Money and Banking

Mr. Vaughan

An Overview of the

Financial System

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Lecture Outline

• Structure of Financial Markets

• Classifications of Financial Markets

• Financial Intermediaries

• Function of Financial Markets

• Trends in Financial Markets 2 - 31

What do financial markets do?

Financial markets transfer funds from surplus units (net lender-savers) to deficit units (net borrower-spenders).

• Net savers - household sector• Net borrowers - business sector

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Structure of Financial Markets

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Classifications of Financial Markets

1. Debt vs. Equity Markets

2. Money vs. Capital Markets

3. Primary vs. Secondary Markets

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Debt vs. Equity Markets

• Debt: fixed income, senior to equity, lower risk• Equity: residual claim, higher risk, higher

return, carries ownership rights.

Debt is a much more important source of external financing for U.S. business firms than equity!

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Primary Market:• New security issues are sold to initial buyers (new

capital raised).

Secondary Market:• Previously issued securities are bought and sold.

Primary vs. Secondary Markets

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Investment bankers:• Financial institutions that assist in the initial

sale of securities in the primary market.• Most primary placements are “firm

commitments.”

Primary vs. Secondary Markets

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Secondary markets are important to a business firm because they provide: • liquidity for primary issues. • signals about the market’s preferences for

securities. • a continuous appraisal of management

performance.

Primary vs. Secondary Markets

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Money vs. Capital Markets

Money Market:• Debt instruments with original maturity ≤ 1 year• Temporary warehouse for surplus funds• Low-risk instruments • Examples: Commercial paper, Treasury bills

Capital Market:• All non-money market instruments• Source of long-term finance• Examples: corporate bonds & stock,

Treasury notes/bonds, mortgages & mortgage-backed securities.

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Money vs. Capital Markets

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Money vs. Capital Markets

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Financial IntermediariesFunctions

Lower transaction costs• Economies of scale• Liquidity services

Reduce Risk• Risk Sharing (Asset Transformation)• Diversification

Asymmetric Information• Adverse Selection (before the transaction)—more likely to

select risky borrower• Moral Hazard (after the transaction)—less likely borrower will

repay loan

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Financial Intermediaries

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Size of Financial Intermediaries

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Government-Sponsored Enterprises:• Chartered by Federal government to channel financial

capital to favored sector of economy.• Privately owned, but seed capital and continuing subsidies

provided by Federal government.• Examples: Mortgage GSEs:

– Federal Home Loan Mortgage Association (Freddie Mac)

– Federal National Mortgage Association (Fannie Mae)

– Federal Home Loan Bank (FHLBanks)

Another Financial Intermediary: GSEs

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MortgageGSE

CreatedPrincipal Activity

Assets ($ billions,

Year-end 2008)

Fannie Mae

1938Purchase/securitize

mortgages$882.6

Freddie Mac

1970Purchase/securitize

mortgages$794.4

FHLBanks 1932Make advances

against mortgages$1,271.8

Another Financial IntermediaryMortgage GSEs

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Function of Financial Markets

Financial markets improve economic efficiency and raise social welfare by:

• Funding investment opportunities• Smoothing consumption• Facilitating risk allocation

– Example: securitization

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Securitization

• Definition: process of transforming otherwise illiquid assets into marketable, capital-market instruments.

• Securitized assets include:– Home mortgages– Auto loans– Credit-card receivables– “Bowie” Bonds

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Securitization of Mortgages

• Principal securitizers: – Ginnie Mae (technically not a GSE, part of HUD)– Fannie Mae– Freddie Mac

• “Win-Win” for originating financial institution:– reduces liquidity risk, interest-rate risk, and credit risk.– provides an “end run” around regulatory constraints.– generates fee income

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Securitization of Mortgages

Securitization Facts: • First “passthrough” mortgage-backed security

offered by Ginnie Mae in 1970.

• Between 1971 and 1992, outstanding “passthroughs” grew at an average rate of 30% per year, to $1.5 trillion.

• Now, just under 60% of home mortgages are securitized.

End result: more mortgages originated!21 - 31

Recent Trends in Financial Markets

1. Financial entrepreneurship

2. Globalization

3. Democratization

4. Deregulation

5. Evolution of financial intermediation

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Financial Entrepreneurship

• Rapid increase in “complex securities” – 1970: 1 of 1,124 securities issues was “innovative.”– 1997: 2,644 of 9,387 (28%) were innovative.– Post-2000 =??? (explosion).

• Evolution of old markets– Evolution of junk-bond market (no longer just “fallen angels,”

thanks to Michael Milken)

• Rise of new instruments/markets– Weather derivatives: first contracts in 1997; April 2005 to

March 2006, contracts had total notional value of $45 billion (up from $9.7 billion in prior year).

– Election futures: Intrade

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Globalization

• Foreign banks have penetrated U.S. banking markets

– At year-end 1980, foreign banks accounted for 10.8% of U.S. banking assets and 6.4% of deposits.

– At year-end 2007, foreign banks accounted for 21.9% of U.S. banking assets and 19.5% of deposits.

• Foreign equity markets have eclipsed the U.S. market

– In 1945, U.S. stocks comprised 90% of world-wide equity capitalization.

– Now, U.S. stocks comprise less than 50% of world capitalization.

• Eurobond market has eclipsed U.S. bond market as source of external finance:

– Eurobond: bond denominated in a currency other than that of country is which it is sold.

– Over 80% of new issues in international bond market are Eurobonds. 24 - 31

Democratization

• Small firms have greater access to financial capital:

– Junk bonds: before 1977, no issues; in 2003 $134 billion issued (2nd highest yearly figure at that date).

• Poorer households have greater access to credit:

– Credit cards: In 1970, 51% of U.S. families had a card; in 2004, 75% had at least one card.

• Small investors have a greater range of options:

– Stock ownership: In 1992, 36.7% of U.S. families owned stocks directly or indirectly; in 2004, 48.6% owned stocks.

– Mutual funds: In 1980, 564 U.S. funds with total net asset value of $134.8 billion; in 2007, 8,029 funds with $12.02 trillion in assets. 25 - 31

Deregulation

• Abolition of fixed brokerage commissions (1975)• Repeal of Regulation Q (1980)• Repeal of federal anti-branching restrictions (1994)• Repeal of Glass-Steagall (1999)

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Evolution of Financial Intermediation

• Fewer, larger banks• Less emphasis on traditional deposit-

taking and loan-making• More emphasis on selling a broad array of

risk-management services

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Evolution of Intermediation Rapid Growth of the Size of U.S. Banks

Data Sources:FDICBLS

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Evolution of Intermediation: Rapid Decline in Number of U.S. Banks

High-water mark in 1984,14,496 banks

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Evolution of Intermediation: Decreasing Importance of Traditional Banking

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Questionsover

Mr. VaughanMoney & Banking

An Overview of the

Financial System?

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