Adopted from “Financial Markets and Institutions” – Mishkin & Eakins (9E)

For TCHE401/TCH401E Classes in FTU only, no further distribution/reproduction allowed.

Suppose you want to start a business manufacturing a household
cleaning robot, but you have no funds.
At the same time, Walter has money he wishes to invest for his
retirement.
If the two of you could get together, perhaps both of your needs
can be met. But how does that happen?
As simple as this example is, it highlights the importance of
financial markets and financial intermediaries in our economy.
We need to acquire an understanding of their general structure
and operation before we can appreciate their role in our economy.
In this chapter, we examine the role of the financial system in an
advanced economy. We study the effects of financial markets and
institutions on the economy, and look at their general structure
and operations. Topics include:
Function of Financial Markets
Structure of Financial Markets
Internationalization of Financial Markets
Function of Financial Intermediaries: Indirect Finance
Types of Financial Intermediaries
Regulation of the Financial System
Channels funds from person or business without investment
opportunities (i.e., “Lender-Savers”) to one who has them (i.e.,
“Borrower-Spenders”)
Improves economic efficiency
Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners
Direct Finance
Borrowers borrow directly from lenders in financial markets by selling
financial instruments which are claims on the borrower’s future income or
assets

Indirect Finance
Borrowers borrow indirectly from lenders via financial intermediaries
(established to source both loanable funds and loan opportunities) by issuing
financial instruments which are claims on the borrower’s future income or
assets
This is important. For example, if you save $1,000, but there are no
financial markets, then you can earn no return on this - might as
well put the money under your mattress.
However, if a carpenter could use that money to buy a new saw
(increasing her productivity), then she is willing to pay you some
interest for the use of the funds.
Financial markets are critical for producing an efficient allocation
of capital, allowing funds to move from people who lack productive
investment opportunities to people who have them.
Financial markets also improve the well-being of consumers,
allowing them to time their purchases better.
It helps to define financial markets along a variety of dimensions
(not necessarily mutually exclusive). For starters…
Debt Markets
Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $39.7 trillion at the end of 2015.
Equity Markets
Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $35.7 trillion at the end of 2015.
Interestingly, Prof. Mishkin did not introduce derivative markets
here (he does in chapter 24), so it is worth to know that:
Derivatives exist in a form of a contract between two parties, with
payoffs come from fluctuations of an underlying asset, and serve
either the purpose of hedging or speculating.
In short, think of it as a gamble between two guys, if you want to
win, try to make a good bet!
Primary Market
New security issues sold to initial buyers
Typically involves an investment bank who underwrites the offering
Secondary Market
Securities previously issued are bought and sold
Examples include the NYSE and Nasdaq
Involves both brokers and dealers (do you know the difference?)
Even though firms don’t get any money, per se, from the secondary
market, it serves two important functions:
Provides liquidity, making it easy to buy and sell the securities of
the companies
Establishes a price for the securities (useful for company
valuation)
We can further classify secondary markets as follows:
Exchanges
Trades conducted in central locations (e.g., New York Stock Exchange, CBT)
Over-the-Counter Markets
Dealers at different locations buy and sell
Best example is the market for Treasury Securities
We can also classify markets by the maturity of the securities:
Money Market: Short-Term
(maturity < 1 year)
Capital Market: Long-Term
(maturity > 1 year) plus equities (no maturity)
The internationalization of markets is an important trend. The U.S.
no longer dominates the world stage.
International Bond Market & Eurobonds
Foreign bonds
Denominated in a foreign currency
Targeted at a foreign market
Eurobonds
Denominated in one currency, but sold in a different market
Now larger than U.S. corporate bond market
Over 80% of new bonds are Eurobonds
Eurocurrency Market
Foreign currency deposited outside of home country
Eurodollars are U.S. dollars deposited, say, London.
Gives U.S. borrows an alternative source for dollars.
World Stock Markets
U.S. stock markets are no longer always the largest—at one point, Japan’s was
larger
As the next slide shows, the number of international stock market
indexes is quite large. For many of us, the level of the Dow or the
S&P 500 is known. How about the Nikkei 225? Or the FTSE 100?
Do you know what countries these represent?
> FOLLOWING THE FINANCIAL NEWS

Foreign Stock Market Indexes Blank

Foreign stock market indexes are published daily in FTSE 100 An index of the 100 most highly
newspapers and Internet sites such as capitalized UK companies listed on the London
www.finance.yahoo.com. Stock Exchange.
The most important of these stock market indices DAX An index of the 30 largest German companies
are: trading on the Frankfurt Stock Exchange.
Dow Jones Industrial Average (DJIA) An index of CAC 40 An index of the largest 40 French companies
the 30 largest publicly traded corporations in the traded on Euronext Paris.
United States maintained by the Dow Jones Hang Seng An index of the largest companies traded
Corporation. on the Hong Kong stock markets.
S&P 500 An index of 500 of the largest companies Strait Times An index of the largest 30 companies
traded in the United States maintained by Standard traded on the Singapore Exchange.
& Poor’s.
Nasdaq Composite An index for all the stocks that
trade on the Nasdaq stock market, where most of
the technology stocks in the United States are
traded.
Instead of savers lending/investing directly with borrowers, a
financial intermediary (such as a bank) plays as the middleman:
the intermediary obtains funds from savers
the intermediary then makes loans/investments with borrowers
This process, called financial intermediation, is actually the
primary means of moving funds from lenders to borrowers.
More important source of finance than securities markets (such as
stocks)
Needed because of transactions costs, risk sharing, and
asymmetric information
Transactions Costs
Financial intermediaries make profits by reducing transactions costs
Reduce transactions costs by developing expertise and taking advantage of
economies of scale
A financial intermediary’s low transaction costs mean that it can
provide its customers with liquidity services, services that make it
easier for customers to conduct transactions
Banks provide depositors with checking accounts that enable them to pay
their bills easily
Depositors can earn interest on checking and savings accounts and yet still
convert them into goods and services whenever necessary
Another benefit made possible by the FI’s low transaction costs is
that they can help reduce the exposure of investors to risk, through
a process known as risk sharing
FIs create and sell assets with lesser risk to one party in order to buy assets
with greater risk from another party
This process is referred to as asset transformation, because in a sense risky
assets are turned into safer assets for investors
Financial intermediaries also help by providing the means for
individuals and businesses to diversify their asset holdings.
Low transaction costs allow them to buy a range of assets, pool
them, and then sell rights to the diversified pool to individuals.
Another reason FIs exist is to reduce the impact of asymmetric
information.
One party lacks crucial information about another party, impacting
decision-making.
We usually discuss this problem along two fronts: adverse
selection and moral hazard.
Adverse Selection
Before transaction occurs
Potential borrowers most likely to produce adverse outcome are ones most
likely to seek a loan
Similar problems occur with insurance where unhealthy people want their
known medical problems covered
Moral Hazard
After transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral)
activities making it more likely that won’t pay loan back
Again, with insurance, people may engage in risky activities only after being
insured
Another view is a conflict of interest
Financial intermediaries reduce adverse selection and moral
hazard problems, enabling them to make profits.
How they accomplish this is covered in many of the chapters to
come.
FIs are able to lower the production cost of information by using
the information for multiple services: bank accounts, loans, auto
insurance, retirement savings, etc. This is called economies of
scope.
But, providing multiple services may lead to conflicts of interest,
perhaps causing one area of the FI to hide or conceal information
from another area (or the economy as a whole). This may actually
make financial markets less efficient!
Type of Intermediary Primary Liabilities Primary Assets
(Sources of Funds) (Uses of Funds)
Depository Institutions Blank Blank

(banks)
Commercial banks Deposits Business and consumer
loans, mortgages, U.S.
government securities,
and municipal bonds
S&L associations Deposits Mortgages
Mutual savings banks Deposits Mortgages
Credit unions Deposits Consumer loans
Type of Intermediary Primary Liabilities Primary Assets (Uses of
(Sources of Funds) Funds)
Contractual savings Blank Blank
institutions
Life insurance companies Premiums from policies Corporate bonds and
mortgages
Fire and casualty Premiums from policies Municipal bonds, corporate
insurance companies bonds and stock, and U.S.
government securities

Pension funds, Employer and employee Corporate bonds and stock

government retirement contributions
funds
Type of Intermediary Primary Liabilities Primary Assets (Uses of
(Sources of Funds) Funds)
Investment intermediaries Blank Blank

Finance companies Commercial paper, Consumer and business loans

stocks, bonds
Mutual funds Shares Stocks, bonds
Money market mutual funds Shares Money market instruments

Hedge funds Partnership Stocks, bonds, loans,

participation foreign currencies, and
many other assets
Type of Intermediary 1990 2000 2010 2015
Blank Blank Blank Blank
Depository institutions (banks)
Commercial banks, savings and
loans, and mutual savings banks 4,779 7,687 15,580 17,368
Credit unions 215 441 912 1,146
Type of Intermediary 1990 2000 2010 2015
Blank Blank Blank Blank
Contractual savings institutions
Life insurance companies 1,367 3,136 5,176 6,350
Fire and casualty insurance cos 533 862 1,242 1,591
Pension funds (private) 1,629 4,355 4,527 8,517
State and local government
retirement funds 737 2,293 2,661 5,641
Type of Intermediary 1990 2000 2010 2015
Contractual savings institutions Blank Blank Blank Blank

Finance companies 610 1,140 1,439 1,474

Mutual funds 654 4,435 7,935 12,843
Money market mutual funds 498 1,812 2,755 2,716
Depository Institutions (Banks): accept deposits and make loans. These
include commercial banks and thrifts.
Commercial banks (about 5,000 at end of 2015)
Raise funds primarily by issuing checkable, savings, and time deposits which are
used to make commercial, consumer and mortgage loans
Collectively, these banks comprise the largest financial intermediary and have the
most diversified asset portfolios
Thrifts: S&Ls & Mutual Savings Banks and Credit Unions (around 900 of
each)
Raise funds primarily by issuing savings, time, and checkable deposits which are
most often used to make mortgage and consumer loans, with commercial loans
also becoming more prevalent at S&Ls and Mutual Savings Banks
Mutual savings banks and credit unions issue deposits as shares and are owned
collectively by their depositors, most of which at credit unions belong to a
particular group, e.g., a company’s workers
All depository institutions provide loans, and
Finance Companies sell commercial paper (a short-term debt
instrument) and issue bonds and stocks to raise funds to lend to
consumers to buy durable goods, and to small businesses for
operations.
All CSIs acquire funds from clients at periodic intervals on a
contractual basis and have fairly predictable future payout
requirements.
Life Insurance Companies receive funds from policy premiums, can invest in
less liquid corporate securities and mortgages, since actual benefit pay outs
are close to those predicted by actuarial analysis
Fire and Casualty Insurance Companies receive funds from policy premiums,
must invest most in liquid government and corporate securities, since loss
events are harder to predict
Pension and Government Retirement Funds hosted by corporations and state
and local governments acquire funds through employee and employer payroll
contributions, invest in corporate securities, and provide retirement income
via annuities
Mutual Funds acquire funds by selling shares to individual
investors (many of whose shares are held in retirement accounts)
and use the proceeds to purchase large, diversified portfolios of
stocks and bonds.
Money Market Mutual Funds acquire funds by selling checkable
deposit-like shares to individual investors and use the proceeds to
purchase highly liquid and safe short-term money market
instruments.
Hedge Funds are a type of mutual fund requiring large investments
($100,000 or more), long holding periods, and are subject to few
regulations. These funds invest across almost all asset classes.
Investment Banks advise companies on securities to issue,
underwriting security offerings, offer M&A assistance, and act as
dealers in security markets.
Securities Companies are alternate version of IBs
1-43
Main Reasons for Regulation
Increase Information to Investors
Ensure the Soundness of Financial Intermediaries
Asymmetric information in financial markets means that investors may
be subject to adverse selection and moral hazard problems that may
hinder the efficient operation of financial markets and may also keep
investors away from financial markets.
The Securities and Exchange Commission (SEC) requires corporations
issuing securities to disclose certain information about their sales,
assets, and earnings to the public and restricts trading by the largest
stockholders (known as insiders) in the corporation.
Such government regulation can reduce adverse selection and moral
hazard problems in financial markets and increase their efficiency by
increasing the amount of information available to investors. Indeed, the
SEC has been particularly active recently in pursuing illegal insider
trading.
Providers of funds (depositors, like you) to financial
intermediaries may not be able to assess whether the institutions
holding their funds are sound or not.
If they have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of both
sound and unsound institutions, which can lead to a financial
panic.
Such panics produces large losses for the public and causes
serious damage to the economy.
To protect the public and the economy from financial panics, the
government has implemented six types of regulations:
Restrictions on Entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
Restrictions on Entry
Regulators have created tight regulations as to who is allowed to set up a
financial intermediary
Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance company, must obtain a
charter from the state or the federal government
Only if they are upstanding citizens with impeccable credentials and a large
amount of initial funds will they be given a charter
There are stringent reporting requirements for financial
intermediaries
Their bookkeeping must follow certain strict principles
Their books are subject to periodic inspection
They must make certain information available to
the public
There are restrictions on what financial intermediaries are
allowed to do and what assets they can hold
Before you put your funds into a bank or some other similar
institution, you want to know that your funds are safe and that the
financial intermediary will be able to meet its obligations to you
One way of doing this is to restrict the financial intermediary from
engaging in certain risky activities
Another way is to restrict financial intermediaries from holding
certain risky assets, or at least from holding a greater quantity of
these risky assets than is prudent
The government can insure people’s deposits to a financial
intermediary from any financial loss if the financial intermediary
should fail
The Federal Deposit Insurance Corporation (FDIC) insures each
depositor at a commercial bank or mutual savings bank up to a
loss of $250,000 per account
Similar government agencies exist for other
depository institutions:
The National Credit Union Share Insurance Fund (NCUSIF) provides
insurance for credit unions
Evidence is weak showing that competition among financial
intermediaries promotes failures that will harm the public.
However, such evidence has not stopped the state and federal
governments from imposing many restrictive regulations.
In the past, banks were not allowed to open branches in other
states, and in some states banks were restricted from opening
additional locations.
Competition has also been inhibited by regulations that impose
restrictions on interest rates that can be paid on deposits
These regulations were instituted because of the widespread belief
that unrestricted interest-rate competition helped encourage bank
failures during the Great Depression
Later evidence did not support this view, and restrictions on
interest rates have been abolished
Because banks play a very important role in determining the
supply of money (which in turn affects many aspects of the
economy), regulation of these financial intermediaries is intended
to improve control over the money supply
One example is reserve requirements, which make it obligatory for
all depository institutions to keep a certain fraction of their
deposits in accounts with the Federal Reserve System (the Fed),
the central bank in the United States
Reserve requirements help the Fed exercise more precise control
over the money supply
Luật Ngân hàng Nhà nước Việt Nam năm 2010
Luật Các tổ chức tín dụng năm 2010 và Luật sửa đổi, bổ sung một
số điều của Luật Các tổ chức tín dụng năm 2017

1-55
In 2016, banking sector assets amounted 194 percent of GDP and accounted for
more than 96 percent of the financial sector assets (insurance companies: 3
percent; and securities and fund management companies: 1 percent).
The four major state-owned credit banks (SOCBs) account for 45 percent of the
banking sector assets and provide half of total credit which, despite cutbacks in
recent years, remains heavily tilted towards the SOE sector.
Stock market capitalization increased to 33 percent of GDP, from 27 percent in
2015.
Attracting foreign capital remains challenging due to
(i) the lack of diversification of securities products;
(ii) the under-developed corporate bonds market;
(iii) the large share of state-owned capital in many enterprises; and
(iv) the low freedom level of capital mobility and the administrative constraints faced by
foreign owners.
Source: IMF staff country report 2017

1-56
No. Type 2020 2021
1 State-owned commercial banks 4 4
2 Compulsory acquired banks 3 3
3 Social Policy Bank 1 1
4 Viet Nam Development Bank 1 1
5 Joint-stock commercial banks 28 28
6 Joint-ventured banks 2 2
7 100% foreign-owned banks 9 9
8 Foreign bank branches 50 51
9 Finance, leasing companies 26 26
10 Cooperative Bank 1 1
11 People’s credit funds 1,181 1,181
12 Microfinance institutions 4 4

Source: SBV annual report 2021

1-57
1-58
Function of Financial Markets: We examined the flow of funds
through the financial system and the role of intermediaries in this
process.
Structure of Financial Markets: We examined market structure
from several perspectives, including types of instruments,
purpose, organization, and time horizon.
Internationalization of Financial Markets: We briefly examined
how debt and equity markets have expanded in the international
setting.
Function of Financial Intermediaries: We examined the roles of
intermediaries in reducing transaction costs, sharing risk, and
reducing information problems.
Types of Financial Intermediaries: We outlined the numerous
types of financial intermediaries to be further examined in later
chapters.
Regulation of the Financial System: We outlined some of the
agencies charged with the oversight of various institutions and
markets.