Chapter 2

An Overview
of the Financial
System

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 Preview

• This chapter presents an overview of the

study of financial markets and institutions.

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 Learning Objectives

• Compare and contrast direct and indirect

finance.
• Identify the structure and components of
financial markets.
• List and describe the different types of
financial market instruments.
• Recognize the international dimensions of
financial markets.

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 Learning Objectives

• Summarize the roles of transaction costs,

risk sharing, and information costs as they
relate to financial intermediaries.
• List and describe the different types of
financial intermediaries.
• Identify the reasons for and list the types of
financial market regulations.

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 Function of Financial Markets

• Performs the essential function of

channeling funds from economic players
that have saved surplus funds to those that
have a shortage of funds
• Direct finance: borrowers borrow funds
directly from lenders in financial markets by
selling them securities

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 Function of Financial Markets

• Promotes economic efficiency by producing

an efficient allocation of capital, which
increases production (Savers are NOT same
as Investors)
• Directly improve the well-being (standard of
living) of consumers by allowing them to
time purchases better

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 Figure 1 Flows of Funds Through the
Financial System

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 Structure of Financial Markets
• Debt and Equity Markets
– Debt instruments (maturity)
– Equities (dividends)

• Primary and Secondary Markets

– Investment banks underwrite securities in
primary markets.
– Brokers and dealers work in secondary
markets.
Broker (match) follows the agent wish. Dealer
(link) follows his own wish.

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 Structure of Financial Markets
• Primary Market: is a financial market in
which new issues of securities are sold to
initial buyers (Direct Finance).
• Secondary Market (SM): is a financial
market in which securities that have been
previously issued can be resold (Indirect
Finance).
Benefits of SM: Make it easier and quicker to
sell these securities (Liquidity). Determine the
price for the next issue in the primary market .

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 Structure of Financial Markets

• Exchanges and Over-the-Counter (OTC)

Markets:
– Exchanges: NYSE, Chicago Board of Trade,
central location.
– OTC markets: Foreign exchange, Federal funds

• Money and Capital Markets:

– Money markets deal in short-term debt
instruments
– Capital markets deal in longer-term debt and
equity instruments

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 Money Market Instruments
• Main Features:
1- Debt Instruments.
2-Their Maturities is less than one year.
3- Their prices do not fluctuate.
4- Considered to be safe investment.
5- They either pay interest rate or discount
price.

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 Money Market Instruments
• United States Treasury Bills:
1- Short-term debt instrument.
2-Maturity 1, 3, 6 months.
3- They Pay no interest rate, but they pay discount
price i.e. purchase price is lower than the price
paid at maturity.
4- Most Liquid and the Safest.
5. No possibility of Default: the issuer is unable to
make interest payment or pay the loan when the
instrument mature.

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 Money Market Instruments
• Negotiable Bank Certificate of Deposit:
1- Short-term Debt instrument.
2-Important source of funds for
commercial banks.
3- It pays annual interest rate and pays
back original loan at the purchase price
on maturity.

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 Money Market Instruments

• Commercial papers
1- Short-term debt instrument.
2- Issued by large banks and well-known
corporations i.e. Microsoft and GM.
3- The debt usually issued at discount
price.

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 Money Market Instruments

• Repurchase Agreements
1- Short-term Loans with maturity less than
two weeks.
2- Treasury Bills serve as collaterals.
3- Example, Microsoft has extra $1 billion, It
Buys Treasury Bills (TBs) from Bank A, then
Bank A repurchase TBs after one or two
weeks at a price higher than the purchase.

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 Money Market Instruments

• Federal (Fed) Funds

1- Short-term debt instruments (overnight).
2- debt between banks
3- To meet the requirements of the Fed.
4. This instrument pay interest rate (federal
fund rate).

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 Financial Market Instruments

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 Capital Market Instruments
• Main Features:
1- Debt and Equity Instruments.
2-Their Maturities are more than one year.
3- They have wider price fluctuations
4- Considered to be risky investment

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 Capital Market Instruments
• Stocks
1- Claims on the net income and assets.

●Mortgages
1- Loans to households or firms to buy
land or house.
2- The land or house serve as a collateral.

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 Capital Market Instruments
• Corporate Bonds
1-Long-term bonds are issued by
corporations with very strong credit
rating.
2- It pays off an interest rate and pays off
a face value when the bond matures.

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 Capital Market Instruments
• US Government Securities (Bonds)
• US Government Agency Securities
(Bonds)
• State and Local Bonds
• Consumer and Bank Commercial Loans

All are long-term bonds

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 Financial Market Instruments

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 Internationalization of Financial
Markets
• Foreign Bonds: sold in a foreign country and
denominated in that country’s currency
• Eurobond: bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies: foreign (national) currencies
deposited in banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets:
– Also help finance the federal government

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 Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs (time and money
spent in carrying out financial transactions)
– Economies of scale
– Liquidity services (checking account, pay
bills, ATM).
• Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation) ): create and
sell low-risk assets and use the proceeds to purchase
riskier assets (due to low transaction cost).
– Diversification: collection of assets (portfolio)
whose returns do not always move together.

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 Function of Financial
Intermediaries: Indirect Finance
• Deal with asymmetric information problems:
• Asymmetric Information: One part
(banks) do not have enough information
about the other part (borrowers).
– Adverse Selection (before the transaction): try
to avoid selecting the risky borrower by gathering
information about them
– Moral Hazard (after the transaction): ensure
borrower will not engage in activities that will
prevent him/her to repay the loan.
• Sign a contract with restrictive covenants.

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 Function of Financial
Intermediaries: Indirect Finance
• Economies of Scope and Conflict of interest
– Economies of Scope: A bank gets
information when he makes loans to his
customers. These information will be used
if the bank wants to sell the bonds of this
firm.
– Conflict of interest: this low cost
information helps to check if this firm has
multiple goals or interests.

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 Function of Financial
Intermediaries: Indirect Finance

• Conclusion:
– Financial intermediaries allow “small” savers and
borrowers to benefit from the existence of
financial markets (by acquiring funds and buying
securities).

See Evidence Next Table!

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 Types of Financial Intermediaries

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 Types of Financial Intermediaries

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 Regulation of the Financial System

• To increase the information available to

investors:
– Reduce adverse selection and moral hazard
problems
– Disclose information about the firm to public,
and reduce insider trading of largest stock
holders (insider) (Securities and Exchange
Commission).

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 Regulation of the Financial System
• To ensure the soundness of financial
intermediaries (Prevent Financial Panic:
Collapse of Financial Intermediaries):
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control
holding of risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates

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 Regulation of the Financial System

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