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Lectures Outline: Tentative Topic 1: Overview

Topic 1: Overview
MSL310 Financial Institutions and Markets Role of the financial system
Topic 1: Overview of the Financial System Financial intermediaries
Financial markets
Topic 2: Bond Market
Topic 3: Money Market
Topic 4: Equity Market
Topic 5: Derivative Market
Topic 6: Foreign Exchange Market
Topic 7: Regulatory Framework
Topic 8: Monetary Policy
Topic 9: Commercial Banks
Topic 10: Investment Banks
Topic 11: Other Financial Institutions
Topic 12: FinTech
Topic 13: Review
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Role of the Financial System Role of the Financial System

The role of the financial system is to gather money from people and Larger the flow of funds and more efficient the financial system,
businesses that currently have more money than they need and greater the economic output and welfare in the economy
transfer it to those that can use it for either business or consumer
For this system to be efficient, however, it requires sufficient volume
expenditures
(many borrowers and many lenders)
This flow of funds through financial markets and institutions in an
Greater the flow of funds, greater possible accommodation of
economy affects business profits, the rate of inflation, interest rates,
individual preferences for spending and saving
and the production of goods and services

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Role of the Financial System Role of the Financial System

Financial system consists of: Financial markets are just like any kind of market: people buy and
sell, haggle and argue, win and lose
Financial markets • In financial markets, people buy and sell financial instruments such as
Financial institutions stocks, bonds

Money Financial institutions such as commercial banks and insurance

companies allow flow of funds from savers to borrowers
Money: The medium of exchange used in the financial system

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Role of the Financial System: Financial Markets
Financial markets have five primary functions:
Facilitate the flow of funds
Provide the mechanism for the settlement of transactions
Generate and disseminate information that assists decision making
Provide means for the transfer and management of risk
Provide ways of dealing with the incentive problems that arise in
financial contracting
Financial Markets: Flow of Funds
Sally gets admission in a university to do a two-year masters course
Needs Rs 10 lakhs for that course
Does not have enough funds to pay fees and to meet other expenses
that will be incurred during the studies
She decides to borrow Rs 10 lakhs from a bank
After obtaining some information (such as that related to course,
past borrowings, future income), bank lends Rs 10 lakhs to Sally

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Financial Markets: Flow of Funds Financial Markets: Flow of Funds

Sally only needs Rs 3 lakhs during first year of her studies and
therefore explores investment options for the remaining amount
Savings account
Term deposit
Shares
Bonds

https://canarabank.com/User_page.aspx?othlink=9
9 10

Financial Markets: Flow of Funds Financial Markets: Flow of Funds

All BSE
Stock Returns-
Top Performers

https://canarabank.com/User_page.aspx?othlink=9 11 https://www.ndtv.com/business/marketdata/stocks-gainers/allbse_yearly 12

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Financial Markets: Flow of Funds Financial Markets: Flow of Funds

BSE200 BSE200
Stock Returns- Stock Returns- “Losers”
Top Performers

https://www.ndtv.com/business/marketdata/stocks-gainers/allbse_yearly 13 https://www.ndtv.com/business/marketdata/stocks-gainers/allbse_yearly 14

Financial Markets: Flow of Funds Financial Markets: Flow of Funds

Sally deposits Rs 7 lakhs in a term deposit and expects to receive 5.1
percent interest on that
Like Sally there are many individuals who deposit funds with banks
so as to earn interest income
Bank has this large pool of funds, which bank can use to make new
investments or lend to businesses and individuals

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Financial Markets: Flow of Funds Financial Markets: Flow of Funds

At the same time that the bank received Sally’s Rs 7 lakhs, it was
reviewing applications from the local café for a Rs 25 lakh loan to
expand its operations
The loan interest rate is 8 percent, payable in five years, and money
from Sally’s deposit is pooled with the money from other deposits to
provide the funding
The bank is happy with the café loan at 8 percent because it has
borrowed the money for 5.1 percent (from Sally and its other
depositors), earning a 2.9 percent (8 – 5.1) gross profit margin
Consistent with its goal of profit maximization, the bank ultimately
decided to make the café loan because of the project’s favorable rate
of return and the owner’s high credit rating standing
Other loan applications were rejected because applicants had poor
credit ratings or the projects’ rates of return were not as favorable as
that of the café project

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Financial Markets: Flow of Funds Financial Markets: Flow of Funds

Balance Sheet: The financial system works properly when
• Consumers receive the highest possible interest rates for their deposits
Assets = Liabilities + Equity • Only loans with favorable rates of return and good credit standing are
financed

Bank: The more efficient and competitive the financial system, the more
likely this is to happen
Sally’s deposit: Liability
Café loan: Asset

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Financial Markets: Economic Units Financial Markets: Economic Units

All economic units can be classified into one of the following groups: Households typically receive income in the form of wages and then
make frequent expenditures for food, clothing, medical needs,
Households
entertainment, education, taxes, and housing (rent/mortgage) etc
Businesses
Businesses sell a variety of goods and services to households and
Governments (local, state, and centre) other businesses for revenues and spend their money on paying
wages, buying inventory and meeting other business expenses, and
Each economic unit operates within a budget constraint imposed by make capital expenditures on new buildings and equipment
its total income for the period
Government units obtain income by collecting taxes and fees and
spend on a wide range of services such as health, welfare, education,
police, the fire service, and defense

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Financial Markets: Economic Units Financial Markets: Economic Units

Budget position of economic units:
Balanced budget position: income and planned expenditures are
equal
Surplus position: Income for the period exceeds planned
expenditure
Deficit position: Planned expenditure for the period exceeds income
Surplus Spending Unit (SSU) and Deficit Spending Unit (DSU)
Surplus spending unit: An economic unit whose income in a period
exceeds expenditure
Deficit Spending Unit: An economic unit whose expenditure in a
period exceeds current income, a DSU sells financial claims on itself
(liabilities) or sells equity to obtain needed funds

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Financial Markets: Economic Units Financial Markets: Economic Units

Centre’s Gross Fiscal Deficit (Rs Crore)

Suppliers of funds (SSUs) Demanders of funds (DSUs)

• Households • Households
Financial Markets
• Businesses • Businesses
• Governments • Governments

25 https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications 26

Financial Markets: Economic Units Financial Markets: Economic Units

Government Bonds
Gross fiscal deficit Financing of GFD - Market borrowings
2000000 Government bonds are the long-term debt obligations of
1800000
governments
1600000
1400000 They are used to finance capital expenditure for things such as
1200000
1000000
schools, highways, and airports
800000 If the budget is in surplus, the government may use the additional
600000
400000
resources to reduce its debt, but if the budget is in deficit, then it will
200000
need to borrow funds to cover the forecast expenditure
0
1982-83

2001-02

2004-05

2007-08
1980-81
1981-82

1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01

2002-03
2003-04

2005-06
2006-07

2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19
2019-20
2020-21

https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications 27 28

Financial Markets: Economic Units Financial Markets: Economic Units

1400000 Flow of Resources to Commercial Sector in India (Rs Cr) Corporate Bonds
1200000 When large corporations need money for capital expenditure, they
1000000
may issue bonds
800000
Corporate bonds are therefore long-term securities that represent a
claim against the firm’s assets
600000
Unlike equity holders’ returns, bondholders’ returns are fixed: they
400000
receive only the amount of interest that is promised plus the
200000 repayment of the principal at the end of the loan contract
0 Even if the corporation turns in unexpected above-market
performance, the bondholders will only receive the fixed amount of
interest agreed to at the bonds’ issue
Bank Credit Domestic Sources Foreign Sources
https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications 29 30

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Financial Markets: Economic Units Financial Markets: Economic Units

Shares The financial system is concerned with transferring money – and
Shares represent an ownership claim on a company’s assets with it purchasing power – from SSUs to DSUs
Also referred to as equity securities, shares differ from debt obligations in DSUs include some households, governments, and many businesses
that equity holders have the right to share in the company’s profits
Other economic units may be SSUs
The higher the company’s net income, the higher the return to
shareholders will be Typically business firms and governments are DSUs
On the other hand, shareholders must share in any of the losses that the Households in general are SSUs
company may incur
In the event of bankruptcy, creditors and debt holders have first claim on
the company’s assets
Most share market transactions take place in the secondary markets
31 32

Financial Markets: Economic Units Financial Markets: Economic Units

Gross Domestic Savings as a Percent of GDP Gross Domestic Savings as a Percent of GDP
In developed countries in recent years household savings have been on decline
as a result of the dramatic growth in personal debt levels

https://data.worldbank.org/indicator/NY.GDS.TOTL.ZS?end=2020&locations=IN-US-CN-GB&start=1970 33 34

Financial Markets: Economic Units Financial Markets: Economic Units

Household Debt /GDP
45
40

Household Debt to GDP Household 35

30
Debt to GDP 25
(Percent) 20
15
10
5
0
1999

2006

2013

2018

2020
1998

2000
2001
2002
2003
2004
2005

2007
2008
2009
2010
2011
2012

2014
2015
2016
2017

2019

Household Debt /GDP

https://www.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=20143 35 https://www.imf.org/external/datamapper/HH_LS@GDD/IND 36

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Financial Markets: Economic Units Financial Markets: Economic Units

Market participants expect wealth creation
SSUs forgo current consumption and accrue savings that are then
invested in the financial markets in return for financial instruments
These financial instruments are expected to provide some return or
income to the SSUs to compensate for foregoing consumption
Household Debt to This return represents an increase in wealth, which can then be used
GDP (Percent) at a later date or reinvested in financial instruments to generate
additional wealth

https://www.imf.org/external/datamapper/HH_LS@GDD/IND/CHN/GBR/USA 37 38

Financial Markets: Financial Claims Financial Markets: Financial Claims

Written promises to pay a specific sum of money (the principal) plus
interest for the privilege of borrowing money over a period of time
Financial claims are claims against someone else’s money at a future
date
Financial claims are issued by DSUs (liabilities) and purchased by
SSUs (assets)
To the DSU, a financial claim is a liability and the interest payments
are the penalty for consuming before income is earned
To the SSU, the financial claim is an asset and the interest earned is
the reward for postponing consumption
Financial claims are liabilities for borrowers (DSUs) and assets for
lenders (SSUs)

39 40

Financial Markets: Financial Claims Financial Markets: Financial Claims

Financial intermediaries buy the financial claims of others and sell Financial claims are sourced from either debt or equity funds
their own claims in financial markets
There are many different types of financial claims issued by financial
Shares: Dividends
intermediaries and other economic units such as the federal
government and large corporations D1 D2 D3 D4 D5 Forever
0 1 2 3 4 5

Bonds: Coupon (Interest) Payments

C C C C C + FV
0 1 2 3 4 5

41 42

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Financial Markets: Financial Claims
Once a financial claim is outstanding, the lender (SSU) may hold the
claim until it matures
Alternatively, the SSU may sell the financial claim (for example,
bonds) to someone else before it matures
The DSU continues to use the funds even the lender is now a
different party
43
Financial Markets: Financial Claims
Providing equity funds involves the acquisition of an ownership
share of a business
This is usually seen as longer term and is consequently referred to as
capital investment
Equity investors face investment risk, which is the possibility that the
investor’s expected return will not be realized
Equity investors are compensated with dividend payments and
capital growth (where the value of the ownership share increases
over time) for bearing investment risk
45
Financial Markets: Financial Claims
If an SSU purchases a financial claim with maturity longer than the
planned investment period, the claim can be resold to another SSU
at the appropriate time
Suppose your investment horizon is five years
You can purchase a 10 year bond and sell it after five years
Another alternative could be that purchase share and sell it after five
years
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Financial Markets: Financial Claims
Debt funds: Funds supplied in the form of a loan
Credit risk: The risk that the borrower will not pay back all or part of
the interest or principal as specified in the loan agreement
In return for exposure to credit risk, the lender is rewarded with
interest income
44
Financial Markets: Financial Claims
The size of equity returns is largely dependent on the performance
of the business and so is less certain than returns on debt funds,
which are usually specified in the debt contract
The ability to resell financial claims is important because it allows
SSUs to purchase financial claims with maturities that do not exactly
match their investment horizon
46
Financial Markets: Financial Claims
Likewise, an SSU can purchase a financial claim with maturity shorter
than its time horizon if additional claims, either new or outstanding,
can easily be purchased
Suppose your investment horizon is five years so you can purchase a
2 year bond and the purchase another 3 year bond
48
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Financial Markets: Financial Claims Financial Markets: Financial Claims

A wide variety of financial claims trade in the financial markets, all
designed to meet the preferences (return, risk, liquidity, timing etc)
of both SSUs and DSUs
SSUs: Risk Preferences
SSUs have different risk preferences and can be classified as either
risk averse, risk neutral, or risk taking
Risk takers are willing to bear more risk than the other categories but
only if they are compensated with higher returns
Conversely, those who are risk averse will accept a lower return to
avoid risk

49 50

Financial Markets: Financial Claims Financial Markets: Financial Claims

SSUs: Timing Preferences SSUs: Timing Preferences
An additional element of risk is the timing of the cash flows related Steady cash flow over the life of the instrument (such as receiving
to the financial instruments fixed rent from a property)
Earlier the returns are realized, the lower the risk because with time Uneven cash flows (dividend payments are not fixed)
comes uncertainty
Payment only occurs at the maturity (such as zero-coupon bonds)
Are contingent on performance (for example, if company is not
profitable, it may not pay any dividend in a particular year)

51 52

Financial Markets: Financial Claims Financial Markets: Financial Claims

SSUs: Liquidity Preferences SSUs: Liquidity Preferences
Liquidity: The ease with which the financial instrument can be
converted back into cash without losing capital value
Most Active by
Liquid instruments can be sold at a price that approximates their
Volume
worth more easily

53 https://www.ndtv.com/business/marketdata/most-active-stocks-by-volume 54

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Financial Markets: Financial Claims Financial Markets: Financial Claims

SSUs: Liquidity Preferences For financial markets to operate efficiently, there is a need to provide
a range of financial instruments to meet the return, risk, timing, and
liquidity preferences of the market participants
Most Active by This will promote an increased flow of funds because savers will be
Value able to structure their savings to suit their needs
Over time, the flow of funds should increase as market participants
create wealth
This in turn provides an increased pool of investment capital that can
be used by DSUs to increase the production capacity of the
economy, and so generate economic growth

https://www.ndtv.com/business/marketdata/most-active-stocks-by-value 55 56

Financial Markets: Financial Claims Financial Markets: Financial Claims

⇒ An efficient and stable financial system is a necessary condition to Primary and Secondary Markets
having an advanced economy
Primary Market: A financial market in which financial claims are first
sold as new issues
Secondary market: A financial market in which participants buy or
sell previously issued financial claims

57 58

Financial Markets: Financial Claims Financial Markets: Financial Claims

Primary and Secondary Markets
Financial claims are initially sold by DSUs in primary financial
markets
An example of a primary market transaction is that a company raises
external funds through the sale of new stock or bonds
Primary and Secondary Markets
Securities can only be sold once in a primary market; all subsequent
transactions take place in secondary markets
Once issued, a financial claim (security) can be traded in the
secondary market on an organized security exchange (such as NSE)
Only members of the exchange may use the facilities, and only
securities listed on the exchange may be traded
Secondary markets provide liquidity for investors who own primary
claims

59 60

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Financial Markets: Financial Claims
Money and Capital Markets
Financial markets are sorted into money and capital markets on the
basis of the term to maturity of a given financial claim
Securities traded in these two markets based on the requirements of
the users and providers of the funds
61
Financial Markets: Financial Claims
Money and Capital Markets
Money markets are a wholesale market for financial claims that have
characteristics very similar to money
Money-market instruments typically have short maturities (usually
90 days or less), are highly liquid (active secondary markets) and
have low risk of default
There is no formal organized exchange for money market securities
(similar to NSE/BSE for the equity markets)
63
Financial Markets: Financial Claims
Money Market: Commercial Paper (example)
Commercial paper is unsecured promissory note of a large business
These are issued by a borrower that undertakes to pay a certain
amount of money (the face value) at a future date
They are also discount securities and typically have maturities
ranging from a few to 120 days
Corporations and finance companies are the major issuers of
commercial paper
Because they are generally unsecured, only companies with good
credit ratings are usually able to issue them
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Financial Markets: Financial Claims
Money and Capital Markets
Commercial banks and other businesses adjust their liquidity
position by borrowing, lending or investing for a short time in money
markets
The RBI conducts monetary policy in the money markets (controlling
the level of funds in the market and the level of interest rates)
Also, in the money markets, businesses, governments and
sometimes, individuals borrow or lend funds for short times
62
Financial Markets: Financial Claims
Money Market: Treasury Notes (example)
Promissory notes issued on behalf of the central government by the
RBI, allowing the government to borrow money from the money
markets
Promissory notes are short-term discount securities
• Difference between the face value and the discounted issue price
represents the return to the investor
64
Financial Markets: Financial Claims
Capital Markets
A financial instrument is classified as a capital-market instrument if it
has an original term to maturity of one year or more
Capital-market transactions match savings to the requirements of
individuals, businesses and governments for investments that are
longer term than those offered in the money markets
For example, the owner of a machine hopes to profit from the sale
of products from the machine shop, and the owner of a factory
hopes to earn a return from the goods produced there
66
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Financial Markets: Financial Claims
Capital Markets
Similarly, owners of apartments, office buildings, warehouses and
other tangible assets hope to earn a stream of future income by
using their resources to provide services directly to consumers or to
other businesses
These assets are called capital goods; they are the stock of assets
used in production
67
Financial Markets: Financial Claims
Capital Markets: Corporate Bonds
Corporate bonds typically have maturities from 5 to 30 years, and
their secondary market is not as active as that for equity securities
There are different forms of corporate bonds and other corporate
debt instruments
69
Financial Markets: Settlement of Transactions
Provide the mechanism for the settlement of transactions
Many transactions in the payments system are settled immediately,
for example, when you use cash to purchase a book
However, high-valued transactions are settled after the terms of the
transaction have been agreed
• For example, when one purchases a house, the settlement occurs on the
settlement date, which is usually either 30 or 60 days after the contract is
signed (when terms are agreed)
Many transactions in the securities markets are settled on a T + n
basis, which is n business days after the trade was agreed
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Financial Markets: Financial Claims
Capital Markets
In capital markets, capital goods are financed with stock or long-term
debt instruments
Compared with money-market instruments, capital market
instruments are less marketable, default risk levels vary widely
between issuers and maturities range from 5 to 30 years
Financial institutions are the connecting link between the short-term
money markets and the longer-term capital markets
• Typically borrow short term and invest in longer-term capital projects,
either indirectly through business loans or directly into capital-market
instruments
68
Financial Markets: Settlement of Transactions
Provide the mechanism for the settlement of transactions
The financial system permits the flow of funds through an economy
Millions of transactions occur each day among the various market
participants
A key role of the financial system is to provide an efficient payment
system for those settlements to occur
70
Financial Markets: Settlement of Transactions
Provide the mechanism for the settlement of transactions
Separate settlement systems have been developed for the usually
small-sized retail transactions and large-value wholesale transactions
An effective payments system is characterized by its efficiency, in
terms of speed, cost and stability in terms of the settlement
mechanism for transferring funds among them
72
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Financial Markets: Settlement of Transactions Financial Markets: Provision of Information

Provide the mechanism for the settlement of transactions Generate and disseminate information that assists decision making

Transaction Type No of Transactions (in lakh) Amount (in Rs. crore)

Loan – Sally for her studies
Nov • Why will bank lend Rs 10 lakhs to Sally?
2021 Nov 2020 Nov 2015 Nov 2021 Nov 2020 Nov 2015 • Which bank will Sally choose to deposit Rs 7 lakhs?
NEFT 3,394 2,734 998 23,14,490 22,18,253 6,37,016
RTGS 156 138 76 98,63,113 79,87,655 53,89,603 Loan - Café owner to expand his business
Mobile 45,046 24,198 405 13,06,948 8,20,024 33,471
Credit Cards – ATM 5 5 5 276 231 258 Insurance – Car, health, life insurance
Credit Cards – POS 2,011 1,663 660 89,217 62,350 20,769
Debit Cards – ATM 5,664 5,868 6,746 2,71,015 2,77,557 2,15,114 Shares/bonds?
Debit Cards - POS 3,404 3,790 999 66,602 67,357 14,899
Decisions in relation to investments, loans, savings, insurance, and
other financial products require information to facilitate them

https://www.npci.org.in/statistics 73 74

Financial Markets: Provision of Information Financial Markets: Provision of Information

A further role of an efficient financial market is to provide sufficient
economic and financial information to enable participants to make
informed investment decisions
For the markets to be efficient, this information needs to be
available in a timely fashion to all market participants so that all have
equal opportunity to act on it
Credit rating agencies play an important role in the provision of
information on companies, governments and other organizations,
and the financial instruments that they use
Credit rating agencies typically publish informed assessments about
the financial standing of securities and institutions using a standard
scale

75 76

Financial Markets: Provision of Information Financial Markets: Provision of Information

https://www.icra.in/Rating/Index?RatingType=CR&CompanyId=20990&CompanyName=Reliance%20Industries%20Limited

https://www.crisil.com/mnt/winshare/Ratings/RatingList/RatingDocs/Reliance_Industries_Limited_May_04_2020_RR.html 77 78

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Financial Markets: Provision of Information Financial Markets: Provision of Information

Credit rating agencies in India
• Credit Analysis and Research Ltd (CARE)
• Credit Rating Information Services of India Ltd (CRISIL) (S&P)
• ICRA Ltd (formerly Investment Information and Credit Rating Agency of
India Limited)
Criticism of ratings agencies:
Conflict of interest: Involved in the management of companies they
are rating and being paid by
Either too slow or reluctant to downgrade organizations
• For example, Enron was rated AAA a week prior to filing for bankruptcy,
despite the ratings agencies being aware of the company’s problems for
several months
Bad loans from flawed assessments of investments by established
ratings agencies was a major cause of the global financial crisis

79 80

Financial Markets: Transfer and Management of Risk Financial Markets: Dealing with Incentive Problems
Provide means for the transfer and management of risk Provide ways of dealing with the incentive problems that arise in
financial contracting
Risk relates to uncertainty and the chance of an unexpected
outcome being achieved The financial system also has a role in mitigating incentive issues that
arise in financial contracts
A key role of the financial system is to allow for financial risk to be
managed and/or transferred to other parties Information asymmetry
Systems to manage the risks they are exposed to including insurance Moral hazard
products, securitization (packaging up like assets and selling them on
Agency problems
to a third party) and derivative products

81 82

Financial Markets: Dealing with Incentive Problems Financial Markets: Dealing with Incentive Problems
Information asymmetry occurs when the contracting parties do not Adverse selection: A market process where a less than optimal
have equal access to relevant information and therefore one party is outcome is achieved due to parties having asymmetric information
at an advantage
For example, a prospective borrower is likely to know more about his
ability to repay, and intended use of the borrowed funds, than the
lender
Outcome: Bank, when presented with a choice between funding
several loans, does not select the best loan as they do not have all
the relevant information available to them

⇒ Adverse selection
83 84

14

Financial Markets: Dealing with Incentive Problems
Moral hazard: Risk that one party to a contract can change their
behavior to the detriment of the other party once a contract has
been concluded
For example, risk that once an asset is insured, the covered party
may not be as careful to protect the asset as they otherwise would
be
85
Financial Markets: Dealing with Incentive Problems
The financial system manages agency problems through various
devices that align the interest of principals and agents
For example,
Regulators
Board
Compensation Contracts
87
Direct and Indirect Financing
An efficient financial system is important because it ensures
adequate capital formation for economic growth
So if the system works properly, firms with the most promising
investment opportunities will receive funding, and those with
inferior opportunities will not receive funding
Similarly, consumers who are willing and able to pay the current
market rate of interest can purchase cars, homes etc on credit,
having them now rather than waiting until they have the money
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Financial Markets: Dealing with Incentive Problems
The principal-agent relationship is created when there is a
separation between ownership (the principal) and control (the
agent) of an asset
• For example, shareholders of a company (principals) employ managers
(agents) to act on their behalf
Problems arise when the interests of the principals and agents are
not aligned
Managers may want to maximize their chances of employment
elsewhere and to improve their yearly bonus
86
Direct and Indirect Financing
The purpose of the financial system is to transfer funds from SSUs to
DSUs as efficiently as possible
The job of bringing DSUs and SSUs together can be done by direct
financing or by indirect financing (financial intermediation)
The goal is to bring the parties together at the least possible cost and
with the least inconvenience
Sally and other depositers → Banks → Cafe
88
Direct Financing
In direct financing, DSUs and SSUs exchange money and financial
claims directly
90
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Direct Financing Direct Financing

Private Placements
Direct Financing The simplest method of transferring funds between SSUs and DSUs
is a private placement
Suppliers of funds (SSUs) Demanders of funds (DSUs)
• Households Funds Financial Markets Funds
• Households A corporation (DSU), sells an entire security issue to a single
• Businesses • Businesses institutional investor or small group of investors
• Governments • Governments
Funds The advantage of a private placement is the speed with which funds
Funds
Funds
can be committed and the low transaction cost of bringing the
securities to market
Financial
Intermediaries An investment bank usually assists corporates in private placements
and charges a fee for helping to design and place the securities
91 92

Direct Financing Direct Financing

Investment Banks Brokers and Dealers
Another direct method of bringing financial claims to market is with Brokers and dealers aid in the process of bringing buyers and sellers
the services of an investment banker, who helps DSUs market newly together
created financial claims, often called initial public offerings (IPOs)
Brokers execute their clients’ transactions and are compensated for
To do this, the investment bank purchases an entire issue of stocks their services with a commission
or bonds from the DSU at a guaranteed price and then resells the
Dealers ‘make markets’ for securities
securities individually to investors at a higher price, a process known • Carry an inventory of securities
as underwriting • Make profits by selling from their inventory and, on average, sell
securities for a higher price (ask price) than they paid for them (bid price)
• Most dealers also function as brokers

93 94

Indirect Financing – Financial Intermediation Indirect Financing – Financial Intermediation

DSUs must find SSUs that want direct claims with precisely the
characteristics they can and will sell
For direct financing to take place, the DSU must be willing to issue a
security with a denomination, maturity, and other characteristics
that match the SSU’s desires exactly
Unless both the SSU and DSU are satisfied simultaneously, the
transfer of money will not take place
Sally needs the proceeds from her student loan to pay for tuition and
books at the beginning of the second semester
She does not want to invest her funds in a 30-year corporate bond
because it has a longer maturity than she needs
Corporate bond and stocks are risky and Sally may not want to risk
having the price of the bonds/stocks go down, jeopardizing her
ability to pay her second year tuition fees
Term deposit gives Sally a safe place to store her money until she
needs it and at the same time earn interest

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Indirect Financing – Financial Intermediation
Financial intermediaries transform financial claims in ways that make
them more attractive to the ultimate investor
Financial intermediaries include commercial banks, life insurance
companies, pension funds, to name a few
These and other financial intermediaries emerged because of
inefficiencies found in direct financing
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Indirect Financing – Financial Intermediation
Financial intermediaries operate to make a profit and they buy and
sell specialized financial products to do so
In the financial intermediation market, the SSU’s claim is against the
financial intermediary rather than the DSU
More specifically, they buy financial claims (held as assets of the
intermediary), such as business loans, consumer loans, corporate
bonds, corporate common stock and government bonds, from DSUs
• These financial claims have characteristics designed to meet the needs of
particular DSUs
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Benefits of Financial Intermediation
In the Sally example, the local bank charge the café owner 8 percent
for the business loan, and the bank’s cost of funds for deposits is 4
percent
The bank’s gross interest margin is 4 percent, from which the bank
has to cover its cost of manufacturing the loan, its overhead
expenses and the risk of not getting paid back (credit risk)
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Indirect Financing – Financial Intermediation
Financial intermediaries intervene between the borrower (DSU) and
the ultimate lender (SSU)
Financial intermediaries purchase direct claims with one set of
characteristics (e.g., term to maturity, denomination) from DSUs and
transform them into indirect claims with a different set of
characteristics, which they sell to the SSU
• This transformation process is called financial intermediation
• Firms that specialize in intermediation are called financial intermediaries
or financial institutions
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Benefits of Financial Intermediation
Financial intermediaries finance the purchase of these financial
claims by selling financial claims on themselves (held as liabilities of
the intermediary), such as cheque accounts, savings accounts, life
insurance policies, and managed funds to SSUs
• These financial claims have characteristics that are attractive to SSUs
To earn profits, financial intermediaries buy financial claims from
DSUs whenever the income generated by the financial claim is
expected to cover all of their borrowing and production costs
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Benefits of Financial Intermediation
Financial intermediaries can achieve economies of scale because of
their specialization
• Handle many transactions therefore they are able to spread out their
fixed costs
They can reduce the transaction costs involved in searching for credit
information
• A consumer who wishes to lend directly can also search for information,
but usually at a higher cost
Financial intermediaries are often able to produce financial services
at a lower cost than individual consumers
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Benefits of Financial Intermediation Intermediation Services

Competition among financial intermediaries tends to force interest In ‘transforming’ direct financial claims into indirect ones, financial
rates to the lowest level compatible with their cost structures intermediaries perform five basic services:
A high rate of economic growth requires a substantial amount of Denomination divisibility
business expenditure (investment)
Currency transformation
The lower interest rates are, the more willing businesses are to make
Maturity flexibility
expenditures on real investments
Credit risk diversification
Liquidity

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Intermediation Services Intermediation Services

Denomination Divisibility
Financial intermediaries are able to produce a wide range of
denominations from one rupee to many millions
They can do this by pooling the funds of many individuals and
investing them in direct securities of varying sizes
Of particular importance is their acceptance of deposits from
individuals who typically do not have money balances large enough
to engage in the wholesale transactions found in direct financial
markets
Currency Transformation
Many companies export goods and services to other countries, but
few individuals are willing to finance the overseas activities of these
companies by buying direct financial claims denominated in a
foreign currency
Financial intermediaries help to finance the global expansion of
domestic companies by buying financial claims denominated in one
currency and selling financial claims denominated in other
currencies

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Intermediation Services Intermediation Services

Maturity Flexibility
Financial intermediaries are able to create securities with a wide
range of maturities from one day to more than 30 years
In this way, they are able to buy direct claims issued by DSUs and
issue indirect securities with precisely the maturities desired by SSUs
Credit Risk Diversification
By purchasing a wide variety of securities, financial intermediaries
are able to spread risk
If the securities purchased are less than perfectly correlated with
each other, the intermediary is able to reduce the fluctuation in the
principal value of the portfolio

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Intermediation Services
Liquidity
For most consumers, the timing of revenues and expenses rarely
coincides
Because of this, most economic units prefer to hold some assets that
have low transaction costs associated with converting them into
money
Many of the financial commodities produced by intermediaries are
highly liquid
• For example, a savings account permits consumers to purchase an asset
or repay a debt with minimal transaction cost
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Intermediation Services
Typically, consumers whose transactions are small in dollar amount
(retail transactions) find that the intermediation market is most cost
effective
Economic units that deal in large amounts (wholesale transactions)
switch back and forth between the two markets, selecting the
market that offers the most favorable interest rate
• For example, many large businesses take out loans from commercial
banks (an intermediation transaction), and also raise money by selling
commercial paper in the direct credit market
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Financial Market Efficiency
Allocational Efficiency
It is a form of economic efficiency that implies that funds will be
allocated to (i.e., invested in) their highest-valued use
Funds could not have been allocated in any other way that would
have made society better off
⇒ Business firms invest in projects offering the highest rates of
return and that households invest in direct or indirect financial
claims offering the highest yields for given levels of risk
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Intermediation Services
Financial intermediaries tailor the characteristics of the indirect
securities they issue to the desires of SSUs
They engage in one or more distinct types of intermediation:
denomination, currency, risk, maturity, and liquidity intermediation
They provide these and other services to earn a profit
SSUs and DSUs use financial intermediation services as long as the
cost of doing so is less than providing the services for themselves
through the direct credit markets
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Financial Market Efficiency
How different aspects of financial market affect the efficiency and
growth of the economy
Allocational, informational, and operational efficiency
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Financial Market Efficiency
Informational Efficiency
The ability of investors to obtain accurate information about the
relative values of different claims (or securities) is critical
Informational efficiency is achieved when securities’ prices are the
best indicators of relative value because they reflect all relevant
information about the securities
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Financial Market Efficiency
Informational Efficiency
When new information about a security arrives in an efficient
market, market prices adjust very quickly
• Analysts and investors are gathering information about securities in a
quest for quick profits
Large profits can be earned by identifying overpriced securities
before the price begins to rise
The actions of analysts and investors ensure that market prices
reflect all information relevant to their values at any time
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Financial Market Efficiency
Operational Efficiency
It is achieved in a market when the costs of conducting transactions
are as low as possible
These transaction costs include broker commissions, bid-ask spreads
and underwriter spreads
Fewer financial transactions will take place and more otherwise
valuable investment projects will be passed up if transaction costs
are high
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Summary
Explain the role of the financial system and why it is important to
individuals and to the economy as a whole
• The role of the financial system is to gather money from SSUs and transfer
it to DSUs in the most efficient manner possible
• Larger the flow and more efficiently the funds are allocated, greater is the
accommodation of individual preferences for current spending and
savings and the ability of businesspeople to invest in their firms
• Financial markets have five primary functions:
(1) facilitating the flow of funds
(2) providing the mechanism for the settlement of transactions
(3) generating and disseminating information that assists decision-making
(4) providing means for the transfer and management of risk, and
(5) providing ways of dealing with the incentive problems that arise in financial
contracting
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Financial Market Efficiency
Informational Efficiency
Why is it important that market prices reflect all relevant
information about securities?
With accurate price information, investors can determine which
investments are the most valuable – providing the highest expected
return for a given level of risk – and invest accordingly
This informational efficiency ensures that the financial markets are
allocationally efficient because households or business firms can get
the information they need to make investment decisions
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Financial Market Efficiency
Operational Efficiency
Firms will be prevented from investing in all the projects that they
want to if transaction costs are high
The forgone investment opportunities mean that fewer people are
employed and economic growth slows or declines
Society becomes worse off
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Summary
Explain the function of direct and indirect financial markets and the
key services provided by financial intermediaries
• Two basic ways the transfer of funds takes place in the economy:
• Direct financing (financial markets): Wholesale market for financial claims in which
DSUs and SSUs trade financial claims among themselves
• Brokers, dealer, and investment bankers facilitate these transactions
• Indirect financing (intermediation markets): financial institutions intermediate, or
stand between, transactions between DSUs and SSUs
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Summary Summary
Financial intermediaries provide five fundamental services: Financial claims of different natures and types are brought and sold
• Denomination divisibility: Producing financial claims of varying dollar in financial markets
amounts
• Currency transformation: Buying financial claims denominated in one Financial claims are initially sold on primary markets and then traded
currency and selling financial claims denominated in another in secondary markets
• Maturity flexibility: Creating financial claims with a wide range of
maturities
• Credit risk diversification: Diversifying risk more efficiently than individual
SSUs might be able to on their own
• Liquidity: Buying direct financial claims with low liquidity and issuing
indirect financial claims with more liquidity

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