Understanding the Financial System: Functions of Financial Markets and Intermediaries, Papers of Banking and Finance

Download Understanding the Financial System: Functions of Financial Markets and Intermediaries and more Papers Banking and Finance in PDF only on Docsity! 1 Chapter 2 – An Overview of the Financial System Function of 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
Promotes economic efficiency by producing an efficient allocation of capital, which increases production
Directly improve the well-being of consumers by allowing them to time purchases better Financial System 2 Direct Finance
Financial Markets  Borrowers borrow directly from lenders by issuing financial instruments
Claims on future income/assets  Assets for lender  Liability for the seller
Repayment promises  Allow individuals to come together and improve efficiency
Allow many individuals to make investments that otherwise are not available (education, housing, …) Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets  Where debt and equity securities are sold and traded  Investment Banks underwrite securities in primary markets  Brokers and dealers work in secondary markets
Exchanges and Over-the-Counter (OTC) Markets  Types of secondary markets
Money and Capital Markets  Money markets deal in short-term debt instruments  Capital markets deal in longer-term debt and equity instruments Debt Markets
Entities use financial markets by issuing debt, usually through a bond or mortgage
Specify a fixed payment amount and the number of payments to the lender until maturity.
Maturity: number of years until the instrument’s expiration date
Short-term: less than one year
Long-term: greater than ten years
Intermediate-term: between one and ten years 5 Markets and Maturity
Money Market  A financial market in which short-term debt instruments are traded
More widely traded, more liquid
Used when entities have surplus funds for a short time
Capital Market  Is the market in which longer-term debt and equity instruments are traded
Financial institutions (insurance companies and pension funds) Money Market Instruments
United States Treasury Bills  1, 3, and 6 month maturities  Pay a set amount at maturity, no interest payment, but are sold at a discount (Saving Bond)
Negotiable Bank Certificates of Deposit  Debt instrument sold by banks to depositors
Commercial Paper  Short-term debt issued by large banks and well-known corporations Money Market Instruments cont.
Banker’s Acceptance  Is a bank draft, similar to a check, issued by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it accepted  Allows firms to purchase goods abroad, the funds are guaranteed even if the corporation goes bankrupt
Federal Funds  Typically overnight loans made by banks to other banks  Usually occurs when a bank falls below its required reserve amount 6 Money Market Instruments cont.
Repurchase Agreements (repos)  Short-term loans, less than two week maturity  A large firm may have excess funds it wants to lend for a week. The firm will buy treasury bills from the bank with an agreement that the bank will repurchase the t- bills in one weeks time.  The firm gets a small interest payment and the bank gets the use of the firms funds Capital Market Instruments
Stocks  Equity claims on the net income and assets of a corporation
Mortgages  Loans to households or firms to purchase housing, land, or other real estate structures  The structural/land serves as collateral
Corporate Bonds  Long-term bonds issued by corporations with strong credit ratings  Sends an interest payments twice a year and pays off the face value of the bond at maturity 7 Capital Market Instruments
U.S. Government Securities  Long-term debt instruments issued by the U.S. Treasury to finance the government deficit
U.S. Government Agency Securities  Long-term bonds used to finance capital
State and Local Government Bonds  Municipal bonds, long-term debt issued by state and local governments. Interest payments are tax free.
Consumer and Bank Commercial Loans Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and denominated in that country’s currency  U.S. bonds sold in Europe and denominated in Euros
Eurobond—bond denominated in a currency other than that of the country in which it is sold  U.S. bonds sold in Europe and denominated in Dollars
Eurocurrencies—foreign currencies deposited in banks outside the home country  Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
World Stock Markets 10 Financial Intermediaries
Allows small savers the ability to provide funds to the financial markets
Financial intermediaries are more successful than individuals on earning returns because they can screen out bad credit risks from good ones  They are able to reduce the risks incurred from moral hazard Types of Intermediaries
Depository institutions (banks)
Contractual savings institutions
Investment intermediaries Depository Institutions
Commercial Banks  Raise funds via checking and saving deposits  Make commercial, consumer, and mortgage loans and buy U.S. securities
Savings and Loan Associations and Mutual Savings Banks  Raise funds via checking, time, and saving deposit.  Initially, constrained to just mortgage loans, but now very similar to banks
Credit Unions  Smaller than banks and organized around a particular group 11 Contractual Savings Institutions
Life Insurance Companies  Acquire funds through premiums by selling annuities once the individual is retired  Buy corporate bonds, mortgages, and some restricted stocks
Fire and Casualty Insurance Companies  Similar to life insurance companies, but experience a greater probability of losses
Pension Funds and Government Retirement Funds  Acquire funds through employee and employer contributions  Purchase corporate bonds and stocks Investment Intermediaries
Finance Companies  Sell commercial paper and issue stocks and bonds  Make loans to consumers
Mutual Funds  Sell shares to individuals and use the funds to purchase diversified portfolios of stocks and bonds
Money Market Mutual Funds  Sell shares to purchase money market instruments, interest is paid to shareholders, and shareholders can write checks against their holdings
Investment Banks  Advises corporations on the type of securities to issue and purchases them at a predetermined price  Also participate in mergers and acquisitions 12 Regulation of the Financial System
To increase the information available to investors:  Reduce adverse selection and moral hazard problems  Reduce insider trading
To ensure the soundness of financial intermediaries:  Restrictions on entry  Disclosure  Restrictions on Assets and Activities  Deposit Insurance  Limits on Competition  Restrictions on Interest Rates