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CHAPTER ONE
AN OVERVIEW OF FINANCIAL INSTITUTIONS
To finance economic activity, money has to flow from those who have excess money (savers) to
those who need the money (borrowers). Financial institutions transfer funds between savers and
borrowers. Any financial system consists of:
 Financial institutions, whose main concern is to transfer funds from those with surplus
money to those who need the money.
 Financial markets, where financial claims or financial instruments are bought and sold.
To understand the working of financial institutions, we introduce the concept of surplus and deficit
spending units:
SURPLUS AND DEFICIT SPENDING UNITS:
All economic units (e.g. firms, government) can be classified into three groups (sectors, economic
agencies):
1- Households (consumers)
2- Business firms (Producers)
3- Government (Public sector)
Each economic unit operate within a budget constraint imposed by its total income for the period.
So in any budget period a unit can have:
1- Balance budget (income = expenditure)
2- Surplus budget (income > expenditure)
3- Deficit budget (income < expenditure)
Units with surplus budget are known as surplus spending units (SSUs).
Units with deficit budget are known as deficit spending units (DSUs).
DSUs may include some households, some firms and sometimes the government. But taken as a
group firms and government are typically DSUs, while households are typically SSUs.
FINANCIAL CLAIMS
To meet their current expenditure DSUs borrow money from SSUs.
This happens by an SSU lending money to and accepting An IOU from a DSU. An IOU (I owe
you): is a written promise to pay a specific amount of money (the principal) plus the interest rate
for borrowing money for a given period of time (maturity).
IOUs are known as financial claims. A financial claim is an asset and a liability at the same time.
 To borrowers (DUSs) financials claim are liabilities.
 To lender (SSUs) financial claims are assets.
This explains the two faces of debts. A debt is a liability for someone and an asset for someone
else. So total financial liabilities outstanding in an economy at a given period should be equal to
total financial assets.
Financial claims can be held until maturity or sold before maturity to someone else.
Financial claims differ among themselves according to their:
 Marketability (the ease by which financial claims can be resold)
 Maturity (number of periods until maturity)
 Risk of default (borrower’s failure to make payments as promised)
 Tax treatment (whether the claim is tax exempt or not)
 Any special issue feature of the claim.
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TRANSFERRING FUNDS FROM SSUs TO DSUs
Transferring funds from SSUs to DSUs can be done by either:
- Direct financing, or
- Indirect financing (intermediation financing)
DIRECT FINANCING
In direct financing, DSUs and SSUs exchange money and financial claims directly. DSUs issue
financial claims on themselves and sell to SSUs against money. The exchange of money and
financial claims takes place directly between them.
The transactions appear as changes in the balance sheet (assets and liabilities holdings) of the two
parties as follow:
----------------------------------------------------------------------------------------------------------SSU
DSU
---------------------------------------------------------------------------------------------------------Assets
Liab.
Assets
Liab.
---------------------------------------------------------------------------------------------------------- Money
+ Money from
- Direct claims
SSU
sold to SSUs
+ Direct claims
from DSUs
---------------------------------------------------------------------------------------The claims issued by DSU are called direct claims and are typically sold in direct credit markets;
such as the money or capital markets. Institutional arrangements to facilitate transfer of funds in
direct credit markets include:
 Private placements: where DSU sells all claims issued to a single institutional investor or a
small group of such investors. The main advantages of this method are: the speed by which
funds are committed, and the low transactions cost.
 Brokers: whose main function is to aid in the search process of bringing buyer and seller
together. They do not sell and buy financial claims, but provide search information and act
as match markers. Their profit comes from commission fees they charge.
 Dealers: Their primary function is to “make a market” for securities (they are market
maker). They sell and buy financial claims. Their profit comes from bid-ask spread
(different between the bid and the ask prices) Bid-price: is the highest price offered by the
dealer to purchase a given securities. Ask-price: is the lowest price at which the dealer is
willing to sell the securities.
 Investment banks: Help DSUs market newly created (issued) financial claims. Their
important function is risk bearing or underwriting. They buy the entire claims at a fixed
price and sell it to investments or SSUs. Their profit comes from underwriting spread
(difference between fixed and sell price).
Main disadvantages with direct financing:
1- Large denominations: few customers are available.
2- Matchmaking problem: Matchmaking between what an SSU wants to hold and the
characteristics of the financial claims issued by DSUs.
To overcome these problems, financial intermediation comes between SSUs and DSUs..
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INDIRECT FINANCING (FINANCIAL INTERMEDIATION)
Here financial intermediaries (institutions) purchase direct claims with a given set of
characteristics (maturity, interest, denomination, etc) from DSUs, and transform them into indirect
claims with different characteristics, which they sell to SSUs.
Different characteristics means, that financial intermediation transform financial claims in way
that make them more attractive to the ultimate investor.
This transformation process of direct financial claims into indirect claims is known as financial
intermediation. Firms involved in this transformation are known as financial intermediaries.
The balance sheet of the three parties involved will be as follows:
SSU
Assets
- money
+Indirect
claims
Liabilities
Financial
Assets
+Direct
claims from
DSUs
Institution
DSU
Liabilities
Assets
Liabilities
Indirect
+ Money
Direct
claims sold
claims
to SSUs
Note that:
- The balance sheet of financial institution consists entirely of financial claims (direct and
indirect).
- A direct claims no longer goes to SSUs and does not appear in their balance sheet.
- Money goes to DSUs from financial institutions who obtain them from SSUs against a
transformed claim.
Financial institutions buy financial claims (bonds, government securities, business loans, consumer
loans, etc), and sell financial claims like checking accounts, saving accounts, etc.
THE BENEFITS OF FINANCIAL INTERMDIATION:
They enjoy three sources of comparative advantages.
1- They can achieve economics of scale by spreading fixed cost and lower operating cost
through specialization.
2- They can reduce transactions costs involved in searching for credit information. (A
consumer who wishes to lend directly can also search for information, but usually at a
higher cost).
3- They are able to obtain important information about borrowers, and reduce risk of default.
INTERMEDIATION SERVICES:
In producing financial commodities, intermediation perform five basic services:
1- Denomination divisibility: They pool SSU savings and allow those with small saving to
participate in large denominations. They are also able to produce denominations with
deferent size.
2- Currency transformation: They help to finance international trade. Intermediations do this
by buying financial claims denominated in one currency and selling financial claims
denominated in other currency.
3- Maturity flexibility: create securities with wide range of maturity, from one day to years.
4- Credit risk diversifications: They are able to spread risk by buying different types of
securities.
5- Liquidity: they provide liquidity to customers.
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TYPES OF FINANCIAL INTERMEDIARIES:
Financial intermediaries are classified as:
1- Deposit type institutions
2- Contractual savings institutions
3- Investment funds
4- Other type of institutions
1- DEPOSIT-TYPE INSTITUTIONS:
The most commonly recognized intermediaries because most people use their services on a daily
basis. They issue checking accounts, saving and time deposits, and they use funds to make loans.
They include:
 Commercial banks: The largest and most diversified, and highly regulated (under control).
 Thrift institutions: Savings and loans associations and mutual saving banks are commonly
called thrift institutions. They issue saving accounts, and use funds for long-term
investment to finance mortgage.
 Credit unions: Credit unions are small non-profit consumer organized and owned. They
specialized in consumer loans.
2- CONTRACTUAL SAVING INSTITUTIONS:
They obtain funds on long-term contractual agreements and invest fund in capital markets. They
have steady flow of funds through contractual agreements. They are able to invest in long-term
securities.
Examples are: Life insurance companies and pension funds.
3- INVESTMENT FUNDS:
These sell shares to investors and use funds to purchase direct financial claims, which are: very
liquid and have very short maturity.
Their operation makes easier for small investors to purchase shares in large denominations.
4- OTHER TYPES OF FINANCIAL INTERMEDIATIONS:
There are several types of financial intermediaries that purchase claims securities from DSUs and
sell indirect claims to SSUs. These include:
 Finance companies:
Makes loan to consumers and small business. They include:
- Consumer finance companies
- Business finance company
- Sales finance companies
 Government agencies:
Government agencies are involved in borrowing and lending activities by selling agency
securities and lend funds to certain economic sectors, which they serve.
INTERMEDIATION AND DISINTERMEDIATION
Disintermediation: is the shift of funds that were previously routed through financial institution
(intermediation markets) to the direct markets.
If market interest rate is higher than the rate that banks can offer, individuals take their savings
from the financial institutions to the direct credit market.
TYPES OF FINANCIAL MARKETS
Financial markets are classified into:
1- Primary and secondary markets
2- Organized exchanges and over-the counter markets
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Spot, futures, and forward markets
Options markets
Foreign exchange markets
International and domestic markets
1- PRIMARY AND SECONARY MARKETS
A financial claim bought by an investor cold be held up to maturity, or resold before maturity.
The initial sale of securities is made in primary markets while the subsequent sale is made in
the secondary market.
PRIMARY MARKETS:
 Are the markets where financial instruments are sold for the first time to the public (selling
claims for the first time).
 Shares sold are either:
- Offering new shares of firms whose shares are already trading in the market place. These
issues are called SEASONED ISSUES
- Or new shares (first time issues) of new firms whose shares are not currently trading in the
market. These first time issues are called INTIAL PUBLIC OFFERING (IPOs).
Most of the new issues are distributed with the aid of underwriters. The underwriter provides:
 Origination, which involves the design, planning, and registration of the new shares.
 Risk bearing, which means the underwriter insures or guarantees the price by purchasing
the securities.
 Distribution, which is the sale of the issue (reselling shares).
SECONDARY MARKETS:
Is where the existing financial claims are resold (selling claims for the second time). Its
existence facilitates selling and buying in the primary market. Investors buy new issue on the
understanding that they can resell them easily in the secondary markets. Marketability of a
security is an important factor that determine its yield.
Dealers and brokers help in the operation of the secondary market.
2-ORGANIZED EXCHANGES AND OVER-THE-COUNTER MARKETS
Financial claims can be traded in organized exchanges or over the counter
 ORGANIZED EXCHANGES:
- Organized exchanged like NYSE, provides a physical place and communications facilities
for member of the market to conduct their transactions.
- Transactions are conducted under specific rules and regulations.
- Only members of the exchange may use the facilities.
- Only securities listed on the exchange may be traded.
 OVER-THE-COUNTER MARKETS (OTC):
- Financial claims are traded by visiting or phoning on OTC dealers or by using a computer
system that links OTC dealers.
- There is no central place or location for OTC, and trade takes place in offices or rooms of
OTC dealers.
- They have strict rules that must be followed by dealers in the market.
- Dealers "make a market" in securities by quoting a "bid" price at which they are willing to
buy the securities and "ask" price at which they are willing to sell the securities. This
means that dealer keep inventories of securities and set their bid/ask prices.
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Most transactions are usually arranged by phone, or by using a computer system that links
the over-the-country dealers.
OTC market includes the trading in securities not listed on one of the organized exchange.
3- SPOT, FUTURE, AND FORWARD MARKETS
SPOT MARKETS: refers to:
- The exchange of securities and other financial claims for immediate payment.
- The term "immediate" can mean a day or a week depending on the settlement procedures in
the particular market.
- The spot market is also called the "cash" market.
FUTURE MARKETS:
- These are markets where people trade contracts for future delivery of securities (such as
government bonds), cash goods (such as a kilo of gold), or the value of securities.
- The delivery date is the future time when the contract is settled by the exchange of cash for
the contacted goods.
- Future contracts are traded in the organized exchanges.
- Contract is standardized in terns of delivery amounts, instruments, and dates.
FORWARD MARKETS: Where
- Contracts for future delivery are negotiated and sold over-the-counter rather than through
an organized exchange.
- Delivery dates, amounts, and terms of forward contract are not standardized but are
negotiated between the two counterparties (buyer and seller).
4- OPTIONS MARKETS:
- These are markets where options contracts are traded.
- Options contracts are contracts that call for conditional future delivery of a security or a good or a
futures contract. They call for one party (the option writer) to perform a specific act if called upon
by the option buyer or owner.
- Option contract gives the buyer the right to either buy or sell a security depending upon whether
the option is a “call” or “put” option.
- Call options: give the buyer the right to buy a predetermined (given) amount of a security at a
given/ agreed price on, or possibly before, the expiry date of the options.
- Put options: give the buyer the right to sell a predetermined (an agreed) amount of a security at
the agreed price prior to the option’s expiry date.
- Options contract are traded on organized exchanges.
5- FOREIGN EXCHANGE MARKET
These are markets on which foreign currencies are bought and sold. Foreign currencies such as
British £, Japanese ¥, and USD $ are traded against other foreign currencies. Foreign currencies are
traded either for spot or forward delivery over the counter at a large commercial banks or
investment bank charges. Future contracts for foreign currencies are traded on organized
exchanges.
6- INTERNATIONAL AND DOMESTIC MARKET
Financial markets can be classified as either domestic or international markets depending upon
where they are located. Among the well known international markets are the Eurodollar and the
Eurobond markets.
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OPERATIONS OF MAJOR FINANCIAL MARKETS:
Financial markets provide a way in which people can arrange to exchange financial claims for cash
or other considerations. They operate by:


Determining the price and quantity to be exchanged (either on the floor of an exchange or
through a computer network, or over the phone in an OTC market.
Following a clearing and settlement procedure to exchange claims for cash according to the
rules of each exchange or market.
Pricing mechanism depends on the type of financial markets:
Its varies from:
- A static (fixed) price in the London gold market, to
- A continuous auction market with specialist on exchange, to
- A continuous negotiated price determination on the OTC markets.
OPERATION OF ORGANIZED EXCHANGES:
 They use specialist system to conduct continuous auction market.
 Companies get their stocks listed on the exchange, if
1- They meet exchange standards regarding company size, No. of shares of stock
securities, No. of stock holders, required information disclosure, and stock voting
requirements.
2- They are willing to pay the required annual fees for exchange listing. (Exchange
listing is valuable to companies since it provide assurance of liquidity, evaluation of
performance, and make company visible to invests)
 Each stock listing is assigned to a specialist who makes the market for the stock listed.
(Using the bid/ask price continuously, he can enter his own orders of buy and sell, to
insure that the bid/ask prices are close to each other).
 He maintains an order book of unfilled orders. This gives him advantage over the
participants in the markets, since he can observe (notice) the build up of buy or sell orders.
OPERATION OF OPTIONS MARKET:
 They use an open-out-cry continuous auction pricing mechanism, without order book like
most exchanges.
 Market makers and dealers continuously call or signed their prices to other members of the
market.
 There are “designated order book officials” who, unlike specialist, do not trade for their
own accounts. The orders in the order book are filled when they are equal to or better than
any offer made by the trading crowds,
OPERATION OF FUTURE MARKETS:
 They use an open-out-cry continuous auction pricing mechanism.
 Dealers and market makers meet an continuously and negotiate trades at the best possible
prices.
 Because of competition among traders, the bid/ask spread tend to the small in most future
markets.
OPERATION OF OVER-THE-COUNTER MARKET:
 Price is determining by negotiation.
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
The bid/ask prices of dealer are published in the “pink” pages of newspapers, and
sometimes on screen and videos.
In general bid/ask prices are made over the phone.
ISSUES RELATED TO INFORMATION FLOWS IN FINANCIAL MARKETS:






The timing, accuracy and the control level of information are very important in financial
markets.
Traders, dealers, and brokers prefer to delay information, and want to sell trading
information.
The public wants information without delay and free.
Market regulator attempt to avail information.
According to regulations, all inside information is to be released to the public. (Insider to a
company is not allowed to trade in its share).
Inside information is a great way to beat the market, but there are many penalties if inside
information is used without being released to the public.
COMPANSATION OF MARKET PARTICPANTS:
Participants in financial markets are compensated in different ways.
1-
EXCHANGE MEMBERS:
Membership fees
Listing fees
Charges or fees for each transaction that is conducted through their facilities.
Charges for provision of information (e.g. providing current price and volume information
on securities traded to non-exchanges members).
2- Dealers:
Dealers earn their “bid/ask” spread when they sell stocks or bonds at an ask price that is
higher than their bid price.
3- BROKERS:
Brokers earn a commission that is often based on the number of items sold or their value.
4- Underwriters:
Underwriters of new securities are issues earn an underwriter’s spread if they are able to
market the new securities at a higher price than they paid the DSU that issues them.
5- INVESTORS:
Different between buy and sell price.
6- TRADERS:
Are able to earn a profit if, by constantly watching the market or computer screens, they are
able to buy securities at a lower prices than they are able to sell them.
7- SCALPERS:
They are traders who follow a strategy of making quick sales in the hope of making many
quick small profits through the day.
FUNDAMENTAL OF FINANCIAL MARKETS:
Financial markets exist to facilitate transfer of funds between lenders (SSUs) and borrowers
(DSUs). They are divided into:
1- MONEY MARKETS: Where the purpose is to finance liquidity in the short-term.
2- CAPITAL MARKETS: Which are concerned with the transfer of funds that can be used for
long-term capital investment.
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FUNCTIONS OF THE MONEY MARKETS
Money markets are markets in which commercial banks and other business firms adjust their
liquidity position by borrowing, lending, or investing for short period of time.
 They are largely used by:
 Commercial banks and business firms to adjust their liquidity position.
 The central bank (Federal system) to conducts its monetary policy.
 The government (Treasury Department) to finance day-to-day operations.
 Business firms to adjust its liquidity position.
 Features
* It consists of a collection of markets each specializing in a different financial claim.
* There is no formal organization such as the NEW YORK STOCK EXCHANGE, NYE, but takes
place lagerly in rooms of dealers and brokers.
* Dealers and brokers are central to the activity of the market.
* Transactions, especially in the secondary markets are usually conducted by phone, but there are
other telecommunications devices such as teletypes and computers.
* It involves large transactions, mostly one million $ and more.
* The money markets are also distinct from other financial markets in that they are wholesale
markets because of the large transactions involved.
* Money market transactions are called open market transactions because of their impersonal and
competitive nature (there are no established customer relationships).
* Settlement of payment from a bank account to another is done by the central bank (Federal
system), and securities are rarely “physically” shipped between buyers and sellers.
ECONOMIC ROLE OF THE MONEY MARKET
Money market instruments allow economic units to bridge the gap between cash receipt and cash
expenditure, thereby solving their liquidity problem. For example if a firm has temporary surplus
of cash, rather than leaving the funds idle in a checking account and earning no interest, the firm
can invest in the money markets for short periods and earn the market rate of interest. This on the
other hand allow firms who need money (have shortage in liquidity) to obtain funds they need
CHARACTERISTICS OF MONEY MARKET INSTRUMENTS
Financial instruments (claims) in the money markets have:
 Low default risk: They are issued by well known sellers or borrowers. If you have money to
invest, you would want to purchase the financial claims of firms having the highest credit
worthiness and thus minimize any loss of principal due to default.
 Low price risk: They have short-term maturities. Long-term securities usually have higher
price risk because they are subject to greater price fluctuations resulting from long-term
changes in interest rates.
 High marketability: They can be bought and sold quickly.
 Low transaction cost: Temporary investments must be marketable quickly and at low cost
in the event that you unexpectedly need the fund before maturity.
Money Market Instruments:
The main financial instrument (claims) in the money markets includes:
- Treasury Bills and Securities (government securities)
- Commercial papers (IOUs of major companies)
- Negotiable certificate of deposits (CDs issued by major banks)
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Bank's acceptance (companies IOUs accepted by major banks)
Repurchase agreements (short-term loans arranged by selling government securities along
with an agreement to buy them later at a higher price)
Central bank funds (Federal Funds):overnight or short-term of immediately available funds
usually transferred through the central bank system)
FUNCTIONS OF THE CAPITAL MARKETS:
 The main function is to provide funds for capital investment.
 Users or issuers of capital markets claims are those who are unable or unwilling to provide
full funds to purchase capital goods. They enter the capital markets as primary borrowers.
Primary borrowers issue capital market claims such as stock and bonds that are secured
by the value of future production expected from the capital assets. Reasons for their
borrowing in capital markets could be that they: (a) are unable to buy capital without
borrowing, or (b) want to avoid risk of investing large amounts of resources in a single
capital (to diversify risk).
 Purchasers of capital market claims are the Surplus Spending Units (SSUs). Households are
the largest suppliers of funds to financial markets. Financial institutions (e.g. commercial
banks) are also important in buying direct claims and reselling them as indirect claims.
 Capital markets trade financial claims with maturities more than one year (long term
financing).
MARKET EFFICIENCY:
Capital markets help increase economic efficiency in various ways. They specially help
achieve:
 ALLOCATIONAL EFFICIENCY: Which implies that funds will be allocated to their highest
productive use. In general this means that business firms invest in projects offering the highest
rate of return, and that household invest in financial claims offering the highest yields for given
level of risk.
INFORMATIONAL EFFICIENCY: implies that information is flowing efficiently to all
market participants. This efficiency refers to the extent to which all market participants are
receiving timely, accurate, and complete information. Market regulators work to insure the
existence of this efficiency.
OPERATIONAL EFFICIENCY:
A market is operationally efficiency if the costs of conducting transactions are as low as
possible – high transaction costs can prevent firms from investing in all desirable projects.
Transaction costs are reduced when there is sufficient competition between market makers
(dealers and brokers, etc).
RISK FACED BY FINANCIAL INSTITUTION
1- Credit risk (default risk). When a financial institution makes a loan or invest in a bond or
other debt security, the institution bear credit risk because it is accepting the possibility that
the borrower will fail to make either interest or principal payment in the amount and at the
time premised.
2- Interest rate risk: Is the risk of fluctuations in a security’s price caused by changes in
market interest rate.
3- Liquidity risk: Is the risk that a financial institution will be unable to generate sufficient
cash inflow to meet required cash outflows.
4- Foreign exchange risk: Is the fluctuations in the earnings or value of a financial claim that
arises from fluctuations in exchange rates.
5- Political risk: Is the fluctuation in value of a financial claim resulting from the actions of
the government.