The financial system ( Explore )

Relationship between financial markets and financial institutions

In direct finance , borrowers borrow funds directly from lenders in financial markets by
selling them securities (also called financial instruments), which are claims on the
borrower’s future income or assets.

As shown above funds also can move from lenders to borrowers by a second route
called indirect finance because it involves a financial intermediary that stands between
the lender-savers and the borrower-spenders and helps transfer funds from one to the
other. A financial intermediary does this by borrowing funds from the lender-savers and
then using these funds to make loans to borrower spenders.

Why is this channeling of funds from savers to spenders so important to the economy?
The answer is that the people who save are frequently not the same people who have
profitable investment opportunities available to them, the entrepreneurs.

Without financial markets, it is hard to transfer funds from a person who has no
investment opportunities to one who has them. Financial markets are thus Essential to
promoting economic efficiency.
Well-functioning financial markets also directly improve the well-being of consumers
by allowing them to time their purchases better. They provide funds to young people to
buy what they need and can eventually afford without forcing them to wait until they
have saved up the entire purchase price. Financial markets that are operating efficiently
improve the economic welfare of everyone in the society.

Financial Markets

A primary market is a financial market in which new issues of a security, such as a

bond or a stock, are sold to initial buyers by the corporation or government agency
borrowing the funds.

A secondary market is a financial market in which securities that have been previously
issued can be resold.

Secondary markets can be organized in two ways.

1.) Organized exchanges

Where buyers and sellers of securities (or their agents or brokers) meet in one central
location to conduct trades

2.) Over-the counter (OTC) market

In which dealers at different locations who have an inventory of securities stand ready
to buy and sell securities “over the counter” to anyone who comes to them and is willing
to accept their prices. Because over-the-counter dealers are in contact via computers
and know the prices set by one another, the OTC market is very competitive and not
very different from a market with an organized exchange.

Another way of distinguishing between markets is on the basis of the maturity of the
securities traded in each market.

1.) Money market

Financial market in which only short-term debt instruments (generally those with original
maturity of less than one year) are traded

2.) Capital market

The market in which longer-term debt (generally with original maturity of one year or
greater) and equity instruments are traded.
Financial Institutions

1.) Depository Institutions

Depository institutions (for simplicity, we refer to these as banks throughout this text)
are financial intermediaries that accept deposits from individuals and institutions and
make loans.

 Commercial Banks

These financial intermediaries raise funds primarily by issuing checkable deposits

(deposits on which checks can be written), savings deposits (deposits that are payable
on demand but do not allow their owner to write checks), and time deposits (deposits
with fixed terms to maturity). They then use these funds to make commercial,
consumer, and mortgage loans and to buy government securities and municipal bonds.

 Savings and Loan Associations (S&Ls) and Mutual Savings Banks

These depository institutions, obtain funds primarily through savings deposits (often
called shares) and time and checkable deposits.

 Credit Unions

These financial institutions are typically very small cooperative lending institutions
organized around a particular group: union members, employees of a particular firm,
and so forth. They acquire funds from deposits called shares and primarily make
consumer loans.

2.) Contractual Savings Institutions

Contractual savings institutions, such as insurance companies and pension funds, are
financial intermediaries that acquire funds at periodic intervals on a contractual basis.

 Life Insurance Companies

Life insurance companies insure people against financial hazards following a death and
sell annuities (annual income payments upon retirement).

 Fire and Casualty Insurance Companies

These companies insure their policyholders against loss from theft, fire, and accidents.

 Pension Funds and Government Retirement Funds

Private pension funds and state and local retirement funds provide retirement income in
the form of annuities to employees who are covered by a pension plan. Funds are
acquired by contributions from employers and from employees, who either have a
contribution automatically deducted from their paychecks or contribute voluntarily.

3.) Investment Intermediaries

This category of financial intermediaries includes finance companies, mutual funds,

money market mutual funds, and investment banks.

 Finance Companies

Finance companies raise funds by selling commercial paper (a short-term debt

instrument) and by issuing stocks and bonds. They lend these funds to consumers (who
make purchases of such items as furniture, automobiles, and home improvements) and
to small businesses.

 Mutual Funds

These financial intermediaries acquire funds by selling shares to many individuals and
use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds
allow shareholders to pool their resources so that they can take advantage of lower
transaction costs when buying large blocks of stocks or bonds.

 Money Market Mutual Funds

These financial institutions have the characteristics of a mutual fund but also function to
some extent as a depository institution because they offer deposit-type accounts.

 Hedge Funds

Hedge funds are a type of mutual fund with special characteristics. Hedge funds are
organized as limited partnerships with minimum investments ranging from $100,000 to,
more typically, $1 million or more.

 Investment Banks

Despite its name, an investment bank is not a bank or a financial intermediary in the
ordinary sense; that is, it does not take in deposits and then lend them out. Instead, an
investment bank is a different type of intermediary that helps a corporation issue
securities. First it advises the corporation on which type of securities to issue (stocks or
bonds); then it helps sell (underwrite) the securities by purchasing them from the
corporation at a predetermined price and reselling them in the market. Investment
banks also act as deal makers and earn enormous fees by helping corporations acquire
other companies through mergers or acquisitions.
Advantages of Financial Financial Markets

1.) Lesser Transaction Costs

Financial intermediaries can substantially reduce transaction costs because

they have developed expertise in lowering them and because their large size allows
them to take advantage of economies of scale, the reduction in transaction costs
per dollar of transactions as the size (scale) of transactions increases.

2.) Reduced Risk by :

Risk Sharing : They create and sell assets with risk characteristics that people are
comfortable with, and the intermediaries then use the funds they acquire by selling
these assets to purchase other assets that may have far more risk.

Diversification : Diversification entails investing in a collection (portfolio) of assets

whose returns do not always move together, with the result that overall risk is lower than
for individual assets

3.) Avoiding Asymmetry of Information

An additional reason is that in financial markets, one party often does not know enough
about the other party to make accurate decisions. This inequality is called asymmetric
information.

Adverse Selection:

Adverse selection is the problem created by asymmetric information before the

transaction occurs. Adverse selection in financial markets occurs when the potential
borrowers who are the most likely to produce an undesirable (adverse) Outcome—the
bad credit risks—are the ones who most actively seek out a loan and are thus most
likely to be selected.

Moral Hazard:

Moral hazard is the problem created by asymmetric information after the transaction
occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might
engage in activities that are undesirable (immoral) from the lender’s point of view
because they make it less likely that the loan will be paid back. Because moral hazard
lowers the probability that the loan will be repaid, lenders may decide that they would
rather not make a loan.

4.) Economies of Scope

That is, they can lower the cost of information production for each service by applying
one information resource to many different services. An investment bank, for example,
can evaluate how good a credit risk a corporation is when making a loan to the firm,
which then helps the bank decide whether it would be easy to sell the bonds of this
corporation to the public.