1. —Chapter 2— A Short History of Stock Markets

2. the Stock Markets and Large Firms
Cast of supporting players
for
the Stock Markets and Large Firms
(1) The commercial banks (2) The investment banks
(3) The money markets
(4) The Central Banks (the Federal Reserve in the US) (5) The government
(6) The professionally managed funds: mutual funds/ hedge funds/ insurance funds/ pension funds
(7) The credit rating agencies and the accounting firms
(8)The Basel Committee on Banking Supervision
(9) The economy

3. (1) Commercial Banks
These are the “high street” banks that offer an interest rate so as to attract deposits and then lend them out at a higher interest rate. Thus, commercial banks function as “financial intermediaries” connecting lenders’ surplus funds with borrowers that are seeking such funds for investment and consumption purposes.

4. (2) Investment Banks
An investment bank prospers by offering services to clients, which might be corporations, other financially related institutions, or governments.
Thus, unlike commercial banks, investment banks do not make money by taking deposits (attracted by offering an interest rate) and lending the money at a higher rate.

5. (2) Investment Banks (cont)
These services encompass:
(i) guiding and managing a firm to becoming “public” via an initial public offering (IPO) of its shares – so that the firm can become listed on the stock exchange, where its stocks can continue to be traded;
(ii) assisting firms and governments to raise finance by a sale of either their bonds or shares (the investment bank typically underwrites the issue by committing to purchase of itself any portion of the issue not taken up by investors);
(iii) structuring and selling financial products which it has helped to create, such as collateralized debt obligations (CDOs), or mortgage backed securities in the global financial crisis; and
(iv) guiding a firm in a takeover bid for another firm, or in its negotiations in a merger with another firm.
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6. (3) The Money Markets
The money markets are used by participants as a means for borrowing and lending in the short term, from several days to a year.
The contracts are referred to by such names as negotiable certificates of deposit (CDs), commercial paper, municipal notes, federal funds and repurchase agreements (repos), bankers acceptances, and Treasury bills (when issued by the government’s central bank).

7. (4) The Central Banks
A central bank seeks to manage the nation’s money supply by managing interest rates (monetary policy) and acting as a lender of last resort to the commercial banking sector during times of bank insolvency or financial crisis.
Central banks also have supervisory powers by which they seek to deter commercial banks and other financial institutions from engaging in reckless or fraudulent behavior.

8. (4) The Central Banks (cont)
The commercial banks typically have accounts with the central bank.
The central bank is therefore able to influence the base rate of interest by setting its own competitive rate. For example, if the central bank offers an annual rate of 3%, banks will require such a rate when lending to another bank – otherwise it would be more profitable for the bank to deposit money in its account with the central bank rather than lend it to another bank.

9. (4) The Central Banks (cont)
The central bank also seeks to influence interest rates by dealing in the money markets.
Thus, if a central bank wishes to raise interest rates, it will sell Treasury bills, thereby taking money away from the money markets so that the money supply is reduced and made more competitive to acquire by borrowing (leading to a higher interest rate), and conversely, if the bank wishes to lower interest rates, it will buy back Treasury bills, adding to the money supply.

10. (4) The Central Banks (cont)
Quantitative easing (QE) allows the central bank to purchase bonds from the banking system with “newly printed” money.
The immediate effect is that instead of holding bonds, the banks are holding cash, which, by adding to the supply, has the effect of lowering interest rates.
The intention is to stimulate the economy by increasing the amount of cash circulating in the economy at a lower interest rate.

11. (5) The Government
The government can raise funds either by taxes – on corporations and its citizens, or by borrowing - by issuing Treasury bonds (or bills) - which are distributed by the central bank.
The funds raised by governments allow for social distribution (welfare payments, for example) as well as for investments (in roads, hospitals, etc).

12. (5) The Government (cont)
The idea of a displacement effect is that the funds so raised would otherwise have allowed for more individual spending (when the government taxes individuals) or more private investments (when the government chooses to commandeer funds by borrowing or by taxing companies).

13. (6) Professionally managed funds
Institutional fund managers manage the insurance and pension premiums and professionally managed wealth of individuals.
They are the “big players” who, funded by individual contributions, dominate the trading, and, thereby, pricing, of stocks and bonds in the market.
Hedge funds are available to wealthy clients and are characterized by using debt to leverage their returns to clients.

14. (7) The Rating Agencies
The big three are Standard & Poor’s (S&P), Moody’s, and Fitch Group, the first two being the dominant pair.
They were instrumental in the destruction that was the global banking/financial crisis of due to their systematic allocation of financially “safe” ratings to products that were highly dependent on the continuing boom of an already overpriced housing market.

15. (8) The Basel Committee on Baking Supervision
The Basel Committee on Banking Supervision (BCBS) is a committee of central bankers from upward of 30 countries that meets at the Bank of International Settlements (BIS) in Basel, Switzerland..
The Basel I, Basel II and Basel III Accords (Basle III was a response to the global financial crisis) are a set of recommendations by the committee for regulation of the commercial banking industry.
The accords are designed to safeguard the commercial banking industry by imposition of constraints on their risk-taking exposure.
The committee does not have the authority to enforce recommendations, although member countries are expected to implement the Committee’s policies as legally binding in the supervision of their banking industry.

16. (9) The Economy
The economy and stock prices will often appear to “ratchet” each other – whereby a rising economy implies greater profitability for firms, and, hence, a justification for higher stock prices, and a rising stock market, in turn, makes people more wealthy and hence more inclined to go out and spend, which causes the economy to expand even more, in a virtuous feedback circle.
This may continue until the stock market and asset prices (such as houses) are made sufficiently unrealistically high that they are recognized as more likely to come down than to continue going up, at which point the virtuous feedback circle becomes a vicious one, as prices fall, leading to more people seeking to sell, leading to further falls, etc.

17. Break time