Chapter_02 overview of the financial system

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-1
Chapter 2
Overview 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
Lender-Savers
1. Households
2. Business firms
3. Government
4. Foreigners
Borrower-Spenders
1. Business firms
2. Government
3. Households
4. Foreigners

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
2. 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

Structure of Financial Markets
1. Debt Markets (e.g., Bond Markets)
– Short-Term (maturity < 1 year)
– Long-Term (maturity > 10 year)
– Intermediate term (maturity in-between)
2. Equity Markets (e.g., Stock Markets)
– Pay dividends, in theory forever
– Represents an ownership claim in the firm

Georgia’s stock market development
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2015 2017 2019 2021 2023
GEL
Billions
Georgian Stock Market Capitalization (N of
Shares * Price)

Georgia’s stock market development
0.00%
0.01%
0.02%
0.03%
0.04%
0.05%
0.06%
0.07%
0
50
100
150
200
250
2015 2016 2017 2018 2019 2020 2021 2022 2023
Liquidity Of GSE Is Historically Low
Number of Trades
Liquidity (Trade Volume/Market Cap)

• NBG allows
USD Issues
• List of
repo-
eligible IFI
issuers
established
• Law on
Securitization
Local bond market size, GEL, bn
• Rated GEL
Denominated
Corporate
bond become
eligible for
Repo
Transactions
0
2
4
6
8
10
12
2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Treasury Bonds
• New Taxation
scheme for
publicly
listed
financial
instruments,
abolishing
the tax on
coupon and
capital gain
• Pension
Reform
• Fund
Management
Law enacted
• GDN
Framework
• Derivatives
law and
ISDA
agreement
• Securities
Holding
• Law
• Covered
Bond
Law
Source: NBG, TBC Capital
Georgia’s Bond market development

1. Primary Market
– New security issues sold to initial buyers
– Typically involves an investment bank who
underwrites the offering
2. Secondary Market
– Securities previously issued are bought
and sold
– Examples include the New York Stock Exchange
(NYSE) and Nasdaq
– Involves both brokers and dealers

Underwriters on Georgian Bond
Market

• 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

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

Bond Market By Maturity
0
100
200
300
400
500
600
700
2 Years 3 Years 5 Years
USD GEL
Bond balances by maturity type, Dec 2023

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
– Eurobonds
• Denominated in one currency, but sold in a different market

Function of Financial
Intermediaries : 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

• 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

Asymmetric Information:
Adverse Selection and Moral Hazard
• 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

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

• 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.

SEC home page
http://www.sec.gov
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) (SEC in
US; Securities and Futures Commission, SFC in Hong
Kong) 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

Chapter_02 overview of the financial system

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