Transcript Topic_02_OVERVIEW

TOPIC 2
OVERVIEW OF
A FINANCIAL SYSTEM
Purpose of Financial System
• Channeling funds from surplus units to deficit units
– Surplus units: person/business without investment opportunitiesLend/Save-Supplier of funds
– Deficit units: person/business with investment opportunities but
shortage of funds-Borrow/Spend –Demander of funds
• Often, surplus units (particularly savers) ≠ people who have
profitable investment opportunities
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Figure 2.2 Channels of Flow of
Funds
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Channels of Funds Flow
1.
Direct Finance
•
•
•
•
Borrowers borrow directly from lenders in financial markets by
selling financial instruments/securities
Financial markets issue claims on borrowers directly to savers
Securities: Asset to buyers (lenders) but liabilities to issuers
(borrowers)
Example: General Motors needs to borrow funds to pay for a new
factory to manufacture electric cars, it might borrow the funds
from savers by selling them a bond or a stock
Why is this channeling of funds from savers to spenders so important to the economy?
-The people who save are frequently not the same people who have
profitable investment opportunities available to them, the
entrepreneurs
-Example: You have saved $1,000 this year, but no borrowing or
lending. What is the effect?
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Channels of Funds Flow
1.
Indirect Finance
•
•
•
Financial intermediaries act as middle-man by holding a
portfolio of assets and issuing claims to savers
Borrowers borrow indirectly from lenders via financial
intermediaries (FI)
FI established to source both loanable funds and loan
opportunities
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Importance of Financial System
• FMs critical for enabling efficient allocation of capital
– Funds transferred from savers to entrepreneurs
– Nonproductive (idle) to productive purposes
– Contributes to higher production and efficiency for overall economy
• FMs improve economic well-being
– Savers-saving returns; borrowers-use opportunities (spend)
– Both can share profit
– Without FM, status quo or even worse off
• Improve well being of consumers by allowing better timing of
purchases
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2. STRUCTURE OF
FINANCIAL MARKETS
How to categorize financial markets? In terms of
1)
2)
3)
How to obtain funds: Debt and equity
Type of markets: Primary and secondary
Types of maturities: Short-term and long-term
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2. CLASSIFICATION
OF FINANCIAL MARKETS
How funds are obtained in the financial markets? Debt versus equity markets
1.
Issue debt instrument – A contractual agreement by the borrower to pay
the holder of the instrument fixed dollar amounts at regular intervals until a
specified date, when the final payment is made
–
Buyers of debt instruments are suppliers (of capital) to the firm, not owners of
the firm
–
Debt instruments have a finite life or maturity date
–
Advantage: debt instrument is a contractual promise to pay with legal rights to
enforce repayment
–
Disadvantage: return/profit is fixed or limited
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2. CLASSIFICATION
OF FINANCIAL MARKETS
How funds are obtain in the financial markets? Debt versus equity markets
2.
Issue equity - Claims to share in net income and assets of a business
–
–
Periodic payments in the form of dividends to holders and have no maturity
date
Investors are owners of the firm
• Own a portion of the firm
• Have voting rights on important issues to the firm and elect its directors
–
Common stock has no finite life or maturity date
–
Advantage: potential high income since return is not fixed or limited
–
Disadvantage: debt payments must be made before equity payments can be
made
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CLASSIFICATIONS
OF FINANCIAL MARKETS
1.
Primary Market
–
–
2.
A primary market is a financial market in which new issues of a security,
such as a bond or a stock, are sold to initial buyers by the corporation or
government agency borrowing the funds.
Investment bank assists in the sale of securities in the primary market.
Involves underwriting: guarantees a price for a corporation’s securities
and sells them to the public
Secondary Market
–
–
–
A secondary market is a financial market in which securities that have
been previously issued can be resold, or Securities previously issued are
bought and sold (resell)
Examples: KLSE, NYSE, NIKKEI and bond markets
2 important functions: Make it easier to sell the financial instruments
(liquidity) & Determine the price of the security that the issuing firm sells
in the primary market
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CLASSIFICATIONS
OF FINANCIAL MARKETS
2 TYPES of secondary market:
1. Organized Exchanges
– Trades conducted in central locations: Buyers & sellers meet in one central
location (e.g., New York Stock Exchange, KLSE)
2. Over-the-Counter (OTC) Markets
– Dealers/ remisiers at different locations buy and sell
– Have an inventory of securities to sell OTC to anyone who comes to them
and is willing to accept their prices
– Very competitive
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CLASSIFICATIONS
OF FINANCIAL MARKETS
Basis of maturity: Number of years until the
instrument’s expiration date
1. Money market
•Financial market in which only short-term debt instruments are traded
•Short-term (maturity < 1 year)
2. Capital market
•
Financial market in which long-term debt and equity instruments are traded
•
Intermediate-term (maturity between 1 to 10 years) and long-term (maturity >
10 years)
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Money market & Capital market
• Money market securities are usually more widely traded than longer-term
securities and so tend to be more liquid. The short-term securities have
smaller fluctuations in prices than long-term securities, making them safer
investments. As a result, corporations and banks actively use the money
market to earn interest on surplus funds that they expect to have only
temporarily.
• Capital market securities, such as stocks and long-term bonds, are often held
by financial intermediaries such as insurance companies and pension funds,
which have little uncertainty about the amount of funds they will have
available in the future.
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3. FUNCTIONS OF
FINANCIAL INTERMEDIARIES
• Facts about Financial Intermediaries (FIs)
1. Engage in process of indirect finance: match savers and
borrowers
2. More important source of finance than financial markets
3. Perform specific tasks: risk-sharing, liquidity, and
information services
4. Needed because of transactions costs and asymmetric
information
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Function of Financial Intermediaries
1. Transactions Costs
1. FIs make profits by reducing transactions costs by:
-Developing expertise
-Taking advantage of economies of scale
2. FI’s low transaction costs mean that it can provide its customers
with 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 yet still
convert them into cash whenever necessary
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Function of Financial Intermediaries
2.
Risk Sharing
FIs help reduce exposure of investors to risk, through a process known as 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, because in a sense
risky assets are turned into safer assets for investors
– Example: lend out to your friend OR save it and bank lend it out
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Function of Financial Intermediaries
3. Asymmetric Information
•
Adverse Selection
–
Before transaction occurs
–
•
•
Potential borrowers most likely to produce adverse outcome are ones
most likely to seek loan and be selected
Moral Hazard
– After transaction occurs
– Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that the loan will not be paid
back
Financial intermediaries reduce adverse selection and moral hazard
problems by building expertise to screen and monitor borrowers
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4. TYPES OF
FINANCIAL INTERMEDIARIES
Size of Financial Intermediaries
Goals of Financial Regulation
1. Provision of information: to increase information to
investors
2. Maintenance of financial stability: to ensure soundness of
financial intermediaries
3. Controlling the money supply: to improve monetary control
4. Encouraging particular activities (like home ownership)
5. Regulation affects ability of financial markets and
institutions to provide risk-sharing, liquidity, and
information services
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Regulation of the Financial System
1. To Increase Information Available to Investors
• AI in FMs means that investors may be subject to adverse selection and
moral hazard problems: may hinder efficient operation of FMs and keep
investors away from FMs
• Securities and Exchange Commission (SEC) requires corporations issuing
securities to disclose certain information about their sales, assets, and
earnings to the public and restricts trading by the largest stockholders
(known as insiders) in the corporation
• Such government regulation can reduce adverse selection and moral hazard
problems in FMs and increase their efficiency by increasing the amount of
information available to investors
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Regulation of Financial System
2. To Ensure Soundness of Financial Intermediaries
•Because providers of funds to financial intermediaries may not be able to assess
whether the institutions holding their funds are sound or not, if they have doubts about
the overall health of financial intermediaries, they may want to pull their funds out of
both sound and unsound institutions, with the possible outcome of a financial panic that
produces large losses for the public and causes serious damage to the economy
•To protect the public and the economy from financial panics, the government has
implemented six types of regulations:
1. Restrictions on Entry
2. Disclosure
3. Restrictions on Assets and Activities
4. Deposit Insurance
5. Limits on Competition
6. Restrictions on Interest Rates
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Ensuring Soundness of Financial
Intermediaries
1. Restrictions on Entry
– Regulators have created very tight regulations as to who is allowed to set
up a financial intermediary, licencing
– Individuals or groups that want to establish an FI, such as a bank or an
insurance company, must obtain a charter from the state or the federal
government
– Only if they are upstanding citizens with impeccable credentials and a
large amount of initial funds will they be given a charter
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Ensuring Soundness of Financial
Intermediaries
2. Disclosure Requirements: There are stringent reporting requirements for
financial intermediaries
– Their bookkeeping must follow certain strict principles
– Their books are subject to periodic inspection
– They must make certain information available to
the public
• Frequent reporting to reduce asymmetric information
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Ensuring Soundness of Financial
Intermediaries
3. Restrictions on Assets and Activities:
– on what FIs are allowed to do and what assets they can hold
– Customers want to ensure that their funds are safe and the bank will be
able to meet its obligations to the customers
– One way of doing this is to restrict the FIs from engaging in certain risky
activities
– Another way is to restrict FI from holding certain risky assets, or at least
from holding a greater quantity of these risky assets
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Ensuring Soundness
of Financial Intermediaries
4. Deposit Insurance: government can insure people providing funds to a FI from
any financial loss if the financial intermediary should fail
– The Federal Deposit Insurance Corporation (FDIC), insures each
depositor at a commercial bank or mutual savings bank up to a loss of
$100,000 per account
– Similar concepts sometimes being applied in other FIs and in other
countries
– Maintain investor confidence
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Ensuring Soundness of Financial
Intermediaries
5. Limits on Competition: Although the evidence that unbridled competition among Fis
promotes failures that will harm the public is extremely weak, it has not stopped the
state and federal governments from imposing many restrictive regulations
– In the past, banks were not allowed to open up branches in other states, and in
some states banks were restricted from opening additional locations
6. Restrictions on Interest Rates: Competition has also been inhibited by regulations that
impose restrictions on interest rates that can be paid on deposits
– These regulations were instituted because of the widespread belief that
unrestricted interest-rate competition helped encourage bank failures during the
Great Depression
– Later evidence does not seem to support this view, and restrictions on interest
rates have been abolished
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Regulation of Financial System
3. To Improve Monetary Control
• Because banks play a very important role in determining the supply of
money (which in turn affects many aspects of the economy), much
regulation of these financial intermediaries is intended to improve control
over the money supply
• One such regulation is reserve requirements, which make it obligatory for all
depository institutions to keep a certain fraction of their deposits in accounts
with the central
• Reserve requirements help the central banks to exercise more precise
control over the money supply
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Table 3.1 Regulation of Financial
Institutions and Markets in the United
States
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