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Overview of Market Participants & Financial Innovation

This chapter provides an overview of participants in financial markets, the business of financial institutions, financial intermediaries, asset & liability management, government regulations, and the primary reasons for financial innovation.

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Overview of Market Participants & Financial Innovation

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  1. Chapter 2 Overview of Market Participants & Financial innovation

  2. Learning Objective • Participants in Financial Markets • Business of Financial institutions • Financial Intermediary • Economic functions of Financial Intermediaries • Asset & Liability management of Financial institutions • Government Regulations • Primary reasons for financial innovation

  3. Classification of Entities • Central governments • Agencies of central government • Municipal governments • Supranational • Non- financial businesses • Financial enterprises • households

  4. Classification of Entities • Central governments Debt obligations issued by central Governments carry full faith & credit of the borrowing Government. • Agencies of central government Federally related institutions, Government sponsored enterprises • Municipal governments • Supranational An organization that is formed by two or more central governments through international treaties.

  5. Classification of Entities • Non- financial businesses Corporations & non-corporate business • Financial enterprises • households

  6. Classification of Entities Financial intermediaries • Depository institutions-commercial banks, S&L associations and credit unions • Insurance companies • Pension funds

  7. Classification of Entities Financial Enterprises • Exchanging financial assets on behalf of customers. (Brokers) • Exchanging financial assets for their own account. (Dealers) • Assisting in creation of financial assets for their customers and then selling those financial assets to other market participants. (Underwriting) • Providing investment advice to other market participants. • Managing portfolios of other market participants.

  8. Role of Financial Intermediaries • Obtain funds by issuing financial claims against themselves to market participants, then investing those funds. • Direct investments- investments made by the financial intermediaries. (assets can be loans /or securities) • Transform financial assets that are less desirable for a large part of the public into other financial assets(their own liabilities ) which are more widely preferred by the public.

  9. Role of Financial Intermediaries This transformation involves four basic economic functions: • Maturity intermediation • Risk reduction and diversification • Reducing the costs of contracting and information processing • Providing a payment mechanism

  10. Nature of Liabilities

  11. Nature of Liabilities • Type I liabilities: • Fixed deposit account • Guaranteed investment contract (GIC) issued by the insurance companies • Type II: • Life insurance policy

  12. Nature of Liabilities • Type III liabilities: • Floating rate Certificate of deposits issued by the depository institutions • Type IV liabilities: • Automobile and home insurance policies

  13. Liquidity Needs • Uncertainty about timing and amount of cash outlays • Potential for the depositor or policy holder to withdraw cash early.

  14. Liquidity Needs Reduction in cash inflows: • Depository institutions- inability to obtain deposits • Insurance companies- reduced premium because of the cancellation of policies • Investment companies- not being able to find new buyers for shares.

  15. Regulation OF Financial Markets • Disclosure Regulation • Financial Activity Regulation • Regulation of Financial Institutions • Regulation of Foreign Participants

  16. Financial Innovation Categorizations of Financial Innovation • Market-broadening Instruments- Increase liquidity of markets and availability of funds by attracting new investors and offering new opportunities for borrowers • Risk- management instruments reallocate risk to those who are less risk averse.

  17. Financial Innovation • Arbitraging instruments and processes- enable investors and borrowers to take advantage of differences in costs and returns between markets.

  18. Motivation for Financial Innovation Causes of Financial Innovation • Increased volatility of interest rates , inflation , equity prices and exchange rates • Advances in computer and telecommunication technologies • Greater sophistication and educational training among professional market partcipants • Financial intermediary competition • Incentives to get around existing regulation and tax laws • Changing global patterns of financial wealth..

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