FIN2001 – FINANCIAL

MARKETS AND INSTITUTIONS

Lecturer: Nguyen, T.T. Quang (PhD)

Faculty of Banking, UD-DUE
 Chapter 1

OVERVIEW OF THE
FINANCIAL SYSTEM

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 Financial system

Financial market

Content Financial intermediaries

Central bank

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Readings
• Chapter 2, 9 and 10, Federic S.
Mishkin, Stanley G. Eakins
(2018), Financial Markets and
Institutions, 9th ed, Pearson.

• Chapter 1, 2 and 3, David S.

Kidwell, David W. Blackwell,
David A. Whidbee, Richard W.
Sias (2012), Financial Institutions,
Markets & Money, 11th ed, John
Wiley & Sons.

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1.1 The financial system
• Financial system consists of financial
markets, financial instruments and
financial institutions which interact to
facilitate the flow of funds through the
financial system.
• There are two basic mechanisms by
which funds flow through the financial
system:
• Direct financing: where funds flow
directly through financial market.
• Indirect financing: where funds
flow indirectly through financial
institutions in the financial
intermediation market.

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How funds flow through the financial system

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 1.2 Financial market

• Functions of financial market

• Function of channeling funds
• Function of encouraging saving and investment.
• Function of raising the financial asset’s liquidity
• Financial markets play an important role in the economy.
• Financial markets allow funds to move from people who
lack productive investment opportunities to people who
have such opportunities.
• Financial markets are critical for producing an efficient
allocation of capital, which contributes to higher
production and efficiency for the overall economy
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 1.2 Financial market

Structure of financial market

• Debt and equity markets
• Primary and secondary markets
• Exchanged and Over-the-counter Markets
• Money and capital markets

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 1.2.2 Structure of financial market

Debt and equity markets

• A firm or an individual can obtain funds in a financial market in
two ways:
• Issuing debt instruments:
• Bonds, T-bills, commercial papers, negotiable certificates of deposit
(NCDs),…
• Short-term, intermediate-term and long-term instruments.
• Issuing equities: common stocks
• Advantage of holding equities is that equity holders benefit
directly from any increases in the corporation’s profitability or
asset value.
• Disadvantage of owning a corporation’s equities rather than its
debt is that an equity holder is a residual claimant

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 1.2.2 Structure of financial market

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
◼A secondary market is a financial market in which
securities that have been previously issued can be resold.
◼Secondary market:
◼makes the financial instruments more liquid
◼determines the price of the security that the issuing firm
sells in the primary market

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 1.2.2 Structure of financial market

Exchanges and Over-the-counter markets

• An exchanges market is a place where buyers and sellers
of securities (or their agents or brokers) meet in one central
location to conduct trades.
• An over-the-counter (OTC) market, in which dealers at
different locations who have an inventory of securities stand
ready to buy and sell securities “over the counter” to anyone
who comes to them and is willing to accept their prices.
• over the- counter dealers are in computer contact
• the OTC market is very competitive

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 1.2 Structure of financial market

Money and capital markets

• The money market is a financial market in which
only short-term debt instruments (generally those
with original maturity of a one year or less) are
traded.
• The capital market is the market in which longer
term debt (generally with original maturity of more
than one year) and equity instruments are traded.

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 1.3 Financial Intermediaries

Functions of financial intermediaries

• Reduce transaction cost: Financial intermediaries reduce
transaction costs because:
• expertise
• economies of scale
• Risk sharing
• Asset transformation
• Diversification
• Asymmetric information:
• Adverse selection
• Moral hazard

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 Types of financial intermediaries:
• Depository Institutions
• Commercial Banks
• Savings and Loan Associations
(S&Ls) and Mutual Savings Banks
• Credit Unions
• Contractual Savings Institutions
• Life Insurance Companies
1.3 Financial • Fire and Casualty Insurance
Intermediaries Companies
• Pension Funds and Government
Retirement Funds
• Investment Intermediaries
• Finance Companies
• Mutual Funds
• Money Market Mutual Funds
• Investment banks
• Securities Firms 14
Types of financial intermediaries

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Revision

• Financial System
• Financial Market
• Debt & Equity market
• Money & Capital market
• Primary & Secondary market
• OTC & Exchange market
• Financial Intermediaries
• Transaction cost, Risk sharing, Information cost
• Financial Instruments

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1.4 Central Bank - Functions

The Government’s bank:

• Manages the finance of the government
• Through interest rate, controls the availability of
money and credit.
• The Banker’s bank:
• Guarantees that sound banks can do business by
lending to them, even during crises.
• Operates a payment system for interbank payment.
• Oversees financial institutions to ensure confidence
in their soundness.

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1.4 Central bank - Objectives

• Low, stable inflation

• High, stable growth
• Financial system stability
• Stable interest rate
• Stable exchange rate

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1.4 Central bank - Tools of monetary
policy

• The conduct of monetary policy by the Federal Reserve

involves actions that affect its balance sheet
• The Central Bank’s Balance Sheet:

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 The Central Bank’s Balance Sheet

• Liabilities: currency in circulation and reserves - the monetary

liabilities.
• The increases in either or both will lead to an increase in the
money supply
• Currency in circulation: Currency in circulation is the amount
of currency in the hands of the public (outside of banks)
• Reserves: consist of deposits at the Fed plus currency that is
physically held by banks
• An increase in reserves leads to an increase in the level of
deposits and hence in the money supply
• Total reserves: reserves that the Fed requires banks to hold
(required reserves) and any additional reserves the banks
choose to hold (excess reserve )
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The Central Bank’s Balance Sheet

• Assets:
• Government securities:
• The U.S Treasury securities are held by Fed.
• The Fed provides reserves to the banking system by
purchasing securities
• An increase in government securities held by the Fed
leads to an increase in the money supply.
• Discount loans:
• The Fed can provide reserves to the banking system by
making discount loans to banks
• An increase in discount loans can also be the source of
an increase in the money supply.

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1.4 Central bank - Tools of monetary
policy

▪ Open market operations

▪ Discount rate
▪ Reserve requirement

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 Open Market Operation

• Open market operations – OMO: refers to the buying and

selling of government securities in the open market in order to
expand or contract the amount of money in the banking system,
facilitated by central banks.
• The most important monetary policy tool.
• The primary determinant of changes in reserves in the banking
system and interest rates
• Two types of open market operations:
• Dynamic open market operations: are intended to change
the level of reserves and the monetary base
• Defensive open market operations: are intended to offset
movements in other factors that affect reserves and the
monetary base
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 Open Market Operations

▪ Monetary base (MB) = currency in circulation (C) + total

reserves (TR) in the banking system

▪ An open market purchase leads to an expansion of reserves

and deposits in the banking system and hence to an expansion
of the monetary base and the money supply.
▪ An open market sale leads to a contraction of reserves and
deposits in the banking system and hence to a decline in the
monetary base and the money supply
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 Discount policy

• The facility at which banks can borrow reserves from the

Federal Reserve is called the discount window.
• The Fed’s discount loans to banks are of three types:
• Primary credit: plays the most important role in
monetary policy
o Healthy banks are allowed to borrow all they want at
very short maturities (usually overnight)
• Secondary credit: is given to banks that are in financial
trouble and are experiencing severe liquidity problems
• Seasonal credit: is given to meet the needs of a limited
number of small banks in vacation and agricultural areas
that have a seasonal pattern of deposits

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Discount policy

• A discount loan leads to an expansion of reserves,

which can be lent out as deposits, thereby leading to an
expansion of the monetary base and the money supply.
• When a bank repays its discount loan and so reduces the
total amount of discount lending, the amount of reserves
decreases along with the monetary base and the money
supply.

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 Reserve requirement

• Reserve requirement is the amount of funds that financial

institutions must hold at the Central bank in order to back
their deposit.
• A rise in reserve requirements leads to a decline of the
monetary multiplier and the money supply.
• A reduction leads to an expansion in the monetary multiplier
and the money supply
• Reserve requirements have rarely been used as a monetary
policy tool because raising them can cause immediate
liquidity problems for banks with low excess reserves.

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Reserve 28
requirement

• Example 1: Computing a Bank’s Excess Reserve Position

• A regional bank receives a new demand deposit (DD) of
$5,000,000, in addition to existing demand deposits of
$4,000,000.
• The current reserve requirement is 10 percent.
• The bank has $100,000 in vault cash and $350,000 in deposits
at the Federal Reserve that are not yet invested.
• How much in excess reserves does the bank have available to
make new loans?
 Reserve requirement
• Example 2: Calculating a Bank’s Reserve Position
A commercial bank has $1,000 in reserves, $9,000 in
loans, and $10,000 of deposits. Answer the following
questions:
(a)If the reserve requirement is 10 percent, what is the
bank’s reserve position?
(b)If the Fed raised the reserve requirement to 20
percent, how would this affect the bank’s reserve
position?
(c)If the bank complies with the new reserve
requirement (20 percent), what is the bank’s new
equilibrium reserve position?

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END OF CHAPTER