An Overview of the Financial System

2012 SEEM 2520 Tutorial 1

An Overview of the Financial System

2012/01/17 17:30-18:15, ERB 712;

2012/01/19 12:30-13:15, ERB 712.

Chapter Review

PREVIEW

Financial markets (bond and stock markets) and financial intermediaries (banks, insurance companies, pension funds) move funds from lender-savers to borrower-spenders.

FUNCTION OF FINANCIAL MARKETS

Financial markets channel funds from those who have saved to those who wish to spend more than their income. This movement of funds can be accomplished by direct finance, where borrowers borrow directly from lenders by selling lenders securities. Securities are also known as financial instruments. This movement of funds improves efficiency by channeling funds to those with productive uses for the funds from those with no investment opportunities, producing an efficient allocation of capital (wealth that is used to produce more wealth). It also allows consumers to better time their purchases.

STRUCTURE OF FINANCIAL MARKETS

Financial markets can be categorized as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets. In a debt market, the borrower issues a debt instrument in which the borrower agrees to pay interest and principal payments until maturity. Alternatively, in an equity market, firms issue stock, which are claims to share the net income and assets of the firm. The owner may also receive dividends. Primary markets are where new issues of a security are sold, often to investment banks that underwrite the securities. Secondary markets are where existing issues are resold. Secondary markets can be exchanges, where buyers and sellers meet in a central location, or over-the-counter where dealers at different locations have an inventory of securities. The money market is where short-term securities (maturity of less than one year) are traded. The capital market is where longer-term debt and equity instruments are traded.

FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT FINANCE

A second route by which funds can move from lenders to borrowers is known as indirect finance because an intermediary is between the lenders and the borrowers. A financial intermediary borrows funds from one group and lends to another in a process known as financial intermediation. Financial intermediaries reduce transactions costs, allow for risk sharing, and solve problems caused by adverse selection and moral hazard.

• Transaction costs associated with borrowing and lending are reduced because banks exploit economies of scale when writing loan contracts. This gain in efficiency allows intermediaries to provide liquidity services to their customers.
• Risk sharing allows intermediaries to sell assets with less risk than the risk of the assets they purchase, which is known as asset transformation. Risk sharing also allows individuals to diversify their assets.
• Financial transactions suffer from asymmetric information because the borrower knows more about the probability of repayment than the lender. Before the transaction, adverse selection may occur because borrowers most unlikely to repay are most eager to borrow. After the transaction, moral hazard may occur if the borrower engages in immoral behavior by using the loan in a way that reduces the probability of repayment. Financial intermediaries screen out bad credit risks to reduce adverse selection, and monitor borrowers to reduce moral hazard.

TYPES OF FINANCIAL INTERMEDIARIES

The primary financial intermediaries are:

• Depository institutions, or banks:  Commercial banks, savings and loan associations, mutual savings banks, and credit unions.
• Contractual savings institutions:  Life insurance companies, fire and casualty insurance companies, and pension funds.

• Investment intermediaries:  Finance companies, mutual funds, money market mutual funds, and investment banks.

Helpful Hints

1.        A financial instrument, such as a corporate bond, is a liability to the firm that issued it and an asset to the person that buys it. Therefore, if the question is asked, “Is a corporate bond an asset or a liability?” the response must be, “to whom?”  That is, the same instrument will appear on different sides of the balance sheet for the issuer and the buyer.

2.        When a security is traded in a secondary market, the firm receives no funds. Yet the secondary market is important to the firm because it makes their securities more liquid, making the securities more desirable and raising their price. In addition, the secondary market also sets the price of the security that the issuing firm receives in the primary market should the firm issue additional securities.