Introduction to Financial

Markets, Institutions, and Assets

Financial Assets: Defined
A financial asset/instrument is …
• a claim against the income or wealth of a business firm, household, or
unit of government,
• represented usually by a certificate, receipt, computer record file, or
other legal document,
• and usually created by or related to the lending of money.
The buyer of financial assets creates a claim on the future
income/wealth of the seller/issuer of the financial asset.
Financial Assets vs Physical/Real Assets
• Real Assets/Physical Assets
• These are tangible assets whose value is based on the physical
properties/utility of the asset.
• Examples include buildings, land, and machinery.
• Financial Assets/Intangible Assets:
• These are intangible assets whose value is based on benefits to be gained from
the asset.
• They represent a financial claim on the future income/asset of the issuer on
behalf of the investor.
• Examples include various financial assets like stock, bonds, and copyrights.
• Financial assets usually originate and are traded in a financial market. However, it
is not a prerequisite for trading financial assets in financial markets.
Characteristics of Financial Assets
• Financial assets are sought after because they promise future returns to
their owners and serve as a store of value (purchasing power). It
allows investors to defer current consumption for a higher level of
future consumption.
• They do not depreciate like physical goods, and their physical
condition or form is usually irrelevant in determining their market
value.
• They have little or no value as a commodity and their cost of
transportation and storage is low.
Kinds/Types of Financial Assets
• There are broadly four types/categorizations of financial assets.
 Any financial asset that is generally accepted in payment for
purchases of goods and services is money. Currency and checking
accounts are forms of money.
 Equities represent ownership shares in a business firm and are claims
against the firm’s profits and proceeds from the sale of its assets.
Common stock and preferred stock are equities. Equity securities
carry voting rights and represent residual claims on the earnings and
assets of the company.
Kinds/Types of Financial Assets
 Debt securities entitle their holders to a priority claim over the
holders of equities to the assets and income of an economic unit. They
can be negotiable or nonnegotiable. Examples include bonds, notes,
accounts payable, and savings deposits.
 Derivatives have a market value that is tied to or influenced by the
value or return on another underlying financial asset. Examples
include futures contracts, options, and swaps.
Definition of Financial Markets
• Financial market is a system which facilitates the flow of funds from
the surplus unit in the economy to the deficit unit through the
exchange of financial assets and with the support of financial
institutions.
• In simpler words, it is the mechanism/channel or an enabler through
which financial assets are exchanged.
• A financial market may not always have a physical presence.
• Even though, most financial assets are created and traded in a financial
market, the existence of a financial market is not a necessary condition
for the creation and exchange of a financial asset.
Types of Financial Markets
• Debt vs. equity markets
• Money market vs. capital market
• Primary vs. secondary market
• Cash or spot vs. futures and derivatives market vs. direct claims
market
• Exchange vs. over-the-counter
Financial Market Participants
• Households
• Business units
• Government
• Government agencies and Municipals
• Supranational
• Regulators
Global Financial Markets
• Global integration
• Many financial markets are globally integrated
• Participants move funds out of one country’s market and into
another
• Foreign investors serve as key surplus units in the U.S. by
purchasing securities
• U.S. investors serve as key surplus units for foreign countries by
purchasing foreign securities
• Market movements and interest rates have become more correlated
between markets
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Reasons for the Globalization of Financial Markets

• Deregulation or liberalization of financial markets

• Technological advances

• Increased institutionalization
Motivation for Using Foreign Markets

• Limited fund availability in internal market

• Reduced cost of funds

• Diversifying funding sources

Financial Institutions
• A financial institution is an organization which works as an
intermediary between the deficit unit (borrower) and surplus unit
(lender) in the financial market to facilitate the flow of funds using
financial instruments.

• Examples of financial institutions include commercial banks, savings

banks, credit unions, investment banks, leasing companies, mutual
funds etc.
Why are financial institutions needed?
• In a perfect market:
• All information about any securities for sale in primary and secondary
markets would be continuously and freely available to all investors
• All information identifying investors interested in purchasing securities
as well as investors planning to sell securities would be freely available
• All securities are infinitely divisible
• However, Markets are imperfect
• Financial institutions are needed to resolve the problems created by
market imperfections. These problems include:
• Maturity mismatch, denomination mismatch, high information search
cost, high default risk, high liquidity risk etc.
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Activities/Services Performed by Financial Institutions
1. Transforming financial assets acquired through the market and constituting
them into a different, more widely preferable type of asset-which becomes their
liability. This is done by facilitating indirect investment. The transformation
happens through maturity intermediation, denomination intermediation,
diversification etc.
2. Exchanging of financial instruments on behalf of customers (Broker)
3. Exchanging of financial instruments for their own accounts (Dealer)
4. Assisting in the creation of financial assets for their customers (Origination),
and selling those financial assets to other market participants (underwriting &
distribution)
5. Providing investment advice to other market participants
6. Managing the portfolio of other market participants
Role of Financial Institutions
• Financial institutions play various important roles in an economy. These include:
• Broker and dealer activities
• Maturity intermediation: FI’s can provide savings/investment conduit for
lenders/borrowers that better reflect the maturity needs of these parties. FI’s
are better capable to manage the risk of maturity mismatch of their assets and
liabilities.
• Denomination intermediation: FI’s, such as mutual funds, allow small
investors to overcome constraints to buying assets imposed by large minimum
denomination size.
• Superior monitoring: FI’s are better equipped to closely monitor the
performance of the borrower thereby better managing default risk. FI’s can
collect more information at a lower average cost due to economies of scale.
Role of Financial Institutions
• Superior credit assessment: FI’s possess the expertise required to conduct
a thorough assessment of the creditworthiness of the borrower (issuer). This
also mitigates default risk.
• Credit Allocation: FI’s are often the main, and at times the only, source of
financing for certain sectors of the economy.
• Transmission of monetary mechanism: Depository financial institutions
are the medium through which the central bank implements/manipulates its
monetary policy to impact the rest of the economy. i.e changing the reserve
requirement of banks to tackle inflation, open market operations etc.
• Payment Services: FI’s like banks develop and facilitate the network of
payment systems used to make purchases and consumption in the economy.
• Risk Management: FI’s provide risk management services to its clients. i.e
diversification of portfolio
Types of Financial Institutions
• Financial institutions can be broadly be classified into two types:
1. Depository Financial Institutions
2. Non-depository financial institutions
• Depository Financial institutions are financial institutions that mainly
obtain their funds by collecting deposits from the general public and
also allow the public to withdraw their funds when needed through a
checking account. Consequently, depository institutions are highly
regulated by the government.
• Non-depository FI’s can also raise funds from the public. However,
these funds cannot be demand deposits (i.e repayable at demand).
Types of Depository Financial Institutions
• The main types are as follows:
1. Banks: These are for-profit entities that raise funds through deposits
and utilize the funds by providing loans and investing in securities.
2. Credit Union: These are financial cooperatives that are owned by
“members” of a particular group. The funds are pooled from the
members and used to make loans and investments. The profits are
distributed among the members. Their operation size is typically,
much smaller compared to commercial banks.
3. Savings Associations: Savings associations mainly focus on making
residential mortgage loans and retail loans.
Types of Non-depository Financial Institutions
1. Investment Bank
2. Leasing Company
3. Insurance Company
4. Venture Capitals
Source of Income for Depository Financial
Institutions
• Depository Financial Institutions generate income from two sources:
• Interest Spread or Margin
• Fee income through service provision
Commercial Banks
• Banks in Bangladesh are of two types:

• Scheduled Banks: The banks that are operated under the Bangladesh Bank
order, 1972. At present, there are 61 scheduled banks in Bangladesh (Source:
BB). They operate under the BB order, 1972 and Bank Companies Act, 1991.

• Non-Scheduled Banks: The banks which are established for special and
definite objective and operate under any act but are not scheduled banks. i.e
Ansar VDP Unnayan Bank, Karmasongsthan Bank, Palli Sanchay Bank etc.
These banks cannot perform all functions of scheduled banks.
Activities/Services provided by banks
• The services can be broadly classified into three categories:
1. Individual/Retail Banking
2. Institutional/Corporate Banking
3. Global Banking
In the context of Bangladesh, Banks also provide SME banking
services.
Activities/Services Provided by Banks
• Individual Banking: Demand deposit, term deposit, Consumer
Lending, residential mortgage loan, credit card financing, automobile
financing, locker service etc.
• Corporate Banking: These includes deposit and loans services
(corporate loan, working capital loan, overdraft, syndicated loans etc.)
provided to other financial, non-financial corporations, and
government. Other services include cash management services, payroll
banking, payment services (fund transfer, cheque clearing etc.).
International trade financing (LC opening, settlement etc.)
• SME banking: Same services as above but provided to SME entities.
Activities/Services Provided by Banks
• Global Banking: This covers a broad range of activities involving
corporate finance and capital market and foreign exchange products
and services. Under corporate finance, the bank helps its customers
to raise funds. This is done through underwriting securities,
providing syndicated loans, providing bank guarantee etc. Under
capital market and foreign exchange services, banks might act as
brokers and dealers. i.e In Bangladesh, one can purchase government
issued treasury bills and bonds by bidding in the auction through
primary dealers (PD). There are 20 PD’s (all commercial banks) in
Bangladesh.
Bank Funding
• There are 3 sources of funds for banks:
• Deposits: demand deposit, savings deposit, and time deposits
• Non - deposit borrowing: Borrowing from the money and capital market
by issuing debt securities, borrowing from other banks in the call money
market, borrowing from the central bank.
• Common stock and retained earnings.
Banks are highly leveraged institutions whose majority funding comes
through borrowing (from the first two sources)
Reserve Requirement of Banks
• A bank cannot invest/loan out all of its deposits. Rather, it has to keep a certain
percentage of its deposits as reserve with the central bank. This is done to protect
the interest of the depositors and safeguard them from default risk and liquidity
risk.
• In Bangladesh, the reserve ratios are as follows:

• CRR (Cash Reserve Ratio) is kept with the central bank in Cash. SLR (Statutory
liquidity reserve) is kept by the banks themselves in liquid assets prescribed by the
central bank.