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Chapter 2

Financial Assets, Money,


Financial Transactions,
and Financial Institutions
McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies,

Learning Objectives
To learn about the important channels
through which funds flow from lenders
and borrowers and back again within the
global system of money and capital
markets.
To discover the nature and
characteristics of financial assets how
they are created and destroyed by
decision makers within the financial
system.
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Learning Objectives
To explore the critical roles played by
money within the financial system and
the linkages between money and
inflation in the prices of goods and
services.
To examine the important jobs carried
out by financial intermediaries in
lending and borrowing and in creating
and destroying financial assets.
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The Role of Financial Assets


The financial system is the mechanism
through which loanable funds reach
borrowers
Operation of the financial market
Money exchanged for financial claims
Stocks
Bonds
Other securities
Transforms savings into investment
Permits the economy to grow
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The Nature and Characteristics of


Financial Assets
A financial asset
A claim against the income or wealth of a
business firm, household, or unit of
government
Represented usually by a certificate
receipt, computer record file, or other legal
document
Usually related to the lending of money

Examples include stocks, bonds,


deposits, and others
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Characteristics of Financial Assets


Financial assets are sought after
because they promise future returns to
their owners and serve as a store of
value (purchasing power).

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Characteristics of Financial Assets


Financial asset value based on faith that
issuer honors contractual promise to pay
Financial assets characteristics
Do not depreciate like physical goods
Physical condition or form usually not relevant
in determining market value
Have little or no value as a commodity
Cost of transportation and storage is low
Financial assets are fungible can easily be
changed in form and substituted for other
assets
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Types of Financial Assets


Money
Financial asset accepted in payment for
purchases of goods and services
Examples are currency and checking

Equities
Ownership shares in a business firm
Claims against the firms profits
Claims against proceeds from the sale of its
assets
Examples are common stock and preferred
stock

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Types of Financial Assets


Debt Securities
Priority claim over the holders of equities to the
assets and income of an economic unit
Can be negotiable or nonnegotiable
Examples include bonds, notes, accounts payable,
and savings deposits

Derivatives
Market value tied to or influenced by the value or
return on a financial asset
Examples include futures contracts, options, and
swaps
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How Financial Assets Are Created


Internal financing to acquire assets
Use current income
Use accumulated savings

External financing to acquire assets


Raise funds by issuing financial liabilities
(debt)
Raise funds by issuing stock (equities)

2-11

Balance Sheets of Units in a


Simple Financial System

2-12

Unit Balance Sheets Following the


Equipment Purchase and Debt Issuance

2-13

Unit Balance Sheets Following Equipment


Purchase and Stock Issuance

2-14

Financial Assets and the Financial System

The act of borrowing or of issuing new


stock simultaneously gives rise to the
creation of an equal volume of financial
assets.
All financial assets are recorded as a
liability or claim on some other
economic units balance sheet.
Volume of financial assets for lenders
= Volume of liabilities issued by borrowers
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Financial Assets and the Financial System


For the balance sheet of any economic
unit,
Total assets = Total liabilities + Net Worth
Where
Assets = Real assets + Financial assets
For the whole economy and financial
system,
Total financial assets = Total liabilities
So, for the economy as a whole,
Total real assets = Total net worth
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Financial Assets and the Financial System

Society can increase its wealth


Saving and increasing the quantity of its
real assets
Real assets enable the economy to
produce more goods and services

The financial system provides the


essential channel
Necessary for the creation and exchange
of financial assets
Exchange is between savers and
borrowers so that real assets can be
acquired
2-17

Financial System Matters


Strong financial system helps society
Reducing barriers to external financing
Lowering cost of capital
Accelerating economic growth

Nations with more fully developed


financial systems
Tends to grow faster
Tends to enjoy a higher standard of living
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Lending and Borrowing in the


Financial System
Economists John Gurley and Edward Shaw
pointed out that each business firm,
household, or unit of government active in
the financial system must conform to:
R - E = FA - D
where
R = Current income receipts
E = Expenditures out of current income
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding
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Lending and Borrowing in the


Financial System
So, for any given time period, each
economic unit must fall into one of
three groups:
Deficit-budget unit (DBU):
E > R, so D > FA (net borrower of
funds)

Surplus-budget unit (SBU):

R > E, so FA > D (net lender of funds)

Balanced-budget unit (BBU):

R = E, so D = FA (neither net lender nor


borrower)
2-20

Lending and Borrowing in the


Financial System
The U.S. Economy in 2006
($ Billions)

Major Sectors
of the
Economy
Households

Net Acquisitions
Net
Net Lender (+)
of Financial Increase in
or Net
Assets
Liabilities Borrower (-)
$865.1
$1,411.1
$ - 546.0

Nonfinancial business
firms
State and local
governments
Federal government
International sector:
foreign investors
and borrowers

599.0

680.5

+ 87.5

80.0

144.0

- 64.0

- 13.6

634.6

- 648.2

1491.9

545.3

+ 946.6

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
2-21

Lending and Borrowing in the


Financial System
The global financial system permits
businesses, households, and
governments to adjust their financial
position from that of net borrower
(DBU) to net lender (SBU) and back
again, smoothly and efficiently.

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What is Money?
All financial assets are valued in terms
of money, and flows of funds between
lenders and borrowers occur through
the medium of money.
Money itself is a financial asset,
because all forms of money in use
today are claims against some public
or private institution.
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Alternative Definitions of Money


M1
Currency and coin held by the public
outside bank vaults
Various kinds of payment accounts at
depository institutions

M2 takes M1 and adjusts


Add small savings and time deposits
Add share accounts at retail money market
mutual funds

MZM takes M2 and adjusts


Subtract small-denomination time deposits

Add institutional money market funds

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Historic Volume of Money

Source: http://www.federalreserve.org/releases/H6/hist/h6hist1.txt
2-25

The Functions of Money


Money serves as a standard of value
(or unit of account)
Money serves as a store of value

Reserve of future purchasing power


Value of money can fluctuate with
inflation

Money serves as a medium of


exchange

Buyers and sellers no longer need to


have an exact coincidence of wants
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The Value of Money and Other Financial


Assets and Inflation

Inflation
Rise in the average price level of all goods
and services
Lowers purchasing power of money
Can damage value of financial contracts

Deflation
The opposite of inflation
Fall in the average price level of all goods
and services
2-27

The Value of Money and Other Financial


Assets and Inflation

Inflation is commonly measured


using price indices, such as:

the Consumer Price Index (CPI),


the Producer Price Index (PPI), or
the Gross Domestic Product (GDP)
deflator Index.

2-28

The Value of Money and Other Financial


Assets and Inflation
Suppose the U.S. CPI rises from 100 to 125
over a five-year period.
Over the five-year period, the cost-of-living
index climbed

125 100 0.25 or 25% ...


100

and the U.S. dollars relative purchasing


power fell

1
100 0.8 .
125

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Impact on Purchasing Power


Changes in purchasing power can be
dramatic
Due to inflation
Even in the United States
Provides a warning about measuring value

Need to think in terms of real values


Purchasing power adjusted
Nominal values can be misleading
2-30

The Evolution of Financial


Transactions
Financial systems change constantly

Shifting demands from the public


Development of new technology
Changes in laws and regulations

The ways of carrying out financial


transactions have evolved
In particular, the transfer of funds
from savers to borrowers can be
accomplished in at least three
different ways
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The Evolution of Financial


Transactions
Direct Finance Direct lending gives rise
to direct claims against borrowers
Flow of funds and other financial services

Borrowers
(DBUs)

(loans of spending power for an


agreed-upon period of time)

Primary Securities

Lenders
(SBUs)

(stocks, bonds, notes, etc., evidencing


direct claims against borrowers)

Simple Difficult to match & risky


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The Evolution of Financial


Transactions
Semidirect Finance Direct lending with the
aid of market makers who assist in the sale
of direct claims against borrowers
Primary Securities

Borrowers
(DBUs)

(direct claims
against
borrowers)

Primary Securities

Security
brokers,
dealers, &
investment
bankers

(direct claims
against
borrowers)

Flow of funds
and other
financial services

Lenders
(SBUs)

Proceeds of
security sales and other
(loans of spending
financial services
power)
(less fees and commissions)
Lower search (information) costs
Risky & matching is still required

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Major Financial Institutions

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The Evolution of Financial


Transactions
Indirect Finance Financial intermediation of
funds
Primary Securities

(direct claims against ultimate


borrowers in the form of loan
contracts, stocks, bonds, notes,
etc.)

Ultimate
borrowers
(DBUs)

Secondary Securities

(indirect claims against ultimate


borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)

Financial intermediaries

(banks, savings and loan associations,


insurance companies, credit unions,
mutual funds, finance companies,
pension funds)

Flow of funds and other


financial services
(loans of spending power)

Ultimate
lenders
(SBUs)

Flow of funds and other


financial services
(loans of spending power)

Low risk & affordable

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Total Financial Assets Held by U.S.


Financial Institutions
($ billions at year-end)
1970
1980
Financial intermediaries:
Commercial banks
$489 $1,248
S&L assoc. and savings banks
252
794
Life insurance companies
201
464
Private pension funds
110
413
Investment co. (mutual funds)
47
64
State & local govt pension funds
60
198
Finance companies
63
199
Property-casualty insurance co.
50
174
Money market funds

74
Credit unions
18
72
Mortgage companies

16
Real estate investment trusts
4
6
Other financial institutions:
Security brokers and dealers
16
36

1990

2000

2006

$3,340
1,358
1,357
1,629
602
820
611
534
498
202
49
13

$6,488
1,219
3,204
4,587
4,457
2,290
1,138
872
1,812
441
36
62

$9,528
1,829
4,479
4,876
6,473
2,791
1,300
1,280
2,014
703
32
385

262

1,221

2,296

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
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Classifying Financial Institutions


Depository institutions
Bulk of their loanable funds from deposit
accounts sold to the public
Commercial banks, savings and loan
associations, savings banks, credit unions

Contractual institutions
Funds from offering legal contracts to
protect the saver against risk
Insurance companies, pension funds
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Classifying Financial Institutions

Investment institutions
Sell shares to the public
Invest the proceeds in stocks, bonds, and
other assets
Mutual funds, money market funds, real
estate investment trusts

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Portfolio (Financial-Asset)
Decisions by Financial Institutions
Deciding what financial assets to buy
or sell
Depends on various asset factors
Different financial assets relative rate of
return
Different financial assets risk
Cost of incoming funds
Volatility of incoming funds
Maturity of incoming funds
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Portfolio (Financial-Asset)
Decisions by Financial Institutions
Also depends on financial institution
size
Larger financial institutions tend to have
more diversified sources and uses
Larger financial institutions also enjoy
economies of scale.

Regulations and competition

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The Disintermediation of Funds


Disintemediation process
Withdrawal of funds from a financial
intermediary by the ultimate lenders
(SBUs)
Lending of those funds to ultimate
borrowers (DBUs)

Disintermediation shifts funds


Away from indirect finance
To direct finance
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The Disintermediation of Funds


Financial Disintermediation
Primary Securities
Ultimate
borrowers
(DBUs)

Financial
intermediaries

Ultimate
lenders
(SBUs)

Loanable funds

2-42

The Disintermediation of Funds


Disintermediation is not a foregone
conclusion
Reintermediation
Reversal of flow of funds
Back to a safe haven of financial
intermediaries
Interest rates are low or declining
Or riskiness of financial instruments appear
to be rising
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New Forms of Disintermediation


Initiation by financial intermediaries

Banks sell off loans


Difficulty in raising capital

Initiation by borrowing customers


Customer learn alternate financing conduits
Nonfinancial retail and industrial firms
attempting to draw financial services
customers
Raise funds in the open market

2-44

Bank-Dominated Versus SecurityDominated Financial Systems


Bank-dominated financial systems
Banks and other similar institutions
dominate
Supply of credit
Attracting savings
Common in economies with less
protection of investor rights or less welldefined rules
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Bank-Dominated Versus SecurityDominated Financial Systems


Security-dominated financial systems
Traditional intermediaries are less
important
More borrowers sell securities to the public
Many economies are gradually moving
toward a more security-dominated financial
system
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Markets on the Net


Answers.com at http://
www.answers.com
/topic/disintermediation
Bondsonline at www.bondsonline.com
Encarta at encarta.msn.com
Encyclopedia.com at encyclopedia.com
Federal Reserve Bank of Atlanta at
www.frbatlanta.org
Federal Reserve Bank of New York at
www.ny.frb.org
2-47

Markets on the Net


Federal Reserve Bank of St. Louis at
research.stlouisfed.org/fred2
Moodys Investor Service at
www.moodys.com
Money Magazine at money.cnn.com
New York Stock Exchange at
www.nyse.com
RePEc at ideas.repec.org
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Markets on the Net


Standard & Poors Corporation at
www.standardandpoor.com
The Bond Market Association at
www.investinginbonds.com
U.S. Bureau of Economic Analysis at
www.bea.gov
U.S. Bureau of Labor Statistics at
www.stats.bls.gov
Wikipedia at en.wikipedia.org
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Chapter Review
Introduction: The role of financial
assets
The creation of financial assets
Characteristics of financial assets
Different kinds of financial assets
How financial assets are born
Financial assets and the financial
system
2-50

Chapter Review
Lending and borrowing in the financial
system
Money as a financial asset
What is money?
The functions of money

The value of money and other financial


assets and inflation
2-51

Chapter Review
The evolution of financial transactions

Direct finance
Semidirect finance
Indirect finance and financial
intermediation

Relative size and importance of major


financial institutions
Classification of financial institutions
2-52

Chapter Review
Portfolio (financial-asset) decisions by
financial intermediaries and other
financial institutions
Disintermediation of funds
New types of disintermediation

Bank-dominated versus securitydominated financial systems


2-53