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Overview of the Financial System
The Economics of Money, Banking, and Financial Markets Mishkin, 7th ed.
Chapter 2
Direct finance and Indirect finance
Direct finance – funds are directly transferred from lenders to borrowers
Indirect finance – financial intermediaries receive funds from savers and lend them to borrowers Securities are assets for the holder
and liabilities for the issuer
Function of Financial Markets
1. Allows transfers of funds from person or business without investment opportunities to one who has them2. Improves economic efficiency
Debt and equity markets Debt instruments – contractual obligation to pay
the holder fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans)
Short-term debt instruments have a maturity of less than one year
Intermediate-term debt instruments have a maturity between 1 and 10 years
Long-term debt instruments have a maturity of ten or more years
Equity – sale of ownership share (owners are residual claimants).
Owners of stock may receive dividends
Primary and secondary markets
Primary market = financial market in which newly issued securities are sold.
Secondary market = financial market in which previously owned securities are sold.
Brokers and dealers Broker – match buyers and sellers Dealers – buy and sell securities
Role of secondary markets Increase liquidity of financial
assets Determine security prices that help
determine the price of securities in primary markets
Exchanges and over-the-counter markets
Exchange – buyers and sellers meet in one central location (e.g., NYSE or Chicago Board of Trade)
Over-the-counter market – transactions take place in multiple locations through dealers
Money and capital markets Money market – market for short-
term debt instruments Capital market – market for
intermediate and long-term debt and equity instruments
International financial markets Foreign bond = bond issued by a foreign entity
that is denominated in the currency of the country in which the bond is sold
Eurobond = bond denominated in a currency other than that of the country in which the bond is sold
Foreign bonds may be used to avoid exchange-rate risk
Eurocurrencies – deposits denominated in a currency other than that of the country in which the bank is located
London, Tokyo and other foreign stock exchanges have grown in importance
Financial intermediaries Reduce transaction costs (due to
economies of scale and lower information costs)
Allow for differences in the desired lending and borrowing time horizons
Risk sharing (asset transformation) lowers risk through diversification
Asymmetric information Moral hazard
The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party
Adverse selection Individuals who are willing to accept a
financial (or other) contract are of lower “quality” than a typical individual in the population
Asymmetric information: Adverse selection,and Moral hazard
Adverse Selection1. Before transaction occurs2. Potential borrowers most likely to produce adverse
outcomes are ones most likely to seek loans and be selected
Moral Hazard1. After transaction occurs2. Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
Types of financial intermediaries
Depository institutions Commercial banks Savings and Loan Associations Mutual savings banks Credit unions
Contractual savings institutions Life insurance companies Fire and casualty insurance companies Pension funds and government retirement
funds Finance companies Mutual funds Money market mutual funds
15
Financial Intermediaries
Size of Financial Intermediaries
Financial market instruments
Money market instruments United States treasury bills (discounted; no default risk) Negotiable bank certificates of deposit (NCD; large
denominations) Commercial paper (CP; direct finance; largest instrument) Banker’s acceptances (use abroad in international trade) Repurchase agreements (repos; <2 wks; need collateral) Federal funds (overnight loan b/w banks of their deposits at
Fed)
Financial market instruments
Capital market instruments Stocks (largest instruments)
Mortgages (FNMA: Fannie Mae; GNMA: Ginnie Mae; FHLMC: Freddie Mac)
Corporate bonds (convertible vs. non-convertible)
US government securities (most liquid security)
US government agency securities State and local government bonds (municipal
bonds; interest tax free)
Consumer and bank commercial loans
19
Regulatory Agencies
20
Regulatory Agencies
Regulation of financial markets
Two Main Reasons for Regulation (Financial sector is one of the most heavily regulated sectors of the economy)
1. Increase information to investorsA. Decreases adverse selection and moral hazard problemsB. SEC forces corporations to disclose information
2. Ensuring the soundness of financial intermediariesA. Prevents financial panicsB. Chartering, reporting requirements, restrictions on
assets and activities, deposit insurance, and anti-competitive measures
Types of regulation Entry restrictions Disclosure laws (SEC) Restriction on assets and activities Deposit insurance Limits on competition Restrictions on interest rates (no
longer in effect)