Function of Financial Markets

Transcription

1 Chapter 2 An Overview of the Financial System Function of Financial Markets Perform the essential function of channeling funds from economic players (households, firms and govt.) that have saved surplus funds to those who have a shortage of funds (an allocation function essentially); the lenders-savers (majority are households) channel the excess funds to borrowersspenders (majority are businesses and the govt.) who need them for their purchases. Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (like bonds, a debt, i.e., liability, security, or a stock, an equity, i.e., ownership, security) Indirect finance: lenders channel their excess funds through intermediaries (like banks) who then turn around and lend these funds to borrowers; thus borrowers do not borrow directly from lenders

2 Function of Financial Markets (cont d) Promotes economic efficiency by producing an efficient allocation of capital (financial wealth, like money, or physical wealth/capital, like a factory, or human capital like workers), which increases production. E.g., suppose there is no financial market; if you have extra money and that extra money won t find its way to a factory manager who has an innovative idea or method to improve production but lacks money, then you re both worse off. Why? Is the economy better off or worse off as a result? 2-3 Function of Financial Markets (cont d) Directly improve the well-being of consumers by allowing them to time purchases better. Examples of timing a purchase (matching the timing of cash inflows with purchases)? Say, you re a young graduate with a good job and salary. You re thinking of buying a small house (or a condo unit). Without a financial market, if given enough time, on your own you d be able to save enough to buy the house in cash. But that can take years. Meanwhile you re stuck in your little apt. With a financial market, and with a little down payment, you can take out a home loan and be able to buy the house payable over time on installment. The same principle applies when using a credit card

3 Figure 1 Flows of Funds Through the Financial System 2-5 Structure of Financial Markets Debt and Equity Markets - With debt instruments (e.g., a bond or a mortgage), the issuer (also the borrower, say, San Miguel Corp.) promises to pay a fixed amount regularly for a number of years until the maturity date is reached (short-term if less than a year, long-term if 10 yrs. or longer). - With equities (e.g., common stock), a lender (say, you, an individual) buys a share of, say, San Miguel Corp., so you own part of the company s net income and assets. The common stock issuer (San Miguel Corp) might make regular dividends to its shareholders. Common stocks have no maturity date. They re considered long-term securities. An equity holder is also considered a residual claimant

4 Structure of Financial Markets (cont.) Primary and Secondary Markets - In primary markets, new issues of a security, a stock or bond, are sold (IPO) to initial buyers by corporations or a govt. agency needing to borrow funds. Investment banks underwrite securities sold in primary markets. They take risks by guaranteeing the price of a newly issued security. - In secondary markets, securities that have previously been issued are resold (after IPO). Brokers and dealers work in secondary markets. Investors who want to buy or sell stocks or bonds rely on brokers (their agents) to execute the trade. Dealers connect buyers and sellers by buying and selling securities at stated prices. 2-7 Structure of Financial Markets (cont.) Primary and Secondary Markets - If you already have a primary market, why would you still want a secondary market? - An important function of secondary markets is to provide liquidity to financial instruments. After firms first issue a new security, if the initial buyers of the security know that there is no secondary market where they can sell these securities in case they decide to, then they probably wouldn t even bother buying them when first issued. Why? - Also, the secondary market helps set the price of the new issues in the primary market. Investors who buy in the primary market will not pay for the new issues any higher than the current price in the secondary market. Why? 2-8 4

5 Structure of Financial Markets (cont d) Exchanges and Over-the-Counter (OTC) Markets (secondary mkt. classified by organization) - Exchanges (organized with a central location to do trading): NYSE, Philippine Stock Exchange, Chicago Board of Trade (commodities like wheat, corn, silver, etc. are traded) - OTC Markets (not centrally located in one place for trading, securities in this mkt. are not listed as in an organized exchange but are just as actively traded through electronic means); in the U.S., also includes foreign exchange and Federal funds Money and Capital Markets (classified by maturity) - Money markets deal in short-term debt instruments (less than a year) - Capital markets deal in longer-term debt and equity instruments (a year or longer) Money Market Instruments in the Phil. (1) Treasury bills = are peso-denominated shortterm fixed income securities issued by the Republic of the Philippines through its Bureau of Treasury with usually a minimum denomination of 50,000 pesos. You buy this at a discount and redeem it at par value. (2) Negotiable Bank Certificate of Deposit = a PDICinsured (thus, safe) time deposit issued by a bank with a higher int. rate than a savings acct.; if it is long-term, i.e., then it has a 5-year maturity (meaning it s not strictly money market in that case); it s traded in the secondary market so it s transferrable; minimum denomination can be 50,000 pesos. As a holder, you receive regular, maybe quarterly, interest payments. (3) commercial paper = unsecured short-term promissory notes usually issued by corporations to meet short-term financial obligations like payroll. Usually, very large denominations, sometimes in millions or billions of pesos. 5

6 Capital Market Instruments in the Phil. (1) Corporate stocks = total market capitalization (# of shares multiplied by price per share) of Philippine corporate stocks amounted to trillion pesos in 2016 (from trillion in 2015). (2) Corporate bonds = long-term securities issued by corporations to finance expansions like a new factory. The typical bond holder receives regular interest payments yearly or twice a year and if he/she holds the security until maturity, redeems the bond at par (face value). (3) Phil Govt. Bonds = longer-term fixed income securities issued by the Republic of the Philippines through its Bureau of Treasury (U.S. govt. bonds are somewhat similar) are held by banks and also households. (4) Commercial Loans = loans that banks make to corp. (5) Residential/Consumer Loans = residential loans are mortgages; an example of a consumer loan is a car loan Internationalization of Financial Markets Foreign Bonds: sold in a foreign country and denominated in that country s currency Eurobond: bond denominated in a currency other than that of the country in which it is sold (e.g., a bond denominated in U.S. dollars and sold in London) - 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 (somewhat similar to Eurodollars in that they are short-term deposits and earn interest) World Stock Markets: Also help finance the U.S. federal government

7 Function of Financial Intermediaries: Indirect Finance Financial intermediation = the process of indirect finance using financial intermediaries like banks. Financial intermediaries are a far more important source of financing for corporations than the securities (stock or bond) markets are. Why? -Financial intermediaries have lower transaction costs (time and money spent in carrying out financial transactions) than a corp. that issues new shares of stock (an equity security) or a company that wants to issue a bond (a debt security); e.g., lawyer costs to come up with an airtight financial contract that protects the issuer s investment Function of Financial Intermediaries: Indirect Finance (cont.) - (1) Financial intermediaries have developed expertise over time that allows them to take advantage of economies of scale (the reduction in costs per dollar of transaction as the size (scale) of transactions go up). E.g., a bank knows how to find a good lawyer who can draw up an airtight loan contract and this same contract can be used over and over again, thus, lowering the costs of transaction. - (2) Because of low transaction costs, banks can also provide liquidity services to its customers. E.g., a bank can offer its customers checking accounts that allow them to pay their bills easily, sometimes electronically, a service that a corp. stock or bond issuer cannot offer

8 Function of Financial Intermediaries: Indirect Finance (cont.) (3) Because of low transaction costs, financial intermediaries can also reduce the exposure of investors to risk (i.e., the uncertainty about the returns that investors can earn on assets). They can do this by a process called risk sharing (also referred to as asset transformation). Financial intermediaries like banks create and sell assets with risk characteristics that people are comfortable with (i.e., less risky like a bank deposit) and then turn around and make loans (assets) that have more risk, in the end earning a return on the spread. - Financial intermediaries also promote risk sharing by letting individuals enjoy diversification of their portfolio, a collection of assets whose returns do not move together, thus, lowering overall portfolio risk Function of Financial Intermediaries: Indirect Finance (cont d) - Financial intermediaries deal with asymmetric information problems (i.e., when one party in a transaction often does not know enough about the other party to make accurate decisions; an inequality). E.g., a loan borrower usually knows more about his risk or likelihood of defaulting on the loan than the bank. - (1) (before the transaction) Adverse Selection: for the bank, try to avoid selecting the risky borrower. Adverse selection = the risk that a potential borrower who is most risky or likely to default on a loan (an adverse outcome) is the one most active in getting a loan and so is more likely to be selected for the loan

9 Function of Financial Intermediaries: Indirect Finance (cont d) - Financial intermediaries gather information about potential borrower. - (2) (after the transaction) Moral Hazard: for the bank, ensure borrower will not engage in activities that will prevent him/her from repaying the loan. Have the customer sign a contract with restrictive covenants. Moral hazard = the risk that the borrower might engage in a risky activity (an immoral act from the lender s point of view) after getting the loan, hence, making it less likely for the loan to be repaid. This makes the lender (the bank) less likely to give the loan. Conclusion: Financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets Table 3 Primary Assets and Liabilities of Financial Intermediaries

10 Regulation of the Financial System To increase the information available to investors: (a) reduce adverse selection and moral hazard problems; (b) 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 2-19 Table 5 Principal Regulatory Agencies of the U.S. Financial System