Chapter 2: An Overview of the Chapter 2: An Overview of the Financial SystemFinancial SystemChapter 2: An Overview of the Chapter 2: An Overview of the Financial SystemFinancial System

• Classifying Financial Markets

• Financial Market Instruments

• Financial Intermediaries

• Regulation

• Classifying Financial Markets

• Financial Market Instruments

• Financial Intermediaries

• Regulation

I. ClassificationI. ClassificationDebt vs. Equity MarketsDebt vs. Equity MarketsI. ClassificationI. ClassificationDebt vs. Equity MarketsDebt vs. Equity Markets

• debt security cash flows are fixed bonds, loans

• equity security cash flow variable, residual common stock

• debt security cash flows are fixed bonds, loans

• equity security cash flow variable, residual common stock

Primary vs. Secondary MarketsPrimary vs. Secondary MarketsPrimary vs. Secondary MarketsPrimary vs. Secondary Markets

• primary market newly issued securities

-- investment banking

• secondary market brokers match buyers and sellers dealers act as buyers and sellers

-- “market-makers”

• primary market newly issued securities

-- investment banking

• secondary market brokers match buyers and sellers dealers act as buyers and sellers

-- “market-makers”

Exchanges vs. OTC MarketsExchanges vs. OTC MarketsExchanges vs. OTC MarketsExchanges vs. OTC Markets

• exchange buying & selling of securities in

physical location NYSE

• OTC (over-the-counter) dealers in many locations buy &

sell securities

• exchange buying & selling of securities in

physical location NYSE

• OTC (over-the-counter) dealers in many locations buy &

sell securities

Money vs. Capital MarketsMoney vs. Capital MarketsMoney vs. Capital MarketsMoney vs. Capital Markets

• money market short-term debt securities (up to 1

yr.) highly liquid, low risk

• capital market longer-term debt equity

• money market short-term debt securities (up to 1

yr.) highly liquid, low risk

• capital market longer-term debt equity

II. Financial Market InstrumentsII. Financial Market InstrumentsII. Financial Market InstrumentsII. Financial Market Instruments

a security or financial instrument

= claim on future income or assets of issuer

a security is an asset for the buyer,

but a liability for the issuer

a security or financial instrument

= claim on future income or assets of issuer

a security is an asset for the buyer,

but a liability for the issuer

exampleexampleexampleexample

• shares of stock in Time Warner, Inc. shares of ownership in TW a claim on the earnings/assets of

TW a liability for Time Warner an asset for me

• shares of stock in Time Warner, Inc. shares of ownership in TW a claim on the earnings/assets of

TW a liability for Time Warner an asset for me

• my mortgage I am the issuer (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

• my mortgage I am the issuer (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

Money Market

20%

25%39%

9%0%

4%3%

U.S. Tbills

CDs

CommercialPaperBanker'sAcceptancesRepos

FederalFundsEurodollars

Capital Market

4% 8%11%

18% 59%

Stock

Mortgages

U.S. bonds

MunicipalbondsLoans

III. Financial IntermediariesIII. Financial IntermediariesIII. Financial IntermediariesIII. Financial Intermediaries

Why have them?

• Transactions costs search costs to find borrower &

lender contract costs economies of scale

Why have them?

• Transactions costs search costs to find borrower &

lender contract costs economies of scale

• Risk sharing intermediaries are experts at

bearing risk asset transformation

• Risk sharing intermediaries are experts at

bearing risk asset transformation

• Asymmetric Information one party has more info than the

other creates problems BEFORE loan is

made creates problems AFTER loan is

made financial intermediaries minimize

these problems

• Asymmetric Information one party has more info than the

other creates problems BEFORE loan is

made creates problems AFTER loan is

made financial intermediaries minimize

these problems

adverse selectionadverse selectionadverse selectionadverse selection

• BEFORE the loan

• people with worst credit are more likely to seek a loan lending not attractive

• solution? banks expert at assessing credit

risks

• BEFORE the loan

• people with worst credit are more likely to seek a loan lending not attractive

• solution? banks expert at assessing credit

risks

moral hazardmoral hazardmoral hazardmoral hazard

• AFTER the loan

• once money is lent, borrower may blow the money

• solution banks monitor borrowers and

enforce lending contracts

• AFTER the loan

• once money is lent, borrower may blow the money

• solution banks monitor borrowers and

enforce lending contracts

Types of intermediariesTypes of intermediariesTypes of intermediariesTypes of intermediaries

Depository institutions

• “banks”

• accept deposits, make loans

Depository institutions

• “banks”

• accept deposits, make loans

• Commercial banks largest in total assets

• Savings & Loans originally restricting to savings deposits

and mortgages less restricted today

• Credit Unions consumer loans nonprofit organized around a group

• Commercial banks largest in total assets

• Savings & Loans originally restricting to savings deposits

and mortgages less restricted today

• Credit Unions consumer loans nonprofit organized around a group

Contractual savings institutions

• acquire funds through payments in return for obligations

• life insurance

• property and casualty insurance

• pension funds

Contractual savings institutions

• acquire funds through payments in return for obligations

• life insurance

• property and casualty insurance

• pension funds

Investment intermediaries

• indirect investment

• finance companies issue commercial paper consumer & commercial loans

• mutual funds sell shares to stock/bond portfolios

• taken away bank business in past 30 years

Investment intermediaries

• indirect investment

• finance companies issue commercial paper consumer & commercial loans

• mutual funds sell shares to stock/bond portfolios

• taken away bank business in past 30 years

• money market mutual funds money market portfolio shares = $1, pay dividends check writing privileges

• money market mutual funds money market portfolio shares = $1, pay dividends check writing privileges

IV. RegulationIV. RegulationIV. RegulationIV. Regulation

• Reducing asymmetry of info disclosure of financial information

-- by companies selling securities

-- by financial institutions restrict insider trading

• Reducing asymmetry of info disclosure of financial information

-- by companies selling securities

-- by financial institutions restrict insider trading

• promoting stability prevent financial panic

-- markets cease to function financial institutions

-- restrict ownership

-- restrict activities

-- insurance on deposits

• promoting stability prevent financial panic

-- markets cease to function financial institutions

-- restrict ownership

-- restrict activities

-- insurance on deposits

• controlling the money supply Federal Reserve System

• controlling the money supply Federal Reserve System