Week 2 - Financial System.pdf
- 1. Lecture 1-2: The Financial System Monetary Economics I Undergraduate Program Faculty of Economics and Business Universitas Gadjah Mada 2021
- 2. § STUDENTS CAN IDENTIFY THE STRUCTURE AND KEY COMPONENTS OF FINANCIAL MARKETS § STUDENTS CAN ANALYZE THE PROBLEMS THAT TRANSACTIONS COSTS, ADVERSE SELECTION, AND MORAL HAZARD POSE FOR THE FINANCIAL MARKET § STUDENTS CAN IDENTIFY THE REASONS FOR AND FORMS OF A GOVERNMENT SAFETY NET IN FINANCIAL MARKETS Learning Objectives of Meeting 2
- 3. Lecture 2: The Financial System Structure of Financial System Economic Analysis of Financial Structure Economic Analysis of Financial Regulation
- 4. FIRMS HOUSEHOLDS LABOR MARKET GOVERNMENT AND CENTRAL BANK FINANCIAL MARKET GOODS AND SERVICES MARKET Payment for Goods and services Goods and Services for consumption Government purchases Goods and Services for investment Transfer Taxes Labor Supply Wage Payment Loans Interest, Dividends Framework of Macroeconomics
- 5. FIRMS HOUSEHOLDS LABORMARKET GOVERNMENT AND CENTRAL BANK FINANCIALMARKET GOODSAND SERVICESMARKET PaymentforGoods and services Goodsand Services forconsumption Governmentpurchases Goodsand Services forinvestment Transfer Taxes LaborSupply WagePayment Loans Interest,Dividends Monetary economics …. § focuses on the monetary and other financial markets, the determination of the interest rate, the extent to which these influence the behavior of the economic units and the implications of that influence in the macroeconomic context. § studies the formulation of monetary policy, with respect to the supply of money and manipulation of interest rates. Focus of Monetary Economics
- 6. Financial Market FINANCIAL MARKET Financial market is a market in which funds are transferred (direct or indirect) from people who have an excess of available funds to people who have a shortage. Lender- Saver Borrower- Spenders Domestic and Foreign: § Households § Businesses § Governments funds funds Domestic and Foreign: § Households § Businesses § Governments Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income.
- 7. § Financial markets are crucial to promoting a greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. § Indeed, well functioning financial markets are a key factor in producing high economic growth. § Activities in financial markets also have direct effects on personal wealth, the behavior of businesses and consumers, and the cyclical performance of the economy. Function of Financial Market
- 8. Financial Market: Flows of Fund FINANCIAL MARKET The arrows show that funds flow from lender-savers to borrower-spenders via two routes: 1. Direct finance: Borrowers borrow funds directly from financial markets by selling securities. 2. Indirect finance: A financial intermediary borrows funds from lender-savers and then uses these funds to make loans to borrower-spenders. Lender- Saver Borrower- Spenders funds funds Direct finance Indirect finance Financial intermediaries
- 9. Financial Market: Structure FINANCIAL MARKET Money Market Capital Market The money market is a financial market in which only short-term debt instruments (generally those with original maturity terms of less than one year) are traded. The capital market is the market in which longer term debt instruments (generally those with original maturity terms of one year or greater) and equity instruments are traded 2 1
- 10. Financial Market: Structure FINANCIAL MARKET Money Market Capital Market Equity/Stock Market Debt/Bond Market Stock market is a financial market in which claims on the earnings and assets of corporations (shares of stock) are traded. Bond market is a financial market in which a debt security, that promises to make periodic payments for a specified period of time, are traded. 2.1 2.2 2 1
- 11. Financial Market: Instruments FINANCIAL MARKET Money Market Capital Market Equity/Stock Market Debt/Bond Market INSTRUMENTS OF BOND MARKET: § Bond § Fixed income securities (e.g. MBS) INSTRUMENTS OF STOCK MARKET: § Stocks/equities § Derivatives (e.g. ETF) INSTRUMENTS OF MONEY MARKET: § Treasury Bills § Certificates of Deposit § Commercial Paper § Repurchase Agreements
- 12. Financial Market: Money Market Money market instruments consist of § Treasury Bills is short-term debt instruments of the government. which are issued in one-, three-, and six-month maturities to finance the federal government § Certificate of deposit (CD) is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. § Commercial paper is a short-term debt instrument issued by large banks and well- known corporations. § Repurchase agreements (repos) are effectively short-term loans (usually with a maturity term of less than two weeks) for which Treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan. Principal Money Market Instruments
- 13. Financial Market: Capital Market Capital market instruments are debt and equity instruments with maturities of greater than one year. § Stocks are equity claims on the net income and assets of a corporation § Mortgages are loans to households or firms to purchase land, housing, or other real structures, in which the structure or land itself serves as collateral for the loans. § Bond is a debt security that promises to make periodic payments for a specified period of time. Principal Capital Market Instruments
- 14. Financial Market: Primary Market FINANCIAL MARKET Money Market Capital Market Equity/Stock Market Debt/Bond Market Primary Market Secondary Market Primary Market Secondary Market A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.
- 15. § The primary markets for securities are not well known to the public because the selling of securities to initial buyers often takes place behind closed doors. § An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. § The investment bank does this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public. The Primary Market
- 16. Financial Market: Secondary Market FINANCIAL MARKET Money Market Capital Market Equity/Stock Market Debt/Bond Market Primary Market Secondary Market Primary Market Secondary Market A secondary market is a financial market in which securities that have been previously issued can be resold.
- 17. § Securities brokers and dealers are crucial to a well-functioning secondary market. § Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices. § Examples: The New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation System), foreign exchange markets, futures markets, and options markets. The Secondary Market
- 18. Secondary markets can be organized in two ways: 1. Exchange market: Buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. 2. Over-the-counter (OTC) market: Dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices. The Secondary Market
- 19. The Secondary Market FUNCTION OF SECONDARY MARKETS 1 Secondary markets determine the price of the security that the issuing firm sells in the primary market. The higher the security’s price in the secondary market, the higher the price the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. 2 Secondary markets make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market.
- 20. Sources of External Funds for Nonfinancial Businesses § The Bank Loans category is made up primarily of loans from depository institutions § The Nonbank Loans are primarily loans by other financial intermediaries § The Bonds category includes marketable debt securities, such as corporate bonds and commercial paper § Stock consists of new issues of new equity (stock market shares). Sources of External Funds for Nonfinancial Businesses Financial Market Instruments
- 21. Household Holdings of Selected Financial Assets (percentage of total financial assets held) in United States (US) The table reports holdings of assets, such as stocks and bonds, that are supplied by financial markets, and assets, such as bank deposits and mutual fund shares, that are supplied by financial intermediaries. Financial Market Instruments: US
- 22. Capital Market Instruments: Indonesia MARKET VALUE FREQUENCY Stock Rp 2,228,798 Billion 163,938 Rights Rp 108.59 Billion 31.6 Warrants Rp 2,237.68 Billion 2,511.8 ETFs Rp 194.12 Billion 23.1 Government Bond Rp 10,624,628 Billion 468,387 Corporate Bond Rp 377,544 Billion 37,788 Trading Summary in Indonesia Stock Exchange The table reports the value of capital market instruments in Indonesia, such as stocks and bonds, that are supplied by financial markets. Trading Summary in Indonesia Stock Exchange 2020
- 23. Lecture 2: The Financial System Structure of Financial System Economic Analysis of Financial Structure Economic Analysis of Financial Regulation
- 24. Indirect Finance: Financial Intermediation FINANCIAL MARKET The process of indirect financing using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers. Lender- Saver Borrower- Spenders funds funds Financial intermediaries Indirect finance Indirect finance
- 25. FINANCIAL MARKET Lender- Saver Borrower- Spenders funds funds Depository institutions Contractual savings institutions Investment intermediaries 1 2 3 Type of Financial Intermediary
- 26. Depository institutions 1 Type of Financial Intermediary DEFINITION: Depository institutions are financial intermediaries that accept deposits from individuals and institutions and make loans. EXAMPLE: Commercial banks, savings and loan associations, mutual savings banks, and credit unions. PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY INSTITUTION
- 27. Contractual savings institutions 2 Type of Financial Intermediary DEFINITION: Contractual savings institutions are financial intermediaries that acquire funds at periodic intervals on a contractual basis. EXAMPLE: Insurance companies and pension funds. PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY INSTITUTION
- 28. Investment intermediaries 3 Type of Financial Intermediary DEFINITION: This category of financial intermediary includes finance companies, mutual funds, money market mutual funds, and hedge funds. PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY INSTITUTION
- 29. Financial Intermediary: United States Primary Financial Intermediaries and Value of Their Assets The table describes the value of assets of the financial intermediaries in each category.
- 30. Financial Intermediary: Indonesia Financial Intermediaries in Indonesia The table describes the number of financial intermediaries in Indonesia in 2020 (July – temporary figures based on Indonesia Financial Service Authority's Database. TIPE LEMBAGA KEUANGAN JUMLAH LEMBAGA JUMLAH ASET 1 BANK 1.1 BANK UMUM 110 Rp 8,725.91 T 1.1 Bank Persero 4 1.2 BUSN Devisa 41 1.3 BUSN Non Devisa 19 1.4 BPD 27 1.5 Bank Campuran 11 1.6 Bank Asing 8 1.2 BANK: BPR 1520 Rp 148.05 T 2 ASURANSI 139 Rp 1,312.71 T 1.1. Asuransi Jiwa 54 1.2. Asuransi Umum 74 1.3. Reasuransi 6 1.4. Asuransi Wajib 3 1.5. Asuransi Sosial (BPJS) 2 3 DANA PENSIUN 217 Rp 293.60 T 2.1. DPPK-PPMP 151 2.2. DPPK-PPIP 43 2.3. DPLK 23 4 LEMBAGA PEMBIAYAAN 236 Rp 571.94 T 3.1. Perusahaan Pembiayaan 177 3.2. Modal Ventura 57 3.3. PP Infrastruktur 2 5 LEMBAGA KEUANGAN KHUSUS 110 Rp 209.95 T 4.1. LPEI 1 4.2. Pergadaian 85 4.3. Lembaga Penjamin 21 4.4. PT SMF (Persero) 1 4.5. PT PNM (Persero) 1 4.6. PT Danareksa (Persero) 1 6 LEMBAGA KEUANGAN MIKRO 146 Rp 0.61 T 7 FINTECH 147 Rp 3.19 T
- 31. FINANCIAL MARKET Why are financial intermediaries and indirect finance so important in financial markets? To answer this question, we need to understand the roles of transaction costs, risk sharing, and information costs in financial markets. Lender- Saver Borrower- Spenders funds funds Financial intermediaries Indirect finance Indirect finance The Importance of Indirect Finance
- 32. Direct Finance Indirect Finance Transaction costs (i.e. the time and money spent in carrying out financial transactions) Financial Market Lender Borrower Financial Market Lender Borrower How Financial Intermediaries Reduce Transaction Costs? Economies of Scale Banks achieve economies of scale in making loans by using standardized loan contracts, having specialized loan officers, and taking advantage of sophisticated computer systems Transaction Costs
- 33. Direct Finance Indirect Finance Financial Market Lender Borrower Financial Market Lender Borrower High Transaction Cost Low Transaction Cost 1. Liquidity Services A financial intermediary can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. Low Transaction Costs: The Benefit
- 34. Direct Finance Indirect Finance Financial Market Lender Borrower Financial Market Lender Borrower High Transaction Cost Low Transaction Cost 2. Risk Sharing A financial intermediary help reduce the exposure of investors to risk—that is, uncertainty about the returns investors will earn on assets. Low Transaction Costs: The Benefit
- 35. § Small investors rarely lend money directly because of transactions costs. § Financial intermediaries can reduce transactions costs partly because of economies of scale, which refers to the reduction in average cost that results from an increase in volume. § For instance, banks achieve economies of scale in making loans by using standardized loan contracts, having specialized loan officers, and taking advantage of sophisticated computer systems. Transaction Costs: A Recap
- 36. Lecture 2: The Financial System Structure of Financial System Economic Analysis of Financial Structure Economic Analysis of Financial Regulation
- 37. Financial Markets Lender Borrower Asymmetric information is a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible for the first party to make accurate decisions when conducting the transaction Asymmetric Information Many financial transactions involve asymmetric information, with one party to the transaction having better information than the other party.
- 38. Lender Borrower Asymmetric Information Economists distinguish between two problems arising from asymmetric information: (1) Adverse selection, dan (2) Moral hazard. Adverse selection !"#$%&# '&()*(+',%) !($'#& '&()*(+',%) Moral Hazard Transaction in Financial Markets Adverse selection occurs before the transaction takes place. Moral hazard occurs after the transaction has taken place. 1 2
- 39. Asymmetric information results in two problems: § Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. § Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back. Asymmetric Information
- 41. § The concepts of asymmetric information, adverse selection, and moral hazard help explain why governments pursue financial regulation. § The government regulates financial markets for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system. Financial Regulation: A Rationale
- 42. Financial Market Lender Borrower Asymmetric Information Asymmetric Information Bank Panic Financial Regulation: A Rationale
- 43. Financial Market Lender Borrower Asymmetric Information Asymmetric Information Bank Panics Uncertainty about the health of the banking system in general can lead to runs on both good and bad banks, and the failure of one bank can hasten the failure of others (referred to as the contagion effect). Financial Regulation: A Rationale
- 44. Financial Market Lender Borrower Asymmetric Information Asymmetric Information Bank Panics Government Safety Net Government Safety Net
- 45. Financial Market Lender Borrower Asymmetric Information Asymmetric Information Bank Panics A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome depositors’ reluctance to put funds into the banking system. Government Safety Net
- 46. Financial Market Lender Borrower Asymmetric Information Asymmetric Information Bank Panics Government Safety Net 1. Deposit insurance 2. Lender of last resort Government Safety Net
- 47. Two primary methods to handle a failed bank. 1. The payoff method: regulator allows the bank to fail and pays off depositors up to the insurance limit. 2. The purchase and assumption method: a regulator reorganizes the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bank’s liabilities so that no depositor or other creditor loses a penny. Handling A Failed Bank
- 48. Although a government safety net can help protect depositors and other creditors and prevent, or ameliorate, financial crises, it is a mixed blessing. § Moral Hazard and the Government Safety Net § Adverse Selection and the Government Safety Net § “Too Big to Fail” Drawbacks of the Government Safety Net
- 49. Although a government safety net can help protect depositors and other creditors and prevent, or ameliorate, financial crises, it is a mixed blessing. § Moral Hazard and the Government Safety Net With a safety net, depositors and creditors know they will not suffer losses if a financial institution fails, so they do not impose the discipline of the marketplace on these institutions by withdrawing funds when they suspect that the financial institution is taking on too much risk. § Adverse Selection and the Government Safety Net § “Too Big to Fail” Drawbacks of the Government Safety Net
- 50. Although a government safety net can help protect depositors and other creditors and prevent, or ameliorate, financial crises, it is a mixed blessing. § Moral Hazard and the Government Safety Net § Adverse Selection and the Government Safety Net Because depositors and creditors protected by a government safety net have little reason to impose discipline on financial institutions, risk-loving entrepreneurs might find the financial industry a particularly attractive one—they know they will be able to engage in highly risky activities. § “Too Big to Fail” Drawbacks of the Government Safety Net
- 51. Although a government safety net can help protect depositors and other creditors and prevent, or ameliorate, financial crises, it is a mixed blessing. § Moral Hazard and the Government Safety Net § Adverse Selection and the Government Safety Net § “Too Big to Fail” Regulators are reluctant to close down large financial institutions and impose losses on their depositors and creditors because doing so might precipitate a financial crisis. Drawbacks of the Government Safety Net
- 52. There are eight basic types of financial regulation aimed at lessening asymmetric information problems and excessive risk taking in the financial system: 1. Restrictions on asset holdings 2. Capital requirements 3. Prompt corrective action 4. Chartering and examination 5. Assessment of risk management 6. Disclosure requirements 7. Consumer protection 8. Restrictions on competition Types of Financial Regulation
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