Chapter 2: An Overview of the

Financial System
The Economics of Money, Banking, And Financial Markets
Frederic S. Mishkin
Chapter Preview

Financial markets (bond and stock markets) and financial intermediaries (such as banks,
insurance companies, and pension funds) serve the basic function of channelizing funds
from those who have a surplus of funds to those who have a shortage of funds (e.g.
firms). More realistically, when Apple invents a better iPad, it may need funds to bring its
new product to market. Similarly, when government needs to build a road or a school, it
may require more funds than the available revenue from taxes. Well functioning financial
markets and financial intermediaries are crucial to economic health.
To study the effects of financial markets and financial intermediaries on the economy, we
need to acquire an understanding of their general structure and operation. In this
chapter, we learn about the major financial intermediaries and the instruments that are
traded in financial markets, as well as how these markets are regulated.
Chapter Preview

Topics include:
1. Meaning of Financial System.
2. Function of Financial Markets.
3. Structure of Financial Markets
Meaning of Financial System

Financial System:

is a set of Financial Markets, Financial institutions, and Regulatory and

supervisory bodies.

Financial markets:

are markets in which funds are transferred from people and Firms who have
an excess of available funds to people and Firms who have a need of funds.
FUNCTION OF FINANCIAL MARKETS

IMPORTANCE OF FINANCIAL MARKETS

1. Perform the essential function of channeling funds from
economic players that have saved surplus funds to those that
have a shortage of funds.
2. Promotes economic efficiency by producing an efficient
allocation of capital, which increases production.
3. Well-functioning financial markets also directly improve the
well-being of consumers by allowing them to time their
purchases better.
Function of Financial Markets
FUNCTION OF FINANCIAL MARKETS

SEGMENTS OF FINANCIAL MARKETS

1. Direct Finance
Borrowers borrow directly from lenders in financial markets by selling financial
instruments which are claims on the borrower’s future income or assets. For
example bonds, securities (financial instruments) are assets for the holder and
liabilities for the issuer.

2. Indirect Finance
Borrowers borrow indirectly from lenders via financial intermediaries (established to
source both loanable funds and loan opportunities) by issuing financial instruments
which are claims on the borrower’s future income or assets.
STRUCTURE OF FINANCIAL MARKETS

There are several basis for classification of Financial Markets:

3.1 Financial • Debt instrument.

instrument • Equity instrument.

3.2 Maturity • Capital Market.

Date • Money Market.

3.3 Security • Primary Market.

Issue • Secondary Market.
STRUCTURE OF FINANCIAL MARKETS

DEBT AND EQUITY MARKETS

• Debt instruments – 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 – sale of ownership share (owners are residual claimants).
• Owners of stock may receive dividends
STRUCTURE OF FINANCIAL MARKETS

CLASSIFYING MARKETS BY SECURITY ISSUE.

1. Primary Markets: (New securities).
is a financial market in which new issues of a security are sold to
initial buyers by the corporation or government agency
borrowing the funds.
Investment Banks: underwrite securities in primary markets,
advising company about market timing, administrative functions
as in help with all legal paper and registration statements with
stock market.
STRUCTURE OF FINANCIAL MARKETS

CLASSIFYING MARKETS BY SECURITY ISSUE.

2. Secondary Market: (Previously issued).

is a financial market in which securities that have been previously
issued can be resold.
Brokers and dealers work in secondary markets.
• Brokers: are agents of investors who make trade on behave of others.
• Dealers: are person who trade business on their own.
STRUCTURE OF FINANCIAL MARKETS

ROLE OF SECONDARY MARKETS

• Even though firms don’t get any money, per se, from the
secondary market, it serves two important functions:
• Provide liquidity, making it easy to buy and sell the securities of
the companies
• Establish a price for the securities
STRUCTURE OF FINANCIAL MARKETS

We can further classify secondary markets as follows:

• Exchanges
where buyers and sellers of securities (or their agents or brokers) meet in one
central location to conduct trades. Trades conducted in central locations
(e.g., New York Stock Exchange, PSX etc.) Chicago Board of Trade for
commodities (wheat, corn, silver, and other raw materials) are examples of
organized exchanges
• Over-the-Counter Markets
in which dealers at different locations who have an inventory of securities stand
ready to buy and sell securities “over the counter” to anyone who comes to
them and is willing to accept their prices.
STRUCTURE OF FINANCIAL MARKETS

We can also further classify markets by the maturity of the

securities:
Money Market:
a financial market in which only short-term debt instruments (generally those
with original maturity terms of less than one year) are traded
Capital Market :
the market in which longer-term debt instruments (generally those with
original maturity terms of one year or greater) and equity instruments are
traded.
Money market securities are usually more widely traded than
longer-term securities and so tend to be more liquid.
FINANCIAL MARKET INSTRUMENTS
Money market instruments
Because of their short terms to maturity, the debt instruments traded
in the money market undergo the least price fluctuations and so are
the least risky investments.
• United States treasury bills (discounted; no default risk)
• Negotiable bank certificates of deposit (NCD; large denominations)
• Commercial paper (CP; direct finance; largest instrument)
• Banker’s acceptances (use abroad in international trade)
• Repurchase agreements (repos; <2 wks; need collateral)
• Federal funds (overnight loan b/w banks of their deposits at Fed)
FINANCIAL MARKET INSTRUMENTS

Capital market instruments

• Stocks (largest instruments)
• Mortgages (FNMA: Fannie Mae; GNMA: Ginnie Mae; FHLMC: Freddie Mac)
• Corporate bonds (convertible vs. non-convertible)
• US government securities (most liquid security)
• US government agency securities
• State and local government bonds (municipal bonds; interest tax free)
• Consumer and bank commercial loans
INTERNATIONALIZATION OF FINANCIAL MARKETS

The internationalization of markets is an important trend.

The U.S. no longer dominates the world stage.
• International Bond Marke
• Foreign bonds
• Denominated in a foreign currency
• Eurobonds
• Denominated in one currency, but sold in a different market
• Eurocurrency Market
• Foreign currency deposited outside of home country
• Eurodollars are U.S. dollars deposited, say, London.
• Gives U.S. borrows an alternative source for dollars.
INTERNATIONALIZATION OF FINANCIAL
MARKETS

The number of international stock market indexes is quite large.

• Dow
• S&P 500
• Nikkei 225
• FTSE 100
• Hang Seng Index
https://www.investing.com/indices/major-indices
Function of Financial Intermediaries : 2-19
Indirect Finance

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
Function of Financial 2-20
Intermediaries : Indirect Finance

• This process, called financial intermediation, is actually the

primary means of moving funds from lenders to borrowers.
• More important source of finance than securities markets (such as
stocks)
• Needed because of transactions costs, risk sharing, and
asymmetric information
Function of Financial 2-21
Intermediaries : Indirect Finance

Transactions Costs
Financial intermediaries make profits by reducing
transactions costs. Reduce transactions costs by 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, services
that make it easier for customers to conduct transactions
Function of Financial 2-22
Intermediaries : Indirect Finance

• Another benefit made possible by the FI’s low

transaction costs is that they can help reduce the
exposure of investors to risk, through a process known as
risk sharing
• FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another
party
• This process is referred to as asset transformation, because in
a sense risky assets are turned into safer assets for investors
Function of Financial 2-23
Intermediaries : Indirect Finance

• Financial intermediaries also help by providing the means for

individuals and businesses to diversify their asset holdings.
• Low transaction costs allow them to buy a range of assets, pool
them, and then sell rights to the diversified pool to individuals.
Function of Financial 2-24
Intermediaries : Indirect Finance

• Another reason FIs 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 fronts: adverse
selection and moral hazard.
Function of Financial 2-25
Intermediaries : Indirect Finance

• Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcome are ones
most likely to seek a loan
3. Similar problems occur with insurance where unhealthy people want
their known medical problems covered
Asymmetric Information: 2-26
Adverse Selection and Moral Hazard

• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral)
activities making it more likely that won't pay loan back
3. Again, with insurance, people may engage in risky activities only after
being insured
4. Another view is a conflict of interest
Types of Financial Intermediaries 2-27

• Finance Companies sell commercial paper (a short-term

debt instrument) and issue bonds and stocks to raise
funds to lend to consumers to buy durable goods, and to
small businesses for operations
• Mutual Funds acquire funds by selling shares to
individual investors (many of whose shares are held in
retirement accounts) and use the proceeds to purchase
large, diversified portfolios of stocks and bonds
Types of Financial Intermediaries 2-28

• Money Market Mutual Funds

acquire funds by selling checkable deposit-like shares to
individual investors and use the proceeds to purchase highly
liquid and safe short-term money market instruments
• Investment Banks
advise companies on securities to issue, underwriting security
offerings, offer M&A assistance, and act as dealers in security
markets.
Regulation of financial markets

Two Main Reasons for Regulation (Financial sector is one

of the most heavily regulated sectors of the economy)
1. Increase information to investors
A. Decreases adverse selection and moral hazard problems
B. SEC forces corporations to disclose information
2.Ensuring the soundness of financial intermediaries
A. Prevents financial panics
B. Chartering, reporting requirements, restrictions on
assets and activities, deposit insurance, and anti-
competitive measures
Types of regulation

• Entry restrictions
• Disclosure laws (SEC)
• Restriction on assets and activities
• Deposit insurance
• Limits on competition
• Restrictions on interest rates (no longer in effect)