CAPITAL MARKETS

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OVERVIEW OF MARKET PARTICIPANTS
AND FINANCIAL INNOVATION
GROUP MEMBERS

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CONTENTS
 ISSUERS AND INVESTORS
 ROLE OF FINANCIAL INDERMEDIARIES

 OVERVIEW OF ASSET/LIABILITY
MANAGEMENT FOR FINANCIAL
INSTITUTIONS
 REGULATION OF FINANCIAL MARKETS

 FINANCIAL INNOVATION

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ISSUER AND INVESTORS
 We focus on one particular group of market
players,called financial intermediaries,because
of the key economic functions they perform in
financial markets.

 Regulators

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 CONT’D
 Various entities issue financial assets,both debt
instruments and equity instruments and various
investors purchase these financial assets

 But these two groups are not mutually exclusive.

 Itis common for an entity to both issue a

financial asset and at the same time invest in a
different financial asset.
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CLASSIFICATION OF ENTITIES
 CentralGovernments
 Agencies of Central Governments

 Municipal Governments

 Supranationals

 Nonfinancial Businesses

 Financial Enterprises

 Households

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 Central governments borrow funds for a wide
variety of reasons.Debt obligations issued by
central governments carry the full faith and
credit of the borrowing government.
 Funds are raised by the issuance of debt
obligations called Treasury Securities.
 Two type of government agencies in the USA are
Federally Related Institutions and
Government Sponsored Enterprises.
 In most countries municipalities raise funds in
the capital market.
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 Supranational Institution:is an organization
formed by two or more central government
through international treaties.
 Two example of supranational institution are
International Bank for Reconstruction and
Development popularly referred to as World
Bank and American Development Bank

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 Businesses are classified into;
 Nonfinancial

 Financial Businesses

These entities borrow funds in the debt market

and raise funds in the equity market.

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 Nonfinancial businesses are the form of three category;
 Corporations

 Farms

 Nonfarms/Noncorporate Business

In the last category businesses produce same products

or provide the same services as corporations,but are
not incorporated.Financial businesses more popularly
referred to as financial institutions provide one or
more of the following services.

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 Transform financial assets acquired through the market
constitute them into a different and more widely
preferable ,type of asset,which becomes their
liability.This function is performed by financial
intermediaries.(most important type of financial
institution)
 Exchange financial assets on behalf of consumers.
 Exchange financial assets on their own account.
 Assist in the creation of financial assets for their
customers and then sell those financial assets to other
market participants.
 Provide investment advice to other market participants.
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 Manage the portfolios of other market participants.
 CONT’D
 Financial intermediaries include depository
institutions(commercial banks,savings and loan
associations) who acquire bulk of their funds by
offering their liabilities to the public mostly in
form of deposit.Others are discussed another
chapters.
 Some subsidiaries of nonfinancial business
provide financial services.These financial
institutions called captive finance companies.
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 Examples of captive finance companies;
o General Motor Acceptance Corporations(a
subsidiary of General Motors)
o General Electric Credit(a subsidiary of General
Electric)

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ROLE OF FİNANCİAL
INTERMEDİARİES
 Financial intermediaries play the basic role of the basic
role of transforming financial assets that are less
desirable for a large part of the public into other financial
assets-their own liabilities-which are more widely
preferred by the public.This transformation involves at
least one of the four economic functions;

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 CONT’D
I. Providing maturity intermediation
II. Risk reduction via diversification
III. Reducing costs of contracting and information
processing
IV. Providing a payments mechanism

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I. Maturity intermediation:by issuing its own
financial claims the commercial commercial
bank in essence transforms a longer-term asset
into a shorter –term one by giving the
borrower a loan for length of time sought and
the investors/depositor a financial asset for the
desired investment horizon.This is called
maturity intermediation.

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II. This economic function of financial intermediaries-
transforming more risky assets into less risky ones-is
called diversification.Even though individual
investors can do it on their own,they may not be able
to to it as cost effectively as a financial
intermediary,depending on the amount of funds they
want to invest.Attaining cost effective diversification
in order to reduce risk by purchasing the financial
assets of a financial intermediary is an important
economic benefit for financial markets.

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 REDUCING THE COSTS OF CONTRACTING
AND INFORMATION PROCCESING
Investors purchasing financial assets must
develop skills necessary to evaluate an investment.
Those skills are developed, investors can apply them
when analyzing specific financial assets for purchase.

Investors who want to make a loan to a

consumer or business need to write loan contract.
Although some people may enjoy devoting leisure time
to this task, most of us find leisure time to be in short
supply and compensation for sacrificing it. The form of
compensation could be a higher return obtained from
an investment.
 In addition to the opportunity cost of time to process
the information about the financial asset, the cost of this
information must also be considered. All these costs are
information processing costs.

The costs of writing loan contracts are referred to as

contracting costs. Another dimension to contracting costs is
the cost of enforcing terms of loan agreement.
 We have two examples of financial intermediaries as
commercial bank and investment company.

So that, economies of scale can be realized in

contracting and processing information because of amount of
funds managed by financial intermediaries.

The lower costs increase to the benefit of investor who

purchases asset and the issuer of financial assets.
 PROVIDING A PAYMENTS MECHAISM

The previous three economic functions may not be

immediately obvious. This last one should be. Most
transactions made today are not with cash. Payments are made
using checks, credit cards, debit cards and electronic transfers
of funds. Financial intermediaries provide these methods for
making payments.

At one time, noncash payments were restricted to

checks. Payment by credit card was also at one time the
exclusive domain of commercial banks, but now other
depository institutions offer this service. Debit cards are offered
by various financial intermediaries.
 A debit card differs from a credit card in that a bill
sent to credit cardholder periodically (usually once a month)
requests payment for transactions made in the past. With a
debit card, funds are immediately withdrawn from the
purchaser’s account at time transaction takes place.

The ability to make payments without cash is critical

for financial market. In short, depository institutions transform
assets that cannot be used to make payments into other assets.
OVERVIEW OF ASSET/LIABILITY MANAGEMENT
FOR FINANCIAL INSTITUTIONS

To understand why managers of financial

institutions invest in particular types of financial assets and
types of investment strategies employed. It is necessary to
have a general information of asset/liability problem.

For example, depository institutions seek to

generate income by difference between return that they
earn on assets and cost of their funds. This difference is
referred to as spread.
 THE NATURE OF LIABILITIES

Liability Type Amount of Cash Timing of Cash

Outlay Outlay
Type I Known Known
Type II Known Uncertain
Type III Uncertain Known
Type IV Uncertain Uncertain
 TYPE I LIABILITY
Both amount and timing are known. For example,
depository institutions know amount that they are
committed to pay on maturity date of a fixed rate deposit,
the depositor does not withdraw funds prior to the maturity
date.
TYPE II LIABILITY
The amount of cash outlay is known, but timing of
cash outlay is uncertain. Life insurance policy can be an
example for this liability. The most of basic many types of
life insurance policy provides that, for annual premium,
this company agrees to make a specified payment to
beneficiaries upon the death of insured.
 TYPE III LIABILITY
Timing is known, but amount is uncertain, such as
when a financial institution has issued an obligation in
which the interest rate adjust based on some interest rate
benchmark.

Depository institutions, for example, issue

liabilities called certificates of deposit with a stated
maturity. The interest rate paid need not to be fixed over
life of deposit but may fluctuate.

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 TYPE IV LIABILITY
Both amount and timing are uncertain. Home
insurance policy is an example. Whenever damage is
done to an insured asset, the amount of payment that
must be made is uncertain.
 The deposit-accepting institution will grant this
request, but assess an early withdrawal penalty.
 Certain types of investment companies give
shareholders the right to redeem their shares at any
time.
 Some life insurance products provide a cash-
surrender value that allows the policyholder to
exchange the policy for a lump sum payment at
specified dates.
 Some life insurance products also offer a loan
value.
 Inaddition to uncertainty
about the timing and
amount of the cash
outlays, and the potential
for the depositor or
policyholder to withdraw
cash early or borrow
against a policy, a
financial institution is
concerned with possible
reduction in cash inflows.
 In the case of a depository institution, it means the
inability to obtain deposits.
 For insurance companies, it means reduced premiums
because of the cancellation of policies.
 For certain types of investment companies, it means not
being able to find new buyers for shares.
 In their regulatory capacities,governments greatly
influence the development and evolution of financial
markets and institutions.
 It is important to realize that governments, issuers, and
investors tend to behave interactively and to affect one
another’s actions in certain ways.
 The standard explanation or justification for
govermental regulation of a market is that the
market, will not produce its particular goods or
services in an efficient manner and at the lowest
possible cost.
 Efficiency and low-cost production are
hallmarks of a perfectly competitive at the time
and that will not gain that status by itself in the
foreseeable future.
 Of course, it is possible that governments may regulate
markets that are viewed as competitive currently, but
unable to sustain competition, and low-cost production,
over the long run.
 A version of this justification for regulation is that the
government controls a feature of the economy that the
market mechanisms of competition and pricing could
not manage without help.
 A short hand expression used by economists to describe
the reasons for regulation is market failure.
 The regulatory structure
in the United States is
largely the result of
financial crises that have
occurred at various
times.Most regulatory
mechanisms are the
products of the stock
market crash of 1929 and
the Great Depression in
the 1930s.
1. Financial Activity Regulation
2. Disclosure Regulation
3. Regulation of Financial
Institutions
4. Regulation of Foreign
Participants
1. DISCLOSURE REGULATION: It requires issuers of
securities to make public a large amount of financial
information to actual and potential investors.The standard
justification for disclosure rules is that the managers of the
issuing firm have more information about the financial
health and future of the firm. The cause of market failure
here, if indeed it occurs, is commonly described as
“asymmetric information,” it means investors and managers
are subject to uneven access to or uneven possession of
information.Also, the problem is said to be one of “agency.”
 The United States is firmly committed to
disclosure regulation.The Securities Act of 1933
and the Securities Exchange Act of 1934 led to the
creation of the Securities and Exchange
Commission (SEC).
 None of the SEC’s requirements or actions
constitutes a guarantee, a certification, or an
approval of the securities being issued.
 Moreover, the government’s rules do not represent
an attempt to prevent the issuance of risky assets.
 2.FINANCIAL ACTIVITY REGULATION: It consists of
rules about traders of securities and trading on financial
markets. A prime example of this form of regulation is the
set of rules against trading by insiders who are corporate
officers and others in positions to know more about a firm’s
prospects than the general investing public. A second
example of this type of regulation would be rules regarding
the structure and operations of exchanges where securities
are traded.
3. REGULATION OF FINANCIAL INSTITUTIONS: Financial
institutions help households and firms to save; as depository institutions.
They also facilitate the complex payments among many elements of the
economy and they serve as conduits for the government’s monetary
policy. The U.S. Government imposed an extensive array of regulations
on financial institutions.
In recent years, expanded regulations restrict how financial institutions
manage their assets and liabilities, in the form of minimum capital
requirements for certain regulated institutions. These capital requirements
are based on the various types of risk faced by regulated financial
institutions and are referred to as risk-based capital requirements.
4. REGULATION OF FOREIGN
PARTICIPANTS:

Government regulation of foreign

participants limits the roles foreign firms
can play in domestic markets and their
ownership or control of financial
institutions. Many countries regulate
participation by foreign firms in
domestic financial securities markets.
Like most countries, the United States
reviews and changes it policies regarding
foreign firms’ activities in the U.S.
financial markets on a regular basis.
FINANCIAL

Regulations that impede the free flow of capital

and competition among financial institutions
(particularly interest rates ceilings) motivate the
development of financial products and trading
strategies to get around these restirictions.

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 Through technological advances and the
reduction in trade and capital bariers, surplus
funds in one country can be shifted more easily
to those who need funds in another country. As a
result…

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CATEGORIZATIONS OF FINANCIAL
INNOVATION

 Market-broadening instruments, which

increase the liquidity of markets and the
availability of funds by attracting new investors
and offering new opportunities for borrowers
 Risk management instruments, which
reallocate financial risks to those who are less
averse to them or who have offsetting exposure,
and who are presumably better able to shoulder
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 Artbitraging instruments and
processes ,which enable investors and
borrowers to take advantage of differences in the
perception of risks,as well as in information,
taxation, and regulations

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MOTIVATION FOR FINANCIAL
INNOVATION

Two extreme views seek to explain financial

innovation.At one extreme are those who believe
that the major impetus for innovation comes out
of the endeavor to circumvent (or “arbitrage”)
regulations and find loopholes in tax rules.At the
other extreme are those who hold that the
essence of innovation is the introduction of more
efficient financial instruments for redistributing
risk among market participants.
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MOTIVATION FOR FINANCIAL
INNOVATION
If we consider the ultimate causes of financial
innovation, the following emerge as the most
important:
1. Increased volatility of interest
rates,inflation,equity prices and exchange rates
2. Advances in computer and telecommunication
technologies

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3. Greater sophistication and educational training
among professional market participants
4. Financial intermediary competition
5. Incentives to get around existing regulations and
tax laws
6. Changing global patterns of financial wealth

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ASSET SECURITIZATION AS A
FINANCIAL INNOVATION
Asset securitization means that more than one
institution may be involved in lending capital.
Consider loans for the purchase of
automobiles.A lending scenario can look like
this:
1. A commercial bank originates automobile loans
2. The commercial bank issues securities backed
by these loans.

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3. The commercial bank obtains credit risk
insurance for the pool of loans from a private
insurance company
4. The commercial bank sells the right to service
the loans to another company that specializes in
the servicing of loans
5. The commercial bank uses the services of
securities firm to distribute the securities to
individuals and institutional investors.
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AS A SUMMARY;
Financial innovation increased dramatically
since the 1960s, particularly in the
late1970s.Although financial innovation can be
result of arbitrary regulations and tax rules,
innovations that persist after changes in
regulations or tax rules, designed to prevent
exploitation, are frequently those that offer a
more efficient means for redistributing risk.

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 THANKS FOR
YOUR ATTENTIONS…

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