likely
borrower will repay loan
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Function of Financial Intermediaries:
Indirect Finance
Adverse Selection: Individuals who are willing to accept a financial
(or other) contract are of lower “quality” than a typical individual in
the population
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are
ones most likely to seek loans and be selected
Moral Hazard: The existence of a contract causes one party to alter
their behavior in a manner detrimental to the other party
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral
hazard problems, enabling them to make profits
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Types of financial intermediaries
• Depository institutions
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Commercial banks
Savings and Loan Associations
Mutual savings banks
Credit unions
• Contractual savings institutions
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Life insurance companies
Fire and casualty insurance companies
Pension funds and government retirement funds
• Investment intermediaries
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Finance companies
Mutual funds
Money market mutual funds
Investment banks
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Regulation of the Financial System
Two Main Reasons for Regulation (Financial sector is one
of the most heavily regulated sectors of the economy)
• To increase the information available to investors:
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Reduce adverse selection and moral hazard problems
SEC forces corporations to disclose information to reduce
insider trading
• To ensure the soundness of financial intermediaries:
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Restrictions on entry
Disclosure Laws (SEC)
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates (no longer in effect)
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