Lesson 3: Overview of the Financial System

Upon completion of this lesson, you should be able to do the following:

  • Describe the purpose of the financial system.
  • Explain how savers and borrowers are linked in the financial markets.
  • Identify the key financial markets.
  • Explain the difference between primary and secondary markets.
  • Describe financial innovation and regulation of the financial markets.
  • Identify the main financial instruments.

Introduction

The financial system transfers funds from savers to borrowers. The savers and borrowers can be anybody. Some households, businesses, and governments are net savers; they spend less than their income. Other households, businesses, and governments are net borrowers. The spend more than their income. For example, many college students are net borrowers. Students' income tends to be lower than their yearly expenses and use student loans to pay the difference. Then the students enter the workforce and begin to pay off their loans. As the former students' income continually increases over time, the former students will pay back their loans and become net savers, saving funds for retirement. Another example is governments. Many local and state governments have laws, requiring them to have balanced budgets. This fiscal responsibility causes many local and state governments to be net savers, while the U.S. Federal government has been a net borrower for the last 30 years.

How Savers and Borrowers are Linked

There are two routes that connect the savers to the borrowers.

  1. Financial intermediation - this is the process of transferring funds through financial institutions. The most common financial intermediaries are banks, mutual funds, and insurance companies. For example, you purchased fire insurance for your home. When you pay your premium, the insurance company will transfer your payment to the financial markets, and invest in financial securities. The financial intermediaries only provide this function for one reason - to earn profits. For example, banks transfer your funds to borrowers and the banks' profit occur when the interest rate paid by the borrowers is greater than the interest rate the bank pays on your accounts.

  2. Direct finance - The net savers, like households, can lend directly to businesses through the financial markets. There are two broadly defined financial instruments.

    1. Common stock - If you buy common stock, you have partial ownership in a corporation. (The ownership is also referred to as equity). You and the stockholders have the right to vote on certain corporate policies and elect the Board of Directors. Each share of stock you own entities you to one vote. If you own 100 shares of stock and this corporation has sold a billion shares, your vote will have little impact on corporate policy. Also, you and the stockholders receive a share of the profits, called dividends.

    2. Bond - A bond is essentially an IOU. All it is a fancy paper giving you legal rights that the corporation promises to pay back a long-term loan (+ interest) to the people who hold the bonds.

Key Financial Markets

There are two broadly defined markets for direct finance.

  • Primary market - Only new securities are bought and sold in this market. The investment banks are the key institution. Investment banks are not like commercial banks; they are more like brokers. Investment banks help corporations and government issue new securities and market the securities. Investment banks tend to have a lot of financial capital. For example, IBM wants to issue new bonds, so they go to an investment bank. The bank comes up with the face value and interest rate on the bond, and sells them for IBM, The investment bank will guarantee the face value of the bond and will buy any bonds not sold out of their own funds. An investment bank is really a marketing agent for new securities. In some countries, investment and commercial banks may be the same bank. In the United State, federal law split these two business activities. If a business wants to be a commercial banker, then federal law prevents that business from also being a investment banker.

Secondary market - In this market, existing financial securities are exchanged. For example, you own 100 shares of Coca-Cola and you want to sell them. You can only sell them in a secondary market, which would be the New York Stock Exchange. If Coca-Cola wanted to raise more funds, then it can issue more stock, which would be sold through the primary market. The only difference between these two markets is the first time a financial instrument is sold, it is sold through the primary market. If the same financial instrument is sold again, then it is sold through the secondary market. The secondary market is extremely important, because it performs three functions.

The Derivatives Market

There are two methods for completing a transaction. Up to this point, you can assume that when a buyer and seller complete a financial transaction, money is immediately exchanged for the financial instrument. This is referred to as cash markets.

A transaction can be completed in another manner. The buyer and seller of a financial instrument can negotiate a price today, but money is exchanged for the financial instrument on a future specific date. This is referred to as the derivatives market.

For example, you negotiate a price today to buy 10 T-bills from a seller for $9,000 each in 6 months. You are entering into a contract with the seller for a future transaction. These contracts can be sold on secondary markets. Do not worry about derivatives now, you will extensively learn them in Lesson 7.

  1. Increased liquidity - The existence of a secondary market increases liquidity for the securities traded there. The securities are a more attractive investment, because investors can easily resell their securities if they no longer want them.

  2. Price setting - The price of securities in the secondary market sets the price of the securities sold in the primary market.

  3. Information provided - The secondary market provides information to the investment banks.

Why would savers want to deposit their money into banks, instead of investing directly into the financial markets? The financial intermediaries provide three functions, which were discussed in Lesson 1.

  1. Liquidity - a bank account has liquidity. If an emergency arises, you can easily withdraw funds from your account. If you directly purchased stock and bonds from the financial markets, there could be time delays and a transaction cost to retrieve yours funds.

  2. Information - financial intermediaries have specialist who collect information about borrowers. The financial intermediaries will only lend to borrowers who have a low chance of defaulting on their loan.

  3. Low risk - the financial intermediaries lower risk. They will lend to a variety of borrowers. This process is called diversification. For example, banks will issue credit cards, grant mortgages, grant loans to a variety of businesses, and buy U.S. government securities. If several credit card holders default, several households stop paying their mortgages, and one business bankrupts, over all, the banks could still earn profits, because the majority of their loans are being paid. If you directly invested in a company that bankrupts, then you lose all of your investment.

Another process can occur which is called financial disintermediation. It occurs when savers take their money out of the financial intermediaries and invest directly in the financial markets, such as buying U.S. government securities. There are two reasons for investing directly in government.

  • The government may offer a higher interest rate than a bank. You savings account may earn 2% interest, while a U.S. Treasury bill can earn 5% interest.

  • The U.S. government has a low risk of default, because governments have the power to tax and "print" money (i.e. seigniorage). If the government gets into financial trouble, it can raise taxes, issue more government securities, or print money. One problem does occur. If government is running up a massive debt, it usually gets money for loans first. Businesses usually come second. If there are limited funds, businesses might not get the money that they need for investing in machines and equipment. A large government debt could have a large impact in the financial markets and hamper business investment.

Innovation and Regulation

The financial markets and institutions are constantly changing. Let's look at several examples.

  1. Financial innovation - if a new financial instrument lowers risk, increases liquidity, or increases information, then investors will be attracted to the new security. For example, mutual funds were one financial innovation. A mutual fund pools together money from many people into a fund and the fund manager invests the fund in a variety of stocks. This method lowers investors' risk through diversification of stocks. For example, you started you own mutual fund and bought 30 different corporate stock. Your Coca-Cola stock may go up one day, while the value of your IBM stock goes down. Overall the average of the fund's 30 stocks will probably earn a return to the fund investors. If you bought only one type of corporate stock, like Kodak, your investment can bankrupt, when this corporation bankrupts.

  2. Globalization - in the last 30 years, savers and borrowers are being linked through international financial markets. For example, a Japanese bank transfers funds from savers in Japan to build a new factory in China. There are three reasons for the rise of international financial markets.

    1. Repealed laws - many countries repealed laws that restricted savers from investing in foreign countries.

    2. Increased savings - the industrialized countries have been growing. As countries grow, people earn higher incomes and save more. The increase in savings is funneled into the financial markets.

    3. International corporations - corporations became global. A corporation produces goods in one country and transports the goods to another country. The corporation needs financing to build the new factory and needs financing to transport goods to other countries. The international financial markets are a source of funds for international business investment.

The transfer of funds from savers to borrowers is very important for the economy. If the borrowers invest the funds by purchasing machines and equipment, the borrowers can produce more goods and services. When more goods and services are produced, the economy grows. Consumers buy more goods and services, causing the living standards to increase. The beauty in the U.S. financial system is if there are 10,000 savers that have $200 in their savings accounts, the bank can potentially loan a business $2 million. The business can buy new machines and equipment and increase its production level, causing the U.S. economy to grow.

The financial sector is extremely important sector of the economy and every country around the world regulates its financial markets. There are three reasons for government regulations.

  1. Accurate information - the financial markets depends on accurate information. Governments want to ensure borrowers are providing accurate information to the investors. In the United States, the Securities and Exchange Commission (SEC) requires publicly traded companies (i.e. sells stock to the public) to disclose financial information based on acceptable accounting standards.

  2. Stability - governments want the financial system to be stable. Many economists believe the Great Depression would not have been so severe, if there was not a massive bankruptcy of financial institutions.

  3. Effectiveness - the money supply and financial markets are intertwined. If the central bank influences the money supply in order to indirectly influence the inflation, business cycle, or interest rates, the central bank also influences the financial markets. Government regulations are needed for central banks to effectively use monetary policy.

Financial Instruments

Financial instruments are categorized into two broadly defined classes.

  1. Money market - it only includes short-term securities that have a maturity less than 1 year. (Maturity is the expiration date of a security). These type of securities are very popular and are simply a loan of funds from party to another.

  2. Capital market - it includes long-term securities that have a maturity of one year or more. The capital market includes common stock, because stock has no expiration date and is considered a long-term security.

You do need to memorize the following securities, because throughout this course, we will be continually refer to these financial instruments. The key to understanding these securities is who issues the security and does it belong in the money market or capital market. All these securities have one purpose -one party owes another party money plus interest. There is only one exception, which is stocks. Stocks are ownership in a corporations and are not a loan.

Every financial instrument, except stock, will have a principal,. interest, and maturity stated on the security.

  1. Principal - how much money the borrower received from the lender.

  2. Interest- the periodic payments paid to the lender, because the lender is allowing the borrower to use the funds. The interest is a cost to the borrower, but income to the lender.

  3. Maturity - the date when the final payment of all the principal plus interest is paid to the lender.

Money Market Instruments - securities that have a maturity less than one year.
Treasury bills (T-bills)
  • Loans to the U.S. Government.
  • Maturity is 15 days to 1 year.
  • They do not state the interest rate.
  • Minimum denomination is $10,000.
  • I bought a $20,000 T-bill (face value) with a maturity of 6 months for $19,000. Six months later, the government gives me $20,000. The $1,000 reflects the interest rate.
Repurchase Agreements
  • Short-term loans.
  • Bank sells T-bills to a customer and promises to buy it back the next day for a higher price (reflects interest).
  • For example, IBM has excess funds in their checking account. The bank uses these funds and sells IBM T-bills. The next day the bank deposits the funds back into IBM's account. plus interest, and takes the T-bills back.
  • The REPO was a way to get around the law, so banks could pay businesses interest on their checking accounts.
Commercial Paper
  • Loans to well-known banks and corporations for a short-time period.
  • An alternative to raise funds, instead of selling more stock and bonds.
  • A form of direct finance and the loan has no collateral.
Federal (Fed) Funds
  • Overnight loans between banks.
  • A bank that has excess funds deposited at the central bank can lend these funds to another bank.
  • Market analysts and the Fed scrutinize the interest rate in this market closely.
Banker's Acceptances
  • Used for international trade.
  • A firm wants to buy from a foreign exporter. The firm deposits money at a bank, and the bank guarantees payment by issuing this security.
  • If the firm does not deposit money at the bank and the bank guarantees payment, then the bank has to pay the foreign exporter, even if the firm bankrupts.
  • These securities are liquid, because they are sold on the secondary market.
Eurodollars
  • U.S. dollars that are deposited in foreign commercial banks outside the U.S. and in foreign branches of U.S. banks.
  • Important source of funds in the international market.
Negotiable Bank Certificates of Deposit
  • Loans to banks and sold to depositors.
  • The CD has a fixed time period.
  • If the CD is withdrawn early, then the investor does not receive the interest.
  • CDs tend to pay a higher interest rate than a savings account.
 
Capital Market Instruments - securities that have maturities longer than a year.
U.S. Treasury securities
  • Loans to the U.S. government.
  • Has a stated interest rate, paid every 6 months.
  • Treasury Notes (T-notes) - issued from 1 to 10 years.
  • Treasury bonds (T-bonds) - maturity is greater than 10 years.
Stocks and Bonds
  • Already defined in the lecture.
U.S. Government Agency Securities
  • Example - Sallie Mae
  • Quasi-government agency.
  • Buys student loans.
  • The student loans are packaged together as a fund. Sallie Mae issues new securities to investors based on this fund. The investors own a portion of the fund and earn the interest from the students payments.
  • Makes student loans more liquid.
Commercial Bank Loans
  • Bank loans to businesses.
  • Does not have a well developed secondary market.
State and Local Government Bonds
  • Also called municipal bonds.
  • Tax-exempt: Do not pay U.S. government taxes on the interest earned.
  • General-Obligation Bonds: Secured (guaranteed) by the taxing power, where they are issued.
  • Revenue Bonds: Secured by the revenues that will be obtained from the project.
  • College builds a new dormitory, using revenue bonds. When students pay to live there, some of the money goes to the bond holders.
Mortgages
  • A loan for a house (property) usually for 15 - 30 years.
  • The property is the collateral.
  • The largest debt market.
  • Funds for mortgages come from savings institutions and banks.
  • If I lose my job and cannot pay the mortgage, the bank takes my house.
  • This property taking process is called foreclosure.
  • U.S. government helped to create secondary markets, causing mortgages to be more liquid.
 

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