Financial System Overview and the Flow of Funds

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Financial System Overview and the Flow of Funds

• Week 1 August 24, 2005

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The Financial System

• What happened on August 9, 2005?
• What was market reaction?
• What are the linkages between those actions and
  business conditions?
• What is occurring in financial markets?
• Interest rates, mortgage borrowing, restructuring
  of financial firms?
• New financial products?
• What framework can be used to comprehend these
  important changes?

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Market Reaction Summer 2005
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This course

• Overview of institutions and markets
• Major institutions and their regulators
• Interest rate determination
• Risk. risk management, and risk premiums
• Important financial markets in depth
• Closer scrutiny of the money market and important
  factors influencing conditions
• Detailed review of important credit markets and
  the market for equity

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Readings in text first two weeks

• This evening will we cover Chapters 1 to 3
• Chapter 1 - Functions of financial system
• Chapter 2 - Markets and funds flows
• Chapter 3 - Efficient markets and information
• Try to review these and raise any questions by
  next time, they are introductory
• Next week, cover Chapters 14 and 15
• Chapter 14 Banks
• Chapter 15 Non-bank thrift institutions

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Stages of financial systems

• Each unit is independent, investments accumulate
  over time, e.g. a farm
• Units can accumulate value in monetary asset
  (e.g. claim on government) in order to save for
  large investments
• Units can borrow and lend individually
• Financial intermediaries raise funds from saving
  units and lend to investing units

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Circular Flows

• Goods and services
• National product accounts, gross domestic product
• Produced by Commerce Department
• Income flows
• National income accounts
• These accounts do not reflect financial market
  activity
• Flow of Funds Accounts of Federal Reserve system
  track financial flows

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Financial Markets

• Money and capital markets
• Open versus negotiated markets
• Competitive market-based funding versus
  intermediated or bank-dominated funding markets
• Primary versus secondary markets
• Spot versus futures, forward, and option markets

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Balance Sheets and Flows
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Sources and uses flows

• Sources and uses are changes in balance sheets
• We want to look at both
• Balance sheets represents stocks, hence total
  size, at a point in time
• Flows represent net changes in stocks (I.e. new
  issues minus repayments of financial assets or
  liabilities)

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Balance sheets and portfolios

• Assets Liabilities (net worth equity,
  common stock shares, etc.)
• Assets
• Financial assets
• Money, loans and bonds, equity investments
• Real assets
• Housing, consumer durables including autos
• Inventory, plant and equipment

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Balance sheets/portfolios (contd)

• Liabilities
• Monetary liabilities (loans, mortgages)
• Other financial liabilities
• Net worth is composed of equity in real assets
  and net financial claims on others
• Sectors are aggregate balance sheets of similar
  units
• Households, business, government
• Financial institutions

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Sectoral balance sheets

• Balance sheets of Households and Non-profit
  organizations
• 2004 largest real and financial assets
• 2004 largest liabilities
• 2004 composition of real asset holdings
• share of monetary assets
• Compare 1980 balance sheets
• Share changes growth and change in portfolio
  composition

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Sectoral balance sheets (contd)

• Farm non-farm non-financial non-corporate
  non-farm non-financial corporate business
• Non-farm non-financial corporate balance sheet
• 2004 largest assets
• 2004 largest liabilities
• 2004 composition of real asset holdings
• share of monetary assets
• Compare 1980 balance sheets

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Wealth and flow of funds

• Primary sectors households, business government
• Financial sector
• Financial claims - financial liabilities (small
  holdings of real assets)
• Aggregate wealth is real assets since all
  financial claims cancel

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Wealth

• Total wealth in 2004 is approximately (billions)
  22,566.2 10,479.1 6,407.9 39.5 trillion
• 2004 GDP is 11,734.9 trillion, so income-capital
  ratio is approximately .30 or capital-income
  ratio 3.4
• 1980 wealth approximately 9,729.7 trillion, GDP
  2,789.5 trillion, so capital-income ratio is
  also about 3.5 (about the same)
• GDP over assets in 1980 and 2004 around 30
• Has tangible wealth composition changed?

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Distribution of GDP

• Employee compensation in 2004 was 6,651, or
  56.7 of GDP
• Business tangible assets were 16,887.0 or 40.7
  of total tangible assets
• Roughly gross before tax return on business
  investment is
• Gross return illustrates top down approach

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Composition of wealth

• Compare composition of tangible
  assets 1980 2004Households Real Estate
  78 83 Durables 21
  16Business (corporate non-corporate) Real
  Estate 67 68 PE 22
  23 Inventories 11 9
• Think of other economies

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The Financial System

• Channels savings into investment
• Financial institutions assist in this process
• Financial institutions create value for primary
  surplus and deficit units through
• Increasing economic efficiency
• Providing financial servies
• The value of flow of funds framework is that we
  can trace the changing roles of financial
  institutions

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Next time

• Before next Wednesday, review Chapters 1 to 3 of
  Money and Capital Markets and identify any
  questions about this evenings session
• Read Chapters 14 and 15 of Money and Capital
  Markets
• Bring a Wall Street Journal to class every Tuesday