1. An Overview of the Financial System Chapter 2

2. 2 Function of Financial Markets To bring lenders and borrowers together to make both of them better-off. To bring lenders and borrowers together to make both of them better-off. Efficient allocation of capital, which increases production Efficient allocation of capital, which increases production Improve the well-being of consumers by allowing them to time purchases better Improve the well-being of consumers by allowing them to time purchases better

3. 3 Flows of Funds Through the Financial System

4. 4 Structure of Financial Markets Debt and Equity Markets Debt and Equity Markets Primary and Secondary Markets (D&E) Primary and Secondary Markets (D&E) Investment Banks underwrite securities in primary markets Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets Brokers and dealers work in secondary markets Exchanges (D&E) Exchanges (D&E) NYSE, NYBE, CBOT NYSE, NYBE, CBOT Over-the-Counter (OTC) Markets Over-the-Counter (OTC) Markets FX, Fed funds FX, Fed funds Money and Capital Markets Money and Capital Markets Money markets deal in short-term debt instruments Money markets deal in short-term debt instruments Capital markets deal in longer-term debt and equity instruments Capital markets deal in longer-term debt and equity instruments

5. 5 Principal Money Market Instruments

6. 6 Principal Capital Market Instruments

7. 7 Internationalization of Financial Markets Foreign Bonds: sold in a foreign country and denominated in that country’s currency Foreign Bonds: sold in a foreign country and denominated in that country’s currency Eurobond: bond denominated in a currency other than that of the country in which it is sold Eurobond: bond denominated in a currency other than that of the country in which it is sold Eurocurrencies: foreign currencies deposited in banks outside the home country Eurocurrencies: foreign currencies deposited in banks outside the home country Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

8. 8 World Stock Markets

9. 9 Function of Financial Intermediaries: Indirect Finance Lower transaction costs (time and money spent in carrying out financial transactions). Lower transaction costs (time and money spent in carrying out financial transactions). Economies of scale Economies of scale Liquidity services (checking account) Liquidity services (checking account) Reduce the exposure of investors to risk Reduce the exposure of investors to risk Risk Sharing (Asset Transformation: packaging risky assets into safer ones for investors) Risk Sharing (Asset Transformation: packaging risky assets into safer ones for investors) Diversification by pooling and issuing new assets Diversification by pooling and issuing new assets

10. 10 Function of Financial Intermediaries: Indirect Finance Deal with asymmetric information problems Deal with asymmetric information problems (before the transaction) Adverse Selection: try to avoid selecting the risky borrower. (before the transaction) Adverse Selection: try to avoid selecting the risky borrower. Gather information about potential borrower. Gather information about potential borrower. (after the transaction) Moral Hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan. (after the transaction) Moral Hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan. Sign a contract with restrictive covenants. Sign a contract with restrictive covenants.

11. 11 Primary Assets and Liabilities of Financial Intermediaries

12. 12 Principal Financial Intermediaries and Value of Their Assets

13. 13 Regulation of the Financial System To increase the information available to investors To increase the information available to investors To ensure the soundness of financial intermediaries To ensure the soundness of financial intermediaries A report on upcoming regulation: http://www.bos.frb.org/economic/conf/conf54/pa pers/blinder.pdf A report on upcoming regulation: http://www.bos.frb.org/economic/conf/conf54/pa pers/blinder.pdf http://www.bos.frb.org/economic/conf/conf54/pa pers/blinder.pdf http://www.bos.frb.org/economic/conf/conf54/pa pers/blinder.pdf

14. 14 Increasing Information Reduce adverse selection and moral hazard problems Reduce adverse selection and moral hazard problems Reduce insider trading (SEC). Reduce insider trading (SEC).

15. 15 Ensuring the Soundness of Intermediaries Restrictions on entry (chartering process). Restrictions on entry (chartering process). Disclosure of information. Disclosure of information. Restrictions on Assets and Activities (control holding of risky assets). Restrictions on Assets and Activities (control holding of risky assets). Deposit Insurance (avoid bank runs). Deposit Insurance (avoid bank runs). Limits on Competition (mostly in the past): Limits on Competition (mostly in the past): Branching Branching Restrictions on Interest Rates Restrictions on Interest Rates

16. 16 Principal Regulatory Agencies of the U.S. Financial System