An introduction to financial institutions, investments & Management Basic Finance The Role of Financial Markets and Financial Institutions 2 An introduction to financial institutions, investments & Management Eleventh Edition

The Role of Money Medium of exchange Liquidity

Measure of the Money Supply coins, currency and demand deposits M-2 M-1 plus savings accounts and small CDs M-2 is not affected by shifting funds between checking and savings accounts

Money Supply

The Role of Interest Rates Allocate scarce credit Short-term rates / Money market Long-term rates / Capital market

Term Structure of Interest Rates

Structure of Yields Yield curve Generally long-term debt implies higher rates (positively sloped yield curve)

Positively Sloped Yield Curve Time and Yields Positively Sloped Yield Curve

Negatively Sloped Yield Curve Time and Yields Negatively Sloped Yield Curve

Supply and Demand

Determinants of Interest Rates Preference for shorter term Marketability Risk Expectations of future rates

from Savers to Business The Transfer of Funds from Savers to Business Income that is saved is subsequently invested The process of investing creates financial claims The direct and indirect transfers

Banks Balance Sheet Equity Assets 900 Loans Deposits Liabilities Bank R.E. 1,000 Equity Assets 900 Loans Deposits 100 Reserves Cash Banks Balance Sheet Liabilities Assets - Liabilities = Equity Demand Deposits

Income Statement Net Income 8 Int. Income 90 Int Expense 50 Salaries 10 Upkeep 20 Pre Tax 10 Tax (20%) 2 Net Income 8

Banks Balance Sheet Assets - Liabilities = Equity Balance Sheet 12/31 Bank R.E. 1,000 Equity Assets 900 Loans Deposits 100 Reserves Cash Liabilities Demand Deposits Banks Balance Sheet Assets - Liabilities = Equity 1,008 190 Reserves Balance Sheet 1/1 Balance Sheet 12/31

The Direct Transfer The saver directly receives a claim (debt or equity) on the issuer The issuer receives the funds

through a Financial Intermediary The Indirect Transfer through a Financial Intermediary The saver receives a claim on the financial intermediary The financial intermediary receives a claim on the ultimate user of the funds

through a Financial Intermediary The Indirect Transfer through a Financial Intermediary Each financial intermediary creates claims on itself and transfers funds from savers to Firms Governments People who need funds

The Variety of Financial Intermediaries Commercial banks Savings and loan associations Mutual savings banks Credit unions Life insurance companies Pension plans Money market mutual funds

Commercial Banks Important source of loans Deposits are banks’ primary sources of funds Demand deposits Savings accounts Certificates of deposit Small equity base

Commercial Banks’ Assets

Commercial Banks’ Liabilities and Equity

Regulation of Banks and Thrift Institutions Regulation by the Federal Reserve Required reserves against deposit liabilities Excess reserves Secondary reserves

Federal Deposit Insurance Corporation (FDIC) Insures accounts up to specified limit Provides another source of regulation of banks Adds stability to the banking system

Life Insurance Companies and Pension Plans Alternatives for savers and borrowers to banks and thrift institutions May serve as financial intermediaries

Money Market Mutual Funds Specialized investment company Make only short-term investments Acquire money market instruments Shares in money funds have become popular investments

Money Market Instruments Negotiable CDs U.S. treasury bills Commercial paper

Money Market Instruments Repurchase agreements (repos) Bankers’ acceptances Tax (or revenue) anticipation notes Eurodollar CDs

Money Market Instruments These debt instruments are Safe Liquid Offer competitive short-term rates