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Chapter 2: The Financial System
Chapter 2 Contents
What is a Financial System
The Flow of Funds
The Functional Perspective
Financial Innovation & the “Invisible Hand”
Financial Markets
Financial Market Rates
Financial Intermediaries
Financial Infrastructure and Regulation
Governmental & Quasi-Governmental Organizations
What is the Financial System?
The financial system encompasses
markets
Intermediaries
other institutions
used to carry out the financial decisions of households, business firms, and governments.
What is the Financial System?
Exchanges & over-the-counter (OTC, off-exchange) markets
Financial intermediaries
providing financial services and products
banks, investment companies, and insurance companies
checking accounts, commercial loans, mortgages, mutual funds, insurance contracts and many other contracts
Financial markets and intermediaries are
linked through networks and global in scope
governed by the regulatory institutions
The Flow of Funds
Fund Flows via Market
Fund Flows via Intermediary
Fund Flows via Intermediary and Market
Fund Flows via Markets and Intermediaries
Funds Flow: Disintermediation
Funds Flow: Secured Credit
The Functional Perspective on Financial System
Financial institutions generally differ across borders and also change over time.
The functional perspective
Financial functions are more stable than financial institutions.
Institutional form follows function.
The primary function of financial system is efficient resource allocation.
Six Key Financial Functions
Transferring Resources across Time & Space
Managing Risk
Clearing and Settling Payments
Pooling Resources and Subdividing Shares
Providing Information
Dealing with the Incentive Problems
Transferring Resources across Time & Space
To facilitate intertemporal transfers of resources
Student loans
Venture capitals
To play an important role in shifting resources from one place to another
The transfer of underused capital from Germany to Russia
The retirement savings of Japanese workers to be used to finance the house purchased by a young couple in the United States
Quick Check
Give an example of a transfer of resources over time that takes place through the financial system.
Is there a more efficient way for this transfer of resources to be handled?
Managing Risk
Transfers of risks through financial system
Insurance policies
The flow of funds bundled with the flow of risks
Finance $100,000 to start a business
$70,000 from an investor, in equity capital in return for a 75% share of the profits
$30,000 from a bank, at an interest rate of 6% per year
The flow of funds unbundled with the flow of risks
A guaranteed loan
Quick Check
Give an example of a transfer of risk that takes place through the financial system.
Clearing and Settling Payments
A financial system provides an efficient payments system to facilitate the exchange of goods, services, and assets.
Traveling abroad
The development of checks, credit cards, and electronic funds transfer
Pooling Resources and Subdividing Shares
A variety of mechanisms to pool or aggregate the wealth of households into large masses of capital
Opportunities for individual households to participate in investments that require large lump sums of money by pooling their funds and then subdividing shares in the investment
You, having only $10,000, want to invest in a race horse that costs $100,000.
Investing in U.S.Treasure bills with the minimum denomination of $10,000 and money-market funds.
Providing Information
Price information that helps coordinate decentralized decision-making in various sectors of the economy
You are 30 years old, just got married, and want to buy a house for $100,000.
Your local bank will make you a mortgage loan for $80,000 at an interest rate of 8% per year, but you need to pay 20% down.
Your 45-year-old sister has a savings account with $20,000 in it for her retirement, earning 6% per year.
If your sister is willing to lend you her retirement savings for your down payment, how do you decide what a “fair” rate of interest rate?
Providing Information
A firm, earning $10 million in profits in a good year, is faced with deciding whether to reinvest it in the business, pay it out in cash dividends to shareholders, or use it to buy back its own shares.
Whenever a new financial instrument is introduced, new possibilities for information extraction are created as a “by-product”.
The trading of option contracts & the information about the volatilities of financial markets
Incentive Problems
Incentive Problems may arise when one party to a financial transaction has information that the other party does not, or when one party is an agent that makes decisions for another.
Incentive Problems limit the ability of a financial system to perform some of the functions.
The Moral-Hazard Problem
The problem exists when having insurance against some risk causes the insured party to take greater risk or to take less care in preventing the event that gives rise to the loss.
Fire insurance for a warehouse
Asymmetry information & financing business ventures
Quick Check
Give an example of how the problem of moral hazard might prevent you from getting financing for something you want to do. Can you think of a way of overcoming the problem?
The Adverse Selection Problem
The problem exists when those who purchase insurance against risk are more likely than the general population to be at risk.
Life annuities
Car leasing
Quick Check
Suppose a bank offered to make loans to potential borrowers without checking their credit history. What would the true of the types of borrowers they would attract compared to banks that did checks of credit history? Would such a bank charge the same interest rate on loans as banks that check credit history?
The Principal-Agent Problem
The problem arises when those who bear the risks associated with the decisions (the principals) delegate the decision-making authority to others (the agents).
Shareholders in a corporation delegate the running of the firm to its managers
Investors in a mutual fund delegate the authority to select the mix of their security holdings to a portfolio manager
Agents may not make the same decisions that the principals would have made if they knew what the agents know and were making the decisions themselves.
Dealing with Incentive Problems
A well-functioning financial system facilitates the resolution of the incentive problems.
Collateralization of loans
Performance-based compensation of management
Takeovers
Conflicts of interest between shareholders and creditors: “equity-kickers”
Financial Innovation and the “Invisible Hand”
Financial innovations are not planned by any central authority but arise from the individual actions of entrepreneurs and firms.
Adam Smith’s observation:
In a competitive market economy, by pursuing one’s own interest one frequently promotes that of society more effectually than when one really intends to promote it.
Financial Innovation and the “Invisible Hand”
An Illustration: Credit Card Business
Another Illustration: Mortgages & securitization
Financial innovations have greatly improved the opportunities for people to receive efficient risk-return trade-offs in their personal investments and more effective tailoring to their individual needs over the entire life cycle.
Analysis of consumer preferences and the forces of competition among financial-service providers helps one to make predictions about future changes in the financial system.
Financial Markets
Basic types of financial assets
Debt (fixed-income instruments)
Equity (the claim of the owners of a firm, residual claim, limited liability)
Derivatives (their value derived from the prices of other assets, options and forward contracts)
Classification by the maturity
Money market (for short term debt, less than one year, globally integrated and liquid)
Capital market (long term debt and equity securities)
Derivatives Instruments Markets
Interest Rates
Financial prices and financial market indicators
An interest rate is a promised rate of return on a fixed-income instrument and depends on the three important factors.
Unit of account
Maturity
Default risk
A variety of interest rates
commercial loan rate, mortgage rate
Effect of Unit of Account: An Illustration
Effect of Unit of Account: An Illustration
Effect of Unit of Account: An Illustration
Effect of Maturity
Effect of Default Risk: Yield Comparisons
Rates of Return on Risky Assets
Market Indexes and Market Indexing
Indexes is a measure of the overall level of stock prices.
Somebody might want a indicator or benchmark against which to measure the value or performance of their investment.
Market Indexes and Market Indexing
Indexing is an investment approach
that seeks to match the investment returns of a specified stock-market index by holding all or a representative sample in the case of very large index (replicate).
emphasizing broad diversification and low portfolio trading activity (cost advantage and “passive” investment strategy).
It is impossible for all stock investors in the aggregate to outperform the overall stock market.
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