1

Ch. 2

AN OVERVIEW OF THE FINANCIAL SYSTEM

To "finance" something means to pay for it. Since money (or credit) is the means

of payment, "financial" basically means "pertaining to money or credit."

Financial markets and financial intermediaries are crucial to a well-functioning

economy because they channel funds from those who do not have a productive use

for them to those who do.

The financial sector plays a vital role in the economy because it helps money be

efficiently channeled from savers to prospective borrowers, making it much easier

for firms to obtain financing for profitable investment in new capital and for

individuals to borrow against their future income (e.g., to pay for college, to buy a

house or car).

Without financial markets and institutions, borrowers would have to borrow

directly from savers. Probably not much borrowing would take place at all,

borrowers would tend to have a hard time finding individuals able and willing to

loan them money.

Without much borrowing, the economy would be a lot less developed, as few

businesses would be able to raises funds to invest in new plant and equipment.

Likewise, relatively few individuals would be able to own their own homes, or buy

a car.

A well-functioning financial sector is necessary for a well-functioning economy.

DIRECT AND INDIRECT FINANCE

Funds can raised directly (direct finance) or indirectly (indirect finance)

Direct finance refers to funds that flow directly from the lender/saver to the

borrowers/investors in financial market.

2

Borrowers sell securities (financial instruments), which represents a claim over

real assets or a future income stream. Such instruments are usually tradable.

Examples of securities include bonds, stocks, bills of exchange, promissory notes,

and certificates of deposit.

Securities are assets for the person who buys them but liabilities (IOUs or debts)

for the individuals or firms who sell (issue) them.

Examples of direct finance include when a person take a loan from his friend, or a

corporation issues new shares of stock or bonds.

Indirect finance refers to funds that flow from the lender/saver to a financial

intermediary who then channels the funds to the borrower/investor. Financial

intermediaries (indirect finance) are the major source of funds for corporations.

FUNCTION OF FINANCIAL MARKETS: DIRECT FINANCE

Financial markets have important function in the economy because they

1. Allow transfer of funds from person or business without investment

opportunities to ones who have them. In the absence of financial markets,

lenders-savers and borrower-spenders may not get together and it becomes

hard to transfer funds from a person who has no investment opportunities to

one who has them

2. Enhance economic efficiency by allocating productive resources efficiently,

which increases production.

3. Improve the economic welfare because they allow consumers to time their

purchases better.

4. Increase returns on investment and increase business profit

5. Set firm value

6. Buy and sell risk: allow you to transfer certain financial risks (arising from

accidents, theft, illness, early death, etc.) to another party (in this case, the

insurance company).

A breakdown of financial markets can result in political instability.

3

STRUCTURE OF FINANCIAL MARKETS

Financial markets can be categorized in four different ways:

1. Debt and Equity Markets

2. Primary and Secondary market

3. Exchanges and Over–the-Counter Market

4. Money and Capital Markets

First: Debt and Equity Markets

A firm or an individual can obtain funds in a financial market in two ways.

The first method of raising fund, which is practiced in debt markets, is to issue

the debt instrument.

Debt instrument is a contractual agreement that oblige the issuer of the instrument

(the borrower) to pay the holder of the instrument (the lender) fixed amounts

(interest and principal payments) at regular intervals until a specified date

(maturity date) when a final payment is made.

The maturity of a debt instrument is the date on which a loan or bond, or other

financial instrument becomes due and is to be paid off.

Debt holders do not share the benefit of increased profitability because their dollar

payment is fixed

A debt instrument is

1. short-term if its maturity is less than one year,

2. long-term debt if its maturity is ten years or longer, and

3. intermediate-term if its maturity is between one and ten years.

Examples of debt instruments include government and corporate bonds.

The second method of raising fund, which is practiced in equity markets, is by

issuing equities, such as common stock.

Equity is a contractual agreement representing claims on the issuer's income

(income after expenses and taxes) and the asset of the business.

Equities often make periodic payments (dividends) to their holders

4

Equities are considered long-term financial instruments because they have no

maturity date.

Since equity holders own the firm, they are entitled to elect members of the firm’s

board of directors and vote on major issues concerning how the firm is managed.

A key feature distinguishing equity from debt is that the equity holders are the

residual claimants: the firm must make payments to its debt holders before

making payments to its equity holders.

Advantage to holders of debt instruments: They receive fixed payments,

regardless of whether the borrower’s income and assets become more or less

valuable over time.

Disadvantage to holders of debt instruments: They do not benefit from an

increase in the value of the borrower’s income or assets.

Advantage to holders of equities: They receive larger payments when the

business becomes more profitable or the value of its assets rises.

Disadvantage to holders of equities: They receive smaller payments when the

business becomes less profitable or the value of its assets falls.

Although more attention is given to the equity (stock) markets, the debt markets

are actually much larger

Second: Primary and Secondary Markets

A primary market is a financial market in which newly-issued securities, such as

bonds or stocks, are sold to initial buyers by the corporation or government agency

borrowing the funds

An important financial institution that assists in the initial sale of securities in the

primary market is the investment bank.

A corporation acquires new funds only when its securities (IPOs) are sold in the

primary market by an investment bank.

Investment Banks underwrite (insure) securities in primary markets.

5

Underwriting is a process whereby investment bankers (underwriters) buy a new

issue of securities from the issuing corporation or government entity and resell

them to the public. Thus, it guarantees a price for a corporation's securities and

then sells them to the public.

A secondary market is a financial market in which previously issued securities

can be resold

Brokers and dealers play an important role in secondary markets.

o A broker is a securities firm or an investment advisor associated with a firm

who matches buyers with sellers of securities. The broker does not own the

securities but acts as an agent for the buyer and seller and charges a

commission for these services.

o A dealer is a securities firm links buyers and sellers by buying and selling

securities for its own account at stated prices and at its own risk.

Note that the originally issuer or borrower receives funds only when its securities

are first sold in the primary market; the issuer does not receive funds when its

securities are traded in the secondary market.

Nevertheless, secondary markets perform two essential functions:

1. They make it easier for the buyers of securities to sell them before the

maturity date, if necessary. That is, they make the securities more liquid.

Since you can resell them any time you want, it is easy and fast to get cash

2. The price in the secondary market determines the price that the corporation

would receive if they choose to sell more stock in the primary market. The

higher the security’s price in the secondary Market, the higher will be the

price that the issuing firm will receive for a new security in the primary

market; and as a result the greater the amount of capital the firm can raise.

6

Third: Exchanges and Over-the-Counter (OTC) Markets

Secondary markets can be organized in two ways.

Exchange is a marketplace where buyers and sellers of securities (or their agents

or brokers) meet in one central location to buy and sell stocks of publicly traded

companies. Examples of exchanges include New York Stock Exchange, Bahrain

Stock Exchange

Over-the-counter (OTC) market is a market in which dealers at different

locations trade via computer and telephone networks.

Dealers who have an inventory of securities are ready to buy and sell securities

“over-the-counter” for their own account to anyone who comes to them and willing

to accept their prices.

Because over the counter dealers are in computer contact and know the prices set

by one another, OTC is very competitive and not very different from a market with

an organized exchange

Many OTC stocks are traded in a market called "NASDAQ," which is set up by

the National Association of Securities Dealers (NASD although the largest

corporations usually have their shares traded at organized stock exchanges.

Fourth: Money and Capital Markets

Financial markets can be divided on the basis of the maturity of the securities

traded in each market to money markets and capital markets

Money markets: Financial markets in which only short-term debt instruments

with maturity of less than one year are traded.

Capital markets: Financial markets in which intermediate-term debt, long-term

debt, and equities are traded; such as stocks and long term bonds

Money market securities are usually more widely traded than longer-term

securities and therefore tend to be more liquid.

Short-term securities have smaller fluctuations in prices compared to long-term

securities making them safer investments.

7

Corporations and banks actively use money market to earn interest on surplus

funds that they expect to have only temporarily.

Capital market securities, such as stocks and long-term bonds, are held by financial

intermediaries such as insurance companies and pension funds, which have a little

uncertainty about the amount of funds they will have available in the future.

FINANCIAL MARKET INSTRUMENTS

A financial instrument is a financial asset for the person who buys or holds one,

and it is a financial liability for the company or institution that issues it.

To discuss financial market instruments we focus first on the instruments traded in

the money market and then turn to instruments traded in the capital market.

Money Market Instruments

All of the money market instruments are, by definition, short-term debt

instruments, with maturities less than one year.

Because of their short terms to maturity, the debt instruments traded in the money

market undergo the least price fluctuations and so are the least risky investment.

The main types of money market instruments include

1. Treasury Bills:

o Short-term debt issued by government to help finance its current and

past deficits.

o Pay a fixed amount at maturity.

o Pay no interest but they are sold at a price lower than their face value.

o The most liquid instruments in the money market, and they are the most

actively traded.

8

o US treasury bills are the safest because there is almost no possibility of

default, a situation in which the party issuing the debt is unable to pay

the interest or the principal. Treasury bills are held mainly by banks.

o Example: A Treasury bill that pays off $1000 at maturity 6 months from

now sells for $950 today. The $50 difference between the purchase price

and the amount paid at maturity is the interest on the loan.

2. Negotiable Bank Certificates of Deposit (CDs)

o A certificate of deposit (CD) is a debt instrument that is issued by a

commercial bank against money deposited with it for a specific period of

time, usually at a specific rate of interest, with a penalty for early

withdrawal.

o Make regular interest payments until maturity.

o At maturity, return the original purchase price (the principal).

o Negotiable CDs means CDs that are traded in the secondary markets.

3. Commercial Paper.

o Commercial Papers are unsecured short-term debt instruments

(obligations) issued by large banks and well-known corporations with

high credit ratings, such as Microsoft and General Motors.

o The investment in commercial Papers is usually relatively low risk.

o The holding period is usually very short, and corporation agrees to pay

the money back even earlier ("on demand"), if asked.

o They can be either discounted or interest-bearing,

o They usually have a limited or nonexistent secondary market.

o They are available in a wide range of denominations.

9

4. Bankers Acceptance.

o It is a bank draft (like a check) issued by a firm, payable at some future

date.

o It is guaranteed that it will be paid by a bank that stamps it “accepted”.

o The firm must deposit the required funds into its account to cover the

draft.

o Bankers Acceptances are created to carry out international trade.

o The advantage to the firm is that the draft is more likely to be accepted

by foreign exporter since the bank guarantee the payment of the draft

even if the local firm goes bankrupt.

o These “accepted” drafts are often resold in the secondary market at a

discount.

5. Repurchase Agreements (repos).

o They are usually very short-term (overnight or one day) but can range up

to a month or more; and use Treasury bills as collateral in case of

default, between a non-bank corporation as the lender and a bank as the

borrower.

o In the case of the repurchase agreement, the non-bank corporation buys

the Treasury bill from the bank. Simultaneously, the bank agrees to

repurchase the Treasury bill later at a slightly higher price.

o The difference between the original price and the repurchase price is the

interest.

o This act has the effect of injecting or removing reserves from the

banking system in order to meet central bank strategies for

implementing monetary policy.

10

6. The Central Bank’s Funds.

o These instruments are typically overnight loans between banks of their

deposits at the Central Bank.

o Designed to enable banks temporarily short of their reserve requirement

to borrow reserves from banks having excess reserves.

Capital Market Instruments

Capital market instruments are debt and equity instruments with maturities of

greater than a year.

They have more price fluctuations than money market instruments and they are

considered to be fairly risky investments. Types of capital market instruments

include

1. Stocks.

o Stocks are equity claims -represented by shares- on the net income and

assets of a corporation.

2. Mortgages (Residential, Commercial, and Farm):

o Mortgages are loans to individuals or firms to purchase houses, land, or

other real structure.

o The structure or land serves as collateral for the loans.

3. Corporate Bonds.

o Intermediate and long-term debt issued by corporations with strong credit

ratings to raise capital.

o They pay the holder an interest payment in regular intervals and pays off the

face value when bond matures.

o Corporate bonds often offer somewhat higher yields than Treasury bonds.

11

4. Convertible Bonds.

o They are bonds that allow the holder to convert them into a specified

number of shares of stock at any time up to the maturity date.

o This feature makes them more desirable to prospective purchasers than

bond without it and allows the corporation to reduce its interest payments.

5. Government debt securities.

o These long-term debt instruments are issued by the government to finance

the deficits of the government.

o They are the most liquid securities traded in the capital market.

6. Consumer and Bank Commercial Loans.

o Loans, originally made by banks, to businesses and households.

o They are also made by finance companies.

o Secondary markets for these loans are only now just developing.

DERIVATIVE INSTRUMENTS

Derivative instruments are contracts such as options, futures, and swaps whose

price is derived from the behavior and performance of an underlying asset (such as

commodities, bonds, and equities), index or reference rate (such as an interest rate

or foreign currency exchange rate).

Derivatives can be used to speculate on market movements or to protect

investments against major swings in market prices. They can be used to manage

risk, reduce cost and enhance returns.

Their time horizons can be very short or quite long.

12

1. Futures contracts,

o Futures refer to contractual obligations with the purchase and sale of

standardized financial instruments or physical commodities for future

delivery at a fixed price and at fixed point in the future.

o For commodities whose prices often fluctuate (e.g., crops, oil), these

contracts are important ways of reducing risk.

o More recently, these kinds of contracts have been used with financial

instruments.

2. Options contracts:

o Options contracts give the holder the right to buy (call option) or sell (put

option) a fixed quantity of a security or commodity at a fixed price, within a

specified period of time.

o Investors often use them to protect, or hedge, an existing investment.

o Options may either be standardized, exchange-traded, and government

regulated, or over-the-counter customized and non-regulated.

o Options are also common, and less risky to purchase, because you have the

option of not making that future trade if the prices have not moved in your

favor.

INTERNATIONALIZATION OF FINANCIAL MARKETS

The growing internationalization of financial markets has become an important

trend.

Foreign Bonds. Bonds that are sold in a foreign country and denominated in that

country’s currency. For example, if a Bahraini company such as Alba sells a bond

in the United States denominated in U.S. dollars, it is classified as a foreign bond.

13

Eurobond. A Eurobond is a bond denominated in a currency other than that of the

country in which it is sold. For example, a bond denominated in USD sold in

Germany.

Eurocurrencies are foreign currencies deposited in banks outside the home

country. The most important of the Eurocurrencies are Eurodollars which are U.S.

dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S.

banks. Because these short-term deposits earn interest, they are similar to the short-

term Eurobonds

FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE

We have now considered a wide variety of financial instruments that arise through

the process of direct finance, in which the lender sells securities directly to the

borrower.

Why does some borrowing and lending take place, instead, through indirect

finance–that is, with the help of a financial intermediary?

Financial intermediaries play a number of special roles, and help solve a number of

special problems, in the process of indirect finance.

Financial intermediation or indirect finance is the process of obtaining or

investing funds through third-party institutions like banks and mutual funds.

As a source of funds for businesses and individuals, indirect finance is far more

common than direct finance. In virtually every country, credit extended by

financial intermediaries is larger as a percentage of GDP than stocks and bonds

combined.

Commercial banks are the financial intermediary we meet most often, but mutual

funds, pension funds, credit unions, savings and loan associations, and insurance

companies are important financial intermediaries.

14

Financial intermediaries are so important in current days economies because:

1. They transform fund efficiently:

o They attract funds from individuals, businesses, and government and

then repackage these funds as new financial products, such as loans,

which satisfies different needs of savers and borrowers in relation to the

amount of funds, the risk levels, and the maturity requirements (usually

borrowing short and lending long term).

o For example, a firm may want $10 million, which is extremely difficult

to find someone willing to lend that amount of money. However, if

small amounts can be gathered from a large number of savers, then it

becomes much easier to raise the capital. The borrowing firm usually

does not have the information necessary to gather such small deposits;

therefore, financial intermediaries step in and provide the capital, which

they collected in small amounts from individual investors.

2. They lower transaction costs.

o Transaction costs refer to the time and money spent in carrying out

financial transactions. Financial intermediaries have the abilities to

lower transaction costs because:

a. Small investors have neither the required expertise nor the time to

research what assets they should invest in. Financial intermediaries

like professional investment firms have the expertise and research

facilities to study firms in-depth and to reduce the transaction costs.

b. Their large size allows them to take advantage of economies of

scale, the reduction in average transaction costs as the size (scale) of

transactions increases. For example, a bank can use the same loan

contract many times, thereby reducing the cost of making new

contract form for every new loan.

15

3. Reducing Risk

o Financial institutions can help to reduce risk that investors may face.

o Risk here mainly refers to the uncertainty about the returns on their

investments.

o Financial intermediaries do reduce risk through risk sharing and

diversification.

o Banks mitigate risk by taking deposits from a large number of individuals

and make loans to large number businesses and investors. Even if a few

loans are bad, most of the loans will be repaid making the overall return less

risky. Thus, financial intermediaries reduce risk by spreading risky

investments among a large number of businesses and clients.

o This process of risk sharing is also sometimes referred to as asset

transformation, because risky assets are turned into safer assets for

investors.

o Diversification means lowering the cost by investing in a collection

(portfolio) of assets whose returns do not always move together. Thus, the

overall risk is lower than for individual assets.

o Here, again, the bank is taking advantage of economies of scale, since it

would be difficult for a smaller investor to make a large number of loans.

4. They provide liquidity services,

o Liquidity services make it easier for customers to conduct transactions.

Liquidity refers to the speed and ease of converting assets into cash.

Although the intermediary may use its funds to make illiquid loans, its

size allows it to hold some funds idle as cash to provide liquidity to

individual depositors.

16

5. They reduce the problem of asymmetric information.

o Financial intermediaries also use their expertise to screen out bad credit

risks and monitor borrowers. They thereby help solve two problems

related to asymmetric information (imperfect information in financial

markets).

o Asymmetric Information Can be defined as information that is known

to some people but not to other people. It refers to the situation when

one party does not know enough about the other party to make accurate

decision.

o Asymmetric information poses two obstacles to the smooth flow of

funds from savers to investors: adverse selection and moral hazard.

o Adverse Selection is a transaction in which one party has relevant

information that the other does not have, and therefore, exploit these

asymmetries in information to its own advantage. For example, someone

with a dangerous occupation or hobby may be more likely to apply for

life insurance.

o In the financial intermediaries, the adverse selection refers to the

problem created by asymmetric information before a loan is made

because borrowers who are bad credit risks tend to be those who most

actively seek out loans. Because adverse selection makes it more likely

that loans might be made to bad credit risks, lenders may decide not to

make any loans even though there are good credit risks in the

marketplace.

o Financial intermediaries can help reduce the problem of adverse

selection by gathering information about potential borrowers and

screening out bad credit risks.

o Moral Hazard is a problem created by asymmetric information after a

loan is made because borrowers may use their funds irresponsibly.

17

o Moral Hazard refers to the lack of any incentive to guard against a risk

when you are protected against it. Moral Hazard is the risk (hazard) that

the borrower might engage in activities that are undesirable (immoral)

from the lenders point of view, because they make it less likely that the

borrower will repay the loan.

o Because moral hazard lowers the probability that the loan will be repaid,

lenders may decide that they would rather make no loans.

o Financial intermediaries can help reduce the problem of moral hazard by

monitoring borrowers’ activities.

TYPES OF FINANCIAL INSTITUTIONS:

1. Depository institutions (banks, credit unions, savings & loan associations)

o Accept (issue) deposits, which then become their liabilities (sources of

funds).

o Make loans, which then become their assets.

2. Insurance companies

o They collect premiums (regular payments) from policy-holders, and pay

compensation to policy-holders if certain events occur (e.g., fire, theft,

sickness, and life).

o They invest the premiums in securities and real estate, and these are their

main assets.

3. Pension funds

o They collect contributions from current workers and make payments to

retired workers.

o Like insurance companies, they invest the contributions in securities and

real estate, and these are their main assets.

18

4. Securities firms

o Thy provide firms and individuals with access to financial markets

o This category covers a wide range of financial institutions:

Investment banks: sell new securities for companies. Unlike regular

banks, they don't hold deposits, or make loans. Closely related are

underwriters, which not only sell the new securities but pledge to

purchase some or all of any unsold shares.

Brokers: buy/sell old securities on behalf of individuals.

Mutual-fund companies: pool the money of small savers (individuals),

who buy shares in the fund, and invest that money in stocks, bonds,

and/or other assets. These are popular because they allow small savers

relatively easy and cheap access and also enable them to reduce risk by

holding a diversified portfolio.

5. Finance companies

o Like banks, they use people's savings to make loans to businesses and

households, but instead of holding deposits, they raise the cash to make

these loans by selling bonds and commercial paper.

o They tend to specialize in certain types of loans, e.g., automobile or

mortgage loans.

6. Government-sponsored enterprises

o Some of these provide loans directly, such as to farmers and home buyers.

o Some guarantee or buy up private loans, notably mortgage and student

loans.

o Some administer social insurance programs.

19

Regulation of the Financial System

Government regulates financial markets and institutions

1. To increase the information available to investors by

a. Reducing adverse selection and moral hazard problems

b. Reducing insider trading

2. To ensure the soundness of financial intermediaries through

a. Restrictions on entry

b. Disclosure

c. Restrictions on Assets and Activities

d. Deposit Insurance

e. Limits on Competition

f. Restrictions on Interest Rates