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Introduction to the Financial System
Wednesday, 26 April 2017

6:21 pm

Objectives:
- Main elements of the financial system
- Outline and details on the main goals of institutions
- Asses links between institutions and instruments
- Role of financial system within an economy circular flow
- Financial intermediation
Basic concept:
Definition: a financial system is a set of markets for the trade of financial
instruments, and the individuals and institutions that trade in them as well as the
regulators of the system
...
Completely direct
a
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Direct lending through a market
a
...
Financial intermediation
a
...
Through a market
Basic concept of financial intermediation:

Financial intermediation:
- Institutions that borrow funds from people who have saved in order to make

Financial intermediation:
- Institutions that borrow funds from people who have saved in order to make
loans to others
- Examples
○ Banks
○ Pension funds
○ Insurance companies
○ Mutual funds
- Benefits of financial intermediation - inefficiencies create profit opportunities
for individuals and institutions to reduce information and transaction costs
○ Reduction of transaction costs- costs of buying a selling a financial
instrument
§ Eg
...
Mutual funds selling shares to individual shareholders
and use the funds to invest externally
□ Consumer banks accept deposits from individuals to lend to
households and firms
§ Economy benefits from the growth generated by intermediaries
(jobs, investment, role in boosting the market)
§ Intermediaries profit by charging a fee for services
§ Intermediaries reduce transaction cost by exploiting economies
of scale: the reduction of costs per unit when the volume traded
decreases
...

□ They can also take advantage of economies of scale to
purchase expensive software and technical systems that
facilitate efficiency in dealing with transactions and
monitoring - something that is too expensive for individual
investors
...

Reduction of information costs - costs that savers incur to determine
the creditworthiness of borrowers and monitoring them due to
asymmetric information
§ If not all parties in a financial transaction will have access to the
same amount of information - information asymmetry exists
□ A change in consumers' preferences might mean that
borrowers face a more challenging market than they
expected and might have difficulties keeping up with their
bond payments
...

□ Borrowers might have private information that the public is
not aware of
® For example, an upcoming lawsuit, expected
unfavorable conditions - this is information
asymmetry, when one party has more information
than the other
...
Car dealers and insurance companies
□ Example: stock market
□ Lenders problem with distinguishing good borrowers from
the bad before making an investment
□ For example in the stock market, investors have to decide
which firm they want to invest in
...
The investors will not have
knowledge about te qulity of the goods and so would value
the stock of both firms equally
...

The shares of the company will b undervalued and the cost
of capital would be higher than if investors had all the
information
...

□ This applies to the bond market as well
...

This applies to the bond market as well
...
- lendsers know about
this problem and may restrict the availability of credit
rather than raise rates to the point where demand and
supply of funds are equal so borrowing is more costly
(credit rationing)
Adverse selection is costly for the economy as good firms
have problems communicating information to the financial
markets and the financing costs rise, which forces the firm
to grow though capital accumulation, investment of
internal funds or investment by firm insiders
...

Costs of adverse selection make it difficult for individuals to
find good investments and potentially raises the cost of
capital for certain firms
...
Financial intermediaries can
charge a fee for this service, earning a profit and filling the
gap in the market
...
Other methods include:
® Direct disclosure of information required by
regulation - in the financial market, the SEC requires
firms to disclose information but there are still issues
as bad firms might try to pain a over-optimistic view
of their operations and some company might be too
young to have information for investors to evaluate
...
Moody's, S&P)
® There is a free rider problem which reduces the
efficiency
® Collateral and net worth: managers can put in
personal assets into the company or as collateral to
the loan so borrowers have more assurance of the
quality of the investment
...

They are better able to distinguish good lenders from bad
lenders sue to expertise and thus earn a profit by charging
a higher rate on their loans than interest rates they pay to

□ Financial intermediaries specialize in gathering information
about he default risk of borrowers and raise funds from
borrowers to deposit them to institutions with good risks
...

§ Moral hazard
□ Occurs after the transaction - monitoring problems
□ Once they have the service, behavior changes in
undesirable ways
□ Once the investor collects information and makes a good
investment, one cannot be sure that the funds are going to
be used in the way you expect
□ Made worse by agency problem as shareholders have
different interests than managers, funds invested might be
used in ways that do not maximize shareholder wealth
□ In equity financing: monitoring increases information costs
in moral hazard as investors want to know that their
investment is being put to good use, being used so that it
can generate returns for the shareholders
...
- a lot of regulatory disclosure (SEC,
PCAOB)
□ For debt markets, the concept is the same its just that
there is a risk of default
□ Can be alleviated by restrictive covenants
□ Financial intermediaries alleviate the problem as delegated
monitors for savers ho deposit with them
...
They reduce information costs by improving
the channeling of funds to borrowers from savers
...


Different types of market:
- There are different markets for different instruments
○ Primary vs secondary markets
○ OTC vs exchange markets
§ Dealers vs brokers
□ The roles of the broker is simply being in the middle to find
someone to buy or sell the securities while it acts as a
dealer when it participates in the transaction by taking the
opposite side of the trade
...
A firm can fulfil a clients sell
order by buying it for their own account

○ Money vs capital market (difference in maturity of instruments)
Different types of instruments:
- Equity
○ Dividends - annual share of profits
○ Voting rights - ownership of company
○ Price of shares fluctuate with supply and demand
○ Can earn by capital appreciation too
- Debt
○ Contractually fixed return
§ Interest received on fixed periods
§ Principal on maturity date
○ No voting rights - no ownership

○ Can earn by capital appreciation too
- Debt
○ Contractually fixed return
§ Interest received on fixed periods
§ Principal on maturity date
○ No voting rights - no ownership
- Money market instruments
○ Treasury bills
§ Government securities that are purchased at below par and at
maturity, holder receives face value
...

§ Popular because they ae affordable to individual investors and
they are safe as backed by US government but this also means
the returns are not great
§ Issued through a competitive bidding process at auctions
○ Negotiable bank certificates of deposit
§ A time deposit with a bank - funds may not be withdrawn on
demand
§ Bears specific maturity rates, specified interest rates and can be
issued in any denomination
§ Offers higher return due to higher default risk because it’s a bank
○ Repos
§ A repurchase agreement used as a form of overnight borrowing
§ A holder of government securities sells them to a lender and
agrees to repurchase them at a future date at an agreed price usually very short term
§ Short maturity and government backing means its low risk
○ Eurodollars
§ They are US dollar denominated deposits in banks outside US
§ This market is relatively free of regulation so banks can operate
on smaller margins so the market has expanded as a way of
circumventing regulatory costs - maturity of < 6 months
§ The average deposit is large and is so out of reach for individuals
unless they use a money market fund
- Capital market instruments
○ Stocks
○ Corporate bonds
○ Consumer loans
Regulation:
- Financial services are regulated by the industry and have been so for a long
time
○ Because banking relies on public confidence
§ Fractional reserves system
§ Liquidity mismatch between assets and liabilities
○ Contagion effect

- Financial services are regulated by the industry and have been so for a long
time
○ Because banking relies on public confidence
§ Fractional reserves system
§ Liquidity mismatch between assets and liabilities
○ Contagion effect
○ Consumer protection
- Problems because of regulation:
○ Moral hazard - government safety nets create moral hazard as it leads
to more risk taking (bailing large corporations out)
○ Costs of entry and exit are higher - more monopoly power



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