Role of FIs ©2007, The McGraw-Hill Companies, All Rights Reserved Why study Financial Markets and Institutions? • They are the cornerstones of the overall financial system in which financial managers operate • Individuals use both for investing • Corporations and governments use both for financing McGraw-Hill/Irwin 1-2 ©2007, The McGraw-Hill Companies, All Rights Reserved Overview of Financial Markets • Primary Markets versus Secondary Markets • Money Markets versus Capital Markets • Foreign Exchange Markets McGraw-Hill/Irwin 1-3 ©2007, The McGraw-Hill Companies, All Rights Reserved Primary Markets versus Secondary Markets • Primary Markets • markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds) • Secondary Markets • markets where financial instruments are traded among investors (e.g. NYSE, NASDAQ) McGraw-Hill/Irwin 1-4 ©2007, The McGraw-Hill Companies, All Rights Reserved Money Markets versus Capital Markets • Money Markets • markets that trade debt securities with maturities of one year or less (e.g. CD’s, U.S. Treasury bills) • Capital Markets • markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year McGraw-Hill/Irwin 1-5 ©2007, The McGraw-Hill Companies, All Rights Reserved Foreign Exchange Markets • “FX” markets deal in trading one currency for another (e.g. dollar for yen) • The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate • The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate McGraw-Hill/Irwin 1-6 ©2007, The McGraw-Hill Companies, All Rights Reserved Derivative Security Markets • The markets in which derivative securities trade. • Derivative Security • An agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future. McGraw-Hill/Irwin 1-7 ©2007, The McGraw-Hill Companies, All Rights Reserved Overview of Financial Institutions • Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds) McGraw-Hill/Irwin 1-8 ©2007, The McGraw-Hill Companies, All Rights Reserved Flow of Funds in a World without FIs: Direct Transfer Financial Claims (Equity and debt instruments) Users of Funds (Corporations) Suppliers of Funds (Households) Cash Example: A firm sells shares directly to investors without going through a financial institution. McGraw-Hill/Irwin 1-9 ©2007, The McGraw-Hill Companies, All Rights Reserved Flow of Funds in a world with FIs: Indirect transfer FI (Brokers) Users of Funds Cash Suppliers of Funds FI (Asset transformers) Financial Claims (Equity and debt securities) Cash Financial Claims (Deposits and insurance policies) McGraw-Hill/Irwin 1-10 ©2007, The McGraw-Hill Companies, All Rights Reserved Types of FIs • Commercial banks • depository institutions whose major assets are loans and major liabilities are deposits • Thrifts • depository institutions in the form of savings and loans, credit unions • Insurance companies • financial institutions that protect individuals and corporations from adverse events (continued) McGraw-Hill/Irwin 1-11 ©2007, The McGraw-Hill Companies, All Rights Reserved • Securities firms and investment banks • financial institutions that underwrite securities and engage in securities brokerage and trading • Finance companies • financial institutions that make loans to individuals and businesses • Mutual Funds • financial institutions that pool financial resources and invest in diversified portfolios • Pension Funds • financial institutions that offer savings plans for retirement McGraw-Hill/Irwin 1-12 ©2007, The McGraw-Hill Companies, All Rights Reserved Services Performed by Financial Intermediaries • Monitoring Costs • Liquidity and Price Risk • Transaction Cost Services • Maturity Intermediation • Denomination Intermediation McGraw-Hill/Irwin 1-13 ©2007, The McGraw-Hill Companies, All Rights Reserved Services Provided by FIs Benefiting the Overall Economy • Money Supply Transmission • Credit Allocation • Intergenerational Wealth Transfers • Payment Services McGraw-Hill/Irwin 1-14 ©2007, The McGraw-Hill Companies, All Rights Reserved Risks Faced by Financial Institutions • Interest Rate Risk • Foreign Exchange Risk • Market Risk • Credit Risk • Liquidity Risk • Off-Balance-Sheet Risk • Technology Risk • Operational Risk • Country or Sovereign Risk • Insolvency Risk McGraw-Hill/Irwin 1-15 ©2007, The McGraw-Hill Companies, All Rights Reserved Regulation of Financial Institutions • FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest • In an attempt to prevent their failure and the failure of financial markets overall McGraw-Hill/Irwin 1-16 ©2007, The McGraw-Hill Companies, All Rights Reserved Globalization of Financial Markets and Institutions • Financial Markets became more global as the value of stocks traded in foreign markets soared • Foreign bond markets have served as a major source of international capital • Globalization also evident in the derivative securities market McGraw-Hill/Irwin 1-17 ©2007, The McGraw-Hill Companies, All Rights Reserved Factors Leading to Significant Growth in Foreign Markets • The pool of savings from foreign investors has increased • International investors have turned to US and other markets to expand their investment opportunities • Information on foreign investments and markets is now more accessible (e.g. internet) • Some mutual funds allow ability to invest in foreign securities with low transaction costs • Deregulation has enhanced globalization of capital flows McGraw-Hill/Irwin 1-18 ©2007, The McGraw-Hill Companies, All Rights Reserved The Role of Financial Markets 1. Liquidity: • • Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low. 2. Information: • Pool and communication information about issuers of financial instruments. 3. Risk sharing: • Provide individuals a place to buy and sell risk. McGraw-Hill/Irwin 1-19 ©2007, The McGraw-Hill Companies, All Rights Reserved Financial Institutions • Firms that provide access to the financial markets, both • to savers who wish to purchase financial instruments directly and • to borrowers who want to issue them. • Also known as financial intermediaries. • Examples: banks, insurance companies, securities firms, and pension funds. • Healthy financial institutions open the flow of resources, increasing the system’s efficiency. McGraw-Hill/Irwin 1-20 ©2007, The McGraw-Hill Companies, All Rights Reserved The Role of Financial Institutions • To reduce transaction costs by specializing in the issuance of standardized securities. • To reduce the information costs of screening and monitoring borrowers. • They curb asymmetries, helping resources flow to most productive uses. • To give savers ready access to their funds. McGraw-Hill/Irwin 1-21 ©2007, The McGraw-Hill Companies, All Rights Reserved • Financial intermediation and leverage in the US have shifted away from traditional banks and toward other financial institutions less subject to government regulations. • Brokerages, insurers, hedge funds, etc. • These have become known as shadow banks. • Provide services that compete with banks but do not accept deposits. • Take on more risk than traditional banks and are less transparent. McGraw-Hill/Irwin 1-22 ©2007, The McGraw-Hill Companies, All Rights Reserved • The rise of highly leveraged shadow banks, combined with government relaxation of rules for traditional banks, permitted a rise of leverage in the financial system as a whole. • This made the financial system more vulnerable to shocks. • Rapid growth in some financial instruments made it easier to conceal leverage and risk-taking. McGraw-Hill/Irwin 1-23 ©2007, The McGraw-Hill Companies, All Rights Reserved • The financial crisis transformed shadow banking. • The largest US brokerages failed, merged, or converted themselves into traditional banks to gain access to funding. • The crisis has encouraged the government to scrutinize any financial institution that could, by risk taking, pose a threat to the financial system. McGraw-Hill/Irwin 1-24 ©2007, The McGraw-Hill Companies, All Rights Reserved The Structure of the Financial Industry • We can divide intermediaries into two broad categories: • Depository institutions, • Take deposits and make loans • What most people think of as banks • Non-depository institutions. • Include insurance companies, securities firms, mutual fund companies, etc. McGraw-Hill/Irwin 1-25 ©2007, The McGraw-Hill Companies, All Rights Reserved The Structure of the Financial Industry 1. Depository institutions take deposits and make loans. 2. Insurance companies accept premiums, which they invest, in return for promising compensation to policy holders under certain events. 3. Pension funds invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers. McGraw-Hill/Irwin 1-26 ©2007, The McGraw-Hill Companies, All Rights Reserved The Structure of the Financial Industry 4. Securities firms include brokers, investment banks, underwriters, and mutual fund companies. • • • Brokers and investment banks underwrite stocks and bonds to corporate customers, trade them, and advise customers. Mutual-fund companies pool the resources of individuals and companies and invest them in portfolios. Hedge funds do the same for small groups of wealthy investors. McGraw-Hill/Irwin 1-27 ©2007, The McGraw-Hill Companies, All Rights Reserved The Structure of the Financial Industry 5. Finance companies raise funds directly in the financial markets in order to make loans to individuals and firms. • Finance companies tend to specialize in particular types of loans, such as mortgage, automobile, or business equipment. McGraw-Hill/Irwin 1-28 ©2007, The McGraw-Hill Companies, All Rights Reserved The Structure of the Financial Industry 6. Government-sponsored enterprises are federal credit agencies that provide loans directly for farmers and home mortgagors. • • Guarantee programs that insure loans made by private lenders. Provides retirement income and medical care through Social Security and Medicare. McGraw-Hill/Irwin 1-29 ©2007, The McGraw-Hill Companies, All Rights Reserved Figure 3.2: Flow of Funds through Financial Institutions McGraw-Hill/Irwin 1-30 ©2007, The McGraw-Hill Companies, All Rights Reserved • Most people need to borrow to buy a house. • Mortgage payment will be your biggest monthly expense so shop around. • Many offers are from mortgage brokers - firms that have access to pools of funds earmarked for use as mortgages. • Who offers your mortgage is not important - get the best rate you can. McGraw-Hill/Irwin 1-31 ©2007, The McGraw-Hill Companies, All Rights Reserved Functions of Financial Institutions • Financial intermediaries channel funds between borrowers and lenders. • Intermediation transforming assets – the function of transforming assets or liabilities into other assets or liabilities • Liabilities – deposits • Assets – loans – this is the principal activity of most financial institutions. – intermediation improves social welfare by channeling resources to their most effective use McGraw-Hill/Irwin 1-32 ©2007, The McGraw-Hill Companies, All Rights Reserved Contd... • Facilitate the acquisition/payment of goods & services via lower transactions costs – Chequing services provided by banks improve economic efficiency. • Facilitate the creation of a “portfolio” – A portfolio is a collection of financial assets – The financial system provides economies of scale & scope • Economies of Scope: cost savings that stem from engaging in complementary activities. • Economies of Scale: obtained when the unit cost of an operation decreases as more of it is done. McGraw-Hill/Irwin 1-33 ©2007, The McGraw-Hill Companies, All Rights Reserved Contd... • Ease liquidity constraints • Reallocate consumption/savings patterns • Often the liquidity required to make certain purchases is not in line with the immediate flow of income available to individuals. Eg. Credit Card • The ability to influence the allocation of consumption and investment is probably the most important function of intermediation. • Provide security • Intermediation provides a host of services that reduce or shift risk. • Financial institutions can also influence the riskiness of financial transactions [contracts and insurance]. McGraw-Hill/Irwin 1-34 ©2007, The McGraw-Hill Companies, All Rights Reserved Contd... • Reduce asymmetric information problem • Moral hazard • the individual perceives as beneficial actions that are deemed undesirable by another. • Adverse selection • decision making that results from the incentive for some people to engage in a transaction that is undesirable to everyone else • Banks have a comparative advantage in offering specialized services that help reduce this problem. • Banks can also take advantage of this asymmetric information problem, with dire consequences. McGraw-Hill/Irwin 1-35 ©2007, The McGraw-Hill Companies, All Rights Reserved Adverse Selection Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes ones most likely to seek loans and be selected 1. are Moral Hazard 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 McGraw-Hill/Irwin 1-36 ©2007, The McGraw-Hill Companies, All Rights Reserved •Brokerage an “agency” function – Brokers are agents who bring would-be buyers and sellers together so transactions can be made. – Intermediation provides value-added but there are potential “externalities”. One intermediary’s actions can have consequences for the entire system. McGraw-Hill/Irwin 1-37 ©2007, The McGraw-Hill Companies, All Rights Reserved • Banks are particularly adept at intermediation because they can perform the necessary functions more cheaply than most institutions. • Technological change and deregulation have narrowed the comparative advantage of banks. McGraw-Hill/Irwin 1-38 ©2007, The McGraw-Hill Companies, All Rights Reserved Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition, Pearson Addison Wesley, 2004 McGraw-Hill/Irwin 1-39 ©2007, The McGraw-Hill Companies, All Rights Reserved Role of Financial Intermediaries Transaction Costs and Economies of Scale – Transaction costs = the time and money spent in carrying out financial transactions. Financial intermediaries help reduce transaction costs by taking advantage of economies of scale. Example: a bank can use the same loan contract again and again, thereby reducing the costs of making each individual loan. 2. Risk Sharing and Diversification - Risk = uncertainty about the returns investors will receive on any particular asset. By purchasing a large number of different assets issued by a wide range of borrowers, financial intermediaries use diversification to help with risk sharing. Example: by lending to a large number of different businesses, a bank might see a few of its loans go bad; but most of the loans will be repaid, making the overall return less risky. 1. McGraw-Hill/Irwin 1-40 ©2007, The McGraw-Hill Companies, All Rights Reserved 3. Adverse Selection and Moral Hazard - Financial intermediaries also use their expertise to screen out bad credit risks and monitor borrowers. They thereby help solve two problems related to imperfect information in financial markets. Adverse Selection = refers to the problem that arises before a loan is made because borrowers who are bad credit risks tend to be those who most actively seek out loans. Financial intermediaries can help solve this problem by gathering information about potential borrowers and screening out bad credit risks. Moral Hazard = refers to the problem that arises after a loan is made because borrowers may use their funds irresponsibly. Financial intermediaries can help solve this problem by monitoring borrowers’ activities. McGraw-Hill/Irwin 1-41 ©2007, The McGraw-Hill Companies, All Rights Reserved