CHAPTER (2) | Overview of the Financial System - Financial intermediary & financial market 2- Direct & indirect Finance 3- Classification of financial markets 4- Why might people wish to direct their funds through a bank instead of lending directly to a business? 5- Types of financial intermediaries 6- Regulation of financial markets 1. Households 1. Business firms 2. Business firms 2. Government 3. Government 3. Households 4, Foreigners 4, Foreigners1- Financial intermediary & financial market A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank. Financial market refers to a marketplace, where creation and trading of financial assets (such as shares, bonds) take place. It acts as an intermediary between the savers and investors. Functions of financial markets - Allows transfers of funds from person or business without investment ‘opportunities to one who has them - the intermediary obtains funds from savers and then makes loans/investments with borrowers - Improves economic efficiency© Direct finance! funds are directly transferred from lenders to borrowers: One way of doing this is by selling securities or shares to raise funds. Securities are assets for the holder and liabilities for the issuer. © Indifect finainee'— financ and lend them to borrowers itermediaries receive funds from savers => Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: = the intermediary obtains funds from savers = the intermediary then makes loans/investments with borrowers <¥ Gassfiatin of anal markets > A firm or an individual can obtain funds in a financial market in 2 ways > Débtinstrument: Issue debt instrument such as bond or mortgage => Equity Instrument: Rising funds by issuing equities (Such as common stock) = contractual obligation to pay the holder fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans) Short-term debt instruments have a maturity of less than one year Intermediate-term debt instruments have a maturity between 1 and 10 years Long-term debt instruments have a maturity of ten or more years: Equity instruments allow a company to raise money without incurring debt. This can include selling stock. - Equity — sale of ownership share. = Note: stocks are the collection of shares of multiple companies or are a collection of shares of a single company. - Owners of stock may receive dividends. Financial Markets Based on Based on Maturity Trading Structure Structure = .— Money Capital Primary Secondary Markets Markets Markets MarketsMoney Market & Capital Market Money market — market for short-term debt instruments = Money market instruments have short maturities. Therefore, they undergo the least price fluctuations. They are the least risky investments Example: Treasury bills > Egyptian Treasury bills: Short-term security one year and less, typically 3 months maturity promissory note issued by the ministry of Finance. T-bills commonly pay no explicit interest but are sold ata discount, their yield being the difference between the purchase price and the Face-value (also called redemption value). Being backed by the government, they come closest to a risk free investment. instruments market for intermediate and long-term debt and equity © Capital market instruments: © Stocks represent fractional ownership in a company. An efficiently functioning stock market is considered critical to economic development, as it gives companies the ability to quickly access capital from the public. => Mortgages are loans to households or firms to purchase land, housing or other real structures in which the structure or land itself serves as a collateral for the loans. > If the borrower doesn't make monthly payments to the lender and defaults on the loan, the bank can sell the home and recoup its money.STOCK BOND Type Equity instrument | Debt instrument Issuer | Companies Government, financial institutions or Companies Return _| Dividend Interest, Guarantee | Not guaranteed —_| guaranteed of return Risk level | High [tow eT o. Primary market = financial market in which newly issued securities are sold. (Investment Banks issue securities such as stocks and bonds). © Secondary market = financial market in which previously owned securities are sold. (investors exchange with each other rather than with the issuing entity). Increase liquidity of financial assets Determine security prices that help determine the price of securities in primary marketsA- reducing transactions costs B- risk sharing (reduce risk) C- reducing asymmetric information A: reducing transactions costs Financial intermediaries make profits by reducing transactions costs through developing expertise and taking advantage of economies of scale A financial intermediary's low transaction costs mean that it can provide its customers with liquidity services (the ease of converting it to cash). B- Risk Sharing Financial intermediaries’ low transaction costs allow them to reduce the exposure of investors to risk, through a process known as risk sharing by spreading funds across a diverse range of investments and loans. jversification entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets.G reducing asymmetric information - Another reason Financial intermediaries exist is to reduce the impact of asymmetric information. - One party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two front adverse selection & moral hazard. ee Before transaction occurs One of the two parties has more accurate information than the other party before they reach an agreement. This puts the less knowledgeable party at a disadvantage because it is more difficult for them to assess the value or risk of the deal. This leads to an inefficient outcome Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan Similar problems occur with insurance where unhealthy people want their known medical problems coveredAfter transaction occurs That means, one of the parties (usually the buyer) accepts a deal with the intention to change their behavior after a deal is made. This happens when they believe they won't have to face the negative consequences of their actions. This puts the less knowledgeable party (usually the seller) at a disadvantage because they are usually the ones who have to face the negative consequences instead. #_Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back # Insurance: people may engage in risky act! insured (as careless driving of insured car ) ies only after being NOTE Financial _intermediaries reduce adverse selection & moral hazard problems, enabling them to make profits, WHY??? Because of their expertise in screening and monitoring, they minimize their losses, earning a higher return on lending and paying higher yields to savers.Eire tems > i FIRST: Depository institutions @ A- Commercial banks @ B-Credit Unions wm SECOND: Canis Sings tRORE @ A- Life insurance companies ™ B- Fire and casualty insurance companies 1 C-Pension funds and government retirement funds A: Commercial banks: financial intermediaries raise funds primarily by issuing checkable deposits, savings deposits, and time deposits. They then use these funds to make commercial, consumer, and ‘mortgage loans and to buy government securities. ™ B- Credit Unions: These financial institutions are very small cooperative lending institutions organized around a particular group: union members, e.g. employees of a particular firm. They acquire funds from deposits called shares and primarily make consumer loans. 10A: Life insurance companies They insure people against hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force and use them to buy corporate bonds & mortgages. They also purchase stocks but are restricted in the amount that they can hold. ™@ B-Fire and casualty insurance companies: Those companies ensure their policy holders against theft, fire and accidents. They are very much like Life insurance companies, receiving funds through premiums for their policies, but they have a greater possibility of loss of funds if a major disaster occurs. Therefore, they use their funds to buy more liquid assets than Life insurance companies do. ™@ C- Pension funds and government r ment funds: Private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and from employees, who either have a contribution automatically deducted from their paychecks or contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and stocks. a——— > ™ 2 Main Reasons for Regulation (Financial sector is one of the most heavily regulated sectors of _ the economy) - Decreases adverse selection and moral hazard problems : The Securities and Exchange Commission SEC forces corporations to disclose information - Prevents financial panics - Reporting requirements & restrictions on assets and activities I Major types of regulation WV. Entry restrictions (tight regulations governing who is allowed to set up a financial intermediary) Disclosure laws (reporting requirements) Restriction on_assets_and_activities (Financial intermediaries are restricted in what they are allowed to do and what assets they can hold) Restrictions on interest rates (imposing restrictions on interest rates that can be paid on deposits) 2