FINANCIAL MARKETS FINANCIAL INSTRUMENTS FINANCIAL INSTITUTIONS. Lecture 2 Monetary policy FINANCIAL MARKETS

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1 FINANCIAL MARKETS FINANCIAL INSTRUMENTS FINANCIAL INSTITUTIONS Lecture 2 Monetary policy FINANCIAL MARKETS markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. well-functioning financial markets are a key factor in producing high economic growth financial markets are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do 1

2 direct finance - the borrowers borrow funds directly from lenders by selling them securities indirect finance - that involves financial intermediary who stands between the lender/savers and the borrower/spenders and helps transfer funds between them Borrowers and lenders do not want to trade in the same types of promises. Thus we find specialized financial institutions and markets that bring borrowers and lenders together. 2

3 STRUCTURE OF FINANCIAL MARKETS Debt and Equity Markets Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets EQUITY VS. DEBT Those who want to obtain funds can use two ways: 1. Issue equities (claims to share in the net income and the assets of a business) 2. Issue a debt instrument (bond, mortgage, ) 3

4 1. EQUITY... means ownership of some property, whether by a single individual or by a group of individuals The advantages of ownership are straightforward: if the asset goes up in value the owner benefits directly the disadvantage is that a value of a property may fall instead of rise But The stockholder is not a creditor while the company is legally obligated to pay the agreed-upon interest to creditors, it is not obligated to make any payments to all to its stockholders it can simply decide not to pay a dividend also the stockholders are residual claimants 2. DEBT INSTRUMENTS A bond is a promise by the borrower to pay a certain sum by a certain date (maturity) and to pay a fixed rate of interest (coupon rate, or just coupon) until then. the owner of a bond can sell a bond before the maturity date. The price is then determined by the supply and demand of such bonds on the market Assets = Liabilities + Shareholders' Equity 4

5 PRIMARY AND SECONDARY MARKETS a primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds these markets are not well known to the public, because the selling of securities to initial buyers usually takes place behind closed doors financial institutions that assist in the sale of securities in the primary market are primary investment banks a secondary market is a financial market in which securities that have been previously issued (secondhand) can be resold Securities brokers and dealers are crucial to well functioning secondary market EXCHANGES AND OVER-THE-COUNTER MARKETS Secondary markets can be organized in two ways: EXCHANGES where the buyers and sellers of securities (or their agents and brokers) meet in one central location to conduct traders OVER-THE-COUNTER in which dealers in different locations stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices. Dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange 5

6 MONEY AND CAPITAL MARKETS on the basis of the maturity of the securities traded in each market The money market is a financial market in which only short term debt instruments are traded (maturity less than a year) The capital market is the market in which long - term debt (with maturity of one year and longer) and equity instrument are traded FINANCIAL MARKET INSTRUMENTS 1. MONEY MARKET INSTRUMENTS short term maturity 2. CAPITAL MARKET INSTRUMENTS debt and equity instruments with maturities longer than one year they have far wider price fluctuations and are consider risky investments 6

7 example: U.S. FINANCIAL MARKET 1. MONEY MARKET INSTRUMENTS US Treasury Bills Short term debt instruments of the US government issued in 3-, 6-, 12- month maturities to finance the federal governments. They have no interest payments but they are initially sold on discount They are the most liquid of all the money market instruments because they are most actively traded They are also the safest because there is almost no possibility of default federal government is always able to meet its debt obligations because it can raise taxes or issue currency They are held mainly by banks, although small amounts are held by household, corporations Negotiable Bank Certificates of Deposit A CERTIFICATE OF DEPOSIT is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price Before CDs were nonnegotiable they could not be sold to someone else and could not be redeemed from the bank before maturity without paying a penalty In Citibank introduced the first negotiable CD in large denominations that could be resold in a secondary market This instrument is now issued by almost all the major commercial banks and has been extremely successful It is important source of funds for commercial banks, money market mutual funds, government agencies 7

8 Commercial Paper is a short-term debt instrument issued by large banks and wellknown corporations (General Motors..). Before 1960 corporations usually borrowed short-term funds from banks. Banker s Acceptances is a bank draft, a promise of payment similar to a check, issued by a firm, payable at some future date and guaranteed for a fee by the bank that stamps it accepted. the issuing firm is required to deposit the required funds into its account to cover the draft the advantage to the firm is that the draft is more likely to be accepted when purchasing goods abroad because the foreign exporter knows that the bank draft will be paid off in any case these drafts are often resold in a secondary market at a discount and are similar in function to Treasury Bills 8

9 Repurchase Agreements (repos) short-term loans, usually with maturity less than two weeks in which Treasury Bills (or other securities) serve as collateral.. Introduced in a large corporation may have some idle funds in its bank account, which it would like to lend for a week. It uses them to buy Treasury bills from a bank, which agrees to repurchase them the next week at a price slightly above purchase price. The effect of this agreement is that a firm makes a loan to the bank and holds the same amount of banks Treasury bills, until the bank repurchase the bills to pay off the loan Federal (FED) Funds typically overnight loans between banks of their deposits at the Federal Reserve One reason why bank might borrow in the federal funds is that it might find it does not have enough deposits to meet the amount required by regulators This market is very sensitive to the credit needs of the banks, so the interest rate on these loans, called the federal funds rate, shows the tightness of credit market conditions in the banking system and the stance of monetary policy: when it is high the banks are strepped for funds; when it is low, bank credit needs are low 9

10 example: U.S. FINANCIAL MARKET 2. CAPITAL MARKET INSTRUMENTS Stocks equity claims on the net income and assets of a corporation Mortgages.. loans to households and firms to purchase housing, land or other real structures where the land serves as a collateral for the loans Corporate Bonds..long term bonds issued by corporations with very strong credit ratings. the typical bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. Some of them, called the convertible bonds have an additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date 10

11 Consumer and Bank Commercial Loans loans to consumers and business made principally by banks and by finance companies U. S. Government Securities U. S. Government Agency securities State and Local Government Bonds also called municipal bonds are long-term debt instruments issued by state and local governments to finance expenditures on schools, roads and other large program Commercial banks are the biggest buyer of these securities FINANCIAL INSTITUTIONS Financial institutions makes financial markets work without them they would not be able to transfer funds from people who save to people who have productive investment opportunities financial institutions also reduce risk They issue a contingent claims on themselves to satisfy lenders demands for such claims 11

12 TYPES OF FINANCIAL INTERMEDIARIES There are two types of financial intermediaries depository and nondepository Depository institutions are financial intermediaries that accept deposits from individuals and institutions and make loans. The study of money and banking focuses special attention on this group of financial institutions, because they are involved in the creation of deposits, an important component of the money supply. These institutions include: commercial banks and the socalled thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions. Nondepository institutions a variety of institutions that have the common thread of providing financial services other than taking deposits Investment Intermediaries that include finance companies, mutual funds and money market mutual funds Contractual Saving Institutions are financial institutions that acquire funds at periodical intervals on contractual basis (insurance companies, pension funds.. ) They can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years so they do not have to worry as much as depository institutions about losing funds That is why the liquidity of assets is not as important for them as it is for depository institutions and they are investing funds primarily in longterm securities such as corporate bonds, stocks, mortgages 12

13 1. DEPOSITORY INSTITUTIONS COMMERCIAL BANKS raise funds primarily by issuing checkable deposits (on which checks can be written), saving deposits (payable on demand but do not allow their owner to write checks) time deposits (deposits with fixed terms of maturity) They use these funds to make commercial, consumer and mortgage loans and buy securities and municipal bonds SAVINGS AND LOAN ASSOCIATIONS obtain funds primarily through saving deposits (called shares) and time and checkable deposits. These funds have traditionally been used to make mortgage loans Until 1980 in the USA, S&L were restricted to making mortgage loans and could not establish checking accounts. Now they are allowed to offer checking accounts and make consumer loans. That is why they are now subject to the same requirements as the commercial banks the distinction between them and commercial banks has blured, they are more alike and much more competitive with each other 13

14 MUTUAL SAVINGS BANKS raise funds by accepting deposits (shares) and use them primarily to make mortgage loans. They are always structured as mutuals or cooperatives: the depositors own the bank In the USA they were similarly affected by the banking legislation in the 1980s so now can issue checkable deposits and make loans other than mortgages CREDIT UNIONS are small cooperative lending institutions organized around a particular group: union members, employees of a particular firm They acquire funds from deposits (shares) and primarily make consumer loans After 1980s they are also allowed to issue checkable deposits and can make consumer loans and mortgage loans in addition 14

15 2. CONTRACTUAL SAVINGS INSTITUTIONS LIFE INSURANCE COMPANIES insure people against financial hazards following a death and sell annuities (annual income payments upon retirement) They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages FIRE AND CAUSALTY INSURANCE COMPANIES insure their policyholders against loss from theft, fire and accidents They are similar to the life insurance companies but have a greater possibility of loss of funds if major disasters occur they use funds to buy more liquid assets than life insurance companies PENSION FUNDS AND GOVERNMENT RETIREMENT FUNDS provide retirement income in the form of annuities to employees who are covered by a pension plan 3. INVESTMENT INTERMEDIARIES FINANCE COMPANIES raise funds by selling commercial paper (a short-term debt instrument) issuing stocks and bonds They lend these funds to consumers and to small businesses some of them are organized by a parent corporation to help sell its product for ex. Ford Motor Credit Company 15

16 MUTUAL FUNDS acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds Shareholders can sell their shares at any time but the value of these shares will be determined by the value of the mutual funds holdings of securities they strongly fluctuate and the value of the mutual shares too investments in the mutual share can be risky MONEY MARKET MUTUAL FUNDS are a relatively new financial institutions that have characteristics of a mutual fund but also function as a depository institution to some extent because they offer deposit-type accounts They sell shares to acquire funds that are then used to buy money market instruments that are both safe and liquid, and the interest rate on these assets is then paid out to the shareholders Shareholders can write checks against the value of their shareholdings (according to some rules, usually is prescribed a minimum of funds needed) 16

17 FUNCTION OF FINANCIAL INTERMEDIARIES..funds can move from lenders to borrowers through indirect finance which involves financial intermediary that stands between and helps transfer funds from one to another A financial intermediary borrows funds from the lender-savers and then uses these funds to make loans to borrow-spenders Appendix: Why are financial intermediaries and indirect finance so important in financial markets Voluntary reading 17

18 Why are financial intermediaries and indirect finance so important in financial markets Transaction costs the time and money spent in carrying out financial transactions Financial intermediaries have developed expertise in lowering transaction costs and their large size allows them to take advantage of economies of scale reduction in transaction costs per currency unit of transactions as the size of transactions increases Asymmetric Information: Adverse Selection and Moral Hazard Asymmetric Information - in financial markets one party often does not know enough about the other party to make accurate decisions.. For ex. a borrower who takes loan usually has better information about the potential returns and risk associated with the investment process for which the funds are needed than the lender does Lack of information creates problems in the financial system on two fronts: before the transaction is entered and after Adverse selection is the problem created by the asymetric information before the transaction occurs occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome the bad credit risk are the ones that most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risk, lenders may decide not to make any loans even though there are good credit risk at the market. Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender s point of view because they make it less likely that the loan will be paid back moral hazard lowers the probability that the loan will be repaid and lenders may decide that they would rather not make the loan 18

19 These problems are an important impediment to well functioning financial market Financial intermediaries have higher earnings on their investments than small savers because they can better screen out good from bad credit risks reducing losses due to adverse selection Also, they have higher earnings because they develop expertise in monitoring the parties they lend to reducing losses due to moral hazard REGULATION OF THE FINANCIAL SYSTEM The financial system is usually the most regulated sector of the national economy The government regulates financial markets for three main reasons: 1. To increase the information available to investors 2. To ensure the soundness of the financial system 3. To improve control of monetary policy 1. INCREASING INFORMATION AVAILABLE TO INVESTORS Government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors Asymmetric information in financial market means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets In USA for example since stock market crash in 1929, political demands for regulation resulted in the Securities Act 1933 and the establishment of the Securities and Exchange Commission (SEC) SEC requires corporations to disclose certain information about their sales assets and earnings to the public and restrict trading by the largest stockholders (so called insiders) in the corporation hoping that investors will be better informed and protected from abuses in financial market (that occured before 1933) 19

20 2. ENSURING THE SOUNDNESS OF FINANCIAL INTERMEDIARIES Asymmetric information can also lead to collapse of financial intermediaries financial panic No information of soundness of financial institutions providers of funds might pull their funds out of both sound and unsound institutions resulting in financial panic that produces large losses for the public and causes serious damage to the economy Types of Regulation US example RESTRICTIONS OF ENTRY Regulation in terms of becoming a financial intermediary is very tight Those who want to establish a financial intermediary must obtain a charter from the state or the federal government they will be given a charter only if they are upstanding citizens with impeccable credentials and a large amount of initial funds DISCLOSURE Reporting requirements for financial intermediaries their bookkeeping must follow certain strict principles, they are a subject to periodic inspections and must make certain information available to the public RESTRICTIONS ON ASSETS AND ACTIVITIES There are restrictions on what activities are allowed to financial intermediaries and what assets they can hold These restrictions serve to protect owners of funds from risky activities of institutions for ex legislation has separated commercial banking from securities industry (risk!) DEPOSIT INSURANCE The government can insure people providing funds to a financial intermediary from any financial loss if the financial intermediary should fail (Federal Deposit Insurance Company) These institutions are usually financed from the contributions of the memebers into the fund which is used in case of failure of a certain financial intermediary 20

21 LIMITS ON COMPETITION restrictive regulations by the government (although the evidence that competition among financial intermediaries promotes failures is weak) RESTRICTIONS ON INTEREST RATES Restricting the level of interest rates that can be paid on deposits Regulation Q until 1986 the FED had set maximum interest rates that banks could pay on savings deposits.. It was a widespread belief that unrestricted interest rate competition encourage bank failures during the Great Depression.. Later evidence does not seem to support this view.. 3. IMPROVING CONTROL OF MONETARY POLICY Banks play very important role in determining the supply of money and much regulation of these financial intermediaries is intendet to improve it Reserve Requirements make it obligatory for all depository institutions to keep a certain fraction of their deposits in special accounts The existence of these institutions gives depositors confidence in the banking system and eliminates widespread bank failures that can cause large, uncontrollable fluctuatiojns in the quantities of money 21