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Chapter 2: An Overview of the Financial System

Chapter 2: An Overview of the Financial System. Classifying Financial Markets Financial Market Instruments Financial Intermediaries Regulation. I. Classification Debt vs. Equity Markets. debt security cash flows are fixed bonds, loans equity security cash flow variable, residual

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Chapter 2: An Overview of the Financial System

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  1. Chapter 2: An Overview of the Financial System • Classifying Financial Markets • Financial Market Instruments • Financial Intermediaries • Regulation

  2. I. ClassificationDebt vs. Equity Markets • debt security • cash flows are fixed • bonds, loans • equity security • cash flow variable, residual • common stock

  3. Primary vs. Secondary Markets • primary market • newly issued securities -- investment banking • secondary market • brokers match buyers and sellers • dealers act as buyers and sellers -- “market-makers”

  4. Exchanges vs. OTC Markets • exchange • buying & selling of securities in physical location • NYSE • OTC (over-the-counter) • dealers in many locations buy & sell securities

  5. Money vs. Capital Markets • money market • short-term debt securities (up to 1 yr.) • highly liquid, low risk • capital market • longer-term debt • equity

  6. II. Financial Market Instruments a security or financial instrument = claim on future income or assets of issuer a security is an asset for the buyer, but a liability for the issuer

  7. example • shares of stock in Time Warner, Inc. • shares of ownership in TW • a claim on the earnings/assets of TW • a liability for Time Warner • an asset for me

  8. my mortgage • I am the issuer (liability) • the bank is the buyer/holder (asset) • the bank has a claim on my house

  9. III. Financial Intermediaries Why have them? • Transactions costs • search costs to find borrower & lender • contract costs • economies of scale

  10. Risk sharing • intermediaries are experts at bearing risk • asset transformation

  11. Asymmetric Information • one party has more info than the other • creates problems BEFORE loan is made • creates problems AFTER loan is made • financial intermediaries minimize these problems

  12. adverse selection • BEFORE the loan • people with worst credit are more likely to seek a loan • lending not attractive • solution? • banks expert at assessing credit risks

  13. moral hazard • AFTER the loan • once money is lent, borrower may blow the money • solution • banks monitor borrowers and enforce lending contracts

  14. Types of intermediaries Depository institutions • “banks” • accept deposits, make loans

  15. Commercial banks • largest in total assets • Savings & Loans • originally restricting to savings deposits and mortgages • less restricted today • Credit Unions • consumer loans • nonprofit • organized around a group

  16. Contractual savings institutions • acquire funds through payments in return for obligations • life insurance • property and casualty insurance • pension funds

  17. Investment intermediaries • indirect investment • finance companies • issue commercial paper • consumer & commercial loans • mutual funds • sell shares to stock/bond portfolios • taken away bank business in past 30 years

  18. money market mutual funds • money market portfolio • shares = $1, pay dividends • check writing privileges

  19. IV. Regulation • Reducing asymmetry of info • disclosure of financial information -- by companies selling securities -- by financial institutions • restrict insider trading

  20. promoting stability • prevent financial panic -- markets cease to function • financial institutions -- restrict ownership -- restrict activities -- insurance on deposits

  21. controlling the money supply • Federal Reserve System

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