Working Title

“Basics of Money & Finance in a Modern World”

Dr. Armin Eckermann

Copywrite © 2019 by Dr. Armin Eckermann

All rights reserved.

No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without written permission from the author, Dr. Armin Eckermann.

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Table of Content1 Introduction to Financial System

1.1 A Brief History of Money and Banking1.2 The Functions of Financial Systems1.3 Taxonomy of Financial Intermediaries1.4 Nature of Financial Instruments1.5 Structure of Financial Markets1.6 Market-based vs. Bank-based Financial Systems

2 The Role of Financial Intermediation

2.1 Why Do Banks Exist?2.2 Services of Financial Intermediaries2.3 Key Theories of Financial Intermediation

3 Banking Regulation

3.1 Economic Crisis, Financial Crisis, and Bubbles3.2 Free Banking vs. Regulated Banking3.3 The Role of Central Banks3.4 Traditional Regulation Mechanism3.5 International Banking Regulation – Basel Accord3.6 Dodd-Frank Reform Act (USA)

4 Ethical Issues in Banking

4.1 Key Stakeholders in Ethical Banking4.2 Recent Cases of Unethical Behavior4.3 Responsibility of a Corporate Citizen4.4 Combating Criminal Activities4.5 The implication of Money Laundering and Terrorist Financing 4.6 FATF – Financial Action Task Force

5 Financial Markets – Transformation of Information

5.1 Introduction5.2 Risk / Return5.3 Efficient Markets5.4 Excess Return5.5 Efficient Market Hypothesis

6 Closing Remarks

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1 Introduction to Financial Systems

The idea to start the book with a brief history of money and banking started a long time ago. One of my motives has been that it appears that many people in recent times connect and interrelate money and banking. Press, social media, literature and society talks are often mixing both names and concepts and a “hodgepodge” of ideas often misguides the interested reader and student.

1.1 A brief history of money and banking

Money and banking, two interrelated subjects that are often connected and considered trivial by most people. Everybody believes one knows what money is or what it means to have too little of it. The lack of money is often perceived as being poor or not having enough resources to obtain all that is desired. On the other hand, we need to understand that money as we know it today has been a cultural, socio-economic invention which developed from a very simple idea to today’s complex money issuing process which culminates in the so-called “FIAT money” or paper money. Only recently the money concept got technologically challenged by the so-called “cryptocurrencies”. Indeed, something which fascinates me, and cryptocurrencies will be briefly touched as well.

Banking is a term often misinterpreted and analyzed. First and foremost, the banking industry as we know it has received lots of attention after the Great Financial Crisis, which is what will be explored in this book. One big reason is that banks deal with money and by dealing with money they make ‘money’. Like any other industry in a ‘market-driven economy’, banking must earn a ‘profit’ to stay in the market place. The implications are profound because banks are not like any other ordinary firm. If banks (or for that matter any other producers in different industries) don’t engage in ‘money-making’ or even produce a ‘loss’, the opposite of a ‘profit’, over a considerable period of time, they might be doomed to leave the market place by closing its business. But it is the special status banks usually get in our modern society that concerns us and which gets debated overtime again and again. Bertolt Brecht, a German theatre play writer, and poet, (1898 -1956), once wrote: “What is the robbing of a bank compared to the founding of a bank?”

This remark reflects the controversial discussions around money and banking. Money may be taken out of the bank's vault by a successful old-fashioned bank heist and put into a bank when you have more money in hand than you need for your daily living. How we came about to connect the two different concepts and elements of money and banking is the subject of this chapter. Or in different words, before we discuss the role of banking and how financial systems developed over time, I would like to provide a brief historical review on money and on banking activities as documented by historians.

Money

Money, paper money, with notes and coins, as we know it today, and the use of currency, for example, the EURO or the US-Dollar is a very modern concept. The Euro was born out of a political process and theoretically or legally created by the provisions in the Maastricht Treaty of 1992. The final currency in terms of bills and notes was introduced in January 2002 for most European

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Countries participating in the common market currency. Malta became a part of the European Union in 2004 and introduced the EURO in January 2008. Accepting the Euro meant for all participating countries giving up whatever money they had in circulation before. They exchanged the old currency for the new Euro bills and coins at a pre-agreed fixed exchange rate.

Before the Euro, we had many different currencies in Europe that had only one thing in common, the currencies had all been based on trust. Yes, trust. If we as a society don’t believe in it, it would not serve us as money. It is a cultural and social construct we all believe in.

The holder of the notes and coins all believed that the money they carried or had in their bank accounts would allow them to purchase goods and services in the country where the money had been issued. Italians used the Italian Lira to purchase goods and services, let us say a great pasta meal, in Italy. The same currency could not buy anything once one crossed the Alps into Austria. The Austrian used the Austrian Shilling before January 2002.

Our current money is named ‘fiat money’ by the experts and is without an ‘intrinsic’ value. This fiat money has been established by government regulation or governmental decree. In other words, fiat money has no use-value or intrinsic value, it has value only because the government maintains its value or institutions engaging in the exchange of it agree on its value.

How did we get to Fiat money in the first place?

Allow us to go back in time well before Jesus Christ was born. We can safely assume that people already produced, consumed and engaged in exchanges of products. This is the time when money, as we know it today, was not around, but we know for sure the people had already different levels of specialization, skill sets, and talents available. Simplistically speaking, this was the time without money in circulation and this period was described as ‘barter economy’. The barter economy differs from the ‘money economy’ in which money is already an integral part of society.

When a producer of wheat wanted to buy some lumber to build a barn, one needed to exchange wheat what one has produced against the lumber. This is the barter exchange. The lumber producer had produced the lumber. The lumberjack must hence provide the lumber to the wheat producer. Which in turn, both get exchanged (at a certain value) and the exchange or deal was done. Wheat was given for lumber. The lumber producer exchanged lumber for wheat. Let aside the aspect of the exchange value (or the relative price) for a while.

Economists have used barter economies to show how money has been developing over time. The most difficult organizational aspect in a barter economy is named the ‘double coincidence of wants’. In a world without money, your desire to exchange your goods against other goods runs into a simple problem. You will need to find the person that is offering what you want AND the person who has the goods you want must, at the same time, want your offered goods in exchange.

Imagine you have the wheat, but the lumberjack does not want the wheat but instead, the lumber supplier wants metal nails to finish his horse wagon. No double coincidence of wants, no deal! As a matter of fact, imagine you need the lumber urgently. Now you must find somebody who offers nails but does not need the lumber but needs the produced wheat. You will see that a barter economy lacks the “kind of money” which is needed as a “method of payment”. Goods are being exchanged against goods, which means the underlying barter economy can hardly be compared to today’s world. Imagine this barter system has only 100 goods produced by 100 individuals. Combinations, a

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concept borrowed from mathematics, tells us that we can combine those 100 goods in 4950 different combinations of two goods together1.

The wheat producer might have to run around for a while to get his lumber if the ‘double coincidence of wants’ does not occur out of sheer luck in her first place.

What follows? One can easily see that the introduction of ‘money in-kind’ or ‘commodity money’ is of great help. It made things much easier in our basic, old economy. People are smart, and the creation of commodity money occurred. Usually, all members of society agreed upon one commodity to be used as the medium of exchange. Goods were no longer bartered against other goods. Money in the form of commodity money was created to help people and society to interact much quicker when doing business together.

From now on, the wheat producer went to the market and gave her wheat away against commodity money. With the newly received money, she could store the money or offer the money to the lumberjack who likes the exchange because he knew he could take the commodity money and buy metal nails with it, as indicated in our above example. The number of prices in our example will be 100. Compare this to 4950 relative prices before. In addition, money separated the act of selling from the act of buying. For the interested reader, Karl Marx (1818-1883), the German Philosopher and Economist, put a great deal of interest into this act of separation which determines Marx’s theory of alienation describing the estrangement of people living in capitalism.

On a side note, with the introduction of money, the economic transaction becomes more efficient and trading started to flourish over time. The smart people noticed that commodity money should have some attributes which made it almost the perfect medium of exchange. It should be easy to transport, divisible and maintain its value, its purchasing power, over time. Usually, commodity money had different usage outside the world of being a medium of exchange. It was created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange (such a good is called a commodity). It could, therefore, be consumed or enter the production process.

If you should ever visit the British Museum in London, please approach the section where you will learn what money meant for older civilizations. Commodity money in other cultures had been stones, bones, festive jewelry, pearls, salt, spices, seeds, etc. etc. Yes, the visit to the museum will pay off, not in terms of money but in terms of knowing more than you did before the visit.

Commodity money

Commodity money existed for a long time and historians will tell you much more about it. What makes it interesting for an economist is the fact that such money was used to finance states or central governments in the past. ‘Coinage’ is the term, the right to mint money. Coinage is the hand-to-hand currency that consists of metallic coins. The European history is full of stories around such coins, which were pieces of metal, normally shaped and stamped with a device which was enough to give evidence of their value and of their legal status as money.

1 Combination C n k with n=100 and k=2 yields n!/k!x(n-k)!

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There was a distinction made between ‘full-bodied’ coins and ‘token coins’. In the case of 'full-bodied' coins, which circulate at a value equal to that of the metal in them, hence, coining is an evidence of their metallic content. As opposed to 'token coins' - here the circulation value is unrelated to their value as metal, coining declares value and establishes their legal status. In almost all countries with established political orders coinage has been reserved for the state.

It is worth noting that the right to coinage was a right of states or other central institutions. Full-bodied coins where commodity money. Why? Please think about it and answer the questions.

The legal entity, which had the right to coinage, often misused its ‘monopoly power’ and reduced the quantity of the prime metal in a 'full-bodied' coin, without a corresponding reduction in its legal nominal value. Hence, the face value and the commodity value of such a manipulated coin diverged. If this happened, we speak from ‘coinage debasement’. Such a reduction in prime metal content was done by clipping and sweating, by reducing the purity of the metal in newly issued coins or by reducing the actual weight of coins on recoinage. Indeed, this was a widely practiced exercise by rulers in the past to obtain finance. Coinage debasement was an indirect way to tax people and obtain financing for the party able to mint the coins. Of course, what happens when the debasement was detected is a different story. Usually, the prices rose and/or the money in circulation went up but the trust in the commodity money shrank and the people started to dislike the coinage and its value, which it represented.

Credit money

Commodity money was created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange. Credit money compares well to fiat money, but it represents a claim on a commodity, which can be redeemed, to a greater or lesser extent. The creation of credit money or representative money is interesting because it already takes us into a different time where members of society could create paper money, the ‘IOU’. Of course, paper needed to be invited beforehand. Paper was supposed to be invented in China and Marco Polo has brought this invention to Europe in the 12th century.

But back to the IOU. IOU stands for ‘I Owe You’ and is signed by the person who has acquired some goods or service but instead of paying the price in terms of money, the buyer issues a paper the so-called IOU (certifying the debt to the holder!). The holder of the IOU believes that the issuer will redeem the IOU in the future, basically pays for the goods and services he received earlier at a later point in time. Technically speaking, this is a credit. The seller trusts that she will get the money from the buyer in the future.

Allow us to make a little experiment. You know the richest man in your town or city. The richest person buys a bicycle from you and is currently out of cash but he will issue an IOU saying that he owes you a particular amount of money for having received the said bicycle. Will you accept this IOU? Assume further that the legal and social system in which the IOU is written supports you in such a way that the issuer of the IOU must make available the money amount written on the IOU piece of paper at sight. That means whenever presented to him. If he fails to pay at sight, the legal and social system will help you to get your right to the outstanding money amount.

The chain of assumptions continues. You have such an IOU, which represents ‘credit money’. Instead of presenting it to the buyer of your commodity, the richest man in town, you go to the grocery

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store instead. Instead of paying the groceries with money, you present the IOU, the credit money. If the seller accepts the IOU as means of payment, the claim will move from you to the grocery store.

Please understand one of the prerequisites is that the grocery store manager knows the IOU, the issuer of the IOU, the richest man in town, and the legal and social system well. He knows that he now can take the IOU to the richest man in town and ask for the redemption of the claim. The chain is completed when the richest man makes good on the IOU, receives the paper and hands out the notional amount written on the IOU. It was taken into consideration that the amount written on the paper or credit money was linked to the primary transaction when you sold the bicycle to the rich man but the claim has been transferred to a new owner.

Let our abstract review of history continue.

During the Medieval Age, trade took place in Europe. Like centuries before in Asia or elsewhere. Traders were moving goods from one place to another. Often traveled for weeks and had little protection when traveling overseas. Good old examples are wine from Portugal went to England and English cloth to Portugal. The trade between Italy and Northern Europe flourished in the Medieval Age. Italian maps of the world wherein high demand in Holland or Prussia in the 17 th century. Well, what do you think the traders did? A rich Dutchman travels to Milano to acquire a series of world maps to sail the big oceans for new land discoveries, spices, tea or new tulip bulbs. Maps of the world had been expensive back then and a hefty amount of ‘full-bodied’ money was needed to purchase them. Traveling overland at those times was an adventure. Whenever the trader left home, they entered into new countries with different rules and different habits. Bandits, tax authorities and fraudsters as well as robber-knights used to stop the traders and usually wanted things of value or money. Again, over time the people started to develop a different system, instead of carrying the heavy weighted full-bodied coins from Holland to Milano, a rich Dutchman known beyond Holland and also well known in Milano came into play. Such rich Dutchman was able to issue an IOU, which documented that the trader has a certain amount of money in Holland. If the trader brought the maps of the world he wanted, the IOU could be presented to the rich Dutchman in Holland for redemption. Or even more, appealing for trading countries and people, this IOU could be delivered to somebody related to the rich Dutchman in Milano for local, Italian reimbursement.

The remaining part of the story is history at its best. Who could be a better representative of the rich Dutchman in Milano then his Cousin of 2nd degree who had married an Italian countess 10 years ago and moved to Milano in Italy. These are the first step into banking. European merchant families of the Medieval Age are still icons of early banking – the Fugger’s of Augsburg, Medici’s of Florence, to name a few.

The creation of banks locally and internationally had to do with the safekeeping of money and lending money to those who were willing and able to repay it. The money, which was not needed to conduct day-to-day business, was given to trusted individuals or institutions. Such institutions became banks over time.

Traders could now trade without carrying and using money in terms of coins and notes. They used credit money or representative money to conduct their business. This happened because the socio-economic system developed, in turn, this made it possible and the first European banks emerged out of such families who had an advantage in dealing with money or had been forced into the money business.

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Be assured that the above schematic view of the development has been more colorful and complex than presented but it is the need for security and business, which helped to create money and banks in the first place. Money serves a medium of exchange, locally and internationally. It helped society and individuals to prosper and grow over time despite a long cultural inhabitation, which had stopped the development of the money business for many centuries in Europe. The church and religion have don’t a major role to stop the money business from growing until a certain point in time when it became acceptable to allow money business to take place in large parts of today’s geographical area of Europe.

Fiat Money

Fiat money was introduced as an alternative to commodity money and credit money. It originated in the 11th century in China and its use became widespread during the Chinese Yuan and Ming dynasties. Fiat money was introduced to Western societies only after 1973 when the ‘Bretton Woods’ Gold Standard system of 1946 failed, and the USA cut its ties to link its currency to the gold reserve it has held in the USA. Up to that day, one could take a US-Dollar to the bank and ask in turn for that US-Dollar for gold, which was backing up the US-Dollar bill.

Gold Standard

The Bretton Woods agreement of 1944 had shaped the post-World War II currency system. This system fixed the price of the US Dollar in terms of gold, while all other world currencies were fixed in value against the US Dollar. Up to 1973, the US Dollar in circulation was backed by Gold.

For example, if the price of 1 oz. of Gold is USD 1.000, then a one USD bill is worth 1/1000 th oz. Gold or it could be exchanged for that amount of gold into 1/1000 th oz. of gold at the USA central bank. The currency in circulation was completely linked to the stock of gold supply the country held. The USA left the Gold standard behind in 1973 and adapted the concept of fiat money.

Fiat money is different. Here the government decoupled the money from the gold. No more need to back the currency with precious metal. It is a currency that a government has declared to be legal tender which is not backed by physical commodity anymore. The value of fiat money solely derives from the relationship between supply and demand rather than the value of the material from which the money is made. What is fiat money worth? It is worth the number of goods and services in an economy that somebody else is going to give you for that currency bill.

Almost all countries around the globe soon adapted the concept of fiat money. Of course, governments won by not backing up the currency in circulation with precious metals like gold. Why? Can you make your point?

Banking

Banks developed quickly after the state and the church allowed the money business to take place legally and it was permitted to charge interest for money lent to others. As a matter of fact, history is

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full of stories around banks - the creation of banks, the growth of banks and the failure of banks. Each country displays different stories, given that its development of banks took place in a certain cultural and socio-economic environment. This is still seen today. Islamic banking started to develop late. This kind of banking business does not allow interest charging when doing lending business within the Islamic community. Hence, different banking products did evolve over time.

Banks and banking products have been constantly adjusted to the supply and demand conditions of each economy. It was a long way of trial and error for the banking world to develop from the medieval money changer to today’s modern banking industry. From a societies’ point of view, we have learned from past success and failure of banking but the debate is still ongoing when we ask ourselves “what kind of banking system we want and need to conduct our economic activities?”

Modern banking is taken for granted by all of us today but it became heavily under attack from customers, lenders and borrowers, policymakers and young IT-driven entrepreneurs during the recent years. Modern banks have developed into something, which we will try to explore in the coming chapters of the book.

To close this chapter, we would like to highlight that humankind needed a couple of inventions, as a prerequisite, to banking as it is known today. Those necessary inventions are taken now for granted but they have been very important over time and shaped our development process. Such inventions have been in no particular order:

Language, which allowed us to communicate ideas Development of numbers and the use of numbers Writing, symbols for letters and numbers and calligraphy such as carving or writing on paper-

like material bookkeeping to ensure that we went beyond the memories of today Arithmetic, higher mathematics, etc. Invention of paper The invention of printing books Communication and infrastructure to shorten distances (I.e. telegraphs, trains, autos,

telephones, etc.) Mobile phones, the internet, smartphones Blockchain or distributed ledger technology2, virtual currencies, etc.

1.2 The functions of financial systems

With our brief historical introduction, you will appreciate that the Dutch trader in the 14th century had clear ideas about a financial system, which would have served one’s dear needs. But we are sure that telephone banking or credit transfer from Holland to Milano in Italy were not even coming up in one’s boldest dreams. Financial systems are truly time-dependent and develop over time with new

2 Blockchain technology is a distributed shared ledger where transactions are recorded and confirmed without the need for a central authority. Applications will be found in Financial Services, Supply Chain Traceability, ID recording and verification, digital currencies and assets management, etc.

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ground-breaking inventions - like paper, book printing, wire communication, or electronic calculators. Even accounting need to be developed to be able to come up with balance sheet ideas and how to measure "stocks" and "flows".

Today's financial system should do one thing, it should support the society to conduct its money business in an efficient way such that the business people or the economy will prosper for the benefit of the total society. If we ask you the question, what should the financial system of your country be capable of, what would your answer be? Maybe you have not thought about it at all. But believe me, business people, politicians or economists will have an idea what the financial system shall provide to all of us.

By and large, the financial system consists of many players and institutions which all try to organize the financial world to support the underlying real economy of each country. Let it be known that we believe that the financial system is subordinated to the real economy, which produces the goods and services we all need to make a living. We produce, we consume, and we are interacting socially in many different ways. The financial system has been developed to make our lives in the real world easier and more efficient. Like money was introduced to be better off, to reduce the transaction cost of finding a trading partner in the barter economy. While doing that, it will support our well being by allowing economic growth and development to take place for all of us.

Most countries around the globe are organized in a market system where all market participants can do what they like within legal limits, of course. In a wider sense, they are free to choose and will not have to follow a central command. Others have coined the system a capitalistic system in which capital is owned by individuals and such individuals can do with capital or resources, to use another name, whatever they like. The same is true for the other factor resources like labor and land. Labor owners and landowners, like capital owners, can employ their resources as they like. Without dwelling on such ideas too much, the combination of the factor resources will bring about the production of goods and services. Such productions of goods will bring about income which is in turn being used to buy goods and services in society.

Many of us are generating income by selling their labor-power, investing their capital or using or renting their land to others. In turn, the related income they earn from providing the factors of production is their factor income and they are free to use it as they like. Be aware, there are legal and illegal activities in any society, and we will not focus on this distinction, but we will assume that all activities are done in the legal sphere of the society for the easy of teaching and communication of ideas.

Economic players in modern societies can easily be divided into those who have and into those how do not have money. Not having money is often expressed as a lack of money or the lack of financial means. For instance, we don't have what it takes to buy a holiday, a house or a car. It means we are lacking the financial means to purchase such goods. In a way we go beyond the concept of just money because we are lacking the resources or assets to sell, hence, to switch the assets into cash or money to purchase the desired goods. We have no assets to sell for money. Or put differently, money or cash is just a different asset class.

Principally, the financial system is a part of our social system it supports the economic activities in society as much as money supports the exchange of goods in the old times. Barter was inefficient, money allowed a quicker and more efficient exchange. A modern financial system must go with the times and provide what is needed in today’s very different social and cultural settings.

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1.2.1 Main Function of the Financial Systems

The main functions of a modern financial system can be summarized as follows, the system shall provide a

A mechanism to transfer funds from surplus units (or lenders-savers) to deficit units (or borrowers-spenders) which are often described as the Channeling of Funds function

A mechanism such that wealth holders can adjust the composition of their investment portfolio, the Resource Mobilization function

Stable payment system to conduct the buying and selling of goods and services and financial instruments, the Monetary Transaction function

A mechanism for risk transfer.

Largely, the financial system will have to support the political, social and economic sphere of society in which the financial system is embedded. Other authors have named the four functions of a financial system slightly different. They have stressed the

Capital allocation function Resource mobilization function Trade facilitation function Risk Management function

Let us have a closer look at the individual four important functions of a modern financial system.

Channeling of Funds

Channeling of funds or moving money from one person to another is one of the main functions. Funds or savings will move from those who have saved surplus funds to those who have a shortage of funds. For simplicity, let us divide the individuals and businesses in an economy into categories according to their overall financial position.

The lender-savers or surplus sector consist of people who are in a positive financial situation. They have more money in control than they use or need. According to their position, they save and can lend their surplus funds to someone else that needs funds. Technically, surplus units are economic units whose assets are greater than their liabilities. The excess of funds is a pre-condition for extending credit to others or the purchase of financial instruments.

The borrowers – spenders or deficit sector consists of people who are in a negative financial situation. They have too little money in comparison to their financing needs and in order to fulfill their plans, they need to borrow to fund their income gap, the funding deficit. Hence, deficit units cannot meet their expenses in a given period from their incomes, which arises during that period, either from the sales of their labor or their assets. They are therefore dependent upon borrowing money or obtaining credit.

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Within the financial system, the most important lender-savers are usually households; while the typical borrower-spenders are firms and the government. Of course, households might be net borrowers as well, but stylized facts will help us to structure our thinking.

The channeling of funds from savers to spenders is very important for two reasons:

1. Lender-savers (with an excess of available funds) do not frequently have profitable investment opportunities, while borrower-spenders have investment opportunities, but they are lacking funds.

2. Borrowers-spenders may want to invest in excess of their current income or lenders-savers and borrower-spenders may want to adjust the composition of their wealth, hence, changing the composition of their assets in their investment portfolio.

Let us use a few examples to illustrate the channeling of funds idea.

Example 1 - You have inherited EUR 50,000 from your grandmother. What do you do with it? Do you have a good idea? Spending or investing? What is influencing your investment decision?

Example 2 - A start-up entrepreneurs need money, more money than they usually have to get their new business ideas off the ground. To whom do they turn to for money?

The examples show independent possible financial situations in society, which could be matched under certain circumstances.

One of the key features in the channeling of fund process occurs when borrowers – spenders receive the funds. What happens is that here the financial system allows the borrowers - spenders to shift

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future consumption or investments into the present. Without the system, you could only buy or invest once the funds have been accumulated to invest or buy prior to the investment. The financial system allows you to pull future income to the present. Financially and economically and incredibly important aspects of modern society. The concept has pushed economic development to unseen heights before.

Resource Mobilization

Similar but different is the resource mobilization function of the modern financial system. Such function enables wealth holders, people who hold different assets, like real estate, stocks, bonds, precious metals, etc, to change their composition of their wealth or the composition of their investment portfolio.

Individual situation changes and wealth holders want to change their investment portfolio. The reasons for such moves are manifold and of no further concerns for us. But our modern financial system offers the infrastructure to change your investment portfolio. Investors or asset holders may move in and out of different asset classes or simply trading different assets. This is often done by investment managers on behalf of their clientele. If cash is needed to undertake an economic activity but cash is not sufficiently available but other assets, for instance, real estate, the selling of real assets will generate cash and that cash may be invested into different asset classes, for instance, equity or gold.

Private or institutional investors using the financial system very much to allocate or re-allocate financial resources to gain income and profits. In fact, institutional investors and investment banks use the financial system or markets to leverage their financial bets. Remember, George Soros, bet against the Bank of England on Sept 16, 1992? We will surely address this point during the course of the book further.

Allow us to return to the aspect of how to invest your surplus money. You have two options, you can either place your surplus money directly with somebody who is looking for a loan or you place the extra funds with some firms in the financial sectors. The above describes the main difference between direct and indirect financing. Once you engage a “middle man”, you are in the world of indirect financing. If you engage directly with a borrower or lender, you are in the business of direct finance.

1.2.2 Direct vs Indirect Finance

You are in DIRECT FINANCE when the deficit sector and the surplus sector deal with each other directly. Here the deficit sector might take on liability by issuing bonds or stocks (equities) to finance any acquisition. The surplus sector will get in return for handing the funds over the securities. In other words, the surplus sector buys the issued securities.

INDIRECT FINANCE indicates that a financial intermediary such as a retail or commercial bank will take the funds from the surplus sector and then somehow gets the funds to the deficit sector. It

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suggests that financial markets and intermediaries are alternatives that perform more or less the same function but in different ways (and perhaps with different degrees of success). Please note, that the process of indirect finance, known as financial intermediation, is the most important way of transferring funds from lenders to borrowers.

The below chart illustrates the distinction. The first picture represents the direct finance, while the second picture resembles the indirect system.

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Financial intermediaries go in between like a trader who buys in bulk and sells in smaller proportions. The same concept applies to the financial intermediaries, which go in between the surplus and deficit units.

The following chart shall highlight additional facts and information and is divided into 3 parts.

Part 1 covers the surplus units, part 2 possible Financial Intermediaries and part 3 the deficits unit.

Part 1 also refers to the main lender-saver group, the households. If you ever want to learn more about how to invest surplus funds in the best possible manner, you might want to take university courses related to investment theory. Here you will learn how to evaluate projects as well as commercial and financial investment opportunities.

The middle part, part 2, gives you a list of financial intermediaries, you better get used to, and you will notice that such institutions will bring the surplus and the deficit units together.

Part 3 refers to corporations and governments who need money, the deficit units. If this part is of academic interest to you, then you will have to focus on Corporate Finance. In Corporate Finance, you will learn how to best raise money for your commercial and financial operations, which require funds.

The same chart receives some arrows to indicate the possible flow of surplus funds to deficit units and their return after the project or investment has been completed.

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The four black arrows indicate how the money will flow from the surplus units to the financial intermediaries. Thereafter to the deficit units and back finally to the surplus units. The $ signs just indicate a quantitative measure which shows how to make sure that all parties gain an income in providing their functions. Value-added from this business will remain in part 2 and part 1. Part 3 will get its value-added from the project, which got realized due to the funds coming form part 2 as they reap the fruits of the investment in their corporation.

But what is better, direct or indirect finance? It all depends, an answer you might have heard too often. Direct lending means you will have to have a direct relationship between the borrower and the lender. Of course, you have cut out the ‘middle person’ and you will have a direct line, a shorter line of a transaction between lender and borrower.

It goes almost without saying that direct financing would be less costly than intermediated financing (via banks), if and only if we had

Perfect knowledge No transaction costs No indivisibility issues.

In such a ‘fictive’ world you would have all the information at hand about everything around you. Transaction costs would not exist, and you could go anywhere without having to spend any resources (i.e. time or money) to get information and information is freely available to you whenever you need it.

Doing a transaction in such a fictive market place incurs no transaction or other costs. Yes, everything is certain to you and anybody else around you. Transacting is free of charge, it will not matter to you. And you have no issue with divisibility, you can buy a tiny fraction of a house or a

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1/10th of a car. Nobody says you cannot invest in a share because its nominal value of the share is above your individual amount available for investment. The world is neatly constructed in such a model. A neat trick to understanding the world in a counterfactual scenario.

Financial intermediations would not be needed if we lived in a “perfect world”! But the real world looks different. Only in this perfect world, which does not exist, we could truly say direct lending is the way to go. Why having a ‘middle man’ - a financial intermediary in-between? You as a borrower-saver or lender-spender could find the right person or company to deal with in a perfect world, without loss of time or cost to find the investor.

But there is no perfect knowledge, there are transaction costs everywhere and the divisibility problem is surrounding you every day in the market place! In fact, you must spend time and money to find information, find a transactional partner and often the issue of divisibility in financial markets incur as a real constraint to decision making. This explains to some extent that financial intermediation is the system of your choice and this is why banks and other intermediaries still exist today.

1.2.2 Monetary Function

The monetary function is linked to the trade or exchange aspect of our economies. The goods and services exchanged in the market place as explained in 1.1.

When we buy and sell our products in the market place we use money. Today’s modern financial systems offer a choice between using ‘cash’ payments, for which we have bills and coins, or using book money. The latter is in our bank accounts and we can command the money into different hands by using our modern financial system payment services. Such payment services are offered by banks and payment service providers. The services go beyond the initial money function as introduced earlier. The main difference is that modern techniques have introduced new features into our world of money keeping, accounting, and banking. The internet and the world-wide-web developments have increased the level of interconnectivity between us all tremendously.

Some of you will still remember the usage of ‘checkbooks’ or ‘bill of exchange’. They have been instruments of payment for quite some time. Surely when introduced, it helped to boost business back then but today who is still using cheques to settle payments? A once modern tool became out-dated after decades due to technological developments. New forms of transferring money and credit have been established. Credit cards had been introduced decades ago. A world without credit and debit cards seems to be unheard of. New payment methods, faster and cheaper than the card business we know it is already coming into the market.

Mobile phone banking and other computer-based payment services (i.e. ApplePay, Paypal, Alipay, etc.) make inroads into the former profitable banking businesses of payments. Such innovations and changes will hit the market as long as technology will keep developing further.

What cash or electronic money have in common is that they allow us to conduct our economic activities within our country and internationally. We take it for granted today to order goods on the internet, the payment side, the most important one to make the goods move from seller to buyer, is hardly noticed. Payments run in the background. But be assured, if the payment side would not

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work, no goods would ever arrive in your hands. Hence, the monetary transaction function is paramount in today’s economy and a simple must have to ensure our economic livelihood.

But what is money which is needed to fulfill the monetary function? How money came about was discussed and described earlier. To get a better grip on money, we have to lean over to economics one more time. Economists think that money must fulfill three functions to be considered money. A good way to check and prove, if something is money or not. Money must be

a medium of exchange, a store of value and a unit of account.

The medium of Exchange – this quality arises from the fact that money is generally accepted in exchange for any goods and services, hence it facilitates transactions since any goods and services can be exchanged for money at any time. It is a handover for goods and services, it is something that is accepted generally. History is full of money examples. Cigarettes have been served as money in hardship times. Other items like pearls and nails have also been chosen in societies to serve as a medium of exchange.

It contrasts nicely to a barter economy in which no money exists. Barter requires the “double coincidence of wants” in order to trade goods. In addition, the medium of exchange should not cause high transaction costs, which means portability, divisibility, durability goes hand it and with it.

Store of Value – this function means that money keeps its value over time, as it is not subject to wear and tear or deterioration as most physical goods are. If you have wealth, you can use the money to store it? Is it a good way to store the value? Only if its value remains over time, hence, inflation not destroying its value, right?

Unit of Account - money represents the unit at which all prices are quoted, and firms’ books are kept.

You can test any good or thing and check out if it can be used as money. It must pass the test of all three functions above. Recall, history is full of different sorts of money. Cigarettes have served as money in prisons, during economic hard times after wars or during wars, tobacco, nails, salt, spices, stones, and jewelry have served as money. In a way, as long as people agree on a particular good to be money, money can be created as long as accepted by everybody in the system.

This leads us temporarily to the question, is Bitcoin the most well-known crypto-currency money? Test it yourself with the described testing tool of economics.

Money or fiat money as we have it today, for instance, the EURO, is actually a ‘public good’ that everybody can have and use once one has received it. Some say that money is “printed freedom” because you can use it whenever you like. You can buy resources with it, goods and services, and you will not get discriminated except for that case that you don’t have enough to come up with the

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requested purchase price. If you have sufficient funds and printed cash, then you will be able to purchase the goods and services in our economic system. This contrast stark to electronic money which is affected by IT-system failures, power outages and other discriminatory actions the controller of the electronic money could exercise whenever possible.

1.2.3 Risk Management Function

This chapter will deal with the overall function of transferring risk in our modern financial society. An important function which is taken for granted today but extremely important because without it some of the bigger projects of our societies would have never occurred because the investment or undertaking would have been too big for one person or one company alone to finance it.

Insurance Companies

The obvious and best-known risk transfer mechanism is with insurance. The main function of insurance is to act as a risk transfer mechanism. Insurance companies have invaded our lives and you can insure almost any potential risk today.

The main trick is that via an insurance contract, you may sign with an insurance company, clearly defined risk elements will be transferred from the insured (you) to the insurer (insurance company). The price you pay is a fee, called the “insurance premium”. This is commonly known but what is the trick?

Insurance companies permit individuals to exchange the risk of a “large loss” for the certainty of a “small loss”. Most common losses people insure against are related to property-, life- and income losses. The purchase of insurance, by paying the premium, spreads the risk associated with any specific contingency over a large number of individuals. Hence, they protect the insured from adverse risks occurring.

The insurance company is using the fact of having a pool of clients who want to be insured against a particular risk, for example, a fire that will destroy property or someone’s home. By pooling the fire insured and by known that the risk of having a fire at home is a very diversified risk, the insurance companies are offering such insurance. If a fire happens and burns down the insured property, the insurance company will pay out the insured amount to the insured person.

Risk transfer is not only a task for insurance companies. Other financial intermediaries, for example, banks, use insurance companies and other financial intermediaries to engage in risk transfer transactions. The modern financial systems offer a wide variety of risk-sharing products that are sold and bought by different market participants.

It is the basic concept that too big or too clumsy projects cannot be borne by one party but sharing the burden may be possible and it can be done when the risk is borne by many parties. Insurance companies and banks are both financial intermediaries that offer exactly this.

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Banks

Banks have been engaging in risk transfer for the last 30 years or so. Allow me to use an example from the history of banking to illustrate my point. Banks limit lending are manifold but the most obvious limits to lend funds have been the deposits banks hold and their own capital position. If a funding request by a deficit unit was too big, the bank could not entertain it. To let the business happened, banks build a consortium of banks. A group of like-minded banks financed the project together, hence, the shared the risk involved in the project according to their individual portions of the financing. This activity is known to be risk-sharing rather than risk-transferring.

Now let us view a financial institution, another name for a bank or for a financial intermediator, which feels it has too much risk on their balance sheet or too many loans booked. This is an impression banker would use when they are involved in the risk management of an individual bank. It means that the bank is of the opinion that they hold too much of a specific risk.

Risk transfer than means the bank could sell that particular risk to other market participants. For instant to you, to another bank or to the government. This is clearly transferring former bank risk to somebody else by selling the claim the bank used to have to a 3 rd party in the financial market. The banks gain back “money” or liquidity. With the freed-up liquidity, the bank is free to sign new business or do enjoy the new “composition of its asset classes”. The bank sold assets – a loan – and received the cash – money – for it.

Example: The new risk manager of our bank views the bank’s credit portfolio differently. She is of the opinion that the bank's exposure to the general car industry is too high in terms of volume and recommends reducing loan exposure to the car industry. The bank has direct loans to the industry car sector and holds corporate bonds issued by Volkswagen AG. Obviously, VW AG is part of the automotive sector in Germany. To reduce the exposure to the sector the bank initiates a sale of the corporate bond issued by VW in the secondary market. The banks act as a seller of the corporate bond and by doing so successfully the bank changes the composition of the assets of the bank. Out goes the corporate bond and income come cash. The bank places a sales order into the secondary bond market with price expectations and a buyer might accept the conditions or both buyer and seller agree upon conditions that are mutually acceptable. The deal is done, the bond moves towards a different bondholder and the bank has reduced its credit exposure to the car industry.

The risk management function described here is a system relevant function. Risk management from an individual bank point of you is very important today. Banking is by and large risk-taking as we will be showing soon in the book. Such individual risk-taking business must be managed in a very careful way to protect the capital of the bank’s shareholder (owner), the deposits of the lender-savers and the loans or credits given to the borrower-spender. The individual bank must manage its risk position very carefully. Why this must happen will be discovered in the following chapters.

We like to close the section with a chart on what modern financial system promote:

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1.3 Taxonomy of financial intermediaries

Financial intermediaries interact in financial markets to bring surplus and deficit units together. Moreover, the intermediaries help to create and trade financial instruments which allows us to bring them together in an efficient way. Moreover, the intermediaries create liquid markets which in turn are needed to “grease the wheels of the real economy”.

Financial economics asserts that our modern financial system, which includes our banking system, is considered to be one of the main drivers of economic growth. Finance has large positive effects on economic growth and brings about efficiency gains. What money has done to the barter economy, that has modern financial intermediation done to the growth of our economies. In other words, our current economic situation would be unthinkable without our modern financial systems. How this system works through financial markets, ho it develops and how it, in turn, affects our financial intermediation will be described in the following chapters. Thereafter a broad quick overview of different financial intermediation will be given.

1.3.1 Financial Markets

A lot has been written on financial markets. We start with the basic question of what should financial markets do? The previous chapter already alluded to the functions needed to be done by financial markets:

1. Channeling funds from savers to spenders.22

2. Financial markets do price financial assets, supply and demand of financial assets meet and determine the price of the respective asset. Once the price of the assets is determined, the signaling of the price function is of utmost importance for those who hold such assets.

3. The pricing has an effect on the wealth situation of the asset holder. When the price is high, the asset value is high as well and a low price will reduce the wealth position of the holder. By and large, consumers and producers might change their consumption or production decision according to the price determined in financial markets.

The 3rd point relates to the fact that modern financial markets are considered to be the main drivers to an increase in production volumes and efficiency in the overall economy. Modern financial systems have broken the limited boundaries of a local community and propelled the financial business to almost every corner of the world. It allows people to take on projects, investments and economic challenges that had been viewed as too big in the past to be considered as feasible and worthwhile investment projects.

Financial markets allow bonds and shares (to be defined later) to be freely traded without being limited to the local market. The financial instruments of Swiss companies are recognized almost everywhere and Toyota, the Japanese car producer is one of the biggest car producers in the world, is able to raise money in most countries around the world.

It is worth mentioning that there are other assets being traded in financial markets (i.e. commodities, precious metals, derivative, etc.) but for the time being, our focus remains on bonds and shares.

1.3.2 Securities / Financial Instruments / Financial Contracts

Bonds and shares are named securities or financial instruments. Both represent financial claims on the issuer’s future income or assets. Mostly governments and corporations raise funds (they are deficit units) to finance their economic activities by issuing debt instruments (bonds) and equity instruments (shares, named stock in the USA).

The broader definition is that bonds are fixed-interest securities issued by institutions that wish to borrow funds for longer periods than 1 year - these maybe government, local authorities or companies. Governments provide a continuous flow of bonds because they run budget deficits and both new and existing companies need to borrow to finance their investments. Bonds issued are debt.

Stocks (equities) are securities that represent a share of ownership in a stock company. They form the basis of a firm’s share capital. They are not dated and so they do not mature, their holders agreeing to put money in the company for an unspecified period of time (equity is long term capital).

A company that wants to grow can either issue bonds or issue stocks to increase the cash position. Please remember, issue debt will not change the ownership structure. Issue equity might change the ownership structure. Is this clearly understood?

The newly injected cash coming from the newly issued securities may be used to grow the business. When such financial instruments can be issued and when investors take them up, the financial markets play a crucial role in placing them to the wider investment community. The market place

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has gotten bigger over time, there are more financial markets all over the globe which simply have increased the market size, the supply of financial instruments and the demand for such instruments that provide the liquidity to the financial markets.

Companies could also turn to banks for their investment needs to grow the business. Banks, like other financial intermediaries, are economic agents who have specialized in the activities of buying and selling securities, but it has been recognized that banks have been more focused on the selling and buying of “financial contracts”.

What is the difference between a “security” and a “financial contract”? As said before, securities like bonds and shares are easily marketable financial instruments. There are special market places where they are traded – stock exchanges. The trading of bonds and shares is easier because the products are to a high degree standardized. International organizations like the London Market Association (“LMA”) try to standardize them to an even higher degree to increase the ability to buy and sell in the (secondary) market place.

Financial contracts, issued by banks, are less marketable. Indeed, they cannot be sold easily once agreed upon. Such financial contracts are loans or deposits, which are contracts between banks and individuals or companies. The typical bank will accept deposits of different kinds form depositors and will, in turn, loan out the deposits to their customer base. Such loans carry very specific features (I.e. maturity profile, repayment arrangements, credit enhancements in the form of guarantees or other collateral positions), which may make it difficult to sell them in general into the market if the bank feels the desire to do so. In other words, the marketability of loans is rather limited in comparison to a much easier sellable bond or stock.

From this perspective, the market for individual loans or smaller loans could be coined in a bank market, while bigger, well-known companies may use the financial market to raise funds directly.

It is worth mentioning, that banks still today form the largest financial intermediaries/ institutions in our economy. The acceptance of deposits and the signing of loan agreements are still very important economic function banks fulfill. However, other financial intermediaries, such as insurance companies, mutual funds, pension funds, IT-based payment service provider and investment banking have been growing their business in the past at the expense of banks which have lost business in turn.

1.3.3 Financial Intermediation

Financial intermediation is not limited to banks alone. How the financial business is conduct depends as said before on many different factors and not geography alone. As said elsewhere, national ideas, when and how the economies have developed has brought about different banking systems and definitions. Hence, the money business takes place in many financial institutions. The most common denominator amongst them is that all financial institutions have to be registered and approved as well as regulated by national monetary authorities.

Approval and on-going oversight are important because financial institutions have a particular effect and influence on our economies. That particular relationship will be highlighted in the following chapter. What follows is a broad overview of the different financial intermediaries. Classification will be offered which resembles facts of today’s world.

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Retail Banking vs. Wholesale Banking

Both terms describe the clientele rather than what kind of banking products are offered. It goes without saying that different client groups demand different banking products. Retail banking is for retail clients - individuals, old and young, using savings and charge accounts for their day-to-day payment services and savings habits. Smaller firms might be retail clients as well. The cluster of products and services offered by them to consumers and small business entities is offered through branches, internet, and other sales channels.

Wholesale banks are aiming at different clients, mostly big companies, municipals and governments who have different needs and demand banking services to engage in the world of business. A distinction between the two groups is the client’s company size. While a retail bank might not discriminate in terms of size, wholesale banks usually will define certain parameters for their target clients. A common one we know is the turnover of business clients. While the author was working for Germany’s largest bank in the late 1990s, the bank did target corporate companies with a turnover above EUR 500 million a year. Additional criteria used for discrimination or selection has been the legal form of the entity. Privately held and run companies, like family-driven companies, would have never been a target either. A distinction is also the transaction volume. Wholesale banks are often “Investment Banks” and engage in Corporate Finance or Corporate Banking activities.

Both of them might call themselves “Commercial Banks” but aiming at very different customers. Commercial banks usually accept deposits (which show up as liabilities on their balance sheet). Deposits get accepted to make loans (which show up as assets on their balance sheet) and/or purchase government bonds. The deposits offered to their clientele are usually saved in the form of an old-fashioned savings book (rather outmoded by now), different savings products differ in terms and interest payments, fixed-term deposits, etc. Often deposits are taken in charging and checking accounts which enable the holder to participate in a modern payment system. Such accounts are linking debit and credit cards which might also be offered by commercial banks or third-party providers which would, in turn, use such accounts for any money they will claim form the client.

Another differentiating feature is where are the banks get their liabilities. Usually, retail banks have deposits and use their own deposits for their lending business. Wholesale banks, on the other hand, tap into the inter-banking market to receive funding. Nowadays, almost 70 % of all European banks fund themselves overnight in the Repo funding markets. Here banks offer collateral like government bonds or corporate bonds against which the bank will receive cash from third party lenders.

Savings and Loans - stand for a particular US American feature of banks. Small banks all over the USA offered deposit-taking accounts and use the funds for local loan making. It was business that was put into real estate lending in a very traditional way. The German equivalent is the Sparkasse system. Here saving banks limited themselves to regional/local business only to do traditional banking. An outsider of the region will most likely not gain access to the funding base. Such self-governed regulatory constraints show the conservative character of the business.

The US saving and loans got hit in the States during the 1970s and 1980s. US interest rate soared and competitor banks offered higher rates. Interest sensible savers moved deposits out of the S&L and created a funding problem for them. Most of the S&L loans were long term with very low yields and with a shrinking funding base, there was a real banking crisis in the making. Changing legislation

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allowed the S&L to compete with the money market products and the situation improved over time. In the 2000s, the savings and loans were the second-largest banking group in the United States of America.

Credit Unions or Volksbanken as said in Germany have a long history in almost any Western country. At the beginning of the industrialization, groups of people noted that there was a need for a non-profit organization in banking. The financial institutions got founded and owned by its members with a very clear focus. Some German farmer noticed the advantages by putting their business interest into such banks who procured farm inputs, collected deposits and loaned out the saved money to members at better conditions. The question regarding what was the primary reason remains secondary. It was in the interest of the members to pool economic activities on the commercial and financial side. You will still find Credit Unions all over the globe with Credit Agricole, starting as a farmer’s bank, being one of the biggest today in Europe. The German DZ bank roots also in credit union ideas developed about 200 years ago in Europe.

Contractual Savings Institution – They acquire funds at periodic intervals on a contractual basis. Insurance companies and pension funds are good examples. In countries with market-based financial features, such institutions play an important rule. They help to organize society how to finance retired people who contribute during their active work lives with periodic payments and receive after retirement the pay-out schedule or retirement funds from them.

Pension Funds

They provide retirement income (in the form of annuities) to employees covered by a pension plan.

The future pensioner or a third party pays monthly contributions that are invested in corporate or governmental long-term securities like bonds and stocks. There are a variety of different models in place. For instance, state pension funds, occupational pension funds, self-employed pension funds, and personal pension funds. In some countries, pensions funds are very important (e.g. USA and UK) whereas elsewhere they are not (e.g. France, Germany, Italy, Malta), because of the different importance of State pension schemes being in place.

Insurance Companies

This takes us to another big group within the financial system, the insurance companies or the insurance sector. Insurance companies want to protect policy-holders from adverse events. Insurance companies receive premiums from policy-holders and promise to pay compensation to policy-holders if particular events occur.

Hence, the purpose of the insurance is to spread the risk of losses that threaten everyone but which will only actually happen to a few of the potential sufferers. Since costs are shared by many, each individual has to pay less than would otherwise have been the case. The insurance contract is signed by the insured, the policy-holder, and the underwriter, the insurer. A so-called premium will be paid by the policy-holder that wishes to arrange insurance at a level, which is usually far less than that of the potential loss that might be incurred. This is our good old insurance model almost anybody knows. Here a quick example of how it works.

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An insurance company provides 100 policyholders with a EUR20K insurance cover for damage to the vehicles. Each policyholder pays an annual premium EUR400. 10 policyholders during the year claim EUR500 for damages, which have occurred. Both the insurance company and the policyholder will have found that insurance was a sensible financial move.

Collective Investment Schemes

Collective investment schemes (“CIS”) are known as pooled funds. Such financial vehicles offer a number of investors the possibility to purchase assets collectively. The funds are managed on a collective basis. This usually suits small to medium-sized investors wishing to invest in a broad spread of investments, or larger investors wishing to gain exposure to specialized sectors. A collective investment scheme may also be called a mutual fund. Shares in a pooled fund are denominated in units that are re-priced regularly to reflect changes in the underlying assets. This allows investors to value their holdings and provides a basis upon which transactions in units can take place.

CIS or mutual funds display clear advantages for common investors, as opposed to High-Net-Worth investors:

1. Mutual funds provide opportunities for small investors to invest in financial securities and diversify risk.

2. Mutual funds take advantage of lower transaction costs when they buy larger blocks of financial securities.

3. Investors are benefiting from a capable management team with extensive experience in financial markets.

Mutual funds differ and give ample opportunities to invest in a variety of economic sectors. The below list is not exhaustive, only informative:

Money market funds Fixed income funds Equity funds Balanced growth funds Commodity funds Total return funds Property funds Infrastructure funds Hedge funds.

Finance Companies

Some of the bigger corporate companies have accumulated profits over decades. Some of the profits got invested in group-related or group-owned finance companies. Such finance companies are supporting the group’s own sales activities. Today you will find that almost all big car producers have their own finance companies. If you want to purchase a VW, PSA or Toyota automobile, the selling company will provide in-house financing at competitive rates to you.

What do they do?

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Grant loans to individuals and businesses. They mainly provide consumer lending, business lending and mortgage financing. Finance companies raise funds through the selling of commercial paper They tend to lend to consumers and businesses with a high-risk profile

Investment Banks

Assist both governments and businesses in the issue of financial tradable securities, such as bonds and shares. They also provide advice for businesses in case of mergers and acquisitions.

Securities Firms

Security firms act as intermediaries in the buying and selling of tradable securities listed on the secondary markets. It is the brokerage activity that financial intermediaries offer. There are two main categories of securities firms – brokers and dealers.

Broker

Brings buyer and seller together to conclude a security transaction The seller sells the security directly to the buyer without any intermediation With the help of the broker, the securities effectively change hands on the floor of the

exchange Trading takes place on centralized trading floors

Dealer

Puts himself in between; buyers’ orders and sellers’ orders are never brought together directly

Buy/ sell orders are executed by market makers 2 separate trades take place, seller A sells Microsoft plc to a dealer and buyer B buys

Microsoft plc from another dealer or the same dealer

This concludes our short overview of different financial intermediaries one can find in today’s financial markets.

1.4 Nature of financial instruments

Financial instruments are broadly divided into two categories – debt and equity. We abstract from other forms of financial instruments to keep the material digestible. Derivative and other hedging instruments offered in modern financial intermediation are important to secure income and cost flows but such instruments will be explained and studied in a different course.

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1.4.1 Debt and Equity

Debt and equity are the most common financial instruments to finance an enterprise, to raise funds for economic activities.

Equity instruments or stocks, as often said in the USA, or shares are real claims of the owner against the assets of a company and more important are claims against the income generated by the company who has issued the shares.

Each company that has chosen the legal form of a stock company will have to issues shares and such shares are representing a portion of the share capital. For example, a fictive stock company named GREATER PLC needs for her economic activities, producing WIDGETS and GADGETS, a capital of EUR 100,000. The founding members decided to have a stock company and want to issue 10,000 shares each worth EUR 10. If you decided to become a shareholder (are you proud to be a part of the founding members) and decided to invest EUR 5,000, you will get in return 500 shares. Your shareholding on GREATER PLC will be equal to 500 shares.

The money you have invested became capital and you invested it with no maturity date in mind. It is long term funding for GREATER Plc and will help to get the company started. Why did you invest? Because you must have believed that the company will not only produce the WIDGETS and GADGETS but you must have seen and believed in the underlying business plan of the company. You expect the company to produce and sell the products and furthermore, you must believe that GREATER Plc will be profitable. Only if the stock company produces profitably, it will be able to give a profit share, the dividend, to you.

What is your share of the company’s profit? Exactly 500 / 10.000. Your portion of the company. In addition, being a shareholder gives you more perks. You are the owner of the company. You may decide and vote who will be a director of the company and who will actively manage the business in the name of the shareholder. Be aware, the role of being a shareholder comes with “rights” and “obligations”. One obligation is that if the company is making a loss, the loss will be covered by your capital contribution. If the company will raise capital, they will approach you first and ask for more capital. You may decline but that has an effect on your relative shares when a successful capital raising has taken place without your contribution.

If the management is behaving illegally and the value of the company in terms of its stock price is falling, your wealth position is affected. On the other side, let us assume the new stock company develops better than expected. It grows, it is profitable for a long period of time. What happens? The stock market price of the company goes up and up and up. You as a shareholder will see a rising stock price and you will gain the full upside of the positive development of the company. This means that you have a chance of capital gains (or capital loss, if it goes “South” instead of “North”) and increasing dividend streams for GREATER Plc. if it becomes a success story economically.

Debt instruments, common instruments are bonds issued by governments or corporations. These are financial instruments used by the issuer to raise debt financing. Such instruments once in the

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hands of the investor represent a claim on the debt issuer to pay a given sum to the investor at a given date. The debt issuer, on the other hand, promises to repay the amount received from the investor at the pre-defined maturity date. For the transfer of money to the issuer, the investor will receive an interest payment, named coupon, when dealing with fixed income debt instruments. Such coupon is a promise of the issuer to pay at certain periods a fixed or variable interest rate based upon the sum invested into the debt instrument. It is safe to say that common bonds are unsecured which means that the money being raised is not backed by any tangible security or collateral. It is just the good name of the issuer that stands up in terms of creditworthiness.

For example, the local government issues a bond with a 5 years maturity – the final date of maturity is 30 Sept 2024. The coupon will be 2.5 % per annum paid twice a year, 31 st of March and 30th of September of every year.

The debt amount raised by the government is equal to EUR 250 million. The issuer is able to sell portions between EUR 500 and EUR 1,000,000 to individual investors. You plan to invest EUR 100,000 and you will get allotted EUR 100,000. Your money will pass over and you will be a government debt holder. Your yearly interest payments are equal to EUR 2,500 or 2 x EUR 1,250. These are the amounts you will get credited into your account end of March and the end of September until the repayment of the bond takes place.

The difference between the two instruments is that the bond will provide you with a secure, fixed interest payment as long as the issuer is solvent and liquid. The stockholder can only expect a dividend for this equity, as long as the stock company makes a profit and the Board of Directors decides positively in the Board Meeting to distribute a dividend to its shareholders.

If the stock company GREATER Plc. is not making any profit, no dividend will be paid. If the bond issuer is not making a profit, the bond issuer still will have to pay the interest payment as long as she is solvent and liquid. In the case of the government bond, we simply assume that a government cannot become insolvent and illiquid or cannot become bankrupt.

Bond Market

The bond market holds many different bonds. One can structure the market according to the issuer quality, interest-payment options, and repayment options. Some bonds have been designed to fit certain regional aspects, like Islamic Bonds. They reflect the religious beliefs and have been invented to tap into the funding base of the Islamic financial systems and nations.

Issuer of Bonds

As said elsewhere, everybody may issue bonds as long as a certain legal procedure is followed. The most known or common bond issuers are governments. They issue bonds to finance government spending programs of any kind. In the last century governments issued “war bonds” to stem the heavy costs of preparing or going to war. In modern times governments are the most regular issuers of bonds. Such bonds are needed to finance government spending. On the demand side, you will find many institutional and private investors investing in government bonds. The main motive to purchase government bonds is the aspect of risk-return. Government bonds, issued by highly rated governments, are almost “risk-free”. If you look for a good investment. which will be returned at the

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maturity day or shall be sold before the maturity day in the secondary market, the government bonds offer a safe haven and are fairly liquid in case you need the liquidity before said maturity day.

The next big class of issuers is financial institutions and large corporations. Banks issue bonds to obtain funds needed for either working capital or strengthening their equity base. By now you are aware of how “wholesale banks” get their funding sources. It will be wholesale banks that regularly tapping into the capital market for raising funds. Large corporations will issue bonds if their company’s good standing allows them to raise sufficient volumes in a certain market place to certain terms and conditions. It goes without saying that a corporate that receives cheaper funds from the banking sector is maximizing something else if they don’t take the bank funds but rather issuing the bond.

Maturity of Bonds

Some issuers require long-term funds and their bonds with a maturity of 5, 10, or 30 years. There are bonds that run 100 years or forever, like, so-called perpetual bonds. On the other extreme, there are short-term commercial papers, which are structured in the range of up to 2 years. Remember issuing a bond is not costless, the related issuer costs are relatively high and any issuer will do the maths to make sure that the funds raised via bond issuing are cost-competitive in relation to other funding alternatives.

Coupons

Bonds have coupons. The term is old fashioned and refers to the time when bonds had coupons attached indicating when you could take such coupon for presentation at a bank’s counter. Against such coupon, the issuer would pay the interest payment. Interest payment features are manifold. Some bonds have fixed interest rates while others have variable rates. The latter is linked to a reference interest-rate, which obviously displays market price features, which are called floating-rates bonds. Other bonds pay the interest rate at maturity. Such zero-coupon bonds are discounted papers and will provide the full par value at maturity only. Well, modern financial systems are very different. There are hardly any coupons or real bonds printed on paper left. Today all bonds are existing in electronic form. The issuing documentation might have been signed for ceremonial reasons, but all of this is available at the issuer’s desk and, if the bonds are traded at exchanges, you will find all related documentation on the websites of the relevant exchanges.

Different feature

Bonds might be issued with the right to have a choice to switch the particular bond into equity at a certain point in time. Such a flexible instrument will allow the bondholder and issuer to change the structure of the debt from debt to equity. These bonds are known to be convertible bonds. Other bonds are index-linked bonds. They have been created to link the value, remember store of value, to something outside the monetary, financial system. For instance, high inflationary countries might issue a bond but to guarantee the future value of the bond, the bond is index-linked to the gold price or another currency like the USD Dollar.

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This list is not comprehensive, but its aim is to serve as an introduction into the world of bonds.

Bond Holders

Bondholders hold bonds in their portfolios. The classical view has been to invest in papers that will provide a constant income stream until maturity. The issuer was of high quality such that the idea of a default hardly came to mind. In recent years, the development of investment banks and the capital market have increased the usage of bonds tremendously. Today, bonds have become prime objects of investors, in particular, the prime target of banks and other financial investors, for instance, pension funds.

Investments in bonds are widespread and you will find bonds everywhere. In the following graph, you will find who is holding Italian Government bonds in 2019. To be precise, the chart shows the %-age of total foreign holdings of Italian sovereign debt. Hence, not the portion which is kept for instance by domestic, Italian financial institutions.

The Financial times issued the below chart in April 2019.

Source: FT Apr 10, 2019 “Italy’s foreign debt investors.....”

You might have heard a lot about the Italian Government debt, which by the way exceeds EUR 2.6 trillion or is an equivalent of over 130 % debt to GDP in 2017. But I would like to draw your attention to the holders of such bonds.

The above chart shows the %-age of total foreign holdings of Italian sovereign debt. This proportion accounts for 30 % of the total amount of outstanding Italian government debt. Hence, 70 % are held domestically mostly by local Italian banks. However, within this 30 % just half of it is in the hands of

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private foreign investors such as professional asset managers, hedge funds, pension funds, and insurance companies. In times of financial stress, those professional investors are very active sellers and buyers (we could call them traders)

and they will use the financial markets to buy and sell such products for the benefit of their investment strategy. Hence, a great example who engages in capital market products like bonds.

1.4.2 Determinants of Interest Rates

The bond interest rates or loan/credit interest rates differ. The question is why do bonds or loans with the same term to maturity have different interest rates? The reason depends on three factors:

1. The issuer’s risk of default2. Liquidity aspects, and3. Taxation issues.

Risk of default

Any bond (or for that matter also any loan) issued and taken by an investor is exposed to the possibility that the bond (or loan) is not being repaid at the time of maturity. This is called risk of default. There are many reasons why a loan or a bond is not being repaid. However, the investor will assess this risk before investing in the financial instrument.

The higher the default risk, the higher the wanted interest rate from an investor’s point of view.

Have a look at the spread of the yields between governments bond with term to maturity 10 years. One is issued by the German Government and the other by the Italian Government.

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Source; FT like before

Given our discoveries, the spread, which is the difference between the two yields, is the expected riskiness between the two different issuers. Now let us do some numerical calculations. The difference in the spread is 2 %. A 2 % difference interest payment on the outstanding Italian government debt is equal to EUR 52 billion. That is a house number for any kind of Government! If Italy would be like Germany, they would save this amount in terms of government spending every year.

Or put simply, the risk of default will drive the yield as established in this section. The higher the default risk of the issuer, the higher the coupon has to be. Only a higher yield will engage the investor by the bond.

Liquidity

Some bonds are liquid. which means they can easily be sold in the market place if a sale is wanted before the maturity date. The greater liquidity will have an effect on the interest rate and more liquid financial instruments, the lower interest rate.

Taxation

Usually, interest income derived from bonds and loans will be taxed. If certain bonds are tax-exempt, this feature will affect the interest rate of the bonds. In general, such tax-exempt bonds will have a lower interest rate.

1.4.3 Term structure of interest rates

This paragraph is about the “yield curve”. But first, we need to discuss what is yield in finance. Yield describes a certain amount earned on a security, over a particular period of time. It refers to the interest or dividend earned on debt or equity, resp., and is conventionally expressed annually as a %-age based on the current market value or face value of the security.

Example 1:

A invests $ 100 into ABC stock company and gets $ 10 as dividend B invests $ 200 into XYZ stock company and gets $ 10 as dividend

o Yield in case of A is 10 % and o B gets 5%.

Both get the same amount, but B gets relatively less because she has invested a higher amount.

Example2:

C buys one stock (or share) whose nominal face value is $ 50. Its current price and annual dividends are $ 53 and $ 2.

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The dividend is given on the face value of the stock and will yield $2/ $50 equals 4 % but the “current yield” is $2 / $ 53 which is 3.77%

Term Structure of Interest Rates

“Yield Curves” or the term structure of interest rates reflects the dimension of time – term to maturity on bonds with identical risk, liquidity and tax characteristic. It is a plot or graph with time on the horizontal or x-axis and the interest rate on the vertical / y-axis.

A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations are called a Yield Curve. They are usually constructed from Government Bonds.

Yield curves display different shapes, they are flat, upward sloping or downward sloping. A downward sloping curve is often named an inverted yield curve.

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There are some theories developed that try to determine the shape of the yield curve. We will not deepen the subject here but it should be mentioned that time plays an important rule here. The most common theories explaining the different shapes can be found in the

Expectation theory Liquidity premium theory and Market Segmentation Approach

Particular interest has been given to the “inverted” yield curve. Some past insides have led some people to believe that it is unlikely for the yield curve to invert without a recession occurring, but a recession can occur without an inverted yield. It is the flattening or steepening to be aware of in banking because it will affect the expectation of the current and future interest rates which, in turn, will change the investment policies of banking.

1.5 Structure of Financial Markets

Structuring and classification have always given humans the comfort of being in control of different aspects. Where would we all be without the definitions, systems, and classification we have done to conquer nature. Financial markets display no difference, we like to measure, define and to differentiate. In this paragraph, I would like to add a few definitions, which will allow you at least to keep on reading the newspaper and understanding key terms of the financial markets.

Primary and Secondary Markets

Financial intermediaries differentiate between a financial transaction that is new at the market place and those which have already been introduced to the financial markets at an earlier time.

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If a transaction is taking place and an issuer of financial securities sells the first time to the initial buyer/ investor, the transaction is taking place in the primary market. This means facilities of new financings issued by a government or large corporates will take place in the primary market.

If a good debt issuer turns to the market, the transaction is often over-subscript. This means that there are more buyers wanting the issued securities than what is actually offered by the issuer. In such a case a fair mechanism is to be established to ensure that the allocation of the offering is done in the least discriminatory fashion. Often a lottery is being used or fractions of the requested amounts given to the respective investors.

Secondary Market – offers holders of securities to re-sell the bonds or equity holdings. As a matter of fact, if you had been unlucky to get your piece of security in a primary market transaction, you may turn to the secondary market (i.e. an organized exchange) and bid for the security. This is when an attractive company got newly listed at an exchange but you remain, due to oversubscription, empty-handed. The secondary market allows you to bid for the wanted security again and given the right price somebody might be willing to sell to you. This would be a typical secondary market transaction.

Most of the trading of securities is done in the secondary market. It is often pointed out that the secondary market function is very important for liquidity purposes. Without a secondary market, the trading – the buying and selling – of financial securities for liquidity reasons would be severely limited and inhibit one of the most important functions in the financial system, the proviso of liquidity. In addition, the secondary market provides pricing information for issuers who already have issued securities and plan to issue another one. A very critical function not to underestimate in the world of finance at all because pricing determines the cost of financing for the issuer but at the same time the income or yield for the investor.

Exchanges and Over-the-Counter Trade (OTC)

Trades in financial securities take place every day and the numbers of such trade are mind-boggling. As mentioned elsewhere, financial systems differ from country to country, but you will most likely find exchanges or bourse in every country. Until recently we divided between exchanges and OTC traders.

Exchanges – here supply and demand meet. The best-known exchange amount financially interested people might be the London or New York Stock Exchange. Here the selling and buying of securities are usually not done by the seller or buyer but a broker will act in the interest of counterparties. Indeed, in the olden days, trading jobs were rare and highly regulated. Only a limited amount of people was allowed to trade in the physical presence exchanges. Exchanges are a centralized place, finely regulated to ensure that no manipulation of pricing will occur.

With the technological revolution of the last 20 years, the physical presence exchanges have been vanishing. Physical presence refers to the simple fact that people, the trader had to be accepted and accredited to be on the trading floor in any exchange in the former days. Today, the exchange trading is dominated by exchanges which are computer-based and do not require any human interventions. For example, if you want to trade VW shares, this can be done at a German presence bourse in Frankfurt or you may choose the electronic platform XETRA for trading.

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Over-the-counter (OTC)

OTC trades are historic. In the old days, people presented the physical securities at the counter for sales. These were usually stocks less common and not easily tradable. They were used by dealers at different locations who had a stock of certain securities and were ready to sell to anyone who was willing to pay the requested price.

Technology increased the linkage between the dealers and OTC transactions became less cumbersome and linked the dealers. In a way, OTC transactions became more competitive and are not much different from electronic exchanges anymore. The US American NASDAQ has been a good example of OTC business. NASDAQ stands for the National Association of Securities Dealers Automated Quotation System.

Capital and Money Markets

The quick divide between the two is that financial securities maturity differs. While money market products are short-term, capital market products are a rather long-term investment. The terminology short-term and long-term characterizes the time frame. While in the 1980s the term ‘long-term’ meant any timeframe beyond 4 or 5 years and hence short- to medium-term anything below 4 years, the subjective feeling towards the time has changed. Today a banker would use the term short-term for anything less than 360 days and long-term for anything longer than 1 year. As a matter of fact, a very interesting phenomenon in modern times.

Capital Markets

This is the place where companies or individuals borrow long-term money in the form of securities. This includes equity instruments, government bonds, and corporate bonds. The long-term nature of capital markets products is extremely attractive for firms who have to invest long term due to their prudent treasury management or often due to regulatory issues. Typical investors would be financial intermediaries like mutual funds, pension funds or insurance companies who have received long term funds from their surplus units with expected long-term horizon pay-out (i.e. retirement pension).

Money Market

The money market is a part of the capital market. Firms and individual borrowers turn to the money market to trade short-term securities which means securities with a duration of less than 1 year.

One of the special features of the money market is, that the participants are wholesale clients, acting professional and fast. The traded volumes are of large size and attract pension funds and money managers who arrange the short-term investments. Typically, money market funds invest in very short-term assets, like government bonds and top-notch corporate debt, to provide clients with a liquid asset alternative to cash.

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Again, pension funds and insurance companies like the money market to park their cash safety which is later needed to pay out pensions or wages at the end of the month. The aim is to maintain its capital at a stable value.

Other forms of intermediation

As you can imagine there are more forms of financial intermediation or financial service companies. Depending on the country of investigation, you will find new features. The Anglo-Saxon world has financial institutions, which are called Dealer or Broker or Dealer/Brokers. A brokerage firm has a license acquired to act in the primary or secondary market for their respective clients.

Payment service providers have been named before. Their target is to facilitate payments among buyers and sellers. However, payment services aren’t financial intermediaries, they don’t get between the surplus and deficit unit. They simply provide a service to those who need to pay and those who need to receive the money to complete the act of exchanging goods or services for money. Remember the monetary function so crucial and needed in our modern financial systems.

Payment as a service, today is known as PAAS, has been the most disruptive technological element which banks have been facing for the last decade. Payments have been for a long time the stronghold of banks in addition to the savings and lending business. The world of payments has been under the attack of new players like PayPal, Apple Pay or Ali Pay. New technologies made it possible to start competing in markets that have been only a few years ago truly under the control of the banking industry. We may safely assume that the process of innovation within the payment services industry is not over yet, in particular, the new blockchain technology will most likely support new developments in this sector.

1.6 Market-based vs. Bank-based financial systems

As mentioned elsewhere the financial systems of every country have been shaped and formed by its history, culture, economic and social development, as well as experiences made by the country when facing economic and financial crises. In a way, it determines the institutions and how counterparties use their financial systems. The distinction that a financial system is market-based or a bank-based financial system has very similar reasons. If the system is more bank-based, a deficit unit / borrower-spender will turn to banks, to “indirect” finance. On the other hand, if it is more market-based, the capital market functions dominate, and borrower-spender / deficit units will look for help outside the banking community. In addition, it would be that “direct” financing is more prevalent with its support of very particular financial market participants offering the related services.

How is it in your country? Where do you turn to in money matters? To the capital market or do you approach banks? Of course, there is no physical address for the “capital market” but banks can be located anywhere. Capital market functions are offered by financial market participants who have specialized in services around capital market products (i.e. services to raise money outside the banking world, placing new debt with investors, working down compliance and regulatory

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requirements, enable stock exchanges to trade your capital market products, loan documentation, legal guidance, and advice, etc.).

I am certain that banks exist in your home country, but I am also certain that some capital market features might be around. The world is too colorful, and each country shows specific financial system characteristics. One might find institutions that might have received the governmental task to set up a pension system for the retired persons in society. Insurance companies will also be around and given the history of some countries, the tasks done today by insurance companies might have been affected by this very past. And last, but not least, the stock exchange in your home country. Is the exchange well known to all in society? Or is the exchange hidden and does the bourse do only very little business? The answer to all those questions might provide us with some insights on how important banks or market mechanisms are in the provision of financial services in your own home country.

The Anglo-Saxon cultures, this refers usually to the United States of America and the United Kingdom, are known to be more market-based when looking at financial markets. Continental Europe with France and Germany is more known to be more bank-based. That is important in many aspects, a more bank-based system requires banks and relies on banks to channel finance between savers and lenders.

One of the interesting fields of studies is how banks and commercial companies in countries are related. While you find little integration of the two in the UK and the USA, you will find close ties between banks and commercial companies in Germany and Japan. For instance, in Germany, the links between the Boards of Directors of banks and commercial companies have been astonishing. The closeness might be valued differently, depending on what you have in mind. But imagine a Board Meeting in a company which will have to discuss an investment project and a Board Member is from a nearby local wholesale bank. Wouldn’t you naturally turn to him for opinion and support?

Storm (2018) points out, that Schumpeter and Gerschenkorn, two economists, celebrated the developmental role played by the bank-based financial system, in which banks form long run, often personal, relationship with firms. They display higher insider knowledge and when being a creditor to the firm, they are in a position to exert strategic pressure on firms. Hence, they could impose certain rational on the management and prioritize the repayment of their own debts.

Well, one would not be open-minded, if we would not see the dependence relationship in this constellation. The bank-based financial systems could weaken the corporate governance of firms because bank managers might be reluctant to bankrupt a firm with which they have had long-term ties. It might lead to cronyism and corruption and it makes it easier for insiders to exploit other creditors and taxpayers. Schumpeter’s relationship bankers could be fallible, weak, prone to mistakes and errors of judgment and not necessarily immune to corruptible influences. In the short, there are reasons to believe that bank-based systems are inferior to an alternative, market-based, financial system. (Levine 2005).

On the other hand, a market-based system is not generating better results per se. Issuing a bond is professional work and the most issuer will turn to a financial advisory service. The corporate finance department in banks or private corporate advisory companies will compete for any bond-issuing mandate. The legality is complex and once done, the raising of the funds might be another interesting hurdle to overcome. When done outside the normal banking frame, the corporate

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advisor will guide the issuer to investors who have the surplus funds. As long as one talks to professional investors who have the expertise in the field, no misinterpretation may be assumed but once you sell to the less educated investor groups, there may be a “conflict of interest”. Will you support the issuer’s interest in raising the funds via a security issue or will you be on the side of the investor who would like to have a “normal return” for his investment. This is an interesting point from a moral and legal point of view, which will no longer be followed up here.

With the technological revolution of the last 25 years, the financial industry has been tremendously challenged and changed. A former board member of the Deutsch Bank AG, Germany, Mr. Cartellieri already said in the 1990s that the banks had to follow the steel industry of the 1980s. He predicted the downfall of the profits and expected tremendous changes to take place. His prophecy was presented to the public too early but today the question of “do we still need banks?” is very acutely discussed today.

The divide between what is banking business and what is non-banking business has surely grown and new competition to the ‘brick-and-mortar’ banks is seen everywhere today. The new competition wants to get the so-called big profits, which historically banks used to make.

Non-banks are allowed to offer investment advice, underwriting capabilities, insurance programs, trust, and property services, yes, the world of financial intermediation is changing again. Banks still carry on with their traditional role of taking deposits and having deposit-based lending models in place.

In the next section, we will examine why financial intermediation, why banks, in particular, exist and we will use economics to show and explain the reasons for their existence. You will gain insights into the functioning of banks and how they add value to society and should generate a profit for its shareholders.

END OF CHAPTER 1

CHAPTER 2 TO CHAPTER 5 WILL FOLLOW SOON

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