Purpose of the Financial System • Transfer funds from savers to borrowers • Savers (lenders) supply the funds, obtaining assets that pay future returns. • Borrowers demand the funds, issuing liabilities that require future returns.
Two Parts of Financial System • Financial markets directly transfer funds from savers to borrowers. • Financial intermediaries indirectly transfer the funds by acting as go-betweens: • The ultimate savers lend to financial intermediaries, which then lend the funds to the ultimate borrowers.
Key Services of Financial System • Risk-sharing • Liquidity • Information about borrowers and returns on financial assets
Risk-Sharing • Risky assets have uncertain returns due to • Default • Fluctuating asset prices • Risk can be reduced by holding a portfolio of assets; i.e. by diversification. • Financial system enables risk to be shifted from those less willing to bear it to those more willing.
Liquidity • Liquid assets — easily, quickly bought or sold at almost equal prices and at little cost • Examples of liquid assets: currency, deposits, Treasury bills, stocks of large companies • Example of an illiquid asset: houses
Information • Financial system collects and communicates information. • It is costly for many individual savers and borrowers to do so themselves.
Financial Markets • Newly issued claims are sold to initial buyers in primary markets. • Previously issued claims are resold in secondary markets. • Active secondary markets engender liquidity.
Types of Secondary Markets • Format • Auction markets; e.g. NYSE • Over-the-counter markets: e.g. NASDAQ • Settlement • Cash markets; e.g. stocks, bonds • Derivative markets; e.g. futures, options
Two Types of Claims • Debt • Equity
Debt • Principal and interest • Maturity date • Term to maturity • Short-term: 1 year; money market • Intermediate-term: >1, < 10 years • Long-term: 10 years • Default
Equity • Claim to a given share of profits and assets • Managers have discretion over how much to distribute. • Dividend — the amount distributed • Default: debt vs. equity • Risk-sharing: debt and equity • Capital market: equity plus intermediate- and long-term bonds
Financial Intermediaries • Collect funds from many savers and transfer the funds to many borrowers • Provide risk-sharing, liquidity and information services
Financial Evolution • Strong competition • Financial innovation • Financial integration in US • Globalization • Recent years • Before 1914
Reasons for Financial Regulation • Prevention of fraud • Financial stability • Monetary control (silly) • Willie Sutton effect
Facts for 2006 • 40% of assets were direct debt and equity instruments • 60% were liabilities of financial intermediaries of which about • 27% in bank deposits • 49% in pension reserves • 19% in mutual funds • 5% in insurance reserves