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Ch-2 Function of Financial Markets: *Channels funds from person or business

without investment opportunities to one who has them.* Improves economic


efficiency. Importance of Financial Markets: Financial markets are critical for-*)
Producing an efficient allocation of capital.*) Improving the well-being of consumers,
allowing them to time their purchases better. Structure of Financial Markets: 1)
Debt Markets: * Short-Term (maturity < 1 year).* Long-Term (maturity > 10 year).*
Intermediate term (maturity in-between).*Represented $41 trillion at the end of
2007.2) Equity Markets: *Pay dividends, in theory forever.*Represents an
ownership claim in the firm.*Total value of all U.S. equity was $19.3 trillion at the
end of 2006.Even though firms dont get any money, per se, from the secondary
market, it serves two important functions: *Provide liquidity, making it easy to buy
and sell the securities of the companies.*Establish a price for the securities.
Function of Financial Intermediaries: Indirect Finance: 1) the intermediary
obtains funds from savers.2) the intermediary then makes loans/investments with
borrowers.3) This process, called financial intermediation, is actually the primary
means of moving funds from lenders to borrowers.4) More important source of
finance than securities markets.5) Needed because of transactions costs, risk
sharing, and asymmetric information. Transactions Costs:1) Financial
intermediaries make profits by reducing transactions costs.2) Reduce transactions
costs by developing expertise and taking advantage of economies of scale. A
financial intermediarys low transaction costs mean that it can provide its
customers with liquidity services, services that make it easier for customers to
conduct transactions- 1) Banks provide depositors with checking accounts that
enable them to pay their bills easily.2) Depositors can earn interest on checking and
savings accounts and yet still convert them into goods and services whenever
necessary. Another benefit made possible by the FIs low transaction costs is that
they can help reduce the exposure of investors to risk, through a process known as
risk sharing 1) FIs create and sell assets with lesser risk to one party in order to buy
assets with greater risk from another party.2) This process is referred to as asset
transformation, because in a sense risky assets are turned into safer assets for
investors.
1) Financial intermediaries also help by providing the means for
individuals and businesses to diversify their asset holdings.2) Low transaction
costs allow them to buy a range of assets, pool them, and then sell rights to the
diversified pool to individuals. Regulation Reason: Increase Investor
Information:1) Asymmetric information in financial markets means One party lacks
crucial information about another party, impacting decision-making.2) The
Securities and Exchange Commission (SEC) requires corporations issuing securities
to disclose certain information about their sales, assets, and earnings to the public
and restricts trading by the largest stockholders in the corporation. The Securities
and Exchange Commission (SEC) requires corporations issuing securities to disclose
certain information about their sales, assets, and earnings to the public and restricts
trading by the largest stockholders in the corporation. Ensure Soundness of
Financial Intermediaries: Providers of funds to financial intermediaries may not
be able to assess whether the institutions holding their funds are sound or not. Such
panics produce large losses for the public and causes serious damage to the
economy. To protect the public and the economy from financial panics, the
government has implemented six types of regulations: 1) Restrictions on Entry.2)
Disclosure.3) Restrictions on Assets and Activities.4) Deposit Insurance.5) Limits on
Competition.6) Restrictions on Interest Rates. Restrictions on Entry: 1) Regulators
have created very tight regulations as to who is allowed to set up a financial

intermediary.2) Individuals or groups that want to establish a financial intermediary,


such as a bank or an insurance company, must obtain a charter from the state or
the federal government. Disclosure: There are stringent reporting requirements for
financial intermediaries 1) their bookkeeping must follow certain strict principles.2)
their books are subject to periodicinspection.3) they must make certain information
available to the public. Restriction on Assets and Activities: There are
restrictions on what financial intermediaries are allowed to do and what assets they
can hold 1) One way of doing this is to restrict the financial intermediary from
engaging in certain risky activities.2) Another way is to restrict financial
intermediaries from holding certain risky assets, or at least from holding a greater
quantity of these risky assets than is prudent. Deposit Insurance: 1)The
government can insure people depositors to a financial intermediary from any
financial loss if the financial intermediary should fail.2) In Bangladesh, a Deposit
Insurance Trust Fund has been created for providing limited protection to a small
depositor in case of winding up of any bank. 3) Commercial Banks have to pay half
yearly insurance premium to Bangladesh Bank based on the insured depositsranging from 0.08-0.10% depending on its CAMEL Rating.Past Limits on
Competition: Although the evidence that unbridled competition among financial
intermediaries promotes failures that will harm the public is extremely weak, it has
not stopped the state and federal governments from imposing many restrictive
regulations. Past Restrictions on Interest Rates: 1) Competition has also been
inhibited by regulations that impose restrictions on interest rates that can be paid
on deposits.2) Later evidence does not seem to support this view, and restrictions
on interest rates have been abolished. Improve Monetary Control:1) Because
banks play a very important role in determining the supply of money much
regulation of these financial intermediaries is intended to improve control over the
money supply.2) Reserve requirements help the Fed exercise more precise control
over themoneysupply.Ch-7 Twelve Federal Reserve banks: A Federal Reserve
Bank is a regional bank of the Federal Reserve System, the central banking system
of the United States. The banks are jointly responsible for implementing the
monetary policy set forth by the Federal Open Market Committee, and are divided
as follows: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago,
St. Louis, Minneapolis, Kansas City, Dallas, San Francisco. Federal open market
committee: The term "monetary policy" refers to the actions undertaken by a
central bank, such as the Federal Reserve, to influence the availability and cost of
money and credit to help promote national economic goals. The Federal Reserve
controls the three tools of monetary policy--open market operations, the discount
rate, and reserve requirements. The Board of Governors of the Federal Reserve
System is responsible for the discount rate and reserve requirements, and the
Federal Open Market Committee is responsible for open market operations. Using
the three tools, the Federal Reserve influences the demand for, and supply of,
balances that depository institutions hold at Federal Reserve Banks and in this way
alters the federal funds rate. Reserve requirements: The reserve requirement is a
central bank regulation employed by most, but not all, of the world's central banks,
that sets the minimum fraction of customer deposits and notes that each
commercial bank must hold as reserves. These required reserves are normally in the
form of cash stored physically in a bank vault or deposits made with a central bank.
Twelve Federal Reserve Banks:1) Each of the twelve districts has a main Federal
Reserve Bank and at least one branch office.2) The banks are quasi-public.**
Owned by member commercial banks in the district.** Member banks elect six

directors, while three directors are appointed by the Board of Governors.** Directors
represent professional bankers, prominent business leaders, and public interests.
Federal Reserve Bank Functions: Monetary Policy: 1) Establish the discount
rate at which member banks may borrow from the Federal Reserve Bank.2)
Determine which bank receive loans. 3) Elect one member to the Federal Advisory
Council. 4) Five of the 12 bank presidents vote in the Federal Open Market
Committee. Board of Governors:1) The seven governors are appointed by the
President, and confirmed by the Senate, for 14-year terms on a rotating schedule.2)
All Board members are members of the FOMC.3) Effectively set the discount rate.4)
Serve in an advisory capacity to the President of the United States, and represent
the U.S. in foreign economic matters. Federal Open Market Committee
Meeting: Important agenda items includes 1) Reports on open market
operations.2) National economic forecasts are presented.3) Discussion of monetary
policy and directives, including views of each member.4) Post-meeting
announcements, as needed. How Independent is the Fed: 1) A broad question of
policy for the Federal Reserve Systems is how free the Fed is from presidential and
congressional pressure in pursuing its goals.2) Instrument Independence: the ability
of the central bank to set monetary policy instruments.3) Goal Independence: the
ability of the central bank to set the goals of monetary policy.4) Evidence suggests
that the Fed is free along both dimensions. The European Central Bank: 1)
Founded in 1999 by a treaty between the European Central Bank (ECB) and the
European System of Central Banks (ESCB).2) The ECB is housed in Frankfurt,
Germany.3) Executive board consists of the president, vice president, and four
members, all serving eight-year terms.4) The policy group consists of the executive
board and governors from the 11 member countries central banks. Difference
between the Fed and the ECB: 1) Budgets of the Fed are controlled by the BOG,
while the National banks that make up the ECB control their own budgets.2)
Monetary operations are conducted at the national level, not directly by the ECB.3)
The ECB is not involved in bank regulation or supervision.4) Only the 18 members
attend the monthly meetings of the ECB, with no staff.5) No voting! All decisions
are made by consensus.6) The ECB holds a press conference following the monthly
meeting, while the Fed typically doesnt. Bank of Canada: 1) Founded in 1934.2)
Directors are appointed by the government for three-year terms, and they appoint a
governor for a seven-year term.3) A governing council is the policy-making group
comparable to the FOMC.4) In 1967, ultimate monetary authority was given to the
government. However, this authority has never been exercised to date. Bank of
England: 1) Founded in 1694.2) The Monetary Policy committee compares with the
U.S. FOMC, consisting of the governor, deputy governors, two other central bank
officials, plus four outside economic experts. 3) The Bank was the least independent
of the central banks, until 1997, when it was granted authority to set
interest rates.4) The government can step in under extreme circumstances, but
has never done so yet. Bank of Japan: 1) Founded in 1882.2) The Policy Board sets
monetary policy, and consists of the governor, two vice governors, and six outside
members. All serve five-year terms.3) Japans Ministry of Finance can exert
authority through its budgetary approval of the Banks non-monetary spending.
Case for Independence:1) The strongest argument for independence is the view
that political pressure will tend to add an inflationary bias to monetary policy. This
stems from short-sighted goals of politicians. For example, in the short-run, high
money growth does lead to lower interest rates. In the long-run, however, this also
leads to higher inflation.2) The notion of the political business cycle stems from the

previous argument **Expansionary monetary policy leads to lower unemployment


and lower interest ratesa good idea just before elections.**Post-election, this
policy leads to higher inflation, and therefore, higher interest rateseffects that
hopefully disappear (or are forgotten) by the next election.
Case Against
Independence: 1) Some view Fed independence as undemocratican elite
group controlling an important aspect of the economy but accountable in few
ways.2) Indeed, we hold the President and Congress accountable for the state of the
economy, yet they have little control over one of the most important tools to direct
the economy.3) Further, the Fed has not always been successful in the past. It has
made mistakes during the Great Depression and inflationary periods in the 1960s
and 1970s.4) Lastly, the Fed can succumb to political pressure regardless of any
state of independence. This pressure may be worse with few checks and balances
in place. Central Bank Independence and Macroeconomic Performance: 1)
Empirical work suggests that countries with the most independent central banks do
the best job controlling inflation.2) Evidence also shows that this is achieved without
negative impacts on the real economy. Ch-15 Facts of Financial Structure: 1)
Stocks are not the most important source of external financing for businesses.2)
Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations.3) Financial intermediaries, particularly banks,
are the most important source of external funds used to finance businesses.4) The
financial system is among the most heavily regulated sectors of economy.5) Only
large, well-established corporations have easy access to securities markets to
finance their activities.6) Collateral is a prevalent feature of debt contracts for both
households and businesses. Transaction cost: A fee charged by a financial
intermediary such as a bank, broker, or underwriter. Example: communication
charges, legal fees, informational cost of finding the price, quality and durability,
etc. In sum, transaction costs freeze many small savers and borrowers out of direct
involvement with financial markets. Financial intermediaries make profits by
reducing transactions costs1) Take advantage of economies of scale (example:
mutual funds).2) Develop expertise to lower transaction costs. Information
Asymmetries and Information Costs: Asymmetric information is a serious
hindrance to the operation of financial markets. It poses two important obstacles to
the smooth flow of funds from savers to investors 1) adverse selection arises
before the transaction occurs.* Lenders need to know how to distinguish good credit
risks from bad.2) Moral hazard occurs after the transaction.* Will borrowers use
the money as they claim?.Adverse Selection: 1) Used car buyers cant tell good
from bad cars.2) Buyers will at most pay an average expected value of good and
bad cars.3) Sellers know if they have a good car, and wont accept less than the
true value.4) Then the market has only the bad cars. Solving the Adverse
Selection Problem: From a social perspective, the problems of adverse selection
are not good **Some companies will pass up good investments.**Economy will not
grow as rapidly as it could. We must find ways for investors and lenders to
distinguish well-run firms from poorly run firms. Collateral and Net Worth: 1)
Another solution for adverse selection is to make sure lenders are compensated
even if borrowers default.*If a loan is insured in some way, then the borrower isnt a
bad credit risk.2) Collateral is something of value pledged by a borrower to the
lender in the event of the borrowers default.*It is said to back or secure a loan. Ex:
Cars, houses.3) Collateral is very prevalent because adverse selection is less of a
concern - the lender gets something of equal or greater value if the borrower
defaults.4) Unsecured loans, like credit cards, are loans made without

collateral.*Because of this they generally have very high interest rates. The net
worth is the owners stake in a firm - the value of the firms assets minus the value
of its liabilities.* Net worth serves the same purpose as collateral.* If a firm defaults
on a loan, the lender can make a claim against the firms net worth.* The
importance of net worth in reducing adverse selection is the reason owners of new
businesses have so much difficulty borrowing money.* Most small business owners
must put up their homes and other property as collateral for their business loans.
Moral Hazard: Problem and Solutions: 1) The phrase moral hazard originated
when economists who were studying insurance noted that an insurance policy
changes the behavior of the person who is insured.2) Moral hazard arises when we
cannot observe peoples actions and therefore cannot judge whether a poor
outcome was intentional or just a result of bad luck.3) A second information
asymmetry arises because the borrower knows more than the lender about the way
borrowed funds will be used and the effort that will go into a project.4) Moral hazard
affects both equity and bond financing. Moral Hazard in Equity Finance:1) It is
more likely that the manager will use the funds in a way that is most advantageous
to them, not you.2) The separation of your ownership from their control creates
what is called a principal-agent problem. Moral Hazard in Debt Finance:1) When
the managers are the owners, moral hazard in equity finance disappears.2) Because
debt contracts allow owners to keep all the profits in excess of the loan payments,
they encourage risk taking.3) Lenders need to find ways to make sure borrowers
dont take too many risks.