FINANCIAL MARKETS AND INSTITUTIONS 1.

Role of Financial Markets and Institutions A financial market is a market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies. This chapter provides a background on financial markets and the financial institutions that participate in them. ROLE OF FINANCIAL MARKETS Financial markets transfer funds from those who have excess funds to those who need funds. They enable college students to obtain student loans, families to obtain mortgages, businesses to finance their growth, and governments to finance many of their expendi- tures. Without financial markets, many students could not go to college, many families could not purchase a home, corporations could not grow, and the government would not have been able to provide funding to corporations. Households and businesses that sup- ply funds to financial markets earn a return on their investment; the return is necessary to ensure that funds are supplied to the financial markets. If funds were not supplied, the financial markets would not be able to transfer funds to those who need them. Those participants who receive more money than they spend are referred to as sur- plus units (or investors). They provide their net savings to the financial markets. Those participants who spend more money than they receive are referred to as deficit units (or borrowers). They access funds from financial markets so that they can spend more money than they receive. Many individuals provide funds to financial markets in some periods and access funds in other periods. College students are typically deficit units, as they often borrow from financial markets to support their education. After they obtain their degree, they earn more income than they spend and thus become surplus units. A few years later, they may become deficit units again by purchasing a home. At this stage, they may provide funds to and access funds from financial markets simultaneously. That is, they may periodically deposit savings in a financial institution, but also borrow money from a financial institution to buy a home.

Many deficit units such as firms and government agencies access funds from financial markets by issuing securities. Securities represent a claim on the issuer. Debt securities represent debt (also called credit, or borrowed funds) incurred by the issuer. Deficit units issue the securities to surplus units and pay interest to the surplus units on a periodic basis (such as every six months). Debt securities have a maturity date, when the surplus units can redeem them, receiving the principal (face value) from the issuer. Equity securities (also called stocks) represent equity or ownership in the issuer. Some businesses issue equity securities as an alternative way of raising funds. Issuing securities enables corporations and government agencies to obtain money from surplus units and thus to spend more money than they receive from normal operations. If the U.S. government wants to spend $70 billion more than it receives in taxes this month, it can issue U.S. Treasury securities to net savers. The U.S. government is a major deficit unit and therefore frequently relies on financial markets. The Treasury securities that it issues are a form of debt owed by the Treasury to the net savers who purchased the securities. Other government agencies also commonly issue debt securities to obtain funds. Similarly, if Google wants to spend $40 million more than it receives in revenue this month, it can issue corporate debt securities to net savers. Alternatively, it can issue equity securities to raise funds. Each method of raising funds has distinct advantages and disadvantages, as will be discussed in later chapters.

Types of Financial Markets

Each financial market is created to satisfy particular preferences of market participants. For example, some participants may want to invest funds for a short-term period, whereas others want to invest for a long-term period. Some participants are willing to tolerate a high level of risk when investing, whereas others need to avoid risk. Some participants that need funds prefer to borrow, whereas others prefer to issue stock. There are many different types of financial markets, and each market can be distinguished by the maturity structure and trading structure of its securities. Money versus Capital Markets The financial markets that facilitate the transfer of debt securities are commonly classified by the maturity of the securities. Those financial markets that facilitate the flow of short-term funds (with

maturities of one year or less) are known as money markets, while those that facilitate the flow of long-term funds are known as capital markets. Primary versus Secondary Markets Money market securities are debt securities that have a maturity of one year or less. They have a relatively high degree of liquidity, due to their short maturities, and because they typically have an active secondary market. Whether referring to money market securities or capital market securities, it is necessary to distinguish between transactions in the primary market and transactions in the secondary market. Primary markets facilitate the issuance of new securities. Secondary markets facilitate the trading of existing securities, which allows for a change in the ownership of the securities. Primary market transactions provide funds to the initial issuer of securities; secondary market transactions do not. The issuance of new corporate stock or new Treasury securities is a primary market transaction, while the sale of existing corporate stock or Treasury security holdings by one investor to another is a secondary market transaction. An important characteristic of securities that are traded in secondary markets is liquidity, which is the degree to which securities can easily be liquidated (sold) without a loss of value. Some securities have an active secondary market, meaning that there are many willing buyers and sellers of the security at a given point in time. Investors prefer liquid securities so that they can easily sell the securities whenever they want (without a loss in value). If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer. During the credit crisis in 2008 and 2009, investors were less willing to invest in many debt securities because they were concerned that these securities might default, meaning that the investors would not receive the interest and principal payments they expected. As the investors reduced their investments, the secondary markets for some debt securities became illiquid. Thus, investors who were holding these securities could not easily sell them. How Financial Markets Facilitate Corporate Finance Finance is commonly partitioned into three segments as shown in Exhibit 1.1: (1) corporate finance, (2) investment management, and (3) financial markets and institutions. Corporate finance involves decisions such as how much funding to obtain and how to invest the proceeds to expand operations.

The financial markets attract funds from investors and channel the funds to corporations. Thus, they serve as the means by which corporations finance their existing operations and their growth. The money markets enable corporations to borrow funds on a short-term basis so that they can support their existing operations. The capital markets enable corporations to obtain long-term funds to support corporate expansion. The decisions by the managers of publicly traded firms affect a firms performance and stock price, which affects the returns to the investors who provided funding in the capital markets by purchasing the stock. How Financial Markets Facilitate Investing Investment management involves decisions by investors regarding how to invest their funds. The financial markets offer investors a wide variety of investment opportunities, including securities issued by the U.S. Treasury and government agencies as well as corporate securities. A major part of investment management is deciding which securities to purchase. When investing in stock, investors assess the financial management of various firms. They look for firms that are currently undervalued and have the potential to improve. They monitor and may even attempt to influence the financial management of the firms in which they invest to ensure that the financial managers make decisions that maximize the stock price. The market price of the stock serves as a measure of how well each publicly traded firm is being managed by its managers. Financial institutions (discussed later in this chapter) are shown in Exhibit 1.1. They serve as intermediaries that execute the transactions within the financial markets so that funds from investors are channeled to corporations. They also commonly serve as investors and channel their own funds to corporations.

SECURITIES TRADED IN FINANCIAL MARKETS Each type of security tends to have specific return and risk characteristics, as described in detail in the chapters covering financial markets. The term risk is used here to represent the uncertainty surrounding the expected return. The more uncertain the expected return, the greater the risk is. When investors have funds available for one year, for example, they can purchase one-year Treasury securities and know exactly what return they will receive on their investment. Alternatively, they can attempt to earn higher returns by investing in debt securities issued by firms, but there is a risk that they will never receive payments if those firms go bankrupt. Equity securities are also risky because their values depend on the future performance of the firms that issued them. Investors differ with respect to the risk they are willing to incur, the amount of liquidity they desire, and their tax status, making some types of securities more desirable to some investors than to others. Normally, investors attempt to balance the objective of high return with their particular preference for low risk and adequate liquidity. Some investors are much more willing than others to invest in risky securities, as long as the potential return is sufficiently high. Securities can be classified as money market securities, capital market securities, or derivative securities. Money Market Securities Money market securities are debt securities that have a maturity of one year or less. They generally have a relatively high degree of liquidity. Money market securities tend to have a low expected return but also a low degree of risk. Common types of money market securities include Treasury bills (issued by the Treasury), commercial paper (issued by corporations), and negotiable certificates of deposit (issued by depository institutions). Capital Market Securities Securities with a maturity of more than one year are called capital market securities. Capital market securities are commonly issued to finance the purchase of capital assets, such as buildings, equipment, or machinery. Three common types of capital market securities are bonds, mortgages, and stocks.

Bonds Bonds are long-term debt securities issued by corporations and government agencies to support their operations. They provide a return to investors in the form of interest income (coupon payments) every six months. Since bonds represent debt, they specify the amount and timing of interest and principal payments to investors who purchase them. At maturity, investors holding the debt securities are paid the principal. Debt securities can be sold in the secondary market if investors do not want to hold them until maturity. Since the prices of debt securities change over time, they may be worth less when sold than when they were purchased. Some debt securities are risky because the issuer could default on its obligation to repay the debt. Under these circumstances, the debt security will not provide the entire amount of coupon payments and principal that was promised. Long-term debt securities tend to have a higher expected return than money market securities, but they have more risk as well. Mortgages Mortgages are long-term debt obligations created to finance the purchase of real estate. Some mortgages are riskier than others. Lenders try to assess the likelihood of loan repayment using various criteria such as the borrowers income level relative to the value of the home. They offer prime mortgages to borrowers who qualify based on these criteria. Subprime mortgages are offered to some borrowers who do not have sufficient income to qualify for prime mortgages or are unable to make a down payment. The subprime mortgages exhibit a higher risk of default, and therefore the lenders providing the mortgages charge a higher interest rate and additional upfront fees to compensate for the higher level of risk. Subprime mortgages have recently received much attention because of their high default rates, which led to the major credit crisis that began in 2008. Mortgage-Backed Securities Mortgage-backed securities are debt obligations representing claims on a package of mortgages. There are many forms of mortgage-backed securities, but in the simplest form, the investors who purchase these securities receive monthly payments that are made by the homeowners on the mortgages backing the securities. Example:

Mountain Savings Bank originates 100 residential mortgages for home buyers and will service the mortgages by processing the monthly payments. However, the bank does not want to use its own funds to finance the mortgages. It issues mortgage-backed securities that represent this package of 100 mortgages to eight financial institutions that are willing to purchase all of these securities. Each month, when Mountain Savings Bank receives interest and principal payments on the mortgages, it passes those payments on to the eight financial institutions that purchased the mortgage-backed securities and thereby provided the financing to the homeowners. If some of the homeowners default on their payments, the payments will be reduced and therefore so will the return on investment earned by the financial institutions that purchased the mortgage-backed securities. The securities they purchased are backed (collateralized) by the mortgages. In many

cases, the financial institution that originates the mortgage is not accustomed to the process of issuing mortgage-backed securities. If Mountain Savings Bank is unfamiliar with the process, another financial institution may participate by bundling Mountains 100 mortgages with mortgages originated by other institutions. Then the financial institution issues mortgage-backed securities that represent all the mortgages in the bundle. Thus, any investor that purchases these mortgage-backed securities is partially financing the 100 mortgages at Mountain Savings Bank and all the other mortgages in the bundle that are backing these securities. Because of the high default rate on mortgages, mortgage-backed securities performed poorly during the credit crisis in 2008 and 2009. Some financial institutions that held a large amount of mortgage-backed securities suffered major losses at this time. Stocks Stocks (also referred to as equity securities) represent partial ownership in the corporations that issued them. They are classified as capital market securities because they have no maturity and therefore serve as a long-term source of funds. Some corporations provide income to their stockholders by distributing a portion of their quarterly earnings in the form of dividends. Other corporations retain and reinvest all of their earnings, which allows them more potential for growth. Equity securities differ from debt securities in that they represent partial ownership. As corporations grow and increase in value, the value of the stock increases, and investors can earn a capital gain from selling the stock for a higher price than they paid for it. Thus, investors can earn a return from stocks in the form of periodic dividends (if there are any) and a capital gain when they sell the stock. Investors can experience a negative return, however, if the corporation performs

poorly and its stock price declines over time as a result. Equity securities have a higher expected return than most long-term debt securities, but they also exhibit a higher degree of risk.

Derivative Securities In addition to money market and capital market securities, derivative securities are also traded in financial markets. Derivative securities are financial contracts whose values are derived from the values of underlying assets (such as debt securities or equity securities). Many derivative securities enable investors to engage in speculation and risk management. Speculation Derivative securities allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets. Some derivative securities allow investors to benefit from an increase in the value of the underlying assets, whereas others allow investors to benefit from a decrease in the assets value. Investors who speculate in derivative contracts can achieve higher returns than if they had speculated in the underlying assets, but they are also exposed to higher risk. Risk Management Derivative securities can be used in a manner

that will generate gains if the value of the underlying assets declines. Consequently, financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities. If a firm maintains investments in bonds, for example, it can take specific positions in derivative securities that will generate gains if bond values decline. In this way, derivative securities can be used to reduce a firms risk. The loss on the bonds is offset by the gains on these derivative securities. Valuation of Securities in Financial Markets Each type of security generates a unique stream of expected cash flows to investors. In addition, each security has a unique level of uncertainty surrounding the expected cash flows that it will provide to investors and therefore surrounding its return. The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty. Since the cash flows and the uncertainty surrounding the cash flows for each security are unique, the value of each security is unique. EXAMPLE Nike stock provides cash flows to investors in the form of quarterly dividends and its stock price at the time investors sell the stock. Both the future dividends and the future stock price are uncertain. Thus, the cash flows that Nike stock will provide to investors in the future are also uncertain. Investors can attempt to estimate the future cash flows that they will receive by obtaining information that may indicate Nikes future performance, such as reports about the athletic shoe industry, announcements by Nike about its recent sales, and published opinions about Nikes management ability. The valuation process is illustrated in Exhibit 1.2. Impact of Information on Valuations Although all investors rely on valuation to make investment decisions, different investors may interpret and use information in different ways. Thus, they may derive different valuations of a security based on the available information. Some investors rely mostly on economic or industry information to value a security, while others rely more on published opinions about the firms management. When investors receive new information about a security that clearly indicates the likelihood of higher cash flows or less uncertainty, they revise their valuations of that security upward. Consequently, the prevailing price is no longer in equilibrium, as most investors now view

the security as undervalued at that price. The demand for the security increases at that price, and the supply of that security for sale decreases. As a result, the market price rises to a new equilibrium level. Conversely, when investors receive unfavorable information, they reduce the expected cash flows or increase the discount rate used in valuation. All of the valuations of the security are revised downward, which results in shifts in the demand and supply conditions and a decline in the equilibrium price. Announcements that do not contain any valuable new information will not elicit a market response. Sometimes, market participants take a position in anticipation of a particular announcement. If an announcement is fully anticipated, there will be no market response when the announcement occurs.

Impact of the Internet on the Valuation Process The Internet has improved the valuation of securities in several ways. Prices of securities are quoted online and can be obtained at any given moment by investors. For some securities, investors can track the actual sequence of transactions. Because much more information about the firms that issue securities is available online, securities can be priced more accurately. Furthermore, orders to buy or sell many types of securities can be submitted online, which expedites the adjustment in security prices to new information. Market Efficiency Because securities have market-determined prices, their favorable or unfavorable characteristics as perceived by the market are reflected in their prices. When security prices fully reflect all available information, the markets for these securities are referred to as efficient. In an efficient market, securities are rationally priced. If a security is clearly undervalued based on public information, some investors will capitalize on the discrepancy by purchasing that security. This strong demand for the security will push the securitys price higher until the discrepancy no longer exists. The investors who recognized the discrepancy will be rewarded with higher returns on their investment. Thus, investors are naturally motivated to monitor market prices of securities. Their actions to capitalize on discrepancies typically ensure that securities are properly priced, based on the information that is available. Even if markets are efficient, a firms securitys price is subject to much uncertainty because investors have limited information available to value the security. The price of the security may change substantially over time as investors obtain more information about the firms management, or its industry, or the economy. EXAMPLE When Google first issued stock on August 18, 2004, there was much uncertainty as to its value. Investors knew that Googles stock would be affected by factors such as its management, industry conditions (such as competition), and economic conditions, but there was much uncertainty surrounding these factors. Some investors thought that Googles initial price of $85 per share was excessive, while others purchased as many shares as they could at that price. Within the first year, more information became available about Googles business plans and performance, and its stock

price more than tripled. Thus, for every $1,000 invested in Google, investors earned more than $3,000 within one year. Much of the information that investors use to value securities issued by firms is provided by the managers of those firms. As part of the valuation process, investors also rely on accounting reports of a firms revenue and expenses as a base for estimating its future cash flows. Although firms with publicly traded stock are required to disclose financial information and accounting statements, a firms managers still possess information about its financial condition that is not necessarily available to investors. This situation is referred to as asymmetric information. Even when information is disclosed, an asymmetric information problem may still exist if some of the information provided by the firms managers is misleading. In some cases, a security is mispriced because of the psychology involved in the decision making. Behavioral finance is the application of psychology to make financial decisions. It explains why markets are not always efficient. EXAMPLE A positive report about Nadal Companys earnings caused the demand for Nadal stock to increase. The stocks price rose by 2 percent, an adjustment in the stocks price that was justified by the new information. As other media reported the same positive news, however, investors demand for Nadal stock increased again, causing the stock price to rise an additional 4 percent. The next day there was more media buzz about how well Nadals stock was performing, and this caused a further increase in demand, and the share price increased another 3 percent. Thus, the stocks price increased much more than was justified because some investors based their investment decisions on the degree of media exposure that the stock received rather than on the actual information. The stocks price declined once the media hype subsided, but the point is that the stock was temporarily priced improperly as a result of the psychology used by investors to make their decisions. Various conditions can affect the psychology used by investors or corporate managers to make decisions. Consequently, behavioral finance can sometimes explain the movements of a securitys price or even the entire stock market. Financial Market Regulation

In general, securities markets are regulated to ensure that the participants are treated fairly. Many regulations were enacted in response to fraudulent practices before the Great Depression. Disclosure Since the use of incorrect information can result in poor investment decisions, many regulations attempt to ensure that businesses disclose accurate information. Similarly, when information is disclosed to only a small set of investors, those investors have a major advantage over other investors. Thus, another regulatory goal is to provide all investors with equal access to disclosures by firms. The Securities Act of 1933 was intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities. The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It also declared illegal a variety of deceptive practices, such as misleading financial statements and trading strategies designed to manipulate the market price. In addition, it established the Securities and Exchange Commission (SEC) to oversee the securities markets, and the SEC has implemented additional regulations over time. Securities laws do not prevent investors from making poor investment decisions but only attempt to ensure full disclosure of information and thus protect against fraud. Regulatory Response to Financial Scandals The financial scandals that occurred in the 20012002 period proved that the existing regulations were not sufficient to prevent fraud. Several wellknown companies such as Enron and WorldCom misled investors by exaggerating their earnings. They also failed to disclose relevant information that would have adversely affected the prices of their stock and debt securities. Firms that have issued stock and debt securities must hire independent auditors to verify that their financial information is accurate. However, in some cases, the auditors who were hired to ensure accuaracy were not meeting their responsibility. In response to the financial scandals, the Sarbanes-Oxley Act (discussed throughout this text) was passed to require firms to provide more complete and accurate financial information. It also imposed restrictions to ensure proper auditing by auditors and proper oversight by the firms board of directors. These rules were intended to regain the trust of investors who supply the funds to the financial markets. Through these measures, regulators tried to eliminate or reduce the asymmetric information problem.

Given the potential wealth that may be earned in financial markets when regulations are circumvented, it is safe to say that unethical behavior of some sort will occur in the future. New financial scandals will result in new regulations, which will be followed by new types of scandals that circumvent the latest regulations. Often the most naive (least informed) investors are those most adversely affected by financial scandals. In 2008, financial problems at financial institutions such as Bear Stearns, Lehman Brothers, and American International Group (AIG) caught many investors by surprise and renewed concerns that the information provided by firms to investors is very limited. The limited financial disclosure by firms is a major reason why there is much uncertainty surrounding their valuations. GLOBAL FINANCIAL MARKETS Financial markets are continuously being developed throughout the world to improve the transfer of funds from surplus units to deficit units. The financial markets are much more developed in some countries than in others, however, and vary in terms of the volumes of funds that are transferred from surplus units to deficit units and the types of funding that are available. Some countries have had financial markets for a long time, but other countries have converted to market-oriented economies and established financial markets relatively recently. Example: Since the early 1990s, many private businesses have been established in developing countries. The governments of these countries have allowed privatization, or the sale of government owned firms to individuals. In addition, some businesses have issued stock, which allows many other investors who do not work in the business to participate in the ownership. Financial markets have been established in these countries to ensure that these businesses can obtain funding from surplus units. With these changes, private businesses are now able to obtain funds by borrowing or by issuing stock to investors. In addition, individuals in these countries have the opportunity to provide credit (loans) to some businesses or become stockholders of other businesses. International Corporate Governance Since financial markets channel funds from surplus units to deficit units, they can function only if surplus units are willing to provide funds to the markets. If there is a lack of information about the securities traded in the market, or a lack of safeguards to ensure that investors are treated fairly, surplus units will not participate. Consequently, the financial markets will not be liquid.

Financial markets have developed slowly in some developing countries for several reasons. First, the issuers of debt securities do not provide much financial information to indicate how they intend to repay the investors who would buy the securities. Second, regulatory agencies provide very little enforcement to ensure that the financial information provided by the issuers is correct. Third, businesses that do not repay the investors are rarely prosecuted. Fourth, courts in these countries do not provide an efficient system that investors can use to obtain the funds they believe they are owed. Global Integration Many financial markets are globally integrated, allowing participants to move funds out of one countrys markets and into anothers. Foreign investors serve as key surplus units in the United States by purchasing U.S. Treasury securities and other types of securities issued by businesses. Conversely, some investors based in the United States serve as key surplus units for foreign countries by purchasing securities issued by foreign corporations and government agencies. In addition, investors assess the potential return and the risk of securities in financial markets across countries and invest in the market that satisfies their return and risk preferences. With these more integrated financial markets, U.S. market movements may have a greater impact on foreign market movements, and vice versa. Because interest rates are influenced by the supply of and demand for available funds, they are now more susceptible to foreign lending or borrowing activities. Example: The most pronounced progress in global financial market integration has occurred in Europe. Numerous regulations have been eliminated so that surplus and deficit units in one European country can now use financial markets throughout Europe. Some stock exchanges in different European countries have merged, making it easier for investors to conduct all of their stock transactions on one exchange. Since 1999, the adoption of the euro as the currency by 16 European countries (the so-called eurozone) has contributed significantly to financial market integration within Europe because transactions between these countries are now denominated in euros. In addition, securities issued within these countries are now denominated in euros. Thus, consumers and investors in any of these countries do not have to convert their currency when purchasing products or securities within the eurozone.

Role of the Foreign Exchange Market International financial transactions (except for those within the eurozone) normally require the exchange of currencies. The foreign exchange market facilitates the exchange of currencies. Many commercial banks and other financial institutions serve as intermediaries in the foreign exchange market by matching up participants who want to exchange one currency for another. Some of these financial institutions also serve as dealers by taking positions in currencies to accommodate foreign exchange requests. Like securities, most currencies have a market-determined price (exchange rate) that changes in response to supply and demand conditions. If there is a sudden shift in the aggregate demand by corporations, government agencies, and individuals for a given currency, or a shift in the aggregate supply of that currency for sale (to be exchanged), the price will change.

ROLE OF FINANCIAL INSTITUTIONS If financial markets were perfect, all information about any securities for sale in primary and secondary markets (including the creditworthiness of the security issuer) would be continuously and freely available to investors. In addition, all information identifying investors interested in purchasing securities as well as investors planning to sell securities would be freely available. Furthermore, all securities for sale could be broken down (or unbundled) into any size desired by investors, and security transaction costs would be nonexistent. Under these conditions, financial intermediaries would not be necessary. Because markets are imperfect, securities buyers and sellers do not have full access to information. Individual who have funds available normally do not have a means of identifying creditworthy borrowers to whom they could lend their funds. In addition, they do not have the expertise to assess the creditworthiness of potential borrowers. Financial institutions are needed to resolve the problems caused by market imperfections. They accept funds from surplus units and channel the funds to deficit units. Without financial institutions, the information and transaction costs of financial market transactions would be excessive. Financial institutions can be classified as depository and non depository institutions. Role of Depository Institutions

Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities. They are popular financial institutions for the following reasons: They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units. They accept the risk on loans provided. They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units. They diversify their loans among numerous deficit units and therefore can absorb defaulted loans better than individual surplus units could. To appreciate these advantages, consider the flow of funds from surplus units to deficit units if depository institutions did not exist. Each surplus unit would have to identify a deficit unit desiring to borrow the precise amount of funds available for the precise time period in which funds would be available. Furthermore, each surplus unit would have to perform the credit evaluation and incur the risk of default. Under these conditions, many surplus units would likely hold their funds rather than channel them to deficit units. Thus, the flow of funds from surplus units to deficit units would be disrupted. When a depository institution offers a loan, it is acting as a creditor, just as if it had purchased a debt security. The more personalized loan agreement is less marketable in the secondary market than a debt security, however, because the loan agreement contains detailed provisions that can differ significantly among loans. Any potential investors would need to review all provisions before purchasing loans in the secondary market. A more specific description of each depository institutions role in the financial markets follows. Commercial Banks In aggregate, commercial banks are the most dominant depository institution. They serve surplus units by offering a wide variety of deposit accounts, and they transfer deposited funds to deficit units by providing direct loans or purchasing debt securities. Commercial banks serve both the private and public sectors, as their deposit and lending services are utilized by households, businesses, and government agencies. Some commercial banks, such

as Bank of America, J.P. Morgan Chase, Citigroup, and SunTrust Banks, have more than $100 billion in assets. Some commercial banks receive more funds from deposits than they need to make loans or invest in securities. Other commercial banks need more funds to accommodate customer requests than the amount of funds that they receive from deposits. The federal funds market facilitates the flow of funds between banks. A bank that has excess funds can lend to a bank with deficient funds for a short-term period, such as one to five days. Thus, the federal funds market facilitates the flow of funds from banks that have excess funds to banks that are in need of funds. Savings Institutions Savings institutions, which are sometimes referred to as thrift institutions, are another type of depository institution. Savings institutions include savings and loan associations (S&Ls) and savings banks. Like commercial banks, S&Ls offer deposit accounts to surplus units and then channel these deposits to deficit units. Whereas commercial banks have concentrated on commercial loans, however, S&Ls have concentrated on residential mortgage loans. This difference in the allocation of funds has caused the performance of commercial banks and S&Ls to differ significantly over time. In recent decades, however, deregulation has permitted S&Ls more flexibility in allocating their funds, so their functions have become more similar to those of commercial banks. Although S&Ls can be owned by shareholders, most are mutual (depositor owned). Savings banks are similar to S&Ls, except that they have more diversified uses of funds. Over time, however, this difference has narrowed. Like S&Ls, most savings banks are mutual. Like commercial banks, savings institutions rely on the federal funds market to lend their excess funds or to borrow funds on a short-term basis. Credit Unions Credit unions differ from commercial banks and savings institutions in that they (1) are nonprofit and (2) restrict their business to the credit union members, who share a common bond (such as a common employer or union). Because of the common bond characteristic, credit unions tend to be much smaller than other depository institutions. They use most of their funds to provide loans to their members. Some of the largest credit unions, such as the Navy Federal Credit Union, the

State Employees Credit Union of North Carolina, and the Pentagon Federal Credit Union, have assets of more than $5 billion. Role of Non depository Financial Institutions Non depository institutions generate funds from sources other than deposits but also play a major role in financial intermediation. These institutions are briefly described here and are covered in more detail in Part 7. Finance Companies Most finance companies obtain funds by issuing securities, then lend the funds to individuals and small businesses. The functions of finance companies and depository institutions overlap, although each type of institution concentrates on a particular segment of the financial markets (explained in the chapters devoted to these institutions). Many large finance companies are owned by large multinational corporations, including American Express and General Electric. Mutual Funds Mutual funds sell shares to surplus units and use the funds received to purchase a portfolio of securities. They are the dominant non depository financial institution when measured in total assets. Some mutual funds concentrate their investment in capital market securities, such as stocks or bonds. Others, known as money market mutual funds, concentrate in money market securities. Typically, mutual funds purchase securities in minimum denominations that are larger than the savings of an individual surplus unit. By purchasing shares of mutual funds and money market mutual funds, small savers are able to invest in a diversified portfolio of securities with a relatively small amount of funds. Securities Firms Securities firms provide a wide variety of functions in financial markets. Some securities firms use their information resources to act as a broker, executing securities transactions between two parties. Many financial transactions are standardized to a degree. For example, stock transactions are normally in multiples of 100 shares. To expedite the securities trading process, the delivery procedure for each security transaction is also somewhat standard.

Brokers charge a fee for executing transactions. The fee is reflected in the difference (or spread) between their bid and ask quotes. The markup as a percentage of the transaction amount will likely be higher for less common transactions, as more time is needed to match up buyers and sellers. It will also likely be higher for transactions involving relatively small amounts to provide the broker with adequate compensation for the time required to execute the transaction. In addition to brokerage services, securities firms also provide investment banking services. Some securities firms place newly issued securities for corporations and government agencies; this task differs from traditional brokerage activities because it involves the primary market. When securities firms underwrite newly issued securities, they may sell the securities for a client at a guaranteed price, or they may simply sell the securities at the best price they can get for their client. Furthermore, securities firms often act as dealers, making a market in specific securities by adjusting their inventory of securities. Although a brokers income is mostly based on the markup, the dealers income is influenced by the performance of the security portfolio maintained. Some dealers also provide brokerage services and therefore earn income from both types of activities. Another investment banking activity offered by securities firms is advisory services on mergers and other forms of corporate restructuring. Securities firms may not only help a firm plan its restructuring but also execute the change in the firms capital structure by placing the securities issued by the firm. Some securities firms, such as Morgan Stanley and Goldman Sachs, play a major role in brokerage, underwriting, and advisory services. Insurance Companies Insurance companies provide individuals and firms with insurance policies that reduce the financial burden associated with death, illness, and damage to property. They charge premiums in exchange for the insurance that they provide. They invest the funds that they receive in the form of premiums until the funds are needed to cover insurance claims. Insurance companies commonly invest the funds in stocks or bonds issued by corporations or in bonds issued by the government. In this way, they finance the needs of deficit units and thus serve as important financial intermediaries. Their overall performance is linked to the performance of the stocks and bonds in which they invest. Large insurance

companies include State Farm Group, Allstate Insurance, Travelers Group, CNA Insurance, and Liberty Mutual. Pension Funds Many corporations and government agencies offer pension plans to their employees. The employees, their employers, or both periodically contribute funds to the plan. Pension funds provide an efficient way for individuals to save for their retirement. The pension funds manage the money until the individuals withdraw the funds from their retirement accounts. The money that is contributed to individual retirement accounts is commonly invested by the pension funds in stocks or bonds issued by corporations or in bonds issued by the government. In this way, pension funds finance the needs of deficit units and thus serve as important financial intermediaries.

Comparison of Roles among Financial Institutions The role of financial institutions in facilitating the flow of funds from individual surplus units (investors) to deficit units is illustrated in Exhibit 1.3. Surplus units are shown on the left side of the exhibit, and deficit units are shown on the right side. Three different flows of funds from surplus units to deficit units are shown in the exhibit. One set of flows represents deposits from surplus units that are transformed by depository institutions into loans for deficit units. A second set of flows represents purchases of securities (commercial paper) issued by finance companies that are transformed into finance company loans for deficit units. A third set of flows reflects the purchases of shares issued by mutual funds, which are used by the mutual funds to purchase debt and equity securities of deficit units. The deficit units also receive funding from insurance companies and pension funds. Because insurance companies and pension funds purchase massive amounts of stocks and bonds, they finance much of the expenditures made by large deficit units, such as corporations and government agencies. Since financial institutions commonly serve the role of investing funds that they have received from surplus units, they are referred to as institutional investors. Securities firms are not shown in Exhibit 1.3, but they play a very important role in facilitating the flow of funds. Many of the transactions between the financial institutions and deficit units are

executed by securities firms. Furthermore, some funds flow directly from surplus units to deficit units as a result of security transactions, with securities firms serving as brokers. Role as a Monitor of Publicly Traded Firms In addition to the roles just described, financial institutions also serve as monitors of publicly traded firms. Because insurance companies, pension funds, and some mutual funds are major investors in stocks, they can have some influence over the management of publicly traded firms. In recent years, many large institutional investors have publicly criticized the management of specific firms, which has resulted in corporate restructuring or even the firing of executives in some cases. Thus, institutional investors not only provide financial support to companies but exercise some degree of corporate control over them. By serving as activist shareholders, they can help ensure that managers of publicly held corporations are making decisions that are in the best interests of the shareholders.

Relative Importance of Financial Institutions Exhibit 1.4 illustrates the relative sizes of the different types of financial institutions, based on assets. The percentage next to the dollar amount for each type of financial institution indicates its proportion of the total dollars in assets held by all financial institutions. Together, all of these financial institutions hold assets equal to about $46 trillion. Commercial banks hold the largest amount of assets of any depository institution. They have $11.2 trillion in assets, representing 24 percent of the total assets held by all financial institutions. Mutual funds hold the largest amount of assets of any nondepository institution. They have about the same amount of assets as commercial banks. Pension funds have about $10 trillion in assets, or about 22 percent of all assets held by financial institutions. Exhibit 1.5 summarizes the main sources and uses of funds for each type of financial institution. Households with savings are served by depository institutions. Households with deficient funds are served by depository institutions and finance companies. Large corporations and governments that issue securities obtain financing from all types of financial institutions. Several different regulatory agencies regulate the various types of financial institutions, and these differential regulations can cause some nancial institutions to have a comparative advantage over others.

Consolidation of Financial Institutions In recent years, commercial banks have acquired other commercial banks so that they can generate a higher volume of business supported by a given infrastructure. By increasing the volume of services produced, the average cost of providing the services (such as loans) can be reduced. Savings institutions have consolidated to achieve economies of scale for their mortgage lending business. Insurance companies have consolidated so that they can reduce the average cost of providing insurance services. From the early 1980s through the early 2000s, the regulations imposed on financial institutions were relaxed, allowing different types of financial institutions to expand the types of services they offer and capitalize on economies of scope. As a result of this reduction in regulation, commercial banks have merged with savings institutions, securities firms, finance companies, mutual funds, and insurance companies. Although the operations of each type of financial institution are commonly managed separately, a financial conglomerate offers advantages to customers who prefer to obtain all of their financial services from a single financial institution. Since a financial conglomerate is more diversified, it may be less exposed to a possible decline in customer demand for any single financial service.

EXAMPLE Wells Fargo is a classic example of the evolution in financial services. It originally focused on commercial banking, but has expanded its nonbank services to include mortgages, small business loans, consumer loans, real estate, brokerage, investment banking, online financial services, and insurance. In a recent annual report, Wells Fargo stated: Our diversity in businesses makes us much more than a bank. Were a diversified financial services company. Were competing in a highly fragmented and fast growing industry: Financial Services. This helps us weather downturns that inevitably affect any one segment of our industry. Typical Structure of a Financial Conglomerate A typical organizational structure of a financial conglomerate is shown in Exhibit 1.6. Historically, each of the financial services (such as banking, mortgages, brokerage, and insurance) had significant barriers to entry, so only a limited number of firms competed in that industry. The barriers prevented most firms from offering a wide variety of these services. In recent years, the barriers to entry have been reduced, allowing firms that had specialized in one service to more easily expand into other financial services. Many firms expanded by acquiring other financial services firms. Thus, many financial conglomerates are composed of various financial institutions that were originally independent, but are now units (or subsidiaries) of the conglomerate. Impact of Consolidation on Competition As financial institutions spread into other financial services, the competition for customers desiring the various types of financial services increased. Prices of financial services declined in response to the competition. In addition, consolidation has provided more convenience. Individual customers can rely on the financial conglomerate for convenient access to life and health insurance, brokerage, mutual funds, investment advice and financial planning, bank deposits, and personal loans. A corporate customer can turn to the financial conglomerate for property and casualty insurance, health insurance plans for employees, business loans, advice on restructuring its businesses, issuing new debt or equity securities, and management of its pension plan.

Impact of the Internet on Financial Institutions The Internet has also led to more intense competition among nancial institutions. Some commercial banks have been created solely as online entities. Because they have lower costs, they can offer higher interest rates on deposits and lower rates on loans. Other banks also offer online services, which can reduce costs, increase efciency, and intensify banking competition. Some insurance companies conduct much of their business online, which reduces their operating costs and forces other insurance companies to price their services competitively. Some brokerage rms conduct much of their business online, which reduces their operating costs; because these rms can lower the fees they charge, they force other brokerage rms to price their services competitively. The Internet has also made it possible for corporations and municipal governments to circumvent securities rms by conducting security offerings online and selling directly to investors. This capability forces securities rms to be more competitive in the services they offer to issuers of securities. Global Expansion by Financial Institutions In addition to consolidating, many financial institutions have expanded internationally to capitalize on their expertise. Commercial banks, insurance companies, and securities firms have expanded through international mergers. An international merger between financial institutions enables the

merged company to offer the services of both entities to its entire customer base. For example, a U.S. commercial bank may have specialized in lending while a European securities firm specialized in services such as underwriting securities. A merger between the two entities allows the U.S. bank to provide its services to the European customer base (clients of the European securities firm), while the European securities firm can offer its services to the U.S. customer base. By combining specialized skills and customer bases, the merged financial institutions can offer more services to clients and have an international customer base. The adoption of the euro by 16 European countries has increased business between European countries and created a more competitive environment in Europe. European financial institutions, which had primarily competed with other financial institutions based in their own country, recognized that they would now face more competition from financial institutions in other countries. Many financial institutions have attempted to benefit from opportunities in emerging markets. For example, some large securities firms have expanded into many countries tom offer underwriting services for firms and government agencies. The need for this service has increased most dramatically in countries where businesses have been privatized. In addition, commercial banks have expanded into emerging markets to provide loans. IMPACT OF THE CREDIT CRISIS INSTITUTIONS ON FINANCIAL Following the abrupt increase in home prices in the 20042006 period, many financial institutions increased their holdings of mortgages and mortgage-backed securities whose performance was based on the mortgage payments made by homeowners. Some financial institutions (especially commercial banks and savings institutions) applied liberal standards when originating new mortgages and did not carefully assess the risk of default by the homeowners. In addition, some financial institutions including commercial banks, savings institutions, insurance companies, securities firms, and pension funds purchased large bundles of mortgages and mortgage-backed securities in the secondary market without carefully assessing the risk of these securities. In the 20072008 period, mortgage defaults increased, and home values declined substantially. As a result, the value of the property collateral backing many mortgages was less than the outstanding mortgage amount. By January 2009, at least 10 percent of all American homeowners were either behind on their mortgage payments or had defaulted on their mortgages.

The mortgage defaults led to the credit crisis, which affected financial institutions in several ways. First, the mortgages and mortgage-backed securities held by financial institutions experienced a major decline in value. Second, some financial institutions lost much of their business because their customers were afraid that the institutions might fail. The flow of funds through financial institutions relies on funding from surplus units who trust that that the institutions are safe. During the credit crisis, the flow of funds in financial markets was disrupted because some investors were no longer willing to invest in financial institutions. Because only very limited information about the potential risk of financial institutions was available, investors became extremely cautious and avoided even institutions that were in good financial condition. On October 3, 2008, Congress enacted the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act), which was intended to resolve the liquidity problems of financial institutions and to restore the confidence of the investors who invest in them. The act directed the Treasury to inject $700 billion into the financial system, primarily by investing money into the banking system by purchasing preferred stock of financial institutions. In this way, the Treasury provided large commercial banks with capital to cushion their losses, thereby reducing the likelihood that the banks would fail. The credit crisis and the subsequent government intervention to resolve the crisis had a major impact on financial markets and institutions, as explained throughout this text. Several of the financial institutions that either failed or were rescued by the government during the credit crisis suffered financial problems because they had taken on excessive risk through their holdings of mortgage-related products. The credit crisis illustrated the need for improved regulations that could ensure the safety of the financial institutions. SUMMARY Financial markets facilitate the transfer of funds from surplus units to deficit units. Because funding needs vary among deficit units, various financial markets have been established. The primary market allows for the issuance of new securities, while the secondary market allows for the sale of existing securities. Securities can be classified as money market (short term) securities or capital market (long-term) securities. Common capital market securities include bonds, mortgages, mortgage-backed securities, and stocks. The valuation of a security represents the present value of future cash flows

that it is expected to generate. New information that indicates a change in expected cash flows or degree of uncertainty affects prices of securities in financial markets. Depository and non depository institutions help to finance the needs of deficit units. Depository institutions can serve as effective intermediaries within financial markets because they have greater information on possible sources and uses of funds, they are capable of assessing the creditworthiness of borrowers, and they can repackage deposited funds in sizes and maturities desired by borrowers. Non depository institutions are major purchasers of securities and therefore provide funding to deficit units. The main depository institutions are commercial banks, savings institutions, and credit unions. The main nondepository institutions are finance companies, mutual funds, pension funds, and insurance companies. Many financial institutions have been consolidated (due to mergers) into financial conglomerates, where they serve as subsidiaries of the conglomerate while conducting their specialized services. Thus, some financial conglomerates are able to provide all types of financial services. Consolidation allows for economies of scale and scope, which can enhance cash flows and increase the financial institutions value. In addition, consolidation can diversify the institutions services and increase its value through the reduction in risk. The credit crisis in 2008 and 2009 had a profound effect on financial institutions. Those institutions that were heavily involved in originating or investing in mortgages suffered major losses. Many investors were concerned that the institutions might fail and therefore avoided them, which disrupted the ability of financial institutions to facilitate the flow of funds.

POINT COUNTER-POINT Will Computer Technology Cause Financial Intermediaries to Become Extinct? Point Yes. Financial intermediaries benefit from access to information. As information becomes more accessible, individuals will have the information they need before investing or borrowing funds. They will not need financial intermediaries to make their decisions. Counter-Point No. Individuals rely not only on information, but also on expertise. Some financial intermediaries specialize in credit analysis so that they can make loans. Surplus units will continue

to provide funds to financial intermediaries rather than make direct loans, because they are not capable of credit analysis, even if more information about prospective borrowers is available. Some financial intermediaries no longer have physical buildings for customer service, but they still require people who have the expertise to assess the creditworthiness of prospective borrowers. Who Is Correct? Use the Internet to learn more about this issue. Offer your own opinion on this issue. QUESTIONS AND APPLICATIONS 1. Surplus and Deficit Units Explain the meaning of surplus units and deficit units. Provide an example of each. Which types of financial institutions do you deal with? Explain whether you are acting as a surplus unit or a deficit unit in your relationship with each financial institution. 2. Types of Markets Distinguish between primary and secondary markets. Distinguish between money and capital markets. 3. Imperfect Markets Distinguish between perfect and imperfect security markets. Explain why the existence of imperfect markets creates a need for financial intermediaries. 4. Efficient Markets Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time? In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient? Explain. 5. Securities Laws What was the purpose of the Securities Act of 1933? What was the purpose of the Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment decisions? FLOW OF FUNDS EXERCISE Roles of Financial Markets and Institutions This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that require the application of concepts presented in the chapter, as they relate to the flow of funds.

Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and 10 other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus, Carsons cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs additional funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems. Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and by making more acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. It is also considering issuing stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and therefore affect its value. a. In what way is Carson a surplus unit? b. In what way is Carson a deficit unit? c. How might finance companies facilitate Carsons expansion? d. How might commercial banks facilitate Carsons expansion? e. Why might Carson have limited access to additional debt financing during its growth phase? f. How might investment banks facilitate Carsons expansion? g. How might Carson use the primary market to facilitate its expansion? h. How might it use the secondary market? i. If financial markets were perfect, how might this have allowed Carson to avoid financial institutions?

j. The loans that Carson has obtained from commercial banks stipulate that Carson must receive the banks approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company?