Chapter

Financial Assets, Money, Financial Transactions, and Financial Institutions

Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition

Peter S. Rose

McGraw Hill / Irwin

Slides by Yee-Tien (Ted) Fu

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Learning Objectives
 To learn about the channels through which funds flow between lenders and borrowers within the global financial system.  To discover the nature and characteristics of financial assets how they are created and retired by decision-makers within the financial system.  To explore the critical roles played by money and the linkages between money and inflation.
McGraw Hill / Irwin
2003 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives
 To examine how financial intermediaries and other financial institutions lend and borrow funds and create and retire financial assets within the global system of markets.

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Introduction
 The financial system is the mechanism through which loanable funds reach borrowers.  Through the operation of the financial markets, money is exchanged for financial claims in the form of stocks, bonds, and other securities, effectively transforming savings into investment so that production, employment, and income can grow.
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The Creation of Financial Assets

A financial asset is  a claim against the income or wealth of a business firm, household, or unit of government,  represented usually by a certificate, receipt, computer record file, or other legal document,  and usually created by or related to the lending of money.
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Characteristics of Financial Assets

 Financial assets are sought after because they promise future returns to their owners and serve as a store of value (purchasing power).

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Characteristics of Financial Assets

 They do not depreciate like physical goods, and their physical condition or form is usually not relevant in determining their market value.  Their cost of transportation and storage is low, such that they have little or no value as a commodity.  Financial assets are fungible they can easily be changed in form and substituted for other assets.
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Different Kinds of Financial Assets

Any financial asset that is generally accepted in payment for the purchases of goods and services is a form of money. Examples include currency and checking accounts. Equities represent ownership shares in a business firm and are claims against the firms profits and proceeds from the sale of its assets. Common stock and preferred stock are equities.
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Different Kinds of Financial Assets

Debt securities entitle their holders to a priority claim over the holders of equities to the assets and income of an economic unit. They are either negotiable or nonnegotiable. Examples include bonds, notes, accounts payable, and savings deposits. Derivatives have a market value that is tied to or influenced by the value or return on a financial asset. Examples include futures contracts, options, and swaps.
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The Creation Process for Financial Assets

 To acquire assets, households and business firms may use current income and accumulated savings internal financing.  An economic unit may also raise funds by issuing financial liabilities (debt) or stock (equities), provided that a buyer can be found external financing.

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Financial Assets and the Financial System

 The act of borrowing or of issuing new stock simultaneously gives rise to the creation of an equal volume of financial assets. For example, a $10,000 financial asset held by a household that had lent money will be exactly matched by a $10,000 liability of the business firm that had borrowed the money. Volume of financial assets created for lenders = Volume of liabilities issued by borrowers
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Financial Assets and the Financial System

 For the balance sheet of any economic unit, Total assets = Total liabilities + Net worth where assets = real assets + financial assets  For the whole economy and financial system, Total financial assets = Total liabilities So, for the economy as a whole, Total real assets = Total net worth
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Financial Assets and the Financial System

 So, society increases its wealth only by saving and increasing the quantity of its real assets, for these assets enable the economy to produce more goods and services in the future.  However, the financial system provides the essential channel necessary for the creation and exchange of financial assets between savers and borrowers so that real assets can be acquired.
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Lending and Borrowing in the Financial System

 Economists John Gurley and Edward Shaw (1960) pointed out that each business firm, household, or unit of government active in the financial system must conform to: R E = (FA (D
where R E (FA (D
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= = = =

Current income receipts Current expenditures Change in holdings of financial assets Change in debt and equity outstanding
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Lending and Borrowing in the Financial System

 So, for any given period of time, the individual economic unit falls into one of three groups: Deficit-budget unit (DBU): E > R, (D > (FA
i.e. net borrower of funds

Surplus-budget unit (SBU): R > E, (FA > (D

i.e. net lender of funds

Balanced-budget unit (BBU): R = E, (D = (FA

i.e. neither net lender nor net borrower
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Lending and Borrowing in the Financial System

The U.S. Economy, 3rd Quarter of 2001 (Annualized)
Major Sectors of the Economy Households Nonfinancial business firms State and local governments Federal government International sector: foreign investors and borrowers Net Net Net Lender(+) Acquisitions Increase or Net in of Financial Borrower(-) Liabilities of Funds Assets $857.8 216.0 29.2 179.5 435.4 $853.1 247.2 68.6 252.2 58.6 $ 4.7 - 31.2 - 39.4 - 72.7 376.8

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts

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Lending and Borrowing in the Financial System

 The global financial system permits businesses, households, and governments to adjust their financial position from that of net borrower (DBU) to net lender (SBU) and back again, smoothly and efficiently.

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What is Money?
 All financial assets are valued in terms of money, and flows of funds between lenders and borrowers occur through the medium of money.  Money itself is a true financial asset, because all forms of money in use today are claims against some institution, public or private.

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What is Money?
M3 M2 M1 The most liquid forms of money, namely currency and checkable deposits. Household holdings of savings deposits, small time deposits, and retail money market mutual funds. Institutional money funds and certain managed liabilities of depositories, namely large + time deposits, repurchase agreements, and Eurodollars.

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U.S. Money Aggregates

Money Supply Measures September 2001
9,000 Billions of Dollars 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0
$7.8 trillion Euros & Repos Institutional MMFs $5.3 trillion Retail Money Funds Small Time Deposits Savings Deposits $1.2 trillion Checkable Deposits Currency M1 M2 Large Time Deposits

M1
Source: http://www.ny.frb.org/pihome/fedpoint/fed49.html

M2

M3

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The Functions of Money

Money serves as a standard of value (or unit of account) for all goods and services. Money serves as a medium of exchange, such that buyers and sellers no longer need to have an exact coincidence of wants in terms of quality, quantity, time, and location. Money serves as a store of value a reserve of future purchasing power although the value of money can experience marked fluctuations.
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The Functions of Money

Money functions as the only perfectly liquid asset in the financial system. It exhibits price stability, ready marketability, and reversibility.

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The Value of Money and Other Financial Assets and Inflation

 Inflation refers to a rise in the average price level of all goods and services.  Inflation lowers the value or purchasing power of money and is a special problem in the financial markets because it can damage the value of financial contracts.  The opposite of inflation is deflation, where the average level of prices for goods and services actually declines.
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The Value of Money and Other Financial Assets and Inflation

 Inflation is commonly measured using price indices, such as:
the Consumer Price Index (CPI), the Producer Price Index (PPI), or the Gross Domestic Product (GDP) Deflator Index.

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The Evolution of Financial Transactions

 Financial systems change constantly in response to shifting demands from the public, the development of new technology, and changes in laws and regulations.  Over time, the ways of carrying out financial transactions have evolved in complexity.  In particular, the transfer of funds from savers to borrowers can be accomplished in at least three different ways.
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The Evolution of Financial Transactions

Direct Finance Direct lending gives rise to direct claims against borrowers.
Flow of funds Borrowers (DBUs)
(loans of spending power for an agreed-upon period of time)

Lenders (SBUs)

Primary Securities
(stocks, bonds, notes, etc., evidencing direct claims against borrowers)

 Simple
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Difficult to match & risky

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The Evolution of Financial Transactions

Semidirect Finance Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers.
Primary Securities Borrowers (DBUs)
(direct claims against borrowers)

Primary Securities
(direct claims against borrowers)

(less fees and commissions)

Proceeds of security sales

Security brokers, dealers, & investment bankers Flow of funds

Lenders (SBUs)

(loans of spending power)

 Lower search (information) costs Risky & matching is still required

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The Evolution of Financial Transactions

Indirect Finance Financial intermediation of funds.
Primary Securities
(direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes, etc.)

Secondary Securities
(indirect claims against ultimate borrowers issued by financial intermediaries in the form of deposits, insurance policies, retirement savings accounts, etc.)

Ultimate borrowers (DBUs)

Financial intermediaries
(banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies, pension funds)

Ultimate lenders (SBUs)

Flow of funds
(loans of spending power)

Flow of funds
(loans of spending power)

 Low risk & affordable

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Relative Size and Importance of Major Financial Institutions

Total Financial Assets Held by U.S. Financial Institutions
($ billions at year-end) 1960 Financial intermediaries: Commercial banks $224 S&L assoc. and savings banks 111 Life insurance companies 116 Private pension funds 38 Investment co. (mutual funds) 17 State & local govt pension funds 20 Finance companies 28 Property-casualty insurance co. 26 Money market funds Credit unions 6 Mortgage companies Real estate investment trusts Other financial institutions: Security brokers and dealers 7 1970 $489 252 201 110 47 60 63 50 18 4 16 1980 $1,248 794 464 413 64 198 199 174 74 72 16 6 36 1990 $3,340 1,358 1,357 1,629 602 820 611 534 498 202 49 13 262 2000 $6,488 1,219 3,204 4,587 4,457 2,290 1,138 872 1,812 441 36 62 1,221

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts

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Classification of Financial Institutions

 Depository institutions derive the bulk of their loanable funds from deposit accounts sold to the public.
Commercial banks, savings and loan associations, savings banks, credit unions.

 Contractual institutions attract funds by offering legal contracts to protect the saver against risk.
Insurance companies, pension funds.
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Classification of Financial Institutions

 Investment institutions sell shares to the public and invest the proceeds in stocks, bonds, and other assets.
Investment companies, money market funds, real estate investment trusts.

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Portfolio (Financial-Asset) Decisions by Financial Institutions

 A number of factors affect the making of portfolio decisions deciding what financial assets to buy or sell. The relative rate of return and risk attached to different financial assets. The cost, volatility, and maturity of incoming funds provided by surplus-budget units.
Hedging principle the approximate matching of the maturity of financial assets held with liabilities taken on.
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Portfolio (Financial-Asset) Decisions by Financial Institutions

The size of the individual financial institution.
Larger financial institutions tend to have greater diversification in their sources and uses of funds and economies of scale.

Regulations and competition.

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Disintermediation of Funds
 Disintermediation refers to the withdrawal of funds from a financial intermediary by the ultimate lenders (savers) and the lending of those funds directly to the ultimate borrowers.  Disintermediation involves the shifting of funds from indirect finance to direct and semidirect finance.

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Disintermediation of Funds
Financial Disintermediation
Primary Securities Ultimate borrowers (DBUs) Ultimate lenders (SBUs)

Financial intermediaries

Loanable funds

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Disintermediation of Funds
 Some new forms of disintermediation have appeared over the past two decades. Initiation by financial intermediaries: Some banks sell off their loans because of difficulties in raising capital. Initiation by borrowing customers: Some borrowing customers learned how to raise funds directly from the open market.
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Bank-Dominated Versus Security-Dominated Financial Systems

 Lesser-developed financial systems are often bank-dominated financial systems, in which banks and other similar institutions dominate in supplying credit and attracting savings.  The more mature systems today are becoming security-dominated financial systems, in which traditional intermediaries play lesser roles and growing numbers of borrowers sell securities to the public to raise the funds they need.
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Money and Capital Markets in Cyberspace

 One popular money management site is Money Magazines http://money.cnn.com/, which helps individuals track the assets they already hold or wish to hold.  To determine how much things are worth after the effects of inflation and to work our way back into the past to see how the purchasing power of our money has changed over time, visit http://www.westegg.com/inflation/.
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Chapter Review
 Introduction  The Creation of Financial Assets
Characteristics of Financial Assets Different Kinds of Financial Assets The Creation Process for Financial Assets

 Financial Assets and the Financial System  Lending and Borrowing in the Financial System
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Chapter Review
 Money as a Financial Asset
What is Money? The Functions of Money

 The Value of Money and Other Financial Assets and Inflation  The Evolution of Financial Transactions
Direct Finance Semidirect Finance Indirect Finance
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Chapter Review
 Relative Size and Importance of Major Financial Institutions  Classification of Financial Institutions  Portfolio (Financial-Asset) Decisions by Financial Intermediaries and Other Financial Institutions  Disintermediation of Funds
New Types of Disintermediation
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Chapter Review
 Bank-Dominated Versus Security-Dominated Financial Systems

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