Lecture 2_EC3332[1] - A Lecture 2 An Overview of the...

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Unformatted text preview: A Lecture 2 An Overview of the Financial System Meaning and Function of Money Economist’s Meaning of Money 1. Anything that is generally accepted in payment for goods and services 2. Not the same as wealth or income Functions of Money 1. Medium of exchange 2. Unit of account 3. Store of value Evolution of Payments System 1. Precious metals like gold and silver 2. Paper currency (fiat money) 3. Checks 4. Electronic means of payment 5. Electronic money: Debit cards, Stored-value cards, Smart cards, E—cash Federal Reserve’s Monetary Aggregates Table 1 Measures of the Monclaiy Aggregates Value as 0! December 2001 (Sbillions) M l = Cuntncy 626.5 + Trawler‘s checks I 7.1 _ + Demand deposits 290.7 . + Other checkable deposits 281.2 I ' Tomi M1 ' 1.206.] M 2 = M] + Small-denomination time deposits and repurchase agreements 1.3.32.3 + Savings deposits uml money market dupusit accounts 2.340;! + Money market mutual fund shares (noninstiluiional) 923.7 Total M2 . .8025 M 3 = M 2 + Large-denomination time deposfiis and rcpun'ltusc agreements _ 1.1052 . + Money market mutual fund shares tinsilauilonal) 767.7 + Repurchase agreements 51 1.7 + Eurodollnrs 341.1 Total M3 8.5282 Scum: umvkxleml]mum.godm§flscvhfillllst. Mme: The vadus [fink item im-lmlrs only lurch-rs rlu-rks issued Ivy nun-hanks. while Inn-1m checks imird by banks are 111'}!de in the Dcmand dams“: atcm. whirl: also encliirles chnkald: dcpmin 10 businessesand whidialsn do not pay intatst. Classifications of Financial Markets 1. Debt Markets Short-term (maturity < 1 year) Money Market Long-term (maturity > 1 year) Capital Market 2. Equity Markets Common stocks 1. Primary Market New security issues sold to initial buyers 2. Secondary Market Securities previously issued are bought and sold 1. Exchanges Trades conducted in central locations (e.g.. New York Stock Exchange) 2. Over-the-Counter Markets Dealers at different locations buy and sell Internationalization of Financial Markets International Bond Market 1. Foreign bonds 2. Eurobonds Now larger than U.S. corporate bond market World Stock Markets ' US. stock markets are no longer always the largest: Japan sometimes larger Growth Rates of Fed’s Annual Growth Rate (Va) 1960 1965 1970 1975 1980 1990 Function of Financial Markets .1. Allows transfers of funds from person or business without Investment _ . opportunltlajsto one who has them . -.-. 2. Improves economic effldéncy .- I“ ' ' Function of Financial Intermediaries Financial Intermediaries 1.Engage in process of indirect finance 2. More important source of finance than securities markets 3. Needed because of transactions costs and asymmetric information Transactions Costs 1.Financial intermediaries make profits by reducing transactions costs 2. Reduce transactions costs by developing expertise and taking advantage of economies of scale Function of Financial Intermediaries Risk Sharing 1.Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation). 2.Also lower risk by helping people to diversify portfolios Asymmetric Information: Adverse Selection,and Moral Hazard Adverse Selection 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard 1. After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits Financial Intermediaries labia 1 Prinmn'iisscls and Liabilities 01FlfliiflCiJIlnicmlfldifllifls Primary Liabilllics Primary-Assets Type oflmermedlary (Sewers 0! Funds) ' (Uses of Funds) Dcposlmry infilllmlnns (hanks) Coautme banks Deposits Business and matsumtr Imus. mortgages. 1.2.5. guttinan summits and municipal bends Sat-mg; and 1mm Maximum Depnsirs Mnrigpgu . Mutual sawing; banks Dq‘mslls Mortgages Cledii unions Deposits Cunsumui Imns Command savings institutions ljlc insuranm mmrnulrs Premiums l'mm poiicins (.‘nrpomlr bands and mungagls Fire and casualty insurance Firmiums fn-m pni‘tcies Memcipai bonds. companies twptlmlc bands and stock. [3.5. gIthmtnl wrun‘lit‘s Pension funds. gweznnuni Employ” and employee: Cut-pom: bonds and stock min-limit l'untls cumributinns Investment Intrrmcdiarlcs Finanrc companies (“.ommrmial paper, t‘nnsumt-r and hLLQI‘WR‘t stocks. hands loans Mutual lunds Slum-s Stacks. bands Mime}- market mutual funds bharcs Money market instruments Size of Financial Intermediaries table 2 Piincipal Financial intermefiiuries and Value 01 Their Assets Value of Assets . . (S billions, end of year) ' Type of lnlermediary 1970 1980 1990 2002 Depository institutions (banks) _ Commercial banks 517 ' 1.481 3.334 7.101 Saving-3 and loan nsmcinlinns ' and mutual savings banks 250 792 1.365 1,333 Credit unions . 18 6? 2.15 553 Contractual savings institutions Life insurance cumpnnies 1,367 3,269 Fire and casualty insurance companies 5.13 894 Pension funds (private) 1,620 3,53) State and iocal government retirement (nude. 732" 1.895 Investment intermediaries Financc companies (~10 . 1 J65 Mutual funds 70 634 3,419 Money market mutual funds . Tn '498 2,106 3mm: Fuler ltnvm- Fin“. ul' l-‘nmls Auxmnh‘ wuwft-dentlmwwegmlrclmsvfilIla-\t'l‘lhhim. Regulatory Agencies Table 3 Principal Regulatory Agencies (if ilie US. Financial System Regulatory Agency Subject of Regulation . Nature of Rugulal'rnns - Scriirilirs and thchnngt Organizrd txt'hangi-s quiiirrs rlifir'lusurt' til Commission (SEC) and financial markets information. restricts insider trading Commodities Futures Futures market Remnants pmcnduries for trading Trading Commission exchanges in futures markets ‘ (CFTC) ' - Office at the Comptmllcr Federally chartered Charters and csamincs the of the. Ctirrr'nt'y mmmrnria] hanks bunks of lederally chartered commercial banks and imposes restrictions on assets they can htild National Credit Union Fedemlly cluttered Owners rind examine-é the Administration (NCUM crudil unions books of Iailcmliy chancruil credlt unions rind impuscs restriit‘ions on assets they can linltl State banking and State-chartered Charters and examines the - insurance commissions depository insriiutinns books of start-charterrd hanks and insumnrt companies. imposes TcstriclirirLs on assets they ran hold. and imposes restrictions mi branching A encies Iahlc3 Principal RCglilfllGr’i‘ Agencies (ii titt- |l.S. Financial System llcguluto Agent Sub actuer ulaiion Naturcofke Intiuns W Y S K“ Frdrml Deposit Itisuniiiue Commercial banks. Provides insumiit‘c amp to Corporation {FDIC} mutual savings banks. $106,000 for writ dcpustlur savings and loan at a bank, examines the books associations of imurtd banks. and imims restrictions on :5sz they can lmlil Federal Reserve System All depository institutions Examian the books oi commercial brink; that are members of the system. sets reserve requirements {or iii] banks Ollite of Thrift Supervision Savings and loan associations Examines the links of savings and lnan associations. imposes restrictions on assets thev can hold .. .. Santa Ixmlrlng and Stair—chartered Chrirtcrs and examines the lliSHml'lCE commissions dt'pusitory institutions bouks oi smut-chartered banks and insurance companies. imposes reszrictlnris tin assets tht‘y can hold, and imposes restrictions un limm‘liirrg Regulation of Financial Markets Two Main Reasons for Regulation 1.lncrease information to investors A. Decreases adverse selection and moral hazard problems B. SEC forces corporations to disclose information 2.Ensuring the soundness of financial intermediaries A. Prevents financial panics B. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures Sources of External Finance in US Nonbank Loans 15.1% Sources of Foreign External Finance Cl UnitedStatas Germany Nonbanl: Loans Puzzles of Financial Structure 1. Stocks are not most important source of external finance for businesses 2. Issuing marketable securities not primary funding source for businesses 3. Indirect finance (financial intermediation) is far more important than direct finance 4. Banks are most important source of external finance 5. Financial system is among most heavily regulated sectors of economy 6. Only large, well established firms have access to securities markets 7. Collateral is prevalent feature of debt contracts 8. Debt COntracts are typically extremely complicated legal documents with restrictive covenants Transaction Costs and Financial Structure Transaction costs hinder flow of funds to people with productive investment opportunities Financial intermediaries make profits by reducing transaction costs 1. Take advantage of economies of scale Example: Mutual Funds 2. Develop expertise to lower transaction costs Explains Puzzle 3 Adverse Selection and Moral Hazard: Definitions Adverse Selection: 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard: 1 .After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back 10 Adverse Selection and Financial Structure Lemons Problem in Securities Markets 1. If can't distinguish between good and bad securities, willing to pay only average of good and bad securities’ values. 2. Result: Good securities undervalued and firms won't issue them; bad securities overvalued, so too many issued. 3. Investors won't want to buy bad securities, so market won't function well. Explains Puzzle 2 and Puzzle 1. Also explains Puzzle 6: Less asymmetric information for well known firms, so smaller lemons problem Tools to Help Solve Adverse Selection (Lemons) Problem . Private Production and Sale of Information Free-rider problem interferes with this solution . Government Regulation to Increase Information Explains Puzzle 5 . Financial lntermediation A. Analogy to solution to lemons problem provided by used-car dealers B. Avoid free-rider problem by making private loans Explains Puzzles 3 and 4 . Collateral and Net Worth Explains Puzzle 7 11 Moral Hazard: Debt versus Equity Moral Hazard in Equity: Principal-Agent Problem 1. Result of separation of ownership by stockholders (principals) from control by managers (agents) 2. Managers act in own rather than stockholders’ interest Tools to Help Solve the Principal-Agent Problem 1. Monitoring: production of information 2. Government regulation to increase information 3. Financial intermediation 4. Debt cOntracts Explains Puzzle 1: Why debt used more than equity Moral Hazard and Debt Markets Moral hazard: borrower wants to take on too much risk Tools to Help Solve Moral Hazard 1. Net worth 2. Monitoring and enforcement of restrictive covenants 3. Financial intermediation Banks and other intermediaries have special advantages in monitoring Explains Puzzles 1—4. 12 Summary: Asymmetric Information Problems and Tools to Solve Them Table 1 iisj'iiinieiric illifli‘llh‘itinl] Problems and Tunis iii Salve lhcne Explains hymmelric Iiifuriruiltun Problem Tools lo Solve [1. Puzzle Nu. Adverse Selection - ' I’riviiic i’roduciion and Sale of information 1. 2 ' Government chulaiintn io int-ruse Information 5 Financial Inizn'nitdiaiinn _ - 3, 4,6 Collmenil and Net Worth 7 l 5 3 1 Mom] Hazard in Equiiy Contracts Production oi lnlonnailim: Monitoring (Prini‘irml—Agn’nl Problem) Government Regulation in Increase iiitomiuiion Fiiimiciat Iiiierniciliuiiun Debi Commas Mural Hazard in Dd“ Cummus Nci “hula Moniiotiiig and Enfui‘wmcnl of Rt’siiiclive Covunaiils Financial lnicrmuliaiinn 3. 4 anr: iii: of puzzle: L Sun-Ls :IR not Iht aim impomnz saute ultxicmal [liming 2. Midwinble Sixul'llki im- mi ‘11! primry mum" of firmx 1 liulimt fimiirc is uinrr :me-mrii ihsn dim! finance. -i. Rinks m iii: mas: imp-1mm sxlrcc nfrxicmnl funds. 5. The fiiuuxiil arm-m L‘- luamig- mguimd tr. Onlylxrgc. litu‘l‘siflb'iiahtd l'imis Iun‘c anus In muiiiics iiiaikcu. 7. (Jellziieu'l is liimiluai in iii-hi commas 8. 3691 mnmris haw nummiw Insir‘naixum'emnis. Financial Development and Economic Growth Financial Repression Leads to Low Growth: Why? 1. Poor legal system 2. Weak accounting standards 3. Government directs credit 4. Financial institutions nationalized 5. Inadequate government regulation 13 Financial Crises Factors Causing Financial Crises 1. Increase in interest rates 2. Increases in uncertainty 3. Asset market effects on balance sheets Stock market effects on net worth Unanticipated deflation Cash flow effects 4. Bank panics 5.Government fiscal imbalances Events in US. Financial Crises 14 Events in Mexican, East Asian, and Argentine Financial Crises Fm Causing Fm Cline! “W mammmpm 15 ...
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Lecture 2_EC3332[1] - A Lecture 2 An Overview of the...

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