Banking and Finance

An Overview of the Financial System

Course Requirements
Course material: everything presented during the classes all slides on CooSpace additional readings Textbook: Mishkin, F.C.: The Economics of Money, Banking and Financial Markets, Addison-Wesley 2010 (9th edition)

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Grading Policy
Class Participation (quiz)/ Midterm: 30%
maximum of 25% absence is allowed; otherwise the semester can not be approved. midterm test contains some multiple-choice and true-false questions also simple problems to solve and short essays for a total of 100 points,

Final exam:

45%

the final contains short and long essays, small calculations for a total of 100 points a student is required to achieve at least 50%+ (pass) of each part of the assessment in order to receive a pass in aggregate

Semester paper Professors evaluation of class performance

15% 10%

topics on CooSpace, other topics are to be agreed on

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Function of Financial Markets

Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities. Promotes economic efficiency by producing an efficient allocation of capital, which increases production Directly improve the well-being of consumers by allowing them to time purchases better Technical intermediaries help in the mutual search process (broker, dealer, dual trader, underwriter)

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Flows of Funds trough the Financial Markets

Savers
(lenders, sufficit) Households Firms Government Foreigners

Funds Securities Direct finance, technical intermediaries

Borrowers
(spenders, deficit) Households Firms Government Foreigners

Indirect finance, financial intermediaries

Financial markets

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Direct finance Borrowers turn directly to lenders offering different securities,

i.e.: IOUs (bonds, stocks, etc.)

Technical intermediaries help in the mutual search process

broker, dealer, dual trader, underwriter

Three major conflicts:

nominal value maturity risk, etc.

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Financial Intermediaries

They solve the conflicts of:

nominal value, maturity, risk, etc. increase the saving and borrowing capacity of the economy

Institutions:
banks, mutual funds, pension funds, insurance companies, etc.

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Structure of Financial Markets

Debt and Equity Markets Debt instruments maturity, interest and principal payment Equities dividend, ownership rights Derivatives rights or obligations of transactions

Primary and Secondary Markets Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets
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Market types
Trade Primary markets new issues are traded Secondary markets previously issued securities are traded Institutional structure Exchanges (concentrated markets) OTC (over the counter) dealers at different locations trade for or from their inventories ATS (alternative trading systems) Maturity Money market (less than 1 year to maturity) Capital market (more than 1 year to maturity)
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Types of Money Market Instruments

Treasury bills Negotiable bank CDs Commercial papers Bankers acceptances Repurchase agreements Eurodollars Fed funds

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Principal Money Market Instruments

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Types of Capital Market Instruments

Corporate stocks Mortgages Corporate bonds Government securities (notes, bonds) State/Region/Local government securities Consumer and bank commercial loans

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Principal Capital Market Instruments

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The Present Model of Securities Trade

Institutional investor

Exchange

Institutional investor

OTC Private investor

Multilateral Trading Facility

Brokerage company

Brokerage company

Private investor

Internalization

Crossing Network Dark Pool ATS

Internalization

Internalization: the client makes an order to his/her brokerage to buy or sell a security which fills the order from its own inventory of the security. Some exchanges prohibit these trades, and brokerages are required to report internalization on exchanges that permit it. 05/09/2012 Zeller: Banking & Finance 14

Alternative Trading Systems

Multilateral Trading Facility (or MTF)
a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments in a way that results in a contract in accordance with the provisions of Title II of MiFID They can be assimilated to alternative trading exchanges providing additional pool of liquidity to their members (banks, major mutual funds and large insurance companies). matches buy and sell orders electronically for execution without first routing the order to an exchange or other displayed market, Instead the order is either anonymously placed into a black box or flagged to other participants of the crossing network. The advantage of the crossing network is the ability to execute a large block order without impacting the public quote. are crossing networks that provide liquidity that is not displayed on order books. This is useful for traders who wish to move large numbers of shares without revealing themselves to the open market.

Crossing network

Dark pools of liquidity

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Market Share of MTFs in Stock Trade

EquiductBerliner (2009. March) NASDAQ OMX Europe (2008. Sept.)
25,00%

Chi-X (2007. March)

Burgundy (2009. May) QUOTE MTF (2009. Sept)

NYSE Arca Europe (2009. mrc.)

Turquoise (2008. Aug) BATS (2008. Oct)

20,00%

15,00%

10,00%

5,00%

0,00%

nov.

okt.

okt.

mr.

mr.

mj.

mj.

szept.

szept.

dec.

nov.

pr.

pr.

aug.

2008. jan.

2009. jan.

aug.

dec.

jl.

jn.

jn.

jl.

febr.

febr.

Forrs: FESE

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2010. jan

feb.

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The Structure of Capital Market (January 2010)

Turquoise 2% BATS Europe 2% Nasdaq OMX Nordic 4% SIX Swiss 5% Spanish Exchanges 7% CHI-X 9%

Other 5%

Markit BOAT 21%

LSE Group 18%

Forrs: Reuters

Deutsche Boerse 10%

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Euronext 17%

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Main Groups of Financial Instruments 1.

Right
Debt - temporary, should be repaid (bond) Equity - permanent, not refunded (stock) Right limiting the trade of a product (bill of lading, warehouse warrant, etc) Right or obligation to buy or sell (option, future) Reparation certificate (a special Hungarian instrument)

Transferability
Registered: given owner, endorsement on the back or on an attached form Bearer entitled: simple sale Negotiable: endorsed drafts, universal obligation

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Main Groups of Financial Instruments 2.

Physical character
Materialized: printed, preserved by the owners, physically transferred when traded Immobilized: printed, deposited at a central place, deposit certificates Immaterialized: not printed; bookkeeping entry or electronic sign; transfer between security accounts

Maturity
Varies country by country, no consent Short term: less than 1 year to maturity (consensus), Medium term: 1-10 years to maturity Long term: 5 - 30 years Conditional (console): matures with an event (life insurance) Without maturity: provides the service till the issuer exists (stock)

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Main Groups of Financial Instruments 3.

Returns
Interest bearing securities permanent: fix interest from the issue to the maturity flexible
changing by a given schedule (increases 1 % yearly) pegged to a well measurable economic phenomenon (inflation, prime rate, exchange rate, etc.) convertible bond (a bond convertible to stock)

Discount papers: issued under and redeemed at the face value Dividend bearing securities: shares

Issuer
Government: federal, state, regional, municipal (local) Special institutions issue special securities:
banks - CDs, mutual funds - mutual fund shares warehouses - warehouse warrants mortgage institutions - mortgage bonds

Companies: bonds, stocks, commercial papers... Anyone: check, drafts...

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Main International Instruments of Financial Markets

Foreign Bonds: sold in a foreign country and denominated in that countrys currency Eurobond: bond denominated in a currency other than that of the country in which it is sold Eurocurrencies: foreign currencies deposited in banks outside the home country Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

World Stock Markets

Help finance governments also

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Function of Financial Intermediary Institutions

Institutions: banks, mutual funds, pension funds, insurance companies,

Reduce the exposure of investors to risk Risk Sharing (Asset Transformation) Diversification
Deal with asymmetric information problems (before the transaction) Adverse Selection: try to avoid selecting the risky borrower. Gather information about potential borrower. (after the transaction) Moral Hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan. Sign a contract with restrictive covenants. Conclusion: Financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets.
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Types, Assets and Liabilities of Fin. Intermediaries

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Financial Intermediaries and Value of Their Assets

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Regulation of the Financial System

To increase the information available to investors: Reduce adverse selection and moral hazard problems Reduce insider trading (SEC) To ensure the soundness of financial intermediaries: Restrictions on entry (chartering process). Disclosure of information. Restrictions on Assets and Activities (control holding of risky assets). Deposit Insurance (avoid bank runs). Limits on Competition (mostly in the past): Branching Restrictions on Interest Rates
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Principal Regulatory Agencies of the U.S. System

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