Chapter 2: An Overview of the Financial System Classifying Financial Markets Financial Market Instruments Financial Intermediaries Regulation Classifying Financial Markets Financial Market Instruments Financial Intermediaries Regulation

I. Classification Debt vs. Equity Markets debt security  cash flows are fixed  bonds, loans equity security  cash flow variable, residual  common stock debt security  cash flows are fixed  bonds, loans equity security  cash flow variable, residual  common stock

Primary vs. Secondary Markets primary market  newly issued securities -- investment banking secondary market  brokers match buyers and sellers  dealers act as buyers and sellers -- “market-makers” primary market  newly issued securities -- investment banking secondary market  brokers match buyers and sellers  dealers act as buyers and sellers -- “market-makers”

Exchanges vs. OTC Markets exchange  buying & selling of securities in physical location  NYSE OTC (over-the-counter)  dealers in many locations buy & sell securities exchange  buying & selling of securities in physical location  NYSE OTC (over-the-counter)  dealers in many locations buy & sell securities

Money vs. Capital Markets money market  short-term debt securities (up to 1 yr.)  highly liquid, low risk capital market  longer-term debt  equity money market  short-term debt securities (up to 1 yr.)  highly liquid, low risk capital market  longer-term debt  equity

II. Financial Market Instruments a security or financial instrument = claim on future income or assets of issuer a security is an asset for the buyer, but a liability for the issuer a security or financial instrument = claim on future income or assets of issuer a security is an asset for the buyer, but a liability for the issuer

exampleexample shares of stock in Time Warner, Inc.  shares of ownership in TW  a claim on the earnings/assets of TW  a liability for Time Warner  an asset for me shares of stock in Time Warner, Inc.  shares of ownership in TW  a claim on the earnings/assets of TW  a liability for Time Warner  an asset for me

my mortgage  I am the issuer (liability)  the bank is the buyer/holder (asset)  the bank has a claim on my house my mortgage  I am the issuer (liability)  the bank is the buyer/holder (asset)  the bank has a claim on my house

III. Financial Intermediaries Why have them? Transactions costs  search costs to find borrower & lender  contract costs  economies of scale Why have them? Transactions costs  search costs to find borrower & lender  contract costs  economies of scale

Risk sharing  intermediaries are experts at bearing risk  asset transformation Risk sharing  intermediaries are experts at bearing risk  asset transformation

Asymmetric Information  one party has more info than the other  creates problems BEFORE loan is made  creates problems AFTER loan is made  financial intermediaries minimize these problems Asymmetric Information  one party has more info than the other  creates problems BEFORE loan is made  creates problems AFTER loan is made  financial intermediaries minimize these problems

adverse selection BEFORE the loan people with worst credit are more likely to seek a loan  lending not attractive solution?  banks expert at assessing credit risks BEFORE the loan people with worst credit are more likely to seek a loan  lending not attractive solution?  banks expert at assessing credit risks

moral hazard AFTER the loan once money is lent, borrower may blow the money solution  banks monitor borrowers and enforce lending contracts AFTER the loan once money is lent, borrower may blow the money solution  banks monitor borrowers and enforce lending contracts

Types of intermediaries Depository institutions “banks” accept deposits, make loans Depository institutions “banks” accept deposits, make loans

Commercial banks  largest in total assets Savings & Loans  originally restricting to savings deposits and mortgages  less restricted today Credit Unions  consumer loans  nonprofit  organized around a group Commercial banks  largest in total assets Savings & Loans  originally restricting to savings deposits and mortgages  less restricted today Credit Unions  consumer loans  nonprofit  organized around a group

Contractual savings institutions acquire funds through payments in return for obligations life insurance property and casualty insurance pension funds Contractual savings institutions acquire funds through payments in return for obligations life insurance property and casualty insurance pension funds

Investment intermediaries indirect investment finance companies  issue commercial paper  consumer & commercial loans mutual funds  sell shares to stock/bond portfolios taken away bank business in past 30 years Investment intermediaries indirect investment finance companies  issue commercial paper  consumer & commercial loans mutual funds  sell shares to stock/bond portfolios taken away bank business in past 30 years

money market mutual funds  money market portfolio  shares = $1, pay dividends  check writing privileges money market mutual funds  money market portfolio  shares = $1, pay dividends  check writing privileges

IV. Regulation Reducing asymmetry of info  disclosure of financial information -- by companies selling securities -- by financial institutions  restrict insider trading Reducing asymmetry of info  disclosure of financial information -- by companies selling securities -- by financial institutions  restrict insider trading

promoting stability  prevent financial panic -- markets cease to function  financial institutions -- restrict ownership -- restrict activities -- insurance on deposits promoting stability  prevent financial panic -- markets cease to function  financial institutions -- restrict ownership -- restrict activities -- insurance on deposits

controlling the money supply  Federal Reserve System controlling the money supply  Federal Reserve System