Lecture 4: Financial instruments and regulation Mishkin chapter 2 – part C Page 28-32, 42-47

Role in the financial system Indirect finance Financial Intermediaries (e.g. bank) Lender Borrower Money Money Financial instrument A (e.g. saving account) Financial instrument B (e.g. student loans) Regulation Financial instruments (e.g. bond, stock) Financial markets Money Direct finance

Financial instruments A financial instrument (also called security) is a claim on the issuer’s future income or assets. Financial assets vs. real assets Classification: Money market instruments and capital market instruments Bonds (debt instruments) and stocks (equity)

Financial Instrument A: Financial Instrument B: Bank Borrower Lender Money Financial Instrument A: e.g. Mortgage loan Financial Instrument B: e.g. Deposit Financial instrument A is ‘issued’ by the borrower and is essentially a claim on borrower’s future income or asset. Financial instrument B is ‘issued’ by the Bank and is essentially a claim on Bank’s future income or asset. After financial instrument A is issued and sold to the Bank, it becomes a financial asset of the Bank. After financial instrument B is issued and sold to the lender, it becomes a financial asset of the lender, the liability of the Bank. back

Financial asset vs. real asset Real assets: houses, equipments, human resources, etc. Financial assets: claims against real assets. Generally, borrowers obtain funds from lenders by selling newly issued claims ("IOU's") against their (borrower’s) real assets. IOUs are essentially financial assets. graph

Money market instruments Money market instrument is shorter-term security generally with one year or less remaining to maturity. Treasury bill, commercial paper, CDs, etc. Many are held by institutions like banks, insurance companies and mutual funds, less often by individuals.

Capital market instruments More than one year to maturity. Stock, residential mortgages, long-term bonds, consumer loans, etc.

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Bonds A bond is a debt security/instrument that promises to make payments periodically for a specified period of time. Bond price is closely (negatively) related to interest rate. Default risk: the possibility that the issuer (borrower) fail to pay back.

Stocks A share of stock is a claim on the net income and assets of the corporation. Holders of common stocks: earn from price appreciation and dividends. have ownership interest in the company proportional to shares owned: ‘residual claimant’ have voting rights, or ‘vote with feet’. Stock prices are volatile.

Regulation in the financial system More regulation than in other industries. Why need regulation? information (efficiency concern) bankruptcy (stability concern) control of monetary policy (optimality concern)

How would regulations help? Increase the information available to investors: SEC forces listed corporations to disclose information reduce insider trading Ensure the soundness of financial intermediaries, fight against bankruptcy, prevent financial panics: Restrictions on entry (chartering), reporting requirements, restrictions on assets and activities, deposit insurance, limits on competition, etc.

Recap Financial instrument Money market instrument vs. capital market instrument Bonds vs. stocks Why is regulation in financial system so important? How would regulation help?