Financial System Prof. Landskroner 1 Overview of The Financial System Prof. Yoram Landskroner M&B, Summer 2004.
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Financial System Prof. Landskroner 1 Overview of The Financial System Prof. Yoram Landskroner M&B, Summer 2004
Financial System Prof. Landskroner 2 Financial System F Economic Functions of the Financial System: Markets, instruments and Institutions. F Main Function of Financial System: Allocation of Resources. F How? Who? What?
Financial System Prof. Landskroner 3 Financial System Topics: F 1. Savings vs. Investments. F 2. Stages of Efficiency in Allocation of Resources: Direct vs. Indirect Financing and Financial Intermediation: * reasons for existence * Specialness F 3. Financial Markets and Instruments. F 4. Markets Participants.
Financial System Prof. Landskroner 4 Savings vs. Investments F Important economic aggregates, affect: aggregate output (economic activity); business cycles; economic growth; F What are they? F Investment: process of capital formation- increase in productive capacity. F Tangible real assets: buildings, equipment, inventories (materials) F (Net) addition to stock of capital- concept of flow F In modern economy done mostly by business
Financial System Prof. Landskroner 5 Savings vs. Investments F Savings: residual concept: Saving = Income – Consumption F By households, business (retained earnings), government (budget surplus) F Relationship between savings and investments on a national level: S = Y- C Y= C+ I Where: Y= national income = national product C= consumption; S= saving; I = investments
Financial System Prof. Landskroner 6 Savings vs. Investments F This is a budget constraint where uses (of funds) have to equal sources (ex post). F The constraint holds also for each economic unit! F Main functions of the financial system: u Separation of savings from investments of economic unit: external as well as internal financing. u Transfer of funds (sources) from surplus (saving) units to deficit (investment) units. Figure
Financial System Prof. Landskroner 7 Stages of Efficiency in the Financial System In increasing order of efficiency: F Barter economy - starting point (yardstick), money does not exist, trade in kind no or very limited transfer of sources between economic units Internal financing only- investment of each unit is constrained by its saving implications?
Financial System Prof. Landskroner 8 Stages of Efficiency in the Financial System F External Direct Financing- separation between saving and investment, direct link between surplus (saving) and deficit (investment) economic units introduce financial assets : claim on future income and /or property- primary security Types of assets/securities: u debt- bonds u equity- common stock
Financial System Prof. Landskroner 9 Stages of Efficiency in the Financial System Primary Market: where financial assets are issued u meeting place for issuers of assets (demand for funds) and buyers of new issues (supply of funds) demand and supply of funds meeting place u financial institutions: brokers, underwrites
Financial System Prof. Landskroner 10 Stages of Efficiency in the Financial System F Indirect financing and financial intermediation flow of funds from saving units to investment units is indirect through intermediary who issues its own liability/security: secondary security Include: Com. Banks, insurance comp., pension and mutual funds. F Disintermediation: shift of funds from financial intermediary to direct financing
Financial System Prof. Landskroner 11 F Reasons for existence of FI: Asymmetric information: important aspect of financial market, demander of funds (firm) have better information on firm/project than external suppliers of funds Example: managers have better information about their business than stockholders and bondholders. This leads to : Adverse selection: due to AI, occurs before the transaction takes place: bad customers are the ones most actively seeking to raise funds. Example: bad credit risks most eager to get a loan
Financial System Prof. Landskroner 12 Lenders may decide not to make loans at all though there are good risks in the market- “credit crunch”. Moral Hazard:occurs after the transaction: the borrower may engage in a risky activity that is undesirable to the lender Example: borrower undertakes risky project with possible high return. The lender shares the bad outcome but not the good one “credit crunch”
Financial System Prof. Landskroner 13 Specialness of Financial Intermediaries Benefits- economies of financial intermediation F Information Costs High cost of information collection Savers must monitor firms (investors), failure to do so exposes them to agency costs Savers appoint FI as a delegated monitor on their behalf FI have incentive to collect information and do it at lower costs due to economies of scale
Financial System Prof. Landskroner 14 Specialness of Financial Intermediaries F Transaction Costs Economies of scale in cost Reduced bid-ask spread and transaction cost (commissions), however may have greater price impact
Financial System Prof. Landskroner 15 Specialness of Financial Intermediaries F Liquidity, divisibility and flexibility Secondary securities more liquid Denomination transformation: Small savers vs. large firms F Maturity Transformation Reduce risk through maturity intermediation, reduce maturity mismatch F Interest rate regime transformation Reduce mismatch Fixed vs. variable rate Currency transformation
Financial System Prof. Landskroner 16 F Price Risk Ability to diversify reduces risk Related to size of FI: many failures of small depository institutions in 1980’s, undiversified geographically or in products
Financial System Prof. Landskroner 17 Financial Markets and Instruments F primary vs. secondary market: newly issued financial claims: fund raising exchanging securities previously issued (seasoned):liquidity, price disclosure F money vs. capital: short-term debt (maturity< 1 year) longer term debt and equity F bond vs. stock: debt instrument:contractual agreement to repay principal and interest equity:residual claim on net income and assets of firm; periodic dividends
Financial System Prof. Landskroner 18 Forganized vs. over-the-counter: exchange: central location to conduct trade (NYSE, CBT); clearing house assumes credit risk OTC: dealers in different locations (NASDAQ,Govt. bonds) F spot vs. forward/futures and options settlement and delivery within two days future delivery of assets at specified price and date symmetric vs. asymmetric agreement F foreign exchange spot and futures/forward organized and OTC market
Financial System Prof. Landskroner 19 Market Participants F households: savers??? F nonfinancial business firms: investment F financial institutions : depository institutions (banks): issue financial claims held by final wealth holders; funds to final demanders of funds other financial intermediaries (insurance, pension, investment companies) non-intermediaries: brokers,dealers, underwriters
Financial System Prof. Landskroner 20 Market Participants F US government : Federal Reserve: OMO US Treasury: bills, notes and bonds Government agencies: related (EXIM,FNMA), sponsored- privately owned (“Sallie Mae”) F Local government: municipal, interest exempt from federal taxation F Foreigners: savings or investments? THE END