Course
FINA 4000
Financial Institutions and Markets
Professor Ralph E. Steuer
Terry College of Business
Fall 2013
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Purpose
To understand
• an economy’s financial system
• how it finances the economy
• how it oversees the economy’s money supply
Does this by facilitating the movement of money
from where it is in excess to where it is most
needed (to help an economy prosper). Also, to
understand
• much about the financial issues we read
about in the paper every day
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Two Parts
1. Financial institutions
2. Financial markets
…and the there is Money
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1. Financial Institutions
commercial banks, mortgage lenders,
investment banks, central bank, government
sponsored enterprises, mutual fund companies,
bond insurance companies, …
Other than for central bank, goal is to bring
money in at a low rate and deploy it at a higher
rate.
Cover costs and make profits mostly by means
of the interest rate spread.
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2. Financial Markets
Bond market, commercial paper market, US Treasuries
market, money market, Fed Funds market, credit
default swaps market, New York Stock Exchange, Overthe-Counter market, primary market, secondary
market,…
Venues where people buy and sell financial claims
(securities or financial instruments). Commissions
and fees typically cover costs and provide profits for
the markets.
Cannot have an advanced economy as in the US,
Canada, Japan, Germany,… without an efficient
financial system.
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Financial Claims
• A financial claim is a claim on the issuer’s future
income or assets.
• With financial claims, there is an issuer and a
holder.
• While issuer remains the same, the holder may
change many times.
• Legislation and regulation give financial claims
strength – makes them legally enforceable.
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Best Known Financial Instruments
A bond is a long-term (one or more years) debt
instrument that obligates the issuer to make
specific payments at specific times to the holder.
A stock is a claim on the income and assets of a
corporation.
While stocks are the most widely followed, world
of debt instruments is much larger.
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Money Markets vs. Capital Markets
Money Markets Capital Markets
< 1 year
≥ 1 year
corporate
stock
short-term
debt
debt more
than one year
yellow is this course
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Money Markets vs. Capital Markets (US)
Money Markets
$10 trillion*
short term
debt
Capital Markets
$50 trillion*
1/3*
corporate
stock
debt more
than one year
*roughly
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How Big is $1 billion?
Annual revenue of UGA is roughly $2 billion.
Marketcaps
Citigroup
Costco
Apple
Exxon Mobil
General Motors
Alcoa
AFLAC
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156B
50B
412B
399B
49B
9B
28B
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Appreciating $1 trillion
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$1 million
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$100 million
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$1 billion
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$1 trillion
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Some Comments about Money
• Although amount of cash outstanding is growing,
usage of cash is in decline.
• Cash in domestic use down to ≈2.5% of GDP.
• $1 bill lasts ≈40 months, costs 10 cents to make.
• While US Mint not producing as many 1’s, 5’s
and 10’s, demand for 100’s has exploded.
• $700 billion in 100’s outstanding, 2/3rds held by
foreigners.
• Total US currency outstanding near $1 trillion.
• “legal tender” means only lenders are required to
accept.
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Economic Units
Economic units (i.e., units that have a budget)
fall into three categories
• Households
• Business firms
• Governments
For any period, an economic unit’s budget
will be in a
• Balanced position
• Surplus position
• Deficit position
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SSUs and DSUs
Surplus spending units (SSUs) have income for the
period that exceeds expenditures, results in savings.
Deficit spending units (DSUs) have spending needs for
the period that exceed money they have on hand.
DSUs issue financial claims to obtain the funds they
need.
SSUs only part with their money if the characteristics of
the financial claims they receive are to their satisfaction.
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Challenge of Financial System
Task of matching up DSUs with SSUs.
1. Direct financing -- one end of financing
continuum. Normally one’s first choice. No
middleman. Often better this way if possible.
2. Indirect financing – other end of continuum.
Involves use of an intermediary. Most
financing is done in this way because direct
financing often not practical.
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Direct Financing
SSU
DSU
Households
Business firms
Governments
Households
Business firms
Governments
Occurs when an SSU purchases a financial
claim directly from a DSU.
Example: Borrowing money from parents to
start a business.
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Difficulties of Direct Financing
SSU
DSU
Households
Business firms
Governments
Households
Business firms
Governments
• DSU and SSU need place to come together
• Characteristics of financial claim must be agreeable
to both parties
•
•
•
•
•
denomination
maturity
risk
liquidity of financial claim (i.e., marketability)
any other important characteristics
Any problem here could be a deal breaker.
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Direct Financing Balance Sheets
SSU
Assets
Liabilities
DSU
Assets
Liabilities
A financial claim is an asset to its holder, and a
liability to its issuer.
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Liquidity
Ability to convert quickly into cash (or cash
equivalent) without a price concession.
• Liquid investments
• Illiquid investments
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Importance of Liquidity (Marketability)
Importance of being able to resell financial claim.
Suppose:
SSU has $2 million
to lend for 3 yrs.
a DSU needs $2
million for 20 yrs.
denomination, okay
risk, okay
maturity, not okay.
Problem solved if there is marketability (SSU able
to sell financial claim for fair price after 3 yrs)
Being able to achieve liquidity, for example, by
marketability always helps a lot. Good to have well
functioning markets.
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Indirect Financing
SSU
DSU
Households
Business firms
Governments
Households
Business firms
Governments
financial
intermediary
Indirect financing is when money flows from an
SSU through an intermediary to a DSU. DSU
and SSU probably never know each other.
An intermediary transforms the characteristics
of financial claims.
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Transformation of Claims
Financial intermediation means selling financial
claims to SSUs with one set of characteristics,
and buying financial claims from DSUs with
another set of characteristics.
Financial intermediaries specialize in this for
SSUs and DSUs to get money moved.
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Indirect Financing Balance Sheets
SSU
Assets
DSU
Assets
Liabilities
Liabilities
Financial Intermediary
Assets
Liabilities
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Indirect Financing
Because an SSU’s claim is against the financial
intermediary rather than the DSU, the financing from
DSU to SSU is indirect.
A commercial bank typically issues financial claims to
SSUs in the form of checking accounts, savings accounts,
certificates of deposit,…
Then with the money, buys financial claims from DSUs.
Whereas SSUs can always achieve liquidity with
financial claims from an intermediary, financial claims
held by a financial intermediary from DSUs are typically
not liquid.
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Advantages of Intermediaries
• Economies of scale due to specialization and
ability to spread out fixed costs.
• Reduced costs in search for credit information
(only done needs to be done once per DSU).
• Often privy to more than what comes up in a
normal credit check due to being an involved as
a member of the community (helps intermediary
make better loans).
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Intermediation Services
1. Denomination Divisibility. Pool the savings of many
small SSUs into large investments.
2. Currency Conversion. Buy and sell financial claims
denominated in various currencies.
3. Maturity Flexibility. Maturities, from 1 day to 30
years, to both DSUs and SSUs.
4. Credit Risk (probability money not paid back as
promised) Diversification. Enables SSUs to not put all
of one’s eggs in one basket.
5. Liquidity. SSU savings at an intermediary are usually
immediately or quickly convertible into cash –
generally accept low rates for the privilege.
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Risks Faced by Financial Institutions
1. Credit risk
2. Interest rate risk – security price fluctuations as a
result of changes in interest rates
3. Liquidity risk
4. Foreign exchange risk – if deal in foreign currencies
or have investments abroad
5. Political risk
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Interest
Conventional theory -- interest is reward an SSU
receives for postponing consumption, and
penalty a DSU pays for consuming before the
money is earned.
In normal times, interest rates adjust to match
supply and demand. Only part-true now because
some rates so close to zero, can’t go down much.
Reward aside, many people now saving just to
keep money safe.
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Brokers vs. Dealers
Brokers do not take a position. Simply specialize
in matching buyers with sellers. Make money by
charging a fixed or percentage fee.
Dealers “make markets” by buying at any time
for inventory, and selling at any time from
inventory. Make money by buying low and
selling high.
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OTC
When people say over-the-counter (OTC), mean
going through a dealer.
OTC markets generally have no central location
like organized exchanges.
Vast majority of debt instrument markets are
OTC.
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Primary Market vs. Secondary Market
Primary market is a financial market where new
issues are sold to initial buyers.
Secondary market is where people can buy and sell
already existing financial claims.
• People are more likely to buy a financial claim in
the primary market if there is a secondary market.
• Provides liquidity (ability to convert to cash) for the
financial claim.
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U.S. Population
Now
nearing 320 million
Net gain of one person every
13 seconds
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2012 World GDP (PPP) and Population
World
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
European Union
United States
China
India
Japan
Russia
Germany
France
Brazil
UK
Mexico
Italy
South Korea
$85,538 billion
16,805
15,685
12,471
4,793
4,487
3,373
3,349
2,372
2,366
2,333
2,022
2,017
1,540
PPP
8/20 is Purchasing Power Parity
7,104 million
320 (3)
1,359
(1)
1,232
(2)
127 (10)
143
(9)
80 (16)
65 (21)
194
(5)
63 (22)
117 (11)
59 (23)
50 (26)
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2012 World GDP Per Capita (PPP)
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4 Categories of Financial Intermedaries
Assets
Liabilities
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11 Types of Financial Intermediaries
Total assets of financial intermediaries ≈ 3 × GDP
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Deposits at FDIC-insured Institutions
Standard insurance amount is $250,000 per depositor/per
institution (through 2013) as follows:
Single Accounts (owned by one person) $250,000 per owner
Joint Accounts (two or more persons)
$250,000 per co-owner
Revocable Trust Accounts
$250,000 per owner per
beneficiary up to 5*
What happens if a married couple has $1 million to
deposit? Can do at one bank, but must open 3 accounts.
Can go over $1 million, but that involves accounts with
non-spousal beneficiaries. Probably best to open
additional accounts at additional institutions.
*can do more than 5 but rules get more strict.
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Comments
1. Credit unions are non-profit, cooperative
organizations. They take in money via checking and
savings accounts with the idea of making consumer
installment loans to members.
2. Life and casualty insurance companies: Since
casualty claims less predictable, a greater proportion
of a casualty insurance company’s investments must
be in highly marketable securities.
3. Thrift institutions also known as “Savings and
Loans.” Like a bank, but chartered under different
set of rules. Still some around, but not as many since
the S&L crisis 1986-1995. Mopping up S&L crisis
cost Government $150 billion.
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Comments (con’t)
4. Since inflow and outflows of pension funds can be
predicted with a considerable accuracy, can invest in
very long-term projects (like private equity, hedge
funds, venture capital).
Private equity: idea is to buy all shares of a company,
restructure company, then sell in later at a higher price
5. Money Market Mutual Funds: Uninsured substitutes
for deposit accounts. They usually buy money market
instruments. SSUs usually get slightly higher rate of
interest.
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Money Market Instruments
Used by financial institutions and businesses to adjust
their liquidity positions.
Three characeristics of money market instruments
(a) maturities < one year,
(b) active secondary markets
(c) low risk of default.
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Disintermediation
when SSUs take money out of a financial
intermediary to invest in financial claims via direct
financing.
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