The financial system

1. The financial system Chapter 1 Money, banking and financial markets Laurance M Ball

2. 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.

3. 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.

4. Financial markets • Currencies of various economies • Securities • A security is a claim on some future flow of income. • Stocks and bonds

5. 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

6. 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

7. 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

8. 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.

9. 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

10. Securities markets channel funds from savers to investors with productive use for the funds. • These markets help people and firms share risks.

11. 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.

12. 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.

13. 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”

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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?

26. Basic hindrance in direct finance is asymmetric information. • Banks overcome the problem by producing information. • They reduce both adverse selection and moral hazard.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.