Lesson 1
Money, Securities and
Financial Institutions: An
Introduction
A. An Introduction to Financial
Institutions
• Financial system: a set of procedures, institutions, instruments and
technologies existing to facilitate trade and transactions.
• Financial institutions provide financial services to their clients,
including:
– Services related to transactions,
– Deposits and
– Investments
• Institutions issue financial claims and contracts in primary markets
and trade instruments in secondary markets
• For example, firms issue stock in primary markets through IPOs
(initial public offerings), and these shares are trade in secondary
markets such as the New York Stock Exchange or the Borsa Italiana.
Partial Listing of Financial Institution
Categories
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Depository Institutions
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Investment Institutions
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Pension funds
Hedge funds
Private equity firms
Venture capital firms
Insurance Companies
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Investment banks
Securities firms
Mutual funds
Unregistered Investment Institutions
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Commercial banks
Savings associations
Credit unions
Life Insurers
Property-casualty insurers
Other Institutions
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Governments
Finance Companies
B. An Introduction to Money and
Central Banks
• Money might be defined as anything that is
generally accepted for the payment of goods
and services or in the repayment of debts.
• Money functions as a
– medium of exchange
– unit of account and
– a store of value
Central Banks
• The central bank of a country (in the United
States, the Federal Reserve System, often
referred to as the Fed; in Europe, the
European Central Bank or ECB) typically
conducts the monetary policy on behalf of
that country or currency area.
• In many banks, the central bank also serves as
a financial or banking regulator.
Typical Central Bank Objectives
• Managing monetary policy so as to maintain a
low long-term inflation rate,
• Maintaining a stable and growing real economy
(low unemployment and sustainable growth rate)
and to smooth business cycles and offset shocks
to the economy. Countries do differ in the
responsibility that their central bank assumes for
the real sector.
• Maintaining an effective and efficient payments
system.
Central Bank Policy Mechanisms
• Issue currency
• Set reserve requirements
• Conduct open market operations: Purchasing (selling)
securities increases (reduces) money supply
• Discount window lending: Central banks often play the role
of lender of last resort.
• Intervention in foreign exchange markets, or fix exchange
rates
• Set the overnight rate: The Fed sets the Fed Funds rate
• Capital requirements: Central banks play a central role in
setting capital requirements
• Margin requirements in securities markets
Central Bank Origins
• The Sveriges Riksbank was the first European central bank, established in
1668 .
• In 1694, the Bank of England, was also chartered as a joint stock company.
– Proposed by William Patterson, a Scot-born entrepreneur as an institution to
serve the public good in perpetuity
– Approved by the U.K. Parliament to provide funding to the government.
• These institutions evolved to serve as lenders of last resort, providing for
liquidity in times of poor harvests or war.
• Initially a private response (privately funded with government approval) to
difficulties that arose in banking systems with many small banks (Gorton
and Huang [2001]).
• Much later, in 1800, the Banque de France was established by Napoleon to
stabilize currency, and, again, to make loans to the government finance.
• The Bank of Spain, National Bank of Austria and numerous other European
central banks were founded for similar purposes.
• Central banks also issued their own currencies.
19th Century Central Banking
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The U.K. and the U.S. experienced many banking crises during the 19th century.
After an 1866 U.K. crisis, and following the advice of Walter Bagehot, the Bank of England adopted
a policy of lending to troubled correspondent banks based on collateral and penalty interest rates.
The U.K. remained free of banking panics from 1866 until 2007.
After two early attempts at chartering and maintaining central banks, with the Bank of the United
States (1791-1811) and the Second Bank of the United States (1816-1836), the U.S. Federal Reserve
System was established in 1913, largely in response to the severe U.S. Banking Panic of 1907. The
interims between the central banks were characterized by significant numbers of banking crises.
Gorton and Huang [2001] note that before establishment of the U.S. Fed, banks formed co-insurance
coalitions issuing "clearinghouse loan certificates" during banking panics. These certificates were a
sort of private currency for which all coalition members were jointly responsible.
This system of co-insurance was the precursor to the modern discount window.
The system led to banks monitoring fellow coalition members, setting the stage for central bank
monitoring.
During the panics of 1893 and 1907, these certificates were issued directly to bank depositors, again,
as a sort of private currency.
These 19th century U.S. coalitions or clearinghouses originated as interbank payments systems.
The Federal Reserve System
• The Federal Reserve System (the Fed) was established
in 1913 as the Central Bank of the United States.
• Its principal responsibility is setting monetary policy for
the United States.
• The Fed's conduct of monetary policy is intended to
promote price stability, full employment, balanced
economic growth and stability in exchange rates.
• The Fed maintains regulatory authority over most
commercial banks, particularly with respect to issues
that might affect the stability of the banking system.
The European Central Bank
• The European Central Bank (ECB), headquartered in Frankfurt was
established by the Treaty of Amsterdam in 1998 as the central bank of the
Eurozone (the 19 EU members that adopted the euro as their official
currency).
• Its stock, totaling roughly €5 billion, is held by the 28 member EU states.
• Its principle mandate is to maintain price stability.
• Its primary responsibility is setting monetary policy for the Eurozone.
• Through its Single Supervisory Mechanism (SSM), the ECB maintains
regulatory authority over the largest 123 Euro area banks, accounting for
approximately 85 of the area's aggregate banking assets.
• The majority of European banks are still monitored by national supervisory
bodies such as the Deutsche Bundesbank and non-Eurozone EU country
banks are exempt from participation.
• More generally, the Eurosystem, comprised of the ECB and Member States
central banks seek to safeguard financial stability and promote European
financial integration
C. Key International Banking and
Financial Institutions
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The International Monetary Fund
The World Bank
– International Development Association (IDA) which finances low profitability projects at easy
terms with government guarantees.
– International Finance Corporation (IFC) which finances projects in private sector without
government guarantees. The IFC sometimes participates in equity of these projects.
– The Multilateral Investment Guarantee Agency (MIGA), which promotes foreign direct
investment into developing countries and
– The International Center for Settlement of Investment Disputes (ICSID).
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Regional Development Banks
The Bank for International Settlements
– The Bank for International Settlements (BIS) was founded as a result of the Hague agreement
of 1930 to facilitate Germany’s payments of reparations for World War I.
– Since WWI, the BIS has evolved into a sort of “bank for central banks,” providing for regulation
and supervision of central banks and commercial banks, fostering transparency and
coordination among central banks and promoting monetary and financial stability.
– The BIS is headquartered in Switzerland, where it has hosted important banking treaties,
including the Basel I and II Capital Accords that, among other things, set standards for bank
risk management.
D. An Introduction to Financial
Intermediation
• A major purpose of the financial system is to
channel funds from agents with surpluses to
agents with deficits.
• A financial facilitator acts as a broker without
transforming those assets.
• Money markets vs. capital markets: investors
their surpluses directly to deficit firms, creating
marketable securities and instruments
• A financial intermediary can facilitate this
channeling process from surplus to deficit agents
by transforming assets.
Financial Transformation
• Preferred terms can be affected by
transformations to contractual terms:
– Maturity transformation
– Risk transformation
– Size transformation
Functions of Financial Intermediaries
(Bhattacharya and Thakor [1993])
Services Provided
Brokerage
Financial
Intermediary
Transactions services (e.g., check-writing, buying/selling securities,
safekeeping)
Financial advice (e.g., advice on where to invest, portfolio
management)
Screening and certification (e.g., bond ratings)
Origination (e.g., originating a loan to a borrower)
Issuance (e.g., taking a security offering to the market)
Miscellaneous (e.g., trust services)
Qualitative
Major Attributes Modified
Term to maturity (e.g., bank financing assets with longer maturity than
Asset
Transformation liabilities)
Divisibility (e.g., a mutual fund holding assets with larger unit size
than its liabilities)
Liquidity (e.g., a bank funding illiquid loans with liquid liabilities
Credit risk (e.g., a bank monitoring a borrower to reduce default risk)
Figure 1: Functions of Financial Intermediaries (Bhattacharya and Thakor [1993])
Why do Financial Intermediaries
Exist?
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Transactions Costs (Benston and Smith [1976])
Delegated Monitoring (Diamond [1994])
Providers of Liquidity
Resolving Problems Related to Incomplete
Markets and Asymmetry of Information
Transactions Costs (Benston and
Smith [1976])
• Financial intermediaries reduce the costs of
transacting by engaging in a variety of
services, ranging from brokering to asset
transformation.
• Scale economies and diversification are key
factors leading to transactions costs reduction
(e.g., .NYSE, dealers).
Delegated Monitoring (Diamond
[1994])
• Banks monitor firms to which they extend financing. Banks take significant
stakes in the firms that they monitor, justifying their roles in corporate
governance, and can maintain flexibility to renegotiate loans when
necessary.
• Securities sold to widely dispersed public investors do not normally lead to
comparable monitoring, governance and renegotiating activities.
• Banks acquire private information in the loan application and screening
process.
• Banks often hold demand deposits of their client borrowers, providing
them with further special information concerning their clients.
• Banks often maintain long-term relationships with their client borrowers.
• Typical bank monitoring activities include:
– Screening bad loan applications from good.
– Evaluating borrower creditworthiness. Again, development of expertise is key.
– Observing the extent to which borrowers adhere
Providers of Liquidity:
Diamond and Dybvig [1983]
• A central role of a bank is to create and enhance liquidity. Banks do so by
financing illiquid assets with more liquid liabilities. Bank liabilities,
particularly demand deposits, which function as a medium of exchange, as
do other services such as credit cards and provisions of ATMs.
• Diamond and Dybvig [1983] describe how agents deposit their
endowments in interest-bearing bank claims that enable them to finance
future, perhaps unanticipated consumption needs. Such deposits enhance
consumption flexibility and increases utility of consumption.
• Alternatively, agents could have invested their endowments in illiquid
production technologies, where higher than anticipated consumption
needs in earlier periods force them to liquidate investments too early,
reducing overall consumption.
• In effect, the deposit serves as an insurance contract against the costs of
unanticipated consumption in earlier periods.
Resolving Problems Related to
Incomplete Markets and Asymmetry
of
Information
• Resolving Problems Related to Incomplete Markets and Asymmetry
of Information: In complete capital markets, financial intermediaries
would not be needed to transform the attributes of securities.
Further, information asymmetries can lead to moral hazard and
adverse selection, which inhibit the channeling of funds from
surplus to deficit agents. Banks contribute to funding efficiency by
engaging in activities that mitigate these information problems:
• Banks enjoy scale economies that enable them to more efficiently
obtain information and share (signal) that information among
members of lending coalitions (loan syndicates ). Asset
diversification is realized from the scale economies.
• Banks monitor their borrowers
• Banks provide capital seek long-term financial relationships. Such
long-term relationships (commitments) enable banks to execute
contracts in the absence of complete contracts and markets.
E. Corporate Securities as Options and
Capital Structure
𝑐𝑇 = 𝑀𝐴𝑋 0, 𝑆𝑇 − 𝑋
𝑝𝑇 = 𝑀𝐴𝑋 0, 𝑋 − 𝑆𝑇
S0

c0

Xe
 rf T
 p0

Black-Scholes
(I)
(II)
(III)
c0  S 0 N d1  
X
e
rf T
N d 2 
1
S  

ln  0    r f   2 T
X
2 

d1   
 T
d 2  d1   T
Black-Scholes in a Corporate
Context: Illustration
S0 = $200
X = $190
T=2
rf = 4%
σ = .8
1
 200  

ln 

.
04

 .82   2
 
190  
2

d1  
 0.682; N (d1 )  .752
.8 2
d 2  0.682  .8 2  .4496; N (d 2 )  .326
Equity Value  c0  200  .752 
190
 .326  93.196
.042
e
F. The Principal-Agent Problem
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The agency problem arises in environments exhibiting incomplete information
availability or information asymmetries.
Generally, agency theory is concerned with the efforts of a principal attempting to
induce an agent to undertake some costly action on behalf of the principal.
The principal’s problem is to design an incentive scheme to induce the agent to
make the best and most productive effort on his behalf.
Jensen and Smith [1985] suggest that there are three primary potential sources of
conflict between managers and shareholders:
– Managerial effort: Broadly defined, effort includes non-pecuniary benefits (e.g., the corporate
jet), shirking (e.g., not undertaking the unpleasant task of firing unproductive employees),
empire-building), etc.
– Human capital: Risk associated with firm-specific human capital cannot be diversified away.
– Time horizons: Shareholders are perpetual stakeholders; manager tenures are limited.
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The shareholder problem is to induce the management team to act in shareholder
interests.
G. Moral Hazard
• Moral hazard originally referred to the
tendency of insured individuals to reduce their
efforts to avoid or mitigate insured losses.
• More generally, moral hazard is postcontractual opportunism where the actions of
one contracting party are not freely
observable. Moral hazard is a problem of
hidden action.
H. Contracting
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Contract theory is concerned with how agents design construct contracts.
Typically, contracting occurs in environments with asymmetric information
availability, though contracting would be simpler with perfect or at least symmetric
information availability.
A complete contract fully specifies all parties’ rights, payoffs and responsibilities
under every contingency for every point in time.
Bounded rationality exists where contingencies cannot all be accounted for, when
individuals cannot properly analyze all their potential strategies and actions or
when communication is imperfect.
Mechanisms to deal with bounded rationality.:
– Relational contracting: frames the relationship among contracting parties, focusing on goals,
objectives and procedures for dealing with unforeseen contingencies rather than attempting
to fully pre-specify all rights and responsibilities under all circumstances.
– Contract law can be enacted to facilitate the efforts of contracting parties to maximize the
joint gains (the “contractual surplus”) from their transactions.
– Implicit contracts are unarticulated shared expectations shared among contracting parties.
The Hold-up Problem
• Klein, Crawford and Alchian (1978) characterize a scenario involving postcontractual opportunism where a transaction requires one agent to make
a relationship-specific investment.
• Since complete contracts are not possible in this scenario, the second
agent might be able to exploit the first’s investment to extract gains.
• Consider General Motors and Fisher Body in the 1920s, it was resolved by
Fisher Body’s vertical integration into General Motors.
• Mergers between potentially competing firms at different stages of the
production process can align incentives and prevent the hold-up problem.
• Actually, Williamson (1985) points out that the ex-ante commitment might
merely be the selection of a partner, policy implementation any other
activity that imposes an opportunity cost or limits the partner’s options.
The initial commitment to a partner might represent a sunk cost, perhaps
sufficient to prevent the hold-up problem.
I. Adverse Selection and Lemons
Markets
• Adverse selection originally referred to the
tendency of higher risk individuals to seek
insurance coverage.
• More generally, adverse selection refers to
pre-contractual opportunism where one
contracting party uses her private information
to the other counterparty’s disadvantage.
• The Lemons Problem (Akerlof)