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Copyright © 2000 Addison Wesley Longman Slide #2-1 Chapter Two AN OVERVIEW OF THE FINANCIAL SYSTEM
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Copyright © 2000 Addison Wesley Longman Slide #2-1
Chapter Two
AN OVERVIEW OF THE FINANCIAL SYSTEM
Copyright © 2000 Addison Wesley Longman Slide #2-2
Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one
who has them
2. Improves economic efficiency
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Classifications of Financial Markets
1. Debt Markets Short-Term (maturity < 1 year) Money Market
Long-Term (maturity > 1 year) Capital Market
2. Equity Markets Common Stock
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Classifications of Financial Markets
1. Primary MarketNew security issues sold to initial buyers
2. Secondary MarketSecurities previously issued are bought and sold
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Classifications of Financial Markets
1. ExchangesTrades conducted in central locations
(e.g., New York Stock Exchange)
2. Over-the-Counter MarketsDealers at different locations buy and sell
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Internationalization of Financial Markets
International Bond Market1. Foreign bonds
2. Eurobonds—Now larger than U.S. corporate bond market
World Stock MarketsU.S. stock markets are no longer always the largest: at one point, Japan's was larger
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Function of Financial Intermediaries
Financial Intermediaries1. Engage in process of indirect finance
2. More important source of finance than securities markets
3. Needed because of transactions costs and asymmetric information
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Function of Financial Intermediaries
Transactions Costs 1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing expertise and taking advantage of economies of scale
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Asymmetric Information: Adverse Selection and Moral
Hazard
Adverse Selection1. Before transaction occurs2. Potential borrowers most likely to produce
adverse outcome are ones most likely to seek loan and be selected
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Asymmetric Information: Adverse Selection and Moral
HazardMoral Hazard
1. After transaction occurs2. Hazard that borrower has incentives to
engage in undesirable (immoral) activities making it more likely that won't pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
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Financial Intermediaries
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Size of Financial Intermediaries
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Regulatory Agencies
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Regulation of Financial Markets
Three Main Reasons for Regulation1. 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 IntermediariesA. Prevents financial panicsB. Chartering, reporting requirements, restrictions on
assets and activities, deposit insurance, and anti-competitive measures
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3. Improving Monetary ControlA. Reserve requirements
B. Deposit insurance to prevent bank panics
Regulation of Financial Markets
