1、Chapter 2,Overview of the Financial System,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-2,Chapter Preview,Suppose you want to start a business manufacturing a household cleaning robot, but you have no funds. At the same time, Walter has money he wishes to invest for his retirement. I
2、f the two of you could get together, perhaps both of your needs can be met. But how does that happen?,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-3,Chapter Preview,As simple as this example is, it highlights the importance of financial markets and financial intermediaries in our eco
3、nomy. We need to acquire an understanding of their general structure and operation before we can appreciate their role in our economy.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-4,Chapter Preview,In this chapter, we examine the role of the financial system in an advanced economy. W
4、e study the effects of financial markets and institutions on the economy, and look at their general structure and operations. Topics include: Function of Financial Markets Structure of Financial Markets Internationalization of Financial Markets Function of Financial Intermediaries Financial Intermed
5、iaries Regulation of the Financial System,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-5,Function of Financial Markets,Channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”) Improves economic eff
6、iciency,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-6,Financial Markets Funds Transferees,Lender-Savers Households Business firms Government Foreigners,Borrower-Spenders Business firms Government Households Foreigners,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-7,Se
7、gments of Financial Markets,Direct Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrowers future income or assets Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries (established to sou
8、rce both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrowers future income or assets,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-8,Function of Financial Markets,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-9,Impor
9、tance of Financial Markets,This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this might as well put the money under your mattress. However, if a carpenter could use that money to buy a new saw (increasing her productivity), then sh
10、ed be willing to pay you some interest for the use of the funds.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-10,Importance of Financial Markets,Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive inv
11、estment opportunities to people who have them. Financial markets also improve the well-being of consumers, allowing them to time their purchases better.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-11,Structure of Financial Markets,It helps to define financial markets along a variety
12、 of dimensions (not necessarily mutually exclusive). For starters, ,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-12,Structure of Financial Markets,Debt Markets Short-Term (maturity 10 year) Intermediate term (maturity in-between) Represented $41 trillion at the end of 2007. Equity Ma
13、rkets Pay dividends, in theory forever Represents an ownership claim in the firm Total value of all U.S. equity was $18 trillion at the end of 2005.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-13,Structure of Financial Markets,Primary Market New security issues sold to initial buyer
14、s Typically involves an investment bank who underwrites the offering Secondary Market Securities previously issued are bought and sold Examples include the NYSE and Nasdaq Involves both brokers and dealers (do you know the difference?),Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-14,
15、Structure of Financial Markets,Even though firms dont get any money, per se, from the secondary market, it serves two important functions: Provide liquidity, making it easy to buy and sell the securities of the companies Establish a price for the securities,Copyright 2009 Pearson Prentice Hall. All
16、rights reserved.,2-15,Structure of Financial Markets,We can further classify secondary markets as follows: Exchanges Trades conducted in central locations (e.g., New York Stock Exchange, SSE) Over-the-Counter Markets Dealers at different locations buy and sell Best example is the market for Treasury
17、 securities,NYSE home page http:/,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-16,Classifications of Financial Markets,We can also further classify markets by the maturity of the securities: Money Market: Short-Term (maturity 1 year) plus equities,Copyright 2009 Pearson Prentice Hall
18、. All rights reserved.,2-17,Internationalization of Financial Markets,The internationalization of markets is an important trend. The U.S. no longer dominates the world stage. International Bond Market Foreign bonds Denominated in a foreign currency Targeted at a foreign market Eurobonds Denominated
19、in one currency, but sold in a different market now larger than U.S. corporate bond market) Over 80% of new bonds are Eurobonds.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-18,Internationalization of Financial Markets,Eurocurrency Market Foreign currency deposited outside of home co
20、untry Eurodollars are U.S. dollars deposited, say, London. Gives U.S. borrows an alternative source for dollars. World Stock Markets U.S. stock markets are no longer always the largestat one point, Japans was larger,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-19,Internationalization
21、 of Financial Markets,As the next slide shows, the number of international stock market indexes is quite large. For many of us, the level of the Dow or the S&P 500 is known. How about the Nikkei 225? Or the FTSE 100? Do you know what countries these represent?,Internationalization of Financial Marke
22、ts,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-21,Global perspective Relative Decline of U.S. Capital Markets,The U.S. has lost its dominance in many industries: auto and consumer electronics to name a few.A similar trend appears at work for U.S. financial markets, as London and Hon
23、g Kong compete. Indeed, many U.S. firms use these markets over the U.S.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-22,Global perspective Relative Decline of U.S. Capital Markets,Why? New technology in foreign exchanges 9-11 made U.S. regulations tighter Greater risk of lawsuit in t
24、he U.S. Sarbanes-Oxley has increased the cost of being a U.S.-listed public company,Function of Financial Intermediaries: Indirect Finance,We now turn our attention to the top part of Figure 2.1 indirect finance.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-24,Function of Financial I
25、ntermediaries : Indirect Finance,Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: the intermediary obtains funds from savers the intermediary then makes loans/investments with borrowers,Copyright 2009 Pearson Prentice Hall
26、. All rights reserved.,2-25,Function of Financial Intermediaries : Indirect Finance,This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers. More important source of finance than securities markets (such as stocks) Needed because of tran
27、sactions costs, risk sharing, and asymmetric information,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-26,Function of Financial Intermediaries : Indirect Finance,Transactions Costs Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by develo
28、ping expertise and taking advantage of economies of scale,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-27,Function of Financial Intermediaries : Indirect Finance,A financial intermediarys low transaction costs mean that it can provide its customers with liquidity services, services t
29、hat 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 goods and services whenever necessary,Copyright 2009 Pears
30、on Prentice Hall. All rights reserved.,2-28,Global Perspective,Studies show that firms in the U.S., Canada, the U.K., and other developed nations usually obtain funds from financial intermediaries, not directly from capital markets. In Germany and Japan, financing from financial intermediaries excee
31、ds capital market financing 10-fold. However, the relative use of bonds versus equity does differ by country.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-29,Function of Financial Intermediaries : Indirect Finance,Another benefit made possible by the FIs low transaction costs is that
32、 they can help reduce the 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 a
33、re turned into safer assets for investors,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-30,Function of Financial Intermediaries : Indirect Finance,Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings. Low transactio
34、n costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-31,Function of Financial Intermediaries : Indirect Finance,Another reason FIs exist is to reduce the impact of asymmetric
35、information. One party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two fronts: adverse selection and moral hazard.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-32,Function of Financial Intermediaries : Indirect Finan
36、ce,Adverse Selection Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan Similar problems occur with insurance where unhealthy people want their known medical problems covered,Copyright 2009 Pearson Prentice Hall. All rights reserv
37、ed.,2-33,Asymmetric Information: Adverse Selection and Moral Hazard,Moral Hazard After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that wont pay loan back Again, with insurance, people may engage in risky activities only
38、after being insured Another view is a conflict of interest,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-34,Asymmetric Information: Adverse Selection and Moral Hazard,Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits. How they d
39、o this is the covered in many of the chapters to come.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-35,Types of Financial Intermediaries,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-36,Types of Financial Intermediaries,Copyright 2009 Pearson Prentice Hall. All rights
40、reserved.,2-37,Types of Financial Intermediaries,Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts. Commercial banks (7,500 currently) Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, c
41、onsumer and mortgage loans Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-38,Types of Financial Intermediaries,Thrifts: S&Ls, Mutual Savings Banks (1,500) and Credit Uni
42、ons (8,900) Raise funds primarily by issuing savings, time, and checkable deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings Banks Mutual savings banks and credit unions issue deposits as shares and ar
43、e owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a companys workers,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-39,Contractual Savings Institutions (CSIs),All CSIs acquire funds from clients at periodic intervals on a contr
44、actual basis and have fairly predictable future payout requirements. Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance
45、 Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-40,Contractual Savings Institutions (CSIs),All CSIs acquire funds from clients at period
46、ic intervals on a contractual basis and have fairly predictable future payout requirements. Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide re
47、tirement income via annuities,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-41,Types of Financial Intermediaries,Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small bus
48、inesses for operations Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-42,Types
49、of Financial Intermediaries,Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.,Copyright 2009 Pearson Prentice Hall. All rights reserved.,2-43,Regulatory Agencies,Copyright 2009 Pearson Prentice Hall. All rights reserved.,
