Chapter 1

1.4. FINANCIAL SYSTEM

 Contents

Topics include:
 Definition of Financial System
 Function and Structure of Financial Markets
 Types and Functions of Financial Intermediaries
 Main Regulation of the Financial System
 The financial system is the
process by which money flows
from savers to users.
 Financial System
• Savers
• Users
• Financial Institutions
• Financial Markets
 Savings is a function of many variables.
 Funds can be transferred between users and savers
directly or indirectly.
 Segments of Financial system

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

 Channels funds from person or business

without investment opportunities (i.e.,
“Lender - Savers”) to one who has them (i.e.,
“Borrower - Spenders”).
• Funds can be transferred between users and
savers directly or indirectly.
 Improves economic efficiency
 Financial Markets Funds Transferees

Lender-Savers 3. Households
1. Households 4. Foreigners
2. Business firms
3. Government
4. Foreigners
Borrower-Spenders
1. Business firms
2. Government
 Importance of Financial Markets

 Financial markets are critical for producing an

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

 Debt Markets
 Short-Term (maturity < 1 year)
 Long-Term (maturity > 10 year)
 Intermediate term (maturity in-between)
 Equity Markets
 Pay dividends
 Represents an ownership claim in the firm
Structure of Financial Markets

 Primary Market
 New security issues sold to initial buyers
 Who does the issuer sell to in the Primary Market?

 Secondary Market
 Securities previously issued are bought
and sold
 Examples include the NYSE and Nasdaq
 Who trades?
 Structure of Financial Markets

Even though firms don’t get any money from the

secondary market, it serves two important functions:
 Provide liquidity, making it easy to buy and sell the
securities of the companies

 Establish a price for the securities

Structure of Financial Markets

We can further classify secondary markets as follows:

1. Exchanges
─ Trades conducted in central locations (e.g., New York
Stock Exchange, CBT)
2. Over-the-Counter Markets
─ Dealers at different locations buy and sell
─ Best example is the market for Treasury securities
www.treasurydirect.gov
NYSE home page http://www.nyse.com
Classifications of Financial Markets

We can also further classify markets by the maturity

of the securities:
1. Money Market: Short-Term
(maturity <= 1 year)
2. Capital Market: Long-Term
(maturity > 1 year) plus equities
Function of Financial Intermediaries:
Indirect Finance
Instead of savers lending/investing directly with
borrowers, a financial intermediary (such as a bank)
plays as the middleman:
 the intermediary obtains funds from savers
 the intermediary then makes loans/investments with
borrowers
Function of Financial Intermediaries:
Indirect Finance
 This process, called financial intermediation,
is actually the primary means of moving
funds from lenders to borrowers.
 More important source of finance than
securities markets (such as stocks)
 Needed because of transactions costs, risk
sharing, and asymmetric information
 Function of Financial
Intermediaries: Indirect Finance

 Transactions Costs
 Financial intermediaries make profits by
reducing transactions costs
 Reduce transactions costs by developing
expertise and taking advantage of
economies of scale
Function of Financial Intermediaries:
Indirect Finance
A financial intermediary’s low transaction costs
mean that it can provide its customers with
liquidity services
 Banks provide depositors with checking accounts that
enable them to pay their bills easily
 Depositors can earn interest on checking and savings
accounts and yet still convert them into goods and
services whenever necessary
 Global Perspective

Studies show that firms in the U.S., Canada, the

U.K., and other developed nations usually obtain
funds from financial intermediaries, not directly
from capital markets.
In Germany and Japan, financing from financial
intermediaries exceeds capital market financing 10-
fold.
 However, the relative use of bonds versus equity
does differ by country.
Function of Financial
Intermediaries: Indirect Finance
FI’s low transaction costs allow them to reduce the
exposure of investors to risk, through a process
known as risk sharing
 FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another
party
 This process is referred to as asset transformation,
because in a sense risky assets are turned into safer assets
for investors
Function of Financial
Intermediaries: Indirect Finance
 Financial intermediaries also help by
providing the means for individuals and
businesses to diversify their asset holdings.
 Low transaction costs allow them to buy a
range of assets, pool them, and then sell
rights to the diversified pool to individuals.
Asymmetric Information: Quiz

 Define Asymmetric Information.

 List and explain the two major types of
Asymmetric Information that affect financial
markets.
Function of Financial
Intermediaries: Indirect Finance
 Another reason FIs exist is to reduce the
impact of asymmetric information.
 One party lacks crucial information about
another party, impacting decision-making.
 We usually discuss this problem along two
fronts: adverse selection and moral
hazard.
Function of Financial
Intermediaries: Indirect Finance
 Adverse Selection
 Before transaction occurs
 Potential borrowers most likely to produce
adverse outcome are ones most likely to seek a
loan
 Similar problems occur with insurance where
unhealthy people want their known medical
problems covered
 Asymmetric Information:
Adverse Selection and Moral Hazard

 Moral Hazard
 After transaction occurs
 Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more
likely that won’t pay loan back
 Again, with insurance, people may engage in risky
activities only after being insured
 Another view is a conflict of interest
Asymmetric Information:
Adverse Selection and Moral Hazard
 Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits. How they
do this is the covered in many of the
chapters to come.
 Because of their expertise in screening and
monitoring, they minimize their losses,
earning a higher return on lending and
paying higher yields to savers.
Types of Financial Intermediaries
Types of Financial Intermediaries
 Regulation of Financial System

 Main Reasons for Regulation

 Increase Information to Investors
• Decreases adverse selection and moral hazard problems
• SEC forces corporations to disclose information
 Ensuring the Soundness of Financial Intermediaries
• Prevents financial panics
• Chartering, reporting requirements, restrictions on assets and
activities, deposit insurance, and anti-competitive measures
 Improving Monetary Control
• Reserve requirements
• Deposit insurance to prevent bank panics
Regulation Reason:
Increase Investor Information
 Asymmetric information in financial markets means that
investors may be subject to adverse selection and moral
hazard problems that may hinder the efficient operation of
financial markets and may also keep investors away from
financial markets
 The Securities and Exchange Commission (SEC) requires
corporations issuing securities to disclose certain
information about their sales, assets, and earnings to the
public and restricts trading by the largest stockholders
(known as insiders) in the corporation
 SEC home page http://www.sec.gov
 Regulation Reason:
Increase Investor Information
 Such government regulation can reduce adverse
selection and moral hazard problems in financial
markets and increase their efficiency by increasing
the amount of information available to investors.
Indeed, the SEC has been particularly active
recently in pursuing illegal insider trading.

SEC home page http://www.sec.gov

Regulation Reason: Ensure Soundness
of Financial Intermediaries

 Asymmetric information makes it difficult to

evaluate whether the financial intermediaries are
sound or not.
 Can result in panics, bank runs, and failure of
intermediaries.
Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)
 To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
 Restrictions on Entry
 Disclosure
 Restrictions on Assets and Activities
 Deposit Insurance
 Limits on Competition
 Restrictions on Interest Rates
Regulation: Restriction on Entry

Restrictions on Entry
 Regulators have created very tight regulations as to who
is allowed to set up a financial intermediary
 Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance
company, must obtain a charter from the state or the
federal government
 Only if they are upstanding citizens with impeccable
credentials and a large amount of initial funds will they
be given a charter.
 Regulation: Disclosure

Disclosure Requirements
There are stringent reporting requirements for
financial intermediaries
 Their bookkeeping must follow certain strict
principles,
 Their books are subject to periodic inspection,
 They must make certain information available to
the public.
 Regulation: Restriction on
Assets and Activities
Restrictions on the activities and assets of
intermediaries helps to ensure depositors that their
funds are safe and that the bank or other financial
intermediary will be able to meet its obligations.
 Intermediary are restricted from certain risky
activities
 And from holding certain risky assets, or at least
from holding a greater quantity of these risky
assets than is prudent
Regulation: Deposit Insurance

 The government can insure people depositors to a

financial intermediary from any financial loss if the
financial intermediary should fail
 The Federal Deposit Insurance Corporation (FDIC)
insures each depositor at a commercial bank or
mutual savings bank up to a loss of $250,000 per
account.
 Regulation:
Limits on Competition
 Although the evidence that unbridled competition among
financial intermediaries promotes failures that will harm the
public is extremely weak, it has not stopped the state and
federal governments from imposing many restrictive
regulations
 In the past, banks were not allowed to open up branches in
other states, and in some states banks were restricted from
opening additional locations
 Regulation: Restrictions
on Interest Rates
 Competition has also been inhibited by regulations
that impose restrictions on interest rates that can be
paid on deposits
 These regulations were instituted because of the
widespread belief that unrestricted interest-rate
competition helped encourage bank failures during
the Great Depression
 Later evidence does not seem to support this view,
and restrictions on interest rates have
been abolished
 Regulation Reason:
Improve Monetary Control
 Because banks play a very important role in determining the
supply of money (which in turn affects many aspects of the
economy), much regulation of these financial intermediaries
is intended to improve control over the money supply
 One such regulation is reserve requirements, which make
it obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts with the Federal
Reserve System (the Fed), the central bank in the United
States
 Reserve requirements help the Fed exercise more precise
control over the money supply
 Financial Regulation Abroad
 Those countries with similar economic systems also
implement financial regulation consistent with the
U.S. model: Japan, Canada, and Western Europe
• Financial reporting for corporations is required
• Financial intermediaries are heavily regulated
 However, U.S. banks are more regulated along
dimensions of branching and services than their
foreign counterparts.