Chapter TwoOverview of the Financial System

Function of Financial Markets Allows transfers of funds from person or business without investment opportunities to one who has themImproves economic efficiency

Function of Financial Markets Figure 2-1: Flow of Funds Through the Financial System

Classifications of Financial MarketsDebt MarketsShort-Term (maturity < 1 year) Money MarketLong-Term (maturity > 1 year) Capital MarketEquity MarketsCommon Stock

Classifications of Financial MarketsPrimary MarketNew security issues sold to initial buyersSecondary MarketSecurities previously issued are bought and sold

Classifications of Financial MarketsExchangesTrades conducted in central locations (e.g., New York Stock Exchange) Over-the-Counter MarketsDealers at different locations buy and sellNYSE home page http://www.nyse.com

Internationalization of Financial MarketsInternational Bond MarketForeign bondsEurobonds (now larger than U.S. corporate bond market)World Stock MarketsU.S. stock markets are no longer always the largest at one point, Japan's was larger

Function of Financial IntermediariesFinancial IntermediariesEngage in process of indirect financeMore important source of finance than securities marketsNeeded because of transactions costs and asymmetric information

Function of Financial IntermediariesTransactions Costs Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale

Asymmetric Information: Adverse Selection and Moral HazardAdverse SelectionBefore transaction occursPotential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected

Asymmetric Information: Adverse Selection and Moral HazardMoral HazardAfter transaction occursHazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan backFinancial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

Financial Intermediaries

Size of Financial Intermediaries

Regulatory Agencies

Regulation of Financial MarketsThree Main Reasons for RegulationIncrease Information to InvestorsDecreases adverse selection and moral hazard problems SEC forces corporations to disclose informationEnsuring the Soundness of Financial IntermediariesPrevents financial panicsChartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measuresImproving Monetary ControlReserve requirementsDeposit insurance to prevent bank panicsSEC home page http://www.sec.gov