15 Introduction to the Financial System CHAPTER This introductory chapter is heavy on jargon and light on analysis. You might consider using a mechanism that gets students to attempt to learn the easier material on their own, directly from the book, so you can use class time to focus on the harder material, or on interesting discussions of current events related to the financial system. One such mechanism is a quiz on the chapter's basic concepts. I encourage you to consider the following variation: Create a brief, multiple choice quiz (to minimize administrative burden and class time); aim for a single page with 6-7 questions, maybe 4 on vocab and 3 on concepts or applications. In class, have the students take the quiz twice: first individually, then in randomly assigned groups of 3-4 students per group. Then go over the answers as a group. Each student’s grade is an average of the score on the two attempts. The individual quiz reduces the free-rider problem. The group quiz creates opportunities for students to expose their thought process to the scrutiny of a small number of their peers, and to discuss the concepts and teach each other (so, less for you to teach them). When going over each question with the entire class, ask them what they chose before giving them the correct answer. Then, you’ll see which concepts the students “get,” and which ones they don’t. This helps you allocate class time more efficiently. I have done this many times with great success. And it does not create much of a burden for me: the entire activity typically takes 30 minutes of class time and 10-15 minutes in my office grading the forms and recording their scores. Contact me if you have questions: rcronovich@carthage.edu If you use this activity, you will not have to go over every slide in this PowerPoint presentation in class. You will be able to pick and choose slides based on students’ performance on the quiz. 15

In this chapter, you will learn: about securities, such as stocks and bonds the economic functions of financial markets how asymmetric information can disrupt financial markets how banks compare to financial markets, and how they combat problems from asymmetric information the financial system’s role in economic growth

Financial Markets Financial markets: where people and firms trade two kinds of assets Currencies Securities – claims on future income flows, e.g. stocks and bonds

Bonds issued by corporations to raise funds for investment, or by the government promise predetermined payments to buyers at specified times in the future also called fixed-income securities represent debt: the buyers are lending to the issuers

Bond jargon Face value: the amount bond pays when it matures Coupon payment: a payment that buyers of certain bonds receive prior to maturity Bonds that mature in under a year: commercial paper – issued by corporations Treasury Bills – issued by U.S. govt Zero-coupon bonds: buyers get no payments until bond matures Default: When a bond issuer fails to pay

Stocks also called equities shares of ownership in corporations, who sell them to raise funds for investment riskier than stocks, because the income comes from corporate profits, which are unpredictable

Economic Functions of Financial Markets 1. Matching savers and investors like in Chapter 3 loanable funds model mutually beneficial transactions Savers earn income by loaning funds to investors Investors get funds they need to finance investment projects (recall economics definition of investment – spending on capital goods)

Economic Functions of Financial Markets 2. Risk sharing allows for diversification, the distribution of wealth among many assets losses or low returns on some assets offset by higher returns on others An easy way to diversify: buy shares of mutual funds, financial firms that buy and hold many different stocks and bonds There’s another way in which financial markets help allocate risk more efficiently. To illustrate, consider this example. Sam faces a risk of some type of loss (e.g. to his health or property or financial wealth). He is willing to pay up to $X to someone else to bear that risk. Matilda would be willing to bear Sam’s risk if she is paid at least $Y. If Matilda is less risk averse than Sam, or if she has more opportunities than Sam to pool and diversify risks, then it is likely that X > Y. If so, Sam and Matilda can settle on some price in the middle, and both are better off (ex ante). Financial markets facilitate many such transactions, thus improving the allocation of risk. I did not put this on the slide because it does not appear at this point in the textbook, and the slides need to be consistent with the book. However, if you feel it would be helpful, please feel free to add this example to the slide and discuss it in class.

CASE STUDY The Perils of Employee Stock Ownership 401(k): a retirement savings fund administered by a firm for its workers, contributions not taxed Most 401(k) plans let workers choose among a set of mutual funds and their company’s own stock. Before Enron went bankrupt in 2001, most of its employees’ 401(k) assets were Enron stock. After an accounting scandal, the price of Enron stock dropped to near zero, wiping out the retirement savings of most of its workers. Enron illustrates the danger of not diversifying. The preceding slide discussed diversification as a way to reduce risk. Holding stock in the company you work for is not diversifying. The Enron case vividly illustrates what can happen when workers fail to diversify. Since Enron, people have been more careful. The percentage of 401(k) funds in company stock fell from 19% in 1999 to 10% in 2008. Government policy has helped: The Pension Reform Act of 2006 limits companies’ efforts to promote employee stock ownership.

Asymmetric Information Asymmetric information: when one party in a transaction has more information than the other party e.g., a firm selling securities knows more about its prospects than the buyers Two types of asymmetric information: adverse selection moral hazard Asymmetric information creates a variety of significant problems in the financial system, some of which contributed to the recent financial meltdown, as will be discussed in the remaining chapters of this book.

Asymmetric Information Adverse selection: when the people or firms most eager to make a transaction are the least desirable to the parties on the other side of the transaction Firms with poor prospects are the most eager to sell their securities; Savers lacking information risk overpaying for a security that will produce low returns. Savers understand this risk and may opt not to buy securities. Then firms with good prospects do not get the funding they need.

Asymmetric Information Moral hazard: the risk that one party will act in a way that harms the other If the buyer of a security cannot observe the issuer’s behavior, the issuer may use the funds for different purposes than promised (e.g. gambling on risky ventures), letting the buyer incur the losses if the venture fails. Savers understand this risk and may opt not to buy securities. Then responsible borrowers do not get the funding they need.

NOW YOU TRY: Asymmetric information Suppose banks could not check loan applicants’ credit histories. a. Which type of asymmetric information problem would result? b. How would this problem affect the market for loans?

ANSWERS: Asymmetric information a. Adverse selection Riskier borrowers would be more eager to take out a loan at a given interest rate than responsible borrowers. b. Banks would expect most loan applicants to be risky, so they would charge higher interest rates on all loans. Result: responsible borrowers pay high rates and get fewer loans.

Banks Financial institutions (financial intermediaries): firms that help channel funds from savers to investors Banks: financial institutions that accept deposits and make loans Deregulation has allowed banks to engage in other activities, such as trading securities Indirect finance channels funds from savers to investors through banks. Direct finance channels funds through financial markets.

Banks and Asymmetric Information Banks reduce adverse selection by screening potential borrowers. Banks combat moral hazard by using loan contracts with covenants, provisions on the borrowers’ behavior which protect the bank. Banks play a very important role in the financial system. By reducing the problems from asymmetric information, they help the financial system operate more efficiently. Chapter 18 discusses banks in detail.

The Financial System & Economic Growth A well-functioning financial system promotes economic growth by channeling saving to the most productive investment projects. In countries with underdeveloped financial systems, it’s hard for firms to raise funds for investment, so aggregate investment and growth are lower. Government policies can help, e.g.: regulations to reduce information asymmetries federal deposit insurance

Two indicators of financial development by income level, 1996-2007 Percent of GDP This graph replicates Figure 15-3 (though it combines both panels of the figure). Stock market capitalization and bank loans are indicators of the level of financial development of a country. The graph shows that these indicators are very strongly related to income levels.

Markets vs. central planning Centrally planned (or command) economy: Govt decides what goods will be produced, who receives them, and what investment projects will be undertaken. Lesson from Microeconomics: Free markets much better than command economies at allocating resources. This lesson holds true in financial markets, where stock prices and interest rates channel funds to the most productive investments. A few examples of command economies: North Korea Cuba the Soviet Union and Eastern Europe until the early 1990 Encourage your students to read the book’s case study, “Investment in the Soviet Union.” It describes the efficiency and incentive problems that caused Russia to fall far behind the West.

CHAPTER SUMMARY The financial system has two central parts: financial markets and banks. Stocks and bonds are securities traded in financial markets. Corporations and governments that issue bonds are borrowing from those who buy the bonds; in return, the issuers make predetermined payments at specified times to the bond holders. A stock is an ownership share in a corporation, and the stockholder receives a share of the corporation’s earnings.

CHAPTER SUMMARY Financial markets channel funds from savers to investors with productive uses for the saved funds. Financial markets also help people reduce risk by diversifying their asset holdings. Financial markets can malfunction because of asymmetric information: issuers of securities know more than buyers. The two types of asymmetric information problems are adverse selection and moral hazard.

CHAPTER SUMMARY Banks raise funds by accepting deposits and use the funds to make private loans. They reduce asymmetric information problems by screening loan applicants, including covenants in loan agreements, and monitoring borrower behavior. A well-functioning financial system promotes economic growth by channeling savings into productive investment. Bad government policies can hinder this function and reduce growth.