An Overview of The Financial System
An Overview of The Financial System
An Overview of The Financial System
MONEY, BANKING,
AND FINANCIAL MARKETS
Peter N. Ireland
Department of Economics
Boston College
http://www2.bc.edu/~irelandp/ec261.html
Chapter 2: An Overview of the Financial System
3. Financial Instruments
This chapter provides an overview of the financial system in the US economy by describing
the various types of financial markets, financial instruments, and financial institutions
or intermediaries that exist.
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The chapter begins with a general statement that clarifies what function financial markets
and financial intermediaries have in the economy as a whole.
It then deals more specifically with:
The structure of financial markets and the ways in which different types of financial
markets can be distinguished. Here, it discusses debt versus equity markets,
primary versus secondary markets, exchanges versus over-the-counter markets,
and money versus capital markets.
The various types of financial instruments, including both money market instruments
and capital market instruments.
The special role played by financial intermediaries in the economy. Here, it describes
how financial intermediaries take advantage of economies of scale to reduce trans-
action costs, how financial institutions assist in the process of risk sharing and
diversification, and how financial institutions overcome the problems of adverse
selection and more hazard.
The major types of financial intermediaries, including depository institutions (banks),
contractual savings institutions, and investment intermediaries.
Repeatedly throughout this course, we’ll be coming across references to the numerous types
of financial markets, financial instruments, and financial institutions. As we go along,
we can always refer back to this overview to recall how a particular type of financial
instrument works or what a particular type of financial intermediary does.
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Mishkin, Financial Intermediaries
Chapter 2, Figure 1 (p.24) Indirect Finance
= Financial Institutions
Financial Intermediaries Funds
Funds
Lenders Borrowers
Funds Funds
Equity = a contractual agreement representing claims to a share in the income and assets
of a business.
A key feature distinguishing equity from debt is that the equity holders are the residual
claimants: the firm must make payments to its debt holders before making payments
to its equity holders.
We can refer to this feature in identifying the major advantages and disadvantages of holding
debt versus equity:
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Although more attention is given to the equity (stock) markets, the debt markets are
actually much larger:
Note that the originally issuer or borrower receives funds only when its securities are first
sold in the primary market; the issuer does not receive funds when its securities are
traded in the secondary market.
They allow the original buyers of securities to sell them before the maturity date, if
necessary. That is, they make the securities more liquid.
They allow participants in the primary markets to make judgements about the value
of newly-issued securities by looking at the prices of similar, existing securities
that are traded in the secondary markets.
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2.3 Exchanges and Over-the-Counter Markets
Exchange = buyers and sellers meet in a central location.
Over-the-Counter (OTC) Market = dealers at different locations trade via computer and
telephone networks.
3 Financial Instruments
3.1 Money Market Instruments
The principal money market instruments are:
US Treasury Bills
Negotiable Bank Certificates of Deposit
Commercial Paper
Banker’s Acceptances
Repurchase Agreements
Federal Funds
Eurodollars
All of these money market instruments are, by definition, short-term debt instruments,
with maturities less than one year.
US Treasury Bills:
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Pay a fixed amount at maturity.
Make no regular interest payments, but sell at a discount.
Example: A Treasury bill that pays off $1000 at maturity 6 months from now sells
for $950 today. The $50 difference between the purchase price and the amount
paid at maturity is the interest on the loan.
Trade on a very active secondary market.
Are the safest of all money market instruments, since it is very unlikely that the US
Government will go bankrupt.
Issued by banks.
Make regular interest payments until maturity.
At maturity, return the original purchase price.
Large CDs, with value over $100,000, trade on a secondary market.
“Negotiable” means that the CD trades on a secondary market.
Commercial Paper:
Banker’s Acceptances:
Bank draft (like a check) issued by a firm and payable at some future date.
Stamped “accepted” by the firm’s bank, which then guarantees that it will be paid.
Often arise in the process of international trade.
Make no interest payments, but sell at a discount.
Trade on a secondary market.
Repurchase Agreements:
Very short-term loans, often overnight, with Treasury bills as collateral, between a
non-bank corporation as the lender and a bank as the borrower.
Non-bank corporation buys the Treasury bill from the bank.
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Simultaneously, the bank agrees to repurchase the Treasury bill later at a slightly
higher price.
The difference between the original price and the repurchase price is the interest.
Federal Funds:
Eurodollars:
Corporate Stocks
Residential, Commercial, and Farm Mortgages
Corporate Bonds
US Government Securities (Intermediate and Long-Term)
State and Local Government (Municipal) Bonds
US Government Agency Bonds
Bank Commercial and Consumer Loans
All of these capital market instruments are, by definition, intermediate-term debt
instruments, long-term debt instruments, or equities.
Corporate Stocks:
Loans to individuals and firms used to purchase land, houses, and other structures.
The land or structure then serves as collateral.
The mortgage market is the biggest debt market in the US.
Secondary markets for mortgages first developed in the 1970s and 1980s and are now
quite large and active.
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Corporate Bonds:
US Government Securities:
Somewhat like a combination between US Treasury bonds and notes and corporate
bonds, but issued by US Government agencies (government-sponsored corpora-
tions).
Examples: Federal National Mortgage Association (FNMA, “Fannie Mae”) and Fed-
eral Home Loan Mortgage Corporation (FHLMC, “Freddie Mac”) sell bonds and
use the proceeds to buy mortgages. Student Loan Marketing Association (SLMA,
“Sallie Mae”) sells bonds and uses the proceeds to buy student loans.
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4 Role of Financial Intermediaries
We have now considered a wide variety of financial instruments that arise through the
process of direct finance, in which the lender sells securities directly to the borrower.
Why does some borrowing and lending take place, instead, through indirect finance–that
is, with the help of a financial intermediary?
Financial intermediaries play a number of special roles, and help solve a number of special
problems, in the process of indirect finance.
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Financial intermediaries can help solve this problem by gathering information about
potential borrowers and screening out bad credit risks.
Moral Hazard = refers to the problem that arises after a loan is made because borrowers
may use their funds irresponsibly.
Financial intermediaries can help solve this problem by monitoring borrowers’ activ-
ities.
Commercial Banks:
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Checking deposits = provide check-writing privileges.
Savings deposits = do not provide check-writing privileges, but allow funds to
be withdrawn at any time.
Time deposits = require that funds be deposited for a fixed period of time, with
penalty for early withdrawal.
Uses of funds (assets): make commercial, consumer, and mortgage loans, buy US
Government and municipal bonds.
Like S&Ls, but structured as “mutuals,” meaning that the depositors own the bank.
Sources of funds: issue deposits.
Uses of funds: make loans, mainly mortgage loans.
Credit Unions:
Set up to serve small groups: union members, employees of a particular firm, etc.
Sources of funds: issue deposits
Uses of funds: make loans, mainly consumer loans.
Collectively, savings and loan associations, mutual savings banks, and credit unions are
called thrift institutions.
The distinctions between commercial banks and thrift institutions are mainly historical and
have blurred over the years.
Example: before 1980, thrift institutions were not permitted to issue checking deposits.
S&Ls and mutual savings banks were not allowed to make consumer loans, and credit
unions were not allowed to make mortgage loans.
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5.1.1 Contractual Savings Institutions
Contractual savings institutions as a group:
Pension Funds:
Mutual Funds:
Mutual funds allow individual investors to pool their resources and thereby hold a
more diversified portfolio of assets with lower transaction costs.
Sources of funds: sells shares to individuals.
Uses of funds: buy stocks and bonds.
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Shareholders can often write checks against the value of their shareholdings.
Mishkin’s Table 2 (p.36) provides information on the growth and size of these various
financial intermediaries:
Type of Intermediary Value of Assets: 1970 2002
Depository Institutions
Commercial Banks 517 billion dollars 7161
S&Ls and Mutual Savings Banks 250 1338
Credit Unions 18 553
Investment Intermediaries
Finance Companies 64 1165
Mutual Funds 47 3419
Money Market Mutual Funds 0 2106
Observations:
6 Conclusion
Throughout this course, we’ll be considering various aspects of the role that these various
financial instruments and financial intermediaries play in the economy as a whole.
With all of these definitions in hand and collected in one place, we’ll always be able to
refer back to this overview if we need to remember how a particular type of financial
instrument works or what a particular type of financial intermediary does.
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