lecture1-money and finance

Reading for this presentationIntroduction

The Financial System and Its RoleLenders and BorrowersWealth arrangement

Roles of Financial MarketsClassi�cation of �nancial markets

Financial IntermediariesSummary

ES20070 Money and FinanceFinancial System

A. H. Ahmad

University of BathDepartment of EconomicsRoom 3E4.10, Ext [email protected]

Ahmad Financial System





Reading for this lecture

Howells and Bain, EMBF, Ch. 1

Howells and Bain, FMI, Ch. 1

Pilbeam, FFM, Ch. 2

Blake, FMA, Ch. 1






Introduction

In this lecture, we shall see:

- What a �nancial system consists of- Who uses it and for what purposes- The distinctive features of �nancial institutions- Why the performance of the �nancial system isrelevant to the rest of the economy

- How �nancial systems may be classi�ed






The Financial System

The Financial System and Its Role

What is a �nancial system?

A �nancial system consist of:

- A set of �nancial institutions (banks, insurance,etc.)

- A set of �nancial markets (equities, bonds, etc.)- The regulatory bodies (central bank, FinancialServices Authority, etc.)

- the end users:

. de�cits�units (borrowers)

. surplus�units (lenders)








The �nancial system provides:1. �Intermediation�between surplus and de�citunits

2. Range of services like insurance, pensions, fundmanagement

3. A payments mechanism4. Portfolio adjustment facilities.

Financial markets are mainly concerned with 1 + 4, in otherwords:

- They facilitate borrowing and lending and- They help savers to achieve their optimumwealth �portfolios�.






The options for lenders and borrowersContrasting interests of lenders and borrowersHow do markets help?Primary and Secondary MarketsIf No Secondary Markets ExistSecurities in secondary markets exceeds value of new issues in primary marketsWithout well-functioning markets

Lenders and Borrowers

Table 1 summarises who constitute borrowers and lenderswithin the economy.

Table 1: Lenders and Borrowers

Lenders-savers Borrowers1. Households Business �rms2. Business �rms Government3. Government Households4. Foreigners Foreigners







The Financial SystemThe options for lenders and borrowers

Figure 1.The options for lenders and borrowers







The Financial SystemThe options for lenders and borrowers: An Example

Suppose you have £ 500 to lend. Would you prefer:

1. To lend to someone who replied to youradvertisement on the notice board, or

2. Put it in a building society account, and why?

Most people would prefer (2) because:

i. It saves advertisingii. There is very little riskiii. They can get the £ 500 back on demand.







Borrowing and lending: Borrowers and lenders havecon�icting requirements

Borrowers and lenders have con�icting requirements.Borrowers prefer:

Long loanMinimum costMinimum risk

Lenders prefer:

Liquidity (ability to retrieve funds quickly for aknown value)Maximum returnMinimum risk







Borrowing and lending

It is often said that lenders are:

- rational- risk-averse- wealth maximisers

Therefore, they want:

- The maximum return for any given level of risk,or

- The minimum risk for any given rate of return

A portfolio which meets these conditions is an e¢ cientportfolio








Table 1 summarizes the contrasting interests of lenders andborrowers.

A (+) indicates a desire to maximize and a (-) shows a desireto minimize.

Table 2: Lenders and Borrowers

Lenders BorrowersReturn + Cost -Risk - Length of loan +Liquidity +








The main con�ict arises over the length of a loan.Note the role of uncertainty for both parties:

- A borrower may wish to borrow for a period thatis su¢ ciently long to ensure that his investmentproject will be earning a pro�t with which torepay the loan. E.g. a �rm borrowing to build anew factory, which is estimated to take twoyears, will try to arrange a loan for three years incase of delays.

- A lender may feel that she has funds which shewill not need for a year, but circumstances couldchange and she could need them sooner.







Borrowing and lending: How do markets help?

How do markets help?

An active market for securities means that borrowers can havea long-term liability while lenders can hold a relatively liquidasset.

A new loan results from a new issue of securities

A �rm borrows when it issues new:

- Ordinary shares (equities)- Corporate bonds- Commercial bills- Eurobonds etc.







Borrowing and lending: Primary and Secondary Markets

These issues take place in the primary market.The buyer is the lender (beware � sometimes called an�investor�).But, having bought, the buyers can sell. . .Markets enable the buyer of a security to sell it later, ifnecessary �quickly and cheaply.This buying and selling takes place in the secondary market.Without this escape route, there would be few buyers in theprimary market.How would the lack of an active secondary market a¤ect theprimary market?







Borrowing and lending: if no secondary markets Exist

This will lead to

- Securities being very illiquid.- This would make them unattractive.- There would be few buyers and they woulddemand a high rate of return.

- There would be little borrowing/lending and itwould be very expensive.








As a rule, trading of existing securities in secondary marketsexceeds the value of new issues in primary markets by a largemultiple.

On the next slide, the LH diagram compares the quantity andcost of lending/borrowing in a �nancial system with highlydeveloped markets with one without.

The RH diagram translates this into a likely e¤ect on realinvestment.








Figure 2








Without well-functioning markets, both the supply of loansand the demand for them would be very limited and the pricewould be high (S, D and i).

With well-functioning markets, there will be more lending andborrowing and at a lower cost (S�, D�and I �). This shouldencourage higher levels of investment.

We have just seen that primary markets allow new borrowingto take place and secondary markets encourage primary buyersbecause they know they can sell if necessary.

Why might holders of securities wish to sell?






Wealth arrangement

The reasons could be due to the followings:

1 They may need to retrieve the money they lent (a �liquiditycrisis�)

2 Their circumstances may change in other ways: they want totake on more/less risk

3 The circumstances of the borrower may change: the �rm maybecome more or less pro�table; the �rm may become more orless risky

4 The circumstances of third parties may change: other �rmsmay become more pro�table or less risky etc.






Wealth arrangement

Any of 2, 3 or 4 will cause lenders to re-arrange their wealth.

Recall that:

- Rational, risk-averse investors are seeking tomaximise return for a given level of risk.

- There are thousands of assets that can becombined to create portfolios that meet thiscondition.

Which portfolio an investor will choose depends upon hisparticular �taste�for risk.






Wealth arrangement

A particularly risk-averse investor will want a low-risk portfolioand will be happy with a low return (provided that it is thebest he can get).

A less risk-averse investor will want a higher-risk portfolio butwill also want the highest return he can get.

The next slide shows a hypothetical investor whose choice isportfolio A.






Wealth arrangement

Figure 3Ahmad Financial System





Wealth arrangement

In the �gure, the curve P � P 0 shows all those portfolios ofassets that yield the highest return for a given level of risk(�e¢ cient portfolios�).

I0 � I2 are indi¤erence curves tracing out the combinations ofrisk and return that give our investor equal satisfaction.

Our investor chooses A since this lies on the highestattainable indi¤erence curve, I1






Wealth arrangement






Wealth arrangement

But now suppose that circumstances change.

Fig. 2 can be read as showing either that our investor hasbecome more risk-averse or that portfolio A has becomeriskier.

Either way, portfolio A is no longer acceptable to our investorwho sells the assets in A and buys the assets that compriseportfolio B.






Wealth arrangement

In order to move from portfolio A to portfolio B our investorwill wish to buy and sell shares, bonds, bills, certi�cates ofdeposit and/or many other types of �nancial assets.He will want to do this in markets where

1. transactions are low2. where the price of the assets represents �fairvalue�and

3. where he knows that his instructions will becarried out:

- assets delivered and- payments made with a high degreeof security.






Adverse SelectionMoral Hazard

Roles of Financial Markets

Notice that most of this activity will involve existing assets �i.e. it will be carried out in �secondary�markets.

This is why trading in secondary markets exceeds the value ofnew issues in primary markets many times over.

Financial markets facilitates:1 Risk reduction;2 Minimisation of transaction costs3 Transformation of maturities- to a greater or lesser extent








In other words, �nancial markets create assets and liabilitiesfor lenders and borrowers, which are more attractive than theywould be if lenders and borrowers dealt directly with eachother.An asset:

- Any piece of property whose ownership providesa �ow of bene�ts over time.

A liability:

- A debt (or obligation) owed to someone else.

Financial markets also help by providing the means forindividuals and businesses to diversify their asset holdings.








Low transaction costs allow them to buy a range of assets,pool them, and then sell rights to the diversi�ed pool toindividuals

Another reason FIs exist is to reduce the impact ofasymmetric information.

One party lacks crucial information about another party,impacting decision-making.

We usually discuss this problem along two fronts:

- adverse selection and- moral hazard







Adverse Selection and Moral Hazard

Adverse Selection

- Before transaction occurs- Potential borrowers most likely to produceadverse outcome are ones most likely to seek aloan

- Similar problems occur with insurance whereunhealthy people want their known medicalproblems covered







Adverse Selection and Moral Hazard

Moral Hazard

- After transaction occurs- Hazard that borrower has incentives to engagein undesirable (immoral) activities making itmore likely that won�t pay loan back

- Again, with insurance, people may engage inrisky activities only after being insured

- Another view is a con�ict of interest






Money vs capital marketsCall vs continuous markets

Classi�cation of �nancial markets

We have already seen that markets can be divided betweenPrimary markets and secondary markets.Primary markets

- are where new issues of securities are made. Anissue of new securities results in newborrowing/lending.

Secondary markets

- are where existing securities can be bought andsold. A sale of existing securities simplytransfers the ownership of an existing debt. Nonew lending/borrowing takes place.








Money vs capital markets;

- Money markets are markets for securities withless than one year to maturity. They are marketsfor short-term assets.

- Capital markets are markets for long-termsecurities �with more than a year to maturity.








Call vs continuous markets; In most markets, it is possible totrade at any time that the market is open. These arecontinuous markets.

However, in some markets trades are �called�at set times. Inbetween the set times, potential orders to buy and sellaccumulate. Call markets are often associated with�auctioneer�or �order-driven�trading.

Auctioneer vs quote-driven markets; In an auctioneer market(sometimes called �order-driven�) orders to sell are matchedwith orders to buy.








To make this possible, orders are often left to accumulateuntil they are su¢ cient to make matching probable. Buyersand sellers may not be able to trade if they insist on a speci�cprice.

In a �quote-driven�market, makers hold inventories ofsecurities and quote continuous prices at which they arewilling to buy and sell.






Financial IntermediariesDeposit-takersNon�deposit-takers

Financial Intermediaries

Intermediation creates assets and liabilities








An interesting consequence follows:

- An increase in lending and borrowing mustinvolve:

a. An increase in liabilities and assetsb. An increase in the size of theintermediary�s balance sheet

And so:

- Changes in intermediaries�output are oftenre�ected in their balance sheets. (Why does thisdi¤er from other �rms?)








Intermediaries also do other things too that include:

1. Create liquidity and money2. Operate a payments mechanism3. Provide �nancial services like pensions andinsurance

4. O¤er �portfolio adjustment facilities�








These �other things�form the basis of a distinction betweentypes of intermediary.

Financial intermediaries can be classi�ed as deposit-takers andnon-deposit-takers.

Deposit-takers:

1. Banks

- retail- corporate- investment

2. Building societies








Non�deposit-takers:

1. Pension funds2. Insurance companies3. Unit trusts4. Investment trusts






Summary

A �nancial system consists of a set of markets, institutions,their users and regulators.

A modern �nancial system is required to carry out a widerange of functions.

Financial markets, in particular, facilitate lending andborrowing through new issues in primary markets.

Secondary markets provide liquidity which makes new issuesmore attractive than they would otherwise be; they providemechanism whereby investors can adjust their wealthportfolios to provide the optimum trade-o¤ between risk andreturn.






Summary

Financial intermediaries make it easier to borrow and lend

In doing this, they create assets and liabilities which appear ontheir balance sheets

They also provide a variety of other �nancial services

This enables us to make a distinction between DTIs andnon-DTIs.


lecture1-money and finance

Documents

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financial systemthe

role lenders

financial services authority

interests of lenders

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borrowers figure

decitsunits borrowers