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Week-1 Into to Money and Banking and Basic Overview of U.S. Financial System

Money and Banking Econ 311

Instructor: Thomas L. Thomas

Financial markets transfer funds from people who have excess available funds to people who have a shortage.

They promote grater economic efficiency by channeling funds from people who do not have a productive use for them to those who do.

Well functioning financial markets are a key factor in producing economic growth, where as, poor functioning financial markets are a major reason many countries in the world remain poor.

Financial Markets

A security or financial instrument is a claim on the issuer’s future income or assets.

A bond is a debt security (IOU) that promises to make payments periodically for a specified period of time.

The bond market is especially important economic activity because it enables businesses and the government to borrow and finance their activities and because it is where interest rates are determined.

An interest rate is the cost of borrowing money or the price to rent (use someone else’s) funds.

Because different interest rates tend to move in unison, economist frequently lump interest rates together and refer to the “interest rate”.

Interest rates are important on a number of levels:

High interest rates retard borrowing

High interest rates induce saving.

Lower interest rates induce borrowing

Lower Interest rates retard saving

Information Asymmetry and Information costs

Why Financial Intermediaries

In the neo-classical world economists have argued financial intermediaries are not necessary. Savers (investors) could manage their risks through diversification.

The logic rests on the perfect market assumption – that is investors can always through their own borrowing and lending compose their portfolios as they see fit, without costs. In such a world there are no bankruptcy costs.

In such a world if taken to the extreme, perfect and complete markets imply that there is no need for financial institutions to intermediate in the financial (capital markets) as every investor (saver) has complete information and can contract with the market at the same terms as banks. E.g. Information Asymmetry

Why Financial Intermediaries Bonds

A common stock (usually called stock) represents a share of ownership in a corporation.

It is usually a security that is a claim on the earnings and assets of the corporation.

Issuing stock and selling it to the public (called a public offering) is a way for corporations to raise the funds to finance their activities.

The stock market is the most widely followed financial market in almost every country that has one – that is why it is generally called the market – here “Wall Street.”

The stock market is also an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. (Note impact examples.)

Why Financial Intermediaries Stock Market

Banking and other financial institutions are what make the markets work. Without them financial markets could not move funds from people who save (investors) and people who have productive investment opportunities.

The financial system is complex comprising may different type of private sector institutions including banks, insurance companies, mutual funds, finance companies, and investment banks.

If a saver wanted to make a loan to IBM of GM for example, he or she would not go directly to the president of the company and offer the company a loan. Rather he or she would lend the money through a financial intermediary.

Why Financial Intermediaries Financial Institutions

Banks are financial institutions that accept deposits and make loans.

Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions.

Banks are the financial intermediaries that the average person interacts with most frequently.

Because banks are the largest financial institutions in our economy, the deserve the most careful study.

Banks

The first and most important issue with this view is incomplete information which comprises several components:

Search Cost – finding all the people willing to make a funds exchange – matching lenders (savers) to borrowers (spenders) – Real cost and Nominal Costs

Transaction Cost – paying for enforceable contracts, accounting costs, collection costs, etc.

Asymmetric Information – default / losses.

Information & Transaction Costs

Asymmetric Information – the lender does not know enough about the borrower to make a accurate decision – “the borrower always knows better how well he can pay back the loan.”

Adverse selection is a problem created when there is asymmetric information before a transaction occurs. It occurs when borrowers who are most likely to default are the ones most actively seeking to obtain loans and are thus selected.

Moral hazard occurs – after the transaction occurs.

The problems created by by adverse selection and moral hazard are an important impediment to well functioning financial markets - and cause systemic fall in confidence e.g. most recent financial market crisis.

Asymmetric Information – Moral Hazard

In such a situation when there are numerous defaults lenders may not make loans even though there are good credit risks (borrowers) in the market place. Government regulation can lead to this situation also – retail mortgage – capital requirements Dodd /Frank Act – expand on it.

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Moral hazard in the financial markets is the risk or hazard that the borrower might engage in activities that are undesirable (immoral) from the lenders point of view.

Strategic default is one example – people walk away from their mortgage because their home value has declined below that outstanding balance on the loan.

Moral hazard can also occur from the lending perspective where management engages in activities that benefit themselves at the expense of the owners shareholders – this is called the separation theorem.

This is often referred to as conflicts of interest. Conflicts of interest are a moral hazard that occur when a person or institution has multiple objectives (interests), and as a result, have conflicts between those objectives.

Moral Hazard

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Financial Innovation the development of any new financial products and services is an important force making the financial market more efficient.

For example dramatic improvements in technology have lead to new products and the ability to deliver financial services electronically like e-finance and the ATM (POS).

It also has a dark side and can lead to moral hazards, and financial crises like the most recent one.

When the financial system sizes up (liquidity dries up) it may produce a financial crisis.

A financial crisis is characterized by sharp declines in asset prices, the failure of numerous financial institutions and rising unemployment.

Financial Innovation

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

The Dialectic Process was developed by the German Philosopher Georg Wilhelm Fredric Hegel (1770-1831).

According to Hegel society is burdened with contradictions and tensions.

Through these contradictions and tensions one goes through a process (dialectic) to discover what he called the “absolute idea or absolute knowledge.

Professor Edward Kane applied this term to banking in the 1970’s

It carries the idea that baking regulation is cyclical interaction between opposing economic and political forces.

Such rules foster a cat and mouse gam benefiting particular institutions thereby motivating other institutions to find loopholes in the system.

Management’s goals become finding ways to circumvent restrictions in order to capture key markets.

Now if a number of institutions are successful in such avoidance, than the regulations are changed and a new dialectic cycle begins.

Regulation& Dialectic Process

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Money also referred to as the money supply is defined as anything that is generally accepted in payment for goods or services or in the repayment of debt.

Money is linked to changes in economic activity and variables that affect all of us and are important to the heath of the economy.

When an economy undergoes pronounced fluctuations evidence suggest that money plays an important role in generating a business cycle.

Monetary theory relates the quantity of money and monetary policy to changers in aggregate economic activity.

Money and Monetary Policy

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

The average price of goods and services in the economy is called the aggregate price level.

Inflation is a continual increase in the price level, affecting individuals, business, and governments.

The price level and money supply generally rise together (Why?)

Milton Friedman, a Nobel Laureate in Economics made the famous statement “Inflation is always and everywhere a monetary phenomenon.”

In addition to inflation, money plays an important role in interest rate fluctuations.

Money & Inflation

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Because money can affect many different economic variables, policymakers often concentrate on the conduct of monetary policy which is the management of money and interest rates.

The organization that is responsible for conducting monetary policy is the central bank. For the United States the central bank is the Federal Reserve System (12 banks).

Fiscal policy involves decisions around government spending and taxation.

A budget deficit is the excess of government expenditures over tax revenues for a particular time period.

A budget surplus arises when tax revenues exceed government expenditures.

The government must finance deficit by borrowing in the financial markets.

Monetary Policy and Fiscal Policy

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Transaction Costs – the time and money spent carrying out financial transactions are the major problems faced by individual lenders.

Financial intermediaries can substantially lower transaction cost because their size allows them to take advantage of economies of scale.

For example banks and insurance companies have large staffs of lawyers who can produce airtight contracts that can be used over and over again.

In addition, they have the resources to develop data systems and expertise to determine a borrowers credit worthiness. This is often referred to as economies of scope.

Economies of scope lower the cost of information production for each service by applying one information source to to many different services.

Function of Financial Intermediaries – Transaction Costs

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Financial intermediaries bring numerous transaction partners together by creating assets (products) with risk characteristics that people are comfortable with.

In addition, the lower transaction costs and risk sharing enable the financial intermediaries to earn a profit (spread) between the return they earn on a risky asset, and payments they make on the assets they have sold.

Financial intermediaries also promote risk sharing by helping individuals diversify the amount of risk they are exposed. Diversification entails investing in a collection (portfolio) of assets whose assets do not always move together, thereby reducing the over all risks compared to that of individual investments. (Note Mutual Funds and Loan Portfolios)

Function of Financial Intermediaries – Risk Sharing

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Individual Investment – An Economic Perspective

Savings and investment is an intertemporal choice between current consumption and future consumption.

The individual will save and consume at level that gives him/her the highest level of satisfaction (utility) depicted by curves U1 through U4 for a given level of income (budget).

The highest attainable level of utility is point C1 where U3 is tangent to the individual’s budget line.

Current Consumption at time t

Future Consumption at time t+1

Budget Line

Current

Consumption

Future Consumption

Savings

Individual Investment – An Economic Perspective Continued

We can apply this same analysis to the owner of a single firm who can either:

consume the firm’s present earnings by liquidating the assets (points O,A)

Or save / invest into future returns (points A, D)

Note the production frontier acts like a budget constraint.

In this case the production frontier represents the combinations of savings and consumption that is used to produce wealth / utility.

Note the curved shape of the frontier is due to the law of diminishing returns.

The level of consumption and investment also equal to the point of highest utility at point C1.

Current Consumption at time t

Future Consumption at time t+1

Production Frontier

Consumption

Future Returns

Investment

Individual Investment – An Economic Perspective Continued

Introducing the capital market allows us to examine investment decisions where there are many owners (shareholders) – this is called the Separation Theorem.

The capital investment decision becomes the company (managers) undertake physical investment until the return from the investment = the market rate of return/interest at point P.

This level of investment results in some dividend flow or appreciation of wealth to the shareholders.

Shareholders make their financial decision by either borrowing or lending in the capital market until their individual time value of money = the capital market return.

This results in the highest aggregate utility at point C2 indifference curve U2.

Future Consumption at time t+1

Total Investment

With CML

Current Consumption at time t

1+r

Capital Market Investment Line (CML)

Required rate

Of Return

Old

Investment

Old Future

Returns

Total Returns

With CML

A firm or individual can obtain funds in the financial market in two ways.

The most common way is to issue a debt instrument (IOU) such as a bond or mortgage which is contractual agreement to pay the holder some dollar amount at regular intervals (interest and principal) over a specified time period.

Maturity is the number of years months, etch until final payment is made.

A short-term instrument is less than one year.

A long-term instrument has a maturity greater than a year.

Debt & Equity Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

The second method for a firm to raise money is by issuing equities such as common stock.

Equities are a claim against the firm’s income and assets. If you own one share out of a 100 shares then you have a 1 percent claim against the company’s income and assets.

You make money either through dividend payment – sharing the income to the share holders or

By selling the shares for a profit base on the market appreciation of the company’s assets and projected income stream.

Debt & Equity Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

A primary market is one where new issues of a security such as a bond or stock are sold to initial buyers (individuals or corporations).

A secondary market is a financial market in where securities that have been previously issued are resold.

Primary markets for securities are generally closed to the public and are conducted behind closed doors (not underwriting)

Investment banks are the primary intermediary for primary security sales.

They do this by underwriting the securities – buying the issue guaranteeing the price to the issuer and selling the securities to corporations for a margin. The corporations then sell the issues to the public.

Primary and Secondary Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

The New York Stock Exchange and NASDAQ are examples of the secondary market.

Securities brokers and dealers are an integral part of the secondary market.

Brokers are agents of investors who match buyers and sellers.

Dealers link buyers and sellers by buying and selling securities at state prices (note bid ask spread).

Secondary Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Secondary Markets are organized in tow ways: exchanges and over the counter (OTC) transactions.

Organized exchanges are locations where buyers and sellers (or their agents or brokers) meet to conduct trades. The Chicago Board of Trade where commodities are like corn or silver etc. is one example.

OTC trades are done by different dealers at different locations who have inventory of securities to buy and sell over the counter willing to pay or receive the bid ask spread (Note Money Desk)

Exchanges and Over the Counter Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Another way to distinguish markets is base on the maturity of the securities traded.

The money market is a financial market in which only short-term debt instruments are traded.

The capital market is the market in where longer-term debt and equity instruments are traded.

Money market securities are usually more widely traded and tend to be more liquid.

Liquid refers to the ability to sell the instrument on the market quickly to raise cash.

Money and Capital Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Because of their short-term maturities these debt instruments are considered less risky (Why?)

U.S Treasury Bills – These are short-term government instruments issued on one, two, three, and six month maturities. (Considered risk-free –why?)

US Treasury bills are the most liquid of all money market instruments because they are the most actively traded.

Money Market Instruments

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Negotiable CDs – A certificate of deposit (CD) is a debt instrument sold by banks to depositors that pay annual interest of a given amount at maturity pays back principal. Negotiable CDs are those sold in the secondary market (why would a bank sell a CD and how is it priced?)

Commercial paper – is a short-term debt instrument issued by large banks and well-know corporations.

Repurchase agreements (repos) are effectively short-term loans for which another instrument serves as collateral. How do they work? What happens if the borrower defaults? What additional risk is present other than default?

Federal Funds (FED Funds) are typically overnight loans between banks of their deposits at the Federal Reserve. Why would banks barrow funds from other banks who hold deposits and the Federal Reserve. Why would banks loan funds to other banks?

The fed funds rate the interest paid on fed funds borrowing is a closely watched rate. It is a barometer of how tight is the credit market (why?)

Money Market Instruments

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.

Capital Market instruments are debt and equity instruments with maturities greater than a year ( why is equity considered a long-term instrument?

Stocks are equity claims on the net assets and income of a corporation. Stocks are divided into common shares and preferred shares.

Mortgages are loans to house holds or firms to purchase land buildings etc. The land or buildings serve as collateral to the loan – what does that mean and how is it important.

Mortgage backed securities are bond like debt instruments backed by the individual mortgages which are collected together whose principal and interest payments are collectively paid to the bond holder. (Discuss Structure).

Corporate bonds are long-term bonds issued by corporations with very strong credit ratings. The typical bond send the holder semi-annual interest payments and pays the face value (principal) at maturity – may be sold in the secondary market at par, loss or gain.

Capital Markets

Note – poor credit borrowers – are not necessarily deceitful. Note, adjustable loan market and subprime lending as an example.