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Chapter 2: An Overview of the Financial System. Classifying Financial Markets Financial Market Instruments Financial Intermediaries Regulation. I. Classification Debt vs. Equity Markets. debt security cash flows are fixed bonds, loans equity security cash flow variable, residual

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chapter 2 an overview of the financial system
Chapter 2: An Overview of the Financial System
  • Classifying Financial Markets
  • Financial Market Instruments
  • Financial Intermediaries
  • Regulation
i classification debt vs equity markets
I. ClassificationDebt vs. Equity Markets
  • debt security
    • cash flows are fixed
    • bonds, loans
  • equity security
    • cash flow variable, residual
    • common stock
primary vs secondary markets
Primary vs. Secondary Markets
  • primary market
    • newly issued securities

-- investment banking

  • secondary market
    • brokers match buyers and sellers
    • dealers act as buyers and sellers

-- “market-makers”

exchanges vs otc markets
Exchanges vs. OTC Markets
  • exchange
    • buying & selling of securities in physical location
    • NYSE
  • OTC (over-the-counter)
    • dealers in many locations buy & sell securities
money vs capital markets
Money vs. Capital Markets
  • money market
    • short-term debt securities (up to 1 yr.)
    • highly liquid, low risk
  • capital market
    • longer-term debt
    • equity
ii financial market instruments
II. Financial Market Instruments

a security or financial instrument

= claim on future income or assets of issuer

a security is an asset for the buyer,

but a liability for the issuer

example
example
  • shares of stock in Time Warner, Inc.
    • shares of ownership in TW
    • a claim on the earnings/assets of TW
    • a liability for Time Warner
    • an asset for me
slide8
my mortgage
    • I am the issuer (liability)
    • the bank is the buyer/holder (asset)
    • the bank has a claim on my house
iii financial intermediaries
III. Financial Intermediaries

Why have them?

  • Transactions costs
    • search costs to find borrower & lender
    • contract costs
    • economies of scale
slide12
Risk sharing
    • intermediaries are experts at bearing risk
    • asset transformation
slide13
Asymmetric Information
    • one party has more info than the other
    • creates problems BEFORE loan is made
    • creates problems AFTER loan is made
    • financial intermediaries minimize these problems
adverse selection
adverse selection
  • BEFORE the loan
  • people with worst credit are more likely to seek a loan
    • lending not attractive
  • solution?
    • banks expert at assessing credit risks
moral hazard
moral hazard
  • AFTER the loan
  • once money is lent, borrower may blow the money
  • solution
    • banks monitor borrowers and enforce lending contracts
types of intermediaries
Types of intermediaries

Depository institutions

  • “banks”
  • accept deposits, make loans
slide17
Commercial banks
    • largest in total assets
  • Savings & Loans
    • originally restricting to savings deposits and mortgages
    • less restricted today
  • Credit Unions
    • consumer loans
    • nonprofit
    • organized around a group
slide18
Contractual savings institutions
  • acquire funds through payments in return for obligations
  • life insurance
  • property and casualty insurance
  • pension funds
slide19
Investment intermediaries
  • indirect investment
  • finance companies
    • issue commercial paper
    • consumer & commercial loans
  • mutual funds
    • sell shares to stock/bond portfolios
  • taken away bank business in past 30 years
slide20
money market mutual funds
    • money market portfolio
    • shares = $1, pay dividends
    • check writing privileges
iv regulation
IV. Regulation
  • Reducing asymmetry of info
    • disclosure of financial information -- by companies selling securities

-- by financial institutions

    • restrict insider trading
slide22
promoting stability
    • prevent financial panic

-- markets cease to function

    • financial institutions

-- restrict ownership

-- restrict activities

-- insurance on deposits

slide23
controlling the money supply
    • Federal Reserve System
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