Overview of The Financial System

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Overview of The Financial System

• Prof. Yoram Landskroner
• MB, Summer 2004

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Financial System

• Economic Functions of the Financial System
  Markets, instruments and Institutions.
• Main Function of Financial System Allocation of
  Resources.
• How? Who? What?

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Financial System

• Topics
• 1. Savings vs. Investments.
• 2. Stages of Efficiency in Allocation of
  Resources Direct vs. Indirect Financing and
  Financial Intermediation
• reasons for existence
• Specialness
• 3. Financial Markets and Instruments.
• 4. Markets Participants.

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Savings vs. Investments

• Important economic aggregates, affect aggregate
  output (economic activity) business cycles
  economic growth
• What are they?
• Investment process of capital formation-
  increase in productive capacity.
• Tangible real assets buildings, equipment,
  inventories (materials)
• (Net) addition to stock of capital- concept of
  flow
• In modern economy done mostly by business

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Savings vs. Investments

• Savings residual concept
• Saving Income Consumption
• By households, business (retained earnings),
  government (budget surplus)
• Relationship between savings and investments on a
  national level
• S Y- C
• Y C I
• Where Y national income national product
• C consumption S saving
• I investments

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Savings vs. Investments

• This is a budget constraint where uses (of funds)
  have to equal sources (ex post).
• The constraint holds also for each economic unit!
• Main functions of the financial system
• Separation of savings from investments of
  economic unit external as well as internal
  financing.
• Transfer of funds (sources) from surplus (saving)
  units to deficit (investment) units.
• Figure

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Stages of Efficiency in the Financial System

• In increasing order of efficiency
• Barter economy - starting point (yardstick),
• money does not exist, trade in kind
• no or very limited transfer of sources between
  economic units
• Internal financing only- investment of each
  unit is constrained by its saving
• implications?

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Stages of Efficiency in the Financial System

• External Direct Financing- separation between
  saving and investment, direct link between
  surplus (saving) and deficit (investment)
  economic units
• introduce financial assets claim on future
  income and /or property- primary security
• Types of assets/securities
• debt- bonds
• equity- common stock

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Stages of Efficiency in the Financial System

• Primary Market where financial assets are issued
• meeting place for issuers of assets (demand for
  funds) and buyers of new issues (supply of funds)
• demand and supply of funds meeting place
• financial institutions brokers, underwrites

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Stages of Efficiency in the Financial System

• Indirect financing and financial intermediation
• flow of funds from saving units to investment
  units is indirect through intermediary who issues
  its own liability/security secondary security
• Include Com. Banks, insurance comp., pension and
  mutual funds.
• Disintermediation shift of funds from financial
  intermediary to direct financing

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• Reasons for existence of FI
• Asymmetric information important aspect of
  financial market, demander of funds (firm) have
  better information on firm/project than external
  suppliers of funds
• Example managers have better information about
  their business than stockholders and bondholders.
• This leads to
• Adverse selection due to AI, occurs before the
  transaction takes place bad customers are the
  ones most actively seeking to raise funds .
• Example bad credit risks most eager to get a
  loan

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• ? Lenders may decide not to make loans at all
  though there are good risks in the market-
  credit crunch.
• Moral Hazardoccurs after the transaction the
  borrower may engage in a risky activity that is
  undesirable to the lender
• Example borrower undertakes risky project with
  possible high return. The lender shares the bad
  outcome but not the good one
• ?credit crunch

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Specialness of Financial Intermediaries

• Benefits- economies of financial intermediation
• Information Costs
• High cost of information collection
• Savers must monitor firms (investors), failure to
  do so exposes them to agency costs
• Savers appoint FI as a delegated monitor on
  their behalf
• FI have incentive to collect information and do
  it at lower costs due to economies of scale

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Specialness of Financial Intermediaries

• Transaction Costs
• Economies of scale in cost
• Reduced bid-ask spread and transaction cost
  (commissions), however may have greater price
  impact

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Specialness of Financial Intermediaries

• Liquidity, divisibility and flexibility
• Secondary securities more liquid
• Denomination transformation Small savers vs.
  large firms
• Maturity Transformation
• Reduce risk through maturity intermediation,
  reduce maturity mismatch
• Interest rate regime transformation
• Reduce mismatch
• Fixed vs. variable rate
• Currency transformation

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• Price Risk
• Ability to diversify reduces risk
• Related to size of FI many failures of small
  depository institutions in 1980s, undiversified
  geographically or in products

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• Financial Markets and Instruments
• primary vs. secondary market
• newly issued financial claims fund raising
• exchanging securities previously issued
  (seasoned)liquidity, price disclosure
• money vs. capital
• short-term debt (maturitylt 1 year)
• longer term debt and equity
• bond vs. stock
• debt instrumentcontractual agreement to repay
  principal and interest
• equityresidual claim on net income and assets of
• firm periodic dividends

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• organized vs. over-the-counter
• exchange central location to conduct trade
  (NYSE, CBT) clearing house assumes credit risk
• OTC dealers in different locations (NASDAQ,Govt.
  bonds)
• spot vs. forward/futures and options
• settlement and delivery within two days
• future delivery of assets at specified price and
  date
• symmetric vs. asymmetric agreement
• foreign exchange
• spot and futures/forward
• organized and OTC market

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• Market Participants
• households savers???
• nonfinancial business firms investment
• financial institutions
• depository institutions (banks) issue financial
  claims held by final wealth holders funds to
  final demanders of funds
• other financial intermediaries (insurance,
  pension, investment companies)
• non-intermediaries brokers ,dealers,
  underwriters

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• Market Participants
• US government
• Federal Reserve OMO
• US Treasury bills, notes and bonds
• Government agencies related (EXIM,FNMA),
  sponsored- privately owned (Sallie Mae)
• Local government municipal, interest exempt
  from federal taxation
• Foreigners savings or investments?
• THE END