1. CHAPTER 2 FEDERICA IELASI Overview of the Financial System

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-2 Agenda We examine the role and the structure of the financial system in an advanced economy. We study the effects of financial markets and institutions on the economy, and look at their general structure and operations. Topics include: – Function of Financial Markets – Structure of Financial Markets – Function of Financial Intermediaries – Financial Intermediaries – Regulation of the Financial System

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-3 Function of Financial Markets Channel funds from person or business without investment opportunities (i.e., “Lender-Savers” – surplus agents) to one who has them (i.e., “Borrower-Spenders” – deficit agents) Surplus agents have funds that they wish to invest; deficit agents do not have sufficient current funds themselves and need to borrow money

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-4 Financial Markets Funds Transferees Lender-Savers 1.Households 2.Firms 3.Government Borrower-Spenders 1.Firms 2.Government 3.Households

5. Financial Markets Funds Transferees You have a business… You need money… Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-5

6. Segments of Financial Markets Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-6 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-6

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-7 Segments of Financial Markets 1.Direct Finance (bottom route) Borrowers borrow directly from lenders in financial markets by selling financial instruments (securities) which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but they are liabilities for the individual or firm that sells (issues) them. 2.Indirect Finance (top route) Borrowers borrow indirectly from lenders via financial intermediaries. A financial intermediary stands between the lender and the borrower and helps transfer funds from one to the other.

8. Segments of Financial Markets A financial intermediary borrows funds from savers (for example a bank might acquire funds by issuing a liability in the form of saving deposits) and lends money to deficit agents… – …by making a loan – …by buying a bond in the financial market Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-8

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-9 Importance of Financial Markets Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the well- being of consumers, allowing them to time their purchases better.

10. Importance of Financial Markets When financial markets break down during financial crises, as they have in Mexico, East Asia and Argentina in recent years, severe economic hardship results, which can even lead to dangerous political instability. Financial markets break downs led to economic instability and led to widespread social problems. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-10

11. Structure of Financial Markets It helps to define financial markets along a variety of dimensions (not necessarily mutually exclusive). For starters, … Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-11

12. Structure of Financial Markets Debt markets Debt instrument (bond): contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payment) until a specified date (the maturity date) The payments for debt holders are fixed Equity markets Equities: claims to share in the net income and the assets of a business Equities often make periodic payments (dividends) to their holders and are considered long-term securities Equity holder is a residual claimant (the corporation must pay all its debt holders before it pays its equity holders) Equity holders benefit directly from any increases in the corporation’s profitability or asset value Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-12

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-13 Structure of Financial Markets 1.Primary Market – New security issues sold to initial buyers – Typically involves an investment bank 2.Secondary Market – Securities previously issued are bought and sold – Examples include the NYSE and Nasdaq

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-14 Structure of Financial Markets Even though firms don’t get any money, per se, from the secondary market, it serves two important functions: Provide liquidity, making it easy to buy and sell the securities of the companies Establish a price for the securities

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-15 Structure of Financial Markets We can further classify secondary markets as follows: 1.Exchanges – Trade conducted in central locations (e.g., New York Stock Exchange) 2.Over-The-Counter Markets – Dealers at different locations who have an inventory of securities are ready to buy and sell securities OTC to anyone who comes to them and is willing to accept their price NYSE home page http://www.nyse.com http://www.nyse.com

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-16 Classifications of Financial Markets We can also further classify markets by the maturity of the securities: 1.Money Market: Short-Term (maturity < 1 year) 2.Capital Market : Long-Term (maturity > 1 year) plus equities

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-17 Classifications of Financial Markets National and international market International Bond Market – Foreign bonds Denominated in a foreign currency Targeted at a foreign market – Eurobonds Denominated in one currency, but sold in a different market Example: a bond denominated in U.S. dollars sold in London Over 80% of new issues in the international bond market are Eurobonds.

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-18 Classifications of Financial Markets A variant of the Eurobond is Eurocurrencies Eurocurrency Market – Foreign currency deposited outside of home country – Eurodollars are U.S. dollars deposited, say, London. The € can cause confusion with these terms…

19. Classifications of Financial Markets A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro. Eurodollars have nothing to do with euros, but are U.S. dollars deposited in banks outside the United States. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-19

20. Key terms ItalianEnglish Risparmio Emettere un titolo Negoziare un titolo Possedere un titolo Concedere un finanziamento Ottenere un finanziamento Rimborsare un prestito Azionista Azione Obbligazione Borsa Obbligazionista Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-20

21. Key terms ItalianEnglish RisparmioSaving Emettere un titoloTo issue a security Negoziare un titoloTo trade a security Possedere un titoloTo hold a security Concedere un finanziamentoTo lend funds Ottenere un finanziamentoTo borrow funds Rimborsare un prestitoTo pay back a loan AzionistaShareholder / stockholder / equity holder BorsaStock Exchange ObbligazionistaBondholder / Debt holder Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-21

22. Key terms EnglishItalian Maturity Bond Common stock Asset Liability Security Mortgage Bank supervision Disclosure Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-22

23. Key terms EnglishItalian MaturityScadenza BondObbligazione Common stockAzione ordinaria AssetAttività LiabilityPassività SecurityTitolo MortgageMutuo Bank supervisionVigilanza bancaria DisclosureTrasparenza Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-23