An overview of the financial system

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An overview of the financial system

• Mishkin, Chap 2

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• Chap 2 (a chapter of definitions mostly)
• I. the financial system and its components
  (financial markets, financial intermediaries,
  regulators)
• II. the structure of the financial markets
  types of markets, instruments
• III. role of financial intermediation in general
• IV. types of intermediaries
• V. role of regulation in general

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• I. Financial System
• Financial system financial markets financial
  intermediaries regulators
• role of financial system to transfer funds from
  savers/lenders to dis-savers/borrowers
• Why transfer funds?
• savers/lenders agents who earn more than they
  spend in a given accounting period
• dis-savers/borrowers agents who spend more than
  they earn in a given accounting period
• agents households, business firms, government,
  foreign households, foreign firms and foreign
  governments
• transfer of funds happen through purchase and
  sale of financial assets/securities/financial
  instruments/financial contracts
• What is a financial asset broadly speaking?

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• The course discusses 3 main types of assets
  money(s), bonds, stocks
• direct finance
• funds are directly transferred from savers to
  dis-savers, lender-savers directly purchase
  securities or assets from borrower-spenders
• example US govt. issues new 10-year notes worth
  10 m. Mary buys 100 of them from a dealer
• indirect finance
• funds are transferred via financial
  intermediaries
• example US govt. issues new 10-year notes worth
  10 m. Marys bank Wells Fargo buys 5 m worth of
  them from a dealer
• What are financial intermediaries? How would you
  describe the dealer?

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Indirect finance
Financial intermediaries


A
A
Borrowers
Lenders-savers

1.households2.business fm 3.government4.foreigners

1.households2.business fm 3.government4.foreigners



Financial markets
A
A
Direct finance
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• II. Different classifications of financial
  markets
• primary vs. secondary
• primary market where new issues (IPO) are sold
  to initial buyers companies acquire funds only
  when new issues are sold.
• secondary markets previously issued securities
  are re-traded companies do not acquire fresh
  funds when their securities are traded again
• What purpose does a secondary market serve then?

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B) Exchanges vs. over the counter markets
exchanges NYSE, ASE, Chicago Board of Trade
etc. over the counter markets - NASDAQ, markets
for US Treasury bonds, foreign exchange
markets Are there any real differences between
the two? C) Money and capital markets (duration
of assets) money markets are markets in which
short term securities are traded capital markets
are markets in which long term securities are
traded What are short, long,
intermediate terms?
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• D) classification by nature of payments made by
  the borrower debt and equity markets
• debt instruments/assets borrower pays lender an
  amount which is fixed either in nominal or in
  real terms at specified time points
• short term debt or money market instruments less
  than a years maturity
• T-bills 3, 6, 12 months maturity periods zero
  coupon bond virtually risk-free government debt
• How many principle types of risk associated with
  debt assets can you think of ?
• (negotiable) certificate of deposits (CD), pays
  interest periodically and principle on maturity
  mainly bank debt
• commercial paper short term debt (mainly)
  corporate debt may be zero coupon or interest
  bearing unsecured

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repurchase agreements (repos) secured loans with
T-bills as collateral mainly bank debt federal
funds overnight inter-bank loans out of their
deposits at the Federal Reserve federal funds
rate is a measure of the tightness of the credit
markets bankers acceptances similar to a bank
draft that can be sold in a secondary market
corporate debt Should we include paper currency
and coin in this list? long and intermediate
term debt or capital market debt instruments
more than a years maturity mortgages loans to
buy real estate which is the collateral
intermediaries play a major role lenders are
banks, savings and loan associations, financial
companies
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these loans are financed by selling mortgage
backed securities (which are guaranteed by
government agencies like GNMA (Ginnie Mae), FHLMC
(Freddie Mac)) in secondary markets to
institutional investors, government agencies like
FNMA(Fannie Mae), corporate bonds interest
bearing, long term corporate debt may be
convertible US government bonds long term
government debt mostly used to finance budget
deficits US government agency bonds long term
debt of govt. agencies such as Ginnie
Mae municipal bonds long term debt of state and
local governments consumer and commercial loans
household and corporate debt, not usually traded
in secondary markets
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equities or claims on residual income are
usually non-debt i.e. loan amount does not have
to be repaid, hence no maturity period payments
to the borrowers are contingent on the issuers
performance Are we talking about a different type
of risk here? common stocks yields periodic
dividends holders (lenders) are largely
institutional investors called funds common
international debt instruments Foreign bonds
bonds issued by foreign companies sold in the
home country in home currency units Eurobonds a
foreign bond denominated in another (not home)
currency units Eurocurrenciesforeign currencies
deposited in banks outside the home country
Eurodollars are US dollars deposited in foreign
banks outside the US or foreign branches of US
banks
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For the curious the course does not discuss but
there exist other types of financial instruments
which are neither debt nor equities derivatives
futures on commodities, financial instruments,
indices options on stocks, futures, debts,
indices, other financial instruments hybrids
contractual securities swap or a contract to
trade one security for another hybrids
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III. Role of financial intermediaries intermediari
es borrow funds from households (savers) and lend
them to businesses (dis-savers) they have no
funds of their own borrowing is done by issuing
debts and equities to households lending is done
by buying debts and equities of
businesses. Intermediaries help maintain the
competitive character of financial markets
by, reducing transaction costs of small lenders
or borrowers examples of transaction costs are
brokerage fees, cost of doing research
etc. reducing problems related to asymmetric
information (adverse selection and moral hazard)
for small lenders or borrowers Reducing risk
(risk sharing) to small lenders by diversifying
and through asset transformation
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• IV. Types of intermediaries
• depository institutions accepts deposits from
  savers - which are therefore their debt lends
  them to others loans are their assets or
  securities
• commercial banks, savings and loan
  associations, credit unions, mutual savings banks
• all issue a variety of checking, savings or
  time deposits and lend to government (federal,
  state or local), consumers or businesses
• depository institutions are heavily
  regulated in their asset composition, as they are
  supposed to provide liquidity to small savers
• B) contractual savings institutions borrow at
  set intervals from lender-savers on a contractual
  basis pays returns or benefits on a contractual
  basis insurance companies, pension funds

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C) investment intermediaries borrows and lends
by using a variety of financial instruments, more
exposed to the risks of financial markets than
category A or B finance companies, mutual funds
of stocks, bonds and other instruments money
market mutual funds Which category does
investment bank belong to?
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Sources and uses of funds of important
intermediaries Intermediaries
sources of funds uses of funds 1.
commercial banks deposits
loans, govt. bonds,

mortgages etc. 2. savings and loan assoc.
deposits mortgages 3. credit
unions deposits
mortgages 4. pension funds
contributions stocks and bonds 5.
mutual funds shares
stocks and bonds 6. money market funds
shares short term assets


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V. Role of regulation government regulations are
essentially aimed at providing more information
to investors so that problems related to
asymmetric information are reduced SEC has a
special role providing insurance in the event of
a breakdown Ensuring soundness of the financial
system restrictions on entry limits on
competition disclosure requirements restrictions
on portfolios and activities restrictions on
payments