BEC 3303 Financial Economics Session 2

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LECTURE OUTLINE
Types of Financial Institutions Structure of Financial Institutions
The Money Markets The Capital Markets Types of Money Market Securities Types of Capital Markets

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Why Study Financial Institutions?

Financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. They thus also play an important role on the performance of the economy as a whole.

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Central Banks and Monetary Policy

The most important F.I. in the financial system is the central bank. Monetary policy is conducted by Central bank. M.P involves the management of interest rates and quantity of money (money supply). M.P. affects interest rates, inflation, and business cycles. M.P. Can be defined as any deliberate action undertaken by the monetary authority or Central bank to achieve the economic development.
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Structure of the Financial System

The financial system is complex, comprising many different types of public/private sector financial institutions, including banks, insurance companies, mutual funds, finance companies, Leasing/Factoring companies, Merchant Banks, Venture Capital companies and investment banks, most of which are heavily regulated by the government.
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Banks and Other Financial Institutions

Banks are financial institutions that accept deposits and make loans. Banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions.

Banks are the financial intermediaries that the average person interacts with most frequently. A person who needs a loan to buy a house, land or a car usually obtains it from a bank.

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Cont.
Most consumers keep a large proportion of their financial wealth in banks in the form of savings accounts, or other types of bank deposits. Eg. Regular, Power, Super savings, Call deposits Generally banks are the largest financial intermediaries in any country.
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Structure of Financial Markets

The Money Market The Capital Market

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The Money Market

The Money market is a subsector of the fixed income sector. It consists of very short-term debt securities Characteristics Highly Marketable (highly liquid) Easily accessible to small investors short-term (mature in one year or less) Low Risk
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Types of Money Market Securities

Treasury Bills T-Bills are the most marketable of all money market instruments. The government raises money by selling TBs to public. At the bills maturity, the holder receives from the government a payment equal to the face value. Purchase Price- Maturity value= Investors earnings
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Treasury Bills
T.B . Are issued with initial maturities of 91, 182 or 364 days. Individuals can purchase T B directly at auction or on the secondary market from a government securities dealer. Highly Liquid and can easily converted to cash

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Certificate of Deposit
CD is a time deposit with a bank. It may not be withdrawn on demand. The bank pays interest and principal amount to the depositor only at the end of the fixed term.

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Commercial Paper
Large, well-known companies often issue short-term unsecured debt notes rather than borrow directly from banks.

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Eurodollars Certificate of Deposit

Eurodollars are dollar denominated deposits at foreign banks or foreign branches of American banks. Most Eurodollar deposits are for large sums, and most are time deposits of less than 6 months maturity. The advantage of Eurodollar CDs over Eurodollar time deposits is that the holder can sell the asset to realize its cash value before maturity. They are considered as less liquid and high riskier than domestic CDs. However, ECDs offer higher yields.
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Repos
Dealers in government securities use repurchase agreements, also called, Repos as a short-term, usually overnight, borrowing. The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. Difference between selling and buying price is interest.
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Yields on Money Market Instruments

Although, most money market securities are of low risk, they are not risk-free. The securities of the money market promise yields greater than those on T-Bills, because of greater relative risk. For example, bank CDs consistently have paid a premium over T Bills. Moreover, premium increased with economic crises such as the energy price shocks associated with the OPEC disturbances( 1975, 1980), the failure of Penn Square bank(1982), the stock market crash in 1987, the collapse of Long Term Capital Management in 1998, and the virtual break-down of the market in subprime mortgages in 2007.

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The Energy Price Shocks

The 1973 oil crisis started in October 1973, when the members of the Organization of Arab Petroleum Exporting Countries(OPEC) proclaimed an oil embargo. An embargo is the partial or complete prohibition of commerce and trade with particular country, in order to isolate it. Between 1978 and 1980 oil prices doubled as a result of disruptions in supply the followed the Iranian Revolution.
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Penn Square Bank

It was a small commercial bank in US. The bank made its name in high-risk energy loans during the late 1970s and early 1980s. Between 1972 and 82, the bank assets increased more than 15 times to $525 million and its deposits swelled from $ 29 million to more than $450 million. As a result primarily of irresponsible lending practices in connection with the sale of over $ 1 billion in loan participations to other bank throughout US, the bank failed in July 1982.
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The Stock Market Crash in 1987

In finance, Black Monday refers to Monday October 19, 1987, when stock market around the world crashed, cracking a huge value in a very short-time. The crash began in Hong Kong and spread west to Europe, hitting the US after other markets had already declined by a significant margin. The DJIA dropped by 508 points to 1738.74 (22.61%)
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Cont.
In Australia and New Zeeland, the 1987 crash is also referred to as Black Tuesday, because of the time zone differences. Due to this crash,
HK had fallen 45.5 % Australia 41.8 Spain 31% U K 26.45% and New Zeeland 60% (Specially hard)
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The Collapse of LTCM

Long Term Capital Management (LTCM) was a speculative hedge fund based in US that utilized absolute return trading strategies. LTCM hedge fund led by Nobel Prize-winning Economists and renowned Wall Street traders that nearly collapsed the global financial system in 1998 as a result of high-risk arbitrage trading strategies. When it collapsed in 1998, it bailout by other financial institutions, under the supervision of the Federal Reserve.
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Cont.
A hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds. Hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on Public markets. They are typically open-ended, meaning that investors can invest and withdraw money at regular, specified intervals.
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Cont.
Investors in some hedge funds had taken huge losses following the collapse of the Russian economy in August, and the Federal Reserve felt it necessary to organize a rescue of a hedge fund called Long-Term Capital Management.

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The subprime mortgage crisis (SMC)

The subprime mortgage crisis, popularly known as the mortgage mess or mortgage meltdown, came to the publics attention when a steep rise in home foreclosures in 2006. The US was one of the first indicators of the financial crisis, characterized by a rise in subprime mortgage and foreclosures, and the resulting decline of securities .
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Cont.
The national financial crisis spread around the world within the year. Consumer spending is down, the housing market has crashed, and the stock market has been vibrated. After, US house sales price peaked in mid 2006 and began their steep decline forthwith, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher interest rates causing higher monthly payments.

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Capital Markets
the capital market is the market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid.

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Internationalization of Financial Markets

The growing internationalization of financial markets has become an important trend. The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of savings in leading financial centers in the world and the deregulation of foreign financial markets, which has enabled them to expand their activities.
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International Bond Market

The traditional instruments in the international bond market are known as foreign bonds. Foreign bonds are sold in a foreign country and are denominated in that countrys currency. For example, if the German automaker Porsche sells a bond in the United States denominated in U.S. dollars, it is classified as a foreign bond. Foreign bonds have been an important instrument in the international capital market for centuries.
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Eurobonds
A more recent innovation in the international bond market is the Eurobond, a bond denominated in a currency other than that of the country in which it is sold.

for example, a bond denominated in U.S. dollars sold in London.

Currently, over 80 percent of the new issues in the international bond market are Eurobonds, and the market for these securities has grown very rapidly.
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Eurocurrencies
A variant of the Eurobond is Eurocurrencies, which are foreign currencies deposited in banks outside the home country. The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are similar to short-term Eurobonds.
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World Stock Markets

Until recently, the U.S. stock market was by far the largest in the world, but foreign stock markets have been growing in importance.

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Primary and Secondary Markets

A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a financial market in which securities that have been previously issued (and are thus secondhand) can be resold.
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Cont.
A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a financial market in which securities that have been previously issued (and are thus secondhand) can be resold.
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Exchanges and Over-the-Counter Markets

Secondary markets can be organized in two ways. (i) exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York and American stock exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver, and other raw materials) are examples of organized exchanges.
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Cont.
The other method of organizing a secondary market (ii) over-the-counter (OTC) market, in which 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 is willing to accept their prices. Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange.
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Function of Financial Intermediaries

A financial intermediary borrows funds from the lender-savers and lends these funds in the form of loans to borrower-spenders.

The process of indirect finance using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers.

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Transaction Costs
the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them; because their large size allows them to take advantage of economies of scale.
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Risk Sharing
Another benefit made possible by the low transaction costs of financial institutions is that they can help reduce the exposure of investors to risk; that is, uncertainty about the returns investors will earn on assets. Financial intermediaries do this through the process known as risk sharing: they create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk. This process of risk sharing is also sometimes referred to as asset transformation.
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Diversification
Financial intermediaries also promote risk sharing by helping individuals to diversify and thereby lower the amount of risk to which they are exposed. Diversification entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets.
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Asymmetric Information
In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked than the lender does.
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Cont.
Lack of information creates problems in the financial system on two fronts: Adverse selection is the problem created by asymmetric information before the transaction occurs.

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Adverse Selection
Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome, that is, the bad credit risksare the ones who most actively seek out a loan and are thus most likely to be selected.

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Cont.
Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace.

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Moral Hazard
Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lenders point of view, because they make it less likely that the loan will be paid back.
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Cont.
Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan

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Financial Intermediaries
financial intermediaries fall into into three categories: (i) depository institutions (banks) (ii) contractual savings institutions, and (iii) investment intermediaries.

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Cont.
Depository institutions (basically, banks) are financial intermediaries that accept deposits from individuals and institutions and make loans. special attention is given on this group of financial institutions, because they are involved in the creation of deposits, an important component of the money supply.

These institutions include commercial banks and the so-called thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions.
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Commercial Banks.
These financial intermediaries raise funds primarily by issuing checkable deposits, savings deposits, and time deposits (deposits with fixed terms to maturity). They then use these funds to make commercial, consumer, and mortgage loans and to buy government securities.

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Savings and Loan Associations (S&Ls) and Mutual Savings Banks.

These depository institutions, obtain funds primarily through savings and time deposits. Over time, the distinction between depository institutions and commercial has blurred. These intermediaries become more alike and are now competitive with each other.
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these banks have more

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Credit Unions
These financial institutions are very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans.

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Contractual Savings Institutions

Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay, the liquidity of assets is not as important a consideration for them as it is for depository institutions. Thus they tend to invest their funds primarily in longterm securities such as corporate bonds, stocks, and mortgages.
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Investment Intermediaries
Finance Companies. Mutual Funds. Money Market Mutual Funds.

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Regulation of the Financial System

The government regulates financial markets for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system.

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Cont.
Increasing Information Available to Investors Government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors.

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Cont.
Ensuring the Soundness of Financial Intermediaries
Asymmetric information can also lead to widespread collapse of financial Intermediaries, referred to as a financial panic. To protect the public and the economy from financial panics, governments implemented different types of regulations.

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Cont.
Restrictions on Entry. Disclosure. Restrictions on Assets and Activities. Deposit Insurance. Limits on Competition. Restrictions on Interest Rates.

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Thank you !
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