OVERVIEW OF THE FINANCIAL SYSTEM
1)
The modern financial system as it has developed is huge and
complex. In this note, we perform a very basic ‘naming of
parts’ exercise. That is, we will seek to get a broad
picture of the major components which constitute the
financial system and their roles, defining some of the
actors and their purpose. Repeatedly throughout this
course, we’ll be coming across references to the numerous
types of financial markets, financial instruments, and
financial institutions outlined here. As we go along, we
can refer back to this overview to recall how a particular
type of financial instrument works or what a particular
type of financial intermediary does. It is useful to
therefore begin with an overall picture. The one at the
end of this overview is taken from Mishkin, page 24.
2)
The fundamental function of the financial markets and
financial intermediaries is to channel funds from agents
who have saved funds and want to lend to agents
who need funds and want to borrow. Typically, we divide
the population up into several units: households,
businesses (non-financial businesses), the government and
the rest of the world (foreigners). The supplement to this
section (the flow of funds table) shows how funds have been
transferred between these units over the last year. As you
should note from the figure all four units are on both
sides of the market. What do you think is the major form of
the borrowings of the household sector? What about the
business sector?
3)
Funds can be channeled to borrowers from lenders in two
ways: first, lenders can put their money in financial
intermediaries (for example a bank) and the financial
intermediary then lends the money on to borrowers, or
lenders can directly lend money to borrowers (through
various markets). Typically, it is not possible for an
individual to directly lend in a market to another
individual. As a result, there are what are known as
‘market makers’ (specialized institutions or firms who
intermediate in markets and who issue claims on borrowers)
who allow for his. Thus for example, if you want to buy a
corporate bond, you often go to a specialized bond broker
who will obtain this for you. But to make the distinction
between putting your money in a bank which then lends on to
firms, say, versus buying a corporate bond, we distinguish
between direct and indirect financing.
4)
The financial system performs several services. It
facilitates:
Risk sharing by allowing savers to hold many assets(through
diversification).
Providing liquidity, which is the ease with which an asset
can be exchanged for money.
Providing information about borrowers and returns on
financial assets
Delegating monitoring activity
Pooling Funds for Investment
5)
There are two broad types of markets that we are interested
in: Debt and Equity Markets
A debt instrument is a contractual agreement by the issuer
of the instrument (the borrower) to pay the holder of the
instrument (the lender) fixed dollar amounts (interest and
principal payments) at regular intervals until a specified
date (maturity date) when a final payment is made. Examples
include Government and corporate bonds. Debt usually has a
maturity associated with it (Short-term = maturity of less
than one year. Long-term = maturity of more than ten years.
Intermediate-term = maturity between one and ten years)
Equity refers to a contractual agreement representing
claims to a share in the income and assets of a business.
Examples would include corporate stock. These have no
maturity date and are hence are considered long-term
securities. Since equity holders own the firm, they are
entitled to elect members of the firm’s board of directors
and vote on major issues concerning how the firm is
managed. A key feature distinguishing equity from debt is
that the equity holders are the residual claimants: the
firm must make payments to its debt holders before making
payments to its equity holders.
We can refer to this feature in identifying the major
advantages and disadvantages of holding debt versus equity:
Advantage to holders of debt instruments:
Receive fixed payments, regardless of whether the
borrower’s income and assets become more or less valuable
over time.
Disadvantage to holders of debt instruments:
Do not benefit from an increase in the value of the
borrower’s income or assets.
Advantage to holders of equities:
Receive larger payments when the business becomes more
profitable or the value of its assets rises.
Disadvantage to holders of equities:
Receive smaller payments when the business becomes less
profitable or the value of its assets falls.
7)
Primary and Secondary Markets
It is important to distinguish between two sorts of markets
within financial markets: Primary markets and secondary
markets.
Primary markets are those in which newly issued claims are
sold to initial buyers.
Secondary markets are those in which previously issued
claims are resold.
A primary market refers to markets in which newly-issued
securities are sold to initial buyers by the corporation or
government borrowing the funds. For example: US Treasury
issues a new US Government bond, and sells it to Morgan
Stanley. In order to do this, Investment banks play an
important role in many primary market transactions by
underwriting securities: they guarantee a price for a
corporation’s securities and then sell those securities to
the public.
A secondary market refers to a market in which previouslyissued securities are traded. For example Morgan Stanley
sells the existing US government bond to Citigroup or to an
individual.
Brokers and dealers play an important role in secondary
markets:
Brokers = facilitate secondary-market transactions by
matching buyers with sellers.
Dealers = facilitate secondary-market transactions by
standing ready to buy and sell securities.
Now it is critical to note that the original issuer or
borrower receives funds only when its securities are first
sold in the primary market; the issuer does not receive
funds when its securities are traded in the secondary
market.
Why have the secondary market then? Well, secondary markets
perform three essential functions: They allow the original
buyers of securities to sell them before the maturity date,
if necessary. That is, they make the securities more
liquid. So if you wanted to exchange your bond for cash,
you could do so. This makes it easier for the bond issuer
to sell the bond in the first place. Second, they allow
participants in the primary markets to make judgments about
the value of newly-issued securities by looking at the
prices of similar, existing securities that are traded in
the secondary markets. Third, they provide information on
the expected future profitability of a company.
7)
Another distinction to make is between Money and Capital
Markets. Money markets are markets in which only short-term
debt instruments are traded (< 1 year). In the capital
market intermediate-term debt, long-term debt, and equities
are traded. We will learn more about the money market in
section (IV). You are, however more familiar already with
the instruments in the capital market. These include
Corporate Stocks (Equity in companies)
Residential, Commercial, and Farm Mortgages (Debt
Instruments of the household sector or businesses)
Corporate Bonds (debt instruments of businesses)
US Government Securities (Intermediate and Long-Term) (Debt
Instruments of the USG)
State and Local Government (Municipal) Bonds (Debt
Instruments of the State and Local Governments)
Bank Commercial and Consumer Loans (Shorter term
instruments for businesses and households).