Chapter 2

AN OVERVIEW OF THE FINANCIAL SYSTEM

The financial sector plays a vital role in the economy because it helps money be eff iciently channeled from savers to prospective borrowers, making it much easier for f irms to obtain f inancing for profitable investment in new capital and for individuals to borrow against their future income (e.g., to pay for college, to buy a house or car).

Without f inancial markets and institutions, borrowers would have to borrow directly from savers.  Probably not much borrowing would take place at al l, borrowers would tend to have a hard t ime finding individuals able and wil l ing to loan them money.

Without much borrowing, the economy would be a lot less developed, as few businesses would be able to raises funds to invest in new plant and equipment.  Likewise, relatively few individuals would be able to own their own homes, or buy a car.

A well-functioning financial sector is necessary for a well-functioning economy.

DIRECT AND INDIRECT FINANCE Funds can raised directly (direct

f inance) or indirectly (indirect f inance) Direct f inance refers to funds that f low

directly from the lender/saver to the borrowers/investors in f inancial market.

Indirect f inance refers to funds that f low from the lender/saver to a financial intermediary who then channels the funds to the borrower/investor. Financial intermediaries (indirect f inance) are the major source of funds for corporations.

FUNCTION OF FINANCIAL MARKETS: DIRECT FINANCE

Financial markets have important function in the economy because they

1. Allow transfer of funds from person or business without investment opportunities to ones who have them. In the absence of f inancial markets, lenders-savers and borrower-spenders may not get together and it becomes hard to transfer funds from a person who has no investment opportunities to one who has them

2. Enhance economic eff iciency by allocating productive resources eff iciently, which

increases production.

3. Improve the economic welfare because they allow consumers to t ime their purchases better.

4. Increase returns on investment and increase business profit

5. Set firm value6. Buy and sell r isk: allow you to transfer

certain f inancial risks (arising from accidents, theft, i l lness, early death, etc.) to another party (in this case, the insurance company).

A breakdown of f inancial markets can result in polit ical instabil i ty.

STRUCTURE OF FINANCIAL MARKETS

Financial markets can be categorized in four different ways:

1. Debt and Equity Markets2. Primary and Secondary market3. Exchanges and Over–the-Counter

Market4. Money and Capital Markets

First: Debt and Equity Markets A firm or an individual can obtain

funds in a f inancial market in two ways:

1. To issue the debt instrument, which is practiced in debt markets.

2. To issue equities (such as common stock) , which is practiced in equity markets, is by issuing,

1. Debt Market Debt instrument is a contractual agreement

that obliges the issuer of the instrument (the borrower) to pay the holder of the instrument (the lender) f ixed amounts (interest and principal payments) at regular intervals unti l a specified date (maturity date) when a f inal payment is made.

The maturity of a debt instrument is the date on which a loan or bond, or other f inancial instrument becomes due and is to be paid off.

Debt holders do not share the benefit of increased profitabil i ty because their dollar payment is f ixed

A debt instrument is 1. short-term if i ts maturity is less than one

year, 2. long-term debt if i ts maturity is ten years or

longer, and 3. intermediate-term if i ts maturity is between

one and ten years. Examples of debt instruments include

government and corporate bonds.

2. Equity Market Equity is a contractual agreement

representing claims on the issuer's income (income after expenses and taxes) and the asset of the business.

Equities often make periodic payments (dividends) to their holders

Equities are considered long-term financial instruments because they have no maturity date.

Since equity holders own the firm, they are entit led to (1) elect members of the f irm’s board of directors and (2) vote on major issues concerning how the firm is managed.

A key feature distinguishing equity from debt is that the equity holders are the residual claimants: the f irm must make payments to its debt holders before making payments to its equity holders.

Although more attention is given to the equity (stock) markets, the debt markets are actually much larger

Advantage and Disadvantages of Both Markets

Debt Market Equity MarketAdvantage

receive f ixed payments, regardless of whether the borrower’s income and assets become more or less valuable over t ime.

do not benefit from an increase in the value of the borrower’s income or asset

Dis-advantage

receive larger payments when the business becomes more profitable or the value of its assets rises

1. receive smaller payments when the business becomes less profitable or the value of its assets falls. 2. R.C.

Second: Primary and Secondary Markets A primary market is a f inancial market in which

newly-issued securit ies, such as bonds or stocks, are sold to init ial buyers by the corporation or government agency borrowing the funds

An important f inancial institution that assists in the init ial sale of securit ies in the primary market is the investment bank.

A corporation acquires new funds only when its securit ies (IPOs) are sold in the primary market by an investment bank.

Investment Banks underwrite (insure) securit ies in primary markets.

Underwrit ing is a process whereby investment bankers (underwriters) buy a new issue of securit ies from the issuing corporation or government entity and resell them to the public. Thus, i t guarantees a price for a corporation's securit ies and then sells them to the public.

A secondary market is a financial market in which previously issued securit ies can be resold

Brokers and dealers play an important role in secondary markets.◦ A broker is a securit ies f irm or an

investment advisor associated with a firm who matches buyers with sellers of securit ies. The broker does not own the securit ies but acts as an agent for the buyer and seller and charges a commission for these services.◦ A dealer is a securit ies f irm links buyers and

sellers by buying and sell ing securit ies for its own account at stated prices and at its own risk.

Note that the originally issuer or borrower receives funds only when its securit ies are f irst sold in the primary market; the issuer does not receive funds when its securit ies are traded in the secondary market.

Nevertheless, secondary markets perform two essential functions:

1. They make it easier for the buyers of securit ies to sell them before the maturity date, i f necessary. That is, they make the securit ies more l iquid.

2. The price in the secondary market determines the price that the corporation would receive if they choose to sell more stock in the primary market.

Third: Exchanges and Over-the-Counter (OTC) Markets

Secondary markets can be organized in two ways.

Exchange is a marketplace where buyers and sellers of securit ies (or their agents or brokers) meet in one central location to buy and sell stocks of publicly traded companies. Examples of exchanges include New York Stock Exchange, Bahrain Stock Exchange

Over-the-counter (OTC) market is a market in which dealers at different locations trade via computer and telephone networks.

Because over the counter dealers are in computer contact and know the prices set by one another, OTC is very competit ive and not very different from a market with an organized exchange

Many OTC stocks are traded in a market called "NASDAQ," which is set up by the National Association of Securit ies Dealers (NASD although the largest corporations usually have their shares traded at organized stock exchanges.

Fourth: Money and Capital Markets Financial markets can be divided on the basis

of the maturity of the securit ies traded in each market to money markets and capital markets

Money markets: Financial markets in which only short-term debt instruments with maturity of less than one year are traded.

Capital markets: Financial markets in which intermediate-term debt, long-term debt, and equit ies are traded; such as stocks and long term bonds

Money market securit ies are (1) usually more widely traded than longer-term securit ies and therefore tend to be more l iquid. (2)They have smaller f luctuations in prices compared to long-term securit ies making them safer investments.

Corporations and banks actively use money market to earn interest on surplus funds that they expect to have only temporari ly.

Capital market securit ies, such as stocks and long-term bonds, are held by f inancial intermediaries such as insurance companies and pension funds, which have a l i t t le uncertainty about the amount of funds they wil l have available in the future.

FINANCIAL MARKET INSTRUMENTS

A financial instrument is a f inancial asset for the person who buys or holds one, and it is a financial l iabil i ty for the company or institution that issues it.

Money Market Instruments All of the money market instruments are, by

definit ion, short-term debt instruments, with maturit ies less than one year.

The main types of money market instruments include:

1. Treasury Bil ls: Short-term debt issued by government to

help f inance its current and past deficits. Pay a f ixed amount at maturity. Pay no interest but they are sold at a

price lower than their face value. The most l iquid instruments in the money

market, and they are the most actively traded.

The most famous and the safest one is US Treasury Bil ls

2. Negotiable Bank Certif icates of Deposit (CDs)

A certif icate of deposit (CD) is a debt instrument that is issued by a commercial bank against money deposited with it for a specif ic period of t ime, usually at a specif ic rate of interest, with a penalty for early withdrawal.

At maturity, return the original purchase price (the principal).

Negotiable CDs means CDs that are traded in the secondary markets.

3. Commercial Paper. unsecured short-term debt instruments

(obligations) issued by large banks and well-known corporations with high credit rat ings, such as Microsoft and General Motors.

The investment in commercial Papers is usually relatively low risk.

The holding period is usually very short, and corporation agrees to pay the money back even earl ier (on demand), i f asked.

They can be either discounted or interest-bearing,

They usually have a l imited or nonexistent secondary market.

They are available in a wide range of denominations.

4. Bankers Acceptance. I t is a bank draft ( l ike a check) issued by a

f irm, payable at some future date. I t is guaranteed that it wil l be paid by a bank

that stamps it “accepted”. The f irm must deposit the required funds into

its account to cover the draft. They are created to carry out international

trade. The advantage to the f irm is that the draft is

more l ikely to be accepted by foreign exporter since the bank guarantee the payment of the draft even if the local f irm goes bankrupt.

These “accepted” drafts are often resold in the secondary market at a discount.

5. Repurchase Agreements (repos). They are usually very short-term (overnight or

one day) but can range up to a month or more; and use Treasury bil ls as collateral in case of default, between a non-bank corporation as the lender and a bank as the borrower.

In the case of the repurchase agreement, the non-bank corporation buys the Treasury bil l from the bank. Simultaneously, the bank agrees to repurchase the Treasury bil l later at a sl ightly higher price. The dif ference between the original price and the repurchase price is the interest.

This act has the effect of injecting or removing reserves from the banking system in order to meet central bank strategies for implementing monetary policy.

6. The Central Bank’s Funds. These instruments are typically overnight

loans between banks of their deposits at the Central Bank.

Designed to enable banks temporarily short of their reserve requirement to borrow reserves from banks having excess reserves.

Capital Market Instruments Capital market instruments are debt and

equity instruments with maturit ies of greater than a year.

They have more price f luctuations than money market instruments and they are considered to be fair ly risky investments. Types of capital market instruments include

1. Stocks. ◦ Stocks are equity claims -represented by

shares- on the net income and assets of a corporation.

2. Mortgages (Residential, Commercial, and Farm):

Mortgages are loans to individuals or f irms to purchase houses, land, or other real structure.

The structure or land serves as collateral for the loans.

3.Corporate Bonds. Intermediate and long-term debt issued by

corporations with strong credit ratings to raise capital.

They pay the holder an interest payment in regular intervals and pays off the face value when bond matures.

Corporate bonds often offer somewhat higher yields than Treasury bonds.

4. Convertible Bonds. They are bonds that al low the holder to

convert them into a specif ied number of shares of stock at any t ime up to the maturity date.

This feature makes them more desirable to prospective purchasers than bond without i t and allows the corporation to reduce its interest payments.

5. Government debt securit ies. These long-term debt instruments are issued

by the government to f inance the deficits of the government.

They are the most l iquid securit ies traded in the capital market.

6. Consumer and Bank Commercial Loans. Loans, originally made by banks, to

businesses and households. They are also made by f inance companies. Secondary markets for these loans are only

now just developing.

DERIVATIVE INSTRUMENTS Derivative instruments are contracts such as

options, futures, and swaps whose price is derived from the behavior and performance of an underlying asset (such as commodities, bonds, and equit ies), index or reference rate (such as an interest rate or foreign currency exchange rate).

Derivatives can be used to (1) speculate on market movements, (2) to protect investments against major swings in market prices, (3) to manage risk, (4) reduce cost, and (5) enhance returns.

Their t ime horizons can be very short or quite long.

1. Futures contracts,◦ Futures refer to contractual obligations with

the purchase and sale of standardized financial instruments or physical commodities for future delivery at a f ixed price and at f ixed point in the future. 

◦ For commodities whose prices often fluctuate (e.g., crops, oi l), these contracts are important ways of reducing risk. 

◦ More recently, these kinds of contracts have been used with f inancial instruments. 

2. Options contracts: Options give the holder the right to buy (call

option) or sell (put option) a f ixed quantity of a security or commodity at a f ixed price, within a specif ied period of t ime.

Investors often use them to protect, or hedge, an existing investment.

Options may either be standardized, exchange-traded, and government regulated, or over-the-counter customized and non-regulated.

Options are also common, and less risky to purchase, because you have the option of not making that future trade if the prices have not moved in your favor.

INTERNATIONALIZATION OF FINANCIAL MARKETS

The growing internationalization of f inancial markets has become an important trend.

Foreign Bonds. Bonds that are sold in a foreign country and denominated in that country’s currency. For example, i f a Bahraini company such as Alba sells a bond in the United States denominated in U.S. dollars, it is classif ied as a foreign bond.

Eurobond. is a bond denominated in a currency other than that of the country in which it is sold. For example, a bond denominated in USD sold in Germany.

Eurocurrencies are foreign currencies deposited in banks outside the home country.

The most important of the Eurocurrencies are Eurodollars which are U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are similar to the short-term Eurobonds

FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE

We have now considered a wide variety of f inancial instruments that arise through the process of direct f inance, in which the lender sells securit ies directly to the borrower.

Why does some borrowing and lending take place, instead, through indirect f inance– that is, with the help of a f inancial intermediary?

Financial intermediation or indirect f inance is the process of obtaining or investing funds through third-party institutions l ike banks and mutual funds.

As a source of funds for businesses and individuals, indirect f inance is far more common than direct f inance. In virtually every country, credit extended by f inancial intermediaries is larger as a percentage of GDP than stocks and bonds combined.

Commercial banks are the financial intermediary we meet most often, but mutual funds, pension funds, credit unions, savings and loan associations, and insurance companies are important f inancial intermediaries.

Financial intermediaries are so important in current days economies because:

1. They transform fund eff iciently: ◦ They attract funds from individuals,

businesses, and government and then repackage these funds as new financial products, such as loans, which satisfies different needs of savers and borrowers in relation to the amount of funds, the risk levels, and the maturity requirements (usually borrowing short and lending long term).

2. They lower transaction costs. ◦ Transaction costs refer to the time and

money spent in carrying out f inancial transactions. Financial intermediaries have the abil i t ies to lower transaction costs because:

a. Small investors have neither the required expertise nor the time to research what assets they should invest in. Financial intermediaries l ike professional investment firms have the expertise and research facil i t ies to study firms in-depth and to reduce the transaction costs.

b. Their large size allows them to take advantage of economies of scale , the reduction in average transaction costs as the size (scale) of transactions increases. For example, a bank can use the same loan contract many times, thereby reducing the cost of making new contract form for every new loan.

3. Reducing Risk◦ Risk here mainly refers to the uncertainty

about the returns on their investments. ◦ Financial intermediaries do reduce risk

through risk sharing and diversif ication. ◦ Banks mitigate risk by taking deposits from

a large number of individuals and make loans to large number businesses and investors. Even if a few loans are bad, most of the loans wil l be repaid making the overall return less risky. Thus, f inancial intermediaries reduce risk by spreading risky investments among a large number of businesses and clients.

◦ This process of r isk sharing is also sometimes referred to as asset transformation, because risky assets are turned into safer assets for investors. ◦ Diversif ication means lowering the cost by

investing in a collection (portfolio) of assets whose returns do not always move together. Thus, the overall r isk is lower than for individual assets. ◦ Here, again, the bank is taking advantage of

economies of scale, since it would be diff icult for a smaller investor to make a large number of loans.

4. They provide l iquidity services ◦ Liquidity services make it easier for

customers to conduct transactions. ◦ Liquidity refers to the speed and ease of

converting assets into cash. ◦ Although the intermediary may use its

funds to make i l l iquid loans, its size allows it to hold some funds idle as cash to provide l iquidity to individual depositors.

5. They reduce the problem of asymmetric information. ◦ imperfect information in f inancial markets is

called asymmetric information.◦ Asymmetric Information Can be defined as

information that is known to some people but not to other people.

◦ I t refers to the situation when one party does not know enough about the other party to make accurate decision.

◦ Financial intermediaries use their expert ise to screen out bad credit r isks and monitor borrowers. They help solve two problems related to asymmetric information.

◦ Asymmetric information poses two obstacles to the smooth f low of funds from savers to investors: adverse selection and moral hazard.◦ Adverse Selection is a transaction in which

one party has relevant information that the other does not have, and therefore, exploit these asymmetries in information to its own advantage. For example, someone with a dangerous occupation or hobby may be more l ikely to apply for l i fe insurance. ◦ In the financial intermediaries, the adverse

selection refers to the problem created by asymmetric information before a loan is made because borrowers who are bad credit risks tend to be those who most actively seek out loans.

◦ Because adverse selection makes it more l ikely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace.◦ Financial intermediaries can help reduce the

problem of adverse selection by gathering information about potential borrowers and screening out bad credit risks.

◦ Moral Hazard is a problem created by asymmetric information after a loan is made because borrowers may use their funds irresponsibly. ◦ Moral Hazard refers to the lack of any

incentive to guard against a risk when you are protected against i t . ◦ Moral Hazard is the risk (hazard) that the

borrower might engage in activit ies that are undesirable (immoral) from the lenders point of view, because they make it less l ikely that the borrower wil l repay the loan.

◦ Because moral hazard lowers the probabil i ty that the loan wil l be repaid, lenders may decide that they would rather make no loans.◦ Financial intermediaries can help reduce the

problem of moral hazard by monitoring borrowers’ activit ies.

TYPES OF FINANCIAL INSTITUTIONS:

1. Depository institutions (banks, credit unions, savings & loan associations)◦ Accept (issue) deposits, which then become

their l iabil i t ies (sources of funds).◦ Make loans, which then become their

assets.2. Insurance companies ◦ They collect premiums (regular payments)

from policy-holders, and pay compensation to policy-holders if certain events occur (e.g., f ire, theft, sickness, and l ife).

◦ They invest the premiums in securit ies and real estate, and these are their main assets.

3. Pension funds◦ They collect contributions from current

workers and make payments to retired workers.

◦ Like insurance companies, they invest the contributions in securit ies and real estate, and these are their main assets.

4. Finance companies◦ Like banks, they use people's savings to

make loans to businesses and households, but instead of holding deposits, they raise the cash to make these loans by sell ing bonds and commercial paper.

◦ They tend to specialize in certain types of loans, e.g., automobile or mortgage loans.

5. Securit ies f irms ◦ Thy provide firms and individuals with

access to f inancial markets◦ This category covers a wide range of

f inancial institutions:◦ Investment banks: sell new securit ies for

companies. Unlike regular banks, they don't hold deposits, or make loans.  Closely related are underwriters, which not only sell the new securit ies but pledge to purchase some or all of any unsold shares.

◦ Brokers: buy/sell old securit ies on behalf of individuals.◦ Mutual-fund companies: pool the money of

small savers (individuals), who buy shares in the fund, and invest that money in stocks, bonds, and/or other assets.  These are popular because they allow small savers relatively easy and cheap access and also enable them to reduce risk by holding a diversif ied portfolio.

6. Government-sponsored enterprises  ◦ Some of these provide loans directly, such

as to farmers and home buyers.◦ Some guarantee or buy up private loans,

notably mortgage and student loans.◦ Some administer social insurance

programs.

Regulation of the Financial System Government regulates f inancial markets and

institutions1. To increase the information available to

investors by (a) reducing adverse selection and moral hazard problems, and (b) reducing insider trading

2. To ensure the soundness of f inancial intermediaries through (a) restrictions on entry (b) disclosure, (c) restrictions on assets and activit ies, (d) deposit Insurance, (e) l imits on competit ion, and (f) restrictions on interest rates