Lesson 1 

Money, Securities and Financial Institutions: An

Introduction 

A. An Introduction to Financial Institutions

• Financial system: a set of procedures, institutions, instruments and technologies existing to facilitate trade and transactions.

• Financial institutions provide financial services to their clients, including:– Services related to transactions, – Deposits and – Investments

• Institutions issue financial claims and contracts in primary markets and trade instruments in secondary markets

• For example, firms issue stock in primary markets through IPOs (initial public offerings), and these shares are trade in secondary markets such as the New York Stock Exchange or the Borsa Italiana.

Partial Listing of Financial Institution Categories

• Depository Institutions– Commercial banks– Savings associations– Credit unions

• Investment Institutions– Investment banks– Securities firms– Mutual funds

• Unregistered Investment Institutions– Pension funds– Hedge funds– Private equity firms– Venture capital firms

• Insurance Companies– Life Insurers– Property-casualty insurers

• Other Institutions– Governments– Finance Companies

B. An Introduction to Money and Central Banks

• Money might be defined as anything that is generally accepted for the payment of goods and services or in the repayment of debts.

• Money functions as a– medium of exchange– unit of account and– a store of value

Central Banks

• The central bank of a country (in the United States, the Federal Reserve System, often referred to as the Fed; in Europe, the European Central Bank or ECB) typically conducts the monetary policy on behalf of that country or currency area.

• In many banks, the central bank also serves as a financial or banking regulator.

Typical Central Bank Objectives

• Managing monetary policy so as to maintain a low long-term inflation rate,

• Maintaining a stable and growing real economy (low unemployment and sustainable growth rate) and to smooth business cycles and offset shocks to the economy. Countries do differ in the responsibility that their central bank assumes for the real sector.

• Maintaining an effective and efficient payments system.

Central Bank Policy Mechanisms

• Issue currency• Set reserve requirements• Conduct open market operations: Purchasing (selling)

securities increases (reduces) money supply• Discount window lending: Central banks often play the role of

lender of last resort.• Intervention in foreign exchange markets, or fix exchange rates• Set the overnight rate: The Fed sets the Fed Funds rate• Capital requirements: Central banks play a central role in

setting capital requirements• Margin requirements in securities markets

Central Bank Origins• The Sveriges Riksbank was the first European central bank, established in 1668 .• In 1694, the Bank of England, was also chartered as a joint stock company.

– Proposed by William Patterson, a Scot-born entrepreneur as an institution to serve the public good in perpetuity

– Approved by the U.K. Parliament to provide funding to the government.• These institutions evolved to serve as lenders of last resort, providing for liquidity

in times of poor harvests or war. • Initially a private response (privately funded with government approval) to

difficulties that arose in banking systems with many small banks (Gorton and Huang [2001]).

• Much later, in 1800, the Banque de France was established by Napoleon to stabilize currency, and, again, to make loans to the government finance.

• The Bank of Spain, National Bank of Austria and numerous other European central banks were founded for similar purposes.

• Central banks also issued their own currencies.

19th Century Central Banking• The U.K. and the U.S. experienced many banking crises during the 19th century. • After an 1866 U.K. crisis, and following the advice of Walter Bagehot, the Bank of England adopted

a policy of lending to troubled correspondent banks based on collateral and penalty interest rates. • The U.K. remained free of banking panics from 1866 until 2007. • After two early attempts at chartering and maintaining central banks, with the Bank of the United

States (1791-1811) and the Second Bank of the United States (1816-1836), the U.S. Federal Reserve System was established in 1913, largely in response to the severe U.S. Banking Panic of 1907. The interims between the central banks were characterized by significant numbers of banking crises.

• Gorton and Huang [2001] note that before establishment of the U.S. Fed, banks formed co-insurance coalitions issuing "clearinghouse loan certificates" during banking panics. These certificates were a sort of private currency for which all coalition members were jointly responsible.

• This system of co-insurance was the precursor to the modern discount window. • The system led to banks monitoring fellow coalition members, setting the stage for central bank

monitoring. • During the panics of 1893 and 1907, these certificates were issued directly to bank depositors, again,

as a sort of private currency.• These 19th century U.S. coalitions or clearinghouses originated as interbank payments systems.

The Federal Reserve System

• The Federal Reserve System (the Fed) was established in 1913 as the Central Bank of the United States.

• Its principal responsibility is setting monetary policy for the United States.

• The Fed's conduct of monetary policy is intended to promote price stability, full employment, balanced economic growth and stability in exchange rates.

• The Fed maintains regulatory authority over most commercial banks, particularly with respect to issues that might affect the stability of the banking system.

The European Central Bank• The European Central Bank (ECB), headquartered in Frankfurt was established

by the Treaty of Amsterdam in 1998 as the central bank of the Eurozone (the 19 EU members that adopted the euro as their official currency).

• Its stock, totaling roughly €5 billion, is held by the 28 member EU states. • Its principle mandate is to maintain price stability.• Its primary responsibility is setting monetary policy for the Eurozone. • Through its Single Supervisory Mechanism (SSM), the ECB maintains regulatory

authority over the largest 123 Euro area banks, accounting for approximately 85 of the area's aggregate banking assets.

• The majority of European banks are still monitored by national supervisory bodies such as the Deutsche Bundesbank and non-Eurozone EU country banks are exempt from participation.

• More generally, the Eurosystem, comprised of the ECB and Member States central banks seek to safeguard financial stability and promote European financial integration

C. Key International Banking and Financial Institutions

• The International Monetary Fund • The World Bank

– International Development Association (IDA) which finances low profitability projects at easy terms with government guarantees.

– International Finance Corporation (IFC) which finances projects in private sector without government guarantees. The IFC sometimes participates in equity of these projects.

– The Multilateral Investment Guarantee Agency (MIGA), which promotes foreign direct investment into developing countries and

– The International Center for Settlement of Investment Disputes (ICSID).• Regional Development Banks• The Bank for International Settlements

– The Bank for International Settlements (BIS) was founded as a result of the Hague agreement of 1930 to facilitate Germany’s payments of reparations for World War I.

– Since WWI, the BIS has evolved into a sort of “bank for central banks,” providing for regulation and supervision of central banks and commercial banks, fostering transparency and coordination among central banks and promoting monetary and financial stability.

– The BIS is headquartered in Switzerland, where it has hosted important banking treaties, including the Basel I and II Capital Accords that, among other things, set standards for bank risk management.

D. An Introduction to Financial Intermediation

• A major purpose of the financial system is to channel funds from agents with surpluses to agents with deficits.

• A financial facilitator acts as a broker without transforming those assets.

• Money markets vs. capital markets: investors their surpluses directly to deficit firms, creating marketable securities and instruments

• A financial intermediary can facilitate this channeling process from surplus to deficit agents by transforming assets.

Financial Transformation

• Preferred terms can be affected by transformations to contractual terms:– Maturity transformation– Risk transformation– Size transformation

Functions of Financial Intermediaries (Bhattacharya and Thakor [1993])

Services Provided

Financial Intermediary

Brokerage

Transactions services (e.g., check-writing, buying/selling securities, safekeeping) Financial advice (e.g., advice on where to invest, portfolio management) Screening and certification (e.g., bond ratings) Origination (e.g., originating a loan to a borrower) Issuance (e.g., taking a security offering to the market) Miscellaneous (e.g., trust services)

Qualitative Asset Transformation

Major Attributes Modified Term to maturity (e.g., bank financing assets with longer maturity than liabilities) Divisibility (e.g., a mutual fund holding assets with larger unit size than its liabilities)

Liquidity (e.g., a bank funding illiquid loans with liquid liabilities Credit risk (e.g., a bank monitoring a borrower to reduce default risk)

Figure 1: Functions of Financial Intermediaries (Bhattacharya and Thakor [1993])

Why do Financial Intermediaries Exist?

• Transactions Costs (Benston and Smith [1976])• Delegated Monitoring (Diamond [1994])• Providers of Liquidity• Resolving Problems Related to Incomplete

Markets and Asymmetry of Information

Transactions Costs (Benston and Smith [1976])  

• Financial intermediaries reduce the costs of transacting by engaging in a variety of services, ranging from brokering to asset transformation.

• Scale economies and diversification are key factors leading to transactions costs reduction (e.g., .NYSE, dealers).

Delegated Monitoring (Diamond [1994])

• Banks monitor firms to which they extend financing. Banks take significant stakes in the firms that they monitor, justifying their roles in corporate governance, and can maintain flexibility to renegotiate loans when necessary.

• Securities sold to widely dispersed public investors do not normally lead to comparable monitoring, governance and renegotiating activities.

• Banks acquire private information in the loan application and screening process.

• Banks often hold demand deposits of their client borrowers, providing them with further special information concerning their clients.

• Banks often maintain long-term relationships with their client borrowers.• Typical bank monitoring activities include:

– Screening bad loan applications from good. – Evaluating borrower creditworthiness. Again, development of expertise is key.– Observing the extent to which borrowers adhere

Providers of Liquidity:Diamond and Dybvig [1983]

• A central role of a bank is to create and enhance liquidity. Banks do so by financing illiquid assets with more liquid liabilities. Bank liabilities, particularly demand deposits, which function as a medium of exchange, as do other services such as credit cards and provisions of ATMs.

• Diamond and Dybvig [1983] describe how agents deposit their endowments in interest-bearing bank claims that enable them to finance future, perhaps unanticipated consumption needs. Such deposits enhance consumption flexibility and increases utility of consumption.

• Alternatively, agents could have invested their endowments in illiquid production technologies, where higher than anticipated consumption needs in earlier periods force them to liquidate investments too early, reducing overall consumption.

• In effect, the deposit serves as an insurance contract against the costs of unanticipated consumption in earlier periods.

Resolving Problems Related to Incomplete Markets and Asymmetry of Information

• Resolving Problems Related to Incomplete Markets and Asymmetry of Information: In complete capital markets, financial intermediaries would not be needed to transform the attributes of securities. Further, information asymmetries can lead to moral hazard and adverse selection, which inhibit the channeling of funds from surplus to deficit agents. Banks contribute to funding efficiency by engaging in activities that mitigate these information problems:

• Banks enjoy scale economies that enable them to more efficiently obtain information and share (signal) that information among members of lending coalitions (loan syndicates ). Asset diversification is realized from the scale economies.

• Banks monitor their borrowers• Banks provide capital seek long-term financial relationships. Such long-term

relationships (commitments) enable banks to execute contracts in the absence of complete contracts and markets.

E. Corporate Securities as Options and Capital Structure

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F. The Principal-Agent Problem

• The agency problem arises in environments exhibiting incomplete information availability or information asymmetries.

• Generally, agency theory is concerned with the efforts of a principal attempting to induce an agent to undertake some costly action on behalf of the principal.

• The principal’s problem is to design an incentive scheme to induce the agent to make the best and most productive effort on his behalf.

• Jensen and Smith [1985] suggest that there are three primary potential sources of conflict between managers and shareholders:

– Managerial effort: Broadly defined, effort includes non-pecuniary benefits (e.g., the corporate jet), shirking (e.g., not undertaking the unpleasant task of firing unproductive employees), empire-building), etc.

– Human capital: Risk associated with firm-specific human capital cannot be diversified away.

– Time horizons: Shareholders are perpetual stakeholders; manager tenures are limited.• The shareholder problem is to induce the management team to act in

shareholder interests.

G. Moral Hazard

• Moral hazard originally referred to the tendency of insured individuals to reduce their efforts to avoid or mitigate insured losses.

• More generally, moral hazard is post-contractual opportunism where the actions of one contracting party are not freely observable. Moral hazard is a problem of hidden action.

H. Contracting

• Contract theory is concerned with how agents design construct contracts. • Typically, contracting occurs in environments with asymmetric information

availability, though contracting would be simpler with perfect or at least symmetric information availability.

• A complete contract fully specifies all parties’ rights, payoffs and responsibilities under every contingency for every point in time.

• Bounded rationality exists where contingencies cannot all be accounted for, when individuals cannot properly analyze all their potential strategies and actions or when communication is imperfect.

• Mechanisms to deal with bounded rationality.:– Relational contracting: frames the relationship among contracting parties, focusing on

goals, objectives and procedures for dealing with unforeseen contingencies rather than attempting to fully pre-specify all rights and responsibilities under all circumstances.

– Contract law can be enacted to facilitate the efforts of contracting parties to maximize the joint gains (the “contractual surplus”) from their transactions.

– Implicit contracts are unarticulated shared expectations shared among contracting parties.

The Hold-up Problem• Klein, Crawford and Alchian (1978) characterize a scenario involving post-

contractual opportunism where a transaction requires one agent to make a relationship-specific investment.

• Since complete contracts are not possible in this scenario, the second agent might be able to exploit the first’s investment to extract gains.

• Consider General Motors and Fisher Body in the 1920s, it was resolved by Fisher Body’s vertical integration into General Motors.

• Mergers between potentially competing firms at different stages of the production process can align incentives and prevent the hold-up problem.

• Actually, Williamson (1985) points out that the ex-ante commitment might merely be the selection of a partner, policy implementation any other activity that imposes an opportunity cost or limits the partner’s options. The initial commitment to a partner might represent a sunk cost, perhaps sufficient to prevent the hold-up problem.

I. Adverse Selection and Lemons Markets

• Adverse selection originally referred to the tendency of higher risk individuals to seek insurance coverage.

• More generally, adverse selection refers to pre-contractual opportunism where one contracting party uses her private information to the other counterparty’s disadvantage.

• The Lemons Problem (Akerlof)