Chapter 2

An Overview
of the Financial
System

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 Students Learning Objectives

• Learn the functions of financial markets

• Understand the structure of financial
markets
• Understand the various financial market
instruments
• Understand the functions of financial
intermediaries
• Understand the regulation of the financial
system

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 Function of Financial Markets

• Perform the essential function of channeling

funds from economic players that have
saved surplus funds to those that have a
shortage of funds
• Direct finance: borrowers borrow funds
directly from lenders in financial markets by
selling them securities.

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 Securities

• Securities:
– also called financial instruments – claims on the
borrowers future income or assets
– Are assets for the person who buys them
– Are liabilities for the individual or firm that sells
them

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 Function of Financial Markets

• Promotes economic efficiency by producing

an efficient allocation of capital, which
increases production
• Directly improve the well-being of
consumers by allowing them to time
purchases better

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 FIGURE 1 Flows of Funds Through
the Financial System

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 Structure of Financial
Markets
• Debt and Equity Markets
– Debt instruments (maturity)
• Example: bond or mortgage
• A contractual agreement by the borrower to pay the holder of
the instrument fixed dollar amounts at regular intervals
(interest and principal payments) until a specified date
(maturity date) when a final payment is made
• Short-term debt instrument: maturity is less than a year
• Long-term debt instrument: maturity is 10 years or longer

• Intermediate term: between 1 and 10 years

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 Structure of Financial Markets

• Equities
– Example: comment stock
– Are claims to the share in the net income (income after expenses
and tax) and the assets of a business
– Often make periodic payments (dividends) to their holders
– Are long-term securities as there are no maturity dates
– Owning stock means that you own a portion of the firm and have
the right to vote on issues important to the firm and to elect its
directors
– Disadvantage of owning equities than debt: equity holder has
residual claimant: corporation must pay all its debt holders before
paying equity holders
– Advantage: equity holders benefit from corporation profits

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 Structure of Financial Markets

• Primary and Secondary Markets

– Investment Banks underwrite securities in primary markets
– Brokers and dealers work in secondary markets
• Primary market:
– A financial market in which new issues of security such as
bond or tock are sold to initial buyers by the corporation or
government agency borrowing the funds
• Secondary market:
– A financial market in which securities that have
been previously issued can be resold

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 Primary and Secondary Markets

• Investment bank
– Assists primary markets
– Underwrites securities: guarantees a price for a
corporations securities and then sells them to the public
• Brokers
– Agents of investors who match buyers and sellers of
securities
• Dealers
– Link buyers and sellers by buying and selling securities at
stated prices

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 Structure of Financial
Markets
• Exchanges and Over-the-Counter (OTC)
Markets
– Buyers and sellers of securities meet in one central
location to conduct trade
– Example 1: NYSE, Chicago Board of Trade
– Example 2:Over the counter (OTC Markets): 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 willing to accept their
prices. Example: Foreign exchange, Federal funds.

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 Structure of Financial Markets

• Money and Capital Markets

– Money markets deal in short-term debt
instruments
– Capital markets deal in longer-term debt (1 year
or more) and equity instruments.

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 Financial Market Instruments

• Money market instruments

– Treasury bills
– Negotiable bank certificates of deposits
– Commercial paper
– Repurchase agreements
– Federal funds
• Capital market instruments
– Stocks
– Mortgages
– Corporate bonds
– US government securities
– Consumer and bank commercial loans
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 Financial Market Instruments

• Money market instruments

• 1. US Treasury bills
– Short term debt instruments of government (1, 3 and 6
month maturities)
– To finance government
– Pay a set amount at maturity
– Has no interest payments
– Example: In March 2012 you buy a six month treasury bill
for $9000 that can be redeemed in November 2012 for
$10000
– Safest of all instruments as there is no default

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 Money market instruments

• 2. Negotiable bank certificates of deposit

– A certificate of deposit (CD) is a debt instrument
sold by a bank to depositors that pays annual
interest of a given amount and at maturity pays
back the original purchase price

• 3. Commercial paper
– Is a short term debt instrument issued by large
banks and well known corporations

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 Money market instruments

• 4. Repurchase agreements
– Short term loans (less than two weeks)
– Important source of bank funds
– Most important lenders are large corporations

• 5. Federal funds
– Overnight loans between banks of their deposits at the
Federal Reserve (Central Bank)
– Banks borrow because they might not have enough
deposits
– The interest rate on this loan is called the federal funds
rate or the discount rate

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 Capital market instruments

• 1. Stocks
– Are equity claims on the net income and assets of a
corporation

• 2. Mortgages
– Loans to households or firms to purchase housing, land or
other real structures where the land or structure itself
serves as collateral for the loans
– Largest debt market
– Commercial banks, savings and loan associations and
mutual savings banks are primary lenders in the residential
markets

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 Capital market instruments

• 3. Corporate bonds
– Long-term bonds
– Issued by corporations with very strong credit
ratings
– Convertible bonds: allows holder to convert them
into specified number of shares of stock at any
time up to the maturity date

• 4. Government securities
– Long-term debt instruments issue by the
government
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 Table 1 Principal Money Market
Instruments

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 Table 2 Principal Capital
Market Instruments

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 Internationalization of Financial
Markets (Glossary)

• Foreign Bonds: sold in a foreign country and

denominated in that country’s currency
• Eurobond: bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in
banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets
– Help finance federal government also

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 Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs (time and money
spent in carrying out financial transactions).
– Economies of scale
– Liquidity services

• Reduce the exposure of investors to risk

– Risk Sharing (Asset Transformation)
– Diversification

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 Function of Financial
Intermediaries: Indirect Finance
• Deal with asymmetric information problems
– (before the transaction) Adverse Selection: try to
avoid selecting the risky borrower.
• Gather information about potential borrower.
– (after the transaction) Moral Hazard: ensure
borrower will not engage in activities that will
prevent him/her to repay the loan.
• Sign a contract with restrictive covenants.

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 Function of Financial
Intermediaries: Indirect Finance
• Conclusion:
– Financial intermediaries allow “small” savers and
borrowers to benefit from the existence of
financial markets.

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 Table 3 Primary Assets and
Liabilities of Financial Intermediaries

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 Table 4 Principal Financial
Intermediaries and Value of Their Assets

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 Regulation of the Financial
System
• To increase the information available to
investors:
– Reduce adverse selection and moral hazard
problems
– Reduce insider trading (SEC).

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 Regulation of the Financial
System
• To ensure the soundness of financial
intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control
holding of risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates

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 Table 5 Principal Regulatory Agencies of
the U.S. Financial System

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 END

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