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Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
CHAPTER 2
Overview of the
Financial System

© 2012 Pearson Prentice Hall. All rights reserved. 2-2
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 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.
 If the two of you could get together, perhaps
both of your needs can be met. But how does
that happen?

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 As simple as this example is, it highlights the
importance of financial markets and financial
intermediaries in our economy.
 We need to acquire an understanding of their
general structure and operation before we can
appreciate their role in our economy.

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In this chapter, we examine the role of the financial
system in an advanced economy. We 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: Indirect Finance
─ Types of Financial Intermediaries
─ Regulation of the Financial System

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 efficiency

Financial Markets Funds Transferees

Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets
1. Indirect Finance
• Borrowers borrow indirectly from lenders via
financial intermediaries (established to source
both loanable funds and loan opportunities) by
issuing financial instruments which are claims on
the borrower’s future income or assets

Function of Financial Markets

Importance 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 she’d be willing to pay you some interest
for the use of the funds.

Importance of Financial Markets
 Financial markets are critical for producing an
efficient allocation of capital, allowing funds to
move from people who lack productive
investment opportunities to people who have
them.
 Financial markets also improve the well-being
of consumers, allowing them to time their
purchases better.

Structure of Financial Markets
It helps to define financial markets along a
variety of dimensions (not necessarily
mutually exclusive). For starters, …

1. Debt Markets
─ Short-Term (maturity < 1 year)
─ Long-Term (maturity > 10 year)
─ Intermediate term (maturity in-between)
─ Represented $52.4 trillion at the end of 2009.
1. Equity Markets
─ Pay dividends, in theory forever
─ Represents an ownership claim in the firm
─ Total value of all U.S. equity was $20.5 trillion at
the end of 2009.

1. Primary Market
─ New security issues sold to initial buyers
─ Typically involves an investment bank who
underwrites the offering
1. 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?)

Even though firms don’t 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

We can further classify secondary markets as
follows:
1. Exchanges
─ Trades conducted in central locations (e.g., New
York Stock Exchange, CBT)
1. Over-the-Counter Markets
─ Dealers at different locations buy and sell
─ Best example is the market for Treasury Securities
NYSE home page http://www.nyse.com

Classifications of
Financial Markets
We can also further classify markets by the
maturity of the securities:
1. Money Market: Short-Term
(maturity < 1 year)
2. Capital Market: Long-Term
(maturity > 1 year) plus equities

Internationalization of
Financial Markets
The internationalization of markets is an important trend.
The U.S. no longer dominates the world stage.
International Bond Market & Eurobonds
─ Foreign bonds
• Denominated in a foreign currency
• Targeted at a foreign market
─ Eurobonds
• Denominated in one currency, but sold in a different market
• now larger than U.S. corporate bond market)
• Over 80% of new bonds are Eurobonds.

Internationalization of
Financial Markets
 Eurocurrency Market
─ Foreign currency deposited outside of home country
─ 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 largest—
at one point, Japan’s was larger

Function of Financial
Intermediaries: Indirect Finance
We now turn our attention to the top part of
Figure 2.1—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

 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 transactions costs,
risk sharing, and asymmetric information

 Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing
expertise and taking advantage of
economies of scale

 A financial intermediary’s low transaction costs
mean that it can provide its customers with
liquidity services, services that make it easier
for customers to conduct transactions
1. Banks provide depositors with checking accounts
that enable them to pay their bills easily
2. Depositors can earn interest on checking and
savings accounts and yet still convert them into
goods and services whenever necessary

 Another benefit made possible by the FI’s low
transaction costs is that 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 are turned into safer
assets for investors

 Financial intermediaries also help by
providing the means for individuals and
businesses to diversify their asset
holdings.
 Low transaction costs allow them to buy
a range of assets, pool them, and then
sell rights to the diversified pool to
individuals.

 Another reason FIs exist is to reduce the
impact of asymmetric 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.

 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek a loan
3. Similar problems occur with insurance
where unhealthy people want their known
medical problems covered

 Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to
engage in undesirable (immoral) activities
making it more likely that won’t pay loan back
3. Again, with insurance, people may engage in
risky activities only after being insured
4. Another view is a conflict of interest
Asymmetric Information:
Adverse Selection and Moral Hazard

Asymmetric Information:
Adverse Selection and Moral Hazard
Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits. How they
do this is the covered in many of the
chapters to come.

Types of Financial
Intermediaries

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, consumer and
mortgage loans
─ Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset portfolios

Types of Financial
Intermediaries
 Thrifts: S&Ls & Mutual Savings Banks (1,300) and
Credit Unions (9,500)
─ 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 are owned collectively by their depositors, most
of which at credit unions belong to a particular group, e.g., a
company’s workers

Contractual Savings
Institutions (CSIs)
 All CSIs acquire funds from clients at periodic intervals
on a contractual 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 Companies receive funds
from policy premiums, must invest most in liquid government
and corporate securities, since loss events are harder to
predict

Contractual Savings
Institutions (CSIs)
 All CSIs acquire funds from clients at periodic 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 retirement income via
annuities

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 businesses
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

Types 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.

Regulation of
Financial Markets
Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial
Intermediaries

Regulation Reason:
Increase Investor Information
 Asymmetric information in financial markets means that
investors may be subject to adverse selection and moral
hazard problems that may hinder the efficient operation
of financial markets and may also keep investors away
from financial markets
 The 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
SEC home page http://www.sec.gov

Regulation Reason:
Increase Investor Information
 Such government regulation can reduce adverse
selection and moral hazard problems in financial
markets and increase their efficiency by increasing the
amount of information available to investors. Indeed,
the SEC has been particularly active recently in
pursuing illegal insider trading.
SEC home page http://www.sec.gov

Regulation Reason: Ensure Soundness
of Financial Intermediaries
 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.
 Such panics produces large losses for the public and
causes serious damage to the economy.

Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)
 To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
─ Restrictions on Entry
─ Disclosure
─ Restrictions on Assets and Activities
─ Deposit Insurance
─ Limits on Competition
─ Restrictions on Interest Rates

Regulation:
Restriction on Entry
 Restrictions on Entry
─ Regulators have created very tight regulations as
to who is allowed to set up a financial intermediary
─ Individuals or groups that want to establish a
financial intermediary, 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.

Regulation: Disclosure
 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.

Regulation: Restriction on
Assets and Activities
 There are restrictions on what financial
intermediaries are allowed to do and what
assets they can hold
 Before you put your funds into a bank or some
other such institution, you would want to know
that your funds are safe and that the bank or
other financial intermediary will be able to meet
its obligations to you

Regulation: Restriction on
Assets and Activities
 One way of doing this is to restrict the financial
intermediary from engaging in certain risky
activities
 Another way is to restrict financial
intermediaries from holding certain risky
assets, or at least from holding a greater
quantity of these risky assets than is prudent

Regulation: Deposit Insurance
 The government can insure people depositors
to a financial intermediary 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
$250,000 per account.

Regulation: Deposit Insurance
 Similar government agencies exist for other
depository institutions:
─ The National Credit Union Share Insurance Fund
(NCUSIF) provides insurance for credit unions

Regulation:
Limits on Competition
 Although the evidence that unbridled competition
among financial intermediaries 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

Regulation: 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

Regulation Reason:
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
Federal Reserve System (the Fed), the central bank in
the United States
 Reserve requirements help the Fed exercise more
precise control over the money supply

Financial Regulation Abroad
 Those countries with similar economic systems
also implement financial regulation consistent
with the U.S. model: Japan, Canada, and
Western Europe
─ Financial reporting for corporations is required
─ Financial intermediaries are heavily regulated
 However, U.S. banks are more regulated along
dimensions of branching and services than
their foreign counterparts.

Chapter Summary
 Function of Financial Markets: We examined
the flow of funds through the financial system
and the role of intermediaries in this process.
 Structure of Financial Markets: We examined
market structure from several perspectives,
including types of instruments, purpose,
organization, and time horizon.

Chapter Summary (cont.)
 Internationalization of Financial Markets: We
briefly examined how debt and equity markets
have expanded in the international setting.
 Function of Financial Intermediaries: We
examined the roles of intermediaries in
reducing transaction costs, sharing risk, and
reducing information problems.

Chapter Summary (cont.)
 Types of Financial Intermediaries: We outlined
the numerous types of financial intermediaries
to be further examined in later chapters.
 Regulation of the Financial System: We
outlined some of the agencies charged with the
oversight of various institutions and markets.

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