Chapter 17 The Financial System

Learning Goals Outline the structure and importance of the financial system. List the various types of securities. Define financial market, and distinguish between primary and secondary financial markets. Describe the characteristics of the major stock exchanges. Discuss the organization and functioning of financial institutions. Explain the functions of the Federal Reserve System and the tools it uses to control the supply of money and credit. Evaluate the major features of regulations and laws affecting the financial system. Describe the global financial system. 1 5 6 2 3 7 4 8

The Financial System The financial system is the process by which money flows from savers to users. A businessperson may need additional capital for inventory, and individuals and governments earn a rate of return from their savings. Businesses can borrow from the bank to obtain capital to purchase inventory. These are typical transactions that make up the financial system.

Understanding the Financial System Savers Users Financial Institutions Financial Markets Savings is a function of many variables. Funds can be transferred between users and savers directly or indirectly. Households, businesses, government, financial institutions, and financial markets make up the financial system. There are households, businesses and government entities that are categorized as savers and/or users.

Types of Securities Securities Money Market Instruments Bonds Stock Financial instruments Obligations on the part of the issuer Businesses and Governments Provide rate of return to purchasers Money Market Instruments Bonds Stock Money market instruments and bonds are both debt securities, and stocks are units of ownership in corporations.

Bonds Government Bonds Municipal Bonds Bonds sold by the U.S. Department of the Treasury. Municipal Bonds Bonds issued by state or local governments Revenue bonds are used toward a project that will produce revenue, General Obligation Bonds are not. Bondholders are creditors of a corporation. By selling bonds, a firm obtains long-term debt capital. Bondholders are creditors, they have a claim on the firm’s assets.

Stocks Common stock – ownership claims in corporations. Vote on major company decisions Cash dividends Price appreciation Preferred stock – stockholders with preference in the payment of dividends. Stocks are ownership. Investors expect stocks with little or no cash dividend to appreciate. Preferred stockholders rarely have voting rights although they do have claim on the firm’s assets ahead of the claim of common stock holders.

Convertible Securities Stockholder has the right to exchange the bond or preferred stock for a fixed number of shares of common stock. Investors are willing to accept lower interest rates because they value the potential for additional gains if the price of the firm’s stock increases.

Understanding Stock Markets Stock market (exchange) – market in which common stocks are traded, such as the New York Stock Exchange.

Financial Institutions Commercial Banks Savings Banks and Credit Unions Non-depository Institutions Financial institutions are one of the most important components of the financial system. They serve as the intermediary between savers and borrowers. Commercial banks are the most important financial institution in the United States. Commercial banks offer the most services from checking and savings accounts to consumer loans, mortgages, credit cards, and trust services. Banks make money by pooling together the funds from savings, checking, and other services and then lending most of the funds out in loans. Banks make money mostly from the interest they collect.

Federal Deposit Insurance Enacted by the Banking Act of 1933 Restore public confidence in the banking system Before deposit insurance, runs were common as people rushed to withdraw their money from the bank Deposit insurance shifts the risk of bank failures from individuals to the FDIC Commercial bank deposits up to a set amount are insured by the Federal Deposit Insurance Corporation. The amount of coverage has been increasing as the banking crisis in 2008 has been growing. FDIC is an important consumer protection to maintain confidence in the financial markets.

The Role of the Federal Reserve Created In 1913 Central bank of the United States Regulate commercial banks Perform banking-related activities for the U.S. Department of Treasury Providing services for banks Setting monetary policy The federal reserve is an important part of the nation’s financial system. Not all banks belong to the Fed, but banks with federal charters are required to belong to the Fed. Large banks are all federally chartered.