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CHAPTER 1 AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS CHAPTER OBJECTIVES 1. This chapter introduces the basic elements of the financial system: financial claims, financial markets, and financial institutions. T ...

CHAPTER 1 AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS CHAPTER OBJECTIVES 1. This chapter introduces the basic elements of the financial system: financial claims, financial markets, and financial institutions. These elements integrate in a conceptual model of the financial system, shown in Exhibit 1-1. This chapter also develops basic vocabulary, which may not be prudently neglected. 2. The chapter compares and contrasts the two basic kinds of financing relationships—direct finance and financial intermediation—in the context of why financial needs exist, how financial claims arise, and what choices for financial activity emerge in different types of institutions and markets. 3. The chapter compares and contrasts major types of financial institutions and financial markets. These mechanisms—institutions and markets—afford participants more liquidity and diversification. Thus more funds flow to the most productive uses, competition among financial institutions lowers costs, and widespread market participation links prices more closely to information, all of which promote market efficiency. A vigorous financial system promotes economic growth and prosperity by maximizing rational opportunities for investment. CHANGES FROM THE LAST EDITION 1. Chapter sections are numbered in this edition. 2. Chapter opener has been revised. 3. Tables, exhibits, and data have been updated. Exhibit 1.6 is new to this edition. 4. The set of learning objectives has been revised. 5. “Do You Understand?” questions: (1) in the first set, old Q.4 has been deleted and remaining questions revised, (2) two sets of DYU questions have been deleted and three added. There are now five sets of DYU questions in the chapter. 6. End-of-chapter questions: old Q.8 has been deleted and 11 new questions added (Qs. 8, 11-20). 7. Changes to Section 1.1, “The Financial System”: - The subsection “A Preview of the Financial System” has been added; - The subsection “Economic Units” has been eliminated; economic units are now discussed in the next subsection, “Budget Positions”, which has been shortened. - The subsection “Financial Claims” has been shortened. 8. The sections “Moving Funds from SSUs to DSUs” and “Benefits of Financial Intermediation” have been eliminated. In their place are Section 1.2, “Financial Markets and Direct Financing”, and Section 1.6, “Financial Institutions and Indirect Financing”, that discuss the same material and more. E.g., Section 1.6 discusses asymmetric information, which gives rise to adverse selection and moral hazard issues. 9. The order of sections has been changed: Section 1.2, “Financial Markets and Direct Financing”, is now followed by the sections related to financial markets (“Types of Financial Markets”, “Money Markets”, and “Capital Markets”), and Section 1.6, “Financial Institutions and Indirect Financing”, is followed by the sections discussing types of intermediaries and risks they face. 110. Section 1.3, “Types of Financial Markets”, has a new subsection on public and private markets. 11. Section 1.7, “Types of Financial Intermediaries”, has an expanded discussion of money market mutual funds (MMMFs). 12. The section “Financial Market Efficiency” has been deleted. 13. Section 1.9, “Regulation of the Financial System”, has been added. It covers regulation related to both consumer protection and stabilizing the financial system, as well as provides the highlights of the Restoring American Financial Stability Act of 2010. 14. The feature previously called “Chapter Take-aways” is now called “Summary of Learning Objectives”. The learning objectives from the beginning of each chapter are copied and followed by a short summary of the chapter material related to each objective. This has been done for every chapter. CHAPTER KEY POINTS 1. The financial system brings savers and borrowers together. Stress these key concepts: SSUs and DSUs, financial claims, direct finance versus financial intermediation, financial institutions, transformation of claims, and types of financial markets. Remind students of financial intermediation in their own lives—checking accounts, insurance, student loans, etc. 2. Direct finance works if preferences of SSUs and DSUs match as to amount, maturity, and risk. Financial intermediaries transform claims to reduce the recurring problem of unmatched preferences: Denomination Divisibility. DSUs prefer to borrow the full funding need all at once. SSUs tend to save small amounts periodically. Intermediaries pool small savings into large investments. Currency Transformation. Intermediaries can buy claims denominated in one currency while issuing claims denominated in another. This would be difficult for most ordinary SSUs. Maturity Flexibility. DSUs generally prefer longer-term financing. SSUs generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both. Credit Risk Diversification. Intermediaries manage risk by evaluating and holding many different securities. SSUs on their own would have to leave “more eggs in one basket.” Liquidity. Many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of DSUs. 3. Financial institutions are classifiable by their origins, purposes, and major characteristics: Depository Institutions Commercial banks Thrifts (savings and loan associations; mutual savings banks) Credit unions Contractual Institutions Insurance companies (life and casualty) Private pension funds State and local government pension funds Investment Funds Mutual Funds Money Market Mutual Funds 2Other Institutions Finance companies Federal agencies 4. Financial markets are classifiable in a number of concurrent ways: Primary or Secondary Public or Private Exchanges or OTC Spot, Futures, or Option Foreign Exchange International or Domestic Money or Capital The respective contributions of money markets and capital markets to the economy are important themes. Representative lists of money and capital market instruments foreshadow chapters covered later in the text. 5. Financial intermediaries are major “information producers” in financial markets. The need for information arises because of asymmetric information – sellers or borrowers in financial transactions usually have more information than buyers or lenders. Asymmetric information is expressed in two ways: adverse selection, which occurs before a financial transaction takes place, and moral hazard, which occurs after the transaction. 6. Risks faced by financial institutions are: Credit risk Interest rate risk Liquidity risk Foreign exchange risk Political risk 7. Financial systems need to be regulated for two reasons: consumer protection and stabilization of financial systems. ANSWERS TO END-OF-CHAPTER QUESTIONS 1. Does it make sense that the typical household is a surplus spending unit (SSU) while the typical business firm is a deficit spending unit (DSU)? Explain. Households are ultimately SSUs, but have deficit periods when a home or other “big ticket” item is purchased. Businesses usually invest more in real assets than they receive in current operating cash flow. 2. Explain the economic role of brokers, dealers, and investment bankers. How does each make a profit? Brokers, dealers, and investment bankers make markets at both primary and secondary stages. Funds are raised and claims issued in primary markets with the help of investment bankers, who purchase securities from issuers at one price and sell them to the investing public at a higher price, earning the underwriter’s spread. In secondary markets brokers help bring buyers and sellers of financial claims together, charging commissions, and dealers trade claims in volume, 3providing liquidity and price discovery and earning the difference between ask and bid price (the bid-ask spread). 3. Why are direct financing transactions more costly or inconvenient than intermediated transactions? The parties to direct finance have to find each other and negotiate a more or less exact match of preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about financial activity, and drive costs down through competition, diversification, and economies of scale. 4. Explain how you believe economic activity would be affected if we did not have financial markets and institutions. Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize their savings. The “production possibilities frontier” of the society would be smaller. 5. Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system? Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus making financial markets more efficient. 6. How do financial intermediaries generate profits? Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this margin. Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries enjoy 3 sources of comparative advantage: Economies of scale —large volumes of similar transactions; transaction cost control—finding and negotiating direct investments less expensively; and risk management expertise—bridging the “information gap” about DSUs’ creditworthiness. 7. Explain the differences between the money markets and the capital markets. Which market would General Motors use to finance a new vehicle assembly plant? Why? Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or “capital goods” are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to “store” cash in money market securities, which are generally, safe, liquid, and short-term. 8. What steps should bank management take to manage credit risk in the bank’s loan portfolio?