Lecture 2 - Financial System

The Financial System
Ryan W. Herzog
Gonzaga University
June 29, 2020

Flow of Funds
Figure: Funds Flowing through the Financial System
GU The Financial System June 29, 2020 1 / 1

Financial System
What is it?
Financial Instrument (legal obligation of one party to transfer
something of value, usually money, to another party at some
future date) - Stocks, bonds, insurance.
Financial Markets
Financial Intermediaries
Households, Businesses, Government
Purpose: Allocate capital, share risk, facilitate trade, and
promote growth
Goal: Channel funds from savers (household, government,
firms) to borrowers (those with profitable business
opportunity).
Internal or external finance.

Introduction
Indirect Finance: An institution stands between lender and
borrower.
We get a loan from a bank or finance company to buy a car.
Direct Finance: Borrowers sell securities directly to lenders in
the financial markets.
Direct finance provides financing for governments and
corporations.
Asset: Something of value that you own.
Liability: Something you owe.

Social vs Industry Goals
Households want high, safe returns. They are willing to trade
off a higher return for a safe, diversified asset.
Financial intermediaries seek to maximize profit which may
not be compatible with household’s objectives. Financial
intermediaries are willing to accept more risk for a higher
return.
The challenge is to minimize the asymmetric information
problems through well designed regulations that do not place
overly large burdens on the financial system.

Asymmetric Information
Think about the used car market. The seller knows more
about the car than the buyer.
In the ﬁnancial system, the borrower knows what they are
going to do with the money and the likelihood of repayment.

Asymmetric Information
Adverse Selection:
1. Insurance: those most likely to use/need insurance are also the
most likely to buy insurance.
2. Loans: The least desirable borrowers are those who most
desire loans. More likely to borrow at high interest rates as
they are unlikely to pay it back.
3. Occurs before a contract is signed.
Moral Hazard: Any post-contractual change in behavior that
injures other parties to the contract (FDIC, bailouts) - After a
contract is signed.
The goal is to make sure the contracts are incentive
compatible, i.e. neither party has an incentive to deviate from
the original agreement (i.e. collateral).

Financial Instruments
Financial Instruments: The written legal obligation of one
party to transfer something of value, usually money, to
another party at some future date, under speciﬁed conditions.
The enforceability of the obligation is important.
Financial instruments obligate one party (person, company, or
government) to transfer something to another party.
Financial instruments specify payment will be made at some
future date.
Financial instruments specify conditions under which a
payment will be made.

Use of Financial Instruments
Financial instruments act as a means of payment (like
money).
Employees take stock options as payment for working.
Financial instruments act as stores of value (like money).
Financial instruments can be used to transfer purchasing power
into the future
Financial instruments allow for the transfer of risk (unlike
money).
Futures and insurance contracts allows one person to transfer
risk to another.

Characteristics of Financial Instruments
These contracts are very complex.
This complexity is costly, and people do not want to bear these
costs.
Standardization of ﬁnancial instruments overcomes potential
costs of complexity.
For example, most mortgages feature a standard application
with standardized terms.
Financial instruments also communicate information,
summarizing certain details about the issuer.
Continuous monitoring of an issuer is costly and diﬃcult.

A Primer for Valuing Financial Instruments
Four fundamental characteristics inﬂuence the value of a
ﬁnancial instrument:
Size of the payment:
Larger payment - more valuable.
Timing of payment:
Payment is sooner - more valuable.
Likelihood payment is made:
More likely to be made - more valuable.
Conditions under with payment is made:
Made when we need them - more valuable.

We organize ﬁnancial instruments by how they are used:
Primarily used as stores of value
Bank loans
Borrower obtains resources from a lender to be repaid in the
future.
Bonds
A form of a loan issued by a corporation or government.
Can be bought and sold in ﬁnancial markets.

Home mortgages
Home buyers usually need to borrow using the home as
collateral for the loan.
A specific asset the borrower pledges to protect the lender’s
interests.
Stocks
The holder owns a small piece of the firm and entitled to part
of its profits.
Firms sell stocks to raise money.
Primarily used as a stores of wealth.

Asset-backed securities
Shares in the returns or payments arising from speciﬁc assets,
such as home mortgages and student loans.
Mortgage backed securities bundle a large number of
mortgages together into a pool in which shares are sold.
Securities backed by sub-prime mortgages played an important
role in the ﬁnancial crisis of 2007-2009.

Financial Markets
Markets where buyers and sellers deal in ﬁnancial instruments
or securities. We have equity, debt, and currency markets.
Primary markets (newly issued securities) or secondary
markets (the resale of securities where you and I are likely to
operate).
Exchange (NYSE or Chicago Board of Trade - centralized) or
Over-the-Counter (run by dealers to facilitate bilateral
exchange, nonstandard securities, CDS - decentralized).
Money market (short term, less than a year) or capital market
(long term ﬁnancing).

The Role of Financial Markets
Market liquidity:
Ensure owners can buy and sell ﬁnancial instruments cheaply.
Keeps transactions costs low.
Information:
Pool and communication information about issuers of ﬁnancial
instruments.
Risk sharing:
Provide individuals a place to buy and sell risk.

Structure of Financial Markets
Distinguish between markets where new ﬁnancial instruments
are sold and where they are resold or traded: primary or
secondary markets.
Categorize by the way they trade: centralized exchange or not.
Group based on the type of instrument they trade: as a store
of value or to transfer risk.

Primary vs Secondary Markets
A primary market is one in which a borrower obtains funds
from a lender by selling newly issued securities.
Occurs out of the public views.
An investment bank determines the price, purchases the
securities, and resells to clients.
This is called underwriting and is usually very proﬁtable

Primary vs Secondary Markets
Secondary ﬁnancial markets are those where people can buy
and sell existing securities.
Buying a share of IBM stock is not purchased from the
company, but from another investor in a secondary market.
These are the prices we hear about in the news.

Debt and Equity versus Derivative Markets
Used to distinguish between markets where debt and equity
are traded and those where derivative instruments are traded.
Debt markets are markets for loans, mortgages, and bonds.
Equity markets are the markets for stocks.
Derivative markets are the markets where investors trade
instruments like futures, options, and swaps.

Characteristics of a Well-Run Financial Market
Essential characteristics of a well-run ﬁnancial market:
Must be designed to keep transaction costs low.
Information the market pools and communicates must be
accurate and widely available.
Borrowers promises to pay lenders much be credible.
Lenders must be able to enforce their right of repayment
quickly and at low cost.

Characteristics of a Well-Run Financial Market
Because of these criteria, the governments are an essential
part of ﬁnancial markets as they enforce the rules of the
game.
Because of this, countries with better investor protections have
bigger and deeper ﬁnancial markets.

Financial Intermediaries
“The market”
Bring buyers and sellers together
Typically borrow short and lend long. Liquid liabilities
(checking accounts) vs. illiquid assets (mortgages) which is
inherently risky.
Oﬀer a way for the saver to diversify, economies of scope and
economies of scale.
Types: deposit institutions (commercial banks, savings banks,
credit unions); insurance companies (use premiums to buy
mutual funds); investment company (pensions, retirement).

Structure
We can divide intermediaries into two broad categories:
Depository institutions: Take deposits and make loans. What
most people think of as banks
Non-depository institutions: Include insurance companies,
securities ﬁrms, mutual fund companies, etc.

Structure
Depository institutions take deposits and make loans.
Insurance companies accept premiums, which they invest, in
return for promising compensation to policy holders under
certain events.
Pension funds invest individual and company contributions in
stocks, bonds, and real estate in order to provide payments to
retired workers.
Securities firms include brokers, investment banks,
underwriters, and mutual fund companies.
Brokers and investment banks issue stocks and bonds to
corporate customers, trade them, and advise customers.
Mutual-fund companies pool the resources of individuals and
companies and invest them in portfolios.
Hedge funds do the same for small groups of wealthy investors.
Finance companies raise funds directly in the financial markets
in order to make loans to individuals and firms.
Finance companies tend to specialize in particular types of

Regulation
Is regulation good or bad?
Four functions:
1 - Reduce asymmetric information (transparency)
2 - Protect consumers
3 - Promote competition and eﬃciency
4 - Soundness of the ﬁnancial system (lender of last resort,
deposit insurance)
Too big to fail?

Lecture 2 - Financial System

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