Lecture 1

Financial Systems, Markets, Institutions, Instruments and Crisis.

IntroductionThe international financial system exists to

facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics.

We obtain financial resources through this system:Directly from markets, and Indirectly through institutions.

Introduction Indirect Finance: An institution stands between

lender and borrower. We get a loan from a bank or finance company to buy

a car.

Direct Finance: Borrowers sell securities directly to lenders in the financial markets. Direct finance provides financing for governments and

corporations.

Asset: Something of value that you own. Liability: Something you owe.

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The Balance SheetThe balance sheet is a snapshot of the

firm’s assets and liabilities at a given point in time

Assets are listed in order of decreasing liquidity Ease of conversion to cash without

significant loss of valueBalance Sheet Identity

Assets = Liabilities + Stockholders’ Equity

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U.S. Corporation Balance Sheet – Table 2.1

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Income StatementThe income statement is more like a

video of the firm’s operations for a specified period of time

You generally report revenues first and then deduct any expenses for the period

Matching principle – GAAP says to recognize revenue when it is fully earned and match expenses required to generate revenue to the period of recognition 7

U.S. Corporation Income Statement - Table 2.2

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Financial Management DecisionsCapital budgeting

What long-term investments or projects should the business take on?

Capital structureHow should we pay for our assets?Should we use debt or equity?

Working capital managementHow do we manage the day-to-day finances

of the firm?

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Forms of Business OrganizationThree major forms in the United States

Sole proprietorshipPartnership

General Limited

Corporation S-Corp Limited liability company

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Goal Of Financial ManagementWhat should be the goal of a corporation?

Maximize profit?Minimize costs?Maximize market share?Maximize the current value of the company’s

stock?Does this mean we should do anything

and everything to maximize owner wealth?

Sarbanes-Oxley Act

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The Agency ProblemAgency relationship

Principal hires an agent to represent its interests

Stockholders (principals) hire managers (agents) to run the company

Agency problemConflict of interest between principal and

agentManagement goals and agency costs

Financial system survey in three steps:

1. Financial instruments or securities Stocks, bonds, loans and insurance. What is their role in our economy?

2. Financial Markets New York Stock Exchange, Nasdaq. Where investors trade financial instruments.

3. Financial institutions What they are and what they do.

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Financial InstrumentsFinancial Instruments: The written legal

obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions.The enforceability of the obligation is

important.Financial instruments obligate one party

(person, company, or government) to transfer something to another party.

Financial instruments specify payment will be made at some future date.

Financial instruments specify certain conditions under which a payment will be made.

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Uses of Financial InstrumentsThree functions:

Financial instruments act as a means of payment (like money). Employees take stock options as payment for working.

Financial instruments act as stores of value (like money). Financial instruments generate increases in wealth

that are larger than from holding money. Financial instruments can be used to transfer

purchasing power into the future.Financial instruments allow for the transfer of risk

(unlike money). Futures and insurance contracts allows one person to

transfer risk to another.3-15

Financial MarketsFinancial markets are places where financial

instruments are bought and sold.These markets are the economy’s central

nervous system.These markets enable both firms and

individuals to find financing for their activities.

These markets promote economic efficiency:They ensure resources are available to those

who put them to their best use.They keep transactions costs low.

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The Role of Financial Markets1. Liquidity:

Ensure owners can buy and sell financial instruments cheaply.

Keeps transactions costs low.

2. Information: Pool and communication information

about issuers of financial instruments.

3. Risk sharing: Provide individuals a place to buy and

sell risk.

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Primary versus Secondary MarketsA primary market is one in which a borrower

obtains funds from a lender by selling newly issued securities.Occurs out of the public views.An investment bank determines the price,

purchases the securities, and resells to clients. This is called underwriting and is usually very

profitable.

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Primary versus Secondary MarketsSecondary financial markets are those where

people can buy and sell existing securities.Buying a share of IBM stock is not purchased

from the company, but from another investor in a secondary market.

These are the prices we hear about in the news.

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MoneyAny generally accepted means of payment

for delivery of goods or the settlement of debt

Legal moneynotes and coins

Customary moneyIOU money based on private debt of the

individuale.g. bank deposit.

©McGraw-Hill Companies, 2010

Money and its functionsMedium of exchange

money provides a medium for the exchange of goods and services which is more efficient than barter

Unit of accounta unit in which prices are quoted and accounts

are keptStore of value

money can be used to make purchases in the future

Standard of deferred paymenta unit of account over time: this enables

borrowing and lending©McGraw-Hill Companies, 2010

Modern bankingA financial intermediary

an institution that specialises in bringing lenders and borrowers together e.g. a commercial bank, which has a

government licence to make loans and issue deposits

including deposits against which cheques can be written

Clearing systema set of arrangements in which debts

between banks are settled

©McGraw-Hill Companies, 2010

A beginner’s guide to the financial markets

Financial asseta piece of paper entitling the owner to a

specified stream of interest payments over a specified period

Cashnotes and coins, paying no interestthe most liquid of all assets

BillsShort-term financial assets paying no

interest directly but with a known date of repurchase by the original borrower at a known price.

highly liquid©McGraw-Hill Companies, 2010

A beginner’s guide to the financial markets (2)

Bonds longer term financial assets – less liquid because

there is more uncertainty about the future income stream

Perpetuitiesan extreme form of bond, never repurchased by the

original issuer, who pays interest forever e.g. Consols

Gilt-edged securitiesgovernment bonds in the UK

Company shares (equities)entitlements to receive corporate dividendsnot very liquid©McGraw-Hill Companies, 2010

Credit creation by banksCommercial banks need to hold only a

proportion of assets as cash reserves.This enables them to create credit by

lending.

Example:Assume banks use a reserve ratio of 10

per cent. Suppose, initially, the non-bank private

sector has wealth of £1000 held in cash:

©McGraw-Hill Companies, 2010

Financial crisesA financial panic is a self-fulfilling prophecy.

Believing a bank will be unable to pay, people rush to get their money out. But this makes the bank go bankrupt.

In a solvency crisis, an institution’s assets have become less than its liabilities.

In a liquidity crisis, an institution is temporarily unable to meet immediate requests for payment.

©McGraw-Hill Companies, 2010

The subprime crisisA subprime mortgage is a housing loan to a low-

income high-risk person.Most of these mortgages were at variable

interest rates: although initially low and ‘affordable’, they could subsequently be raised

US house prices peaked in 2006. As they then fell, lenders became worried and began to raise mortgage interest rates, driving many of the poor to default.

Suddenly, these subprime mortgages were worth a lot less than had been thought.

©McGraw-Hill Companies, 2010

SecuritisationSecuritisation transformed this into a global

problem. Financiers had bundled lots of individual subprime mortgages into large bundles and sold them on to new buyers in London, Frankfurt and Mumbai.

The market was convinced that although one poor subprime household might default, they would not all do so together.

However buyers of securitized mortgages had miscalculated.

©McGraw-Hill Companies, 2010

The Credit CrisisIt was quite likely that circumstances could arise

in which all subprime borrowers got into trouble at the same time.

And so they did. As US house prices fell sharply, banks found their assets worth much less than they had thought.  

As the solvency of banks came into question, people became reluctant to lend to banks, and banks themselves became reluctant to lend to anyone else

©McGraw-Hill Companies, 2010

Top World’s Biggest Financial Crises Ever

Panic of 1819, a U.S. recession with bank failures; culmination of U.S.'s first boom-to-bust economic cycle

Panic of 1825, a pervasive British recession in which many banks failed, nearly including the Bank of England

Panic of 1837, a U.S. recession with bank failures, followed by a 5-year depression

Panic of 1847, United Kingdom Panic of 1857, a U.S. recession with bank failures Panic of 1866, Europe Panic of 1873, a U.S. recession with bank failures, followed by a 4-

year depression Panic of 1884, United States and Europe Panic of 1890, mainly affecting the United Kingdom and Argentina Panic of 1893, a U.S. recession with bank failures Black Monday (stock crashes 22% 1987) Credit Crisis of 1772 1907 Banker's Panic

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Top World’s Biggest Financial Crises Ever German Hyperinflation, 1918-1924 OPEC Oil Price Shock (1973) Wall Street Crash The Great Depression 1998 Russian Crises 1997 Asian Crises Japan’s "Lost Decade," 1990-2000 Financial crises of 2008 Subprime mortgage crisis in the U.S. starting in 2007 2008 United Kingdom bank rescue package 2009 United Kingdom bank rescue package 2008–2009 Belgian financial crisis 2008–2012 Icelandic financial crisis 2008–2009 Russian financial crisis 2008–2009 Ukrainian financial crisis 2008–2012 Spanish financial crisis 2008–2011 Irish banking crisis European Sovereign Debt Crisis, 2009 onward

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Black MondayIn the finance world, The Black Monday

refers to the time of October 19, 1987. During that day, there was a widespread stock market crash all around the world. The beginning of this crash originated in Honk Kong and eventually spread to Europe. Ultimately, the United States was affected as well. The Dow Jones dropped by 22.1%, and it took almost 2 years to reach even the previous high of 1987

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1907 Banker's Panic

The Panic of 1907 saw the Dow drop almost 50% from the high of the previous year. It was triggered by the usual suspects: over-expansion and poor speculation. The stock market crashed in March, and a second crash in October led to a run on banks and every trust in New York, notably causing the massive National Bank of North America to fail.

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Credit Crisis 1770This crisis originated in London and spread to other parts

of Europe, such as Netherlands. Ironically, it had been preceded by a period of great prosperity for Britain. The mid 1760s and 1770s saw a credit boom which spurred greater manufacturing and industrial activity. The period of 1770 to 1772 was politically very stable for Britain and its colony, America. However, there was a deeper systemic problem that prevailed under the surface of this prosperity. Speculative practices thrived to generate more credit, and this led to a false feeling of optimism in the market. On June 8, 1772, the fleeing of one of the partners of the Banking House “Neal, James, Fordyce and Down” due to failure to repay debts led to panic.

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Japan’s "Lost Decade," 1990-2000The collapse of the Japanese asset bubble in 1991

led to a prolonged period of low growth, which has since been extended to incorporate the decade since the year 2000. The original lost decade was caused by an unsustainable level of speculation, large amounts of credit and low interest rates (sound familiar?). When the government stepped in to control this, credit became much harder to obtain, and capital investment dropped significantly.

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Dot-Com BubbleThis speculative bubble related to internet based

companies saw massive rises in equity stock values of industrialized nations from 1997-2000. This bubble began because of easy credit availability in 1997-1998. These start-up companies wanted to establish a high market share by establishing more coverage. This meant that many of the services were freely provided, and large operational losses were actually occurring. They wanted to establish a brand and then charge profitable rates. The phrase “Get large or get lost” operated in the minds of company founders. 

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European Sovereign Debt Crisis, 2009 onwardThis is the most recent of the crises on our

list, and no one is yet certain about when, or how, it is going to end. Markets have grown increasingly concerned about the ability of nations, particularly Greece, Ireland, Spain, Portugal, and Italy, to pay their debts, and the exposure of international banks to these potentially toxic debts has played a large part in the enormous market falls of recent days — some of the worst on record.

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Financial crises of 2008

This crises was considered the worst one since the Great Depression itself. This easy availability of credit propelled greater demand for housing and a bubble started. However, once this ended, there was a big crash in housing prices. Mortgage values now exceeded the values of houses bought. A great level of lending to less credit worthy borrowers had also prevailed, called sub-prime lending. The existence of financial instruments like Collateralized Mortgage obligations (CMOs) allowed the effect to spread to the entire financial market. Financial innovations led to far greater risk taking appetite. However, the eventual collapse of trust in the market froze lending activity.

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