chapter 2 overview of the financial system

8/2/2019 Chapter 2 Overview of the Financial System

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OVERVIEW OF THE

FINANCIAL SYSTEMChapter #2by;

Sajad Ahmad



Money Market Instruments

Money market instruments are, short-term debt instruments withmaturities less than one year.

• The principal money market instruments are:

•

Treasury Bills• Negotiable Bank Certificates of Deposit

• Commercial Paper

• Banker’s Acceptances

• Repurchase Agreements



Three BasicCharacteristics

• 1. They are usually sold in largedenominations

• 2. They have low default risk

• 3. They mature in one year or lessfrom their original issue date. Most ofthe instruments mature in less than120 days



The Purpose of the MoneyMarkets

• The investors use the markets as aninterim investment that provides a

higher return than holding cash ormoney in banks.

• The money markets provide means to

invest idle funds and to reduce theopportunity cost.



What is an opportunity cost?

• An opportunity cost represents what someonemust give up in order to attain something else.

• For example, If a CD costs $15 and a cup

costs $1, the opportunity cost for the CD is 15cups. You must give up the purchasing powerof 15 cups to buy one CD.

• or

• Opportunity cost is the cost incurred(sacrifice) by choosing one option over thenext best alternative.

http://answers.ask.com/Business/Finance/what_is_an_opportunity_cost

http://answers.ask.com/Business/Finance/what_is_an_opportunity_cost



Treasury Bills

• Issued by the Government.

• Currently issued with maturities of 1, 3, and 6 months.

• Pay a fixed amount at maturity.

• Make no regular interest payments, but sell at a discount.

• Example: A Treasury bill that pays off $1000 at maturity 6 monthsfrom now sells for $950 today. The $50 difference between thepurchase price and the amount paid at maturity is the interest on theloan.

• Are the safest of all money market instruments, since it is very

unlikely that the Government will go bankrupt.



Negotiable Certificates of Deposit(CDs)

• Issued by banks.

• Make regular interest payments until maturity.At maturity, return the original purchase price.

• Large CDs, with value over $100,000, trade on asecondary market.“Negotiable” means that the CD trades on a

secondary market.



Commercial Paper

• These are unsecured promissory notes,issued by corporations, that mature in nomore than 270 days. Only the largest andmost creditworthy corporations issuecommercial paper

• Make no interest payments, but sell at adiscount. Trade on a secondary market.



Banker’s Acceptances

• Bank draft (like a check) issued by a firm andpayable at some future date.

• Stamped “accepted” by the firm’s bank, which

then guarantees that it will be paid. Often arise inthe process of international trade, to financegoods that have not yet been transferred from the

seller to the buyer• Make no interest payments, but sell at a discount.

Trade on a secondary market.



Repurchase Agreements

• Repurchase Agreement is an agreement whereby the firmagrees to buy back the securities at a specified futuredate.

•

Very short-term loans, with Treasury bills as collateral,between a non-bank corporation as the lender and a bankas the borrower.

• Most repos have a very short-term, the most common

being for 3 to 14 days.



• Non-bank corporation buys the Treasurybill from the bank.

•

Simultaneously, the bank agrees torepurchase the Treasury bill later at aslightly higher price.

•

The difference between the original priceand the repurchase price is the interest.



Capital Market Instruments

• The securities baught and sold on Capital Market are called CapitalMarket Instruments. Or

• Long-term debt instruments, or equities.

• The principal capital market instruments are:

• Corporate Stocks

• Mortgages (Residential, Commercial, and Farm)

• Corporate Bonds

• US Government Securities (Intermediate and Long-Term)

• State and Local Government (Municipal) Bonds

• Bank Commercial and Consumer Loans



Corporate Stocks

• Equity claims to the income and assets ofcorporations.



Mortgages (Residential,Commercial, and Farm)

intermediate-term debt

Loans to individuals and firms used to purchaseland, houses, and other structures. The land or

structure then serves as collateral.

• The mortgage market is the biggest debt marketin the US.

• Secondary markets for mortgages first developedin the 1970s and 1980s and are now quite largeand active.



Corporate Bonds

• Intermediate and long-term debtInstruments issued by corporations.

•

Usually make regular interest paymentstwice per year.

• Return a fixed amount (face value) at

maturity.



US Government Securities

• Treasury Notes = Currently issued withmaturities of 2, 5, and 10 years; henceintermediate-term debt instruments.

• Treasury Bonds = Before October 2001, issuedwith maturity of 30 years; hence long-term debt.

• In October 2001, the US Treasury stopped

issuing 30-year bonds, making the 10-year• Make regular interest payments twice per year

and return a fixed amount at maturity.



State and Local Government(Municipal) Bonds

• Intermediate and long-term debt issued bystate and local governments.

•

Interest payments are exempt from federalincome taxes, making municipal bondsespecially attractive to some investors.



Commercial and ConsumerLoans

• Loans, originally made by banks, tobusinesses and households.Secondary markets for these loans are onlynow just developing.



Function of FinancialIntermediaries: Indirect Finance

We now turn our attention to indirect finance.



Function of FinancialIntermediaries : Indirect Finance

Instead of savers lending/investingdirectly with borrowers, a financialintermediary (such as a bank) plays as

the middleman:• the intermediary obtains funds from

savers

• the intermediary then makesloans/investments with borrowers




• This process, called financialintermediation, is actually the primarymeans of moving funds from lenders to

borrowers.

• More important source of finance thansecurities markets (such as stocks)

• Needed because of transactions costs, risksharing, and asymmetric information.




• Transactions Costs:• “The time and money spent in carrying out financial

transactions is called transaction costs”.

• Financial intermediaries help reduce transaction costs bytaking advantage of economies of scale.

• What is Economies of scale?

• Economies of scale, refers to the cost advantages that a

business obtains due to expansion.

• Example: a bank can use the same loan contract again andagain, thereby reducing the costs of making each individualloan.




• A financial intermediary’s low transaction costs

mean that it can provide its customers withliquidity services, services that make it easier

for customers to conduct transactions1. Banks provide depositors with checking accounts

that enable them to pay their bills easily

2. Depositors can earn interest on checking andsavings accounts and yet still convert them intogoods and services whenever necessary



Global Perspective

• Studies show that firms in the U.S., Canada, theU.K., and other developed nations usuallyobtain funds from financial intermediaries, not

directly from capital markets.• In Germany and Japan, financing from financial

intermediaries exceeds capital market financing

10-fold.




• Risk Sharing and Diversification

• Risk = uncertainty about the returns investors will receive onany particular asset.

•

By purchasing a large number of different assets issued by awide range of borrowers, financial intermediaries usediversification to help with risk sharing.

• Example: by lending to a large number of different businesses,a bank might see a few of its loans go bad; but most of the

loans will be repaid, making the overall return less risky.• Here, again, the bank is taking advantage of economies of

scale, since it would be difficult for a smaller investor to make alarge number of loans.



Asymmetric Information

• Another reason FIs exist is to reduce theimpact of asymmetric information.

•

One party lacks crucial information aboutanother party, impacting decision-making.

• We usually discuss this problem along two

fronts: adverse selection and moral hazard.




• Adverse Selection and Moral Hazard• Financial intermediaries also use their expertise to screen out bad

credit risks and monitor borrowers.

•

They thereby help solve two problems related to imperfect informationin financial markets.

• Adverse Selection = refers to the problem that arises before a loan ismade because borrowers who are bad credit risks tend to be thosewho most actively seek out loans.

• Financial intermediaries can help solve this problem by gatheringinformation about potential borrowers and screening out bad creditrisks.




• Moral Hazard = refers to the problem thatarises after a loan is made becauseborrowers may use their fundsirresponsibly.

• Financial intermediaries can help solve thisproblem by monitoring borrowers’ activities.



Asymmetric Information:Adverse Selection and Moral Hazard

• Financial intermediaries reduce adverseselection and moral hazard problems,enabling them to make profits. How theydo this is the covered in many of thechapters to come.



Types of Financial Intermediaries



Types of Financial Intermediaries

• Depository Institutions (Banks):

• Commercial Banks

• Savings and Loan Associations

• Mutual Savings Banks

• Credit Unions

•

Contractual Savings Institutions• Life Insurance Companies

• Fire and Casualty Insurance Companies

• Pension Funds

• Investment Intermediaries

• Finance Companies

• Mutual Funds

• Money Market Mutual Funds

• Investment Banks



Depository Institutions (Banks)

• Depository Institutions (Banks): accept deposits and make loans.These include commercial banks and thrifts.

• What is thrift?

• An organization formed for the purpose of holding deposits for

individuals. E.g Saving &Loan Associations, Mutual Savings Banksand Credit Unions

• Depository institutions as a group:

• Accept (issue) deposits, which then become their liabilities.

• Make loans, which then become their assets.




• Commercial banks

• Sources of funds (liabilities): issue deposits

• Checking deposits = provide check-writing privileges.

•

Savings deposits = do not provide check-writing privileges, but allowfunds to be withdrawn at any time.

• Time deposits = require that funds be deposited for a fixed period oftime, with penalty for early withdrawal.

• Uses of funds (assets): make commercial, consumer, and mortgage

loans, buy US Government and municipal bonds.




• Savings and Loan Associations(S&Ls):

•Sources of funds: issue deposits.

• Uses of funds: make loans, mainlymortgage loans.




• Mutual Savings Banks:

• Like S&Ls, but structured as “mutuals,”

meaning that the depositors own the bank.Sources of funds: issue deposits.

• Uses of funds: make loans, mainly

mortgage loans.




• Credit Unions:

• Set up to serve small groups: union

members, employees of a particular firm,etc. Sources of funds: issue deposits

• Uses of funds: make loans, mainly

consumer loans.

Difference Commercial Banks and



Difference Commercial Banks andThrifts

• Collectively, savings and loan associations, mutual savings banks,and credit unions are called thrift institutions.

• The distinctions between commercial banks and thrift institutions aremainly historical and have blurred over the years.

• Example: before 1980, thrift institutions were not permitted to issuechecking deposits.S&Ls and mutual savings banks were not allowed to make consumerloans, and credit unions were not allowed to make mortgage loans.

C t t l S i



Contractual SavingsInstitutions (CSIs)

• All CSIs acquire funds from clients at periodicintervals on a contractual basis and have fairlypredictable future payout requirements.

–

Life Insurance Companies receive funds from policypremiums, can invest in less liquid corporate securitiesand mortgages, since actual benefit pay outs are closeto those predicted by actuarial analysis

– Fire and Casualty Insurance Companies receive

funds from policy premiums, must invest most in liquidgovernment and corporate securities, since loss eventsare harder to predict

C t t l S i



Contractual SavingsInstitutions (CSIs)

• All CSIs acquire funds from clients at periodicintervals on a contractual basis and have fairlypredictable future payout requirements.

– Pension and Government Retirement Funds hostedby corporations and state and local governmentsacquire funds through employee and employer payrollcontributions, invest in corporate securities, and

provide retirement income via annuities



Investment Intermediaries

• Finance Companies sell commercial paper (ashort-term debt instrument) and issue bonds andstocks to raise funds to lend to consumers to buydurable goods, and to small businesses foroperations

• Example: Ford Motor Credit sells commercialpaper and bonds and uses the proceeds to make

loans to people who buy Ford cars and trucks.




• Mutual Funds acquire funds by sellingshares to individual investors and use theproceeds to purchase large, diversified

portfolios of stocks and bonds




• Money Market Mutual Funds acquire funds byselling checkable deposit-like shares to individualinvestors and use the proceeds to purchase

highly liquid and safe short-term money marketinstruments

• Investment Banks advise companies onsecurities to issue, underwriting security

offerings, offer Merger and Acquisition (M&A)assistance, and act as dealers in securitymarkets.



Regulatory Agencies



Regulation of Financial Markets

• Main Reasons for Regulation

1. Increase Information to Investors

2. Ensure the Soundness of FinancialIntermediaries

Regulation Reason:



Regulation Reason:Increase Investor Information

• Asymmetric information in financial markets means thatinvestors may be subject to adverse selection and moralhazard problems that may hinder the efficient operation offinancial markets and may also keep investors away from

financial markets• The Securities and Exchange Commission (SEC) requires

corporations issuing securities to disclose certaininformation about their sales, assets, and earnings to the

public and restricts trading by the largest stockholders(known as insiders) in the corporation

Regulation Reason:



Regulation Reason:Increase Investor Information

• Such government regulation can reduce adverseselection and moral hazard problems in financial marketsand increase their efficiency by increasing the amount ofinformation available to investors. Indeed, the SEC has

been particularly active recently in pursuing illegal insidertrading.

Regulation Reason: Ensure Soundness



Regulation Reason: Ensure Soundnessof Financial Intermediaries

• Providers of funds to financial intermediaries maynot be able to assess whether the institutionsholding their funds are sound or not.

•

If they have doubts about the overall health offinancial intermediaries, they may want to pulltheir funds out of both sound and unsoundinstitutions, with the possible outcome of a

financial panic.• Such panics produces large losses for the public

and causes serious damage to the economy.

Regulation Reason: Ensure Soundness



Regulation Reason: Ensure Soundnessof Financial Intermediaries (cont.)

• To protect the public and the economy fromfinancial panics, the government hasimplemented six types of regulations:

–

Restrictions on Entry – Disclosure

– Restrictions on Assets and Activities

– Deposit Insurance

– Limits on Competition

– Restrictions on Interest Rates



Regulation: Restriction on Entry

• Restrictions on Entry

– Regulators have created very tight regulations as towho is allowed to set up a financial intermediary

– Individuals or groups that want to establish afinancial intermediary, such as a bank or an insurancecompany, must obtain a charter from the state or thefederal government

– Only if they are upstanding citizens with impeccable(faultless) credentials and a large amount of initialfunds will they be given a charter.



Regulation: Disclosure

• Disclosure Requirements

• There are stringent reporting requirements forfinancial intermediaries

– Their bookkeeping must follow certain strict principles,

– Their books are subject to periodic inspection,

– They must make certain information available to

the public.

Regulation: Restriction on Assets and



Regulation: Restriction on Assets andActivities

• There are restrictions on what financialintermediaries are allowed to do and what assetsthey can hold

• Before you put your funds into a bank or someother such institution, you would want to knowthat your funds are safe and that the bank or

other financial intermediary will be able to meetits obligations to you

Regulation: Restriction on Assets and



Regulation: Restriction on Assets andActivities

– One way of doing this is to restrict the financialintermediary from engaging in certain riskyactivities

– Another way is to restrict financialintermediaries from holding certain riskyassets, or at least from holding a greaterquantity of these risky assets than is prudent



Regulation: Deposit Insurance

• The government can insure people depositors toa financial intermediary from any financial loss ifthe financial intermediary should fail

• The Federal Deposit Insurance Corporation(FDIC) insures each depositor at a commercialbank or mutual savings bank up to a loss of$100,000 per account.



Regulation: Deposit Insurance

• Similar government agencies exist for otherdepository institutions:

– The National Credit Union Share Insurance Fund

(NCUSIF) provides insurance for credit unions



Regulation: Past Restrictions



Regulation: Past Restrictionson Interest Rates

• Competition has also been inhibited (prevented)by regulations that impose restrictions on interestrates that can be paid on deposits

•

These regulations were instituted because of thewidespread belief that unrestricted interest-ratecompetition helped encourage bank failuresduring the Great Depression

• Later evidence does not seem to support thisview, and restrictions on interest rates havebeen abolished

Regulation Reason: Improve Monetary



Regulation Reason: Improve MonetaryControl

• Because banks play a very important role in determiningthe supply of money (which in turn affects many aspectsof the economy), much regulation of these financialintermediaries is intended to improve control over the

money supply• One such regulation is reserve requirements, which

make it obligatory for all depository institutions to keep acertain fraction of their deposits in accounts with the DAAFGHANISTAN BANK , the central bank of Afghanistan.

• Reserve requirements help the Da Afghanistan Bankexercise more precise control over the money supply

Fi i l R l i Ab d



Financial Regulation Abroad

• Those countries with similar economic systemsalso implement financial regulation consistentwith the U.S. model: Japan, Canada, and

Western Europe – Financial reporting for corporations is required

– Financial intermediaries are heavily regulated

•

However, U.S. banks are more regulated alongdimensions of branching and services than theirforeign counterparts.

F i f Fi i l M k



Function of Financial Markets

• Channels funds from person or businesswithout investment opportunities (i.e.,“Lender -Savers”) to one who has them (i.e.,

“Borrower -Spenders”)

• Improves economic efficiency

Fi i l M k F d T f



Financial Markets Funds Transferees

Lender-Savers

1. Households

2. Business firms

3. Government

4. Foreigners

Borrower-Spenders

1. Business firms

2. Government

3. Households

4. Foreigners

S t f Fi i l M k t



Segments of Financial Markets

1. Direct Finance• Borrowers borrow directly from lenders in financial

markets by selling financial instruments which areclaims on the borrower’s future income or assets

2. Indirect Finance• Borrowers borrow indirectly from lenders via financial

intermediaries (established to source both loanable

funds and loan opportunities) by issuing financialinstruments which are claims on the borrower’s futureincome or assets

F ti f Fi i l M k t



Function of Financial Markets

I t f Fi i l M k t



Importance of Financial Markets

• This is important. For example, if you save$1,000, but there are no financial markets,then you can earn no return on this – might

as well put the money under your mattress.

• However, if a carpenter could use thatmoney to buy a new tool (increasing her

productivity), then she’d be willing to payyou some interest for the use of the funds.

I t f Fi i l M k t



Importance of Financial Markets

• Financial markets are critical for producingan efficient allocation of capital, allowingfunds to move from people who lack

productive investment opportunities topeople who have them.

• Financial markets also improve the well-

being of consumers, allowing them to timetheir purchases better.

St t f Fi i l M k t



Structure of Financial Markets

It helps to define financial markets along avariety of dimensions....

St t f Fi i l M k t




1. Debt Markets

– Short-Term (maturity < 1 year)

– Long-Term (maturity > 1 year)

2. Equity Markets – Pay dividends, forever

– Represents an ownership claim in the firm

St t f Fi i l M k t




1. Primary Market

– New security issues sold to initial buyers

– Typically involves an investment bank whounderwrites the offering

2. Secondary Market

– Securities previously issued are boughtand sold

– Examples include the NYSE and Nasdaq

– Involves both brokers and dealers (do you know thedifference?)

Brokers and Dealers



Brokers and Dealers

• Brokers:

• facilitate secondary-market transactions bymatching buyers with sellers.

• Dealers:

• facilitate secondary-market transactions by

standing ready to buy and sell securities.





Even though firms don’t get any money,

from the secondary market, it serves twoimportant functions:

• Provide liquidity, making it easy to buyand sell the securities of the companies

• Establish a price for the securities





We can further classify secondary markets as follows:

1. Exchanges

– Trades conducted in central locations

(e.g., New York Stock Exchange)2. Over-the-Counter Markets

– Dealers at different locations trade via computer andtelephone networks.

• Examples: NASDAQ (National Association of SecuritiesDealers’ Automated Quotation System); US Government

bond market.

Classifications of Financial Markets



Classifications of Financial Markets

We can also further classify markets bythe maturity of the securities:

1. Money Market: Short-Term (maturity < 1

year)

2. Capital Market : Long-Term (maturity > 1year) plus equities

chapter 2 overview of the financial system

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