The financial system

Chapter 1Money, banking and financial markets

Laurance M Ball

• The financial system is part of our daily life.– Buy things with debit or credit cards.– You use ATMs to get cash– You may borrow money from a bank.

• Financial system is also an important part of overall economy.

• When the system works well it channels funds to investment projects that make economy more productive.

Financial markets

• Two main parts of a financial system– Financial markets– Banks

• What is a market?– Market consists of people and firms who buy and

sell something– Financial markets are made up of people and firms

who buy and sell two kinds of assets.

Financial markets

– Currencies of various economies– Securities

• A security is a claim on some future flow of income.– Stocks and bonds

Financial markets

• Bonds– Security that promises predetermined payments

at certain points in the future.– Also called a fixed income security– Face value, coupon, maturity.

• Corporations issue bonds to finance investment projects e.g new factories, extensions etc

Financial markets

• Governments issue bonds when they need funds to cover budget deficits.

• In both cases they borrow money from those who buy the bonds.

• The issuer receives the funds immediately and makes future payments in return.

• Commercial paper• Treasury bills( T-bills)• Zero - coupon bond • Default

• Stocks – A stock, or equity, is an ownership share in a

corporation.– Companies issue stock for the same reason they

issue bonds: to raise funds for investment.– This too produces a flow of income

• The earnings from a company’s stocks are a share of profits, and profits are unpredictable.

• Buying stocks is usually riskier then buying bonds.

• Stockholders have ultimate control over the corporation while bondholders have no such privilege.

Economic functions of financial markets

• What is the purpose of stock and bond market?

• Why do people participate in them?• and why are they important for economy?

2 main answers

• Securities markets channel funds from savers to investors with productive use for the funds.

• These markets help people and firms share risks.

Matching savers and investors

• Matching savers and investors– Savers: who accumulate wealth by spending less then

they earn.– Investors: people who expand the productive capacity of

businesses. e.g by building factories, buying equipment and hiring workers.

– The term investor is often used differently.• Brit might say he is investing when he buys stocks or bonds

from Harriet but for us purchasing securities is a form of saving.• Harriet does the investing when she buys computers and hires

programmers.

Risk sharing

• Diversification: the distribution of wealth among many assets, such as securities issued by different firms and governments.

• It reduces the risk to a person’s wealth.• Most of the time some companies do well and others

do badly. E.g the software industry might boom while the steel industry loses money or vice versa.

• One software company may succeed while another fails.

Risk sharing

• If a person’s wealth is tied to one company, he loses a lot if the company is unsuccessful.

• If he buys the securities of many companies, bad luck and good luck tend to average out.

• Diversification lets savers earn healthy returns from securities while minimizing the risk of disaster.

• James Tobin won the Noble prize in economics in 1981 largely for developing theories of asset diversification. “don’t put all your eggs in one basket”

Asymmetric information

• The problem that one side of an economic transaction knows more then the other.

• One party has more or better information then the other.

• This creates an imbalance of power in transactions which can sometimes cause transactions to go wrong.

• Information asymmetry causes misinformation.

• In some cases sellers have better information while in some cases buyers have better information. E.g used car sales person, life insurance.

• In financial markets, the seller of the securities know more than the buyers.

• Two types of asymmetric information exist in financial markets.

• First, the sellers of the securities know more than buyers about their own characteristics.

• This can effect the value of the securities.• This problem produces the problem of adverse

selection.• Second, after investors sell securities, they know

more than security holders do about the use of funds.

• This produces the problem of moral hazard.

Adverse selection

• Adverse selection: means that the people or firms who are most eager to make a transaction are the least desirable to parties on the other side of the transaction.

• In adverse selection ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction.

• E.g people who are high risk are more likely to buy insurance.

Adverse selection

• In securities markets, firms are most eager to issue stocks and bonds if they are a bad deal for buyers.

• Simply, a bad product or service are more likely to be selected due to lack of information.

Moral hazard

• The risk that one party to a transaction takes actions that harm another party.

• a moral hazard is a situation where a party will have a tendency to take risks because the costs that could result will not be felt by the party taking the risk.

• In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.

Moral hazard

• The ignorant party lacks information about performance of the agreed-upon transaction

• In securities markets, investors may take actions that reduce the value of the securities they have issued, harming buyers of the securities.

• The buyers can’t prevent this because they lack information of investors’ behavior.

• Adverse selection savers don’t observe investors’ characteristics investors with worst project are more eager to sell securities savers wont buy securities.

• Moral hazard savers don’t observe investors’ uses of funds investors have incentives to misuse funds savers wont buy the securities.

Banks

• A bank is one kind of financial institution.• Financial institution or financial intermediary is

a firm that helps channel funds from savers to investors.

• Bank is a financial institution defined by two characteristics.– First, it raises funds by accepting deposits– Second, a bank uses its funds to make loans to

companies and individuals.

• These loans are private loans.• Private loan: loan negotiated between one

borrower and one lender.• This makes them different from the borrowing

that occurs when companies sell bonds to public at large.

Banks versus financial markets

• Banks play the same basic role as financial markets: they channel funds from savers to investors.

• Funds flow through a bank in a two step process.– Savers deposit money in the bank, and then the bank

lends to investors.• In financial markets, savers provide funds directly

to investors by buying their stocks and bonds.

• For these reasons channeling funds through banks is called indirect finance.

• And channeling through financial markets is direct finance.

• indirect finance is costly. Why?• Still people use them. Why?

• Basic hindrance in direct finance is asymmetric information.

• Banks overcome the problem by producing information.

• They reduce both adverse selection and moral hazard.

Reducing adverse selection

• They reduce adverse selection by screening potential borrowers.

• When two investors apply for loans, they must provide information about their business plans, past careers and finances.

• Bank loan officers are trained to evaluate this information and decide whose project is likely to succeed.

• They care because a firm with a bad project may go bankrupt, and a bankrupt firm defaults on bank loans as well as on bonds.

• So banks try to produce more and more information to reduce information asymmetries and in this way the funds flow to the most productive investment.

Reducing moral hazard

• To reduce moral hazard, banks include covenants.

• Covenants: provision in a loan contract that restricts the borrower’s behavior.

• E.g Harriet’s lender might include a covenant requiring that she spends her loan on computers and not parties at clubs.

• Banks monitor their borrowers to make sure they obey covenants and don’t waste money.

• Harriet must send her bank periodic reports on her spending. If Harriet misuses her loans– thereby increasing the risk of bankruptcy– the bank demands its money back.

• Harriet’s business expands, Britt too earns but less then the Harriet pays for her loan.

Who needs banks?

• Some firms raise funds by issuing securities; others can’t and depend on bank loans.

• Asymmetric information. • Savers have more information about large and well

established firms and its easy to find out more.• Savers know less about newer or smaller firms.

Someone who starts a company cant issue securities immediately because savers cant judge the company’s prospects.

• Individuals.