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Financial Markets and Institutions

Chapter 1: Financial Markets vs.

Financial Institutions

Dr. Tamer Mohamed Shahwan

 Chapter Preview

To start, we preview subjects of interest to anyone who is a

part of a productive society. We motivate how financial
markets and institutions have significant impact on important
questions about our financial well-being. Topics include:
•Why Study Financial Markets?
•Why Study Financial Institutions?
•How Will We Study Financial Markets and Institutions?
 Why Study Financial Markets and
Institutions?
•• They
They are
are the
the cornerstones
cornerstones of of the
the overall
overall financial
financial
system
system in
in which
which financial
financial managers
managers operate.
operate. These
These
markets
markets and
and institutions
institutions channel
channel funds
funds from
fromsavers
savers
to
to investors,
investors, thereby
thereby promoting
promoting economic
economic
efficiency.
efficiency.
•• Individuals
Individuals use
useboth
both for
for investing
investing
•• Corporations
Corporations and and governments
governments use use both
both for
for
financing
financing
•• Market
Market activity
activity affects
affects personal
personal wealth,
wealth, the
the behavior
behavior
of
of business
business firms,
firms, and
and economy
economy as as aa whole
whole
 Overview of Financial Markets

•• Primary
Primary Markets
Markets versus
versus Secondary
Secondary
Markets
Markets
•• Money
Money Markets
Markets versus
versus Capital
Capital Markets
Markets
•• Foreign
Foreign Exchange
Exchange Markets
Markets
 Primary Markets versus Secondary
Markets

•• Primary
Primary Markets
Markets
–– markets
markets inin which
which users
users of
of funds
funds (e.g.
(e.g.
corporations,
corporations, governments)
governments) raiseraise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.
(e.g. stocks
stocks and
and
bonds)
bonds)
•• Secondary
Secondary Markets
Markets
–– markets
markets where
where financial
financial instruments
instruments are
are traded
traded
among
among investors
investors (e.g.
(e.g. NYSE,
NYSE, NASDAQ)
NASDAQ)
Money Markets versus Capital Markets

•• Money
Money Markets
Markets
–– markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.
(e.g. CD’s,
CD’s, U.S.
U.S.
Treasury
Treasury bills)
bills)
•• Capital
Capital Markets
Markets
–– markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and equity
equity
(stock)
(stock) instruments
instruments with
with maturities
maturities of
of more
more
than
than one
one year
year
 Foreign Exchange Markets

•• “FX”
“FX” markets
markets deal
deal in
in trading
trading one
one currency
currency forfor
another
another (e.g.
(e.g. dollar
dollar for
for yen)
yen)
•• The
The “spot”
“spot” FX
FX transaction
transaction involves
involves the
the
immediate
immediate exchange
exchange of of currencies
currencies atat the
the current
current
exchange
exchange rate
rate
•• The
The “forward”
“forward” FX FX transaction
transaction involves
involves the
the
exchange
exchange ofof currencies
currencies at at aa specified
specified date
date in
in the
the
future
future and
and at
at aa specified
specified exchange
exchange rate
rate
Bond Market and Interest Rates
 Overview of Financial Institutions (FIs)

•• Institutions
Institutions that
that perform
perform the the essential
essential
function
function of
of channeling
channeling fundsfunds from
from those
those
with
with surplus
surplus funds
funds toto those
those with
with shortages
shortages
of
of funds
funds (e.g.
(e.g. banks,
banks, thrifts,
thrifts, insurance
insurance
companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, finance
finance companies,
companies,
mutual
mutual funds,
funds, pension
pension funds)
funds)
Flow of Funds in a World without FIs:
Direct Transfer (1)
Financial Claims
(Equity and debt
instruments)
Users of Funds Suppliers of
(Corporations) Funds
(Households)
Cash

Example: A firm sells shares directly to investors without going

through a financial institution
 Flow of Funds in a World without FIs:
Direct Transfer (2)

• Without FIs: Low level of fund flows.

– Information costs:
• Economies of scale reduce costs for FIs to screen
and monitor borrowers
– Less liquidity
– Substantial price risk
 Flow of Funds in a world with FIs:
Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

FI
(Asset
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and Insurance policies)
 Financial Intermediation
• As shown in the previous slide, the process
of indirect flow of funds from users to
suppliers is called “Financial intermediary”.
• The financial institutions which transfer
funds are called “Financial intermediaries”.
• Financial intermediation plays an important
economic role, that is the capital formation
through several functions or services.
 Functions of FIs

– Acting as broker, that is, as an agent for

investors:
• Provide information and offer transaction services
• e.g. Merrill Lynch, Charles Schwab
• Reduce costs through economies of scale
• Encourages higher rate of savings
– Asset transformer:
• Purchase primary securities by selling financial
claims to households
• These secondary securities often more marketable
 Specialness of FIs

– Secondary claims issued by FIs may be more liquid

and/or have less price risk than the primary claims and
securities they hold
– FIs have advantage in diversifying risks and may
repackage risks.
– S&L debacle of 1980s was partly caused by the
inadequate diversification of S&Ls
– FIs may have lower transaction & information costs,
mainly because of their economies of scale.
 Why Study Financial Institutions?
We will also spend considerable time discussing financial
institutions—the corporations, organizations, and networks that
operate the so-called “marketplaces.” These institutions play a
crucial role in improving the efficiency of the economy. We
will look at:
1. Structure of the Financial System
─ Helps get funds from savers to investors
2. Financial Crises
─ The financial crises of 2007–2009 was the worst
financial crisis since the Great Depression. Why did it
happen?
 Why Study Financial Institutions?
3. Central Banks and the Conduit of Monetary Policy
─ The role of the Fed, and foreign counterparts, in the
management of interest rates and the money supply
4. The International Financial System
─ Capital flows between countries impacts domestic
economies
─ Need to understand exchange rates, capital controls,
and the role of agencies such as the IMF
 Why Study Financial Institutions?
5. Banks and Other Financial Institutions
– Includes the role of insurance companies,
mutual funds, pension funds, etc.
6. Financial Innovation
– Focusing on the improvements in technology
and its impact on how financial products are
delivered
7. Managing Risk in Financial Institutions
– Focusing on risk management in the
financial institution.
 Types of Financial Institutions as
Financial Intermediaries
•• Commercial
Commercial banks banks
–– depository
depository institutions
institutions whose
whose major
major assets
assets are
are
loans
loans and
and major
major liabilities
liabilities are
are deposits
deposits
•• Thrifts
Thrifts
–– depository
depository institutions
institutions in
in the
the form
form of
of savings
savings
and
and loans,
loans, credit
credit unions,
unions, etc.,
etc.,
•• Insurance
Insurance companies
companies
–– financial
financial institutions
institutions that
that protect
protect individuals
individuals and
and
corporations
corporations from
from adverse
adverse events
events
(continued)
•• Securities
Securities firms
firms andand investment
investment banksbanks
–– financial
financial institutions
institutions that
that underwrite
underwrite securities
securities
and
and engage
engage inin securities
securities brokerage
brokerage and
and trading
trading
•• Finance
Finance companies
companies
–– financial
financial institutions
institutions that
that make
make loans
loans to
to
individuals
individuals and
and businesses
businesses
•• Mutual
Mutual Funds
Funds
–– financial
financial institutions
institutions that
that pool
pool financial
financial
resources
resources and
and invest
invest in
in diversified
diversified portfolios
portfolios
•• Pension
Pension Funds
Funds
–– financial
financial institutions
institutions that
that offer
offer savings
savings plans
plans for
for
retirement
retirement
 Services (Functions) Performed by
Financial Intermediaries

•• Monitoring
Monitoring Costs
Costs
–– aggregation
aggregation of of funds
funds provides
provides greater
greater incentive
incentive
to
to collect
collect aa firm’s
firm’s information
information and
and monitor
monitor
actions.
actions.
•• Liquidity
Liquidity and
and Price
Price Risk
Risk
–– provide
provide financial
financial claims
claims toto savers
savers with
with superior
superior
liquidity
liquidity and
and lower
lower price
price risk.
risk.

(continued)
•• Transaction
Transaction Cost
Cost Services
Services
–– transaction
transaction costs
costs are
are reduced
reduced through
through
economies
economies ofof scale
scale
•• Maturity
Maturity Intermediation
Intermediation
–– greater
greater ability
ability to
to bear
bear risk
risk of
of mismatching
mismatching
maturities
maturities of
of assets
assets and
and liabilities
liabilities
•• Denomination
Denomination Intermediation
Intermediation
–– allow
allow small
small investors
investors to
to overcome
overcome constraints
constraints
imposed
imposed to
to buying
buying assets
assets imposed
imposed by
by large
large
minimum
minimum denomination
denomination size. size.
Services Provided by Financial Institutions
Benefiting the Overall Economy

•• Money
Money Supply
Supply Transmission
Transmission
–– Depository
Depository institutions
institutions are
are the
the conduit
conduit
(medium)
(medium) through
through which
which monetary
monetary policy
policy
actions
actions impact
impact the
the economy
economy in in general
general
•• Credit
Credit Allocation
Allocation
–– often
often viewed
viewedas as the
the major
major source
sourceof
of financing
financing
for
for aa particular
particular sector
sector of
of the
the economy
economy (e.g.
(e.g.
farming
farming andand real
real estate)
estate)
(continued)
Services Provided by Financial Institutions
Benefiting the Overall Economy

•• Intergenerational
Intergenerational Wealth
Wealth Transfers
Transfers
–– life
life insurance
insurance companies
companies andand pension
pension funds
funds
provide
provide savers
savers with
with the
the ability
ability toto transfer
transfer
wealth
wealth from
from one
one generation
generation to to the
the next
next
•• Payment
Payment Services
Services
–– efficiency
efficiency with
with which
which depository
depository institutions
institutions
provide
provide payment
payment services
services directly
directly benefits
benefits the
the
economy
economy
 Risks Faced by Financial Institutions

•• Interest
InterestRate
RateRisk
Risk
•• Foreign
ForeignExchange
ExchangeRisk
Risk
•• Market
MarketRisk
Risk
•• Credit
CreditRisk
Risk
•• Liquidity
LiquidityRisk
Risk
•• Off-Balance-Sheet
Off-Balance-SheetRisk
Risk
•• Technology
TechnologyRisk
Risk
•• Operation
OperationRisk
Risk
•• Country
CountryororSovereign
SovereignRisk
Risk
•• Insolvency
InsolvencyRisk
Risk
 Regulation of Financial Institutions

•• Financial
Financial Institutions
Institutions provide
provide vital
vital financial
financial services
services
to
to all
all sectors
sectors of
of the
the economy;
economy; therefore,
therefore, their
their
regulation
regulation isis in
in the
the public
public interest.
interest.
•• In
In an
an attempt
attempt toto prevent
prevent their
their failure
failure and
and the
the failure
failure
of
of financial
financial markets
markets overall
overall
•• What
What isis the
the relation
relation between
between regulation
regulation ofof FIs
FIs and
and
the
the current
current global
global financial
financial crises?
crises?
 Globalization of Financial Markets and
Institutions

•• Financial
Financial Markets
Markets became
became more
more global
global as
as the
the
value
value of
of stocks
stocks traded
traded in
in foreign
foreign markets
markets
soared
soared
•• Foreign
Foreign bond
bond markets
markets have
have served
served asas aa major
major
source
source of
of international
international capital
capital
•• Globalization
Globalization also
also evident
evident inin the
the derivative
derivative
securities
securities market
market
 Factors Leading to Significant Growth
in Foreign Markets
•• The
The pool
pool of
of savings
savings from
from foreign
foreign investors
investors has
has
increased
increased
•• International
International investors
investors have
have turned
turned toto U.S.
U.S. and
and other
other
markets
markets to
to expand
expand their
their investment
investment opportunities
opportunities
•• Information
Information on on foreign
foreign investments
investments and and markets
markets isis
now
now more
more accessible
accessible (e.g.
(e.g. internet)
internet)
•• Some
Some mutual
mutual funds
funds allow
allow ability
ability to
to invest
invest in
in foreign
foreign
securities
securities with
with low
low transaction
transaction costs
costs
•• Deregulation
Deregulation hashas enhanced
enhanced globalization
globalization of of capital
capital
flows
flows