Ch-2 Function of Financial Markets: *Channels funds from person or business without investment opportunities to one who has them.* Improves economic efficiency. Importance of Financial Markets: Financial markets are critical for-*) Producing an efficient allocation of capital.*) Improving the well-being of consumers, allowing them to time their purchases better. Structure of Financial Markets: 1) Debt Markets: * Short-Term (maturity < 1 year).* Long-Term (maturity > 10 year).* Intermediate term (maturity in-between).*Represented $41 trillion at the end of 2007.2) Equity Markets: *Pay dividends, in theory forever.*Represents an ownership claim in the firm.*Total value of all U.S. equity was $19.3 trillion at the end of 2006.Even though firms don’t get any money, per se, from the secondary market, it serves two important functions: *Provide liquidity, making it easy to buy and sell the securities of the companies.*Establish a price for the securities. Function of Financial Intermediaries: Indirect Finance: 1) the intermediary obtains funds from savers.2) the intermediary then makes loans/investments with borrowers.3) This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers.4) More important source of finance than securities markets.5) Needed because of transactions costs, risk sharing, and asymmetric information. Transactions Costs:1) Financial intermediaries make profits by reducing transactions costs.2) Reduce transactions costs by developing expertise and taking advantage of economies of scale. A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions- 1) Banks provide depositors with checking accounts that enable them to pay their bills easily.2) Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary. Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing 1) FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party.2) This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors. 1) Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings.2) Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals. Regulation Reason: Increase Investor Information:1) Asymmetric information in financial markets means One party lacks crucial information about another party, impacting decision-making.2) The Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders in the corporation. The Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders in the corporation. Ensure Soundness of Financial Intermediaries: Providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not. Such panics produce large losses for the public and causes serious damage to the economy. To protect the public and the economy from financial panics, the government has implemented six types of regulations: 1) Restrictions on Entry.2) Disclosure.3) Restrictions on Assets and Activities.4) Deposit Insurance.5) Limits on Competition.6) Restrictions on Interest Rates. Restrictions on Entry: 1) Regulators have created very tight regulations as to who is allowed to set up a financial intermediary.2) Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government. Disclosure: There are stringent reporting requirements for financial intermediaries 1) their bookkeeping must follow certain strict principles.2) their books are subject to periodicinspection.3) they must make certain information available to the public. Restriction on Assets and Activities: There are restrictions on what financial intermediaries are allowed to do and what assets they can hold 1) One way of doing this is to restrict the financial intermediary from engaging in certain risky activities.2) Another way is to restrict financial intermediaries from holding certain risky assets, or

at least from holding a greater quantity of these risky assets than is prudent. Deposit Insurance: 1)The government can insure people depositors to a financial intermediary from any financial loss if the financial intermediary should fail.2) In Bangladesh, a Deposit Insurance Trust Fund has been created for providing limited protection to a small depositor in case of winding up of any bank. 3) Commercial Banks have to pay half yearly insurance premium to Bangladesh Bank based on the insured deposits- ranging from 0.08-0.10% depending on its CAMEL Rating.Past Limits on Competition: Although the evidence that unbridled competition among financial intermediaries promotes failures that will harm the public is extremely weak, it has not stopped the state and federal governments from imposing many restrictive regulations. Past Restrictions on Interest Rates: 1) Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits.2) Later evidence does not seem to support this view, and restrictions on interest rates have been abolished. Improve Monetary Control:1) Because banks play a very important role in determining the supply of money much regulation of these financial intermediaries is intended to improve control over the money supply.2) Reserve requirements help the Fed exercise more precise control over themoneysupply.Ch-7 Twelve Federal Reserve banks: A Federal Reserve Bank is a regional bank of the Federal Reserve System, the central banking system of the United States. The banks are jointly responsible for implementing the monetary policy set forth by the Federal Open Market Committee, and are divided as follows: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, San Francisco. Federal open market committee: The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. Reserve requirements: The reserve requirement is a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves. These required reserves are normally in the form of cash stored physically in a bank vault or deposits made with a central bank. Twelve Federal Reserve Banks:1) Each of the twelve districts has a main Federal Reserve Bank and at least one branch office.2) The banks are “quasi-public”.** Owned by member commercial banks in the district.** Member banks elect six directors, while three directors are appointed by the Board of Governors.** Directors represent professional bankers, prominent business leaders, and public interests. Federal Reserve Bank Functions: Monetary Policy: 1) “Establish” the discount rate at which member banks may borrow from the Federal Reserve Bank.2) Determine which bank receive loans. 3) Elect one member to the Federal Advisory Council. 4) Five of the 12 bank presidents vote in the Federal Open Market Committee. Board of Governors:1) The seven governors are appointed by the President, and confirmed by the Senate, for 14-year terms on a rotating schedule.2) All Board members are members of the FOMC.3) Effectively set the discount rate.4) Serve in an advisory capacity to the President of the United States, and represent the U.S. in foreign economic matters. Federal Open Market Committee Meeting: Important agenda items includes 1) Reports on open market operations.2) National economic forecasts are presented.3) Discussion of monetary policy and directives, including views of each member.4) Post-meeting announcements, as needed. How Independent is the Fed: 1) A broad question of policy for the Federal Reserve Systems is how free the Fed is from presidential and congressional pressure in pursuing its goals.2) Instrument Independence: the ability of the central bank to set monetary policy instruments.3) Goal Independence: the ability of the central bank to set the goals of monetary policy.4) Evidence suggests that the Fed is free along both dimensions. The European Central Bank: 1) Founded in 1999 by

a treaty between the European Central Bank (ECB) and the European System of Central Banks (ESCB).2) The ECB is housed in Frankfurt, Germany.3) Executive board consists of the president, vice president, and four members, all serving eight-year terms.4) The policy group consists of the executive board and governors from the 11 member countries central banks. Difference between the Fed and the ECB: 1) Budgets of the Fed are controlled by the BOG, while the National banks that make up the ECB control their own budgets.2) Monetary operations are conducted at the national level, not directly by the ECB.3) The ECB is not involved in bank regulation or supervision.4) Only the 18 members attend the monthly meetings of the ECB, with no staff.5) No voting! All decisions are made by consensus.6) The ECB holds a press conference following the monthly meeting, while the Fed typically doesn’t. Bank of Canada: 1) Founded in 1934.2) Directors are appointed by the government for three-year terms, and they appoint a governor for a seven-year term.3) A governing council is the policy-making group comparable to the FOMC.4) In 1967, ultimate monetary authority was given to the government. However, this authority has never been exercised to date. Bank of England: 1) Founded in 1694.2) The Monetary Policy committee compares with the U.S. FOMC, consisting of the governor, deputy governors, two other central bank officials, plus four outside economic experts. 3) The Bank was the least independent of the central banks, until 1997, when it was granted authority to set interest rates.4) The government can step in under “extreme” circumstances, but has never done so yet. Bank of Japan: 1) Founded in 1882.2) The Policy Board sets monetary policy, and consists of the governor, two vice governors, and six outside members. All serve five-year terms.3) Japan’s Ministry of Finance can exert authority through its budgetary approval of the Bank’s non-monetary spending. Case for Independence:1) The strongest argument for independence is the view that political pressure will tend to add an inflationary bias to monetary policy. This stems from short-sighted goals of politicians. For example, in the short-run, high money growth does lead to lower interest rates. In the long-run, however, this also leads to higher inflation.2) The notion of the political business cycle stems from the previous argument **Expansionary monetary policy leads to lower unemployment and lower interest rates—a good idea just before elections.**Post-election, this policy leads to higher inflation, and

therefore, higher interest rates—effects that hopefully disappear (or are forgotten) by the next election.

Case Against Independence: 1) Some view Fed independence as “undemocratic”—an elite group controlling an important aspect of the economy but accountable in few ways.2) Indeed, we hold the President and Congress accountable for the state of the economy, yet they have little control over one of the most important tools to direct the economy.3) Further, the Fed has not always been successful in the past. It has made mistakes during the Great Depression and inflationary periods in the 1960s and 1970s.4) Lastly, the Fed can succumb to political pressure regardless of any state of independence. This pressure may be worse with few checks and balances in place. Central Bank Independence and Macroeconomic Performance: 1) Empirical work suggests that countries with the most independent central banks do the best job controlling inflation.2) Evidence also shows that this is achieved without negative impacts on the real economy. Ch-15 Facts of Financial Structure: 1) Stocks are not the most important source of external financing for businesses.2) Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.3) Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.4) The financial system is among the most heavily regulated sectors of economy.5) Only large, well-established corporations have easy access to securities markets to finance their activities.6) Collateral is a prevalent feature of debt contracts for both households and businesses. Transaction cost: A fee charged by a financial intermediary such as a bank, broker, or underwriter. Example: communication charges, legal fees, informational cost of finding the price, quality and durability, etc. In sum, transaction costs freeze

many small savers and borrowers out of direct involvement with financial markets. Financial intermediaries make profits by reducing transactions costs1) Take advantage of economies of scale (example: mutual funds).2) Develop expertise to lower transaction costs. Information Asymmetries and Information Costs: Asymmetric information is a serious hindrance to the operation of financial markets. It poses two important obstacles to the smooth flow of funds from savers to investors 1) adverse selection arises before the transaction occurs.* Lenders need to know how to distinguish good credit risks from bad.2) Moral hazard occurs after the transaction.* Will borrowers use the money as they claim?.Adverse Selection: 1) Used car buyers can’t tell good from bad cars.2) Buyers will at most pay an average expected value of good and bad cars.3) Sellers know if they have a good car, and won’t accept less than the true value.4) Then the market has only the bad cars. Solving the Adverse Selection Problem: From a social perspective, the problems of adverse selection are not good **Some companies will pass up good investments.**Economy will not grow as rapidly as it could . We must find ways for investors and lenders to distinguish well-run firms from poorly run firms. Collateral and Net Worth: 1) Another solution for adverse selection is to make sure lenders are compensated even if borrowers default.*If a loan is insured in some way, then the borrower isn’t a bad credit risk.2) Collateral is something of value pledged by a borrower to the lender in the event of the borrower’s default.*It is said to back or secure a loan. Ex: Cars, houses.3) Collateral is very prevalent because adverse selection is less of a concern - the lender gets something of equal or greater value if the borrower defaults.4) Unsecured loans, like credit cards, are loans made without collateral.*Because of this they generally have very high interest rates. The net worth is the owner’s stake in a firm - the value of the firm’s assets minus the value of its liabilities.* Net worth serves the same purpose as collateral.* If a firm defaults on a loan, the lender can make a claim against the firm’s net worth.* The importance of net worth in reducing adverse selection is the reason owners of new businesses have so much difficulty borrowing money.* Most small

business owners must put up their homes and other property as collateral for their business loans.

Moral Hazard: Problem and Solutions: 1) The phrase moral hazard originated when economists who were studying insurance noted that an insurance policy changes the behavior of the person who is insured.2) Moral hazard arises when we cannot observe people’s actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck.3) A second information asymmetry arises because the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project.4) Moral hazard affects both equity and bond financing. Moral Hazard in Equity Finance:1) It is more likely that the manager will use the funds in a way that is most advantageous to them, not you.2) The separation of your ownership from their control creates what is called a principal-agent problem. Moral Hazard in Debt Finance:1) When the managers are the owners, moral hazard in equity finance disappears.2) Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking.3) Lenders need to find ways to make sure borrowers don’t take too many risks.