function & structure of FIM

7/29/2019 function & structure of FIM

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Function of Financial Markets Basic Function: Channeling of funds from savers

(households, firms and government) toborrowers, including investors

Borrowers can borrow directly from savers, sayhouseholds, by selling them securities (financialinstruments) e.g. selling bonds via the bondmarkets.

Historically, the indirect route was being adoptedof going through a financial institution say abank. The world is now changing with the biggerborrowers taking the direct route more often.

This disintermediation has huge implications for

the players involved


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Blurring of the Distinction

In the context of what we have just discussed,think of the dramatic way in which the businessmix of the financial institutions say in the US has

changed over the past few decades theblurring of the distinction between the productsoffered by the commercial banks, investmentbanks and insurance companies


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Threat perceived by Indianbanks during the 90s

With the stock markets picking up hugemomentum in the 90s, the commercial bankshad felt gravely threatened. They felt that theywould get bypassed on account ofdisintermediation, with Mutual Funds &insurance Companies, taking away theresources and the big borrowers going direct tothe market


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Look at what actually happened in Indiaduring the last decade, 1999-2009

The aggregate loan book of commercial bankswent up from Rs 4 trillion to Rs 29.41 trillion

CD ratio of the banks went up from 53.3% to

70.3%The assets and net profits of Axix Bank, ICICI &

HDFC Bank went up by much more than 10times and the assets and net profits of SBI, PNB

and BOB went up by more than 3 to 4 times.


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Structure of Financial MarketsDebt and Equity Markets

Most common way of raising money in the market is by issuing adebt instrument a bond or a mortgage

Short term maturity of less than one year

Intermediate term of maturity between one and ten years

Long term maturity of ten years or longer

The other - less used - option is of issuing equity

Total value of equities in the US has fluctuated between $1 and $20trillion since the 70s

The value of the debt instruments ($35.1 trillion at the end of 2004)was more than 50% larger than the value of equities in the US($15.9 trillion at the end of 2004)


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Structure of Financial MarketsPrimary and Secondary Markets

Primary Market Investment Bank assists in the sale of securities

in the primary market. It does it by underwritingsecurities it guarantees a price for a

corporations securities and then arranges to sellthem to the public


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Primary and Secondary Markets Secondary Market NYSE is the best known example of an exchangeAs per Wikipedia, as at the end of 2008, the size of the

international bond market was an estimated $67.0trillion, of which the size of the outstanding U.S. bondmarket was $33.5 trillion.Nearly all of the $923 billion average daily tradingvolume (as of early 2007) in the U.S. bond market takesplace between broker-dealers and large institutions in adecentralized, over-the-counter (OTC) market. However,a small number of bonds, primarily corporate, are listedon exchanges.

Other examples are foreign exchange markets, futuresmarkets and options markets Brokers, as agents of investors, and dealers, who buy

and sell securities, are important players in thesecondary markets


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Structure of Financial MarketsExchanges and Over-the-counter Markets

Organized exchanges

NYSE for stocks, and CBOT (Chicago Boardof Trade) for commodities, like wheat, corn,

silver, gold, are best known examples oforganized exchanges


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Exchanges and Over-the-counter Markets

OTC market

The other way of organizing a secondary market is tohave an OTC market, in which dealers at differentlocations have an inventory of different securities andstand ready to buy and sell securities overthe counterto anyone who comes to them and is willing to accepttheir prices. Because the OTC dealers are in computercontact and know the prices set by one another, theOTC market is very competitive, and not very different inthis regard from a market with an organized exchange


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Structure of Financial MarketsMoney and Capital Markets

Money market: Only short term debt instruments(original maturity of less than 1 year) are traded

Capital market: Market in which longer term

debt (original maturity of one year or greater)and equity instruments are traded


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Internationalization of Financial Markets

Before the 80s, the US financial markets weremuch larger than markets outside the US

In recent years the dominance of US marketshas been disappearing

American corporations and banks are now morelikely to tap international capital markets to raisefunds and American investors seek investment

opportunities abroad Similarly, corporations from other countries raise

funds from Americans, and foreigners havebecome important investors in the US


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Foreign Bonds

Foreign bonds are sold in a foreign country andare denominated in that countrys currency.

For example, if a German carmaker sells a bond

in the US, denominated in USD, it will be aforeign bond

As another example, a large percentage of USrailroads built in the 19th century were financed

by sale of foreign bonds in Britain


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Euro Bond

Euro Bond: A bond denominated in the currencyother than that of the country, in which it is sold.

An example: A bond denominated in USD sold

in London


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Eurocurrencies/Eurodollars

Eurocurrencies are foreign currencies that aredeposited in banks, outside of the home country

The most important of the eurocurrencies, the

eurodollars, are US dollars deposited in foreignbanks outside the US, or in foreign branches ofUS banks


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The Euro confusion

A bond denominated in euros is called aeurobond only if it is sold outside the countriesthat have adopted the euro

In fact, most bonds issued by euro zone entitiesare not denominated in euros but insteaddenominated in USD

Eurodollars have nothing to do with euros, or for

that matter with Europe, but are instead USdollars deposited in banks outside the US


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World Stock markets

While NYSE had been the leading SE for a longtime, currently the list is headed by NYSE-Euronext. The relative importance of the other

major markets has been growing Nasdaq OMX, Tokyo SE, Shanghai, Shenzhen,

London are among the other major stockexchanges


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Financial Intermediation

The process of moving funds from savers toborrowers

While the media focus is on the securities

markets, in particular the stock markets, thefinancial intermediaries are a far more importantsource of finance for corporations


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Transaction costs & economies of scale

Financial intermediaries can substantially reducetransaction costs because they have developedthe expertise and their large size enables them

to take advantage of economies of scale


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Risk Sharing

Financial Intermediaries promote risk sharing byhelping individuals to diversify


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Asymmetric informationAn additional reason for the importance of financial intermediaries

What is asymmetric information?An additional reason for the importance offinancial intermediaries is that in financialmarkets, one party often does not know enough

about the other party to make accurate decisions.This inequality is called asymmetric information.


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Problems arising due to asymmetric information

Adverse selection is the problem created by asymmetric

information before the transaction occurs. An example of the above: all other things being equal,

you as a lender are more likely to entertain a worse riskas it would be more persistent in chasing you for loanthan a better risk

Moral hazard is the problem created by asymmetricinformation after the transaction occurs

An example of that would be a borrower engaging inundesirable activity from a lenders point of view

Financial Intermediaries can alleviate these problems bydeveloping processes for better assessment of creditrisks and monitoring loans


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Financial Intermediaries 1. Depository Institutions (In US these are Commercial Banks and

thrifts)

Commercial Banks Savings & Loans Associations

Mutual Savings Banks

Credit Unions

2. Contractual Savings Institutions

Life Insurance Companies Fire & casualty Insurance companies

Pension funds & Government Retirement Funds

3. Investment Intermediaries

Finance Companies

Mutual Funds

Money Market Mutual Funds


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Regulation of the US Financial System

The financial system is among the most regulated sectors of the USeconomy

The main regulatory agencies/subjects of regulation are:

Securities & Exchange Commission-organized exchanges & fin mkts Commodities Futures & Trading Commission-futures exchanges

Office of the Controller of the Currency-federally chartered com banks

National Credit Union Administration-federally chartered credit unions

State Bkg & Insurance Commissions-state chartered dep institutions

Federal Deposit insurance Corporation-Com banks, mutual savingbanks, savings and loans associations

Office of Thrift supervision-savings and loans associations

Federal Reserve System-All depository institutions


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Why regulations? Increasing the information available to investors

The stock market crash of 1929 led to the Securities Act of 1933and establishment of the SEC

The SEC requires corporations issuing securities to disclosecertain information, restricts trading by the largest stockholders(known as insiders) in the corporation

Ensuring the soundness of financial intermediaries Regulations have been imposed on the intermediaries in regard to

restrictions on their entry into business, disclosures by them,restrictions on assets & activities, insurance of deposits by FDIC(created in 1934) & other agencies, limits on opening of branches

and locations, restrictions on interest rates

Improving control of monetary policy

Reserve requirements etc.

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function & structure of FIM

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