A Primer on Financial Markets & Institutions

Why study Financial Markets and Institutions?

They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

Overview of Financial Markets

Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets

Primary Markets versus Secondary Markets

Primary Markets
markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds)

Secondary Markets
markets where financial instruments are traded among investors (e.g. Bolsa Madrid, NYSE, NASDAQ)
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Money Markets versus Capital Markets

Money Markets
markets that trade debt securities with maturities of one year or less (e.g. Spanish Government bonds, U.S. Treasury bills)

Capital Markets
markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year
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Foreign Exchange Markets

FX markets deal in trading one currency for another (e.g. dollar for yen) The spot FX transaction involves the immediate exchange of currencies at the current exchange rate The forward FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate

Overview of Financial Institutions (FIs)

Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)

Flow of Funds in a World without FIs: Direct Transfer

Financial Claims (Equity and debt instruments) Users of Funds (Corporations) Cash Example: A firm sells shares directly to investors without going through a financial institution
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Suppliers of Funds (Households)

Flow of Funds in a world with FIs: Indirect transfer

Users of Funds FI (Brokers) Suppliers of Funds

Financial Claims (Equity and debt securities)

FI (Asset transformers)

Financial Claims (Deposits and Insurance policies)

Broad Functions of FIs

Brokerage function
Acting as an agent for investors:
e.g. Merrill Lynch, Charles Schwab Reduce costs through economies of scale Encourages higher rate of savings

Asset transformer:
Purchase primary securities by selling financial claims to households
These secondary securities often more marketable
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Types of FIs
Commercial banks depository institutions whose major assets are loans and major liabilities are deposits Thrifts and savings banks depository institutions in the form of savings banks, savings and loans, credit unions, credit cooperatives Insurance companies financial institutions that protect individuals and corporations from adverse events

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 Securities firms and investment banks financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies financial institutions that make loans to individuals and businesses Mutual Funds financial institutions that pool financial resources and invest in diversified portfolios Pension Funds financial institutions that offer savings plans for retirement
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Features Common to Most FIs

High Amount of Financial Leverage Low equity/assets ratios. Capital requirements. Off-balance sheet items Contingent claims that under certain circumstances may eventually become balance sheet items (ex. Derivatives, commitments) Revenue: Interest Income & Fees Costs: Interest Expenses and Personnel

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Services Performed by Financial Intermediaries

Monitoring Costs
aggregation of funds provides greater incentive to collect a firms information and monitor actions

Liquidity and Price Risk

provide financial claims to savers with superior liquidity and lower price risk

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 Transaction Cost Services transaction costs are reduced through economies of scale Maturity Intermediation greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

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Services Provided by FIs Benefiting the Overall Economy

Money Supply Transmission Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate)

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Services Provided by FIs Benefiting the Overall Economy

Intergenerational Wealth Transfers life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services efficiency with which depository institutions provide payment services directly benefits the economy

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Risks Faced by Financial Institutions

Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operation Risk Country or Sovereign Risk Insolvency Risk
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Regulation of Financial Institutions

FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall

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Globalization of Financial Markets and Institutions

Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market

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Factors Leading to Significant Growth in Foreign Markets

The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows
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Transaction Costs
information and other transaction costs in financial system can be substantial How do transaction costs affect investing? How can financial intermediaries reduce transaction costs?

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Asymmetric Information
one party to a transaction has better information to make decisions than the other party
asymmetric information in financial market causes two main problems
adverse selection moral hazard
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Adverse Selection
asymmetric information problem that occurs prior to a transaction examples of adverse selection result of adverse selection is that lenders may decide not to make loans if they can not distinguish between good and bad credit risks

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Moral Hazard
asymmetric information problem that occurs after a transaction risk that borrower will undertake risky activities that will increase the probability of default result of moral hazard is that lenders may decide not to make a loan

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Lemons Problem
idea presented in article by George Akerlof in terms of lemons in used car market used car buyers are unable to determine quality of car - good car or lemon? What amount is buyer willing to pay for this used car of unknown quality? How can buyer improve information on quality?

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Lemons Problem in Stock and Bond Market

asymmetric information prevents investors from identifying good and bad firms What price will these investors pay for stock? Who has better information about the firm? Which firms will come to the market for financing under these conditions?

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Principal-Agent Problem
define the principal-agent problem
Who is the principal and who is the agent? What problem does a separation of ownership and control cause? How could we prevent principal-agent problem?
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Solutions to Financing Puzzles

lemons or adverse selection problem tells why marketable securities are not the primary source of financing
situation is similar in corporate bond market tells why stocks are not the most important source of external financing
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More Solutions to Financial Structure Puzzles

importance of financial intermediaries explains importance of indirect financing explains why banks are most important source of external financing explains why markets are only available to large, well-known firms
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FIs are the most regulated of all firms

Safety and Soundness Regulation
Deposit Insurance

Monetary Policy Regulation

Reserve Requirements

Credit Allocation Regulation (eg., mortgages) Consumer Protection Regulation

Community Reinvestment Act, Home Mortgage Disclosure Act, Truth in Lending Protection

Investor Protection Regulation Entry Regulation

http://www.bangladeshbank.org/aboutus/regulationguideline/guidelist.php
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Changing Dynamics of Specialness

Trends in the United States Decline in share of depository institutions. Increases in pension funds and investment companies. May be attributable to net regulatory burden imposed on depository FIs. Technological changes affect delivery of financial services and regulatory issues Potential for regulations to be extended to hedge funds Result of Long Term Capital Management disaster
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Future Trends
Weakening of public trust and confidence in FIs may encourage disintermediation Increased merger activity within and across sectors Citicorp and Travelers, UBS and Paine Webber More large scale mergers such as J.P. Morgan and Chase, and Bank One and First Chicago Growth in Online Trading Increased competition from foreign FIs at home and abroad Mergers involving worlds largest banks Mergers blending together previously separate financial services sectors
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Financial Sector Overview: http://www.bangladeshbank.org/pub/halfyearly/financialsrev /jan09/financialerev.php

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