Overview of Money & Banking Course

Jeffrey H. Nilsen

The Financial System Overview 1

Financial System Central Bank
Struc ture Money Supply Instruments Goals & Strategies

Govt

Regulation Ch. 11

Banks and other FI

Ch. 10, 12

Ch. 13 Ch. 14 Ch. 15 Ch. 16

Borrower (firm)

Stock Market
Ch. 7, 8

LenderSaver

FX Market
Ch. 17

Bond Market
Ch. 4, 5, 6

Financial Markets

The Financial System Overview 2

Financial System Financial Markets FI

Central Bank
A.D. P A.S.

Inflation
Ch. 24

Ch. 22

Introduction: The Financial System

Flows of Funds Role of Financial Intermediaries (FI) Role of Money

The Financial System - Overview

FI
FI to Mkt: sells CD and buys bonds

Borrower (firm)
Lacks funds but has profitable investment opportunity Issues securities

Market

LenderSaver
Has excess funds, willing to delay consumption

Many types, e.g. Bond Market, Stock Market, FX Market

Diagram shows funds flows, note securities flow in opposite direction

Security: claim on issuers future income or assets

Bond: security promising to make periodic payments for set length of time (maturity) Equity: security promising share of issuing corporations net income each period in indefinite/infinite future (as long as corporation exists)

Exchange Rate USD to basket (higher is appreciation)

Different Ways to Categorize Financial Markets

Primary: IPO, investment bank underwrites new equity or bond issue Secondary: Previously issued security traded (issuer receives no new funds)
Makes security more liquid Establishes a market price for given security to allow estimated value for new issue

OTC: dealers with inventory of securities buy/sell Exchange: institution where buyers/sellers interact (securities standardized) Money market: short-term securities (mature in less than 1 year)
More liquid Small price fluctuations

Capital market: long-term securities traded

Financial Market Instruments

Money Market table 2.1
Repurchase agreement:
Entity with extra funds $1,000 T-bill Entity with Tbill requiring funds

One week later

$1,010 T-bill

Fed funds: bank with excess res lends to bank needing res.

Capital Market table 2.2

Mortgage: loan on which land or structure serves as collateral

Money Market Instruments

Capital Market Instruments

Euro strangeness
Eurobond defined: bond denominated in currency other than of nation where sold (80% of new issues). Examples:
$-denominated bond sold in London or Tokyo -denominated bond sold in BG or in New York NB: -denominated bond sold in D not a eurobond (!!)

Eurocurrency: foreign currency deposited outside nation where issued. Example:

My $-denominated account in BG

F.I.(indirect finance) advantage 1:

Banks established loan expertise ameliorates information asymmetries:
Screening cuts adverse selection [pre-

transaction]: find creditworthy borrowers (those most wanting loans are the least creditworthy) Monitoring limits moral hazard [posttransaction]: dampen borrowers incentive to take greater risks after loan granted

F.I.s Advantage 2
Dep 1 Dep 1 Dep 1 33 33 Bank Fixed cost 5 33 100 Firm

Cuts transactions costs: bank distributes loan initiation costs over many depositors so each saver pays part of the fixed cost to make loan

F.I.s Advantage 3
33 Firm

Dep 1

100

Bank

33

Firm

33

Firm

Single depositors funds distributed to many firms the bank lends to which diversifies the depositors risk

Types of Financial Intermediaries (Tables 2.3 and 2.4)

Depository Institutions: take deposits and make loans Contractual Savings Institutions (outpayment timing known so less subject to liquidity shocks than banks) Pension funds Insurance companies Investment Intermediaries Mutual fund (sell shares to individual savers and buy stocks and bonds) MMMF (take deposits, buy diverse money market instruments) Investment banks (advises firm on security issue and underwrites [buys securities at predetermined price to then sell to public])

Primary Assets and Liabilities of Financial Intermediaries

Principal Financial Intermediaries and Value of Their Assets

Financial System Regulation

SEC requires bank to regularly provide information to protect investors Restrict entry of start-up banks Restrict asset holdings (e.g. US commercial banks not permitted to buy common stocks) Deposit insurance (FDIC) Restrictions on interest rates (regulation Q abolished in 1986)

Regulation: Europe / Intl

CEBS: BIS:
http://www.c-ebs.org/Aboutus.aspx

http://www.bis.org/stability.htm

Money
Defined: generally accepted as payment for goods & services or to repay debt
Includes currency (paper money and coins) and checks Includes checking accounts and may include savings accounts since easily converted into currency

Note distinction between money and income or wealth

Functions of Money: the blood of the financial system

Medium of exchange (vs. barter): key difference to other assets
Makes transactions efficient: eliminates double coincidence of wants and allows specialization Must be standardized, widely accepted, divisible, easy to carry, and durable

Store of value (stores purchasing power over time)

Many assets store value, but money the most liquid
Liquid: ease with which an asset transformed into medium of exchange

Most money pays i = 0%, so > 0 => money pays negative real return.

Unit of account (easy to compare value). Each goods price stated in terms of money (80 stotinki per banitza)

US Monetary Aggregates

Questions:
A security is a _____ for the issuer and a _____ for the purchaser. If an individual moves funds from a savings account to a demand deposit account
M1 M1 M1 M1 decreases, M2 remains the same stays the same, M2 increases stays the same, M2 stays the same increases, M2 stays the same

What place do internet lending sites occupy in the financial system ?