0. An Overview of the Financial System
Lecture
An Overview of the Financial System
Chapter 2

1. Types of Financial Instruments
Securities: pieces of paper that give the owner a claim on the issuer’s assets or future payment.
- Simple contracts
- Negotiable (can be resold, traded)
- Used in both direct and indirect finance
Loans:
Contracts that are more complicated than securities.
Usually non-negotiable. Have collateral requirements and covenants.
Used almost exclusively indirect finance.

2. Types of Finance Direct Finance Indirect Finance
Borrowers borrow directly from lenders in financial markets by selling financial instruments (securities)which are claims on the borrower’s future income or assets
Indirect Finance
Borrowers borrow indirectly from lenders via financial intermediaries that issue financial instruments which are claims on the borrower’s future income or assets

3. World Without Financial Intermediaries
Equity and Debt Securities
Lender – Saver
(Households…)
Borrower - spender
(Businesses…)
Cash
In this world - the flow of funds from savers to borrowers is likely to be low:
As a lender, how do you know you will get your money back (problem of adverse selection)
As a lender, how do you know the borrower will use funds as stated? (problem of moral hazard)
Monitoring is a hassle. Prefer to leave the monitoring to others.
Lack of liquidity.

4. World With Financial Intermediaries (FI)
Lender – Saver
(Households….)
FI Broker
Borrower – spender
Businesses….)
FI Asset Transformer
Cash
Debt and Equity
Deposits and Insurance policies
Here we have both direct and indirect finance.

5. Mishkin’s Representation: Function of Financial Markets

6. Indirect Finance Involves Asset Transformation
Assets
Liabilities and Net Worth
Something of value that you own
Something you owe.
Net Worth = Assets - Liabilities

7. Financial Institution - Commercial Bank
Assets
Liabilities and Net Worth
Cash (vault cash)
Deposits at Fed (Reserves)
Mortgages
Commercial Loans
US Gov’t bonds
Demand Deposits
Time Deposits
Debt (Borrowing)
Equity Capital(Bank Capital)
Asset Transformation – Banks issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics.
Also, referred to as maturity Transformation – Bank liabilities are short-term, assets are long-term.

8. Financial Institution - Insurance Company
Assets
Liabilities and Net Worth
Insurance Policies (contingent liability)
Equity Capital
Cash
- Mortgages
Corporate Bonds
US Gov’t bonds
Equity (Google Stock
Asset Transformation – Insurance companies issue liabilities and use the proceeds to purchase assets

9. Examples of Direct Finance:
Initial Public Offering of a stock
Ford sells bonds to the public
GE issues commercial paper to public to fund its payroll
Bowie Bonds

10. Structure of Financial Markets
Debt Markets
Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $52.4 trillion at the end of 2009.
Equity Markets
Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $20.5 trillion at the end of 2009.

11. Structure of Financial Markets
Primary Market
New security issues sold to initial buyers
Typically involves an investment bank that underwrites the offering
Secondary Market
Previously issued securities are bought and sold
Examples include the NYSE and Nasdaq
Involves both brokers and dealers (do you know the difference?)

12. Structure of Financial Markets
Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:
Provides liquidity, making it easy to buy and sell the securities of the companies
Establish a price for the securities

13. Structure of Financial Markets
We can further classify secondary markets as follows:
Exchanges
Trades conducted in central locations - Auction (e.g., New York Stock Exchange, CBT)
Over-the-Counter Markets
Dealers at different locations buy and sell
Best example is the market for Treasury Securities

14. Classifications of Financial Markets
We can also further classify markets by the maturity of the securities:
Money Market: Short-Term (maturity < 1 year)
Capital Market: Long-Term (maturity > 1 year)

15. Principal Money Market Instruments: Short-term debt instruments with maturity < 1 year 15

16. Principal Capital Market Instruments Maturity > 1 year

17. Internationalization of Financial Markets
Foreign Bonds: bonds sold in a foreign country and denominated in that country’s currency
Eurobond: bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies: foreign currencies deposited in banks outside the home country
Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks 17

18. Financial Intermediaries - Indirect Finance
This is actually the primary means of moving funds from lenders to borrowers.
More important source of finance than securities markets (such as stocks)
Why? Transaction costs, information costs (asymmetric information), risk sharing and liquidity.

19. Transaction Cost - Direct Finance is Expensive
Legal Costs: Loans and securities are legal contracts which must be written carefully to be enforced. Loans are more complicated – covenants and collateral.
Regulatory costs: Securities. SEC filing requirements. Must file registration statement, prospectus, periodic financial statements.
Sales Costs: Cost of matching buyers and sellers
- Primary Markets: Investment bankers market to
potential buyers and guarantee a minimum initial price
for a fee.

20. Financial Intermediaries Reduce Transactions Costs
Financial intermediaries make profits by reducing transactions costs
Reduce transaction costs by developing expertise (screening and monitoring) and taking advantage of economies of scale

21. Financial Intermediaries - Economies of Scale
Most transaction costs associated with a financial transaction are fixed costs
Independent of size of transactions and number of transactions.
- Legal cost for a $100,000 loan similar to
$1,000,000 loan.
- Repeated transactions => spread the cost over a
large number of loans (e.g. spread $10,000
legal cost over 2,000 loans = $5.00 per loan)

22. Financial Intermediaries - liquidity
Banks provide liquidity services - services that make it easier for customers to conduct transactions
Banks provide depositors with checking accounts that enable them to pay their bills easily
Depositors can earn interest on checking and savings accounts and convert them into goods and services whenever necessary

23. Financial Intermediaries – reduce risk
reduce the exposure of investors to risk, through risk sharing
FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party
This process is referred to as asset transformation, risky assets are turned into safer assets for investors

24. Financial Intermediaries – reduce risk
Allow individuals and businesses to diversify their asset holdings.
Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.

25. Financial Intermediaries: Indirect Finance
Information cost - asymmetric information.
One party lacks crucial information about another party, impacting decision-making.
adverse selection and moral hazard.

26. Function of Financial Intermediaries: Indirect Finance
Adverse Selection
Before transaction occurs
Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan
Similar problems occur with insurance where unhealthy people want their known medical problems covered

27. Asymmetric Information: Adverse Selection and Moral Hazard
After transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
Again, with insurance, people may engage in risky activities only after being insured

28. Types of Financial Intermediaries

29. Types of Financial Intermediaries
Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts.
Commercial banks (around 7,000)
Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans
Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios

30. Types of Financial Intermediaries
Thrifts: S&Ls & Mutual Savings Banks (1,300) and Credit Unions (9,500)
Raise funds primarily by issuing savings, time, and checkable deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings Banks
Mutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company’s workers

31. Contractual Savings Institutions (CSIs)
CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.
Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis
Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict
Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities

32. Types of Financial Intermediaries Investment Intermediaries
Finance Companies sell commercial paper (a short-term debt instrument), and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations
Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds

33. Types of Financial Intermediaries
Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments
Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.

34. Regulatory Agencies

35. Regulatory Agencies (cont.)

36. Regulation of Financial Markets
Main Reasons for Regulation
Increase Information to Investors
Ensure the Soundness of Financial Intermediaries

37. Regulation of the Financial Markets
Ensure the soundness of financial intermediaries:
Restrictions on entry (chartering process).
Disclosure of information (SEC)
Restrictions on Assets and Activities (control holding of risky assets).
Deposit Insurance (avoid bank runs).
In the past, regulation placed limits on competition
Restrictions on bank branches
Restrictions on Interest Rates

38. Classifying Financial Instruments
1. Type of claim -
Equity (Common Stock): Gives owner a share of
the firm’s assets and profits. Also have voting
rights.
Debt (loans, bonds, commercial paper): Entitles
owner to specific payments on specific dates.
If firm fails, get paid before equity holders.
Equity holders have a residual claim.
2. Maturity: Length of the claim. Money Market or
Capital Market. Equity does not mature.

39. Classifying Financial Instruments
3. Risk: degree of uncertainty as to payment.
Equity generally has the highest risk. Next is various
grades of debt, then unsecured debt such as consumer
loans. Safest: treasury bills and insured bank deposits
4. Liquidity: How quickly converted into medium
of exchange (money). Demand deposits, followed by
savings deposits, treasury securities.

40. Classifying Financial Instruments
Expected Returns.
As shown on the next slide, returns are typically higher for riskier, less liquid and longer-maturity assets.
Highest risk: Equities, followed by various grades of debt.
Lowest risk: Treasury bills, demand deposits.

41. Risk and Return by Asset Class - Ibbotson Associates
2009
2009
9.8
11.8
2009
11.9
16.6

42. The Ibbotson Chart Returns are at 5 % increments.
Most risk - Equity ( small cap). Low, spread-out “skylines”.
Least Risk - Treasury bills. Narrow skyline.