ECON 311 Chapter 2

Liabilities

(IOUs or debts) for the individual or firm that sells (issues) them.

Economies of Scope

The ability to use one resource to provide many different products and services.

Flow of Funds in an Economic System

The arrows show that funds flow from lender-savers to borrower-spenders via two routes: direct finance, in which borrowers borrow funds directly from financial markets by selling securities, and indirect finance, in which a financial intermediary borrows funds from lender-savers and then uses these funds to make loans to borrower-spenders.

Takeaway #1

The basic function of financial markets is to channel funds from savers who have an excess of funds to spenders who have a shortage of funds. Financial markets can do this either through direct finance, in which borrowers borrow funds directly from lenders by selling them securities, or through indirect finance, which involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. This channeling of funds improves the economic welfare of everyone in society. Because they allow funds to move from people who have no productive investment opportunities to those who have such opportunities, financial markets contribute to economic efficiency. In addition, channeling of funds directly benefits consumers by allowing them to make purchases when they need them most.

Takeaway #7

The government regulates financial markets and financial intermediaries for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system. Regulations include requiring disclosure of information to the public, restrictions on who can set up a financial intermediary, restrictions on what assets financial intermediaries can hold, the provision of deposit insurance, limits on competition, and restrictions on interest rates.

Federal Funds Rate

The interest rate on overnight loans of deposits at the Federal Reserve.

Takeaway #6

The principal financial intermediaries fall into three categories: (a) banks—commercial banks, savings and loan associations, mutual savings banks, and credit unions; (b) contractual savings institutions—life insurance companies, fire and casualty insurance companies, and pension funds; and (c) investment intermediaries—finance companies, mutual funds, money market mutual funds, hedge funds, and investment banks.

Takeaway #3

The principal money market instruments (debt instruments with maturities of less than one year) are U.S. Treasury bills, negotiable bank certificates of deposit, commercial paper, repurchase agreements, and federal funds. The principal capital market instruments (debt and equity instruments with maturities greater than one year) are stocks, mortgages, corporate bonds, U.S. government securities, U.S. government agency securities, state and local government bonds, and consumer and bank commercial loans.

Asymmetric Information

The unequal knowledge that each party to a transaction has about the other party.

State and Local Government Bonds

also called municipal bonds, these are long-term debt instruments issued by state and local governments to finance expenditures on schools, roads, and other large programs.

Stocks

are equity claims on the net income and assets of a corporation.

Depository Institutions

are financial intermediaries that accept deposits from individuals and institutions and make loans. *money and banking focuses special attention on this group of financial institutions because they are involved in the creation of deposits, an important component of the money supply* -Commercial banks -Savings and loan associations -Mutual savings banks -Credit Unions

Indirect Finance

A flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers).

Takeaway #4

An important trend in recent years is the growing internationalization of financial markets. Eurobonds, which are denominated in a currency other than that of the country in which they are sold, are now the dominant security in the international bond market and have surpassed U.S. corporate bonds as a source of new funds. Eurodollars, which are U.S. dollars deposited in foreign banks, are an important source of funds for American banks.

Takeaway #5

Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn, use those funds to acquire assets by purchasing securities or making loans. Financial intermediaries play an important role in the financial system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral hazard. As a result, financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets, thereby increasing the efficiency of the economy. However, the economies of scope that help make financial intermediaries successful can lead to conflicts of interest that make the financial system less efficient.

Takeaway #2

Financial markets can be classified as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets.

Disclosure

Reporting requirements for financial intermediaries are stringent; must follow certain strict principles, their books are subject to periodic inspection, and they must make certain information available to the public.

Federal Reserve System (FED)

Subject of Regulation: All depository institutions Nature of Regulations: Examines the books of commercial banks and systemically important financial institutions; sets reserve requirements for all banks

Federal Deposit Insurance Corporation (FDIC)

Subject of Regulation: Commercial banks, mutual savings banks, savings and loan associations Nature of Regulations: Provides insurance of up to $250,000 for each depositor at a bank, examines the books of insured banks, and imposes restrictions on assets they can hold

Office of the Comptroller of the Currency

Subject of Regulation: Federally-chartered commercial banks and thrift institutions Nature of Regulations: Charters and examines the books of federally chartered commercial banks and thrift institutions; imposes restrictions on assets they can hold

National Credit Union Administration (NCUA)

Subject of Regulation: Federally-chartered credit unions Nature of Regulations: Charters and examines the books of federally chartered credit unions and imposes restrictions on assets they can hold

Commodities Futures Trading Commission (CFTC)

Subject of Regulation: Futures market exchanges Nature of Regulations: Regulates procedures for trading in futures markets

Securities and Exchange Commission (SEC)

Subject of Regulation: Organized exchanges and financial markets Nature of Regulations: Requires disclosure of information; restricts insider trading

State banking and insurance commissions

Subject of Regulation: State-chartered depository institutions and insurance companies Nature of Regulations: Charter and examine the books of state-chartered banks and insurance companies, impose restrictions on assets they can hold, and impose restrictions on branching

Eurodollars

U.S. dollars that are deposited in foreign banks outside the United States or in foreign branches of U.S. banks.

Portfolio

a collection or group of assets.

Certificates of Deposit (CDs)

a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price.

Capital Market

a financial market in which longer-term debt (generally with an original maturity of greater than one year) and equity instruments are traded.

Primary Market

a financial market in which new issues of a security are sold to initial buyers.

Money Market

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

Secondary Market

a financial market in which securities that have previously been issued (and are thus secondhand) can be resold.

Direct Finance

a flow of funds from savers to firms through financial markets, such as the New York Stock Exchange

Conflict of Intrest

a manifestation of the moral hazard problem. Conflicts of interest occur when a financial institution provides multiple services with conflicting goals, a situation that may lead the firm to conceal important information or disseminate misleading information.

OTC (over-the-counter) Market

a secondary 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.

Default

a situation in which the party issuing a debt instrument is unable to make interest payments or pay off the amount owed when the instrument matures.

Hedge Funds

a type of mutual fund with special characteristics. They're are organized as limited partnerships with minimum investments ranging from $100,000 to, more typically, $1 million or more. These limitations mean that hedge funds are subject to much weaker regulation than other mutual funds. They invest in many types of assets, with some specializing in stocks, others in bonds, others in foreign currencies, and still others in far more exotic assets.

Eurocurrencies

a variant of the Eurobond; foreign currencies deposited in banks outside the home country.

Mutual Funds

acquire funds by selling shares to many individuals and then using 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.

Brokers

agents for investors; brokers match buyers with sellers.

Limits on Competition

at times have imposed restrictions on the opening of additional locations (branches). In the past, banks were not allowed to open branches in other states, and in some states banks were restricted from opening branches in additional locations.

Eurobond

bonds denominated in a currency other than that of the country in which they are sold. For example, a bond denominated in U.S. dollars sold in London. (Currently, makeup over 80% of the new issues in the international bond market)

Foreign Bonds

bonds sold in a foreign country and denominated in that country's currency.

Direct Finance Route

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

Liquid

can be easily converted to cash

Equities

claims to share in the net income and assets of a corporation (such as common stock).

Capital Market Instruments

debt and equity instruments with maturities of greater than one year.

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

depository institutions, of which there are approximately 1,000 in the United States, obtain funds primarily through savings deposits (often called shares) and time and checkable deposits.

Repurchase Agreements

effectively short-term loans (usually with a maturity term of less than two weeks) for which Treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan; now an important source of bank funds (over $100 billion).

Credit Unions

financial institutions which 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.

Restrictions on Assets and Activities

financial intermediaries are restricted in what they are allowed to do and what assets they can hold.

Commercial Banks

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 owners 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 U.S. government securities and municipal bonds.

Investment Intermediaries

financial intermediaries which don't includes finance companies, mutual funds, money market mutual funds, and hedge funds.

Investment Banks

firms that offer a variety of services related to initial public stock offerings, mergers and acquisitions, and other investment matters (Most Importantly: assist in the initial sale of securities in the primary market.)

Deposit Insurance

government can insure people's deposits so that they do not suffer great financial loss if the financial intermediary that holds these deposits should fail.

Underwriting

guaranteeing the price for a corporation's securities and then selling them to the public.

Life Insurance Companies

insure people against financial hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages.

Fire and Casualty Insurance Companies

insure their policyholders against loss from theft, fire, and accidents. They are very much like life insurance companies, receiving funds through premiums for their policies, but they have a greater possibility of loss of funds if major disasters occur.

Diversification

investing in a collection (portfolio) of assets whose returns do not always move together, with the result that the overall risk is lower than that on the individual assets.

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.

Consumer and Bank Commercial Loans

loans to consumers and businesses are made principally by banks but, in the case of consumer loans, also by finance companies.

Mortgages

loans to households or firms that wish to purchase housing, land, or other real structures; the structure or land itself serves as collateral for the loan. (third largest debt market in the United States)

Corporate Bonds

long-term bonds are issued by corporations with very strong credit ratings. The typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures.

U.S. Government Agency Securities

long-term bonds are issued by various government agencies such as Ginnie Mae, the Federal Farm Credit Bank, and the Tennessee Valley Authority to finance such items as mortgages, farm loans, or power-generating equipment.

U.S. Government Securities

long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government. (the most liquid security traded in the capital market)

Currency

paper money (such as dollar bills) and coins.

Dealers

people who link buyers with sellers by buying and selling securities at stated prices.

Dividends

periodic payments made by equities to shareholders.

Pension Funds and Government 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.

Financial Regulation Abroad

provision of information is improved by requiring foreign corporations issuing securities to report details about assets and liabilities, earnings, and sales of stock, and by prohibiting insider trading. The soundness of intermediaries is ensured by licensing, periodic inspection of financial intermediaries' books, and provision of deposit insurance

Economies of Scale

the reduction in transaction costs per dollar of transaction as the size (scale) of transactions increases.

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 use them to purchase such items as furniture, automobiles, and home improvements, and to small businesses.

Restrictions on Interest Rates

regulations that impose restrictions on interest rates that can be paid on deposits.

Contractual Savings Institutions

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 -Fire and casualty insurance companies -Pension funds, government retirement funds

Exchanges

secondary markets in which buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades.

Mortgage-Backed Securities

securities that cheaply bundle and quantify the default risk of the underlying high-risk mortgages.

Liquidity Services

services that financial intermediaries provide to their customers to make it easier for the customers to conduct their transactions.

Commercial Paper

short-term debt instrument issued by large banks and well-known corporations, such as Microsoft and General Motors, and the amount outstanding is around $1 trillion.

U.S. Treasury Bills

short-term debt instruments of the U.S. government are issued in one-, three-, and six-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount—that is, at a price lower than the set amount paid at maturity.

Money Market Instruments

short-term debt securities issued by governments, financial institutions, and corporations.

Money Market Mutual Funds

similar to mutual funds but also function to some extent as depository institutions because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds. These funds are then used to buy money market instruments that are both safe and very liquid. The interest on these assets is paid out to the shareholders.

Risk

the degree of uncertainty associated with the return on an asset.

Risk Sharing

the process of creating and selling assets with risk characteristics that people are comfortable with and then using the funds acquired by selling these assets to purchase other assets that have far more risk.

Financial Intermediation

the process of indirect finance whereby financial intermediaries link lender-savers with borrower-spenders.

Asset Transformation

the process of turning risky assets into safer assets, accomplished by creating and selling assets with risk characteristics that people are comfortable with and then using the funds acquired by selling these assets to purchase other assets that have far more risk.

Moral Hazard

the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view. 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.

Maturity

the time to the expiration date (maturity date) of a debt instrument.

Financial Panic

the widespread collapse of financial markets and intermediaries in an economy.

Restrictions on Entry

tight regulations governing 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 upstanding citizens with impeccable credentials and a large amount of initial funds will be given a charter.

Federal (Fed) Funds

typically overnight loans between banks of their deposits at the Federal Reserve. The designation is somewhat confusing because these loans are not made by the federal government or by the Federal Reserve but rather by banks to other banks.

Capital

wealth, either financial or physical in form, that is employed to produce more wealth.

Intermediate Term

with reference to a debt instrument, having a maturity of between one and ten years

Short Term

with reference to a debt instrument, having a maturity of one year or less.

Long Term

with reference to a debt instrument, having a maturity of ten years or more.