Lecture 2

An
Overview
of the
Financial
System
 A. FUNCTION OF FINANCIAL
MARKETS
“the essential function of channeling fund from
households, firms and government that have saved
surplus fund by spending less then their income to
those that have a shortage of funds because they
wish to spend more then their income”

Other functions:
• Allow fund to move from people who lack productive
Investment opportunities to people who have such
opportunity.
• Well-functioning markets also directly improve the
well-being of consumer by allowing them to time
their purchase better.
Function of Financial Markets
•1. Allows transfers of funds from
person or business without
investment opportunities to one who
has them
•2. Improves economic efficiency

Figure 1: Flows of Funds Through the Financial System

 LEFT: RIGHT:
•Those who have saved and are •Those who must borrow funds
lending funds (lender – savers) to finance their spending
• principal: > households , (borrower – spender)
business, government •Principal: > business,
(sometime find themselves with government, households or
excess fund and lend them out) foreigner (personal use)

Funds Flow from lender –saver to

! borrower-spender via two routes:
i. Direct Finance
ii. Indirect Finance
 i. Direct Finance
• Borrower borrow fund direct from lender in FM by
selling them security (financial instruments) – which
are claim on the borrower’s future income or assets.
* Or Borrowers sell securities directly to lenders
e.g. corporate and Treasury bonds

> security : are assets for the person who

buys them – debt securities that
promises to make payment periodically for a
specified period of time.

(liabilities debts): for the individual or firm that sell (issues) them
Example:

Firm A need to borrow funds from savers

to pay/plant anew factory to
manufacture new product.
- it might borrow funds by selling them
(saver) bonds (security) - (debt securities that
promises to make payment periodically for a specified period of
time.

> liabilities??? – the bonds that firm A sell to saver

 ii. Indirect Finance
* Borrowers and lenders meet through a financial
intermediary ( ex: bank….)
– Loan is a liability for borrower, and asset for a
bank

Lenders – savers

funds to the Financial Intermediaries

Borrowers – spenders
STRUCTURE OF FINANCIAL MARKETS
Classifications of Financial Markets
1. Debt Markets
Short-term (maturity < 1 year) Money Market
Long-term (maturity > 1 year) Capital Market
2. Equity Markets
Common stocks
3. Primary Market
New security issues sold to initial buyers
4. Secondary Market
Securities previously issued are bought and sold
5. Exchanges
Trades conducted in central locations (ex:BSM)
6. Over-the-Counter Markets
Dealers at different locations buy and sell
7. Money market
– short-term debt securities (up to 1 yr.) - highly liquid, low risk
8. Capital market
– longer-term debt - equity
 1. Debt & Equity Markets:
• Firm/individual Obtain in FM in 2 ways:

1. Issue a debt instrument (bond/mortgage)

Contractual agreement by borrower to pay the
holder of the instrument fix dollar amount at
regular intervals. (interest & principal payment)
until specified date (the maturity date) when a final
payment is made.

• Maturity – the numb of years (term) until that instrument’s

expiration date
• Debt instrument :
1. short-term – maturity < 1 year
2. long-term – maturity 10 years or longer
3. Intermediate –term – between 1-10 years
2. Issuing equities
(common stock – claim to share in the net Y (Y after
expenses and taxes) and the asset of a business).
Exp: if you own one share of common stock in a
company let say 1 million. You are entitled to 1
million of the firm’s net Y; and 1 million of the
firm’s assets.

• Equities – often make a periodic payment (dividend)

to their holder. Consider long-term securities because
they have no maturity date.

Owning stock meant that you own a portion

of the firm and have right to vote on issues
! important and to elect its directors
• Disadvantage : of owning equities rather than
its debt – is an equity holder is a residual
claimant;
- the corporation / firm must pay all its
debts holders before it pays its equity
holders.

• Advantage : equity holder benefit directly

from any increment in corporation’s
profitability or asset value.
- debt holder do not share in this benefit –
because their dollar payment are fixed.
 2. Primary & Secondary Market

1. Primary Market – financial Market in which

new issues of a security (such as bond &
stock) are sold to initial buyers by the G or
corporation agency borrowing the funds.

2. Secondary Markets – financial market in

which securities that have been previously
issued (second hand) can be resold.

• Investment Bank:
Financial institution that assists in the initial sale of
securities in the primary market and not well known
to the public because the selling of securities to
initial buyers often takes place behind closed doors.
• Investment bank does by :
1. Underwriting securities
It guarantees a price for a corporation’s
security and then sells them to the public
2. Brokers
are agents of investors who match buyers
with sellers of security
3. Dealers
links buyer & seller by buying and selling
securities at stated prices
 When iandividual buys a security in
! secondary market………….
1. A person who sold the security receive money in exchange for
the security but
2. The corporation that issued the security no new funds.
- only can acquires new funds if sold in primary market
Secondary market serve 2 important functions:
1. They make it easier and quicker to sell these financial
instruments to raise cash
- make it more liquid
- increased liquidity make more desirable & thus easier
for the issuing firm to sell in the primary market.

2. They determine the P of the security that the issuing

firms sells in the primary market
 3. Exchanges & Over-the-counter
(OTC) markets:
• Secondary market can be organized in two ways:

1. To organize exchanges;
- Where buyers/sellers of securities (or their agents/brokers) meet
in one central location to conduct trades.

2. Over-the-counter (OTC) market

- Dealers at different locations who have an inventory of securities
stand ready to buy and sell securities “OTC” to anyone who
comes to them and is willing to accept their prices
- b’coz OTC dealers are in computer contact and know the $ set
by one another.
- OTC market is very competitive and not very different from a
market with an organized exchanged
 4. Money & Capital Markets

• Money Market – financial market in which

only short-term debt instruments (maturity < 1
yr) are traded

• Capital market – the market in which longer-

term debt and equity instrument are traded
(maturity 1 or grater)
 *Money market securities – usually more
widely traded that than longer-term securities
! and so tend to be more liquid.
-short term securities have smaller fluctuations
in $ than long-term securities, making them
safer investment

Corporation & banks actively use the money market to earn interest on
surplus funds that they expect to have only temporarily

*Capital Market (stock/long term bonds)

- Often held by financial intermediaries
! such as insurance companies and pension
funds, which have little uncertainty about
the amount of funds they will have
available in the future
 B. FUNCTION OF FINANCIAL
INTERMEDIARIES:
• Indirect Finance – borrow funds from the lender-
saver and then using these funds to make loans to
borrow spenders.

Exp: Bank acquire funds by issuing liability to public

(asset to public) in the form of saving deposit
- Then bank might use the funds to acquire an asset by
making loan to company A or
- Buying a company A bond in financial market
- Show that funds have been transferred from the public
to the borrower with the help of FI (bank)
 1. Transaction cost
• The time & management in carrying out financial
transactions (for people who have excess fund to
lend)
Exp : A lend to B – pay to lawyer (transaction cost)

• Financial Intermediaries – substantially can reduce

transaction cost because
1. They have developed expertise in buying them
2. Large size – allow them to take advantages of
economic of scale.
- The reduction in transaction cost per dollar of
transactions as the size (scale) of transaction
increase
exp: bank know the lawyer- used the contract
over again. legal cost per transaction lower
Advantages :
- Financial intermediaries also can
provide the investment
opportunities
- Liquidity services – services that
can make customer conduct
transaction easily –exp checking
accounts, pay bill etc
 2. Risk Sharing
• Besides providing the lower transaction cost , FI also can
help reduce the exposure of investors to risk.

• “RISK” - uncertainty about the returns investors will earn

on assets
• “RISK SHARING”
- FI create and sell assets with risk
characteristics that people are comfortable with
- FI use the funds they acquire by selling these
assets to purchase other assets that may have
far more risk.
 3. Asymmetric Information
• Different information – one party often does
not know enough about the other party to
make accurate decision
exp: borrower know better than lender
a) Adverse Selection
• Problem created by AI “before” transaction occurs

• AS – occurs when the potential borrowers – who

are the most likely to produce an undesirable
(adverse) income – (the bad credit risks) – are the
ones who most actively seek out a loan and are
thus most likely to be selected
b) Moral Hazard
• Problem created by AI “after” transaction
occurs
• is a risk (hazard) that the borrower might
engage in activities that are undesirable
(immoral) from the lender’s point of view,
because they make it less likely that the loan
will be paid back
• Because MH lowers the probability repaid of
loan so lenders decide would rather not
make a loan.
 Types of Intermediaries
1. Depository Institution

a) Commercial Bank
– Issuing checkable deposit
(deposit on which check can be written)
- Saving deposit
(deposit that are payable on demand but do not
allow their owner to write checks
- Time deposit
(deposit with fixed terms of maturity)

CB – will use these fund to make commercial

- consumer & mortgage loans – to buy securities
or municipal bonds .
>>> exp of commercial Bank??
b) Saving & Loan Assoc. (S & Ls) and mutual
saving Bank
- obtain funds through saving deposits
(shares) and checkable deposits

c) Credit Unions
- a small cooperatives lending institution –
organized around a particular group (union
member, employees of firm etc)
- acquired funds from deposit called shares
and primarily make consumer loans
2. Contractual Saving Institution
- acquire funds at periodic
intervals on a contractual basis.
- don’t worry about losing funds – coz
can predict how much they will
have to pay out in benefits in the
coming years.
- so liquidity assets is not important
and tend to invest funds in long term
security as bond, stock and mortgages
a) Life Insurance Companies
- insure people against financial hazards
following a death and sell annuities
(annual Y payment upon retirement)
- fund – from premium

b) Fire & Casualty Insurance Companies

- insure policy holders against loss from theft,
fire and accident
- fund – premium
- greater possibility of loss funds if major
disaster occur
c) Pension Funds & Government
retirement funds:

- provide retirement Y in the form of

annuities to employees who are
covered by a pension plan
- fund – from employer/employees
- contribution from paycheck
or voluntarily
3. Investment Intermediaries

a) Finance Companies :
- funds – sell commercial paper
(a short-term debt instrument)
- issuing stock and bonds

- FC – lend funds to consumers

( who make purchases of such
items as furniture, automobile
etc….)
b) Mutual Funds :
- sell shares to many individuals and use the
proceeds to purchase diversified portfolio of
stock and bond.

- pool resources – low transaction cost when

buy large stock and bond.

- can sell share any time - but value will

determined by mutual funds’ holding

- risky
c) Money Market Mutual Funds :

- have characteristic of a mutual funds but also

functions to some extent as a depository institution –
because offer deposit-type accounts.

- like mutual funds – they sell shares to acquire funds

that are then used to but money market instruments –
both are safe and liquid.

-shareholders can write checks against the value of

their shareholdings.

- its functions like checking account deposits that pay

interest.
d) Investment Bank:

- is NOT a bank or a financial intermediary.

- it does NOT take in deposits and then lend

them out.
Types of Intermediaries