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Moving Funds Through the Financial

System
Purpose of the Financial System

• Transfer funds from savers to


borrowers.
• Savers are suppliers of funds,
Borrowers are demanders of funds.
• Financial markets issue claims on
borrowers.
• Financial intermediaries act as go-
betweens.
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
buyers.
• 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
be:
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?
Beginning December 11, 2001 the
Series EE savings bonds you buy will
be inscribed with the special legend
"Patriot Bond." These specially
designated Series EE Patriot Bonds
offer Americans one more way to
express their support for our
Nation's anti-terrorism efforts. Please
follow the links below for more
information about the Patriot Bond.

Example of Government issued debt


An innovator in the financial market as well.
Maturity

• 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

Popular search engine company files for its eagerly


anticipated initial public offering.
April 30, 2004: 7:56 AM EDT
By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) - Google, the world's No. 1 Internet


search engine, finally filed for its initial public stock offering
Thursday and promised to maintain its long-term focus
even though it will soon face the intense scrutiny of Wall
Street
Primary Market
• Advantages and Disadvantages of:
Debt
- Issuers of debt continue to own their assets
and can pay fixed payments
- For lenders, there is the risk of default
Equity
- 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
information
• 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
flowing.
• 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
globalization

• Financial Integration is on the rise


• Much innovation
• Higher globalization
• Financial structure: bank-based vs. stock
market-based
– 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
investment)
– 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
threat)
• 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
stand?
– 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