Chapter 3 Overview of the Financial System

1
Chapter 3Overview of the Financial System
2
Purpose of the Financial System

• Transfer funds from savers to borrowers
• Savers (lenders) supply the funds, obtaining
  assets that pay future returns.
• Borrowers demand the funds, issuing liabilities
  that require future returns.

3
Two Parts of Financial System

• Financial markets directly transfer funds from
  savers to borrowers.
• Financial intermediaries indirectly transfer the
  funds by acting as go-betweens
• The ultimate savers lend to financial
  intermediaries, which then lend the funds to the
  ultimate borrowers.

4
(No Transcript)
5
Key Services of Financial System

• Risk-sharing by allowing savers to hold many
  different assets
• Liquidity i.e. the ease with which an asset can
  be exchanged for money
• Information about borrowers and returns on
  financial assets

6
Risk-Sharing

• Risky assets have uncertain returns due to
• Default
• Fluctuating asset prices
• Risk can be reduced by holding a portfolio of
  assets i.e. by diversification.
• Financial system enables risk to be shifted from
  those less willing to bear it to those more
  willing.

7
Liquidity

• Liquid assets easily, quickly bought or sold at
  almost equal prices and at little cost
• Examples of liquid assets currency, deposits,
  Treasury bills, stocks of large companies
• Example of an illiquid asset houses

8
Information

• Financial system collects and communicates
  information.
• It is costly for many individual savers and
  borrowers to do so themselves.

9
Financial Markets

• Newly issued claims are sold to initial buyers in
  primary markets.
• Previously issued claims are resold in secondary
  markets.
• Active secondary markets engender liquidity.

10
Types of Secondary Markets

• Format
• Auction markets e.g. NYSE
• Over-the-counter markets e.g. NASDAQ
• Settlement
• Cash markets e.g. stocks, bonds
• Derivative markets e.g. futures, options

11
Two Types of Claims

• Debt
• Equity

12
Debt

• Principal and interest
• Maturity date
• Term to maturity
• Short-term ? 1 year money market
• Intermediate-term gt1, lt 10 years
• Long-term ? 10 years
• Default

13
Equity

• Claim to a given share of profits and assets
• Managers have discretion over how much to
  distribute.
• Dividend the amount distributed
• Default debt vs. equity
• Risk-sharing debt and equity
• Capital market equity plus intermediate- and
  long-term bonds

14
Financial Intermediaries

• Collect funds from many savers and transfer the
  funds to many borrowers
• Provide risk-sharing, liquidity and information
  services

15
Financial Evolution

• Strong competition
• Financial innovation
• Financial integration in US
• Globalization
• Recent years
• Before 1914

16
Reasons for Financial Regulation

• Prevention of fraud
• Financial stability
• Monetary control (silly)
• Willie Sutton effect

17
Facts for 2006

• 40 of assets were direct debt and equity
  instruments
• 60 were liabilities of financial intermediaries
  of which about
• 27 in bank deposits
• 49 in pension reserves
• 19 in mutual funds
• 5 in insurance reserves