An Overview An Overview of the of the

Financial Financial SystemSystem

Chapter 2Chapter 2

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Function of Financial MarketsFunction of Financial Markets To bring lenders and borrowers together to To bring lenders and borrowers together to

make both of them better-off.make both of them better-off.Efficient allocation of capital, which increases Efficient allocation of capital, which increases

productionproduction Improve the well-being of consumers by Improve the well-being of consumers by

allowing them to time purchases betterallowing them to time purchases better

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Flows of Funds Through the Flows of Funds Through the Financial SystemFinancial System

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Structure of Financial MarketsStructure of Financial Markets Debt and Equity MarketsDebt and Equity Markets

Primary and Secondary Markets (D&E)Primary and Secondary Markets (D&E) Investment Banks Investment Banks underwriteunderwrite securities in primary markets securities in primary markets Brokers and dealers work in secondary marketsBrokers and dealers work in secondary markets

Exchanges (D&E)Exchanges (D&E) NYSE, NYBE, CBOTNYSE, NYBE, CBOT

Over-the-Counter (OTC) Markets Over-the-Counter (OTC) Markets FX, Fed fundsFX, Fed funds

Money and Capital MarketsMoney and Capital Markets Money markets deal in short-term debt instrumentsMoney markets deal in short-term debt instruments Capital markets deal in longer-term debt and Capital markets deal in longer-term debt and

equity instrumentsequity instruments

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Principal Money Market Principal Money Market InstrumentsInstruments

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Principal Capital Market Principal Capital Market InstrumentsInstruments

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Internationalization of Internationalization of Financial MarketsFinancial Markets

Foreign Bonds: sold in a foreign country and Foreign Bonds: sold in a foreign country and denominated in that country’s currencydenominated in that country’s currency

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

Eurocurrencies: foreign currencies deposited in Eurocurrencies: foreign currencies deposited in banks outside the home countrybanks outside the home country Eurodollars: U.S. dollars deposited in foreign banks Eurodollars: U.S. dollars deposited in foreign banks

outside the U.S. or in foreign branches of U.S. banksoutside the U.S. or in foreign branches of U.S. banks

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World World Stock Stock

MarketsMarkets

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Function of Financial Function of Financial Intermediaries: Indirect FinanceIntermediaries: Indirect Finance

Lower transaction costs (time and money Lower transaction costs (time and money spent in carrying out financial transactions). spent in carrying out financial transactions). Economies of scaleEconomies of scaleLiquidity services (checking account)Liquidity services (checking account)

Reduce the exposure of investors to riskReduce the exposure of investors to riskRisk Sharing (Asset Transformation: packaging Risk Sharing (Asset Transformation: packaging

risky assets into safer ones for investors)risky assets into safer ones for investors)Diversification by pooling and issuing new Diversification by pooling and issuing new

assetsassets

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Function of Financial Function of Financial Intermediaries: Indirect FinanceIntermediaries: Indirect Finance

Deal with asymmetric information Deal with asymmetric information problemsproblems (before the transaction) Adverse Selection: try (before the transaction) Adverse Selection: try

to avoid selecting the risky borrower.to avoid selecting the risky borrower.Gather information about potential borrower.Gather information about potential borrower.

(after the transaction) Moral Hazard: ensure (after the transaction) Moral Hazard: ensure borrower will not engage in activities that will borrower will not engage in activities that will prevent him/her to repay the loan. prevent him/her to repay the loan. Sign a contract with restrictive covenants. Sign a contract with restrictive covenants.

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Primary Assets and Liabilities of Primary Assets and Liabilities of Financial IntermediariesFinancial Intermediaries

1212

Principal Financial Intermediaries Principal Financial Intermediaries and Value of Their Assetsand Value of Their Assets

1313

Regulation of the Financial SystemRegulation of the Financial SystemTo increase the information available to To increase the information available to

investorsinvestorsTo ensure the soundness of financial To ensure the soundness of financial

intermediariesintermediariesA report on upcoming regulation: A report on upcoming regulation:

http://www.bos.frb.org/economic/conf/conf54/pahttp://www.bos.frb.org/economic/conf/conf54/papers/blinder.pdfpers/blinder.pdf

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Increasing InformationIncreasing InformationReduce adverse selection and moral Reduce adverse selection and moral

hazard problemshazard problemsReduce insider trading (SEC).Reduce insider trading (SEC).

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Ensuring the Soundness of Ensuring the Soundness of IntermediariesIntermediaries

Restrictions on entry (chartering process).Restrictions on entry (chartering process).Disclosure of information. Disclosure of information. Restrictions on Assets and Activities Restrictions on Assets and Activities

(control holding of risky assets). (control holding of risky assets). Deposit Insurance (avoid bank runs).Deposit Insurance (avoid bank runs).Limits on Competition (mostly in the past):Limits on Competition (mostly in the past):

Branching Branching Restrictions on Interest RatesRestrictions on Interest Rates

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Principal Regulatory Agencies of Principal Regulatory Agencies of the U.S. Financial Systemthe U.S. Financial System