Chapter 2: Overview of the Financial System

Chapter2
OverviewoftheFinancialSystem
FunctionofFinancialMarkets
StructureofFinancialMarkets
DebtandEquityMarkets
PrimaryandSecondaryMarkets
ExchangesandOvertheCounterMarkets
MoneyandCapitalMarkets
InternationalizationofFinancialMarkets
InternationalBondMarket,Eurobonds,andEurocurrencies
GlobalBox:AreU.S.CapitalMarketsLosingTheirEdge?
WorldStockMarkets
FunctionofFinancialIntermediaries:IndirectFinance
TransactionCosts
FollowingtheFinancialNews:ForeignStockMarketIndexes
GlobalBox:TheImportanceofFinancialIntermediariesRelativetoSecurities
Markets:AnInternationalComparison
RiskSharing
AsymmetricInformation:AdverseSelectionandMoralHazard
EconomiesofScopeandConflictsofInterest
TypesofFinancialIntermediaries
DepositoryInstitutions
ContractualSavingsInstitutions
InvestmentIntermediaries
RegulationoftheFinancialSystem
IncreasingInformationAvailabletoInvestors
EnsuringtheSoundnessofFinancialIntermediaries
FinancialRegulationAbroad

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Mishkin/EakinsFinancial Markets and Institutions, Eighth Edition

Overview and Teaching Tips

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Chapter 2: Overview of the Financial System

Chapter2isanintroductorychapterthatcontainsthebackgroundinformationonthestructureandoperation
offinancialmarketsthatisneededinlaterchaptersofthebook.Thischapterallowstheinstructortobranch
outtovariouschoicesoflaterchapters,thusallowingdifferentdegreesofcoverageoffinancialmarkets
andinstitutions.
Themostimportantpointtotransmittothestudentisthatfinancialmarketsandfinancialintermediaries
arecrucialtoawellfunctioningeconomybecausetheychannelfundsfromthosewhodonothavea
productiveuseforthemtothosewhodo.Someinstructorswillwanttoteachthischapterindetail,and
thosewhofocusoninternationalissueswillwanttospendsometimeonthesectionInternationalization
ofFinancialMarkets.However,thosewhoslanttheircoursetopublicpolicyissuesmaywanttogivethis
chapteramorecursorytreatment.Nomatterhowmuchclasstimeisdevotedtothischapter,Ihavefound
thatitisagoodreferencechapterforstudents.Youmightwanttotellthemthatifinlaterchapterstheydo
notrecallwhatparticularfinancialintermediariesdoandwhoregulatesthem,theycanreferbacktothis
chapter,especiallytotables,suchasTables2.1and2.3.

Answers to End-of-Chapter Questions

1. TheshareofMicrosoftstockisanassetforitsownerbecauseitentitlestheownertoashareofthe
earningsandassetsofMicrosoft.TheshareisaliabilityforMicrosoftbecauseitisaclaimonits
earningsandassetsbytheowneroftheshare.
2. Yes,Ishouldtakeouttheloan,becauseIwillbebetteroffasaresultofdoingso.Myinterestpayment
willbe$4,500(90%of$5,000),butasaresult,Iwillearnanadditional$10,000,soIwillbeaheadof
thegameby$5,500.SinceLarrysloansharkingbusinesscanmakesomepeoplebetteroff,asinthis
example,loansharkingmayhavesocialbenefits.(Oneargumentagainstlegalizingloansharking,
however,isthatitisfrequentlyaviolentactivity.)
3. Yes,becausetheabsenceoffinancialmarketsmeansthatfundscannotbechanneledtopeoplewho
havethemostproductiveuseforthem.Entrepreneursthencannotacquirefundstosetupbusinesses
thatwouldhelptheeconomygrowrapidly.
4. TheprincipaldebtinstrumentsusedwereforeignbondswhichweresoldinBritainanddenominated
inpounds.TheBritishgainedbecausetheywereabletoearnhigherinterestratesasaresultof
lendingtoAmericans,whiletheAmericansgainedbecausetheynowhadaccesstocapitaltostartup
profitablebusinessessuchasrailroads.
5. Thisstatementisfalse.Pricesinsecondarymarketsdeterminethepricesthatfirmsissuingsecurities
receiveinprimarymarkets.Inaddition,secondarymarketsmakesecuritiesmoreliquidandthus
easiertosellintheprimarymarkets.Therefore,secondarymarketsare,ifanything,moreimportant
thanprimarymarkets.
6. Youwouldratherholdbonds,becausebondholdersarepaidoffbeforeequityholders,whoarethe
residualclaimants.
7. Becauseyouknowyourfamilymemberbetterthanastranger,youknowmoreabouttheborrowers
honesty,propensityforrisktaking,andothertraits.Thereislessasymmetricinformationthanwith
astrangerandlesslikelihoodofanadverseselectionproblem,withtheresultthatyouaremorelikely
tolendtothefamilymember.

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Mishkin/EakinsFinancial Markets and Institutions, Eighth Edition

9. Loansharkscanthreatentheirborrowerswithbodilyharmifborrowerstakeactionsthatmight
jeopardizepayingofftheloan.Henceborrowersfromaloansharkarelesslikelytoengagein
moralhazard.
10. Theymightnotworkhardenoughwhileyouarenotlookingormaystealorcommitfraud.
11. Yes,becauseevenifyouknowthataborroweristakingactionsthatmightjeopardizepayingoffthe
loan,youmuststillstoptheborrowerfromdoingso.Becausethatmaybecostly,youmaynotspend
thetimeandefforttoreducemoralhazard,andsomoralhazardremainsaproblem.
12. True.Iftherearenoinformationortransactioncosts,peoplecouldmakeloanstoeachotheratno
costandwouldthushavenoneedforfinancialintermediaries.
13. Becausethecostsofmakingtheloantoyourneighborarehigh(legalfees,feesforacreditcheck,
andsoon),youwillprobablynotbeabletoearn5%ontheloanafteryourexpenseseventhoughit
hasa10%interestrate.Youarebetteroffdepositingyoursavingswithafinancialintermediaryand
earning5%interest.Inaddition,youarelikelytobearlessriskbydepositingyoursavingsatthebank
ratherthanlendingthemtoyourneighbor.
14. Financialintermediariesbenefitbecausetheycanearnprofitsonthespreadsbetweenthereturnsthey
earnonriskyassetsandtheypaymentstheymakeontheassetstheyhavesold.Householdsandfirms
benefitbecausetheycannowownassetsthathavelowerrisk.

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