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Chapter 2
Financial Assets, Money,
Financial Transactions,
and Financial Institutions
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Learning Objectives 
 To learn about the important channels
through which funds flow from lenders
and borrowers and back again within
the global system of money and capital
markets.
 To discover the nature and
characteristics of financial assets –
how they are created and destroyed by
decision makers within the financial
system.
2-3
 Learning Objectives 
 To explore the critical roles played by
money within the financial system and
the linkages between money and
inflation in the prices of goods and
services.
 To examine the important jobs carried
out by financial intermediaries in
lending and borrowing and in creating
and destroying financial assets.
2-4
The Role of Financial Assets
 The financial system is the mechanism
through which loanable funds reach
borrowers
 Operation of the financial market
 Money exchanged for financial claims
 Stocks
 Bonds
 Other securities
 Transforms savings into investment
 Permits the economy to grow
2-5
The Nature and Characteristics of
Financial Assets
 A financial asset
 A claim against the income or wealth of a
business firm, household, or unit of
government
 Represented usually by a certificate
receipt, computer record file, or other legal
document
 Usually related to the lending of money
 Examples include stocks, bonds,
deposits, and others
2-6
Characteristics of Financial Assets
 Financial assets are sought after
because they promise future returns to
their owners and serve as a store of
value (purchasing power).
2-7
Characteristics of Financial Assets
 Financial asset value based on faith that
issuer honors contractual promise to pay
 Financial assets characteristics
 Do not depreciate like physical goods
 Physical condition or form usually not
relevant in determining market value
 Have little or no value as a commodity
 Cost of transportation and storage is low
 Financial assets are fungible – can easily be
changed in form and substituted for other
assets
2-8
Types of Financial Assets
Money
 Financial asset accepted in payment for
purchases of goods and services
 Examples are currency and checking
Equities
 Ownership shares in a business firm
 Claims against the firm’s profits
 Claims against proceeds from the sale of its
assets
 Examples are common stock and preferred
stock
2-9
Types of Financial Assets
Debt Securities
 Priority claim over the holders of equities to the
assets and income of an economic unit
 Can be negotiable or nonnegotiable
 Examples include bonds, notes, accounts payable,
and savings deposits
Derivatives
 Market value tied to or influenced by the value or
return on a financial asset
 Examples include futures contracts, options, and
swaps
2-10
How Financial Assets Are Created
 Internal financing to acquire assets
 Use current income
 Use accumulated savings
 External financing to acquire assets
 Raise funds by issuing financial liabilities
(debt)
 Raise funds by issuing stock (equities)
2-11
Balance Sheets of Units in a
Simple Financial System
2-12
Unit Balance Sheets Following the
Equipment Purchase and Debt Issuance
2-13
Unit Balance Sheets Following Equipment
Purchase and Stock Issuance
2-14
Financial Assets and the Financial System
 The act of borrowing or of issuing new
stock simultaneously gives rise to the
creation of an equal volume of financial
assets.
 All financial assets are recorded as a
liability or claim on some other
economic unit’s balance sheet.
Volume of financial assets for lenders
= Volume of liabilities issued by borrowers
2-15
Financial Assets and the Financial System
 For the balance sheet of any economic
unit,
Total assets = Total liabilities + Net Worth
Where
Assets = Real assets + Financial assets
 For the whole economy and financial
system,
Total financial assets = Total liabilities
 So, for the economy as a whole,
Total real assets = Total net worth
2-16
Financial Assets and the Financial System
 Society can increase its wealth
 Saving and increasing the quantity of its
real assets
 Real assets enable the economy to
produce more goods and services
 The financial system provides the
essential channel
 Necessary for the creation and exchange
of financial assets
 Exchange is between savers and
borrowers so that real assets can be
acquired
2-17
Financial System Matters
Strong financial system helps society
 Reducing barriers to external financing
 Lowering cost of capital
 Accelerating economic growth
Nations with more fully developed
financial systems
 Tends to grow faster
 Tends to enjoy a higher standard of living
2-18
Lending and Borrowing in the
Financial System
 Economists John Gurley and Edward Shaw
pointed out that each business firm,
household, or unit of government active in
the financial system must conform to:
R - E = FA - D
where
R = Current income receipts
E = Expenditures out of current income
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding
2-19
Lending and Borrowing in the
Financial System
 So, for any given time period, each
economic unit must fall into one of
three groups:
 Deficit-budget unit (DBU):
E > R, so D > FA (net borrower of funds)
 Surplus-budget unit (SBU):
R > E, so FA > D (net lender of funds)
 Balanced-budget unit (BBU):
R = E, so D = FA (neither net lender nor
borrower)
2-20
Lending and Borrowing in the
Financial System
The U.S. Economy in 2006
($ Billions)
Major Sectors
of the
Economy
Households
Net Acquisitions
Net
Net Lender (+)
of Financial Increase in
or Net
Assets
Liabilities Borrower (-)
$865.1
$1,411.1
$ - 546.0
Nonfinancial business
firms
State and local
governments
Federal government
International sector:
foreign investors
and borrowers
599.0
680.5
+ 87.5
80.0
144.0
- 64.0
- 13.6
634.6
- 648.2
1491.9
545.3
+ 946.6
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
2-21
Lending and Borrowing in the
Financial System
 The global financial system permits
businesses, households, and
governments to adjust their financial
position from that of net borrower
(DBU) to net lender (SBU) and back
again, smoothly and efficiently.
2-22
What is Money?
 All financial assets are valued in terms
of money, and flows of funds between
lenders and borrowers occur through
the medium of money.
 Money itself is a financial asset,
because all forms of money in use
today are claims against some public
or private institution.
2-23
Alternative Definitions of Money
M1
 Currency and coin held by the public
outside bank vaults
 Various kinds of payment accounts at
depository institutions
M2 takes M1 and adjusts
 Add small savings and time deposits
 Add share accounts at retail money market
mutual funds
MZM takes M2 and adjusts
 Subtract small-denomination time deposits
 Add institutional money market funds
2-24
Historic Volume of Money
8000
7000
6000
5000
4000
3000
2000
1000
0
2000
2001
2002
2003
M1
2004
2005
2006
2007
M2
Source: http://www.federalreserve.org/releases/H6/hist/h6hist1.txt
2-25
The Functions of Money

Money serves as a standard of value
(or unit of account)
Money serves as a store of value




Reserve of future purchasing power
Value of money can fluctuate with
inflation
Money serves as a medium of
exchange

Buyers and sellers no longer need to
have an exact coincidence of wants
2-26
The Value of Money and Other Financial
Assets and Inflation
 Inflation
 Rise in the average price level of all goods
and services
 Lowers purchasing power of money
 Can damage value of financial contracts
 Deflation
 The opposite of inflation
 Fall in the average price level of all goods
and services
2-27
The Value of Money and Other Financial
Assets and Inflation
 Inflation is commonly measured
using price indices, such as:
 the Consumer Price Index (CPI),
 the Producer Price Index (PPI), or
 the Gross Domestic Product (GDP)
deflator Index.
2-28
The Value of Money and Other Financial
Assets and Inflation
 Suppose the U.S. CPI rises from 100 to 125
over a five-year period.
 Over the five-year period, the cost-of-living
index climbed
125  100  0.25 or 25% ...
100
and the U.S. dollar’s relative purchasing
power fell
1
100  0.8 .
125
2-29
Impact on Purchasing Power
Changes in purchasing power can be
dramatic
 Due to inflation
 Even in the United States
 Provides a warning about measuring value
Need to think in terms of real values
 Purchasing power adjusted
 Nominal values can be misleading
2-30
The Evolution of Financial
Transactions
 Financial systems change constantly
 Shifting demands from the public
 Development of new technology
 Changes in laws and regulations
 The ways of carrying out financial
transactions have evolved
 In particular, the transfer of funds
from savers to borrowers can be
accomplished in at least three
different ways
2-31
The Evolution of Financial
Transactions
Direct Finance – Direct lending gives rise
to direct claims against borrowers
Flow of funds and other financial services
(loans of spending power for an
agreed-upon period of time)
Borrowers
(DBUs)
Lenders
(SBUs)
Primary Securities
(stocks, bonds, notes, etc., evidencing
direct claims against borrowers)
 Simple  Difficult to match & risky
2-32
The Evolution of Financial
Transactions
Semidirect Finance – Direct lending with the
aid of market makers who assist in the sale
of direct claims against borrowers
Primary Securities
(direct claims
against
borrowers)
Borrowers
(DBUs)
Proceeds of
security sales and other
financial services
(less fees and commissions)
Primary Securities
Security
brokers,
dealers, &
investment
bankers
(direct claims
against
borrowers)
Lenders
(SBUs)
Flow of funds
and other
financial services
(loans of spending
power)
 Lower search (information) costs
 Risky & matching is still required
2-33
Major Financial Institutions
2-34
The Evolution of Financial
Transactions
Indirect Finance – Financial intermediation of
funds
Primary Securities
(direct claims against ultimate
borrowers in the form of loan
contracts, stocks, bonds, notes,
etc.)
Ultimate
borrowers
(DBUs)
Secondary Securities
(indirect claims against ultimate
borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)
Financial intermediaries
(banks, savings and loan associations,
insurance companies, credit unions,
mutual funds, finance companies,
pension funds)
Ultimate
lenders
(SBUs)
Flow of funds and other
financial services
Flow of funds and other
financial services
(loans of spending power)
(loans of spending power)
 Low risk & affordable
2-35
Total Financial Assets Held by U.S.
Financial Institutions
($ billions at year-end)
1970
1980
Financial intermediaries:
Commercial banks
$489 $1,248
S&L assoc. and savings banks
252
794
Life insurance companies
201
464
Private pension funds
110
413
Investment co. (mutual funds)
47
64
State & local gov’t pension funds
60
198
Finance companies
63
199
Property-casualty insurance co.
50
174
Money market funds
––
74
Credit unions
18
72
Mortgage companies
––
16
Real estate investment trusts
4
6
Other financial institutions:
Security brokers and dealers
16
36
1990
2000
2006
$3,340
1,358
1,357
1,629
602
820
611
534
498
202
49
13
$6,488
1,219
3,204
4,587
4,457
2,290
1,138
872
1,812
441
36
62
$9,528
1,829
4,479
4,876
6,473
2,791
1,300
1,280
2,014
703
32
385
262
1,221
2,296
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
2-36
Classifying Financial Institutions
 Depository institutions
 Bulk of their loanable funds from deposit
accounts sold to the public
 Commercial banks, savings and loan
associations, savings banks, credit unions
 Contractual institutions
 Funds from offering legal contracts to
protect the saver against risk
 Insurance companies, pension funds
2-37
Classifying Financial Institutions
Investment institutions
 Sell shares to the public
 Invest the proceeds in stocks, bonds, and
other assets
 Mutual funds, money market funds, real
estate investment trusts
2-38
Portfolio (Financial-Asset)
Decisions by Financial Institutions
 Deciding what financial assets to buy
or sell
 Depends on various asset factors
 Different financial assets relative rate of
return
 Different financial assets risk
 Cost of incoming funds
 Volatility of incoming funds
 Maturity of incoming funds
2-39
Portfolio (Financial-Asset)
Decisions by Financial Institutions
Also depends on financial institution
size
 Larger financial institutions tend to have
more diversified sources and uses
 Larger financial institutions also enjoy
economies of scale.
Regulations and competition
2-40
The Disintermediation of Funds
 Disintemediation process
 Withdrawal of funds from a financial
intermediary by the ultimate lenders
(SBUs)
 Lending of those funds to ultimate
borrowers (DBUs)
 Disintermediation shifts funds
 Away from indirect finance
 To direct finance
2-41
The Disintermediation of Funds
Financial Disintermediation
Primary Securities
Ultimate
borrowers
(DBUs)
Financial
intermediaries
Ultimate
lenders
(SBUs)
Loanable funds
2-42
The Disintermediation of Funds
Disintermediation is not a foregone
conclusion
Reintermediation
 Reversal of flow of funds
 Back to a “safe haven” of financial
intermediaries
 Interest rates are low or declining
 Or riskiness of financial instruments appear
to be rising
2-43
New Forms of Disintermediation
 Initiation by financial intermediaries
 Banks sell off loans
 Difficulty in raising capital
 Initiation by borrowing customers
 Customer learn alternate financing
conduits
 Nonfinancial retail and industrial firms
attempting to draw financial services
customers
 Raise funds in the open market
2-44
Bank-Dominated Versus SecurityDominated Financial Systems
 Bank-dominated financial systems
 Banks and other similar institutions
dominate
 Supply of credit
 Attracting savings
 Common in economies with less
protection of investor rights or less welldefined rules
2-45
Bank-Dominated Versus SecurityDominated Financial Systems
Security-dominated financial systems
 Traditional intermediaries are less
important
 More borrowers sell securities to the public
 Many economies are gradually moving
toward a more security-dominated financial
system
2-46
Markets on the Net
 Answers.com at
http://www.answers.com/topic/disinter
mediation
 Bondsonline at www.bondsonline.com
 Encarta at encarta.msn.com
 Encyclopedia.com at encyclopedia.com
 Federal Reserve Bank of Atlanta at
www.frbatlanta.org
 Federal Reserve Bank of New York at
www.ny.frb.org
2-47
Markets on the Net
 Federal Reserve Bank of St. Louis at
research.stlouisfed.org/fred2
 Moody’s Investor Service at
www.moodys.com
 Money Magazine at money.cnn.com
 New York Stock Exchange at
www.nyse.com
 RePEc at ideas.repec.org
2-48
Markets on the Net
 Standard & Poor’s Corporation at
www.standardandpoor.com
 The Bond Market Association at
www.investinginbonds.com
 U.S. Bureau of Economic Analysis at
www.bea.gov
 U.S. Bureau of Labor Statistics at
www.stats.bls.gov
 Wikipedia at en.wikipedia.org
2-49
Chapter Review
 Introduction: The role of financial
assets
 The creation of financial assets
 Characteristics of financial assets
 Different kinds of financial assets
 How financial assets are born
 Financial assets and the financial
system
2-50
Chapter Review
 Lending and borrowing in the financial
system
 Money as a financial asset
 What is money?
 The functions of money
 The value of money and other financial
assets and inflation
2-51
Chapter Review
 The evolution of financial transactions
 Direct finance
 Semidirect finance
 Indirect finance and financial
intermediation
 Relative size and importance of major
financial institutions
 Classification of financial institutions
2-52
Chapter Review
 Portfolio (financial-asset) decisions by
financial intermediaries and other
financial institutions
 Disintermediation of funds
 New types of disintermediation
 Bank-dominated versus securitydominated financial systems
2-53