Financial markets

and Institutions

Required Reading: Mishkin, Chapter 1 and

Chapter 2

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CONTENTS

FINANCIAL MARKETS
FINANCIAL INSTITUTIONS
FINANCIAL REGULATIONS

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AN OVERVIEW OF FINANCIAL
SYSTEM

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I. AN OVERVIEW OF FINANCIAL
MARKETS

What is Financial Markets?

Structure of Financial markets?
Instruments traded in Financial markets?
Functions of Financial markets

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What is Financial system?
Financial system (FS) a framework for
describing set of markets, organisations, and
individuals that engage in the transaction of
financial instruments (securities), as well as
regulatory institutions.
- the basic role of FS is essentially channelling of
funds within the different units of the economy
from surplus units to deficit units for
productive purposes.

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1. What is Financial Markets?
Financial markets perform the essential function of
channeling funds from economic players that have saved
surplus funds to those that have a shortage of funds
At any point in time in an economy, there are individuals or
organizations with excess amounts of funds, and others
with a lack of funds they need for example to consume or
to invest.

Exchange between these two groups of agents is

settled in financial markets
The first group is commonly referred to as lenders, the
second group is commonly referred to as the
borrowers of funds. 6
I.1 What is Financial Markets?
We will start our discussion on financial markets with some
basic definitions:
There exist two different forms of exchange in financial markets.
The first one is direct finance, in which lenders and borrowers
meet directly to exchange securities.
Securities are claims on the borrowers future income or assets.
Common examples are stock, bonds or foreign exchange
The second type of financial trade occurs with the help of
financial intermediaries and is known as indirect finance. In this
scenario borrowers and lenders never meet directly, but lenders
provide funds to a financial intermediary such as a bank and
those intermediaries independently pass these funds on to
borrowers

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I.2 Structure of Financial Markets
Financial markets can be categorized as follows:

Debt vs Equity markets

Primary vs Secondary markets
Exchange vs Over the Counter (OTC)
Money vs Capital Markets

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 Debt vs Equity
Financial markets are split into debt and equity markets.

Debt titles are the most commonly traded security. In these arrangements,
the issuer of the title (borrower) earns some initial amount of money
(such as the price of a bond) and the holder (lender) subsequently receives
a fixed amount of payments over a specified period of time, known as
the maturity of a debt title.
Debt titles can be issued on short term (maturity < 1 yr.), long term
(maturity >10 yrs.) and intermediate terms (1 yr. < maturity < 10 yrs.).

The holder of a debt title does not achieve ownership of the borrowers
enterprise.

Common debt titles are bonds or mortgages.

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 Debt vs Equity
Equity titles are somewhat different from bonds. The most common
equity title is (common) stock.

First and foremost, an equity instruments makes its buyer (lender) an

owner of the borrowers enterprise.

Formally this entitles the holder of an equity instrument to earn a share of

the borrowers enterprises income, but only some firms actually pay
(more or less) periodic payments to their equity holders known as
dividends. Often these titles, thus, are held primarily to be sold and
resold.

Equity titles do not expire and their maturity is, thus, infinite. Hence
they are considered long term securities.

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PRIMARY MARKETS Vs SECONDERY MARKETS

Markets are divided into primary and secondary markets

Primary markets are markets in which financial instruments are

newly issued by borrowers.

Secondary markets are markets in which financial instruments

already in existence are traded among lenders.

Secondary markets can be organized as exchanges, in which titles

are traded in a central location, such as a stock exchange, or
alternatively as over-the-counter markets in which titles are sold
in several locations.

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MONEY MARKETS VS CAPITAL MARKETS

Finally, we make a distinction between money and capital markets.

Money markets are markets in which only short term debt titles
are traded.

Capital markets are markets in which longer term debt and equity
instruments are traded.

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 I.3 INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS
Principal Money Market Instruments (maturity < 1 yr.)

Source: Miskin 13
 I.3. INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS (Cont)
INSTRUMENTS TRADED IN THE CAPITAL MARKETS

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Source: Miskin
 I.3 INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS

Most commonly you will encounter:

Corporate stocks are privately issued equity instruments, which
have a maturity of infinity by definition and, thus, are classified as
capital market instruments

Corporate bonds are private debt instruments which have a

certain specified maturity. They tend to be long-run instruments
and are, hence, capital market instruments

The short-run equivalent to corporate bonds are commercial

papers which are issued to satisfy short-run cash needs of private
enterprises.
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 I.3 INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS

Most commonly you will encounter:

On the government side, the most commonly used long-run debt
instruments are Treasury Bonds or T-Bonds. Their maturity exceeds ten
years.

Short-run liquidity needs are satisfied by the issuance of Treasury Bills

or T-Bills, which are short-run debt titles with a maturity of less than one
year.

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 Valuing a Bond

C1 C2 1,000 CN
PV 1
2
... N
(1 r) (1 r) (1 r)

Price of a bond is the sum of the discounted future cash flows.

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 Valuing a Bond
What is the discount rate = market determined,
affected by perceived risk?

As discount rates the price

Inverse relationship between price and yield

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 Valuing a Bond
Clearly higher rates lead to a fall in price

Also note: Bond price par

as bond maturity.

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Interest Rates
Sensitivity of bond prices to interest rate changes?

Longer dated bonds - more sensitive

Lower coupon bonds - more sensitive

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What effects bond prices?
1. Interest rates
2. Coupon and Maturity
3. Credit ratings, (Moodys, S&P etc.)
4. Economic Environment

Flight to quality?

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 Functions of Financial markets

Borrowing and Lending

Financial markets channel funds from households, firms,
governments and foreigners that have saved surplus funds to those
who encounter a shortage of funds (for purposes of consumption
and investment)

Price Determination
Financial markets determine the prices of financial assets. The
secondary market herein plays an important role in determining the
prices for newly issued assets
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 Functions of Financial markets
Coordination and Provision of Information
The exchange of funds is characterized by a high amount of incomplete
and asymmetric information. Financial markets collect and provide much
information to facilitate this exchange.

Risk Sharing
Trade in financial markets is partly motivated by the transfer of risk from
borrowers to lenders who use the obtained funds to invest

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 Functions of Financial markets

Liquidity
The existence of financial markets enables the owners of assets to
buy and resell these assets. Generally this leads to an increase in
the liquidity of these financial instruments

Efficiency
The facilitation of financial transactions through financial markets
lead to a decrease in informational cost and transaction costs,
which from an economic point of view leads to an increase in
efficiency.
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 II.FINANCIAL INSTITUTIONS
What are Financial Institutions?
Financial Institutions and their function
Types of Financial Institutions

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II.1What are Financial Institutions ?

Financial intermediaries are firms that collect the funds from lenders and
channel those funds to borrowers (Mishkin)
Financial intermediaries are firms whose primary business is to provide
customers with financial products and services that can not be obtained
more efficiently by transacting directly in securities markets (Z.Bodie
&Merton)

Any classification of financial institutions is ultimately somewhat

arbitrary, since financial markets are subject to high dynamics and
frequent innovation. Thus, we roughly use four categories:
Brokers
Dealers Engage in trade in securities
Investment banks (direct finance)

Financial intermediaries Engage in financial asset

transformation (indirect
finance) 26
II.1What are Financial Institutions? (Cont)

Brokers are agents who match buyers with sellers for a desired
transaction.

A broker does not take position in the assets she/he trades (i.e. does not
maintain inventories of those assets)

Brokers charge commissions on buyers and/or sellers using their services

Examples: Real estate brokers, stock brokers

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II.1What are Financial Institutions? (Cont)

Like brokers, dealers match sellers and buyers of financial assets.

Dealers, however, take position in their assets, their trading.

As opposed to charging commission, dealers obtain their profits from

buying assets at low prices and selling them at high prices.

A dealers profit margin, the so-called bid-ask spread is the difference

between the price at which a dealer offers to sell an asset (the asked
price) and the price at which a dealer offers to buy an asset (the bid
price)

Examples: Dealers in U.S. government bonds, Nasdaq stock dealers

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II.1What are Financial Institutions? (Cont)

Investment Banks

Investment banks assist in the initial sale of newly issued securities (e.g.
IPOs)

Investment banks are involved in a variety of services for their customers,

such as advice, sales assistance and underwriting of issuances

Examples: Morgan-Stanley, Goldman Sachs, ...Lehman Brothers

..(Before Crisis 2008)

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II.1What are Financial Institutions? (Cont)
Financial Intermediaries

Financial intermediaries match sellers and buyers indirectly through the

process of financial asset transformation.
As opposed to three above mentioned institutions. they buy a specific
kind of asset from borrowers usually a long term loan contract and
sell a different financial asset to savers usually some sort of highly-
liquid short-run claim.
Although securities markets receive a lot of media attention, financial
intermediaries are still the primary source of funding for businesses.
Even in the United States and Canada, enterprises tend to obtain funds
through financial intermediaries rather than through securities
markets.
Other than historic reasons, this prevalence results from a variety of
factors.
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 II.2 Function of Financial Intermediaries:
Indirect Finance
Lower transaction costs
Economies of scale
Liquidity services
Since transaction costs are reduced, financial intermediaries are able to provide
customers with additional liquidity services, such as checking accounts which can be
used as methods of payment or deposits which can be liquidated any time while still
bearing some interest.

Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Through the process of asset transformation not only maturities, but also the risk
of an asset can change: A financial intermediary uses funds it acquires (e.g.
through deposits) and often turns them into a more risky asset (e.g. a larger loan).
The risk then is spread out between various borrowers and the financial
intermediary itself.
The process of risk sharing is further augmented through diversification of 32assets
(portfolio-choice), which involves spreading out funds over a portfolio of assets
 II.2 Functions of Financial Intermediaries:
Indirect Finance
Reduce Asymmetric Information
Asymmetric Information in financial markets - one party often
does not know enough about the other party to make accurate
decisions.
Adverse Selection (before the transaction)more likely to
select risky borrower
Moral Hazard (after the transaction)less likely borrower will
repay loan
=> Financial intermediaries are important in the production of
information. They help reduce informational asymmetries
about some unobservable quality of the borrower for example
through screening, monitoring or rating of borrowers, Net
worth and collateral.

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II.2 Functions of Financial Intermediaries:
Indirect Finance

Finally, some financial intermediaries specialize on services such as

management of payments for their customers or insurance contracts
against loss of supplied funds.

Through all of these channels financial intermediaries increase market

efficiency from an economic point of view.

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 II.3TYPES OF FINANCIAL
INTERMEDIARIES
There are roughly three classes of financial intermediaries:
Depository institutions accept deposits from savers and transform
them into loans (Commercial banks, savings and loan associations,
mutual savings banks and credit unions)

Contractual savings institutions acquire funds at periodic intervals

on a contractual basis (insurance and pension funds)

Investment intermediaries serve different forms of finance. They

include finance companies, mutual funds and money market
mutual funds.

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 Commercial Bank

Savings and Loans Associations (S&L)

Depository
Institutions Mutual Saving Banks

Credit Unions

Specialized Banks

Financial Contractual
Intermed savings Insurance Companies
iaries Institutions
Pension Funds

Finance Companies
Investment
Intermedarie
s Mutual Funds (Investment Funds)
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Money market Mutual Funds

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 III. FINANCIAL REGULATION
Why regulate financial markets?
Financial markets are among the most regulated
markets in modern economies.

The first reason for this extensive regulation is to

increase the information available to investors (and,
thus, to protect them).

The second reason is to ensure the soundness of the

financial system.
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III. FINANCIAL REGULATION
1. Increasing information available to investors

As mentioned above, asymmetric information can cause severe

problems in financial markets (Risk behavior, insider trades,....)
Certain regulations are supposed to prohibit agents with superior
information from exploiting less informed agents.

In the U.S. the stock-market crash of 1929 led to the

establishment of the Securities and Exchange Commission
(SEC), which requires companies involved in the issuance of
securities to disclose certain information relevant to their
stockholders. The SEC further prohibits insider trades

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III. FINANCIAL REGULATION
2. Ensuring the soundness of financial intermediaries

Even more devastating consequences from asymmetric information

manifest themselves in collapses of the entire financial system so
called financial panics.

Financial panics occur if providers of funds on a large scale withdraw

their funds in a brief period of time from the financial system leading
to a collapse of the system. These panics can produce enormous damage
to an economy.

Examples of some recent panics are the crises in the Asian Tiger states,
Argentina or Russia. The United States, while spared for most of the
second half of 20th century, has a long tradition of financial crises
throughout the 19th century up to the Great Depression.
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III. FINANCIAL REGULATION
3. Solutions for ensuring the soundness of financial
intermediaries

Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates

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 Financial regulation
Limits to Competition
An argument of politics rather than economics is that overly hard
competition in the banking sector increases the risk of bank
failure. This belief has (especially in the past) led to some
restrictions in the commercial banking sectors

In the U.S. private banks e.g. were prohibited to open branches in

different states

The empirical evidence for the benefits of limiting competition is

weak and from an economic point of view it appears more as an
obstacle to risk diversification rather than a useful regulation

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 Financial regulation
Restriction of interest rates

The experience of the Great Depression in the U.S. has led to the
widespread belief that interest rate competition paid on deposits
might facilitate bank failure and to strong regulation of interest
rates on bank deposits

Unlike most other developed economies, banks in the U.S. were

prohibited from paying any interest on deposits from 1933. Under
what is known as Regulation Q, the Federal Reserve System had the
power to set the maximum interest rates payable on savings deposits
until 1986.

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