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Chapter 3 - Market Structures

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This Lecture

Financial Systems

Markets

Intermediaries

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This Lecture

options of financial demand and supply

regional differences in financial structures

how people save and invest

criteria of financial market classifications

the trade-off between risk and return

the international dimension

the interconnectedness of markets

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Options

Which options has a private household in western Europe

• looking to finance the purchase of a new car, a house, or other consumer durables?

• looking for an opportunity to save?

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Options

a private household in western Europe looking to finance the purchase of consumer durables can

• take a bank loan

• look for special finance (mortgage, consumer loan offered by a car producer ...)

• use a credit card

• spend own savings ...

in most cases a financial intermediary is needed

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Options

a private household in western Europe looking for an opportunity to save can

• open a savings account

• buy bonds or shares

• speculate in foreign exchange

• invest in derivatives

• buy insurance

• keep the money under the mattress

in most cases a financial intermediary is needed

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Financial intermediaries

• take the money from one party and give it to another in exchange for a small fee or other form of compensation, or

• arrange for capital demand and supply to meet in organised markets.

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Providers of financial services include

• banks

• investment funds

• insurance companies

• credit card companies

• non-bank financial firms (GE Capital, Ford Motor Credit Company) ...

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Options

Which options has a business firm in western Europe looking to

• finance an investment or

• its daily expenses or

• actively manage financial risks?

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Options

A business firm can

• take a bank loan

• issue securities

• buy and sell short-term papers, bonds and shares

• engage in money market and foreign exchange transactions

• engage in derivatives trading

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Options

Firms’ financial options depend on size:

In financial markets, larger customers

• get better conditions both as borrower and investor;

• face a wider spectrum of financial instruments and

• have better market access

than smaller ones.

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Options

Discuss:

In which way do business firms and households differ with respect to

• transparency

• creditworthiness

• overall economic performance?

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Business firms

Special case: Institutional Investors

• mutual funds

• life insurance companies

• pension funds

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Business firms

Institutional Investors are characterised by

• financial strength

• professional management of collective

portfolios

• strict prudential rules for asset allocation

• long-term engagements, buy-and-hold strategy

• strong preference for stable markets and

smooth trading

• high risk of reverse price movements, strong focus on traditional debt instruments and equity.

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Business firms

Institutional Investors are:

• large and reliable sources of finance;

• enhancing market stability;

• contributing to financial development

• and economic growth.

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Table 3.1: The Financial Structure in the Euro Area, Japan and the United States1

Assets Liabilities Net PositionEuro Area Households 202 57 145 Non-financial corporations 147 240 -93 Financial corporations 371 369 2 Government 28 80 -52 Total 748 746 2Japan Households 281 78 203 Non-financial corporations 140 250 -110 Financial corporations 596 598 -2 Government 86 146 -60 Total 1,104 1,072 32United States Households 322 80 242 Non-financial corporations 112 132 -20 Financial corporations 334 332 3 Government 20 62 -42 Total 788 606 1821 In 2001, as percentage of GDP.

Source: Hartmann, Philipp, Maddaloni, Angela and Manganelli, Simone (2003): The Euro Area FinancialSystem: Structure, Integration and Policy Initiatives, European Central Bank, Working Paper No. 230,http://www.ecb.int/pub/wp/ecbwp230.pdf, Table 1.

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In Europe, as in the United States and Japan, households are the ultimate providers of funds for non-financial corporations and governments.

Financial corporations merely function as intermediaries.

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Table 3.2: How People Save and Invest1

Europe Japan United StatesMutual Funds 8 4 11Securities 28 10 37Pensions 15 9 32Life Insurance 17 18 3Deposits 32 59 17Total 100 100 1001 In percent.

Source: Delphine Sallard (1999): Risk Capital Markets, a Key to Job Creation in Europe. FromFragmentation to Integration. Euro Paper No. 32, Brussels: European Commission, Figure 7,http://Europa.eu.int/comm/economy_finance/publications/Euro_papers/2001/eup32en.pdf.

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Europeans appear more risk averse than US Americans.

They spend more on life insurance and less on securities and mutual funds.

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Table 3.3: Sources of Financing and Investments in the Euro Area1

Sources of Financing InvestmentsHouseholds Loans 52 Debt securities 0 19 Shares 0 67

Currency and deposits 0 61Non-financial Corporations Loans 68 Debt securities 8 9 Shares 132 77 Currency and deposits 0 15Financial Corporations Loans 12 Debt securities 50 80 Shares 75 69 Currency and deposits 170 77Government Loans 15 Debt securities 57 2 Shares 0 9 Currency and deposits 4 6

Total Loans 95 Debt securities 115 110 Shares 207 222 Currency and deposits 174 1591 In percent of GDP.

Source: Hartmann, Philipp, Maddaloni, Angela and Manganelli, Simone (2003): The Euro Area FinancialSystem: Structure, Integration and Policy Initiatives, European Central Bank, Working Paper No. 230,http://www.ecb.int/pub/wp/ecbwp230.pdf, Table 2 and 3.

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European households

• rely on loans for external funding and

• invest their money above all in shares and bank accounts.

For companies in Europe

• the stock markets are the most important source of external finance

• followed by bank loans.

• Debt securities play a minor role.

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Other European characteristics are:

• the importance of internal funding

• the role of private equity

Both can be explained in parts by the comparably high share of small and medium-sized firms in Europe.

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Figure 3.1: Financial Market Products

Non-transferables

loans

deposits

mortgages

…

Securities

equities

bonds

notes

...

Derivatives forwards swaps options ...

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Financial market diversity reflects the variety of

needs and preferences ...

and the inherent dangers and limitations.

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There is a constant trade-off between risk and

return

underlying all financial transactions:

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Figure 3.2: Risk and Return Relations

D D'

C

C' B' B

A'

A

Return

Risk

Borrowing

Investment

If overall risk in a market rises from A to A’, investors will invest less in this market and demand a higher return. As a consequence, returns will rise. Higher returns mean higher borrowing costs leading to a decline in borrowing from C to C’. Since at higher risks some investments will not be made at all total investment will decline from D to D’.

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Discuss:

In which way do the positions of shareholders and bond holders differ with respect to

• flexibility

• overall risk

• return of their investment?

Distinguish between institutional investors and private households.

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Products are only one way to classify markets ...

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Table 3.4: Financial Market Classification

Criterion Features Examples

Products Tradability, transferability,ownership, maturity,denomination, substance

Equity, debt instruments,derivatives

Services Technical, advisory, informationand knowledge-based,administrative

IT support, research andanalysis, custody

Ways of Trading Physical, electronic, virtual Over-the-counter, exchange,internet

Actors Professionals, non-professionals,institutions, individuals, officials

Banks, central banks, non-bankfinancial companies, institutionalinvestors, business firms,households

Origin Domestic, cross-border,regional, international

National markets, regionallyintegrated markets, Euromarkets,domestic/foreign currencymarkets, onshore/offshoremarkets

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Financial Market Classification

Services

• technical

• advisory

• information and knowledge based

• administrative

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Financial Market Classification

Ways of Trading

• physical

• electronic

• virtual

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Financial Market Classification

Actors

• professionals

• non-professionals

• institutions

• individuals

• officials

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Financial Market Classification

Origin

• domestic

• cross-border

• regional

• international

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Internationalisation and globalisation of financial services have widened the range of opportunities:

• borrowing and investing are not restricted to domestic markets;

• borrowing and investing are not restricted to the domestic currency;

• borrowing and investing are not restricted to domestic suppliers of financial services.

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Why do financial institutions, borrowers and investors go abroad?

• market access:

actors may be excluded from sources in one place that are available to them in others;

• risk and return considerations:

conditions in international markets may be more favourable;

risk monitoring and managing simpler and more reliable;

diversification opportunities more numerous.

• cost and efficiency considerations:

financial institutions may realise additional economies of scale.

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Domestic, foreign and international financial markets offer a wide range of risk and return combinations.

Actors usually engage in a variety of borrowing and lending activities.

As a consequence, markets are highly interconnected:

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Example:

a decline in shareholders’ trust in a company’s future performance may trigger a chain reaction ...

Figure 3.3: Micro-interdependencies

FIRM LEVEL

STOCK

MARKET

BOND

MARKET

SHORT-TERM FIXED- INCOME MARKET

BANKING

SECTOR

Profits

Share price

Bond price

Access to short-term finance

Access to credit lines

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Links exist

• across markets

• within industries

• between industries

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Summary

• Europe’s financial landscapes are characterised by diversity.

• Compared to the US, Europeans appear more risk averse.

• Internal funding and private equity play an important role.

• The diversity of financial products reflects the variety of needs

and preferences.

• Financial market participants face a constant trade-off

between risks and returns.

• As a consequence of internationalisation and globalisation

financial opportunities are not restricted to domestic markets.

• Financial markets for different products are highly

interconnected.

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Key Words Assets Financial claims or pieces of property that are a store of

value; in the balance sheet: items representing what a

company owns (in contrast to liabilities which describe what

a company owes)

Loan The temporary provision of money which is usually repaid

with interest

Security Claim on a borrowers’ future income that is sold to the

lender; already existing securities can be bought and sold on

exchanges or over the counter (OTC)

Bond A debt security issued by a company, government or other

borrower usually paying interest and traded in a market; by

some practitioners only used to describe long-term debt

instruments

Equity Claims to share a corporation’s net income and assets

Private Equity Equity securities of companies that have not listed their

stock on a public exchange; investors wishing to sell private equity

must find a buyer in the absence of a marketplace

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Key Words Institutional Investor An organisation whose core activity is to invest its own

assets or those held in trust by it for others

Risk premium The part of the rate of return which compensates the

investor for assuming risk

Internal finance Finance generated within a firm by retained earnings and

depreciation.

Tradability Characteristic of a financial asset allowing it to be publicly

bought and sold

Transferability The ability to change ownership or title

Market The place where potential buyers and sellers meet; the total

of all the existing and potential buyers of a product or

service

Exchange An organized market providing a facility for members to

trade