Lecture
Chapter 2
An Overview of the Financial System
Types of Financial Instruments
• Securities: pieces of paper that give the owner a claim on
the issuer’s assets or future payment.
- Simple contracts
- Negotiable (can be resold, traded)
- Used in both direct and indirect finance
• Loans:
– Contracts that are more complicated than securities.
– Usually non-negotiable. Have collateral requirements
and covenants.
– Used almost exclusively indirect finance.
Types of Finance
1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments
(securities)which are claims on the borrower’s
future income or assets
2. Indirect Finance
• Borrowers borrow indirectly from lenders via
financial intermediaries that issue financial
instruments which are claims on the borrower’s
future income or assets
World Without Financial Intermediaries
Equity and Debt Securities
Lender – Saver
(Households…)
Cash
Borrower - spender
(Businesses…)
In this world - the flow of funds from savers to
borrowers is likely to be low:
• As a lender, how do you know you will get your
money back (problem of adverse selection)
• As a lender, how do you know the borrower will
use funds as stated? (problem of moral hazard)
• Monitoring is a hassle. Prefer to leave the
monitoring to others.
• Lack of liquidity.
2-3
World With Financial Intermediaries (FI)
Lender – Saver
(Households….)
Cash
FI Broker
FI Asset
Transformer
Borrower – spender
Businesses….)
Debt and Equity
Deposits and Insurance
policies
Here we have both direct and indirect
finance.
2-4
Mishkin’s Representation: Function of Financial
Markets
Indirect Finance Involves Asset Transformation
Assets
Something of
value that you
own
Liabilities and Net Worth
Something you
owe.
Net Worth = Assets - Liabilities
Financial Institution - Commercial Bank
Assets
– Cash (vault cash)
– Deposits at Fed (Reserves)
– Mortgages
– Commercial Loans
– US Gov’t bonds
Liabilities and Net Worth
–Demand Deposits
–Time Deposits
–Debt (Borrowing)
–Equity Capital(Bank Capital)
Asset Transformation – Banks issue liabilities with one
set of characteristics and use the proceeds to purchase
assets with a different set of characteristics.
Also, referred to as maturity Transformation – Bank
liabilities are short-term, assets are long-term.
Financial Institution - Insurance Company
Assets
– Cash
- Mortgages
– Corporate Bonds
– US Gov’t bonds
– Equity (Google Stock
Liabilities and Net Worth
– Insurance Policies
(contingent liability)
– Equity Capital
Asset Transformation – Insurance companies
issue liabilities and use the proceeds to purchase
assets
Examples of Direct Finance:
– Initial Public Offering of a stock
– Ford sells bonds to the public
– GE issues commercial paper to public to
fund its payroll
– Bowie Bonds
Structure of Financial Markets
1. Debt Markets
─
─
─
─
Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $52.4 trillion at the end of 2009.
2. Equity Markets
─
─
─
Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $20.5 trillion at
the end of 2009.
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
─ Previously issued securities are bought
and sold
─ Examples include the NYSE and Nasdaq
─ Involves both brokers and dealers (do you know
the difference?)
Structure of Financial Markets
 Even though firms don’t get any money, per
se, from the secondary market, it serves two
important functions:
 Provides liquidity, making it easy to buy and
sell the securities of the companies
 Establish a price for the securities
Structure of Financial Markets
We can further classify secondary markets as
follows:
1. Exchanges
─ Trades conducted in central locations - Auction
(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 further classify markets by the maturity
of the securities:
1. Money Market: Short-Term (maturity < 1 year)
2. Capital Market: Long-Term (maturity > 1 year)
Principal Money Market Instruments:
Short-term debt instruments with maturity < 1 year
http://research.stlouisfed.org/fred2/graph/?id=COMPOUT
Principal Capital Market Instruments Maturity > 1 year
Internationalization of Financial Markets
• Foreign Bonds: bonds sold in a foreign country and
denominated in that country’s currency
• 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
Financial Intermediaries - Indirect Finance
 This is actually the primary means of moving
funds from lenders to borrowers.
 More important source of finance than
securities markets (such as stocks)
 Why? Transaction costs, information costs
(asymmetric information), risk sharing and
liquidity.
Transaction Cost - Direct Finance is Expensive
• Legal Costs: Loans and securities are legal contracts which
must be written carefully to be enforced. Loans are more
complicated – covenants and collateral.
• Regulatory costs: Securities. SEC filing requirements.
Must file registration statement, prospectus, periodic
financial statements.
• Sales Costs: Cost of matching buyers and sellers
- Primary Markets: Investment bankers market to
potential buyers and guarantee a minimum initial price
for a fee.
Financial Intermediaries Reduce Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transaction costs by developing
expertise (screening and monitoring) and taking
advantage of economies of scale
Financial Intermediaries - Economies of Scale
• Most transaction costs associated with a financial
transaction are fixed costs
• Independent of size of transactions and number of
transactions.
- Legal cost for a $100,000 loan similar to
$1,000,000 loan.
- Repeated transactions => spread the cost over a
large number of loans (e.g. spread $10,000
legal cost over 2,000 loans = $5.00 per loan)
Financial Intermediaries - liquidity
 Banks provide liquidity services - services that
make it easier for customers to conduct
transactions
 Banks provide depositors with checking accounts
that enable them to pay their bills easily
 Depositors can earn interest on checking and
savings accounts and convert them into goods and
services whenever necessary
Financial Intermediaries – reduce risk
 reduce the exposure of investors to risk, through
risk sharing
─ FIs 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,
risky assets are turned into safer assets for investors
Financial Intermediaries – reduce risk
 Allow individuals and businesses to
diversify their asset holdings.
 Low transaction costs allow them to buy a
range of assets, pool them, and then sell
rights to the diversified pool to individuals.
Financial Intermediaries: Indirect Finance
 Information cost - asymmetric information.
─ One party lacks crucial information about
another party, impacting decision-making.
─ adverse selection and moral hazard.
Function of Financial
Intermediaries: Indirect Finance
 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek a loan
3. Similar problems occur with insurance
where unhealthy people want their known
medical problems covered
Asymmetric Information:
Adverse Selection and Moral Hazard
 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
3. Again, with insurance, people may engage in
risky activities only after being insured
Types of Financial Intermediaries
Types of Financial Intermediaries
 Depository Institutions (Banks): accept deposits and
make loans. These include commercial banks and
thrifts.
 Commercial banks (around 7,000)
─
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
Types of Financial Intermediaries
 Thrifts: S&Ls & Mutual Savings Banks (1,300) and
Credit Unions (9,500)
─
Raise funds primarily by issuing savings, time, and checkable
deposits which are most often used to make mortgage and
consumer loans, with commercial loans also becoming more
prevalent at S&Ls and Mutual Savings Banks
─
Mutual savings banks and credit unions issue deposits as
shares and are owned collectively by their depositors, most of
which at credit unions belong to a particular group, e.g., a
company’s workers
Contractual Savings Institutions (CSIs)
 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 state and local governments acquire funds
through employee and employer payroll contributions, invest
in corporate securities, and provide retirement income via
annuities
Types of Financial Intermediaries
Investment Intermediaries
 Finance Companies sell commercial paper
(a short-term debt instrument), and issue bonds
and stocks to raise funds to lend to consumers to
buy durable goods, and to small businesses for
operations
 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
Types of Financial Intermediaries
 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
 Investment Banks advise companies on
securities to issue, underwriting security
offerings, offer M&A assistance, and act as
dealers in security markets.
Regulatory Agencies
Regulatory Agencies (cont.)
Regulation of Financial Markets
Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial
Intermediaries
Regulation of the Financial Markets
• Ensure the soundness of financial intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information (SEC)
– Restrictions on Assets and Activities (control holding of risky
assets).
– Deposit Insurance (avoid bank runs).
– In the past, regulation placed limits on competition
• Restrictions on bank branches
• Restrictions on Interest Rates
Classifying Financial Instruments
1. Type of claim Equity (Common Stock): Gives owner a share of
the firm’s assets and profits. Also have voting
rights.
Debt (loans, bonds, commercial paper): Entitles
owner to specific payments on specific dates.
If firm fails, get paid before equity holders.
Equity holders have a residual claim.
2. Maturity: Length of the claim. Money Market or
Capital Market. Equity does not mature.
Classifying Financial Instruments
3. Risk: degree of uncertainty as to payment.
Equity generally has the highest risk. Next is various
grades of debt, then unsecured debt such as consumer
loans. Safest: treasury bills and insured bank deposits
4. Liquidity: How quickly converted into medium
of exchange (money). Demand deposits, followed by
savings deposits, treasury securities.
Classifying Financial Instruments
5. Expected Returns.
As shown on the next slide, returns are typically higher for
riskier, less liquid and longer-maturity assets.
Highest risk: Equities, followed by various grades of debt.
Lowest risk: Treasury bills, demand deposits.
Risk and Return by Asset Class - Ibbotson Associates
2009
2009
9.8
2009
11.9
11.8
16.6
The Ibbotson Chart
• Returns are at 5 % increments.
• Most risk - Equity ( small cap). Low, spread-out
“skylines”.
• Least Risk - Treasury bills. Narrow skyline.