chapter-1-banking-introduction.power point

Business

1. 1
An Overview of the Financial
System
Chapter 1

2. 2
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Atanypointintimeinaneconomy,thereareindividualsor
organizationswithexcessamountsoffunds,andotherswitha
lackoffundstheyneedforexampletoconsumeortoinvest.
•Exchangebetweenthesetwogroupsofagentsissettledin
financialmarkets
•Thefirstgroupiscommonlyreferredtoaslenders,thesecond
groupiscommonlyreferredtoastheborrowersoffunds.

3. 3
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Wewillstartourdiscussionoffinancialandmoneymarketswith
somebasicdefinitions:
•1.Thereexisttwodifferentformsofexchangeinfinancialmarkets.
Thefirstoneisdirectfinance,inwhichlendersandborrowersmeet
directlytoexchangesecurities.
•Securitiesareclaimsontheborrower’sfutureincomeor
assets.Commonexamplesarestock,bondsorforeignexchange

4. 4
1. An Overview of the Financial System
•1. Introduction to Financial Markets and
Institutions
–Basicdefinitions:
•Thesecondtypeoffinancialtradeoccurswiththehelpof
financialintermediariesandisknownasindirectfinance.
•Inthisscenarioborrowersandlendersnevermeetdirectly,but
borrowersprovidefundstoafinancialintermediarysuchas
abankandthoseintermediariesindependentlypassthese
fundsontolenders.

5. 5
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Basicdefinitions:
•2.Financialmarketsaresplitintodebtandequitymarkets.
•Debttitlesarethemostcommonlytradedsecurity.Inthesearrangements,
theissuerofthetitle(borrower)earnssomeinitialamountofmoney
(suchasthepriceofabond)andtheholder(lender)subsequentlyreceivesa
fixedamountofpaymentsoveraspecifiedperiodoftime,knownas
thematurityofadebttitle.
•Debttitlescanbeissuedonshortterm(maturity<1yr.),longterm
(maturity>10yrs.)andintermediateterms(1yr.<maturity<10yrs.).
•Theholderofadebttitledoesnotachieveownershipoftheborrower’s
enterprise.
•Commondebttitlesarebondsormortgages.

6. 6
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Basicdefinitions:
•Equitytitlesaresomewhatdifferentfrombonds.Themostcommonequity
titleis(common)stock.
•Firstandforemost,anequityinstrumentsmakesitsbuyer(lender)anowner
oftheborrower’senterprise.
•Formallythisentitlestheholderofanequityinstrumenttoearnashareof
theborrower’senterprise’sincome,butonlysomefirmsactuallypay
(moreorless)periodicpaymentstotheirequityholdersknownasdividends.
Oftenthesetitles,thus,areheldprimarilytobesoldandresold.
•Equitytitlesdonotexpireandtheirmaturityis,thus,infinite.Hence
theyareconsideredlongtermsecurities.

7. 7
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Basicdefinitions:
•3.Marketsaredividedintoprimaryandsecondarymarkets
•Primarymarketsaremarketsinwhichfinancialinstrumentsare
newlyissuedbyborrowers.
•Secondarymarketsaremarketsinwhichfinancialinstruments
alreadyinexistencearetradedamonglenders.
•Secondarymarketscanbeorganizedasexchanges,inwhichtitles
aretradedinacentrallocation,suchasastockexchange,or
alternativelyasover-the-countermarketsinwhichtitlesaresold
inseverallocations.

8. 8
1. An Overview of the Financial System
•1. Introduction to Financial Markets and
Institutions
–Basicdefinitions:
•4.Finally,wemakeadistinctionbetweenmoneyandcapital
markets.
–Moneymarketsaremarketsinwhichonlyshorttermdebt
titlesaretraded.
–Capitalmarketsaremarketsinwhichlongertermdebtand
equityinstrumentsaretraded.

9. 9
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Principal Money Market Instruments (maturity < 1 yr.)
Source: Miskin

10. 10
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Principal Capital Market Instruments (maturity > 1yr.)
Source: Miskin

11. 11
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Most commonly you will encounter:
•Corporatestocksareprivatelyissuedequityinstruments,which
haveamaturityofinfinitybydefinitionand,thus,areclassifiedas
capitalmarketinstruments
•Corporatebondsareprivatedebtinstrumentswhichhaveacertain
specifiedmaturity.Theytendtobelong-runinstrumentsandare,
hence,capitalmarketinstruments
•Theshort-runequivalenttocorporatebondsarecommercial
paperswhichareissuedtosatisfyshort-runcashneedsofprivate
enterprises.

12. 12
1. An Overview of the Financial System
•1. Introduction to Financial Markets and Institutions
–Most commonly you will encounter:
•Onthegovernmentside,themostcommonlyusedlong-rundebt
instrumentsareTreasuryBondsorT-Bonds.Theirmaturity
exceedstenyears.
•Short-runliquidityneedsaresatisfiedbytheissuanceofTreasury
BillsorT-Bills,whichareshort-rundebttitleswithamaturityofless
thanoneyear.

13. 13
1. An Overview of the Financial System
•1. Introduction to Financial Markets and
Institutions
–Basicdefinitions:
•AnOverview:
•Financialmarketscanbecategorizedasfollows:
Direct vs. Indirect Finance
Debt vs. Equity Markets
Primary vs. Secondary Markets
Money vs. Capital Markets

14. 14
1. An Overview of the Financial System
•2. Functions of Financial Markets
–Borrowing and Lending
•Financialmarketschannelfundsfromhouseholds,firms,
governmentsandforeignersthathavesavedsurplusfundsto
thosewhoencounterashortageoffunds(forpurposesof
consumptionandinvestment)
–PriceDetermination
•Financialmarketsdeterminethepricesoffinancialassets.The
secondarymarkethereinplaysanimportantrolein
determiningthepricesfornewlyissuedassets

15. 15
1. An Overview of the Financial System
•2. Functions of Financial Markets
–Coordination and Provision of Information
•Theexchangeoffundsischaracterizedbyahighamountof
incompleteandasymmetricinformation.Financialmarkets
collectandprovidemuchinformationtofacilitatethis
exchange.
–RiskSharing
•Tradeinfinancialmarketsispartlymotivatedbythetransfer
ofriskfromlenderstoborrowerswhousetheobtainedfunds
toinvest

16. 16
1. An Overview of the Financial System
•2. Functions of Financial Markets
–Liquidity
•Theexistenceoffinancialmarketsenablestheownersof
assetstobuyandreselltheseassets.Generallythisleadsto
anincreaseintheliquidityofthesefinancialinstruments
–Efficiency
•Thefacilitationoffinancialtransactionsthroughfinancial
marketsleadtoadecreaseininformationalcostand
transactioncosts,whichfromaneconomicpointofviewleads
toanincreaseinefficiency.

17. 17
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Anyclassificationoffinancialinstitutionsisultimatelysomewhat
arbitrary,sincefinancialmarketsaresubjecttohighdynamics
andfrequentinnovation.Thus,weroughlyusefourcategories:
•Brokers
•Dealers
•Investment banks
•Financial intermediaries
Engage in trade in securities
(direct finance)
Engage in financial asset
transformation(indirect
finance)

18. 18
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Brokersareagentswhomatchbuyerswithsellersforadesired
transaction.
•Abrokerdoesnottakepositionintheassetsshe/hetrades(i.e.
doesnotmaintaininventoriesofthoseassets)
•Brokerschargecommissionsonbuyersand/orsellersusingtheir
services
•Examples:Realestatebrokers,stockbrokers

19. 19
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Like brokers, dealers match sellers and buyers of financial assets.
•Dealers,however,takepositionintheyassetstheirtrading.
•Asopposedtochargingcommission,dealersobtaintheirprofitsfrom
buyingassetsatlowpricesandsellingthemathighprices.
•Adealer’sprofitmargin,theso-calledbid-askspreadisthe
differencebetweenthepriceatwhichadealerofferstosellanasset
(theaskedprice)andthepriceatwhichadealerofferstobuyan
asset(thebidprice)
•Examples:DealersinU.S.governmentbonds,Nasdaqstockdealers

20. 20
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Investment Banks
•Investmentbanksassistintheinitialsaleofnewlyissued
securities(e.g.IPOs)
•Investmentbanksareinvolvedinavarietyofservicesfortheir
customers,suchasadvice,salesassistanceandunderwritingof
issuances
•Examples:Morgan-Stanley,MerillLynch,GoldmanSachs,...

21. 21
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•Financialintermediariesmatchsellersandbuyersindirectlythrough
theprocessoffinancialassettransformation.
•Asopposedtothreeabovementionedinstitutions.theybuya
specifickindofassetfromborrowers–usuallyalongtermloan
contract–andselladifferentfinancialassettosavers–usually
somesortofhighly-liquidshort-runclaim.

22. 22
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•Althoughsecuritiesmarketsreceivealotofmediaattention,
financialintermediariesarestilltheprimarysourceof
fundingforbusinesses.
•EvenintheUnitedStatesandCanada,enterprisestendto
obtainfundsthroughfinancialintermediariesrather
thanthroughsecuritiesmarkets.
•Otherthanhistoricreasons,thisprevalenceresultsfroma
varietyoffactors.

23. 23
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•First,financialintermediarieslowertransactioncostsfor
borrowersandlenders(economiesofscale,professional
experience,...)
•Sincetransactioncostsarereduced,financialintermediariesareable
toprovidecustomerswithadditionalliquidityservices,suchas
checkingaccountswhichcanbeusedasmethodsofpayment
ordepositswhichcanbeliquidatedanytimewhilestillbearingsome
interest.

24. 24
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•Second,financialintermediariescanreduceaninvestor’s
exposuretoriskthroughrisksharing.
•Throughtheprocessofassettransformationnotonlymaturities,but
alsotheriskofanassetcanchange:Afinancialintermediaryuses
fundsitacquires(e.g.throughdeposits)andoftenturnsthemintoa
moreriskyasset(e.g.alargerloan).Theriskthenisspreadout
betweenvariousborrowersandthefinancialintermediaryitself.
•Theprocessofrisksharingisfurtheraugmentedthrough
diversificationofassets(portfolio-choice),whichinvolves
spreadingoutfundsoveraportfolioofassetswithdifferent
typesofrisk.

25. 25
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•Third,financialintermediariesareimportantintheproductionof
information.Theyhelpreduceinformationalasymmetriesabout
someunobservablequalityoftheborrowerforexamplethrough
screening,monitoringorratingofborrowers.
•Twoproblemsareusuallyconnectedtoinformationalasymmetries:
–Adverseselection(precedingatransaction),e.g.selectionof“bad”
debtor
–Moral hazard(succeeding a transaction), e.g. undesirable activities by
the debtor

26. 26
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•Finally,somefinancialintermediariesspecializeonservicessuch
asmanagement ofpaymentsfortheircustomersorinsurance
contractsagainstlossofsuppliedfunds.
•Throughallofthesechannelsfinancialintermediariesincrease
marketefficiencyfromaneconomicpointofview.

27. 27
1. An Overview of the Financial System
•3. Financial Institutions and their Functions
–Financial Intermediaries
•Thereareroughlythreeclassesoffinancialintermediaries:
–Depositoryinstitutionsacceptdepositsfromsaversandtransform
themintoloans(Commercialbanks,savingsandloanassociations,
mutualsavingsbanksandcreditunions)
–Contractualsavingsinstitutionsacquirefundsatperiodicintervals
onacontractualbasis(insuranceandpensionfunds)
–Investmentintermediariesservedifferentformsoffinance.They
includefinancecompanies,mutualfundsandmoneymarket
mutualfunds.

28. 28
1. An Overview of the Financial System
•4. Financial regulation
–Why regulatefinancial markets?
•Financialmarketsareamongthemostregulatedmarketsin
moderneconomies.
•Thefirstreasonforthisextensiveregulationistoincreasethe
informationavailabletoinvestors(and,thus,toprotectthem).
•Thesecondreasonistoensurethesoundnessofthefinancial
system.

29. 29
1. An Overview of the Financial System
•4. Financial regulation
–1. Increasing information available to investors
•Asmentionedabove,asymmetricinformationcancausesevere
problemsinfinancialmarkets(Riskbehavior,insidertrades,....)
•Certainregulationsaresupposedtoprohibitagentswithsuperior
informationfromexploitinglessinformedagents.
•IntheU.S.thestock-marketcrashof1929ledtothe
establishmentoftheSecuritiesandExchangeCommission
(SEC),whichrequirescompaniesinvolvedintheissuanceof
securitiestodisclosecertaininformationrelevanttotheir
stockholders.TheSECfurtherprohibitsinsidertrades.

30. 30
1. An Overview of the Financial System
•4. Financial regulation
–2. Ensuring the soundness of financial intermediaries
•Evenmoredevastatingconsequencesfromasymmetricinformation
manifestthemselvesincollapsesoftheentirefinancialsystem–
socalledfinancialpanics.
•Financialpanicsoccurifprovidersoffundsonalargescale
withdrawtheirfundsinabriefperiodoftimefromthe
financialsystemleadingtoacollapseofthesystem.Thesepanics
canproduceenormousdamagetoaneconomy.
•ExamplesofsomerecentpanicsarethecrisesintheAsianTiger
states,ArgentinaorRussia.TheUnitedStates,whilesparedformost
ofthesecondhalfof20
th
century,hasalongtraditionoffinancial
crisesthroughoutthe19
th
centuryuptotheGreatDepression.

31. 31
1. An Overview of the Financial System
•4. Financial regulation
–Overview of financial regulationsin the United States
•1. Restrictions to entry:
–StatebankingandinsurancecommissionsandtheOfficeofthe
ComptrolleroftheCurrencyhavesethighstandardsfor
marketentryasafinancialintermediary.
–Generallythestateorfederalgovernmentgrantsacharterto
newfinancialintermediariessubjecttostrictcriteriasuch
asvolumeofinitialfunds,etc.

32. 32
1. An Overview of the Financial System
•4. Financial regulation
–Overview of financial regulationsin the United States
•2. Disclosure
–Generallyfinancialintermediarieshavetofollowstrictrulesfor
bookkeeping
–Booksaresubjecttoperiodicinspectionandcertain
informationmustbemadepublic.

33. 33
1. An Overview of the Financial System
•4. Financial regulation
–Overview of financial regulationsin the United States
•3. Restrictions on Assets and Activities
–Financialintermediariesarerestrictedfromholdingcertain
riskyassets(e.g.Commercialbanksarenotallowedtohold
commonstock)
–UnlikeinmanyEuropeancountrieslegislationintheU.S.
separatedcommercialbankingfromsecuritiestrade
from1933to1999

34. 34
1. An Overview of the Financial System
•4. Financial regulation
–Overview of financial regulations in the United States
•4. Deposit insurance
–Ifafinancialintermediaryfails,thecentralgovernment(or
sometimesaprivateconglomerateofbanks)caninsurethe
depositsoflenders
–IntheU.S.depositinsuranceofcommercialbanksisgranted
mainlythroughtheFederalDepositInsuranceCorporation
(FDIC),whichwascreatedaftertheseverebankingcrisisofthe
GreatDepressionin1930-1933

35. 35
1. An Overview of the Financial System
•4. Financial regulation
–Overview of financial regulations in the United States
•5. Limits to Competition
–Anargumentofpoliticsratherthaneconomicsisthatoverlyhard
competitioninthebankingsectorincreasestheriskofbank
failure.Thisbeliefhas(especiallyinthepast)ledtosome
restrictionsinthecommercialbankingsectors
–IntheU.S.privatebankse.g.wereprohibitedtoopen
branchesindifferentstates
–Theempiricalevidenceforthebenefitsoflimiting
competitionisweakandfromaneconomicpointofviewit
appearsmoreasanobstacletoriskdiversificationrather
thanausefulregulation

36. 36
1. An Overview of the Financial System
•4. Financial regulation
–Overview of financial regulations in the United States
•6. Restriction of interest rates
–TheexperienceoftheGreatDepressionintheU.S.hasledto
thewidespreadbeliefthatinterestratecompetitionpaidon
depositsmightfacilitatebankfailureandtostrong
regulationofinterestratesonbankdeposits
–Unlikemostotherdevelopedeconomies,banksintheU.S.were
prohibitedfrompayinganyinterestondepositsfrom
1933.UnderwhatisknownasRegulationQ,theFederal
ReserveSystemhadthepowertosetthemaximuminterest
ratespayableonsavingsdepositsuntil1986.