CHAPTER 2 - OVERVIEW OF THE FINANCIAL SYSTEM

Financial markets (bond and stock) and financial intermediaries (banks, ins cos., pension funds) perform the econ function of channeling/directing funds from people who have a surplus of funds ( Y > C) to those who have a shortage of funds ( C > Y). Savers to Borrowers. Suppliers of credit to demanders of credit.

Show life cycle diagram.

People could deal directly with each other (direct finance) , but there are risks. What are they?

Direct finance - when borrowers and savers deal directly with each other.

Example: GM borrows money from a life insurance company.
Investor buys a new issue of stock directly from the company.

Indirect finance - mutual funds, pension funds, insurance companies buy stocks and bonds.

Importance of financial markets - benefits those with savings/excess funds. You have $1000 to invest for several years. There are thousands of investment opportunities to choose from. You get the benefit of a rate of return, a reward for postponing consumption.

Benefits those who either have a great business idea or invention but have no funds. People with excess funds and those with great ideas are not usually the same people.  See story page 20.

Also, borrowing allows us to live beyond our current income level. We can live off of future income and escape the limitation of current income. Transfer our purchasing power from the future to the present.

Example: We can buy a $20,000 car today without having all the cash. We can buy a $100,000 house without having all the cash. We can go to school today by borrowing money, etc.


STRUCTURE OF THE FINANCIAL MARKETS SOME BASIC CONCEPTS -

Debt vs Equity - Firms/Individuals can obtain funds in two ways:

1. Debt/Fixed Income - bonds, term loans, commercial paper, mortgages, etc.
Short term debt - one year or less
Intermediate-term - 1-10 yrs
Long-term - +10 yrs (usually 30 yrs, some 40-50 yr bonds)

2. Equity - common stock. You have a ownership position. One share of 1m outstanding shares gives you a 1/1m claim to firm's net income and 1/1m claim to the firms assets.

Residual claimant - you have a residual claim to the firms income AFTER all others have been paid - interest pmts, wages, taxes, etc. and you have a residual claim to a firm's assets in liquidation AFTER all others have been paid. DIVs paid from NET INCOME.

Disadvantage - as an owner of the company, you are at the bottom of the list or end of the line for your claim to income or assets.

Advantage - you benefit as an owner if the firm does really well. Stock price could double or triple in a short period of time. As a bondholder/debtholder, you are paid a fixed rate of return.

Point: Equity is riskier, pays a higher expected rate of return.

Stocks - Avg about 10-12%/yr
Bonds - Avg about 5-6%/yr


PRIMARY VS. SECONDARY MARKETS

Primary market - newly issued securities, bonds/stocks, being sold to initial purchasers by corporation or govt agency through an investment bank, which underwrites the securities. Underwriting - guaranteed price.

Secondary market - trading of previously issued stocks and bonds. Secondhand market. You buy GM stock from another individual who is selling. GM has nothing to do with the transaction.

NYSE and the AMEX (organized exchanges/physical location) and NASDAQ (over-the-counter, computer linked dealers all over the country) are the three national secondary stock markets.

Liquidity: the degree to which an asset can be converted to cash 1) quickly and 2) with little loss of value.


MONEY VS. CAPITAL MARKETS

Money markets - debt securities with less than one yr to maturity. Safe, liquid.

Capital mkts - debt/equity with more than one yr to maturity. Riskier.

Money Market Instruments:

1. US Tbills (3, 6 and 12 month maturities). Risk-free securities of Fed gov. Sold at a discount and pay no int. Ex. Buy @ $9000 with a $10,000 maturity in one year. (Int = 11.11%).

2. Negotiable CDs ($100,000+) - sellable in the secondary market.

3. Commercial paper - short term debt issued by large corporations in direct finance to other large corporations or ins cos or banks. Example of financial disintermediation. Maturity of 270 days or less. No SEC requirements.

Example - GM needs to borrow $1m for 30 days. Instead of going to bank, they go to Ford or Met Life.

4. Banker's Acceptances - letter of credit from a bank to facilitate international trade. Bank guarantees payment, usually of an import order. Example: local liquor company wants to purchase beer/wine from Germany. Banker's acceptance is used to guarantee payment.

5. Fed Funds Mkt - nothing to do with the FRS or the Fed gov. Overnight lending between banks to meet reserve requirements. Example: 10% reserve requirement on Demand Deposits. Fed funds rate is the int rate on overnight borrowing between banks. Closely watched rate by FRS.

6. Eurodollars - dollar denominated deposits in foreign banks. Or Yen denominated deposits outside Japan. Started with Soviet Union being worried about political risk.

See pages 26 and 27.


CAPITAL MARKET INSTRUMENTS

1. Stocks - equity. $10T value at end of 1996. New issues make up only about 1% of total value of shares. 50% equity held by ind, 50% by pension funds, mutual funds and ins cos.

2. Mortgages - Debt secured by real property (land and/or buildings). Largest debt market in US. Historically, mortgages were mostly available from S&Ls. Now, due to de-reg, commercial banks offer mortgages and private mortgage companies offer mortgages.

Securitization of mortgage industry - now represents 2/3 of mortgages. Mortgage-backed securities. Mortgages are packaged by banks and mort cos. and sold in large groups of $1m or more to a third party, like an ins co or pension fund. Fed Gov agency called GNMA, guarantees payment. See page 31 - Box 1. "Liar's Poker" by Michael Lewis.

3. Corporate Bonds - 10-50 year long term debt instruments to finance expansion of firm. Unsecured debt. Int payable twice a year. Convertible bond - convertible to common stock at a fixed rate. Example = one bond convertible to 40 shares of common stock until maturity. Advantage to bondholder - share in profits of successful company. Advantage to company = can reduce int pmts after conversion.

4. US T-notes and T-bonds.

5. State and local govt bonds. Municipal bonds. Tax-exempt.

See page 29.


INTERNATIONALIZATION OF FINANCIAL MARKETS

Before 1980s, U.S. economy and financial markets dominated the world markets because of the large size of U.S. economy, U.S. companies, stock market, credit markets, bond markets, etc. U.S. GDP used to be about 50% of world GDP. Now it's about 25%.

Now there has been 1) tremendous growth in other economies and other financial markets and 2) increasing international integration of world markets and world economies, increasing financial flows and increasing international trade flows of goods and services.

Due to 1) trend toward deregulation of financial markets worldwide and 2) information technology reducing transactions costs - Internet, fax, satellite, fiber optics, computers, etc.

U.S. corporations, banks and government now have increasing access to international sources of funds. Supply of foreign credit to U.S. from foreign investors/savers, banks and foreign institutions (mutual funds, pension funds, etc.). U.S. investors now have increasing access to overseas capital markets for investment opportunities. Americans supplying credit overseas to foreign governments, banks, corporations, etc.

Now a global financial marketplace. Typical instruments:

Foreign Bonds - bonds sold in a foreign country, denominated in the foreign currency. Examples: 1) Volvo (Swedish automaker) might raise capital by selling bonds in the U.S., denominated in dollars. 2) 1800s - U.S. sold foreign bonds in U.K. to finance construction of railroads. Denominated in British pounds.

Eurobonds - bonds sold overseas in a currency other than the currency of the country where it is sold.

Example: U.S. bonds sold overseas, denominated in dollars instead of the local currency. U.S. company issues bonds in London, denominated in U.S. dollars. Portuguese company issues bonds in Spain denominated in German marks or U.S. dollars. 80% of international bond market is Eurobonds.


World Stock Markets
U.S. is no longer always the largest market. The value of Japanese stocks has sometimes exceeded the U.S. Increase in international investing. Many mutual funds specialize in the foreign stocks to allow investors to achieve intl diversification.

International fund - foreign stocks only.
Global fund - foreign and U.S. stocks.

Many stock mutual funds may have some foreign companies. And many U.S. companies are now global, so you are investing globally even by owning "U.S." companies. Examples: McDonald's has restaurants all over the world. GM sells cars all over the world. 55% of MS sales are overseas, 67% for Coke, 58% for Intel.

We hear most about DJIA, but there is also the London index (FT 100) and the Tokoyo index (Nikkei 225) and the DJGlobal World Index (3000 companies in about 30 countries). DJ also has indexes for each country and also for different groups of countries (Americas (Can, US, Mex), Europe, Asia/Pacific, etc.) See WSJ or handout.

Book (p. 32-33): Foreign supply of capital, e.g. from Japanese, has helped the U.S. economy grow in the 1980s, by supplying investment capital and credit for the U.S. government budget deficits.


FUNCTIONS OF FINANCIAL INTERMEDIARIES

Banks/Fin Intermediaries act as middlemen to transfer funds from savers to borrowers. Why is that important?

1. Transactions costs - costs in terms of money and time, of executing a transaction. Matching up savers and borrowers, legal contract, etc.

2. Economies of scale - banks can lower trans costs because of economies of scale. They process thousands of loans, so they are efficient at matching borrowers/savers, having contracts drawn up, doing credit checks, sending out payment books, offering auto withdrawal/pmt, etc.. Also, due to thousands of loans, they can absorb the losses from a few bad loans.


POTENTIAL PROBLEMS IN THE CREDIT MARKETS

Asymmetric Information - Inequality of information. Borrower may not reveal all information to the lender about the riskiness of the project, potential payoffs, etc. Example: trade-in your car. You have better knowledge of the problems than the dealer. Dealer has better knowledge of the market for used cars. Asymmetric info presents two problems:

1. Adverse selection (a potential problem BEFORE the transaction takes place). Least creditworthy borrowers are the ones most actively seeking credit, and may be the most likely ones to obtain credit/be SELECTED. Bad credit risks are more aggressive in trying to get credit. Potential Danger is when banks decide to make very few loans because of adverse selection, they may be overlooking good credit risks.

Examples: Least qualified tenants may be the ones most likely to be seeking new housing, because their tenant history is so bad and they have been evicted, so they may be selected.

IMF/World Bank offers development funds to countries with econ problems - the least creditworthy countries may apply.

2. Moral Hazard - a problem of asymmetric info AFTER the loan occurs. Risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender's point of view. Potential conflict of interest between lenders and borrowers.

Example: Company borrows $100,000 at a fixed rate of 10%. They originally agreed to use money to finance a project with an expected return of 15%. Suddenly a risky project becomes available with an expected return of 30%. They could switch projects and increase the riskiness to the bank. If the new project pays off, all profits go to the owners, none to the bank. If the project fails, and the load goes bad, the bank suffers.

Example: S&L owners used federally insured deposits and invested in very risky projects after deregulation. They got all the benefit if projects paid off, took none of the risk or losses if projects/bank failed.

Solution: terms of loan usually put restrictions on borrower to avoid moral hazard.

Examples: taxes/insurance are escrowed on a mortgage. Bond agreement puts restrictions on DIV pmts or requires sinking fund.

Adverse selection and moral hazard can inhibit credit/financial markets, causing them to operate inefficiently or break down completely. Financial intermediaries can more easily solve the problems of adverse selection and moral hazard than individuals. Better able to screen borrowers (before loan), minimize adverse selection vs individuals. Better able to monitor borrowers (after loan), minimize moral hazard, vs. individuals. Explains why we don't see a credit market of individuals dealing directly with each other - too risky. Adverse selection and moral hazard would cause those credit markets to break down, disappear.

Points: a) Well functioning/efficient credit markets are essential for an economy to reach full potential.
b. Adverse selection and moral hazard are barriers to efficient credit and financial markets.
c. Financial intermediaries can minimize adverse selection and moral hazard, resulting in more credit, increased efficiency, lower overal cost to the economy, etc.

PROBLEMS OF FIN INTERMED IN E. EUR & FORMER SOVIET UNION

Poorly functioning credit markets inhibit growth.

Example: Poland - no central clearinghouse for bankruptcies, no way to record mortgages.


FINANCIAL INTERMEDIARIES

Three categories of financial intermediaries: See page 38.

1. Banks (depository institutions)
2. Contractual savings institutions (insurance companies and pension funds)
3. Investment intermediaries (finance companies, mutual funds, money market funds)

The sources and uses of funds, or liabilities and assets, help to understand the difference.
Banks accept deposits in the form of checking deposits/accounts, savings deposits/accounts and time deposits (CDs, fixed term to maturity, 1 or 5 year CD). These deposits are liabilities for the bank and provide the source of funds.

The banks then lend the money out in the form of business loans, consumer loans (auto, student, home improvement, etc.), mortgages. These are assets of the bank. Banks also invest in treasury securities and municipal bonds. Not allowed to own stocks, restrictions on bonds.

Profits: pay 3-4% to attract deposits, lend out at 8-12%, banks make money.

Historically, commercial banks were restricted to only offering checking accounts and commercial loans. S&Ls were restricted to offering svgs accounts and mortgages. Interest rates were fixed. Checking = 0%. Svgs = maximum set by Regulation Q, Fed Reserve.
1980 - major deregulation. Req Q abolished. Interest on checking was allowed. S&Ls could offer checking and commercial loans, commercial banks could offer savings and mortgages. The distinction between commercial banks and S&Ls is now very blurry. They are very much alike and they are very competitive with each other, because they basically offer the same services.

Commercial banks - 10,000
S&Ls - 1500
See page 39.

Note: Number of S&Ls was growing in the 50s and 60s. S&Ls had lots of problems in the 1970s and 1980s. Reason: rising interest rates. Problem: long-term assets (30 year mortgages), short term liabilities (deposits).

Contractual Savings:
1. Insurance Companies - source of funds: premiums. Assets: stocks, bonds, mortgages, T-bonds. Mostly long-term assets based on actuarial projections.

2. Pension funds - employer/employee contributions provide source of funds. Assets are bonds and stocks, usually through mutual funds.

Investment Intermediaries:
1. Finance companies - like GMAC, Ford Credit, Toyota Credit. Issue commercial paper, bonds and stocks to attract funds. Lend out commercial loans.

2. Mutual funds - source of funds: savers/investors buying shares. Assets: portfolios of stocks and bonds (capital markets). Advantages: 1) lowers transactions costs for investors by pooling large sums of money and 2) provides excellent diversification - most mutual funds own 100s of companies.

Money market mutual funds - same as above, but investment is in short-term money market, credit instruments (commercial paper, t-bills, etc.), not capital markets. Often shareholders have checking privileges, so it is an alternative to a checking account with restrictions ($500 minimum). Started in 1971, as a form of financial disintermediation, depositors left the banks. Money market mutual funds were a way to get around the prohibition of paying interest on checking. Money markets yield about 5% now vs. 2-3% in checking.


REGULATION OF THE FINANCIAL SYSTEM

The financial system is one of the most heavily regulated sectors of the U.S. economy. See page 43 for an overview of the many agencies that regulate economic activity in the banking and finance areas.

Much of the regulation goes back to legislation passed in the 1920 and 1930s, in response to the stock market crash, banking failures (15,000) and Great Depression.

McFadden Act(1927) - prohibited branch banking across state lines. Forces all banks to be small and local.

Glass-Steagall (1933) - separated commercial and investment banking. Banks had to make a choice. Commercial banking charter or investment banking charter.

SEC (1933) - established to monitor the stock exchanges and publicly traded companies. SEC has many disclosure laws and filing requirements to guarantee that information is released by publicly traded companies. Restricts trading by insiders, etc.

FDIC (1934) - established to provide deposit insurance for commercial banks. Because of federally-insured deposits, banking activities/assets were restricted to minimize risk of default. No stock ownership, for example. First max: $2500 per DEPOSITOR. Now: $100,000 per DEPOSIT.

Req Q (1933) - interest rate controls, intended to prevent competition among banks. Historical regulation led to banks operating under the "3-6-3" rule. Government enforced cartel. Protected/insulated banks from competition. It is now all breaking down.


FINANCIAL REGULATION ABROAD

Our banking system is very different from banks in Japan, Europe and even Canada, due to regulatory differences. No other country has restricted branch banking like the U.S. And other countries have far fewer restrictions on the services and assets of a bank. For example, banks in Germany and Japan can legally invest in common stocks, and in many cases the banks are major shareholders of corporations.


Questions: 2, 3, 4, 6, 7, 10, 13