Overview of Money & Banking: Financial Markets and Intermediaries, Study notes of Banking and Finance

Download Overview of Money & Banking: Financial Markets and Intermediaries and more Study notes Banking and Finance in PDF only on Docsity! ECON 310 C01 Money & Banking J. Scott Sperling Summer 2001 jsperlin@gmu.edu Overview of the Financial System† 1 Financial Markets Financial markets channel funds from people who have an excess of funds (lender-savers) to those who need funds (borrower-spenders). A borrower can obtain funds in one of two ways: direct finance (through financial markets) or indirect finance (through financial intermediaries). In direct finance, borrowers get funds from lenders directly by selling securities (securities are also called financial instruments). Why do financial markets improve efficiency? Because they do a better job of matching lenders and borrowers. Remember specialization from you microeconomics classes? Financial markets specialize in getting borrowers and lenders together, thus reducing transaction costs. Imagine if you had to go find someone to lend you money everytime you needed to borrow. 2 Financial Market Structure 2.1 Debt & Equity Markets There are two ways of raising funds in a financial market: issuing a debt instrument or issuing equities. 2.1.1 Debt Instruments • E.g. bonds, mortgages • contract between lender and borrower • maturity: the term of the instrument (time at which it expires) • short-term: less than 1 year • intermediate-term: 1 to 10 years • long-term: 10 years or longer †If you find any errors or have any questions about these notes, please email me at jsperlin@gmu.edu. ECON 310 C01, Summer 2001 Overview of the Financial System Page 2 of 6 2.1.2 Equities • E.g. stocks • A share of stock is a claim on the assets and net income of a business • residual claimant The disadvantage of being a residual claimant is that a company must pay off its debt holders before it pays its equity holders. The advantage of being an equity holder is that the value of your share(s) increase with the value of the company whereas the value of a debt holders contract remains the same. 2.2 Primary and Secondary Markets 2.2.1 Primary Market New issues of securities are sold in the primary market. This is done mostly behind closed doors at large investment banks. 2.2.2 Secondary Market Previously issued securities can be resold on a secondary market. The secondary markets you are probably most familiar with are the NYSE and NASDAQ. Secondary markets provide liquidity to securities, i.e. they are more easily converted to money. Secondary markets can be organized as exchanges (buyers and sellers, or their agents, meet in a central location) or as OTC markets (over-the-counter, dealers at different locations). 2.3 Money Market and Capital Market We can also classify markets by the maturity of the securities that are traded in that market. Securities with terms less than one year (typically) are traded in the money market, while securities with longer terms (generally one-year or greater) and equities are traded in the capital market. Money market instruments tend to be traded more frequently than capital market instruments, and thus tend to be more liquid. Money market instruments also tend to see smaller price fluctuations. ECON 310 C01, Summer 2001 Overview of the Financial System Page 5 of 6 Financial intermediaries are able to mitigate assymetric information by screening, e.g. they can cheaply obtain credit reports. 3.2.2 Moral Hazard Moral hazard occurs after a transaction has been made. For example, after lending money to someone, they might participate in risky behavior which increases the probability the loan will not be repaid. Moral hazard can be reduced by monitoring. Financial intermediaries can monitor at a lower cost than, say, you or I. 3.3 Types of Financial Intermediaries 3.3.1 Depository Institutions Depository institutions accept deposits and make loans. We will study these closely because they have important effects on the money supply. Depository institutions include: • Commercial banks • Savings and Loan associations • Mutual savings banks • Credit unions 3.3.2 Contractual Savings Institutions • Life insurance companies • Fire & Casualty insurance • Pension funds & government retirement funds 3.3.3 Investment Intermediaries • Finance Companies • Mutual Funds • Money Market Mutual Funds ECON 310 C01, Summer 2001 Overview of the Financial System Page 6 of 6 3.4 Regulation The financial system is among the most highly regulated sectors in the economy. Regulators have three main arguments as to why the regulate; regulation: 1 Increases information – therefore reducing assymetric information problems 2 Increases soundness – reduces probability of financial panic 3 Improves control of monetary policy We will examine regulation more closely later in the course.