1. Overview of the Financial System
The Economics of Money, Banking, and Financial Markets Mishkin, 7th ed. Chapter 2
Overview of the Financial System

2. Direct finance and Indirect finance
Direct finance – funds are directly transferred from lenders to borrowers
Indirect finance – financial intermediaries receive funds from savers and lend them to borrowers
Securities are assets for the holder and liabilities for the issuer

3. Function of Financial Markets
1. Allows transfers of funds from person or business without investment opportunities to one who has them
2. Improves economic efficiency

4. Debt and equity markets
Debt instruments – contractual obligation to pay the holder fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans)
Short-term debt instruments have a maturity of less than one year
Intermediate-term debt instruments have a maturity between 1 and 10 years
Long-term debt instruments have a maturity of ten or more years
Equity – sale of ownership share (owners are residual claimants).
Owners of stock may receive dividends

5. Primary and secondary markets
Primary market = financial market in which newly issued securities are sold.
Secondary market = financial market in which previously owned securities are sold.

6. Brokers and dealers Broker – match buyers and sellers
Dealers – buy and sell securities

7. Role of secondary markets
Increase liquidity of financial assets
Determine security prices that help determine the price of securities in primary markets

8. Exchanges and over-the-counter markets
Exchange – buyers and sellers meet in one central location (e.g., NYSE or Chicago Board of Trade)
Over-the-counter market – transactions take place in multiple locations through dealers

9. Money and capital markets
Money market – market for short-term debt instruments
Capital market – market for intermediate and long-term debt and equity instruments

10. International financial markets
Foreign bond = bond issued by a foreign entity that is denominated in the currency of the country in which the bond is sold
Eurobond = bond denominated in a currency other than that of the country in which the bond is sold
Foreign bonds may be used to avoid exchange-rate risk
Eurocurrencies – deposits denominated in a currency other than that of the country in which the bank is located
London, Tokyo and other foreign stock exchanges have grown in importance

11. Financial intermediaries
Reduce transaction costs (due to economies of scale and lower information costs)
Allow for differences in the desired lending and borrowing time horizons
Risk sharing (asset transformation) lowers risk through diversification

12. Asymmetric information
Moral hazard
The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party
Adverse selection
Individuals who are willing to accept a financial (or other) contract are of lower “quality” than a typical individual in the population

13. Asymmetric information: Adverse selection,and Moral hazard
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

14. Types of financial intermediaries
Depository institutions
Commercial banks
Savings and Loan Associations
Mutual savings banks
Credit unions
Contractual savings institutions
Life insurance companies
Fire and casualty insurance companies
Pension funds and government retirement funds
Finance companies
Mutual funds
Money market mutual funds

15. Financial Intermediaries

16. Size of Financial Intermediaries

17. Financial market instruments
Money market instruments
United States treasury bills (discounted; no default risk)
Negotiable bank certificates of deposit (NCD; large denominations)
Commercial paper (CP; direct finance; largest instrument)
Banker’s acceptances (use abroad in international trade)
Repurchase agreements (repos; <2 wks; need collateral)
Federal funds (overnight loan b/w banks of their deposits at Fed)

18. Financial market instruments
Capital market instruments
Stocks (largest instruments)
Mortgages (FNMA: Fannie Mae; GNMA: Ginnie Mae; FHLMC: Freddie Mac)
Corporate bonds (convertible vs. non-convertible)
US government securities (most liquid security)
US government agency securities
State and local government bonds (municipal bonds; interest tax free)
Consumer and bank commercial loans

19. Regulatory Agencies

20. Regulatory Agencies

21. Regulation of financial markets
Two Main Reasons for Regulation (Financial sector is one of the most heavily regulated sectors of the economy)
1. Increase information to investors
A. Decreases adverse selection and moral hazard problems
B. SEC forces corporations to disclose information
2. Ensuring the soundness of financial intermediaries
A. Prevents financial panics
B. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures

22. Types of regulation Entry restrictions Disclosure laws (SEC)
Restriction on assets and activities
Deposit insurance
Limits on competition
Restrictions on interest rates (no longer in effect)