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