Financial Markets and Institutions

13th Edition
by Jeff Madura

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 1 Role of Financial Markets and Institutions
Chapter Objectives

• Describe the types of financial markets that

facilitate the flow of funds.
• Describe the types of securities traded within
financial markets.
• Describe the role of financial institutions within
financial markets.
• Explain how financial institutions were exposed
to the credit crisis.

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2
 Financial Market

A market in which financial assets (securities) such as

stocks and bonds can be purchased or sold. Funds are
transferred in financial markets when one party purchases
financial assets previously held by another party.

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 © 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 © 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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 Role of Financial Markets (1 of 3)

Financial markets transfer funds from those who have

excess funds to those who need funds.
• Surplus units: participants who receive more money
than they spend, such as investors.
• Deficit units: participants who spend more money than
they receive, such as borrowers.
• Securities: represent a claim on the issuers
• Debt securities - debt (also called credit, or borrowed funds)
incurred by the issuer.
• Equity securities - (also called stocks) represent equity or
ownership in the firm.

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 Role of Financial Markets (2 of 3)

Accommodating Corporate Finance Needs: The

financial markets serves as the mechanism whereby
corporations (acting as deficit units) can obtain funds from
investors (acting as surplus units).
Accommodating Investment Needs: Financial institutions
serve as intermediaries to connect the investment
management activity with the corporate finance activity.
(Exhibit 1.1)

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 Exhibit 1.1 How Financial Markets Facilitate
Corporate Finance and Investment Management

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 What if financial institutions did not
exist?

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 FUNCTIONS

• Price Determination:
• Demand and supply determine their price
• Investors are the supplier of the funds,
• Industries are in need of the funds,
• Interaction between these two participants and other market forces
helps to determine the price.

• Mobilization of savings:
• helps in connecting those with money with those who require money.

• Ensures liquidity:
• can easily sell those assets and convert them into cash whenever needed

• Saves time and money

• a platform where buyers and sellers can easily find each other without
making too much efforts or wasting time.
• helps to achieve economies of scale.
• lower transaction cost and fees

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 Role of Financial Markets (3 of 3)

Primary versus Secondary Markets

• Primary markets - facilitate the issuance of new
securities
• Secondary markets - facilitate the trading of existing
securities, which allows for a change in the ownership of
the securities
• Liquidity is the degree to which securities can easily be
liquidated (sold) without a loss of value.
• If a security is illiquid, investors may not be able to find a
willing buyer for it in the secondary market and may have to
sell the security at a large discount just to attract a buyer.

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 Types of Financial Market

PRIMARY SECONDARY
• New Issue of Securities ◼ Trading Previously Issued
Securities
• Exchange of Funds for ◼ No New Funds for Issuer
Financial Claim

• Funds for Borrower; an IOU ◼ Provides Liquidity for

for Lender Seller

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 Types of Financial Market

◼ Money ◼ Capital
◼ Short-Term, < 1 Year ◼ Long-Term, >1Yr

◼ High Quality Issuers ◼ Range of Issuer Quality

◼ Debt Only ◼ Debt and Equity

◼ Primary Market Focus ◼ Secondary Market Focus

◼ Liquidity Market--Low ◼ Financing Investment--

Returns Higher Returns
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 Securities Traded in Financial Markets (1 of 7)

Securities can be classified as money market securities,

capital market securities, or derivative securities.
Money Market Securities
• Money markets facilitate the sale of short-term debt
securities by deficit units to surplus units.
• Debt securities that have a maturity of one year or less.

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 Securities Traded in Financial Markets (2 of 7)

Capital Market Securities - facilitate the sale of long-term

securities by deficit units to surplus units.
• Bonds - long-term debt securities issued by the Treasury,
government agencies, and corporations to finance their
operations.
• Mortgages - long-term debt obligations created to finance
the purchase of real estate.
• Mortgage-backed securities - debt obligations
representing claims on a package of mortgages.
• Stocks - represent partial ownership in the corporations
that issued them.

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 Securities Traded in Financial Markets (3 of 7)

Derivative Securities - financial contracts whose values

are derived from the values of underlying assets
• Speculation - allow an investor to speculate on movements
in the value of the underlying assets without having to
purchase those assets.
• Risk management - financial institutions and other firms
can use derivative securities to adjust the risk of their
existing investments in securities.

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 Securities Traded in Financial Markets (4 of 7)

Valuation of Securities
• Impact of information on valuation
• Estimate future cash flows by obtaining information that
may influence a stock’s future cash flows. (Exhibit 1.2)
• Use economic or industry information to value a security.
• Use published opinions about the firm’s management to
value a security.

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 Securities Traded in Financial Markets (5 of 7)

Valuation of Securities (continued)

• Impact of Behavioral Finance on Valuation
• Various conditions can affect investor psychology.
Behavioral finance can sometimes explain the movements
of a security’s price.
• Behavioral Finance - the application of psychology to
make financial decisions.
• Uncertainty Surrounding Valuation of Securities
• Limited information leads to uncertainty in the valuation of
securities.

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 Exhibit 1.2 Use of Information to Make
Investment Decisions

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 Securities Traded in Financial Markets (6 of 7)

• Securities Regulations on Financial Disclosure

• The Securities Act of 1933 was intended to ensure
complete disclosure of relevant financial information on
publicly offered securities and to prevent fraudulent
practices in selling these securities.
• The Securities Exchange Act of 1934 extended the
disclosure requirements to secondary market issues.
• The Sarbanes-Oxley Act of 2002 required that firms
provide more complete and accurate financial information.

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 Securities Traded in Financial Markets (7 of 7)

International Financial Markets

Financial markets vary across the world in terms of:
• Degree of financial market development
• Volume of funds transferred from surplus to deficit units
• International Integration of Financial Markets-Under
favorable economic conditions, the international
integration of financial markets allows governments and
corporations easier access to funding from creditors or
investors in other countries to support their growth.
• Role of Foreign Exchange Market - International
financial transactions normally require the exchange of
currencies. The foreign exchange market facilitates this
exchange.
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 Role of Financial Institutions (1 of 6)

Financial institutions are needed to resolve the limitations

caused by market imperfections such as limited
information regarding the creditworthiness of borrowers.
Role of depository institutions - Depository institutions
accept deposits from surplus units and provide credit to
deficit units through loans and purchases of securities.
• Offer liquid deposit accounts to surplus units
• Provide loans of the size and maturity desired by deficit
units
• Accept the risk on loans provided
• Have more expertise in evaluating creditworthiness
• Diversify their loans among numerous deficit units

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 Role of Financial Institutions (2 of 6)

Role of Depository Institutions (continued)

• Commercial Banks
• The most dominant type of depository institution
• Transfer deposit funds to deficit units through loans or purchase
of debt securities
• Federal Funds Market - facilitates the flow of funds between
depository institutions
• Savings Institutions
• Also called thrift institutions and include Savings and Loans
(S&Ls) and Savings Banks
• Concentrate on residential mortgage loans
• Credit Unions
• Nonprofit organizations
• Restrict business to CU members with a common bond
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 Role of Financial Institutions (3 of 6)

Role of Non-depository Institutions

• Finance companies - obtain funds by issuing securities
and lend the funds to individuals and small businesses.
• Mutual funds - sell shares to surplus units and use the
funds received to purchase a portfolio of securities.
• Securities firms - provide a wide variety of functions in
financial markets. (Broker, Underwriter, Dealer, Advisory)
• Insurance companies - provide insurance policies that
reduce the financial burden associated with death, illness,
and damage to property. Charge premiums and invest in
financial markets.
• Pension funds – manage funds until they are withdrawn
for retirement

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26 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (4 of 6)

Comparison of Roles among Financial Institutions

• Financial institutions facilitate the flow of funds from
individual surplus units (investors) to deficit units. (Exhibit
1.3)
• Institutional Role as a Monitor of Publicly Traded
Firms
• Since insurance companies, pension funds, and some
mutual funds are major investors in stocks, they can
influence the management of publicly traded firms.
• By serving as activist shareholders, they can help ensure
that managers of publicly held corporations make
appropriate decisions that are in the best interests of the
shareholders.

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 Exhibit 1.3 Comparison of Roles
among Financial Institutions

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 Role of Financial Institutions (5 of 6)

Relative Importance of Financial Institutions (Exhibit 1.4)

• Households with savings are served by depository
institutions.
• Households with deficient funds are served by depository
institutions and finance companies.
• Several agencies regulate the various types of financial
institutions, and the various regulations may give some
financial institutions a comparative advantage over others.

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 Role of Financial Institutions (6 of 6)

Consolidation of Financial Institutions

• Exhibit 1.5 depicts the typical organizational structure of
a financial conglomerate. The operations of each type of
financial service are commonly managed separately, a
financial conglomerate offers advantages to customers
who prefer to obtain all of their financial services from a
single financial institution.
• Global Consolidation of Financial Institutions - Many
financial institutions have expanded internationally to
capitalize on their expertise.

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 Exhibit 1.5 Organizational Structure of
a Financial Conglomerate

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31 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Difference between banks and FIs?

• FIs cannot issue cheques, pay-orders or demand drafts.

• FIs cannot receive demand deposits,
• FIs cannot be involved in foreign exchange financing,
• FIs can conduct their business operations with diversified financing
modes like syndicated financing, bridge financing, lease financing,
securitization instruments, private placement of equity etc.

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 Systemic Risk among Financial Institutions

• Systemic risk is defined as the spread of financial problems among

financial institutions and across financial markets that could cause a
collapse in the financial system.
• During the credit crisis of 2008 and 2009, mortgage defaults affected
financial institutions in several ways.
• First, many financial institutions that originated mortgages shortly before
the crisis sold them to other financial institutions.
• Second, many other financial institutions that invested in mortgage-
backed securities received lower payments as mortgage defaults
occurred.
• Third, some financial institutions (especially securities firms) relied
heavily on short-term debt to finance their operations and used their
holdings of mortgage-backed securities as collateral.
• Fourth, as mortgage defaults increased, there was an excess of
unoccupied housing.
• Eventually, most financial institutions that invested heavily in equities
experienced large losses on their investments during the credit crisis.
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 Exhibit 1.5 Organizational Structure of a Financial
Conglomerate

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 Overview of Financial Institution of Bangladesh

Banks
After the independence, banking industry in Bangladesh started its journey
with 6 Nationalized commercialized banks, 3 State owned Specialized
banks and 9 Foreign Banks. In the 1980's banking industry achieved
significant expansion with the entrance of private banks. Now, banks in
Bangladesh are primarily of two types:
Scheduled Banks: The banks that remain in the list of banks maintained
under the Bangladesh Bank Order, 1972.
Non-Scheduled Banks: The banks which are established for special and
definite objective and operate under any act act but are not Scheduled
Banks. These banks cannot perform all functions of scheduled banks.

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 Overview of Financial Institution of Bangladesh

There are 59 scheduled banks in Bangladesh who operate under full control and
supervision of Bangladesh Bank which is empowered to do so through Bangladesh
Bank Order, 1972 and Bank Company Act, 1991. Scheduled Banks are classified into
following types:

State Owned Commercial Banks (SOCBs): There are 6 SOCBs which are fully or majorly
owned by the Government of Bangladesh.
Specialized Banks (SDBs): 3 specialized banks are now operating which were
established for specific objectives like agricultural or industrial development. These banks
are also fully or majorly owned by the Government of Bangladesh.
Private Commercial Banks (PCBs): There are 41 private commercial banks which are
majorly owned by individuals/the private entities. PCBs can be categorized into two
groups:
Conventional PCBs: 33 conventional PCBs are now operating in the industry. They
perform the banking functions in conventional fashion i.e interest based operations.
Islami Shariah based PCBs: There are 8 Islami Shariah based PCBs in Bangladesh and
they execute banking activities according to Islami Shariah based principles i.e. Profit-
Loss Sharing (PLS) mode.
Foreign Commercial Banks (FCBs): 9 FCBs are operating in Bangladesh as the
branches of the banks which are incorporated in abroad.

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 Overview of Financial Institution of Bangladesh

There are now 5 non-scheduled banks in Bangladesh which are:

Ansar VDP Unnayan Bank,
Karmashangosthan Bank,
Grameen Bank,
Jubilee Bank,
Palli Sanchay Bank

FIs
Non Bank Financial Institutions (FIs) are those types of financial institutions
which are regulated under Financial Institution Act, 1993 and controlled by
Bangladesh Bank. Now, 34 FIs are operating in Bangladesh while the maiden
one was established in 1981. Out of the total, 2 is fully government owned, 1
is the subsidiary of a SOCB, 15 were initiated by private domestic initiative
and 15 were initiated by joint venture initiative. Major sources of funds of FIs
are Term Deposit (at least three months tenure), Credit Facility from Banks
and other FIs, Call Money as well as Bond and Securitization.

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 Insurance sector in Bangladesh emerged after independence with 2
nationalized insurance companies- 1 Life & 1 General; and 1 foreign insurance
company. In mid 80s, private sector insurance companies started to enter in the
industry and it got expanded. Now days, 62 companies are operating under
Insurance Act 2010. Out of them-
18 are Life Insurance Companies including 1 foreign company and 1 is state-
owned company,
44 General Insurance Companies including 1 state-owned company.
Insurance companies in Bangladesh provide following services:
1. Life insurance,
2. General Insurance,
3. Reinsurance,
4. Micro-insurance,
5. Takaful or Islami insurance.

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 Flow of Funds exercise

This continuing exercise focuses on the interactions of a single manufacturing firm (Carson
Company) in the financial markets. It illustrates how financial markets and institutions are
integrated and facilitate the flow of funds in the business and financial environment. At the end of
every chapter, this exercise provides a list of questions about Carson Company that requires the
application of concepts presented in the chapter as they relate to the flow of funds.

Carson Company is a large manufacturing firm in California that was created 20 years ago by the
Carson family. It was initially financed with an equity investment by the Carson family and10 other
individuals. Over time, Carson Company obtained substantial loans from finance companies and
commercial banks. The interest rates on those loans are tied to market interest rates and are
adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate
movements. The company has a credit line with a bank in case it suddenly needs additional funds
for a temporary period. It has purchased Treasury securities that it could sell if it experiences any
liquidity problems.

Carson Company has assets valued at approximately $50 million and generates sales of nearly
$100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because it
expects the U.S. economy to be strong in the future, Carson plans to grow by expanding its
business and by making more acquisitions. It expect that it will need substantial long-term
financing and plans to borrow additional funds either through obtaining loans or by issuing bonds.
It is also considering issuing stock to raise funds in the next year. Carson closely monitors
conditions in financial markets that could affect its cash inflows and cash outflows and thereby
affect its value.
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 Questions

a. In what way is Carson a surplus unit?

b. In what way is Carson a deficit unit?
c. How might finance companies facilitate Carson’s expansion?
d. How might commercial banks facilitate Carson’s expansion?
e. Why might Carson have limited access to additional debt financing during its
growth phase?
f. How might securities firms facilitate Carson’s
expansion?
g. How might Carson use the primary market to facilitate its expansion?
h. How might it use the secondary market?
i. If financial markets were perfect, how might this factor have allowed Carson
to avoid financial institutions?
j. The loans that Carson has obtained from commercial banks stipulate that
Carson must receive the bank’s approval before pursuing any large projects.
What is the purpose of this condition? Does this condition benefit the owners of
the company?

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 Q&A

Discussion

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 SUMMARY (1 of 3)

• Financial markets facilitate the transfer of funds from surplus

units to deficit units. Because funding needs vary among
deficit units, various financial markets have been established.
The primary market allows for the issuance of new securities,
and the secondary market allows for the sale of existing
securities.
• Securities can be classified as money market (short-term)
securities or capital market (long-term) securities. Common
capital market securities include bonds, mortgages, mortgage-
backed securities, and stocks. The valuation of a security
represents the present value of future cash flows that it is
expected to generate. New information that indicates a
change in expected cash flows or degree of uncertainty affects
prices of securities in financial markets.

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42 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (2 of 3)

• Depository and nondepository institutions help to finance the

needs of deficit units. The main depository institutions are
commercial banks, savings institutions, and credit unions. The
main nondepository institutions are finance companies, mutual
funds, pension funds, and insurance companies.
• Many financial institutions have been consolidated (due to
mergers) into financial conglomerates, where they serve as
subsidiaries of the conglomerate while conducting their
specialized services. Thus, some financial conglomerates are
able to provide all types of financial services. Consolidation
allows for economies of scale and scope, which can enhance
cash flows and increase the financial institution’s value. In
addition, consolidation can diversify the institution’s services
and increase its value through the reduction in risk.

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 SUMMARY (3 of 3)

• Financial institutions are subject to systemic risk, because

they commonly invest in the same types of securities and are
similarly exposed to conditions that could cause the prices of
those securities to decline substantially. The credit crisis of
2008 and 2009 illustrates how massive mortgage defaults can
cause a major decline in the prices of mortgagebacked
securities and equity securities, which are investments
commonly held by many types of financial institutions.

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