Chapter 1: Introduction

1.1. Overview of Financial System

 Suppose you want to start a business manufacturing a household cleaning robot,

but you have no funds.
 At the same time, Mr. X has money he wishes to invest for his retirement.
 If the two of you could get together, perhaps both of your needs can be met. But
how does that happen?

 As simple as this example is, it highlights the importance of financial markets and
financial intermediaries in our economy.
 We need to acquire an understanding of their general structure and operation
before we can appreciate their role in our economy.
 Direct Finance

• In a simple economy we have firms and households

• Households are the savers and firms are the investors.

• The mechanism by which households save is by demanding securities from

firms

• The mechanism by which firms invest is by supplying securities to

households.

• These securities are claims to the assets of the firm

 Simple model of direct finance

FUNDS LENT

HOUSEHOLDS FIRMS

FINANCIAL CLAIMS
 Direct Finance

• Lending and borrowing can occur as a result of direct transacting.

• But there are costs associated with direct finance.

• Search costs – searching for potential transactors

• Verification costs – costs in evaluating investment proposals.

• Monitoring costs – costs of monitoring the actions of borrowing.

• Enforcement costs – costs of enforcing contracts

 Efficient Direct Finance

• Some of these costs can be reduced through the organisation of a market.

• Direct financing requires the existence of an efficient securities market.

• However not all costs are minimised through a securities market.

• An additional issue is that the maturity period of finance for the firm is long
term.

• The maturity period of the household is mostly short term.

• The maturity mismatch of households and firms provide the incentive for
the development of intermediated finance.
 Indirect Finance

• The mechanism whereby surplus funds from ultimate savers are

matched to deficits incurred by ultimate borrowers

• The process by which ultimate savers are matched to ultimate

borrowers.

• Saving = Income – Consumption

• Typically decisions to save are made independently of decisions to

invest.
 Indirect (Intermediated) Finance

Funds Lent

HOUSEHOLDS Financial
Intermediary FIRMS

Financial Claims
 Who are the savers and borrowers?

• Savers or lenders are households, firms, governments and foreigners

• Investors or borrowers are households, firms, governments and foreigners.

• Savers can hold corporate securities (shares), government securities

(bonds), currency, bank deposits, foreign currency assets

• Borrowers can sell shares, sell bonds, issue currency, take bank loans, issue
foreign currency liabilities
 General Flow of Funds

Indirect
Finance

Financial
Intermediary

Borrowers – Spenders
Lenders – Savers
1. Firms
1. Households
FINANCIAL 2. Government
2. Firms MARKET 3. Households
3. Government
Foreigners
4. Foreigners

Direct Finance
 1.2. Financial Institutions

Why do financial intermediaries exist?

Transactions costs
• search costs to find borrower & lender
• contract costs
• Monitoring costs
economies of scale
Risk sharing
 intermediaries are experts at bearing risk.
Managing risk:
The risk a bank facing can be classified into three broad
categories:
• 1 credit risk that comes into play because information is not
symmetrically distributed among all economic agents (adverse selection
and moral hazard).
• liquidity risk is due to the fact that loans are illiquid while deposits are
liquid and can be withdrawn.
• interest rate risk comes from different maturity between bank.
Asset transformation-Liquidity insurance.
short-term to long-term
illiquid to liquid
 The idea is that depository institutions provide a “pool of liquidity” and
therefore insurance against idiosyncratic shocks that after their
consumption needs.
Information sharing coalitions. Adverse selection in financial market
generate scale economies in the borrowing-lending activity which allows to
interpret FI as information sharing coalitions (Lealand-Pyle (1977)).
Financial Intermediation as Delegated Monitoring. Banks perform
project monitoring on behalf of small investors. Why cannot individuals
perform the same job? Where the comparative advantage of banks come
from?
scale economies in monitoring, which implies that a typical bank finances
many projects.
small capacity of investors compared to the size of the investment
project
low cost of delegation: the cost of controlling the FI is lower than the gain
from scale economies in monitoring by FI.
 Types of financial intermediaries

primary liabilities primary assets

type of FI (sources of fund) (use of funds)
I. depository institutions

business and consumer loans,

commercial banks deposit mortgages, government securities
savings and loan associations deposit mortgages
mutual savings banks deposit mortgages
credit unions deposit consumer loans
II. Contractual savings institutions

life insurance companies premiums from policies coporate bonds and mortages

municipal bonds, corporate bonds

fire and causality insurance companies premiums from policies and stock, government securities

employer and employee

Pension funds contributions coporate bonds and mortages
III. Investment intermediaries
commercial paper, stocks,
finance companies consumer loans , business loans
bonds
mutual funds shares stocks, bonds
money market mutual funds shares money market instruments
 Overview and Role of Bank

What is a bank or “bank-like” financial intermediary

-Freixas and Rochet (2008), “A bank is an institution whose current
operations consist of granting loans and receiving deposits from the public. ”

 Current used because occasionally most Industrial or commercial

firms borrow from their suppliers or lend to customers).
 Important that the two activities are together. The fact that both
loans are offered and deposits are received is important because
it is the combination of lending and borrowing that is typical of
commercial bank.
 “Public” emphasizes that banks provide unique services (liquidity
and means of payment) to the public.
 Generally, their functions are classified into four categories

 This, of course, does not mean that every bank has to perform each of these
functions. Universal banks do, but specialized banks need not.
𝑟= 𝑟𝐿
 Since 𝑟= 𝑟𝐿 and 𝑟𝐿 = 𝑟𝐷 it is clear that the only possible equilibrium is such that all
interest rates are equal: 𝑟=𝑟𝐿 = 𝑟𝐷
 Similar is true in uncertainty case.

 An immediate consequence is that all banks still make a zero

profit, independent of the volume and characteristics of the
securities they buy and sell.
 This explains why the general equilibrium model with complete
financial markets cannot be used for studying the banking sector.
 As we have just seen, the Arrow-Debreu paradigm leads to a
world in which banks are redundant institutions. It does not
account for the complexities of the banking industry.
 1.3.Financial Market

In economics, a financial market is a mechanism that allows people to easily buy

and sell (or trade),

• Financial securities,

• Currencies

• Commodities such as

– precious metals or

– agricultural goods

• and other items

 At low transaction costs and at prices that reflect the Efficient-Market

Hypothesis.

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Types of Financial Market
The financial markets can be divided into different subtypes:
a) Capital markets which consist of
• Stock markets, which is financing through the issuance of shares or
common stocks.
• Bond markets, which is financing through the issuance of bonds.
b) Money markets: which provide short term debt financing and investment
a) Capital market
• It is a market in which long-term debt and equity instruments are traded
• Capital market securities can be traded either in primary or secondary market.
i) Primary Market: It is a part of the capital markets that deals with the
issuance of new securities.
• It is a market in which newly issued securities, such as bonds or stock are sold
– to initial buyers by the corporation or government agency. 22
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• Companies or government institutions can obtain fund through the sale of

– a new stock or

– bond issue.

• This is typically done through a syndicate of securities dealers

• The process of selling new issues to investors is called underwriting

• When a new stock issued to the public, this sale is called an initial public offering (IPO).

• Dealers earn a commission which is inbuilt into the price of the security offering, They are often
issued by,

– Smaller,

– younger companies seeking capital to expand,

• It can also be done by large privately-owned companies looking to become publicly traded
Procedure
• It involves one or more investment banks as "underwriters"
• The company offering its shares, or the "issuer" enters a contract with a lead underwriter to sell its
shares to the public.

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b) Secondary Market: It is also known as the aftermarket,
• It is the financial market where previously issued securities such as
– stock,
– bonds,
– Other financial securities are bought and sold
• The term "secondary market" is also used to refer to the market for any
used goods or assets.
• In the primary market investors purchase securities directly from issuers
such as
– corporations issuing shares in an IPO
– directly from the federal government in the case of treasuries
 After the initial issuance, investors can purchase from other investors
in the secondary market.
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• When an individual buys a security in the secondary market, the person
who has sold the security receives money in exchange for the security,

– but the corporation which issued the security acquires no new

funds.

• A corporation acquires funds only when its securities are first sold in the
primary market

Functions of secondary market

Secondary market may serve two functions

i. Secondary markets make easier selling of financial instruments in the

primary market

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• It makes the financial instruments more liquid

• Increasing liquidity makes financial instruments more desirable

• Thus, it makes easier for the issuing firm to sell them in the
primary market.

ii. Secondary market determines the price of securities in the

primary market

• the price of securities in the primary market is derived from the

price in the secondary market

– if it has been issued previously

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• Generally speaking, conditions in the secondary markets are the most
important to the corporation issuing security

Thus, focus is given to the secondary market analysis.

Secondary market can be organized,

• Exchange Market (organized market) and

• Over the Counter (OTC)

Exchange Markets (Organized Market):

• In such market organization, buyers and sellers of securities or their agents and
brokers meet in one central location to conduct trades.

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• Such market can be organized for both financial instruments and commodities.

Internationally most known organized markets are

• New York Stock Exchange Market: Major companies stocks are traded

• Chicago Board of Trade: This is most known commodity market.

Commodities like,

– gold,

– silver,

– wheat,

– corn, and the like are commonly traded.

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B) Over The Counter Market (OTC):-

• Here dealers at different locations having an inventory of securities stand ready

– to buy and/or

– to sell securities over the counter to any one who comes to them and
willing to accept their prices.

• Over-the-counter dealers are in computers contact with each other and know
the price set by each other,

• the OTC markets are very competitive and are not very different from a market
with an organized exchange

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Examples of Secondary Markets
• In USA
– NYSE,
– the NASDAQ,
– the Amex,
• European examples of stock exchanges include
– the London Stock Exchange,
– the Deutsche Börse
– Paris Bourse,
– Euro-next (now )

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