An Overview

of the Financial System

2
Function of Financial Markets
1. Allows
transfers of
funds from
person or
business
without
investment
opportunities
to one who
has them
2. Improves
economic
efficiency
3
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
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
4
Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Exchanges and Over-the-Counter (OTC) Markets
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and
equity instruments
5
Principal Money Market Instruments

6
Capital Market Instruments

An Economic Analysis of
Financial Structure
8
Sources of External Finance in U.S
9
Sources of Foreign External Finance
10
Sources of Foreign External Finance
11
Eight Basic Facts
1. Stocks are not the most important sources of
external financing for businesses
2. Issuing marketable debt and equity securities is not
the primary way in which businesses finance their
operations
3. Indirect finance is many times more important than
direct finance
4. Financial intermediaries are the most important
source of external funds
12
Eight Basic Facts (contd)
5. The financial system is among the most heavily
regulated sectors of the economy
6. Only large, well-established corporations have easy
access to securities markets to finance their
activities
7. Collateral is a prevalent feature of
debt contracts
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive
covenants on borrowers
13
Demonstration
How will a buyer determine what to offer?
How will the seller determine what to charge?
What if I offered to buy at $800?
Will everyone sell?
What happens to the average value of the cars
offered for sale when I offer $800?
14
Function of Financial
Intermediaries
Financial Intermediaries
1. Engage in process of indirect finance
2. More important source of finance than securities markets
3. Needed because of transactions costs and asymmetric
information
15
Transaction Costs
Financial intermediaries have evolved to
reduce transaction costs
Economies of scale
Expertise
16
Function of Financial
Intermediaries
Risk Sharing
1. Create and sell assets with low risk characteristics and then
use the funds to buy assets with more risk (also called asset
transformation).
2. Also lower risk by helping people to diversify portfolios
17
Transaction Costs and Financial
Structure
Transaction costs hinder flow of funds to people with
productive investment opportunities
Financial intermediaries make profits by reducing transaction
costs
1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transaction costs
Explains Fact 3
18
Asymmetric Information
The secret of success is to know something nobody
else knows -Aristotle Onassis

Hot tip from the broker vs. insider trading

Lemons Problem (Akerlof)

The Nobel Laureates of 2001.
http://www.nobel.se/economics/laureates/2001/index
.html
19
Asymmetric Information
Adverse selection occurs before
the transaction
Moral hazard arises after the transaction
Agency theory analyses how
asymmetric information problems affect
economic behavior
20
Adverse Selection:
The Lemons Problem
If quality cannot be assessed, the buyer is willing to
pay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at
the price for average quality
The buyer will decide not to buy at all because all
that is left in the market is poor quality items
This problem explains fact 2 and partially explains
fact 1
21
Adverse Selection: Solutions
Private production and sale of information
Free-rider problem
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7
22
Moral Hazard in Equity
Contracts
Called the Principal-Agent Problem
Separation of ownership and control
of the firm
Managers pursue personal benefits and power
rather than the profitability of the firm
23
Principal-Agent Problem:
Solutions
Monitoring (Costly State Verification)
Free-rider problem
Fact 1
Government regulation to increase information
Fact 5
Financial Intermediation
Fact 3
Debt Contracts
Fact 1
24
Moral Hazard in Debt Markets
Borrowers have incentives to take on
projects that are riskier than the lenders
would like
25
Moral Hazard: Solutions
Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information
Financial Intermediation
Facts 3 & 4
26
27
Function of Financial
Intermediaries: Indirect Finance
Lower transaction costs
Economies of scale
Liquidity services
Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Asymmetric Information
Adverse Selection (before the transaction)more likely to select
risky borrower
Moral Hazard (after the transaction)less likely borrower will
repay loan
28
Internationalization
of Financial Markets
Foreign Bondssold in a foreign country and
denominated in that countrys currency
Eurobondbond denominated in a currency other
than that of the country in which it is sold
Eurocurrenciesforeign currencies deposited in
banks outside the home country
EurodollarsU.S. dollars deposited in foreign banks outside
the U.S. or in foreign branches of U.S. banks
World Stock Markets
29
Financial Intermediaries
30
Size of Financial Intermediaries
31
Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
Reduce insider trading
To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
32
Regulatory Agencies
33
Regulatory Agencies
34
Conflicts of Interest
Type of moral hazard problem caused by economies of scope
Arise when an institution has multiple objectives and, as a
result, has conflicts between those objectives
A reduction in the quality of information in financial markets
increases asymmetric information problems
Financial markets do not channel funds into productive
investment opportunities
The economy is not as efficient as it could be
35
Why Do Conflicts of Interest
Arise?
Underwriting and Research in
Investment Banking
Information produced by researching companies is used to
underwrite the securities. The bank is attempting to
simultaneously serve two client groups whose information
needs differ.
Spinning occurs when an investment bank allocates hot, but
underpriced, IPOs to executives of other companies in
return for their companies future business
36
Why Do Conflicts
of Interest Arise? (contd)
Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments and
opinions to win consulting business
Auditors may be auditing information systems or tax and
financial plans put in place by their nonaudit counterparts
Auditors may provide an overly favorable audit to solicit or
retain audit business
37
Conflicts of Interest: Remedies
Sarbanes-Oxley Act of 2002 (Public Accounting
Return and Investor
Protection Act)
Increases supervisory oversight to monitor and prevent
conflicts of interest
Establishes a Public Company Accounting Oversight Board
Increases the SECs budget
Makes it illegal for a registered public accounting firm to
provide any nonaudit service to a client contemporaneously
with an impermissible audit
38
Conflicts of Interest:
Remedies (contd)
Sarbanes-Oxley Act of 2002 (contd)
Beefs up criminal charges for white-collar crime
and obstruction of official investigations
Requires the CEO and CFO to certify
that financial statements and disclosures are
accurate
Requires members of the audit committee to be
independent
39
Conflicts of Interest:
Remedies (contd)
Global Legal Settlement of 2002
Requires investment banks to sever the link between
research and securities underwriting
Bans spinning
Imposes $1.4 billion in fines on accused
investment banks
Requires investment banks to make their analysts
recommendations public
Over a 5-year period, investment banks are required to
contract with at least 3 independent research firms that would
provide research to their brokerage customers
40
Financial Development
and Economic Growth
Financial Repression Leads to Low Growth: Why?
1. Poor legal system
2. Weak accounting standards
3. Government directs credit
4. Financial institutions nationalized
5. Inadequate government regulation

41
Appendix
Slides after this point will most likely not be
covered in class. However they may contain
useful definitions, or further elaborate on
important concepts, particularly materials
covered in the text book.

They may contain examples Ive used in the
past, or slides I just dont want to delete as I
may use them in the future.

42
Financial Crises
and Aggregate Economic Activity
Crises can be caused by:
Increases in interest rates
Increases in uncertainty
Asset market effects on balance sheets
Problems in the banking sector
Government fiscal imbalances
43
Events in U.S. Financial Crises
44
Events in Mexican, East Asian, and Argentine
Financial Crises
45
Summary: Asymmetric Information
Problems and Tools to Solve Them