Finance, Banking, and Money - lardbucket...Chapter 5: The Economics of Interest-Rate Fluctuations.....82 Interest Rate Fluctuations.....83 Shifts in Supply and Demand

Finance, Banking, andMoney

v. 1.1

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Table of ContentsAbout the Authors................................................................................................................. 1Acknowledgments ................................................................................................................. 3Preface..................................................................................................................................... 4Chapter 1: Money, Banking, and Your World ................................................................. 5

Dreams Dashed ............................................................................................................................................... 6Hope Springs .................................................................................................................................................. 9Suggested Browsing..................................................................................................................................... 11Suggested Reading ....................................................................................................................................... 12

Chapter 2: The Financial System ..................................................................................... 13Evil and Brilliant Financiers?...................................................................................................................... 14Financial Systems......................................................................................................................................... 16Asymmetric Information: The Real Evil .................................................................................................... 19Financial Markets......................................................................................................................................... 22Financial Intermediaries ............................................................................................................................. 26Competition Between Markets and Intermediaries ................................................................................. 30Regulation..................................................................................................................................................... 32Suggested Reading ....................................................................................................................................... 34

Chapter 3: Money ................................................................................................................ 35Of Love, Money, and Transactional Efficiency.......................................................................................... 36Better to Have Had Money and Lost It Than to Have Never Had Money at All .....................................41A Short History of Moolah .......................................................................................................................... 44Commodity and Credit Monies ................................................................................................................... 47Measuring Money ........................................................................................................................................ 53Suggested Reading ....................................................................................................................................... 55

Chapter 4: Interest Rates................................................................................................... 56The Interest of Interest ............................................................................................................................... 57Present and Future Value............................................................................................................................ 58Compounding Periods ................................................................................................................................. 64Pricing Debt Instruments ............................................................................................................................ 66What’s the Yield on That? ........................................................................................................................... 71Calculating Returns ..................................................................................................................................... 75Inflation and Interest Rates ........................................................................................................................ 78Suggested Reading ....................................................................................................................................... 81

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Chapter 5: The Economics of Interest-Rate Fluctuations ........................................... 82Interest Rate Fluctuations........................................................................................................................... 83Shifts in Supply and Demand for Bonds .................................................................................................... 87Liquidity Preference .................................................................................................................................... 95Predictions and Effects .............................................................................................................................. 100Suggested Reading ..................................................................................................................................... 103

Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves ................. 104A Short History of Interest Rates ............................................................................................................. 105Interest-Rate Determinants I: The Risk Structure.................................................................................. 108The Determinants of Interest Rates II: The Term Structure ................................................................. 114Suggested Reading ..................................................................................................................................... 120

Chapter 7: Rational Expectations, Efficient Markets, and the Valuation ofCorporate Equities ............................................................................................................ 121

The Theory of Rational Expectations....................................................................................................... 122Valuing Corporate Equities ....................................................................................................................... 126Financial Market Efficiency ...................................................................................................................... 132Evidence of Market Efficiency .................................................................................................................. 138Suggested Reading ..................................................................................................................................... 145

Chapter 8: Financial Structure, Transaction Costs, and AsymmetricInformation ........................................................................................................................ 146

The Sources of External Finance .............................................................................................................. 147Transaction Costs, Asymmetric Information, and the Free-Rider Problem ........................................ 150Adverse Selection....................................................................................................................................... 154Moral Hazard.............................................................................................................................................. 160Agency Problems........................................................................................................................................ 164Suggested Reading ..................................................................................................................................... 170

Chapter 9: Bank Management ........................................................................................ 171The Balance Sheet ...................................................................................................................................... 172Assets, Liabilities, and T-Accounts ........................................................................................................... 175Bank Management Principles ................................................................................................................... 180Credit Risk................................................................................................................................................... 190Interest-Rate Risk ...................................................................................................................................... 194Off the Balance Sheet................................................................................................................................. 199Suggested Reading ..................................................................................................................................... 201

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Chapter 10: Innovation and Structure in Banking and Finance ............................. 202Early Financial Innovations ...................................................................................................................... 203Innovations Galore..................................................................................................................................... 206Loophole Mining and Lobbying ................................................................................................................ 209Banking on Technology............................................................................................................................. 212Banking Industry Profitability and Structure......................................................................................... 216Suggested Reading ..................................................................................................................................... 224

Chapter 11: The Economics of Financial Regulation ................................................. 225Public Interest versus Private Interest .................................................................................................... 226The Great Depression as Regulatory Failure ........................................................................................... 230The Savings and Loan Regulatory Debacle.............................................................................................. 235Better but Still Not Good: U.S. Regulatory Reforms ............................................................................... 240Basel II’s Third Pillar.................................................................................................................................. 243Suggested Reading ..................................................................................................................................... 248

Chapter 12: The Financial Crisis of 2007–2009 ........................................................... 249Financial Crises .......................................................................................................................................... 250Asset Bubbles.............................................................................................................................................. 253Financial Panics.......................................................................................................................................... 257Lender of Last Resort ................................................................................................................................. 260Bailouts........................................................................................................................................................ 263The Crisis of 2007–2008 ............................................................................................................................. 265Suggested Reading ..................................................................................................................................... 271

Chapter 13: Central Bank Form and Function ............................................................ 272America’s Central Banks ........................................................................................................................... 273The Federal Reserve System’s Structure ................................................................................................. 277Other Important Central Banks................................................................................................................ 280Central Bank Independence...................................................................................................................... 282Suggested Reading ..................................................................................................................................... 286

Chapter 14: The Money Supply Process ....................................................................... 287The Central Bank’s Balance Sheet ............................................................................................................ 288Open Market Operations ........................................................................................................................... 290A Simple Model of Multiple Deposit Creation......................................................................................... 295Suggested Reading ..................................................................................................................................... 300

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Chapter 15: The Money Supply and the Money Multiplier ...................................... 301A More Sophisticated Money Multiplier for M1 ..................................................................................... 302The M2 Money Multiplier ......................................................................................................................... 310Summary and Explanation........................................................................................................................ 313Suggested Reading ..................................................................................................................................... 316

Chapter 16: Monetary Policy Tools ............................................................................... 317The Federal Funds Market and Reserves................................................................................................. 318Open Market Operations and the Discount Window.............................................................................. 323The Monetary Policy Tools of Other Central Banks ............................................................................... 327Suggested Reading ..................................................................................................................................... 329

Chapter 17: Monetary Policy Targets and Goals ........................................................ 330A Short History of Fed Blunders............................................................................................................... 331Central Bank Goal Trade-offs.................................................................................................................... 336Central Bank Targets ................................................................................................................................. 338The Taylor Rule .......................................................................................................................................... 342Suggested Reading ..................................................................................................................................... 347

Chapter 18: Foreign Exchange........................................................................................ 348The Economic Importance of Currency Markets.................................................................................... 349Determining the Exchange Rate............................................................................................................... 352Long-Run Determinants of Exchange Rates ............................................................................................ 356Short-Run Determinants of Exchange Rates........................................................................................... 360Modeling the Market for Foreign Exchange ........................................................................................... 368Suggested Reading ..................................................................................................................................... 372

Chapter 19: International Monetary Regimes ............................................................ 373The Trilemma, or Impossible Trinity....................................................................................................... 374Two Systems of Fixed Exchange Rates..................................................................................................... 378The Managed or Dirty Float ...................................................................................................................... 382The Choice of International Policy Regime............................................................................................. 387Suggested Reading ..................................................................................................................................... 393

Chapter 20: Money Demand............................................................................................ 394The Quantity Theory.................................................................................................................................. 395Liquidity Preference Theory..................................................................................................................... 399Head to Head: Friedman versus Keynes .................................................................................................. 403Suggested Reading ..................................................................................................................................... 409

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Chapter 21: IS-LM.............................................................................................................. 410Aggregate Output and Keynesian Cross Diagrams ................................................................................. 411The IS-LM Model ........................................................................................................................................ 420Suggested Reading ..................................................................................................................................... 426

Chapter 22: IS-LM in Action............................................................................................ 427Shifting Curves: Causes and Effects.......................................................................................................... 428Implications for Monetary Policy............................................................................................................. 432Aggregate Demand Curve.......................................................................................................................... 435Suggested Reading ..................................................................................................................................... 437

Chapter 23: Aggregate Supply and Demand, the Growth Diamond, and FinancialShocks.................................................................................................................................. 438

Aggregate Demand..................................................................................................................................... 439Aggregate Supply ....................................................................................................................................... 442Equilibrium Analysis.................................................................................................................................. 445The Growth Diamond................................................................................................................................. 449Financial Shocks......................................................................................................................................... 454Suggested Reading ..................................................................................................................................... 459

Chapter 24: Monetary Policy Transmission Mechanisms ........................................ 460Modeling Reality ........................................................................................................................................ 461How Important Is Monetary Policy? ........................................................................................................ 465Transmission Mechanisms........................................................................................................................ 468Suggested Reading ..................................................................................................................................... 473

Chapter 25: Inflation and Money ................................................................................... 474Empirical Evidence of a Money-Inflation Link ....................................................................................... 475Why Have Central Bankers So Often Gotten It Wrong? ......................................................................... 481Suggested Reading ..................................................................................................................................... 485

Chapter 26: Rational Expectations Redux: Monetary Policy Implications ........... 486Rational Expectations ................................................................................................................................ 487New Keynesians.......................................................................................................................................... 490Inflation Busting ........................................................................................................................................ 493Suggested Reading ..................................................................................................................................... 496

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About the Authors

About Robert E. Wright

I attribute my enduring interest in money and banking, political economy, andeconomic history to the troubled economic conditions of my youth. Born in 1969 inRochester, New York, to two self-proclaimed factory rats, I recall little of myearliest days except the Great Inflation and oil embargo, which stretched the familybudget past the breaking point. My only other noneconomic memories are of thePlanet of the Apes films (all five of them!) and the 1972 Olympics massacre in Munich;my very young mind conflated the two because of the aural similarity of the wordsgorilla and guerilla. The recession in the early 1980s also injured my family’s materialwelfare and was seared into my brain.

After taking degrees in history from Buffalo State College (B.A., 1990) and theUniversity of Buffalo (M.A., 1994; Ph.D., 1997), I began teaching a variety of coursesin business, economics, evolutionary psychology, finance, history, and sociology ata variety of schools until 2009, when I became the Nef Family Chair of PoliticalEconomy at Augustana College in Sioux Falls, South Dakota. I’ve also been an activeresearcher, editing, authoring, and co-authoring books about the development ofthe U.S. financial system (Origins of Commercial Banking, Hamilton Unbound, Wealth ofNations Rediscovered, The First Wall Street, Financial Founding Fathers, One Nation UnderDebt), construction economics (Broken Buildings, Busted Budgets), life insurance(Mutually Beneficial), and publishing (Knowledge for Generations). Due to my uniquehistorical perspective on public policies and the financial system, I’ve also becomesomething of a media maven, showing up on NPR and other radio shows, as well asvarious television programs, and getting quoted in major newspapers like the WallStreet Journal, New York Times, Chicago Tribune, and the Los Angeles Times. I publish op-eds and make regular public speaking appearances nationally and, increasingly,internationally, and I serve as director of the Thomas Willing Institute for the Studyof Financial Markets, Institutions and Regulations

I wrote this textbook because I strongly believe in the merits of financial literacy forall. Our financial system struggles sometimes in part because so many peopleremain feckless financially. My hope is that people who read this book carefully,dutifully complete the exercises, and attend class regularly will be able to follow thefinancial news and even critique it when necessary. I also hope they will makeinformed choices in their own financial lives.

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About Dr. Vincenzo Quadrini

I was born and raised in a small town in the Marche region in Italy. In 1990 Ireceived a B.A. in Economics and Business from Ancona University and in 1991 aone-year Master in Economics from Coripe-Piemonte in Turin. After fulfilling a one-year mandatory military service between 1991 and 1992, I moved to the UnitedStates to start my Ph.D. in Economics at the University of Pennsylvania, where Igraduated in 1996. Since my Ph.D. graduation I have been teaching at severalinstitutions: Pompeu Fabra University in Barcelona, Duke University, New YorkUniversity, and University of Southern California. I have been teaching courses onmonetary economics, macroeconomics, international trade, and internationalfinance. My research interests are in similar topics, and since my graduation in 1996I have published several articles in scholarly journals including American EconomicReview, Journal of Monetary Economics, Journal of Political Economy, and Review ofEconomic Studies.

My current research projects focus on the macroeconomic impact of credit andfinancial shocks similar to the ones that are currently affecting the U.S. economy. Iam also interested in understanding how these shocks are propagatedinternationally to other economies. Another research interest focuses on theunderstanding of how differences in financial markets across countries can lead tolarge financial imbalances, that is, a situation in which some countries, like theUnited States, borrow heavily from other countries like China and Japan.

About the Authors

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Acknowledgments

Many people have helped to make this project a reality. At Unnamed Publisher,Shannon Gattens and Jeff Shelstad helped to shepherd the concept and themanuscript through the standard trials and tribulations. Along the way, a score ofanonymous academic readers helped to keep our economic analyses and prose onthe straight and narrow. Paul Wachtel and Richard Sylla, two colleagues at NewYork University’s Stern School of Business, also aided us along the way withmeasured doses of praise and criticism. We thank them all. Thanks too to theUniversity of Virginia’s Department of Economics, especially the duo of economichistorians and “money guys” there, Ron Michener and John James, for putting upwith Wright one very hot summer in Charlottesville. Very special thanks go to themembers of Wright’s Summer I 2007 Money and Banking class at the University ofVirginia, who suffered through a free but error-prone first draft, mostly with goodhumor and always with helpful comments: Kevin Albrecht, Adil Arora, Eric Bagden,Michelle Coffey, Timothy Dalbey, Karina Delgadillo, Christopher Gorham, JoshuaHefner, Joseph Henderson, Jamie Jackson, Anthony Jones, Robert Jones, RistoKeravuori, Heather Koo, Sonia Kwak, Yiding Li, Patrick Lundquist, Maria McLemore,Brett Murphy, Daniel Park, Bensille Parker, Rose Phan, Patrick Reams, ArjunSharma, Cole Smith, Sandy Su, Paul Sullivan, Nedim Umur, Will van der Linde, NealWood, and June Yang. The students and professors who provided feedback onversion 1.0 of this book also have our hearty gratitude.

It’s customary at this point for authors to assume full responsibility for the factsand judgments in their books. We will not buck that tradition: the buck stops here!Unlike a journal article or academic monograph, textbooks afford ample room forrevision in subsequent editions, of which we hope there will be many. So if you spota problem, contact the publisher and we’ll fix it at the earliest (economicallyjustifiable) opportunity.

Robert E. Wright, January 2011, Sioux Falls, South Dakota.

Vincenzo Quadrini, February 2009, Los Angeles, California

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Preface

“Dad,” my kids regularly ask me, “why do you write such boring books?” They thengiggle and run away before I have a chance to tickle them to tears. They are still tooyoung to realize that boring, like beauty, is in the eye of the beholder. The financialcrisis of 2007–2008 has made the study of money and banking almost as exciting assex, drugs, and rock ’n’ roll because it has made clear to all observers just howimportant the financial system is to our well-being. This is the first textbook toexamine that crisis and its aftermath, including the regulatory reform passed in July2010 commonly called the Dodd-Frank Wall Street Reform and Consumer ProtectionAct. This book is also exciting, or at least not boring, because of the writing style wehave employed. Numerous humorous links are provided and slang terms arepeppered throughout. Seemingly complex subjects like money, interest rates,banking, financial regulation, and the money supply are treated in short, snappysections, not longwinded treatises. Yet we have sacrificed little in the way ofanalytical rigor.

This book is designed to help you internalize the basics of money and banking. Thereis a little math, some graphs, and some sophisticated vocabulary, but nothingterribly difficult, if you put your brain to it. The text’s most important goal is to getyou to think for yourselves. To fulfill that goal, each section begins with one ormore questions, called Learning Objectives, and ends with Key Takeaways thatprovide short answers to the questions and smartly summarize the section in a fewbullet points. Most sections also contain a sidebar called Stop and Think. Ratherthan ask you to simply repeat information given in the chapter discussion, the Stopand Think sidebars require that you apply what you (should have) learned in thechapter to a novel situation. You won’t get them all correct, but that isn’t the point.The point is to stretch your brain. Where appropriate, the book also drills you onspecific skills, like calculating bond prices. Key terms and chapter-level objectivesalso help you to navigate and master the subject matter. The book is deliberatelyshort and right to the point. If you hunger for more, read one or more of the bookslisted in the Suggested Reading section at the end of each chapter. Keep in mind,however, that the goal is to internalize, not to memorize. Allow this book to informyour view of the world and you will be the better for it, and so will your loved ones.

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Chapter 1

Money, Banking, and Your World

CHAPTER OBJECTIVES

By the end of this chapter, students should be able to:

1. Describe how ignorance of the principles of money and banking hasinjured the lives of everyday people.

2. Describe how understanding the principles of money and banking hasenhanced the lives of everyday people.

3. Explain how bankers can simultaneously be entrepreneurs and lend toentrepreneurs.

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1.1 Dreams Dashed

LEARNING OBJECTIVE

1. How can ignorance of the principles of money and banking destroy yourdreams?

At 28, Ben is in his prime. Although tall, dark, and handsome enough to be a moviestar, Ben’s real passion is culinary, not thespian. Nothing pleases him more thanapplying what he learned earning his degrees in hospitality and nutrition toprepare delicious yet healthy appetizers, entrees, and desserts for restaurant-goers.He chafes, therefore, when the owner of the restaurant for which he works forceshim to use cheaper, but less nutritional, ingredients in his recipes. Ben wants to behis own boss and thinks he sees a demand for his style of tasty, healthy cuisine.Trouble is, Ben, like most people, came from humble roots. He doesn’t have enoughmoney to start his own restaurant, and he’s having difficulty borrowing what heneeds because of some youthful indiscretions concerning money. If Ben is right, andhe can obtain financing, his restaurant could become a chain that mightrevolutionize America’s eating habits, rendering Eric Schlosser’s exposé of the U.S.retail food industry, Fast Food Nation (2001),www.amazon.com/Fast-Food-Nation-Eric-Schlosser/dp/0060838582/sr=8-1/qid=1168386508/ref=pd_bbs_sr_1/104-9795105-9365527?ie=UTF8&s=books as obsolete as The Jungle(1901),http://sinclair.thefreelibrary.com/Jungle;http://sunsite.berkeley.edu/Literature/Sinclair/TheJungle/ Upton Sinclair’s infamous description of thedisgusting side of the early meatpacking industry. If Ben can get some financial helpbut is wrong about Americans preferring natural ingredients to hydrogenized thisand polysaturated that, he will have wasted his time and his financial backers maylose some money. If he cannot obtain financing, however, the world will never knowwhether his idea was a good one or not. Ben’s a good guy, so he probably won’t turn todrugs and crime but his life will be less fulfilling, and Americans less healthy, if henever has a chance to pursue his dream.

Married for a decade, Rose and Joe also had a dream, the American Dream, a hugehouse with a big, beautiful yard in a great neighborhood. The couple could notreally afford such a home, but they found a lender that offered them low monthlypayments. It seemed too good to be true because it was. Rose and Joe unwittingly agreedto a negative amortization mortgage1 with a balloon payment2. Their monthlypayments were so low because they paid just part of the interest due each year andnone of the (growing) principal. When housing prices in their area began to slidedownward, the lender foreclosed, although they had never missed a payment. They

1. A mortgage with periodicpayments lower than whatwould be required to pay theinterest on the loan. Instead ofdeclining over time, theprincipal owed increases asunpaid interest is added to it.

2. A principal payment due in alarge lump sum, usually at theend of the loan period.

Chapter 1 Money, Banking, and Your World

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http://www.amazon.com/Fast-Food-Nation-Eric-Schlosser/dp/0060838582/sr=8-1/qid=1168386508/ref=pd_bbs_sr_1/104-9795105-9365527?ie=UTF8&s=bookshttp://www.amazon.com/Fast-Food-Nation-Eric-Schlosser/dp/0060838582/sr=8-1/qid=1168386508/ref=pd_bbs_sr_1/104-9795105-9365527?ie=UTF8&s=bookshttp://www.amazon.com/Fast-Food-Nation-Eric-Schlosser/dp/0060838582/sr=8-1/qid=1168386508/ref=pd_bbs_sr_1/104-9795105-9365527?ie=UTF8&s=bookshttp://sinclair.thefreelibrary.com/Junglehttp://sunsite.berkeley.edu/Literature/Sinclair/TheJungle/http://sunsite.berkeley.edu/Literature/Sinclair/TheJungle/

lost their home and, worse, their credit. The couple now rents a small apartmentand harbors a deep mistrust of the financial system.

Rob and Barb had a more modest dream of a nice house in a good location withmany conveniences, a low crime rate, and a decent public school system. Theyfound a suitable home, had their offer accepted, and obtained a conventional thirty-year mortgage. But they too discovered that their ignorance of the financial systemcame with a price when they had difficulty selling their old house. They put it upfor sale just as the Federal Reserve,http://www.federalreserve.gov/ America’scentral bank (monetary authority), decided to raise the interest rate3 because theeconomy, including the housing market, was too hot (growing too quickly),portending a higher price level across the economy (inflation). Higher interestmeant it was more expensive to borrow money to buy a house (or anything else forthat matter). To compensate, buyers decreased the amount they were willing tooffer and in some cases stopped looking for a new home entirely. Unable to pay themortgage on both houses, Rob and Barb eventually sold their old house for muchless than they had hoped. The plasma TV, new carpeting, playground set in theyard, sit-down mower, and other goods they planned to buy evaporated. That mayhave been good for the economy by keeping inflation in check, but Rob and Barb, like Rose,Joe, and Ben, wished they knew more about the economics of money, banking, and interestrates.

Samantha too wished that she knew more about the financial system, particularlyforeign exchange4. Sam, as her friends called her, had grown up in Indiana, whereshe developed a vague sense that people in other countries use money that issomehow different from the U.S. dollar. But she never gave the matter muchthought, until she spent a year in France as an exchange student. With only $15,000in her budget, she knew that things would be tight. As the dollar depreciated (lostvalue) vis-à-vis France’s currency, the euro, she found that she had to pay more andmore dollars to buy each euro. Poor Sam ran through her budget in six months.Unable to obtain employment in France, she returned home embittered, herconversational French still vibrating with her Indiana twang.

Jorge would have been a rich man today if his father had not invested his inheritance in U.S.government bonds in the late 1960s. The Treasury promptly paid the interestcontractually due on those bonds, but high rates of inflation and interest in the1970s and early 1980s reduced their prices and wiped out most of their purchasingpower. Instead of inheriting a fortune, Jorge received barely enough to buy amidsized automobile. That his father had worked so long and so hard for so littlesaddened Jorge. If only his father had understood a few simple facts: when thesupply of money increases faster than the demand for it, prices rise and inflationensues. When inflation increases, so too do nominal interest rates. And wheninterest rates rise, the prices of bonds (and many other types of assets that pay

3. The price of borrowed money.

4. Buying and selling of foreigncurrencies, for example, theBritish pound, the Japaneseyen, and the European Union’seuro.


1.1 Dreams Dashed 7

http://www.federalreserve.gov/

fixed sums) fall. Jorge’s father didn’t lack intelligence, and he wasn’t even atypical.Many people, even some otherwise well-educated ones, do not understand thebasics of money, banking, and finance. And they and their loved ones pay for it,sometimes dearly.

Madison knows that all too well. Her grandparents didn’t understand theimportance of portfolio diversification (the tried-and-true rule that you shouldn’tput all of your eggs in one basket), so they invested their entire life savings in asingle company, Enron.www.riskglossary.com/link/enron.htm They lost everything(except their Social Security checks)www.ssa.gov/ after that bloated behemothwent bankrupt in December 2001. Instead of lavishing her with gifts, Madison’sgrandparents drained resources away from their granddaughter by constantlyseeking handouts from Madison’s parents. When the grandparents died—withoutlife insurance5, yet another misstep—Madison’s parents had to pay big bucks fortheir “final expenses.”www.fincalc.com/ins_03.asp?id=6

Stop and Think Box

History textbooks often portray the American Revolution as a rebellion againstunjust taxation, but the colonists of British North America had other, moreimportant grievances. For example, British imperial policies set in Londonmade it difficult for the colonists to control the supply of money or interestrates. When money became scarce, as it often did, interest rates increaseddramatically, which in turn caused the value of colonists’ homes, farms, andother real estate to decrease quickly and steeply. As a consequence, many losttheir property in court proceedings and some even ended up in special debtors’prisons. Why do history books fail to discuss this important monetary cause ofthe American Revolution?

Most historians, like many people, generally do not fully understand theprinciples of money and banking.

KEY TAKEAWAY

• People who understand the principles of money and banking are morelikely to lead happy, successful, fulfilling lives than those who remainignorant about them.

5. A contract that promises to paya sum of money tobeneficiaries upon the death ofan insured person.


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1.2 Hope Springs

LEARNING OBJECTIVE

1. How can knowledge of the principles of money and banking help you toachieve your dreams?

Of course, sometimes things go right, especially when one knows what one is doing.Henry Kaufman,www.theglobalist.com/AuthorBiography.aspx?AuthorId=126 whoas a young Jewish boy fled Nazi persecution in the 1930s, is now a billionairebecause he understood what made interest rates (and as we’ll see, by extension, theprices of all sorts of financial instruments) rise and fall. A little later, anotherimmigrant from Central Europe, George Soros, made a large fortune correctlypredicting changes in exchange rates6.www.georgesoros.com/ Millions of otherindividuals have improved their lot in life (though most not as much as Kaufman and Soros!)by making astute life decisions informed by knowledge of the economics of money andbanking. Your instructor and I cannot guarantee you riches and fame, but we canassure you that, if you read this book carefully, attend class dutifully, and studyhard, your life will be the better for it.

The study of money and banking can be a daunting one for students. Seeminglyfamiliar terms here take on new meanings. Derivatives refer not to calculus (thoughcalculus helps to calculate their value) but to financial instruments for tradingrisks. Interest is not necessarily interesting; stocks are not alive nor are theyholding places for criminals; zeroes can be quite valuable; CDs don’t contain music;yield curves are sometimes straight lines; and the principal is a sum of money or anowner, not the administrative head of a high school. In finance, unlike in retail orpublishing, returns are a good thing. Military-style acronyms and jargon also abound:4X, A/I, Basel II, B.I.G., CAMELS, CRA, DIDMCA, FIRREA, GDP, IMF, LIBOR, m,NASDAQ, NCD, NOW, OTS, r, SOX, TIPS, TRAPS, and on and on.www.acronym-guide.com/financial-acronyms.html; http://www.garlic.com/~lynn/fingloss.htm

People who learn this strange new language and who learn to think like a banker(or other type of financier) will be rewarded many times over in their personallives, business careers, and civic life. They will make better personal decisions, run theirbusinesses or departments more efficiently, and be better-informed citizens. Whether theyseek to climb the corporate ladder or start their own companies, they will discoverthat interest, inflation, and foreign exchange rates are as important to success asare cell phones, computers, and soft people skills. And a few will find a career in6. The price of one currency in

terms of another.


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banking to be lucrative and fulfilling. Some, eager for a challenging and rewardingcareer, will try to start their own banks from scratch. And they will be able to do so,provided they are good enough to pass muster with investors and with governmentregulators charged with keeping the financial system, one of the most importantsectors of the economy, safe and sound.

One last thing. This book is about Western financial systems, not Islamic ones.Islamic finance performs the same functions as Western finance but tries to do so ina way that is sharia-compliant, or, in other words, a way that accords with theteachings of the Quran and its modern interpreters, who frown upon interest. Tolearn more about Islamic finance, which is currently growing and developing veryrapidly, you can refer to one of the books listed in Suggested Readings.

Stop and Think Box

Gaining regulatory approval for a new bank has become so treacherous thatconsulting firms specializing in helping potential incorporators to navigateregulator-infested waters have arisen and some, likeNubank,www.nubank.com/ have thrived. Why are regulations so stringent,especially for new banks? Why do people bother to form new banks if it is sodifficult?

Banking is such a complex and important part of the economy that thegovernment cannot allow anyone to do it. For similar reasons, it cannot allowjust anyone to perform surgery or fly a commercial airliner. People run theregulatory gauntlet because establishing a new bank can be extremelyprofitable and exciting.

KEY TAKEAWAY

• Not everyone will, or can, grow as wealthy as Henry Kaufman, GeorgeSoros, and other storied financiers, but everyone can improve their livesby understanding the financial system and their roles in it.


1.2 Hope Springs 10

http://www.nubank.com/

1.3 Suggested Browsing

Financial Literacy Foundation: http://www.finliteracy.org/

The FLF “is a nonprofit organization created to address the growing problem offinancial illiteracy among young consumers.” Similar organizations include theCommunity Foundation for Financial Literacy(http://www.thecommunityfoundation-ffl.org) and the Institute for FinancialLiteracy (http://www.financiallit.org/).

Museum of American Finance: http://www.moaf.org/index

In addition to its Web site and its stunning new physical space at the corner ofWilliam and Wall in Manhattan’s financial district, the Museum of AmericanFinance publishes a financial history magazine. One of this book’s authors (Wright)sits on the editorial board.


11

http://www.finliteracy.org/http://www.thecommunityfoundation-ffl.orghttp://www.financiallit.org/http://www.moaf.org/index

1.4 Suggested Reading

Ayub, Muhammed. Understanding Islamic Finance. Hoboken, NJ: John Wiley and Sons,2008.

El-Gamal, Mahmoud. Islamic Finance: Law, Economics, and Practice. New York:Cambridge University Press, 2008.

Kaufman, Henry. On Money and Markets: A Wall Street Memoir. New York: McGraw Hill,2001.

Soros, George. Soros on Soros: Staying Ahead of the Curve. Hoboken, NJ: John Wiley andSons, 1995.


12

Chapter 2

The Financial System

CHAPTER OBJECTIVES

By the end of this chapter, students should be able to:

1. Critique cultural stereotypes of financiers.2. Describe the financial system and the work that it performs.3. Define asymmetric information and sketch the problems that it causes.4. List the major types of financial markets and describe what

distinguishes them.5. List the major types of financial instruments or securities and describe

what distinguishes them.6. List the major types of intermediaries and describe what distinguishes

them.7. Describe and explain the most important trade-offs facing investors.8. Describe and explain borrowers’ major concerns.9. Explain the functions of financial regulators.

13

2.1 Evil and Brilliant Financiers?

LEARNING OBJECTIVE

1. Are bankers, insurers, and other financiers innately good or evil?

Ever notice that movies and books tend to portray financiers as evil and powerfulmonsters, bent on destroying all that decent folks hold dear for the sake of a fastbuck? In his best-selling 1987 novel Bonfire of the Vanities,www.amazon.com/Bonfire-Vanities-Tom-Wolfe/dp/0553275976 for example, Tom Wolfe depicts WallStreet bond trader Sherman McCoy (played by Tom Hanks in the movieversion)www.imdb.com/title/tt0099165/ as a slimy “Master of the Universe”: rich,powerful, and a complete butthead. Bashing finance is not a passing fad; you mayrecall the unsavory Shylock character from Shakespeare’s play The Merchant ofVenice.http://www.bibliomania.com/0/6/3/1050/frameset.html And who couldforget Danny DeVitowww.imdb.com/name/nm0000362/ as the arrogant littledonut-scarfing “Larry the Liquidator” juxtaposed against the adorable old factoryowner Andrew Jorgenson (played by Gregory Peck)www.imdb.com/name/nm0000060/ in Other People’s Money.www.imdb.com/title/tt0102609/ Even theChristmas classic It’s a Wonderful Lifewww.nndb.com/films/309/000033210/ containsat best a dual message. In the film, viewers learn that George Bailey, the lovablepresident of the local building and loan association (a type of community bank)played by Jimmy Stewart, saved Bedford Falls from the clutches of a characterportrayed by Lionel Barrymore, actress Drew Barrymore’s grand-uncle, the ancientand evil financier Henry F. Potter. (No relation to Harry, I’m sure.) That’s hardly aringing endorsement of finance.video.google.com/videoplay?docid=4820768732160163488&pr=goog-sl

Truth be told, some financiers have done bad things. Then again, so have membersof every occupational, geographical, racial, religious, and ethnic group on theplanet. But most people, most of the time, are pretty decent, so we should not malign entiregroups for the misdeeds of a few, especially when the group as a whole benefits others.Financiers and the financial systems they inhabit benefit many people in wealthiercountries. The financial system does so much good for the economy, in fact, thatsome people believe that financiers are brilliant rocket scientists or at least “thesmartest guys in the room.”en.wikipedia.org/wiki/The_Smartest_Guys_in_the_Room This positive stereotype, however, is as flawed asthe negative one. While some investment bankers, insurance actuaries, and otherfancy financiers could have worked for NASA, they are far from infallible. Thefinancial crisis that began in 2007 reminds us, once again, that complex

Chapter 2 The Financial System

14

http://www.amazon.com/Bonfire-Vanities-Tom-Wolfe/dp/0553275976http://www.amazon.com/Bonfire-Vanities-Tom-Wolfe/dp/0553275976http://www.imdb.com/title/tt0099165/http://www.bibliomania.com/0/6/3/1050/frameset.htmlhttp://www.imdb.com/name/nm0000362/http://www.imdb.com/name/nm0000060/http://www.imdb.com/name/nm0000060/http://www.imdb.com/title/tt0102609/http://www.nndb.com/films/309/000033210/http://video.google.com/videoplay?docid=4820768732160163488&pr=goog-slhttp://video.google.com/videoplay?docid=4820768732160163488&pr=goog-slhttp://en.wikipedia.org/wiki/The_Smartest_Guys_in_the_Roomhttp://en.wikipedia.org/wiki/The_Smartest_Guys_in_the_Room

mathematical formulas are less useful in economics (and other social sciences) thanin astrophysics. Financiers, like politicians, religious leaders, and, yes, college professors,have made colossal mistakes in the past and will undoubtedly do so again in the future.

So rather than lean on stereotypes, this chapter will help you to form your ownview of the financial system. In the process, it will review the entire system. It’s wellworth your time and effort to read this chapter carefully because it contains a lot ofdescriptive information and definitions that will help you later in the text.

KEY TAKEAWAYS

• Financiers are not innately good or evil but rather, like other people,can be either, or can even be both simultaneously.

• While some financiers are brilliant, they are not infallible, and fancymath does not reality make.

• Rather than follow prevalent stereotypes, students should form theirown views of the financial system.

• This important chapter will help students to do that, while also bringingthem up to speed on key terms and concepts that will be usedthroughout the book.


2.1 Evil and Brilliant Financiers? 15

2.2 Financial Systems

LEARNING OBJECTIVE

1. What is a financial system and why do we need one?

A financial system1 is a densely interconnected network of financialintermediaries, facilitators, and markets that serves three major purposes:allocating capital, sharing risks, and facilitating intertemporal trade. That soundsmundane, even boring, but it isn’t once you understand how important it is tohuman welfare. The material progress and technological breakthroughs of the lasttwo centuries, ranging from steam engines, cotton gins, and telegraphs, toautomobiles, airplanes, and telephones, to computers, DNA splicing, and cellphones, would not have been possible without the financial system. Efficientlylinking borrowers to lenders is the system’s main function. Borrowers includeinventors, entrepreneurs, and other economic agents, like domestic households,governments, established businesses, and foreigners, with potentially profitablebusiness ideas (positive net present value projects2) but limited financialresources (expenditures > revenues). Lenders or savers include domestichouseholds, businesses, governments, and foreigners with excess funds (revenues >expenditures). The financial system also helps to link risk-averse entities calledhedgers to risk-loving ones known as speculators. As Figure 2.1 "“The financialsystem at work for you”?" illustrates, you are probably already deeply imbedded inthe financial system as both a borrower and as a saver.

1. A densely interconnectednetwork of financialintermediaries, facilitators,and markets that allocatescapital, shares risks, andfacilitates intertemporal trade.

2. A project likely to be profitableat a given interest rate aftercomparing the present valuesof both expenditures andrevenues. This will make moresense after you navigateChapter 4 "Interest Rates".


16

Figure 2.1 “The financial system at work for you”?

Occasionally, people and companies, especially small businesses or ones that sellinto rapidly growing markets, have enough wealth (a stock) and income (a flow) toimplement their ideas without outside help by plowing back profits (aka internalfinance3). Most of the time, however, people and firms with good ideas do not have thesavings or cash needed to draw up blueprints, create prototypes, lease office or productionspace, pay employees, obtain permits and licenses, or suffer the myriad risks of bringing anew or improved good to market. Without savings, a rich uncle or close friend, or someother form of external finance4, people remain wannabe entrepreneurs andcompanies cannot complete their projects. That should concern you because theworld is a poorer place for it.www.innovation-america.org/archive.php?articleID=79

Why do we need a financial system? Why can’t individuals and companies simplyborrow from other individuals and companies when they need to? Lending, likesupplying many other types of goods, is most efficiently and cheaply conducted byspecialists, companies that do only one thing (or a couple of related activities) very wellbecause they have much practice doing it and because they tap economies of scale. Thefixed costs of making loans—advertising for borrowers, buying and maintainingcomputers, leasing suitable office space, and the like—are fairly substantial. Torecoup those fixed costs, to drive them toward insignificance, lenders have to doquite a volume of business. Little guys usually just can’t be profitable. This is not to

3. Financing that comes from thecompany itself, the plowing ofprofits back into the business.

4. Obtaining short- or long-termfunding from outside sources(those external to thecompany).


2.2 Financial Systems 17

http://www.innovation-america.org/archive.php?articleID=79http://www.innovation-america.org/archive.php?articleID=79

say, however, that bigger is always better, only that to be efficient financialcompanies must exceed minimum efficient scale5.

KEY TAKEAWAYS

• The financial system is a dense network of interrelated markets andintermediaries that allocates capital and shares risks by linking savers tospenders, investors to entrepreneurs, lenders to borrowers, and therisk-averse to risk-takers.

• It also increases gains from trade by providing payment services andfacilitating intertemporal trade.

• A financial system is necessary because few businesses can rely oninternal finance alone.

• Specialized financial firms that have achieved minimum efficient scaleare better at connecting investors to entrepreneurs than nonfinancialindividuals and companies.

5. The smallest a business can beand still remain efficient and/or profitable.


2.2 Financial Systems 18

2.3 Asymmetric Information: The Real Evil

LEARNING OBJECTIVE

1. What is asymmetric information, what problems does it cause, and whatcan mitigate it?

Finance also suffers from a peculiar problem that is not easily overcome by just anybody.Undoubtedly, you’ve already encountered the concept of opportunity costs, thenasty fact that to obtain X you must give up Y, that you can’t have your cake and eatit too. You may not have heard of asymmetric information, another nasty fact thatmakes life much more complicated. Like scarcity6, asymmetric information inheresin nature, the devil incarnate. That is but a slight exaggeration. When a seller(borrower, a seller of securities) knows more than a buyer (lender or investor, abuyer of securities), only trouble can result. Like the devil in Dante’sInferno,http://www.fullbooks.com/Dante-s-Inferno.html this devil has two big uglyheads, adverse selection7, which raises Cain before a contract is signed, and moralhazard8, which entails sinning after contract consummation. (Later, we’ll learnabout a third head, the principal-agency problem, a special type of moral hazard.)

Due to adverse selection, the fact that the riskiest borrowers are the ones who moststrongly desire loans, lenders attract sundry rogues, knaves, thieves, and ne’er-do-wells, like pollen-laden flowers attract bees (Natty Lightwww.urbandictionary.com/define.php?term=natty+light attracts frat boys?). If they are unaware of that selectionbias, lenders will find themselves burned so often that they will prefer to keep their savingsunder their mattresses rather than risk lending it. Unless recognized and effectivelycountered, moral hazard will lead to the same suboptimal outcome. After a loan hasbeen made, even good borrowers sometimes turn into thieves because they realize that theycan gamble with other people’s money. So instead of setting up a nice little ice creamshop with the loan as they promised, a disturbing number decide instead to try toget rich quick by taking a quick trip to Vegas or AtlanticCitywww.pickeringchatto.com/index.php/pc_site/monographs/gambling_on_the_american_dream for some potentially lucrative fun at theblackjack table. If they lose, they think it is no biggie because it wasn’t their money.

One of the major functions of the financial system is to tangle with those devilishinformation asymmetries. It never kills asymmetry, but it usually reduces itsinfluence enough to let businesses and other borrowers obtain funds cheaplyenough to allow them to grow, become more efficient, innovate, invent, and expand

6. The finite availability ofresources coupled with theinfinite demand for them; thefact that goods are notavailable in sufficient quantityto satisfy everyone’s wants.

7. The fact that the least desirableborrowers and those who seekinsurance most desire loansand insurance policies.

8. Any postcontractual change inbehavior that injures otherparties to the contract.


19

http://www.fullbooks.com/Dante-s-Inferno.htmlhttp://www.urbandictionary.com/define.php?term=natty+lighthttp://www.urbandictionary.com/define.php?term=natty+lighthttp://www.pickeringchatto.com/index.php/pc_site/monographs/gambling_on_the_american_dreamhttp://www.pickeringchatto.com/index.php/pc_site/monographs/gambling_on_the_american_dream

into new markets. By providing relatively inexpensive forms of external finance, financialsystems make it possible for entrepreneurs and other firms to test their ideas in themarketplace. They do so by eliminating, or at least reducing, two major constraintson liquidity9 and capital10, or the need for short-term cash and long-termdedicated funds. They reduce those constraints in two major ways: directly (thoughoften with the aid of facilitators11) via markets12 and indirectly viaintermediaries13. Another way to think about that is to realize that the financialsystem makes it easy to trade intertemporally, or across time. Instead ofimmediately paying for supplies with cash, companies can use the financial systemto acquire what they need today and pay for it tomorrow, next week, next month,or next year, giving them time to produce and distribute their products.

Stop and Think Box

You might think that you would never stoop so low as to take advantage of alender or insurer. That may be true, but financial institutions are not worriedabout you per se; they are worried about the typical reaction to asymmetricinformation. Besides, you may not be as pristine as you think. Have you everdone any of the following?

• Stolen anything from work?• Taken a longer break than allowed?• Deliberately slowed down at work?• Cheated on a paper or exam?• Lied to a friend or parent?

If so, you have taken advantage (or merely tried to, if you were caught) ofasymmetric information.

9. The ease, speed, and cost ofsale of an asset.

10. In this context, long-termfinancing.

11. In this context, businesses thathelp markets to function moreefficiently.

12. Institutions where the quantityand price of goods aredetermined.

13. Businesses that connectinvestors to entrepreneurs viavarious financial contracts, likechecking accounts andinsurance policies.


2.3 Asymmetric Information: The Real Evil 20

KEY TAKEAWAYS

• Asymmetric information occurs when one party knows more about aneconomic transaction or asset than the other party does.

• Adverse selection occurs before a transaction takes place. Ifunmitigated, lenders and insurers will attract the worst risks.

• Moral hazard occurs after a transaction takes place. If unmitigated,borrowers and the insured will take advantage of lenders and insurers.

• Financial systems help to reduce the problems associated with bothadverse selection and moral hazard.


2.3 Asymmetric Information: The Real Evil 21

Figure 2.2 Nineteenth-century picture of maletelegraph operator

2.4 Financial Markets

LEARNING OBJECTIVE

1. In what ways can financial markets and instruments be grouped?

Financial markets come in a variety of flavors to accommodate the wide array of financialinstruments or securities that have been found beneficial to both borrowers and lenders overthe years. Primary markets are where newly created (issued) instruments are soldfor the first time. Most securities are negotiable. In other words, they can be sold toother investors at will in what are called secondary markets. Stock exchanges, orsecondary markets for ownership stakes in corporations called stocks (aka shares orequities), are the most well-known type, but there are also secondary markets fordebt, including bonds (evidences of sums owed, IOUs), mortgages, and derivatives14and other instruments. Not all secondary markets are organized as exchanges,centralized locations, like the New York Stock Exchange or the Chicago Board ofTrade, for the sale of securities. Some are over-the-counter (OTC) markets run bydealers15 connected via various telecom devices (first by post and semaphore [flagsignals], then by telegraph, then telephone, and now computer). Completelyelectronic stock markets have gained much ground in recent years.“StockExchanges: The Battle of the Bourses,” The Economist (31 May 2008), 77–79.

Money markets are used to trade instruments with less than ayear to maturity (repayment of principal). Examples includethe markets for T-bills (Treasury bills or short-termgovernment bonds), commercial paper (short-termcorporate bonds), banker’s acceptances (guaranteedbank funds, like a cashier’s check), negotiablecertificates of deposit (large-denomination negotiableCDs, called NCDs), Fed funds (overnight loans ofreserves between banks), call loans (overnight loans onthe collateral of stock), repurchase agreements (short-term loans on the collateral of T-bills), and foreignexchange (currencies of other countries).

Securities with a year or more to maturity trade in capitalmarkets. Some capital market instruments, calledperpetuities, never mature or fall due. Equities(ownership claims on the assets and income of

14. Derivatives are complexfinancial instruments, theprices of which are based onthe prices of underlying assets,variables, or indices. Someinvestors use them to hedge(reduce) risks, while others(speculators) use them toincrease risks.

15. Businesses that buy and sellsecurities continuously at bidand ask prices, profiting fromthe difference or spreadbetween the two prices.


22

© 2010 JupiterimagesCorporation

corporations) and perpetual interest-only loans areprime examples. (Some interest-only loans mature infifteen or thirty years with a so-called balloon payment,in which the principal falls due all at once at the end ofthe loan.) Most capital market instruments, includingmortgages (loans on real estate collateral16), corporatebonds, government bonds, and commercial and consumer loans, have fixedmaturities ranging from a year to several hundred years, though most capitalmarket instruments issued today have maturities of thirty years or less. Figure 2.3"Types of financial markets" briefly summarizes the differences between varioustypes of financial markets.

Figure 2.3 Types of financial markets

Derivatives contracts trade in a third type of financial market. Derivatives allow investorsto spread and share a wide variety of risks, from changes in interest rates and stockmarket indicesquote.yahoo.com/m1?u to undesirable weatherconditionswww.cme.com/trading/prd/weather/index.html (too sunny for farmers,too rainy for amusement parks, too cold for orange growers, too hot for ski resorts).Financial derivatives are in some ways even more complicated than the derivativesin calculus, so they are usually discussed in detail only in more specialized oradvanced courses. (Here is a spot where your instructor might provide customcontent.)

Some call financial markets “direct finance,” though most admit the term is a misnomerbecause the functioning of the markets is usually aided by one or more market facilitators,including brokers, dealers, brokerages, and investment banks. Brokers facilitatesecondary markets by linking sellers to buyers of securities in exchange for a fee ora commission, a percentage of the sale price. Dealers “make a market” bycontinuously buying and selling securities, profiting from the spread, or thedifference between the sale and purchase prices. (For example, a dealer might buy acertain type of bond at, say, $99 and resell it at $99.125, ten thousand times a day.)16. Property pledged as security

for the repayment of a loan.


2.4 Financial Markets 23

http://quote.yahoo.com/m1?uhttp://www.cme.com/trading/prd/weather/index.html

Brokerages engage in both brokering and dealing and usually also providing theirclients with advice and information. Investment banks facilitate primary marketsby underwriting stock and bond offerings, including initial public offerings (IPOs) ofstocks, and by arranging direct placements17 of bonds. Sometimes investmentbanks act merely as brokers, introducing securities issuers to investors, usuallyinstitutional investors like the financial intermediaries discussed below. Sometimesthey act as dealers, buying the securities themselves for later (hopefully soon!)resale to investors. And sometimes they provide advice, usually regardingmergers18 and acquisitions19. Investment banks took a beating during the financialcrisis that began in 2007. Most of the major ones went bankrupt or merged withlarge commercial banks. Early reports of the death of investment banking turnedout to be premature, but the sector is depressed at present; two large ones andnumerous small ones, niche players called boutiques, remain.“American Finance:And Then There Were None. What the death of the investment bank means for WallStreet,” The Economist (27 September 2008), 85–86.

Stop and Think Box

In eighteenth-century Pennsylvania and Maryland, people could buy realestate, especially in urban areas, on so-called ground rent, in which theyobtained clear title and ownership of the land (and any buildings or otherimprovements on it) in exchange for the promise to pay some percentage(usually 6) of the purchase price forever. What portion of the financial systemdid ground rents (some of which are still being paid) inhabit? How else mightground rents be described?

Ground rents were a form of market or direct finance. They were financialinstruments or, more specifically, perpetual mortgages akin to interest-onlyloans.

Financial markets are increasingly international in scope. Integration of transatlanticfinancial markets began early in the nineteenth century and accelerated after themid-nineteenth-century introduction of the transoceanic telegraph systems. Theprocess reversed early in the twentieth century due to World Wars I and II and thecold war; the demise of the gold standard;John H. Wood, “The Demise of the GoldStandard,” Economic Perspectives (Nov. 1981): 13-23.economics.about.com/od/foreigntrade/a/bretton_woods.htm system of fixed exchange rates, discretionarymonetary policy, and capital immobility. (We’ll explore these topics and a relatedmatter, the so-called trilemma, or impossible trinity, in Chapter 19 "International

17. A sale of financial securities,usually bonds, via directnegotiations with buyers,usually large institutionalinvestors like insurance andinvestment companies.

18. A merger occurs when two ormore extant business firmscombine into one through apooling of interests or throughpurchase.

19. When one company takes acontrolling interest in another;when one business buysanother.



http://economics.about.com/od/foreigntrade/a/bretton_woods.htmhttp://economics.about.com/od/foreigntrade/a/bretton_woods.htm

Monetary Regimes".) With the end of the Bretton Woods arrangement in the early1970s and the cold war in the late 1980s/early 1990s, financial globalizationreversed course once again. Today, governments, corporations, and other securitiesissuers (borrowers) can sell bonds, called foreign bonds, in a foreign countrydenominated in that foreign country’s currency. (For example, the Mexicangovernment can sell dollar-denominated bonds in U.S. markets.) Issuers can alsosell Eurobonds or Eurocurrencies, bonds issued (created and sold) in foreigncountries but denominated in the home country’s currency. (For example, U.S.companies can sell dollar-denominated bonds in London and U.S. dollars can bedeposited in non-U.S. banks. Note that the term Euro has nothing to do with theeuro, the currency of the European Union, but rather means “outside.” A Euro loan,therefore, would be a loan denominated in euro but made in London, New York,Tokyo, or Perth.) It is now also quite easy to invest in foreign stockexchanges,www.foreign-trade.com/resources/financel.htm many of which havegrown in size and importance in the last few years, even if they struggled throughthe panic of 2008.

Stop and Think Box

To purchase the Louisiana Territory from Napoleon in 1803, the U.S.government sold long-term, dollar-denominated bonds in Europe. Whatportion of the financial system did those bonds inhabit? Be as specific aspossible.

Those government bonds were Eurobonds because the U.S. government issuedthem overseas but denominated them in U.S. dollars.

KEY TAKEAWAYS

• Financial markets can be categorized or grouped by issuance (primaryvs. secondary markets), type of instrument (stock, bond, derivative), ormarket organization (exchange or OTC).

• Financial instruments can be grouped by time to maturity (money vs.capital) or type of obligation (stock, bond, derivative).



http://www.foreign-trade.com/resources/financel.htm

2.5 Financial Intermediaries

LEARNING OBJECTIVE

1. In what ways can financial intermediaries be classified?

Like financial markets, financial intermediaries are highly specialized. Sometimescalled the indirect method of finance, intermediaries, like markets, link investors/lenders/savers to borrowers/entrepreneurs/spenders but do so in an ingenious way, by transformingassets20. Unlike facilitators, which, as we have seen, merely broker or buy and sellthe same securities, intermediaries buy and sell instruments with different risk21,return22, and/or liquidity characteristics. The easiest example to understand is thatof a bank that sells relatively low risk (which is to say, safe), low return, and highlyliquid liabilities23, called demand deposits, to investors called depositors and buysthe relatively risky, high return, and nonliquid securities of borrowers in the formof loans, mortgages, and/or bonds. Note, too, that investor–depositors own claimson the bank itself rather than on the bank’s borrowers.

Financial intermediaries are sometimes categorized according to the type of assettransformations they undertake. As noted above, depository institutions, includingcommercial banks, savings banks, and credit unions, issue short-term deposits andbuy long-term securities. Traditionally, commercial banks specialized in issuingdemand, transaction, or checking deposits and making loans to businesses. Savingsbanks issued time or savings deposits and made mortgage loans to households andbusinesses, while credit unions issued time deposits and made consumer loans.(Finance companies also specialize in consumer loans but are not considereddepository institutions because they raise funds by selling commercial paper,bonds, and equities rather than by issuing deposits.)

Due to deregulation24, though, the lines between different types of depository institutionshave blurred in recent years. Ownership structure, charter terms, and regulatoryagencies now represent the easiest way to distinguish between different types ofdepository institutions. Almost all commercial and many savings banks are joint-stock corporations. In other words, stockholders own them. Some savings banksand all credit unions are mutual corporations and hence are owned by those whohave made deposits with them.

Insurance companies are also divided between mutual and joint-stock corporations. Theyissue contracts or policies that mature or come due should some contingency occur, which is

20. Assets are “things owned” asopposed to liabilities, whichare “things owed.”

21. The probability of loss.

22. The percentage gain or lossfrom an investment.

23. Liabilities are “things owed” toothers, as opposed to assets,which are “things owned.”

24. Generally, deregulation refersto any industry whereregulations are eliminated orsignificantly reduced. In thiscontext, deregulation refers toa series of regulatory reformsof the financial industryundertaken in the 1980s and1990s.


26

a mechanism for spreading and sharing risks. Term life insurance policies pay off if theinsured dies within the contract period, while life annuities pay off if the insured isstill alive. Health insurance pays when an insured needs medical assistance.Property or casualty insurance, such as fire or automobile insurance, comes due inthe event of a loss, like a fire or an accident. Liability insurance pays off whensomeone is sued for a tort (damages). Insurers invest policyholder premiums25 instocks, corporate and government bonds, and various money market instruments,depending on the nature of the contingencies they insure against. Life insurancecompanies, for example, invest in longer-term assets than automobile or healthinsurers because, on average, life insurance claims occur much later than propertyor health claims. (In the parlance of insurance industry insiders, life insurance has amuch longer “tail” than property insurance.)

The third major type of intermediary is the investment company, a category that includespension and government retirement funds, which transform corporate bonds and stocks intoannuities, and mutual funds and money market mutual funds, which transform diverseportfolios of capital and money market instruments, respectively, into nonnegotiable26but easily redeemable27 “shares.”

As Figure 2.4 "Share of total U.S. financial assets, year-end, 1945–2010"shows, therelative importance of commercial banks and life insurance companies has waned sinceWorld War II due to the proliferation of additional investment options. As Figure 2.5"Assets of financial intermediaries, selected years, 1945–2005" shows, their declineis relative only; the assets of all major types of intermediaries have grown rapidlyover the last six decades. The figures are in current dollars, or dollars not adjustedfor inflation, and the U.S. economy has grown significantly since the war, in nosmall part due to the financial system. Nevertheless, as shown in Figure 2.6"Financial assets to gross domestic product (GDP), 1945–2010", the assets offinancial intermediaries have grown steadily as a percentage of GDP28.

25. In this context, a sum paid foran insurance contract.

26. Nontransferable to thirdparties.

27. In this context, changeable intocash money by the fund.

28. GDP, or gross domesticproduct, is one of severaldifferent measures ofaggregate output, the totalvalue of all final goods andservices produced in aneconomy.


2.5 Financial Intermediaries 27

Figure 2.4 Share of total U.S. financial assets, year-end, 1945–2010

Figure 2.5 Assets of financial intermediaries, selected years, 1945–2005



Figure 2.6 Financial assets to gross domestic product (GDP), 1945–2010

Financial markets have exhibited similar growth. For example, the Dow Jones IndustrialAverage (DJIA),www.djindexes.com/mdsidx/index.cfm?event=showAverages amechanism for tracking the prices of the shares of the nation’s most importantcorporations, grew from less than 200 at the end of World War II to just shy of 700when John F. Kennedy took office in 1961, to around 1,000 when Ronald Reaganbecame president twenty years later, to over 3,200 in 1992 and over 10,000 by1999.www.measuringworth.org/datasets/DJA/ Trading volumes on the New YorkStock Exchangewww.nyse.com/ and the NASDAQwww.nasdaq.com/ have likewisesoared. In 1945, daily trading volumes rarely exceeded 2 million shares. By 1975, 10million shares was considered a slow day. By 2005, over 1 billion shares wereregularly traded each day.

KEY TAKEAWAY

• Financial intermediaries, including depository institutions (commercialbanks, savings banks, credit unions) and insurers (life, health, propertyand casualty), can be grouped by the composition of their balance sheets(nature of their assets and liabilities and the asset transformations theyundertake) or their ownership structure, the origin of their corporatecharters, and/or the identity of their regulators.



http://www.djindexes.com/mdsidx/index.cfm?event=showAverageshttp://www.measuringworth.org/datasets/DJA/http://www.nyse.com/http://www.nasdaq.com/

2.6 Competition Between Markets and Intermediaries

LEARNING OBJECTIVE

1. What trade-offs do investors face? How do borrowers decide whether touse financial markets or intermediaries to obtain the funds they need?

Why do investors (savers) sometimes choose to invest in intermediaries rather thandirectly in financial markets? Why do borrowers sometimes choose to reduce theirliquidity and capital constraints via intermediaries and sometimes via markets?Markets and intermediaries often fulfill the same needs, though in different ways.Borrowers/securities issuers typically choose the alternative with the lowest overall cost,while investors/savers choose to invest in the markets or intermediaries that provide themwith the risk-return-liquidity trade-off that best suits them.

Risk is a bad thing, while return and liquidity are good things. Therefore, every saverwants to invest in riskless, easily saleable investments that generate high returns.Of course, such opportunities occur infrequently because investors bid up theirprices, thus reducing their returns. (As we’ll see in Chapter 4 "Interest Rates", thehigher the price of an investment, the lower its return, ceteris paribus29.) To keepreturns high, some investors will be willing to give up some liquidity or to take onmore risk. For example, they might buy securities not backed by collateral (assetslike buildings, businesses, or safe financial instruments like T-bills that theborrower promises to forfeit in case of default30). As a result of the competitionbetween investors, and between borrowers, the financial system offers instrumentswith a wide variety of characteristics, ranging from highly liquid, very safe, butlow-return T-bills and demand deposits, to medium-risk, medium-liquidity,medium-return mortgages, to risky but potentially lucrative and easily soldderivatives like put options and foreign exchange futures contracts.

Investors care about more than risk, return, and liquidity, but generally other considerationsare secondary. For example, investors will pay more for investments with fixedredemption dates rather than ones that can be called (repaid) at the borrower’soption because fixed redemption dates reduce investors’ uncertainty. They will alsosometimes pay a little more for instruments issued by environmentally or sociallyconscious companies and countries and less for those issued by dirty, rude ones.

29. All else equal.

30. Non- or partial payment of aloan, bond, or other paymentobligation.


30

Stop and Think Box

In the fall of 2006, interest rates on conventional thirty-year home mortgageswithout a prepayment penalty were about 6.5 percent per year. But mortgageswith otherwise identical terms that contained a prepayment penalty for thefirst seven years of the loan could be had for 6.25 percent per year. Why wasthat the case?

In addition to risk, return, and liquidity, investors are concerned about theuncertainty of repayment terms. They are willing to receive a lower return(ceteris paribus, of course) in exchange for a guarantee that a loan will not berepaid for a significant period of time.

As noted above, borrowers also compete with each other for the lowest costmethods of meeting their external financing needs. Obviously, borrowers want topay as little for funds as possible and would like nothing better than to borrow hugesums forever, unconditionally, and at zero interest. Nobody wants to lend on thoseterms, though, so borrowers compete with each other for funds by offeringinvestors higher returns, less risk, or more liquid instruments. They use whicheverpart of the financial system, markets or intermediaries, offers them the best deal. Acompany may sell commercial paper in the money market rather than obtain abank loan, for example, if it is large enough and well-known enough to interestenough investors and market facilitators. A smaller, newer company, though, mayfind that a bank loan is much easier and cheaper to obtain.

KEY TAKEAWAYS

• Investors primarily trade off among risk, return, and liquidity, and to alesser extent they also value the certainty of redemption terms.

• Borrowers want to obtain funds as cheaply as possible and on repaymentterms as flexible as possible.


2.6 Competition Between Markets and Intermediaries 31

2.7 Regulation

LEARNING OBJECTIVE

1. What are the major goals of financial regulation?

Like investors, borrowers are concerned about the total net costs (all costs plus all benefits)of different types of finance. One big consideration is government and self-regulation.Compared to most other parts of modern capitalist economies, the financial system isrelatively heavily regulated. Regulators like the Securities and Exchange Commission(SEC, which oversees exchanges and OT

Documents

Finance, Banking, and Money - lardbucket...Chapter 5: The Economics of Interest-Rate Fluctuations.....82 Interest Rate Fluctuations.....83 Shifts in Supply and Demand