Chapter 2

Overview of Market Participants and Financial Innovation

Players

• Governments
– Federal government
– Government-sponsored enterprises
– State governments
– Local governments
• Nonfinancial Corporations

– Ford

– General Electric

• Depository Institutions

– Commercial banks

– Savings and loan associations

– Savings banks

– Credit unions

• Insurance Companies
Life Insurance
Property and Casualty Insurance
• Asset Management Firms
– Pension Funds
– Regulated investment companies
– Exchange-traded funds
– Hedge funds
– Real estate investment trusts
– Collateralized debt obligations
– Structured finance operating companies
• Investment Banks

– Assistance in obtaining funds

– For investors, act as broker and dealer

– May be a subsidiary of

• Commercial banks

• Insurance companies

• Nonprofit Organizations

– Classified as

• Commercial enterprises

• Not-for-profit organizations

• Foundations

• endowments

• Foreign Investors
 – Individuals

– Nonfinancial businesses

– Financial entities

– Supranational institutions

• Two or more central governments through treaties

Role of Financial Intermediaries

• Transform financial assets and re-constitute them into different types of assets.
• Exchange financial assets on behalf of customers.
• Exchange financial assets for their own account.
• Assist in the creation of financial assets for their customers and then sell those financial
assets to other market participants.

• Provide investment advice to other market participants.

• Manage the portfolios of other market participants.

• Maturity Intermediation

• commercial bank in essence transforms a longer-term asset into a shorter-term asset

• Risk Reduction via Diversification

• transforming more risky assets into less risky ones

• Reducing the Costs of Contracting and Information Processing

• Cost of the acquisition and analysis of the information about the financial asset and
its issuer

• Cost of writing the loan contract

• Cost of enforcing the contract terms

• Providing a Payment Mechanism

• Credit cards, debit cards, electronic transfers

Overview of Asset/Liability Management for Financial Institutions

• Type I Liabilities
– Guaranteed Investment Contracts, Bonds
• Type II Liabilities
– Life Insurance Policy
• Type III Liabilities

– Certificates of Deposits (CD’s)

• Type IV Liabilities

– Property and Casualty Insurance

Regulation of Financial markets

• Justification for Regulation

– the market, left to itself, will not produce its particular goods or services in an efficient
manner and at the lowest possible cost
– The regulatory structure in the United States is largely the result of financial crises
that have occurred at various times
• Forms of Federal Government Regulation of Financial Market
 – Disclosure Regulation

– Financial Activity Regulation

– Financial Institution Regulation

– Foreign Participant Regulation

Financial Innovation

• Market-broadening instruments
– increase the liquidity of markets and the availability of funds
• Risk-management instruments
– reallocate financial risks
• Arbitraging instruments and processes
– take advantage of differences in costs and returns between markets
• Price-risk-transferring innovations

• Credit-risk-transferring instruments

• Liquidity-generating innovations

• Credit-generating instruments

• Equity-generating instruments

Motivation for Financial Innovation

– Increased volatility of interest rates, inflation, equity prices, and exchange rates

– Advances in computer and telecommunication technologies

– Greater sophistication and educational training among professional market

participants

– Financial intermediary competition

– Incentives to get around existing regulation and tax laws

– Changing global patterns of financial wealth

Securitization and Financial Innovation

• securitization is a process by which a financial relationship is converted into a financial

transaction
– Loans
– Stocks
– Corporate bonds