CHAPTER 2

MARKET PARTICIPANTS AND FINANCIAL INNOVATION

CONTENTS

• ISSUERS AND INVESTORS

• ROLE OF FINANCIAL INDERMEDIARIES

• OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL INSTITUTIONS

• REGULATION OF FINANCIAL MARKETS

• FINANCIAL INNOVATION

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ISSUER AND INVESTORS

• We focus on one particular group of market players, called financial intermediaries, because of the key economic functions they perform in financial markets.

• Regulators

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Cont’d

• Various entities issue financial assets,both debt instruments and equity instruments and various investors purchase these financial assets

• But these two groups are not mutually exclusive.

• It is common for an entity to both issue a financial asset and at the same time invest in a different financial asset.

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CLASSIFICATION OF ENTITIES

Central GovernmentsAgencies of Central GovernmentsMunicipal GovernmentsSupranationalsNonfinancial BusinessesFinancial EnterprisesHouseholds

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• Central governments borrow funds for a wide variety of reasons.Debt obligations issued by central governments carry the full faith and credit of the borrowing government.

• Funds are raised by the issuance of debt obligations called Treasury Securities.

• Two type of government agencies in the USA are Federally Related Institutions and Government Sponsored Enterprises.

• In most countries municipalities raise funds in the capital market.

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• Supranational Institution:is an organization formed by two or more central government through international treaties.

• Two example of supranational institution are International Bank for Reconstruction and Development popularly referred to as World Bank and American Development Bank

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• Businesses are classified into; Nonfinancial Financial Businesses

These entities borrow funds in the debt market and raise funds in the equity market.

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Nonfinancial businesses are the form of three category; Corporations Farms Nonfarms/Noncorporate Business

In the last category businesses produce same products or provide the same services as corporations,but are not incorporated.Financial businesses more popularly referred to as financial institutions provide one or more of the following services:

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Transform financial assets acquired through the market constitute them into a different and more widely preferable type of asset,which becomes their liability.This function is performed by financial intermediaries.(most important type of financial institution)

Exchange financial assets on behalf of consumers.Exchange financial assets on their own account.Assist in the creation of financial assets for their customers

and then sell those financial assets to other market participants.

Provide investment advice to other market participants.Manage the portfolios of other market participants.

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Cont’d• Financial intermediaries include depository

institutions(commercial banks,savings and loan associations) who acquire bulk of their funds by offering their liabilities to the public mostly in form of deposit.Others are discussed another chapters.

• Some subsidiaries of nonfinancial business provide financial services.These financial institutions called captive finance companies.

• Examples of captive finance companies;o General Motor Acceptance Corporations(a subsidiary of

General Motors)o General Electric Credit(a subsidiary of General Electric)

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Role of Financial Intermediaries

• Financial intermediaries play the basic role of the basic role of transforming financial assets that are less desirable for a large part of the public into other financial assets-their own liabilities-which are more widely preferred by the public.This transformation involves at least one of the four economic functions:

I. Providing maturity intermediationII.Risk reduction via diversificationIII.Reducing costs of contracting and information

processingIV.Providing a payments mechanism

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I. Maturity intermediation:by issuing its own financial claims the commercial commercial bank in essence transforms a longer-term asset into a shorter –term one by giving the borrower a loan for length of time sought and the investors/depositor a financial asset for the desired investment horizon.This is called maturity intermediation.

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II. This economic function of financial intermediaries-transforming more risky assets into less risky ones-is called diversification. Even though individual investors can do it on their own,they may not be able to to it as cost effectively as a financial intermediary, depending on the amount of funds they want to invest. Attaining cost effective diversification in order to reduce risk by purchasing the financial assets of a financial intermediary is an important economic benefit for financial markets.

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III. Reducing the cost of contracting and information processing. Investors purchasing financial assets must develop skills necessary to evaluate an investment. Those skills are developed, investors can apply them when analyzing specific financial assets for purchase.

Investors who want to make a loan to a consumer or business need to write loan contract. Although some people may enjoy devoting leisure time to this task, most of us find leisure time to be in short supply and compensation for sacrificing it. The form of compensation could be a higher return obtained from an investment.

In addition to the opportunity cost of time to process the information about the financial asset, the cost of this information

must also be considered. All these costs are information processing costs.

The costs of writing loan contracts are referred to as contracting costs. Another dimension to contracting costs is the

cost of enforcing terms of loan agreement.We have two examples of financial intermediaries as commercial

bank and investment company.

So that, economies of scale can be realized in contracting and processing information because of amount of funds managed

by financial intermediaries.

The lower costs increase to the benefit of investor who purchases asset and the issuer of financial assets.

IV. Providing Payment Mechanism. The previous three economic functions may not be immediately obvious. This last one should be. Most transactions made today are not with cash. Payments are made using checks, credit cards, debit cards and electronic transfers of funds. Financial intermediaries provide these methods for making payments. At one time, noncash payments were restricted to checks. Payment by credit card was also at one time the exclusive domain of commercial banks, but now other depository institutions offer this service. Debit cards are offered by various financial intermediaries.

A debit card differs from a credit card in that a bill sent to credit cardholder periodically (usually once a month) requests payment for transactions

made in the past. With a debit card, funds are immediately withdrawn from the purchaser’s account

at time transaction takes place.

The ability to make payments without cash is critical for financial market. In short, depository

institutions transform assets that cannot be used to make payments into other assets.

OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL

INSTITUTIONSTo understand why managers of financial

institutions invest in particular types of financial assets and types of investment strategies employed.

It is necessary to have a general information of asset/liability problem.

For example, depository institutions seek to generate income by difference between return that

they earn on assets and cost of their funds. This difference is referred to as spread.

THE NATURE OF LIABILITIES

Liability Type Amount of Cash Outlay

Timing of Cash Outlay

Type I Known Known

Type II Known Uncertain

Type III Uncertain Known

Type IV Uncertain Uncertain

TYPE I LIABILITYBoth amount and timing are known. For example,

depository institutions know amount that they are committed to pay on maturity date of a fixed rate deposit,

the depositor does not withdraw funds prior to the maturity date.

TYPE II LIABILITYThe amount of cash outlay is known, but timing of

cash outlay is uncertain. Life insurance policy can be an example for this liability. The most of basic many types of

life insurance policy provides that, for annual premium, this company agrees to make a specified payment to

beneficiaries upon the death of insured.

TYPE III LIABILITYTiming is known, but amount is uncertain, such as

when a financial institution has issued an obligation in which the interest rate adjust based on some interest rate benchmark. Depository institutions, for example, issue

liabilities called certificates of deposit with a stated maturity. The interest rate paid need not to be fixed over

life of deposit but may fluctuate.

TYPE IV LIABILITYBoth amount and timing are uncertain. Home

insurance policy is an example. Whenever damage is done to an insured asset, the amount of payment that must

be made is uncertain.

• The deposit-accepting institution will grant this request, but assess an early withdrawal penalty.

• Certain types of investment companies give shareholders the right to redeem their shares at any time.

• Some life insurance products provide a cash-surrender value that allows the policyholder to exchange the policy for a lump sum payment at specified dates.

• Some life insurance products also offer a loan value.

• In addition to uncertainty about the timing and amount of the cash outlays, and the potential for the depositor or policyholder to withdraw cash early or borrow against a policy, a financial institution is concerned with possible reduction in cash inflows.

• In the case of a depository institution, it means the inability to obtain deposits.

• For insurance companies, it means reduced premiums because of the cancellation of policies.

• For certain types of investment companies, it means not being able to find new buyers for shares.

• In their regulatory capacities,governments greatly influence the development and evolution of financial markets and institutions.

• It is important to realize that governments, issuers, and investors tend to behave interactively and to affect one another’s actions in certain ways.

• The standard explanation or justification for govermental regulation of a market is that the market, will not produce its particular goods or services in an efficient manner and at the lowest possible cost.

• Efficiency and low-cost production are hallmarks of a perfectly competitive at the time and that will not gain that status by itself in the foreseeable future.

• Of course, it is possible that governments may regulate markets that are viewed as competitive currently, but unable to sustain competition, and low-cost production, over the long run.

• A version of this justification for regulation is that the government controls a feature of the economy that the market mechanisms of competition and pricing could not manage without help.

• A short hand expression used by economists to describe the reasons for regulation is market failure.

• The regulatory structure in the United States is largely the result of financial crises that have occurred at various times.Most regulatory mechanisms are the products of the stock market crash of 1929 and the Great Depression in the 1930s.

1. Financial Activity Regulation

2. Disclosure Regulation

3. Regulation of Financial

Institutions

4. Regulation of Foreign

Participants

1. DISCLOSURE REGULATION: It requires issuers of securities to make public a large amount of financial information to actual and potential investors.The standard justification for disclosure rules is that the managers of the issuing firm have more information about the financial health and future of the firm. The cause of market failure here, if indeed it occurs, is commonly described as “asymmetric information” it means investors and managers are subject to uneven access to or uneven possession of information.Also, the problem is said to be one of “agency.”

• The United States is firmly committed to disclosure regulation.The Securities Act of 1933 and the Securities Exchange Act of 1934 led to the creation of the Securities and Exchange Commission (SEC).

• None of the SEC’s requirements or actions constitutes a guarantee, a certification, or an approval of the securities being issued.

• Moreover, the government’s rules do not represent an attempt to prevent the issuance of risky assets.

2. FINANCIAL ACTIVITY REGULATION: It consists of rules about traders of securities and trading on financial markets. A prime example of this form of regulation is the set of rules against trading by insiders who are corporate officers and others in positions to know more about a firm’s prospects than the general investing public. A second example of this type of regulation would be rules regarding the structure and operations of exchanges where securities are traded.

3. REGULATION OF FINANCIAL INSTITUTIONS: Financial institutions help households and firms to save; as depository institutions. They also facilitate the complex payments among many elements of the economy and they serve as conduits for the government’s monetary policy. The U.S. Government imposed an extensive array of regulations on financial institutions.

In recent years, expanded regulations restrict how financial institutions manage their assets and liabilities, in the form of minimum capital requirements for certain regulated institutions. These capital requirements are based on the various types of risk faced by regulated financial institutions and are referred to as risk-based capital requirements.

4. REGULATION OF FOREIGN PARTICIPANTS

Government regulation of foreign participants limits the roles foreign firms can play in domestic markets and their ownership or control of financial institutions. Many countries regulate participation by foreign firms in domestic financial securities markets. Like most countries, the United States reviews and changes it policies regarding foreign firms’ activities in the U.S. financial markets on a regular basis.

FINANCIAL INNOVATION

Regulations that impede the free flow of capital and competition among financial institutions (particularly interest rates ceilings) motivate the development of financial products and trading strategies to get around these restirictions.Through technological advances and the reduction in trade and capital bariers, surplus funds in one country can be shifted more easily to those who need funds in another country. As a result, a need arises for financial products and trading strategies to more efficiently protect against the adverse movements of foreign currencies.

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CATEGORIZATIONS OF FINANCIAL INNOVATION

Market-broadening instruments, which increase the liquidity of markets and the availability of funds by attracting new investors and offering new opportunities for borrowers

Risk management instruments, which reallocate financial risks to those who are less averse to them or who have offsetting exposure, and who are presumably better able to shoulder them.

Artbitraging instruments and processes ,which enable investors and borrowers to take advantage of differences in the perception of risks,as well as in information, taxation, and regulations.

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MOTIVATION FOR FINANCIAL INNOVATION

Two extreme views seek to explain financial innovation. At one extreme are those who believe that the major impetus for innovation comes out of the endeavor to circumvent (or “arbitrage”) regulations and find loopholes in tax rules. At the other extreme are those who hold that the essence of innovation is the introduction of more efficient financial instruments for redistributing risk among market participants.

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MOTIVATION FOR FINANCIAL INNOVATION

If we consider the ultimate causes of financial innovation, the following emerge as the most important:

1.Increased volatility of interest rates,inflation,equity prices and exchange rates.

2.Advances in computer and telecommunication technologies.

3.Greater sophistication and educational training among professional market participants.

4.Financial intermediary competition.5.Incentives to get around existing regulations and tax laws.6.Changing global patterns of financial wealth

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ASSET SECURITIZATION AS A FINANCIAL INNOVATION

Asset securitization means that more than one institution may be involved in lending capital. Consider loans for the purchase of automobiles. A lending scenario can look like this:

1.A commercial bank originates automobile loans.2.The commercial bank issues securities backed by these

loans.3.The commercial bank obtains credit risk insurance for the

pool of loans from a private insurance company.4.The commercial bank sells the right to service the loans to

another company that specializes in the servicing of loans.5.The commercial bank uses the services of securities firm to

distribute the securities to individuals and institutional investors.

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AS A SUMMARY…

Financial innovation increased dramatically since the 1960s, particularly in the late1970s. Although financial innovation can be result of arbitrary regulations and tax rules, innovations that persist after changes in regulations or tax rules, designed to prevent exploitation, are frequently those that offer a more efficient means for redistributing risk.

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