Lecture 5

Financial
Markets and
Institutions
Readings
Mishkin (2021), The Economics of Money,
Banking, and Financial Markets, 13th
edition, Pearson, Chapters 2+8.
Cecchetti and Schoenholtz (2014), Money,
Banking, and Financial Markets, 4th edition,
McGraw-Hill, Chapter 3.

2
Introduction
The international financial system exists to
facilitate the design, sale, and exchange of
a broad set of contracts with a very
specific set of characteristics.
We obtain financial resources through this
system:
– Directly from markets, and
– Indirectly through institutions.

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Introduction

3-4
4
Introduction
Indirect Finance: An institution stands
between lender and borrower.
– We get a loan from a bank or finance
company to buy a car.
Direct Finance: Borrowers sell securities
directly to lenders in the financial
markets.
– Direct finance provides financing for
governments and corporations.

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Introduction
We will survey the financial system in
three steps:
1. Financial instruments or securities
– Stocks, bonds, loans and insurance.
– What is their role in our economy?
2. Financial Markets
– New York Stock Exchange, Nasdaq…
– Where investors trade financial
instruments.
3. Financial institutions
– What they are and what they do. 6
Financial Instruments
Financial Instruments: The written legal
obligation of one party to transfer something
of value, usually money, to another party at
some future date, under certain conditions.
– The enforceability of the obligation is
important.
– Financial instruments obligate one party
(person, company, or government) to
transfer something to another party.
– Financial instruments specify payment
will be made at some future date.
– Financial instruments specify certain
conditions under which a payment will be
made.
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Underlying Versus Derivative Instruments

Two fundamental classes of financial

instruments.
– Underlying instruments are used
by savers/lenders to transfer
resources directly to
investors/borrowers.
• This improves the efficient allocation
of resources.
• Examples: stocks and bonds.

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Underlying Versus Derivative Instruments

Derivative instruments are those

where their value and payoffs are
“derived” from the behavior of the
underlying instruments.
– Examples are futures and options.
– The primary use is to shift risk
among investors.

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Financial Markets
• Financial markets are places where financial
instruments are bought and sold.
• These markets are the economy’s central
nervous system.
• These markets enable both firms and
individuals to find financing for their
activities.
• These markets promote economic
efficiency:
– They ensure resources are available to
those who put them to their best use.
– They keep transactions costs low.
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The Role of Financial Markets
1. Allocation of capital
– Efficient allocation of capital, which
increases production
2. Liquidity:
– Ensure owners can buy and sell financial
instruments cheaply.
– Keeps transactions costs low.
3. Information:
– Pool and communication information
about issuers of financial instruments.
4. Risk sharing:
– Provide individuals a place to buy and sell
risk. 11
The Structure of Financial Markets
 Debt and Equity Markets
 Primary and Secondary Markets (D&E)
 Investment Banks underwrite securities in primary markets
 Brokers and dealers work in secondary markets
 Exchanges (D&E)
 NYSE, NYBE, CBOT
 Over-the-Counter (OTC) Markets
 FX, Fed funds
 Money and Capital Markets
 Money markets deal in short-term debt instruments
 Capital markets deal in longer-term debt and
equity instruments

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Internationalization of Financial Markets
Foreign Bonds: sold in a foreign country
and denominated in that country’s currency
Eurobond: bond denominated in a currency
other than that of the country in which it is
sold
Eurocurrencies: foreign currencies
deposited in banks outside the home country
– Eurodollars: U.S. dollars deposited in
foreign banks outside the U.S. or in foreign
branches of U.S. banks

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Financial Institutions
Firms that provide access to the financial
markets, both
– to savers who wish to purchase financial
instruments directly and
– to borrowers who want to issue them.
Also known as financial intermediaries.
– Examples: banks, insurance companies,
securities firms, and pension funds.
Healthy financial institutions open the flow
of resources, increasing the system’s
efficiency.
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Figure 1 Sources of External Funds for Nonfinancial Businesses:
A Comparison of the United States with Germany, Japan,
and Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Results,” Johann
Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and are gross flows as
percentage of the total, not including trade and other credit data, which are not available.
Eight Basic Facts
1. Stocks are not the most important sources
of external financing for businesses
2. Issuing marketable debt and equity
securities is not the primary way in which
businesses finance their operations
3. Indirect finance is many times more
important than direct finance
4. Financial intermediaries, particularly
banks, are the most important source of
external funds used to finance businesses.
Eight Basic Facts (cont’d)
5. The financial system is among the most heavily
regulated sectors of the economy
6. Only large, well-established corporations have
easy access to securities markets to finance
their activities
7. Collateral is a prevalent feature of debt
contracts for both households and businesses.
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive
covenants on borrowers
Transaction Costs
Financial intermediaries have evolved to
reduce transaction costs
– Economies of scale
– Expertise
Asymmetric Information: Adverse Selection
and Moral Hazard
Adverse selection occurs before the
transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetric
information problems affect economic
behavior
The Lemons Problem: How Adverse Selection
Influences Financial Structure

If quality cannot be assessed, the buyer is

willing to pay at most a price that reflects the
average quality
Sellers of good quality items will not want to
sell at the price for average quality
The buyer will decide not to buy at all
because all that is left in the market is poor
quality items
This problem explains fact 2 and partially
explains fact 1
Tools to Help Solve Adverse Selection Problems

Private production and sale of information

– Free-rider problem
Government regulation to increase
information
– Not always works to solve the adverse
selection problem, explains Fact 5.
Financial intermediation
– Explains facts 3, 4, & 6.
Collateral and net worth
– Explains fact 7.
How Moral Hazard Affects the Choice
Between Debt and Equity Contracts
Called the Principal-Agent Problem
– Principal: less information (stockholder)
– Agent: more information (manager)
Separation of ownership and control
of the firm
– Managers pursue personal benefits and
power rather than the profitability of the
firm
Tools to Help Solve the Principal-Agent Problem

Monitoring (Costly State Verification)

– Free-rider problem
– Fact 1
Government regulation to increase
information
– Fact 5
Financial Intermediation
– Fact 3
Debt Contracts
– Fact 1
How Moral Hazard Influences Financial Structure
in Debt Markets
Borrowers have incentives to take on projects
that are riskier than the lenders would like.
– This prevents the borrower from paying
back the loan.
Tools to Help Solve Moral Hazard in Debt Contracts

Net worth and collateral

– Incentive compatible
Monitoring and Enforcement of Restrictive
Covenants
– Discourage undesirable behavior
– Encourage desirable behavior
– Keep collateral valuable
– Provide information
Financial Intermediation
– Facts 3 & 4
Summary Table 1: Asymmetric Information
Problems and Tools to Solve Them
Function of Financial Intermediaries:
Indirect Finance
Lower transaction costs (time and money
spent in carrying out financial
transactions).
– Economies of scale
– Liquidity services (checking account)
Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation:
packaging risky assets into safer ones
for investors)
– Diversification by pooling and issuing
new assets 27
Function of Financial Intermediaries:
Indirect Finance
Deal with asymmetric information problems
– (before the transaction) Adverse
Selection: try to avoid selecting the
risky borrower.
• Gather information about potential
borrower.
– (after the transaction) Moral Hazard:
ensure borrower will not engage in
activities that will prevent him/her to
repay the loan.
• Sign a contract with restrictive covenants.

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Financial intermediation and leverage in the
US have shifted away from traditional banks
and toward other financial institutions less
subject to government regulations.
– Brokerages, insurers, hedge funds, etc.
These have become known as shadow banks.
– Provide services that compete with banks
but do not accept deposits.
– Take on more risk than traditional banks
and are less transparent.

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The rise of highly leveraged shadow banks,
combined with government relaxation of
rules for traditional banks, permitted a rise
of leverage in the financial system as a
whole.
– This made the financial system more
vulnerable to shocks.
Rapid growth in some financial instruments
made it easier to conceal leverage and
risk-taking.

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The financial crisis transformed shadow
banking.
– The largest US brokerages failed,
merged, or converted themselves into
traditional banks to gain access to
funding.
The crisis has encouraged the government
to scrutinize any financial institution that
could, by risk taking, pose a threat to the
financial system.

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The Structure of the Financial Industry

We can divide intermediaries into two

broad categories:
– Depository institutions,
• Take deposits and make loans
• What most people think of as banks
– Non-depository institutions.
• Include insurance companies,
securities firms, mutual fund
companies, etc.

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The Structure of the Financial Industry
1. Depository institutions take deposits
and make loans.
2. Insurance companies accept premiums,
which they invest, in return for
promising compensation to policy
holders under certain events.
3. Pension funds invest individual and
company contributions in stocks, bonds,
and real estate in order to provide
payments to retired workers.

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The Structure of the Financial Industry
4. Securities firms include brokers, investment
banks, underwriters, and mutual fund
companies.
– Brokers and investment banks issue
stocks and bonds to corporate customers,
trade them, and advise customers.
– Mutual-fund companies pool the
resources of individuals and companies
and invest them in portfolios.
– Hedge funds do the same for small
groups of wealthy investors.

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The Structure of the Financial Industry
5. Finance companies raise funds directly
in the financial markets in order to
make loans to individuals and firms.
– Finance companies tend to specialize
in particular types of loans, such as
mortgage, automobile, or business
equipment.

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The Structure of the Financial Industry
6. Government-sponsored enterprises are
federal credit agencies that provide
loans directly for farmers and home
mortgagors.
– Guarantee programs that insure
loans made by private lenders.
– Provides retirement income and
medical care through Social Security
and Medicare.

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Primary Assets and Liabilities of
Financial Intermediaries

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Other readings
Videos:
Understanding the Financial Crisis:
http://www.youtube.com/watch?
v=qqUGoVez8xg&feature=related
The Moral Hazard of Funny Money:
http://www.youtube.com/watch?
v=WzPij_Ty2aU&feature=related
Other readings
Readings:
Tobias Adrian and Hyun Song Shin, "Financial Intermediaries
and Monetary Economics,":
http://www.newyorkfed.org/research/staff_reports/sr398.htm
l
Amadeo, An Introduction to the Financial Markets:
http://useconomy.about.com/od/themarkets/a/capital_marke
ts.htm
BIS, "The future of the financial sector", Annual Report, Jun
2010: http://www.bis.org/publ/arpdf/ar2010e6.pdf
NY Times, Moral Hazard: A Tempest-Tossed Idea:
http://www.nytimes.com/2012/02/26/business/moral-hazard-
as-the-flip-side-of-self-reliance.html?pagewanted=all
Jeb Hensarling: Dodd-Frank's Unhappy Anniversary:
http://online.wsj.com/article/SB10000872396390443437504
577547320318621132.html?mod=googlenews_wsj