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Moving Funds Through the Financial

Purpose of the Financial System

• Transfer funds from savers to

• Savers are suppliers of funds,
Borrowers are demanders of funds.
• Financial markets issue claims on
• Financial intermediaries act as go-
Key Services Provided by the
Financial System
• Risk sharing by allowing savers to hold many
assets (through diversification)
• Providing liquidity, which is the ease with
which an asset can be exchanged for money
• Providing information about borrowers and
returns on financial assets
• Delegating monitoring activity
• Pooling Funds for Investment
An alternative to using the financial
system for monitoring
Services Provided by the Financial
System Diagram
Describing the Financial System

• Direct Financing and Indirect Financing

• Direct Financing: lenders lend directly to
borrowers in a market
• Indirect financing: lenders lend to financial
intermediaries who then lend to borrowers.
(Financial Intermediaries: two broad types:
bank and non-bank intermediaries (mutual
funds, hedge funds etc.)
Financial Markets

• Primary markets are those in which

newly issued claims are sold to initial
• Secondary markets are those in which
previously issued claims are resold.
Direct Finance

• Primary markets: newly issued claims are

sold to buyers from the borrower. This could
a. Debt (Requires borrower to pay principal
(amount of loan)+ interest. Types?
b. Equity (Allows for variable payments to be
made, and lender gets to own share of profits
and assets of firm)
Which do you think accounts for larger amount
of funds raised?
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Example of Government issued debt

An innovator in the financial market as well.

• Short-term debt maturity of less than

a year
• Intermediate-term debt instruments of
maturity of less than a year
• Long term debt >10 years
Google sets $2.7 billion IPO

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April 30, 2004: 7:56 AM EDT
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Primary Market
• Advantages and Disadvantages of:
- Issuers of debt continue to own their assets
and can pay fixed payments
- For lenders, there is the risk of default
- Issuers of Equity do not have a fixed
scheduled payment (expect to give dividends)
- For lenders there is the risk of no returns
Describing Secondary Markets

• The Capital Market: where equity and

debt whose maturity (length to payment)
is greater than one year is traded
• The Money Market where debt whose
maturity (length to payment) is less than
one year is traded
Secondary Market
• Market where debt and equity from the
primary market are bought and sold
• Why have it? Provides for diversification of
portfolio, promotes liquidity, and gives
• Auction and Over the Counter markets.
Auction (prices are set by competitive
bidding-e.g. stock exchange). OTC (prices
are posted and can be bought at that price).
Types of Secondary
Financial Markets

• Maturity: money and capital markets

• Trading places: auction and
over-the-counter markets
• Settlement: cash or derivative
Important Financial Instruments

• Money market instruments- Treasury Bills,

Commercial Paper, Banker’s acceptances,
Repurchase agreements, Federal Funds,
Eurodollars, CD
• Capital Market Instruments- Treasury
securities, Government agency securities,
Municipal Bonds, Stocks, Corporate Bonds,
Mortgages, Commercial Bank Loans
Flow of Funds is a good source of data

• The US produces a flow of funds table

which provides some useful information
about where funds and liquidity are
• This is available on class website
Goals of Financial Regulation

• Provision of information
• Maintenance of financial stability
• Controlling the money supply
• Encouraging particular activities
Changes in Financial Integration and

• Financial Integration is on the rise

• Much innovation
• Higher globalization
• Financial structure: bank-based vs. stock
– Three questions about the relationships
between financial intermediation and real
economic activity:
• (1) Does FS affect economic activity?
Evidence: Yes
• (2) Direction of causality: FS leads econ activity
or vice versa? Evidence: both
• (3) Does the structure of the FS matter?
• Role of banks in promoting investment
– Pooling savings (under the view that savings cause
– Reducing liquidity risk (maturity transformation)
– Information about investment opportunities (economies of
scale in information gathering/processing)
– Delegated monitoring
– Customized financial products financial and
technological innovation
• Criticism of bank-based systems:
– Rent extraction (from information)
– Close bank-firm ties preclude competition
• Role of stock markets (for investment)
– Information about profitability of investment
– Reduce the cost of capital: importance of SM
liquidity, not just size
– Pressure on management: takeovers (effective or
• Criticism of SM-based systems
– Economic content of SM signals (do prices reflect
fundamentals – see later, chap 10)
– Takeovers: do not necessarily increase efficiency;
hostile takeovers (costly); promoting short-termism
in management
• Banks vs. SM: where does research
– Complementarity of banks and SM
– More productive research avenues:
• Financial services view (both banks and SM)
• Law and finance view: creditor and investor
rights; quality of the legal system