Financial System

Financial System
Why have financial intermediaries?

To Lower transaction costs

Types of markets
 

Common themes in market discussion: the Financial SystemThe financial system is made up of those who need money and those who have money to lend.
Those that have the money are called surplus spending units (SSUs) while those who need money are called Deficit Spending units (DSUs). Traditionally, households are thought of as SSUs and corporations thought of as DSUs but this is not always the case. There are times when any party can be either a DSU or a SSU.
 
 

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Most of what we will talk about this semester deals with how these two parties "get together."Indeed, the existence of all financial intermediaries (of which financial markets and other institutions are included) lies in their ability to lower transactions costs associated with SSUs and DSUs getting together.
 
 

Overview of Financial markets
There are many ways to classify markets
For example:

Money vs capital marketsPrimary vs Secondary
Organized vs. Over-the-Counter
Equity vs Debt
Spot vs Future

Financial market themes
 

1. Risk and Return tradeoff
 

• Most investors are risk averse, thus to buy risky investments, must be coerced with higher returns

2. Market efficiency

• based on the idea that it is extremely difficult (nearly impossible?) to CONSISTENTLY beat the market
• Market price is on average correct
• Competition for higher returns and less risk will drive markets to efficient price
Forms of market efficiency
1. Weak
2. Semistrong form
3. Strong form

3. Market Regulation may be a necessary evil
 

Regulations may be government imposed or self-imposed by the market and/or participants.Many of the regulations come about from abuses within the financial system. For example, to protect investors from fraudulent firm offerings and other "unfair" practices, the SEC was formed.
Attempt to level the playing field, but with every regulation comes a change in behavior. An example that we should be familiar with from Money and Banking is that of bank regulations harming the banking industry.
Usually the role of government is to provide a clearinghouse of impartial information or to punish after the fact
Regulations also attempt to limit risks (example circuit breakers that limit the amount an asset (often thought of in terms of a stock exchange).

4. Globalization
 

Have seen a tremendous trend towards globalization of all financial markets. This trend has come in part due to technology but also in part because of deregulation.

5. Role of Financial Intermediaries
 

To lower transaction costs

Example do not need to travel door to door to find a place to invest money.Lower information search costs
 

Types of Financial intermediaries

Depository Institutions

1. Commercial Banks
2. Saving Institutions
3. Credit Unions

Characteristics of depository institutions

• They offer deposit accounts that can accommodate the amount and liquidity desires of SSUs
• Repackage funds and make loans to DSUs
Non-Depository InstitutionsFinance Companies Mutual funds-hugely successful Security Firms-Investment bankers, brokers, and dealers Pension Funds Insurance Companies  Relative sizes  See exhibit 1.3  Changing roles of intermediaries  More competitionDeregulation has increased competition As the financial world has become more international, so too have the intermediaries. Example most of the major Investment bankers in Europe are US based. As the world becomes more tightly aligned, events in one nation have repercussions across borders and across markets. For example, the Stock Market Crash of 1987 hurt bond markets as well. The Asian crisis on 1998 hurt stock markets worldwide.