Financial Institutions

Chapter One
Introduction

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Why study Financial Markets and Institutions?
•• They are the cornerstones of the overall They are the cornerstones of the overall financial system in which financial financial system in which financial managers operate managers operate •• Individuals use both for investing Individuals use both for investing •• Corporations and governments use both for Corporations and governments use both for financing financing

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Overview of Financial Markets •• Primary Markets versus Secondary Primary Markets versus Secondary Markets Markets •• Money Markets versus Capital Markets Money Markets versus Capital Markets •• Foreign Exchange Markets Foreign Exchange Markets

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Primary Markets versus Secondary Markets
•• Primary Markets Primary Markets
– markets in which users of funds (e.g. – markets in which users of funds (e.g. corporations, governments) raise funds by corporations, governments) raise funds by issuing financial instruments (e.g. stocks and issuing financial instruments (e.g. stocks and bonds) bonds)

•• Secondary Markets Secondary Markets
– markets where financial instruments are traded – markets where financial instruments are traded among investors (e.g. NYSE, NASDAQ) among investors (e.g. NYSE, NASDAQ)
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Money Markets versus Capital Markets
•• Money Markets Money Markets
– markets that trade debt securities with – markets that trade debt securities with maturities of one year or less (e.g. U.S. maturities of one year or less (e.g. U.S. Treasury bills) Treasury bills)

•• Capital Markets Capital Markets
– markets that trade debt (bonds) and equity – markets that trade debt (bonds) and equity (stock) instruments with maturities of more (stock) instruments with maturities of more than one year than one year
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Money Market Instruments Outstanding, 1990-1999 ($Bn)
1400 1200 1000 800 600 400 200 0 1990 1995 1999 Fed Funds and Repo Banker's accept.

Commercial paper U.S. T-bills
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Capital Market Instruments Outstanding, 1990-1999 ($Bn)
20000 15000 10000 5000 0 1990 1995 1999
Res. Mortgages Corp. bonds St. & Loc. Gov. bonds U.S. gov sponsored agencies

Corp. stocks Comm/farm mort. Treas. Sec. U.S. gov owned agencies Bank and consumer loans
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Foreign Exchange Markets
•• “FX” markets deal in trading one currency for “FX” markets deal in trading one currency for another (e.g. dollar for yen) another (e.g. dollar for yen) •• The “spot” FX transaction involves the The “spot” FX transaction involves the immediate exchange of currencies at the current immediate exchange of currencies at the current exchange rate exchange rate •• The “forward” FX transaction involves the The “forward” FX transaction involves the exchange of currencies at a specified date in the exchange of currencies at a specified date in the future and at a specified exchange rate future and at a specified exchange rate
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Overview of Financial Institutions •• Institutions that perform the essential Institutions that perform the essential function of channeling funds from those function of channeling funds from those with surplus funds to those with shortages with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance of funds (e.g. banks, thrifts, insurance companies, securities firms and companies, securities firms and investment banks, finance companies, investment banks, finance companies, mutual funds, pension funds) mutual funds, pension funds)
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Flow of Funds in a World without FIs: Direct Transfer
Financial Claims (Equity and debt instruments) Users of Funds (Corporations) Cash Example: A firm sells shares directly to investors without going through a financial institution Suppliers of Funds (Households)

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Flow of Funds in a world with FIs: Indirect transfer
Users of Funds FI (Brokers) FI (Asset transformers) Suppliers of Funds

Financial Claims (Equity and debt securities)

Financial Claims (Deposits and Insurance policies)

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Types of FIs
•• Commercial banks Commercial banks – depository institutions whose major assets are – depository institutions whose major assets are loans and major liabilities are deposits loans and major liabilities are deposits •• Thrifts Thrifts – depository institutions in the form of savings – depository institutions in the form of savings and loans, credit unions and loans, credit unions •• Insurance companies Insurance companies – financial institutions that protect individuals – financial institutions that protect individuals and corporations from adverse events and corporations from adverse events
(continued)
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•• Securities firms and investment banks Securities firms and investment banks – financial institutions that underwrite securities – financial institutions that underwrite securities and engage in securities brokerage and trading and engage in securities brokerage and trading •• Finance companies Finance companies – financial institutions that make loans to – financial institutions that make loans to individuals and businesses individuals and businesses •• Mutual Funds Mutual Funds – financial institutions that pool financial – financial institutions that pool financial resources and invest in diversified portfolios resources and invest in diversified portfolios •• Pension Funds Pension Funds – financial institutions that offer savings plans for – financial institutions that offer savings plans for retirement retirement
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Services Performed by Financial Intermediaries
•• Monitoring Costs Monitoring Costs
– aggregation of funds provides greater incentive – aggregation of funds provides greater incentive to collect a firm’s information and monitor to collect a firm’s information and monitor actions actions

•• Liquidity and Price Risk Liquidity and Price Risk
– provide financial claims to savers with superior – provide financial claims to savers with superior liquidity and lower price risk liquidity and lower price risk
(continued)
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•• Transaction Cost Services Transaction Cost Services
– transaction costs are reduced through – transaction costs are reduced through economies of scale economies of scale

•• Maturity Intermediation Maturity Intermediation
– greater ability to bear risk of mismatching – greater ability to bear risk of mismatching maturities of assets and liabilities maturities of assets and liabilities

•• Denomination Intermediation Denomination Intermediation
– allow small investors to overcome constraints – allow small investors to overcome constraints imposed to buying assets imposed by large imposed to buying assets imposed by large minimum denomination size minimum denomination size
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Services Provided by FIs Benefiting the Overall Economy
•• Money Supply Transmission Money Supply Transmission
– Depository institutions are the conduit through – Depository institutions are the conduit through which monetary policy actions impact the which monetary policy actions impact the economy in general economy in general

•• Credit Allocation Credit Allocation
– often viewed as the major source of financing – often viewed as the major source of financing for a particular sector of the economy (e.g. for a particular sector of the economy (e.g. farming and real estate) farming and real estate)
(continued)
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Services Provided by FIs Benefiting the Overall Economy
•• Intergenerational Wealth Transfers Intergenerational Wealth Transfers
– life insurance companies and pension funds – life insurance companies and pension funds provide savers with the ability to transfer provide savers with the ability to transfer wealth from one generation to the next wealth from one generation to the next

•• Payment Services Payment Services
– efficiency with which depository institutions – efficiency with which depository institutions provide payment services directly benefits the provide payment services directly benefits the economy economy
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Risks Faced by Financial Institutions
•• •• •• •• •• •• •• •• •• •• Interest Rate Risk Interest Rate Risk Foreign Exchange Risk Foreign Exchange Risk Market Risk Market Risk Credit Risk Credit Risk Liquidity Risk Liquidity Risk Off-Balance-Sheet Risk Off-Balance-Sheet Risk Technology Risk Technology Risk Operation Risk Operation Risk Country or Sovereign Risk Country or Sovereign Risk Insolvency Risk Insolvency Risk

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Regulation of Financial Institutions •• FIs provide vital financial services to all FIs provide vital financial services to all sectors of the economy; therefore, their sectors of the economy; therefore, their regulation is in the public interest regulation is in the public interest •• In an attempt to prevent their failure and In an attempt to prevent their failure and the failure of financial markets overall the failure of financial markets overall

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Globalization of Financial Markets and Institutions
•• Financial Markets became more global as the Financial Markets became more global as the value of stocks traded in foreign markets value of stocks traded in foreign markets soared soared •• Foreign bond markets have served as a major Foreign bond markets have served as a major source of international capital source of international capital •• Globalization also evident in the derivative Globalization also evident in the derivative securities market securities market
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Factors Leading to Significant Growth in Foreign Markets
•• The pool of savings from foreign investors has The pool of savings from foreign investors has increased increased •• International investors have turned to U.S. and other International investors have turned to U.S. and other markets to expand their investment opportunities markets to expand their investment opportunities •• Information on foreign investments and markets is Information on foreign investments and markets is now more accessible (e.g. internet) now more accessible (e.g. internet) •• Some mutual funds allow ability to invest in foreign Some mutual funds allow ability to invest in foreign securities with low transaction costs securities with low transaction costs •• Deregulation has enhanced globalization of capital Deregulation has enhanced globalization of capital flows flows
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