Lecture 1

Financial Systems, Markets, Institutions,

Instruments and Crisis.
Introduction
The international financial system exists to
facilitate the design, sale, and exchange of a
broad set of contracts with a very specific set
of characteristics.
We obtain financial resources through this
system:
Directly from markets, and
Indirectly through institutions.
Introduction
 Indirect Finance: An institution stands between
lender and borrower.
 We get a loan from a bank or finance company to buy
a car.
 Direct Finance: Borrowers sell securities
directly to lenders in the financial markets.
 Direct finance provides financing for governments and
corporations.
 Asset: Something of value that you own.
 Liability: Something you owe.

3-3
The Balance Sheet
The balance sheet is a snapshot of the
firm’s assets and liabilities at a given point
in time
Assets are listed in order of decreasing
liquidity
 Ease of conversion to cash without
significant loss of value
Balance Sheet Identity
 Assets = Liabilities + Stockholders’ Equity

4
5
U.S. Corporation Balance Sheet –
Table 2.1

6
Income Statement
The income statement is more like a
video of the firm’s operations for a
specified period of time
You generally report revenues first
and then deduct any expenses for
the period
Matching principle – GAAP says to
recognize revenue when it is fully
earned and match expenses required
to generate revenue to the period of
recognition 7
U.S. Corporation Income Statement - Table
2.2

8
Financial Management Decisions
Capital budgeting
What long-term investments or projects
should the business take on?
Capital structure
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances
of the firm?

9
Forms of Business Organization
Three major forms in the United States
Sole proprietorship
Partnership
 General
 Limited

Corporation
 S-Corp
 Limited liability company

10
Goal Of Financial Management
What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s
stock?
Does this mean we should do anything
and everything to maximize owner
wealth?
Sarbanes-Oxley Act
11
The Agency Problem
Agency relationship
Principal hires an agent to represent its
interests
Stockholders (principals) hire managers
(agents) to run the company
Agency problem
Conflict of interest between principal and
agent
Management goals and agency costs

12
Financial system survey in
three steps:
1. Financial instruments or securities
 Stocks, bonds, loans and insurance.
 What is their role in our economy?

2. Financial Markets
 New York Stock Exchange, Nasdaq.
 Where investors trade financial instruments.

3. Financial institutions
 What they are and what they do.

3-13
Financial Instruments
Financial Instruments: The written legal
obligation of one party to transfer something
of value, usually money, to another party at
some future date, under certain conditions.
The enforceability of the obligation is
important.
Financial instruments obligate one party
(person, company, or government) to transfer
something to another party.
Financial instruments specify payment will be
made at some future date.
Financial instruments specify certain
conditions under which a payment will be
made.
3-14
Uses of Financial Instruments
Three functions:
 Financial instruments act as a means of payment (like
money).
 Employees take stock options as payment for working.

 Financial instruments act as stores of value (like

money).
 Financial instruments generate increases in wealth

that are larger than from holding money.

 Financial instruments can be used to transfer

purchasing power into the future.

 Financial instruments allow for the transfer of risk
(unlike money).
 Futures and insurance contracts allows one person to

transfer risk to another.

3-15
Financial Markets
Financial markets are places where financial
instruments are bought and sold.
These markets are the economy’s central
nervous system.
These markets enable both firms and
individuals to find financing for their
activities.
These markets promote economic efficiency:
They ensure resources are available to those
who put them to their best use.
They keep transactions costs low.

3-16
The Role of Financial Markets
1. Liquidity:
 Ensure owners can buy and sell
financial instruments cheaply.
 Keeps transactions costs low.

2. Information:
 Pool and communication information
about issuers of financial instruments.
3. Risk sharing:
 Provide individuals a place to buy and
sell risk.
3-17
Primary versus Secondary Markets
A primary market is one in which a borrower
obtains funds from a lender by selling newly
issued securities.
Occurs out of the public views.
An investment bank determines the price,
purchases the securities, and resells to clients.
 This is called underwriting and is usually very
profitable.

3-18
Primary versus Secondary Markets
Secondary financial markets are those where
people can buy and sell existing securities.
Buying a share of IBM stock is not purchased
from the company, but from another investor in
a secondary market.
These are the prices we hear about in the
news.

3-19
Money
Any generally accepted means of payment
for delivery of goods or the settlement of
debt
Legal money
notes and coins
Customary money
IOU money based on private debt of the
individual
e.g. bank deposit.
©McGraw-Hill Companies, 2010
Money and its functions
Medium of exchange
money provides a medium for the exchange of
goods and services which is more efficient
than barter
Unit of account
a unit in which prices are quoted and accounts
are kept
Store of value
money can be used to make purchases in the
future
Standard of deferred payment
a unit of account over time: this enables
borrowing and lending
©McGraw-Hill Companies, 2010
Modern banking
A financial intermediary
an institution that specialises in bringing
lenders and borrowers together
 e.g. a commercial bank, which has a
government licence to make loans and issue
deposits
 including deposits against which cheques can
be written
Clearing system
a set of arrangements in which debts
between banks are settled

©McGraw-Hill Companies, 2010

A beginner’s guide to the financial
markets
Financial asset
a piece of paper entitling the owner to a
specified stream of interest payments over a
specified period
Cash
notes and coins, paying no interest
the most liquid of all assets
Bills
Short-term financial assets paying no
interest directly but with a known date of
repurchase by the original borrower at a
known price.
highly liquid©McGraw-Hill Companies, 2010
A beginner’s guide to the financial
markets (2)
 Bonds
 longer term financial assets – less liquid because
there is more uncertainty about the future income
stream
 Perpetuities
 an extreme form of bond, never repurchased by the
original issuer, who pays interest forever
 e.g. Consols

 Gilt-edged securities
 government bonds in the UK
 Company shares (equities)
 entitlements to receive corporate dividends
 not very liquid©McGraw-Hill Companies, 2010
Credit creation by banks
Commercial banks need to hold only a
proportion of assets as cash reserves.
This enables them to create credit by
lending.

Example:
Assume banks use a reserve ratio of 10
per cent.
Suppose, initially, the non-bank private
sector has wealth of £1000 held in cash:

©McGraw-Hill Companies, 2010

Financial crises
A financial panic is a self-fulfilling prophecy.
Believing a bank will be unable to pay, people
rush to get their money out. But this makes the
bank go bankrupt.

In a solvency crisis, an institution’s assets have

become less than its liabilities.

In a liquidity crisis, an institution is temporarily

unable to meet immediate requests for payment.

©McGraw-Hill Companies, 2010

The subprime crisis
A subprime mortgage is a housing loan to a low-
income high-risk person.
Most of these mortgages were at variable
interest rates: although initially low and
‘affordable’, they could subsequently be raised
US house prices peaked in 2006. As they then
fell, lenders became worried and began to raise
mortgage interest rates, driving many of the poor
to default.
Suddenly, these subprime mortgages were worth
a lot less than had been thought.
©McGraw-Hill Companies, 2010
Securitisation
Securitisation transformed this into a global
problem. Financiers had bundled lots of
individual subprime mortgages into large
bundles and sold them on to new buyers in
London, Frankfurt and Mumbai.

The market was convinced that although one

poor subprime household might default, they
would not all do so together.

However buyers of securitized mortgages had

miscalculated.
©McGraw-Hill Companies, 2010
The Credit Crisis
It was quite likely that circumstances could arise
in which all subprime borrowers got into trouble
at the same time.
And so they did. As US house prices fell sharply,
banks found their assets worth much less than
they had thought.
As the solvency of banks came into question,
people became reluctant to lend to banks, and
banks themselves became reluctant to lend to
anyone else

©McGraw-Hill Companies, 2010

Top World’s Biggest Financial
Crises Ever
 Panic of 1819, a U.S. recession with bank failures; culmination of
U.S.'s first boom-to-bust economic cycle
 Panic of 1825, a pervasive British recession in which many banks
failed, nearly including the Bank of England
 Panic of 1837, a U.S. recession with bank failures, followed by a 5-
year depression
 Panic of 1847, United Kingdom
 Panic of 1857, a U.S. recession with bank failures
 Panic of 1866, Europe
 Panic of 1873, a U.S. recession with bank failures, followed by a 4-
year depression
 Panic of 1884, United States and Europe
 Panic of 1890, mainly affecting the United Kingdom and Argentina
 Panic of 1893, a U.S. recession with bank failures
 Black Monday (stock crashes 22% 1987)
 Credit Crisis of 1772
 1907 Banker's Panic
3-30
Top World’s Biggest Financial
Crises Ever
 German Hyperinflation, 1918-1924
 OPEC Oil Price Shock (1973)
 Wall Street Crash
 The Great Depression
 1998 Russian Crises
 1997 Asian Crises
 Japan’s "Lost Decade," 1990-2000
 Financial crises of 2008
 Subprime mortgage crisis in the U.S. starting in 2007
 2008 United Kingdom bank rescue package
 2009 United Kingdom bank rescue package
 2008–2009 Belgian financial crisis
 2008–2012 Icelandic financial crisis
 2008–2009 Russian financial crisis
 2008–2009 Ukrainian financial crisis
 2008–2012 Spanish financial crisis
 2008–2011 Irish banking crisis
 European Sovereign Debt Crisis, 2009 onward

3-31
Black Monday
In the finance world, The Black Monday
refers to the time of October 19, 1987.
During that day, there was a widespread
stock market crash all around the world. The
beginning of this crash originated in Honk
Kong and eventually spread to Europe.
Ultimately, the United States was affected as
well. The Dow Jones dropped by 22.1%, and it
took almost 2 years to reach even the
previous high of 1987

3-32
1907 Banker's Panic

The Panic of 1907 saw the Dow drop almost

50% from the high of the previous year. It
was triggered by the usual suspects: over-
expansion and poor speculation. The stock
market crashed in March, and a second crash
in October led to a run on banks and every
trust in New York, notably causing the
massive National Bank of North America to
fail.

3-33
Credit Crisis 1770
This crisis originated in London and spread to other parts
of Europe, such as Netherlands. Ironically, it had been
preceded by a period of great prosperity for Britain. The
mid 1760s and 1770s saw a credit boom which spurred
greater manufacturing and industrial activity. The period
of 1770 to 1772 was politically very stable for Britain and
its colony, America. However, there was a deeper
systemic problem that prevailed under the surface of this
prosperity. Speculative practices thrived to generate
more credit, and this led to a false feeling of optimism in
the market. On June 8, 1772, the fleeing of one of the
partners of the Banking House “Neal, James, Fordyce
and Down” due to failure to repay debts led to panic .

3-34
Japan’s "Lost Decade," 1990-
2000
The collapse of the Japanese asset bubble in 1991
led to a prolonged period of low growth, which
has since been extended to incorporate the
decade since the year 2000. The original lost
decade was caused by an unsustainable level of
speculation, large amounts of credit and low
interest rates (sound familiar?). When the
government stepped in to control this, credit
became much harder to obtain, and capital
investment dropped significantly.

3-35
Dot-Com Bubble
This speculative bubble related to internet based
companies saw massive rises in equity stock values
of industrialized nations from 1997-2000. This
bubble began because of easy credit availability in
1997-1998. These start-up companies wanted to
establish a high market share by establishing more
coverage. This meant that many of the services
were freely provided, and large operational losses
were actually occurring. They wanted to establish
a brand and then charge profitable rates. The
phrase “Get large or get lost” operated in the
minds of company founders.
3-36
European Sovereign Debt Crisis,
2009 onward
This is the most recent of the crises on our
list, and no one is yet certain about when, or
how, it is going to end. Markets have grown
increasingly concerned about the ability of
nations, particularly Greece, Ireland, Spain,
Portugal, and Italy, to pay their debts, and
the exposure of international banks to these
potentially toxic debts has played a large part
in the enormous market falls of recent days —
some of the worst on record.

3-37
Financial crises of 2008
This crises was considered the worst one since the
Great Depression itself. This easy availability of credit
propelled greater demand for housing and a bubble
started. However, once this ended, there was a big
crash in housing prices. Mortgage values now
exceeded the values of houses bought. A great level of
lending to less credit worthy borrowers had also
prevailed, called sub-prime lending. The existence of
financial instruments like Collateralized Mortgage
obligations (CMOs) allowed the effect to spread to the
entire financial market. Financial innovations led to far
greater risk taking appetite. However, the eventual
collapse of trust in the market froze lending activity.
3-38