Purposes of the Financial System

·       Provides channels for funds to flow from savers to borrowers

·       Debt issued to a borrower is a liability to the borrower and an asset to the lender

·       Financial intermediaries act as go-betweens by holding assets and issuing claims to savers

·       Returns are the incentive for savers to put money into the financial system

·       The financial system provides liquidity: The ability to convert an asset to cash

• The financial system provides liquidity by allowing savers to hold a number of assets
•   The financial system creates liquidity
•     It provides information on borrowers and returns on assets
• Watching stock prices tells a lot about the prices of firms

Aymmetric info

The most commonly issued claim is ____

The other type of claim is

Maturity

• Risk-sharing and liquidity are provided in secondary markets by the ability to buy or sell multiple funds without delay
•  Equities are unpredictable
• Watching stock prices tells a lot about the prices of firms
• More debt equals a greater return, and greater risk

Derivative markets

Financial futures

Options

Financial intermediaries have 2 tasks.  

1. match savers and borrowers
2. Provide risk-sharing, liquidity, and information services 

·       Banks allow you to lend money without your money becoming illiquid.  Ex.  Cash in your checking and savings accounts are lent to borrowers giving you a return

Money market instruments

Commercial Paper

Bankers acceptances

US treasury securities

US government agency securities

Stocks

Corporate bonds

·       Governments want to ensure that all participants in the financial system have access to information and that markets and intermediaries give savers and borrowers accurate and timely information

• Governments maintain financial stability

·       1 Restrictions on financial institutions ability to hold certain assets impact risk sharing and diversification

·       2 stringent limits in domestic markets create opportunities for international competition

·       Regulation affects the ability of financial markets and institutions to provide risk-sharing, liquidity, and information services

·       Restrictions on types of instruments that can be traded in financial markets impact liquidity

Restrictions on financial institutions ability to hold certain assets or to operate in certain locations impact risk sharing and diversification

Expected “real rate of return” account for tax benefits & costs

• common risk shared by all assets and can’t be eliminated through diversification
• Probability of loss common to all businesses and investmentopportunities, and inherent in all dealings in a market. It cannot be circumvented or eliminated by portfoliodiversification but may be reduced by hedging.

Unsystematic (idiosyncratic)

costs of buying and selling a financial instrument.

• Ex. Brokerage commissions, minimum investment requirements, lawyers fees

Information costs

Credit rationing

Financial market participants can ________

Lemons problem

• asymmetric information in a market leads to adverse selection.
•  Lemons problem raises lending costs.
• Lemons problems in the bond market lead to credit rationing.

These institutions reduce the costs of matching savers and borrowers and provide risk-sharing, liquidity and information services. Investment banks help raise new capital in primary markets and perform underwriting

• investment banks, brokerage firms, and organized exchanges

___________ create liquidity within the market and hold an inventory to help match buyers

Exchanges

a physical location at which securities are traded.  An institution providing an auction market for securities.

• Ex. New York Stock Exchange

Over-the-counter trading

Investment Institutions

• mutual funds and finance companies
•  Investment institutions raise funds to invest in loans and securities.

Why do finance companies sell securities?

to make small loans to households and businesses.

Contractual Saving

What do firms offer as an additional incentive for employees to work for them

Law of large numbers

enables insurance companies to predict loss for large groups.

• Ex. Millions of people saving reduces the risk for all and creates liquidity for emergency funds

What problems do insurance companies face

adverse selection and moral hazard.

• Ex. If you have cancer you are more likely to request a companies services and require a greater payout. 

Pension funds

Retirement is ________.

Depository institutions

Commercial banks ________.

Federal credit agencies

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999

The National Banking Act of 1863

·       created the banking system of federal and state banks.

·       Up until 1863 was the Free Banking Period. States controlled banks within their borders. Their was little government intervention

·       Federally chartered banks were originally allowed to issue bank notes as currency.

·       State banks came up with the demand deposit as a substitute for bank notes to avoid fed tax on bank notes-  An account against which convertible checks can be written

Free Banking Period.

The Federal Reserve System

Bank run

Contagion

Bankers’ private information ________.

Why does the government intervene in the banking system?

Why was the 1913 Federal Reserve created?

Banks were restricted on ___________.

Banks avoided branching restrictions with ___________.

The Glass-Steagall Act

• prohibited commercial banks from investment banking activities.
• Restrictions have weakened. 
• Commercial banks could not act as dealer/brokers or underwrite corporate securities

• Investment Banks were permitted from deposit taking

What do Commercial banks do? 

What do Investment Banks do?