Transcript *Chapter 2* A Short History of Stock Markets

—CHAPTER 2—
A SHORT HISTORY OF STOCK
MARKETS
—Chapter 2—
A Short History of Stock Markets
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Cast of players
(1) The commercial banks
(2) The investment banks
(3) The money markets
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(4) The Central Banks (the Federal Reserve in the US)
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(6) The professionally managed funds: mutual funds/
(5) The government
hedge funds/ insurance funds/ pension funds
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(7) The credit rating agencies and the accounting firms
(8) The economy
(9)The Basel Committee on Banking Supervision
(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.
(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.
(2)
Investment Banks (cont)
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These services encompass:
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(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;
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(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);
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(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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(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).
(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.
(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.
(4) The Central Banks (cont)
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The central bank also seeks to influence interest rates by dealing in the money
markets.
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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.
(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.
(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).
(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).
(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.
(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 2007-09 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.
(8) The Economy
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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.
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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.
(9) The Basel Committee on Baking
Supervision
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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..
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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.
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The accords are designed to safeguard the commercial banking industry by imposition of constraints on
their risk-taking exposure.
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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.
Break time