1. Financial Markets: International Context: MN10403
Semester 2, 2009/10
Lecturer: Richard Fairchild.

2. Introduction to the Financial System
The components of the Financial System.
What a Financial System Does.
Financial Intermediaries.
The key features of financial markets.
The users of the system, and the benefits they receive.

3. Financial System A set of markets.
Individuals and institutions trading in those markets.
Supervisory bodies responsible for regulation (eg FSA).
End-users: People and Firms wishing to borrow and lend.

4. Borrowers and Lenders Deal directly with each other.
Trade in organised markets =>
Lenders buy liabilities issued by borrowers.
Newly issued liability: issuer (borrower) receives funds directly from lender.
Or a lender will buy an existing liability from another lender => secondary transaction.

5. Intermediaries
Alternatively, borrowers and lenders may trade with each other through institutions or intermediaries.
Lender has a non-tradable asset (eg bank or building society account)
Intermediaries create liabilities: loans to borrowers
Intermediaries also trade in markets: issuing and buying securities

6. Function of financial system
Helping funds flow from lenders to borrowers.
Other functions:
Means of making payments.
Insuring risk-averse individuals.
Cheap and efficient way for investors to re-arrange their portfolios.

7. Financial System and economic growth
Efficient borrowing and lending makes it easier for firms to raise finance and invest in economic growth.
Efficient payment system encourages trade and exchange.
Quantity of money in circulation => aggregate demand (to be examined later).

8. Increasing complexity in financial decision-making.
Lots of new financial products (financial innovation).
=>Increased asymmetric information and moral hazard.
=>Increased number of scandals
=> Increase in Financial Regulation.

9. Financial Institutions as firms.
Financial Institutions can be analysed using Economist’s “theory of the firm.”
Productive firm using inputs to produce outputs.
Financial firm borrows from customers, and lends the money out: they create liquidity.
Assumption: profit-maximisers: charging interest to borrowers higher than that paid to lenders.

10. Financial Institutions as Intermediaries.
Intermediation: Go-between between borrowers and lenders.
Surplus sectors or units => deficit sectors or units
Financial Intermediaries Create assets for savers/liabilities for borrowers more efficiently than if the parties had to deal with each other directly: eg mortgage on a house.

11. Creation of assets and liabilities
Financial Intermediation =>
More assets and liabilities than under direct lending alone.
And lending and borrowing have become easier => lower transactions costs of lending and borrowing.
Financial intermediaries are able to manage risk more efficiently than individuals.

12. Economics concept
For any given interest rate, the equilibrium level of borrowing and lending will be higher with financial intermedation.

13. Liquidity
Speed and convenience with which an asset can be converted into money of a certain value.
Under financial intermediation, lenders can recall their loan more quickly and with greater certainty.
Liquidity: 3 dimensions: time, risk, and cost.

14. Maturity transformation
Intermediaries must satisfy conflicting needs of borrowers and lenders.
Maturity transformation.
Accept deposits of a given maturity, transform them into loans of a much different maturity.
Eg: building societies: accept deposits of a short maturity (liability): lend them to house buyers up to 25 years (asset).

15. Maturity Transformation
How can financial intermediaries do this safely (ie lending money on for a long period, when the lenders may want their money back at short notice)?
Size.
=> large number of depositors => statistically, net flows will be more stable.

16. Risk Transformation.
Reduction in risk achieved by diversification of lending and by screening of borrowers.
Risk reduction.
Default risk.
Capital risk.
Income risk.