1 Chapter 2 An Overview of the Financial System

2 Function of Financial Markets  Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds  Promotes economic efficiency by producing an efficient allocation of capital, which increases production  Directly improve the well-being of consumers by allowing them to time purchases better. Allow intertemporal substitution of income.

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4 Structure of Financial Markets  Debt and Equity Markets. Bonds are debt, stocks are equity.  Primary and Secondary Markets Investment Banks “underwrite” securities in primary markets: they guarantee a minimum price for IPOs. Firms collect funds ONLY in the primary market (IPOs). Not in the secondary market. ISE is a secondary market. A secondary market is where a security is resold to second, third and more times. Secondary market stock prices determine the amount of funds that the firm can raise in the primary market. Also determines the “net worth”, i.e. total value of the firm. Securities that do not have a secondary market are less liquid, therefore more difficult to sell in the primary market. Presence of a secondary market makes it easier to raise funds….

Structure of Financial Markets  Organized Exchanges and Over-the-Counter (OTC) Markets  Money and Capital Markets Money markets deal in short-term debt instruments. Securities with maturity less than a year. Ex: Repo and reverse-repo market. Short-term liquidity is traded in money mkts. Trade Volume is higher in money markets. Examples:  CBRT Interbank Money Market  ISE REPO market Capital markets deal in longer-term debt and equity instruments. Bonds with maturity longer than a year and stocks are capital mkts. “Long-term securities” refer to longer than 10 years. 5

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8 Internationalization of Financial Markets  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 Turkish govt. bonds denominated in TRL and traded in London, NY, Tokyo.  Eurocurrencies—currencies deposited in banks outside of the country they were printed Eurodollars—U.S. dollars deposited in other countries than US.  World Stock Markets

9 Function of Financial Intermediaries: Indirect Finance  Lower transaction costs Economies of scale: pooling of funds helps reduce transaction costs of diversification. It is difficult to diversify for a small investor: transaction costs per dollar are large. Ex: lawyer fees for a credit contract. Banks pool contracts wholesale: transaction costs per dollar are small. Liquidity services. Banks collect low-return liquid liabilities (deposits) and transform them into high-return illiquid assets. They take “maturity mismatch risk”. Firms and households need banks because they might need liquidity at uncertain times in the future. This is like insurance. For example, if you have TL, you could buy a house with high return, but what if you might get ill next month and need money?  Also, customers can use cards and not carry cash.

Function of Financial Intermediaries: Indirect Finance  Reduce Risk Risk Sharing. Depositors share the risk of selling their assets at a loss. For example, if you have TL, you could buy a house with high return, but what if you might get ill next month and need money? Banks reduce risk, but on the other hand they share part of the profit as a compensation for taking the risk. Banks can diversify easier than individuals b/c they pool funds and specialize 10

11 Function of Financial Intermediaries: Indirect Finance  Asymmetric Information Adverse Selection (before the transaction)— more risky borrowers are more likely to apply for loans Moral Hazard (after the transaction)— borrower engages in actions that make it less likely to repay the loan (i.e. borrower might take too much risk, unknown to the lender)

12 Types Of Financial İntermediaries  Depository Institutions Commercial Banks, Savings & Loan Associations, Credit Unions (Kredi Kooperatifleri).  Contractual Savings Institutions Life, Fire, Casualty and Car Insurance Private Pension Funds (Ozel Emeklilik), Govt. Social Security System (retirement funds) (SGK)  Investment Intermediaries: Inv. Banks,

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15 Regulation and Monitoring of the Financial System  Increase the information available to investors in securities markets: Reduce adverse selection and moral hazard problems Reduce insider trading. İncrease control of the investors-shareholders on the company’s managers: “principal-agent problem.” SEC in US, Capital Markets Board (SPK) in TR.

Regulation and Monitoring of the Financial System  Ensure the soundness of financial intermediaries: Restrictions on entry (BRSA, SDIF, etc.) Disclosure, transparency, regular reporting of balance sheet Various minimum reserve requirements for short, long, domestic, foreign deposits and credits Restrictions on Assets and Activities Deposit Insurance Limits on Competition: Restrictions (caps) on Interest Rates 16

17 Regulatory Institutions in Turkey  Banking Regulation and Supervision Agency, (Bankacılık Düzenleme ve Denetleme Kurulu BDDK,  Capital Markets Board (Sermaye Piyasasi Kurulu  Central Bank of the Republic of Turkey TCMB (  Savings Deposit Insurance Fund (Tasarruf Mevduatı Sigorta Fonu

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