The Economics of Money,
Banking, and Financial Markets
Mishkin, 7th ed.
Chapter 2
Overview of the Financial System
Direct finance and Indirect finance
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Direct finance – funds are directly
transferred from lenders to borrowers
Indirect finance – financial
intermediaries receive funds from
savers and lend them to borrowers
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Securities are assets for the holder and
liabilities for the issuer
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
Debt and equity markets
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Debt instruments – contractual obligation to pay the
holder fixed payments at specified dates (e.g.,
mortgages, bonds, car loans, student loans)
Short-term debt instruments have a maturity of less
than one year
Intermediate-term debt instruments have a maturity
between 1 and 10 years
Long-term debt instruments have a maturity of ten or
more years
Equity – sale of ownership share (owners are residual
claimants).
Owners of stock may receive dividends
Primary and secondary markets
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Primary market = financial market in
which newly issued securities are sold.
Secondary market = financial market in
which previously owned securities are
sold.
Brokers and dealers
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Broker – match buyers and sellers
Dealers – buy and sell securities
Role of secondary markets
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Increase liquidity of financial assets
Determine security prices that help
determine the price of securities in
primary markets
Exchanges and over-the-counter
markets
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Exchange – buyers and sellers meet in
one central location (e.g., NYSE or
Chicago Board of Trade)
Over-the-counter market – transactions
take place in multiple locations through
dealers
Money and capital markets
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Money market – market for short-term
debt instruments
Capital market – market for
intermediate and long-term debt and
equity instruments
International financial markets
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Foreign bond = bond issued by a foreign entity that
is denominated in the currency of the country in
which the bond is sold
Eurobond = bond denominated in a currency other
than that of the country in which the bond is sold
Foreign bonds may be used to avoid exchange-rate
risk
Eurocurrencies – deposits denominated in a currency
other than that of the country in which the bank is
located
London, Tokyo and other foreign stock exchanges
have grown in importance
Financial intermediaries
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Reduce transaction costs (due to
economies of scale and lower
information costs)
Allow for differences in the desired
lending and borrowing time horizons
Risk sharing (asset transformation)
lowers risk through diversification
Asymmetric information
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Moral hazard
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The existence of a contract causes one
party to alter their behavior in a manner
detrimental to the other party
Adverse selection
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Individuals who are willing to accept a
financial (or other) contract are of lower
“quality” than a typical individual in the
population
Asymmetric information:
Adverse selection,and Moral hazard
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse
outcomes are ones most likely to seek loans and be selected
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
Types of financial intermediaries
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Depository institutions
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Commercial banks
Savings and Loan Associations
Mutual savings banks
Credit unions
Contractual savings institutions
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Life insurance companies
Fire and casualty insurance companies
Pension funds and government retirement funds
Finance companies
Mutual funds
Money market mutual funds
Financial Intermediaries
15
Size of Financial Intermediaries
Financial market instruments
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Money market instruments
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United States treasury bills (discounted; no default risk)
Negotiable bank certificates of deposit (NCD; large
denominations)
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Commercial paper (CP; direct finance; largest instrument)
Banker’s acceptances (use abroad in international trade)
Repurchase agreements (repos; <2 wks; need collateral)
Federal funds (overnight loan b/w banks of their deposits
at Fed)
Financial market instruments
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Capital market instruments
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Stocks (largest instruments)
Mortgages (FNMA: Fannie Mae; GNMA: Ginnie Mae; FHLMC:
Freddie Mac)
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Corporate bonds (convertible vs. non-convertible)
US government securities (most liquid security)
US government agency securities
State and local government bonds (municipal bonds;
interest tax free)
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Consumer and bank commercial loans
Regulatory Agencies
19
Regulatory Agencies
20
Regulation of financial markets
Two Main Reasons for Regulation (Financial sector
is one of the most heavily regulated sectors of the economy)
1.Increase information to investors
A. Decreases adverse selection and moral hazard problems
B. SEC forces corporations to disclose information
2.Ensuring the soundness of financial
intermediaries
A. Prevents financial panics
B. Chartering, reporting requirements, restrictions on
assets and activities, deposit insurance, and anticompetitive measures
Types of regulation
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Entry restrictions
Disclosure laws (SEC)
Restriction on assets and activities
Deposit insurance
Limits on competition
Restrictions on interest rates (no longer
in effect)