1. Course FINA 4000 Financial Institutions and Markets
Professor Ralph E. Steuer
Terry College of Business
Fall 2015

2. Purpose To understand an economy’s financial system
how it finances the economy
how it oversees the economy’s money supply
much about the financial issues we read about in the paper every day
Does this by facilitating the movement of money from where it is in excess to where it is most needed (to help economy prosper). Also, to understand

3. Two Parts Financial institutions Financial markets
…and then there is Money

4. 1. Financial Institutions
commercial banks, mortgage lenders, investment banks, central bank, government sponsored enterprises, mutual fund companies, insurance companies, …
Other than for central bank, goal is to bring money in at a low rate and deploy it at a higher rate.
Cover costs and make profits mostly by means
of the interest rate spread.

5. 2. Financial Markets
Bond market, commercial paper market, US Treasuries market, money market, Fed Funds market, credit default swaps market, New York Stock Exchange, primary market, secondary market,…
Venues where people buy and sell financial claims
(securities or financial instruments). Commissions and fees typically cover costs and provide profits for the markets.
Cannot have an advanced economy as in the US, Canada, Japan, Germany,… without an efficient financial system.

6. Financial Claims
A financial claim is a claim on the issuer’s future income or assets.
With financial claims, there is an issuer and a holder.
While issuer remains the same, the holder may change many times.
Legislation and regulation give financial claims strength – makes them legally enforceable.

7. Best Known Financial Instruments
A bond is a long-term (one or more years) debt instrument that obligates the issuer to make specific payments at specific times to the holder.
A stock is a claim on the income and assets of a corporation.
While stocks are the most widely followed, world of debt instruments is much larger. Course is mostly about debt instruments.

8. Money Markets vs. Capital Markets
Money Markets Capital Markets
< 1 year ≥ 1 year
corporate
stock
short-term
debt
debt more
than one year
yellow is this course

9. Money Markets vs. Capital Markets (US)
Money Markets Capital Markets
$8 trillion* $60 trillion*
corporate
stock
short term debt
debt more than one year
*roughly

10. How Big is $1 billion? Annual revenue of UGA is roughly $2 billion.
Annual Revenue / Marketcap
Citigroup / 177B
Costco / 63B
Apple / 701B
Exxon Mobil / 347B
Ford / 60B
Alcoa / 13B
General Electric / 264B

11. How Big is $1 trillion?

12. $1 million

13. $100 million

14. $1 billion

15. $1 trillion

16. Some Comments about Money
Although amount of cash outstanding is growing, usage of cash is in decline.
Cash in domestic use down to ≈2.5% of GDP (GDP is $18 trillion).
$1 bill lasts ≈5 years, costs 10 cents to make.
While US Mint not producing as many 1’s, 5’s and 10’s, demand for 100’s has exploded.
Total US currency outstanding $1.4 trillion.
80% in form of 100’s, most held by foreigners.
“legal tender” means only lenders are required to accept.

17. Economic Units
Economic units (i.e., units that have a budget) fall into three categories
Households
Business firms
Governments
For any period, an economic unit’s budget will be in a
Balanced position
Surplus position
Deficit position

18. SSUs and DSUs
Surplus spending units (SSUs) have income for the period that exceeds expenditures, results in savings.
Deficit spending units (DSUs) have spending needs for the period that exceed money they have on hand.
DSUs issue financial claims to obtain the funds they need.
SSUs only part with their money if the characteristics of the financial claims they receive are to their satisfaction.

19. Challenge of Financial System
Task of matching up DSUs with SSUs.
Direct financing -- one end of financing continuum. Ideally one’s first choice. No middleman. Often better this way if possible.
Indirect financing – other end of continuum. Involves use of an intermediary. Most financing is done in this way because direct financing often not practical.

20. Direct Financing
SSU
Households
Business firms
Governments
DSU
Households
Business firms
Governments
Occurs when an SSU purchases a financial claim directly from a DSU.
Example: Borrowing money from parents to start a business.

21. Difficulties of Direct Financing
SSU
Households
Business firms
Governments
DSU
Households
Business firms
Governments
SSU and DSU must be able to find each other
To work, characteristics of financial claim must be agreeable to both parties
denomination
maturity
risk
liquidity of financial claim (i.e., marketability)
any other important characteristics
Any problem here could be a deal breaker.

22. Direct Financing Balance Sheets
SSU
DSU
Assets Liabilities
Assets Liabilities
A financial claim is an asset to its holder, and a liability to its issuer.

23. Liquidity One has liquidity if one has:
Cash or something that can be quickly converted to cash without having to sacrifice face value.
Liquid investments
Illiquid investments

24. Importance of Liquidity (Marketability)
Importance of being able to resell financial claim. Suppose:
SSU has $2 million
to lend for 3 yrs.
a DSU needs $2
million for 20 yrs.
denomination, okay
risk, okay
maturity, not okay.
Problem solved if there is marketability (SSU able to sell financial claim for fair price after 3 yrs)
Being able to achieve liquidity, for example, by marketability always helps a lot. Good to have well functioning markets.

25. Indirect Financing
SSU
Households
Business firms
Governments
DSU
Households
Business firms
Governments
financial
intermediary
Indirect financing is when money flows from an SSU through an intermediary to a DSU. DSU and SSU probably never know each other.
An intermediary transforms the characteristics of financial claims.

26. Transformation of Claims
Financial intermediation means selling financial claims to SSUs with one set of characteristics, and buying financial claims from DSUs with another set of characteristics.
Financial intermediaries specialize in this for SSUs and DSUs to get money moved.

27. Indirect Financing Balance Sheets
SSU
DSU
Assets Liabilities
Assets Liabilities
Financial Intermediary
Assets Liabilities

28. Indirect Financing
Because an SSU’s claim is against the financial intermediary rather than the DSU, the financing from DSU to SSU is indirect.
Consider a commercial bank. Issues financial claims to SSUs in the form of checking accounts, savings accounts, certificates of deposit,…
Then with the money, buys financial claims from DSUs.
Whereas SSUs can always achieve liquidity with financial claims from an intermediary, financial claims held by a financial intermediary from DSUs are typically not liquid.

29. Advantages of Intermediaries
Economies of scale due to specialization and ability to spread out fixed costs.
Reduced costs in search for credit information (only done needs to be done once per DSU).
Banks, for instance, often privy to more than what comes up in a normal credit check due to involvement in the community (helps bank make sounder loans)

30. 11 Types of Financial Intermediaries
Total assets of financial intermediaries ≈ 3 × GDP

31. 4 Categories of Financial Intermedaries
Assets
Liabilities

32. Intermediation Services
Denomination Divisibility. Pool the savings of many small SSUs into large investments.
Currency Conversion. Buy and sell financial claims denominated in various currencies.
Maturity Flexibility. Maturities, from 1 day to 30 years, to both DSUs and SSUs.
Credit Risk (probability money not paid back as promised) Diversification. Enables SSUs to not put all of one’s eggs in one basket.
Liquidity. SSU savings at an intermediary are usually immediately or quickly convertible into cash – generally accept low rates for the privilege.

33. Risks Faced by Financial Institutions
Credit risk
Interest rate risk – security price fluctuations as a result of changes in interest rates
Liquidity risk
Foreign exchange risk – if deal in foreign currencies or have investments abroad
Political risk

34. Brokers vs. Dealers
Brokers do not take a position. Simply specialize in matching buyers with sellers. Make money by charging a fixed or percentage fee.
Dealers “make markets” by buying at any time for inventory, and selling at any time from inventory. Make money by buying low and selling high.

35. OTC
When people say over-the-counter (OTC), mean going through a dealer. OTC markets generally have no central location like organized exchanges. Vast majority of debt instrument markets are OTC.

36. Primary Market vs. Secondary Market
Primary market is a financial market where new issues are sold to initial buyers.
Secondary market is where people can buy and sell already existing financial claims.
People are more likely to buy a financial claim in the primary market if there is a secondary market.
Provides liquidity (ability to convert to cash) for the financial claim.

37. 2014 GDP (nominal) and Populations
country trillions millions rank
United States (3)
China , (1)
Japan (10)
Germany (16)
UK (22)
France (20)
Brazil (5)
Italy (23)
Russia (9)
India , (2)
Canada (37)
Source: CIA
Nominal determined by currency exchange rates.

38. PPP is Purchasing Power Parity (takes into account local prices).
2014 GDP (PPP)
country trillions millions rank
China
United States
India
Japan
Germany
Russia
Brazil
France
Indonesia (4) UK
Mexico (11)
Source: CIA
PPP is Purchasing Power Parity (takes into account local prices).

39. GDP per Capita PPP (Source: CIA)1
 Qatar
102,100
2013 est. 2
 Luxembourg
92,400
2014 est. 3
 Lichtenstein
89,400
2009 est. -
 Macau
88,700
 Bermuda
86,000
2011 est.
 Isle of Man
83,100
2007 est. 4
 Singapore
81,300 5
 Monaco
78,700 6
Brunei
77,700 7
Kuwait
71,000
 St Maartin
66,800 8
 Norway
65,900 9
 U.A.E
65,000
 Jersey
57,000
2005 est.
 Falkland Is.
55,400
2002 est. 10
 Switzerland
55,200
 Hong Kong 11
 San Marino
55,000 12
 United States
54,800

40. Working Numbers & Ratios
US pop 320 million
UGA revenues billion
China pop billion
US student loan debt billion
Money Market trillion
Capital markets trillion
US GDP trillion
Total US national debt 18 trillion
Equity portion of capital market 1/3
Assets held in fin intermediaries 3*GDP

41. Deposits at FDIC-insured Institutions
Standard insurance amount is $250,000 per depositor/per institution is as follows:
Single Accounts (owned by one person) $250,000 per owner
Joint Accounts (two or more persons) $250,000 per co-owner
Revocable Trust Accounts $250,000 per owner per beneficiary up to 5*
What happens if a married couple has $1 million to deposit? Can do at one bank, but must open 3 accounts.
Can go over $1 million, but that involves accounts with non-spousal beneficiaries. Probably best to open additional accounts at additional institutions.
*can do more than 5 but rules get more strict.

42. Comments
Credit unions are non-profit, cooperative organizations. They take in money via checking and savings accounts with the idea of making consumer loans to members.
Casualty vs. life insurance companies: Since casualty claims less predictable, a greater proportion of a casualty insurance company’s investments must be in highly marketable securities.
Thrift institutions also known as “Savings and Loans.” Like a bank, but chartered under different set of rules. Still some around, but not as many since the S&L crisis Mopping up S&L crisis cost Government $150 billion.

43. Comments (con’t)
Since inflow and outflows of pension funds can be predicted with a considerable accuracy, can invest (like life insurance companies) in very long-term projects (e.g., private equity, hedge funds, timber, venture capital).
Money Market Mutual Funds: Uninsured substitutes for deposit accounts. They usually buy money market instruments. Historically, SSUs have earned slightly higher rates of interest, but about same at the moment.
Private equity: idea is to buy all shares of a company, improve
company, sell later (maybe 5 to 7 years) at a higher price

44. Disintermediation
when SSUs take money out of financial intermediaries to invest in financial claims via direct financing.