business to

CHAPTER 11 – INTERNATIONALIZATION OF
FINANCIAL MARKETS

The flow of operate and

money around grow. Stock
the world is markets are
essential for places where
business to individual as
operate and well as
grow. Stock institutional
markets are orporations)
places where investors can
individual as trade
well as currencies,
institutional invest in
orporations) companies and
investors can arrange loans
trade The flow of
currencies, money around
invest in the world is
companies and essential for
arrange loans business to
The flow of operate and
money around grow. Stock
the world is markets are
essential for
places where
markets. In the first place it is hard to decide
exactly what transaction should be included under
the expression financial markets", and there is no

individual as practical way to compile complete data on each of

the millions of sales and purchases occurring each

well as
year.
CROSS-BORDER MEASURE

institutional Another way of measuring the growth of finance is

to examine the value of cross border financing.

orporations) Cross-border finance is by no means new, and at

various times in the past (in the late 19th century,
for example) it has been quite large relative to the
investors can size of the world economy. The period since 1990
has been marked by huge increase in the amount

trade of international financing broken by financial crises

in Asia and Russia in1998, the recession in the

currencies,
United States in 2001, and the financial meltdowns
of 2008-09 in the United States and 2008-13 in
Europe. The total stock of cross-border finance in

invest in 2016, including international bank loans and debt

issues, was more than $46 trillion, according to the

companies and
Bank for International Settlements.
INTERNATIONAL BOND MARKET, EUROBONDS,

arrange loans AND EUROCURRENCIES

The traditional instruments in the international
The flow of money around the world is essential for bond market are known as foreign bonds. Foreign
business to operate and grow. Stock markets are bonds are sold in a foreign country and are
places where individual as well as denominated in that country's currency. For
institutional corporations) investors can trade example, if the German automaker Porsche sells a
currencies, invest in companies and arrange bond in the United States denominated in U.S.
loans. dollars, it is classified as a foreign bond. Foreign
Without the global financial markets, governments bonds have been an important instrument in the
would not be able to borrow money, companies international capital market for centuries.
would not have access to the capital they need to FACTORS AFFECTING THE LONG-RUN TRENDS OF
expand and, investors and individuals would be INCREASED FINANCIAL MARKET ACTIVITY
unable to buy and sell foreign currencies.
A. Lower inflation
WORLD STOCK MARKETS Inflation rates around the have fallen
By all these measures, financial markets grew markedly since the 1990s. Inflation
rapidly during the 1990s. At the start of the erodes the value of financial assets and
decade, active trading in financial instruments was increases the value of physical assets, such
confined to a small number of countries, and as houses and machines, which will cost far
involved mainly the same types of securities, bonds more to replace than they are worth today.
and equities that had dominated trading for two B. PENSIONS
countries. By the first years of the 21st century, A significant change in pension policies
financial markets were thriving in dozens of occurred many countries starting in the
countries, and new instruments accounted for a 1990s. Changes in demography and
large proportion of market dealings. working patterns have made pay-as-
you-go schemes increasingly costly to
SIZE OF THE MARKETS support, as there are fewer young workers
Estimating the overall size of the financial markets relative to the number of pensioners.
is difficult. It is hard in the first place to decide C. Stock and bond market performance
exactly what transactions should be included under A rapid increase in financial wealth
the rubric "financial markets", and there is no way feeds on itself: investors whose
to compile complete data on each of the millions of portfolios have appreciated are willing to
sales and purchases occurring each year. It is reinvest some of their profits in the
different to estimate the overall size the financial financial markets. And the appreciation in
 institutional
the value of their financial assets
gives investors the collateral to
borrow additional money, which can then
be invested.
D. Risk management investors are
investment
Innovation has generated many new
financial products, such as derivatives
and asset-backed securities, whose basic
purpose is to redistribute risk. This led to
enormous growth in the use of financial
companies,
markets for risk-management purposes.
E. The Investors which
The driving force behind financial markets is
the desire of investors to earn a return on
their assets. This return has two distinct
combine the
components:
 Yield is the income the investor investments of
receives while owning an
investment.
 Capital gains are increases in the
a number of
value of the investment itself, and
are often not available to the owner individuals
with the aim of
until the investment is sold.

THE CATEGORIES OF INVESTORS

 Individuals
achieving
Collectively, individuals own a small
proportion of financial assets. Most particular
households in the wealthier countries
own some financial assets, often in the form
of retirement savings or of shares in the
financial goals
employer of household member. Most such
holdings, however, are quite small, and in an
their composition varies greatly from one
country to another.
 Institutional Investors
efficient way.
Insurance companies and other institutional
investors (see below), including high- Mutual funds
and unit are
frequency traders, are responsible for most
of the trading in financial markets.

Types of investment
Institutional companies
Investors that typically
 Mutual accept an
funds unlimited
The fastest-
growing
number of
guaranteed benefit once the individual
reaches retirement age.
 Algorithmic traders

individual Algorithmic trading, also known as high-

frequency trading, has expanded

investments.
dramatically in recent years as a result of
increased computing power and the
Types of Institutional Investors availability of low-cost, high-speed
communications. Investors specializing in
 Mutual funds this type of trading program computers to
The fastest-growing institutional enter buy and sell orders automatically
investors are investment companies, in an effort to exploit tiny price
which combine the investments of a differences in securities and currency
number of individuals with the aim of markets.
achieving particular financial goals in an
efficient way. Mutual funds and unit are OTHER INSTITUTIONS
investment companies that typically accept Other types of institutions such as banks,
an unlimited number of individual foundations and university endowment
investments. funds, are also substantial players in the
 Hedge funds markets.
Another type of investment company, a
hedge fund, can accept investments from INTERNATIONAL MONEY AND CAPITAL MARKETS
only a small number of wealthy International Credit Markets
individuals or big institutions. In
return it is freed from most types of There are three major types of international credit
regulation meant to protect consumers markets:
Hedge funds are able to employ aggressive  Eurocredits
investment strategies, such as using This is the market for floating-rate bank
borrowed money to increase the loans whose rates are tied to LIBOR, which
amount invested and focusing stands for London Interbank Offer Rate.
investment on one or another type LIBOR is the interest rate offered by the
of asset rather than diversifying. largest and strongest banks on large
 Insurance companies deposits. Eurocredits are usually issued for
Insurance companies are the most a fixed term with no early repayment.
important type of institutional investor, Currently, Eurocredit exist for most major
owning one-third of all the financial assets trading currencies. An example of a
owned by institutions. In the past, most of Eurocredit is a Eurodollar deposit, which
these holdings were needed to back life is a U.S. dollar deposited in a bank outside
insurance policies. In recent years, a the United States.
growing share of insurers' business has  Eurobond Marker
consisted of annuities, which guarantee A Eurobond is an international bond
policy holders a sum of money each year as underwritten by an international syndicate
long as they live, rather than merely paying of banks and sold to investors in countries
their heirs upon death. The growth of pre- other than the one in whose money unit
funded individual pensions has benefited the bond is denominated
insurance companies, because on  Foreign Bond Market
retirement many workers use the money in Foreign bonds are international bonds
their accounts to purchase annuities. issued in the country in whose
 Pension funds currency the bond is denominated, and
Pension funds aggregate the retirement they are underwritten by investment bank
savings of a large number of workers. in that country.
Typically, pension funds are sponsored by
an employer, a group of employers or a CHAPTER 12 – FINANCIAL INSTITUTIONS AND
labor union. In the Philippines, the SSS and INTERMEDIARIES
GSIS represent the largest investors of FINANCIAL INSTITUTIONS
pension fund. Unlike individual pension
accounts, pension funds do not give It is a company engaged in the business of dealing
individuals control over how their savings with financial and monetary transactions such as
are invested, but they do typically offer a
deposits, loans, investments, and currency
exchange.
CONTRACTUAL SAVINGS INSTITUTIONS
It encompasses a broad range of business
Insurance Companies – specialize in writing
operations within the financial service sector
contracts to protect their policyholders
including, banks, trust companies, insurance
from the risk of financial losses associated
companies, brokerage firms and investment
with particular events.
dealers.
The financial system matches savers and Two segments:
borrowers through two channels:  Life insurance companies – sell
1. Financial markets policies to protect households
2. Banks and other financial intermediaries against a loss of earnings from the
disability; retirement or death of the
These two channels are distinguished by how funds
insurance person.
flow from savers, or lenders, to borrowers and by
 Property and casualty – companies
the financial institutions involved. Funds flow from
sell policies to protect households
lenders to borrowers directly through financial
and firms from the risks of illness,
markets or indirectly through financial
theft, fire, accidents and natural
intermediaries, such as banks.
disasters.
FINANCIAL INTERMEDIARIES Pension Funds – financial intermediary that
invests contributions of workers and firms
It is a financial firm such as a bank, that borrows
in stocks, bonds, and mortgages to provide
funds from savers and lends them to borrowers.
pension benefit payment during workers’
BASIC STRUCTURE OF FINANCIAL retirement.
INSTITUTIONS/INTERMEDIARIES
Types of Pension Funds Plans
A. DEPOSITORY INSTITUTIONS
The two basic types of pension plans are:
1. COMMERCIAL BANKS/UNIVERSAL
a) Defined contribution plan
BANKS
2. SAVINGS AND LOANS ASSOCIATIONS Employer places contributions
3. MUTUAL SAVINGS BANK from employer into investments
4. CREDIT UNION such as mutual funds, chosen by
B. CONTRACTUAL SAVINGS INSTITUTIONS the employees. Employees own
1. INSURANCE COMPANIES the value of the funds in the
2. PENSION FUNDS plan. They also bear the risk of
C. INVESTMENT INTERMEDIARIES poor investment returns.
1. INVESTMENT BANKS
If the employee’s investments
2. MUTUAL FUNDS
are profitable, employer’s
3. HEDGE FUNDS
income during retirement will be
4. FINANCE COMPANIES
high. On the other hand if the
5. MONEY MARKET MUTUAL FUNDS
employees investment are not
DEPOSITORY INSTITUTIONS profitable, employee’s income
during retirement will be low.
COMMERCIAL BANKS
b) Defined benefit plan
It is the most important intermediaries. It plays a
An employer promises
key role in the financial system by taking in
employees a particular peso
deposits from households and firms and investing
benefit payment, based on each
most of those deposits, either to households and
employee’s earnings and years
firms or by buying securities, such as government
of service. The benefit payments
bonds, or securitized loans.
may or may not be indexed to
increase with inflation.

If the funds in the pension plan

UNIVERSAL BANKS exceed the amount promised,
the excess remains with the
Also referred to as a full-service financial
employer managing the fund.
institutions, a universal bank provides a large array
of services including those of commercial banks
and investment banks.
 If the funds in the pension plan funds are similar to mutual funds in that they
are insufficient to pay the accept money from investors and use the funds to
promised benefit, the plan is buy a portfolio of assets. However, a hedge fund
underfunded and the employer typically has no more than 99 investors, all of
is liable for the different. whom are wealthy individuals or institutions such
as pension funds. Hedge funds usually make riskier
Investment Intermediaries
investments than do mutual funds, and they charge
Investment intermediaries are financial firms that investors much higher fees.
raise funds to invest in loans and securities. The
Hedge funds frequently short securities whose
most important investment intermediaries are
prices they think may decline, meaning that they
investment banks, mutual funds, hedge funds
buy the securities from a dealer and sell them in
finance companies and money market mutual
the market, planning to bring them back after their
fund. Mutual funds and hedge funds, in particular,
prices decline.
have come to play an increasingly important role in
the financial system. Finance Companies.
Investment Banks. Investment banks, such as Finance companies are nonbank financial
Goldman, Sachs and Morgan Stanley, Merrill Lynch intermediaries that raise funds through sales of
differ from commercial banks in that they do not commercial paper and other securities and use the
take in deposits and until very recently rarely lent funds to make small loans to households and firms.
directly to households. Finance companies raise funds by selling
commercial paper (a short-term debt investment)
Mutual Funds. These financial intermediaries allow
and by issuing stocks and bonds. They lend these
savers to purchase shares in portfolio of financial
funds to consumers, who make purchases of such
assets, including stocks, bonds, mortgages, and
items as cars, furniture and home improvements,
money market securities. Mutual funds offer savers
and to small business. Some finance companies are
the advantage of reducing transactions costs.
organized by a parent corporation to help sell its
Rather than buy many stocks, bonds, or other
product.
financial assets individually each with its own
transactions costa saver can buy a proportional The three main types of finance companies are
share of these assets by buying into the fund with
 Consumer finance companies
one purchase. Mutual funds provide risk-sharing
These companies make loans to enable
sharing benefits by offering a diversified portfolio
consumers to buy cars, furniture and
of assets and liquidity benefits because savers can
appliances; to finance home improvement
easily sell the shares.
and to refinance household debts.
Types of mutual funds  Business finance companies
These companies are engaged in factoring
1. Closed-end mutual funds
that is, purchasing at a discount the
This mutual fund issues a fixed number of accounts receivable of small business firms.
nonredeemable shares, which investors may then Some business finance companies purchase
rode in over-the counter markets just as stocks are expensive equipment, such as airplanes or
traded. The price of a share fluctuates with the construction equipment and then leave the
market value of the assets often called the net equipment to firms over a fixed length of
asset value (NAV) in the fund. time.
 Sales finance companies
2. Open-end mutual fund
These companies are affiliated with
This mutual fund issues share that investors can department stores and companies that
redeem each day after the markets close for a price manufacture and sell high-priced goods.
tied to the NAV.
Large department stores issue credit cards
Many mutual funds are called no-load funds
that consumers can use to finance
because they do not charge buyers a commission,
purchases at those stores.
or “load.”

Hedge Funds. Money Market Mutual Funds.

Hedge funds are financial firms organized as a These are relatively new financial institutions that
partnership of wealthy investors that make have the attributes of a mutual fund but also
relatively high risk, speculative investments. Hedge function to some extent as a depositing institution
because they offer deposit-type accounts. Like
most mutual funds, they sell shares to acquire
funds that are then used to buy money market
instruments that are both safe and very liquid. The
interest on these assets is then paid out to the
shareholders. These money market mutual funds
invest exclusively in short-term assets, such as
treasury bills, negotiable certificates of deposit and
commercial paper.

CHAPTER 13 – COMMERCIAL BANKING

THE BANK BALANCE SHEET
A bank’s sources and uses of funds are summarized
on its balance sheet, which is a statement that lists
an individual’s or a firm’s assets and liabilities to and entail greater default risk and higher
indicate the individual’s or firm’s financial position information costs. As a result, the interest rates
on a particular day. banks receive on loans are higher than those they
receive on marketable securities.
 An asset is something of value that an
individual or firm owns. 1. Loans to businesses called commercial and
 A liability is something that an individual or industrial, or C&l, loans
a firms owes, particularly a financial claim 2. Consumer loans, made to households
on an individual of a firm. primarily to buy automobiles, furniture and
 Bank capital also called shareholders’ other goods
equity is the difference between the value 3. Real estate loans, which include mortgage
of the bank’s assets and the value of its loans and any other loans backed with real
liabilities. estate as collateral. Mortgage loans made
to purchase homes are called residential
BANK ASSETS
mortgages, while mortgages made to
Banks acquire bank assets with the funds they purchase stores, offices, factories, and
receive from depositors, the funds they borrow, other commercial buildings, are called
the funds they acquire from their shareholders commercial mortgages.
purchasing the bank’s new stock issues, and the
Other Assets
profits they retain from their operations. A bank
manager builds a portfolio of assets that reflect Other assets include banks’ physical assets, such as
both the demand for loans by the bank's customers computer equipment and buildings. This category
and the bank’s need to balance returns against risk, also includes collateral received from borrowers
liquidity, and information costs. The following are who have defaulted on loans.
the most important bank assets.
BANK LIABILITIES
Reserves and Other Cash Assets
The most important bank liabilities are the funds a
The most liquid asset that banks hold is reserves, bank acquires from savers. The bank uses the funds
which consist of vault cash- cash on hand and in to make investments, for instance, by buying
the bank (including in ATMs) or in deposits at other bonds, or to make loans to households and firms.
banks – and deposits banks have with the Central Bank deposits offer households and firms certain
Bank (Bangko Sentral ng Pilipinas). As authorized advantages over other ways in which they might
by Congress, the BSP mandates that banks hold a hold their funds.
percentage of their demand deposits and NOW
Demand or Current Account Deposits
accounts (but not Money Market Deposit Accounts
(MMDAs) as required reserves. Reserves that banks Bank offer savers demand or current account
hold over and above those that are required are deposits, which are accounts against which
called excess reserves. depositors can write checks. Current account
deposits come in different varieties, which are
Securities
determined partly by banking regulations and
Marketable securities are liquid assets that banks partly by the desire of bank managers to tailor the
trade in financial markets. Banks are allowed to checking accounts they offer to meet the needs of
hold securities issued by the government. Treasury households and firms. Demand deposits and NOW
and other government agencies, corporate bonds (negotiable order of withdrawal) accounts are the
that received investment-grade rating when they most important categories of checkable deposits.
were first issued, and some limited amounts of Demand deposits are current account deposits on
municipal bonds, which are bonds issued by state which banks do not pay interest. NOW accounts
and local governments. Because of their liquidity, are checking accounts that pay interest. Businesses
bank holding of Government Treasury securities often hold substantial balances in demand deposits
are sometimes are sometimes called secondary because demand deposits represent a liquid asset
reserves. Commercial banks cannot invest than can be accessed with very low transactions
checkable deposits in corporate bonds (although costs.
they may purchase them using other funds) or
Nondemand Deposits
common stock in nonfinancial corporations.
Savers use only some of their deposits for day-to-
day transaction. Banks offer nondemand deposits
Loans Receivable for savers who are willing to sacrifice immediate
access to their funds in exchange for higher
By far largest category of bank assets is loans.
interest payments. The most important types of
Loans are illiquid relative to marketable securities
nontransaction deposists are saving accounts,
money market deposit accounts (MMDAs), and
time deposits, or certificates of deposit (CDs).
Borrowings
Banks often have more opportunities to make
loans than they can finance with funds they attract
from depositors. To take advantage of these
opportunities, banks raise funds by borrowing. A
bank can earn a profit from this borrowing if the
interest rate it pays to borrow funds is lower than
the interest it earns by lending the funds to
households and firms. Borrowings include short-
term loans in the BSP funds market, loans from a
bank’s foreign branches or other subsidiaries or
affiliates, repurchase agreements, and discount
loans from the BSP. The federal funds market is the
market in which banks make short-term loans
often just overnight – to other banks. Although the
name indicates that government money is
involved, in fact, the loans in the federal funds
market involve the bank's own funds.