Financial Markets, Money and

Banking
Université Paris-Dauphine
2018
Najat El Mekkaoui & Yeganeh Forouheshfar

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2
 Aims
• To examine how financial markets work;

• To examine how financial institutions such as

banks, pension funds, insurance companies
work;

• To examine the role of money in the economy

 Why Study Financial Markets?
• Financial markets are markets in which funds
are transferred from people and enterprises
who have an excess of funds to people and
enterprises who have a need of funds.
 Why Study Financial Institutions
and Banking?
• Financial intermediaries: institutions that borrow funds from
people who have saved and in turn make loans to other
people.
– Banks: accept deposits and make loans
– Other financial institutions: insurance companies, finance companies,
pension funds, mutual funds and investment companies
• Financial innovation: the development of new financial
products and services
– Can be an important force for good by making the financial system
more efficient
 Why Study Money and Monetary
Policy?
• Evidence suggests that money plays an
important role in generating business cycles.
• Recessions (unemployment) and expansions
affect all of us.
• Monetary theory ties changes in the money
supply to changes in aggregate economic
activity and the price level.
 Money and Interest Rates
• Interest rates are the price of money
• Prior to 1980, the rate of money growth and
the interest rate on long-term Treasury bonds
were closely tied
• Since then, the relationship is less clear but
the rate of money growth is still an important
determinant of interest rates
 Fiscal Policy and Monetary Policy
• Monetary policy is the management of the money supply and
interest rates
– Conducted in the U.S. by the Federal Reserve System (Fed)

• Fiscal policy deals with government spending and taxation

 Introduction to this course
• Outline of the course:

– Ch1: Introduction (N)

– CH2: Financial system (N)
– CH3: Financial institutions, Government interventions and
Growth (Y)
– CH4: Finance growth nexus
– CH5: Nonbank financial institutions and financial innovation (N)
– CH6: Money and interest rate
– CH7: Macroeconomic management

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 Textbook

Financial markets and institutions – Mishkin & Eakins (8th edition, 2015)
 References
• “Development Finance debates dogmas and new directions”-
Stephen Spratt (2009)

• Finance and growth: theory and evidence – Ross Levine (2005)

• Financial markets and institutions – Mishkin & Eakins (8th

edition, 2015)

• Handbook of finance (2008) Volume 1- Chapter1

• Economix : How Our Economy Works (and Doesn't Work) by

Michael Goodwin
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 Evaluation (oral and written) + tests

• Oral presentation in class during 20mm about your project

outline
• Group of 2 students
• Select one topic according to the class session
• Write a short report (deadline: 14th, May)

• Written exams: mid-term exam and final (23, March and 9, May)

• Evaluation: 50% (oral and report) - 50% exams

 Chapter 1 :

Introduction

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The Trillion Dollar Club
The Trillion Dollar Club
Companies with over $1 trillion in assets under
management

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 Chapter 2 :

Financial system

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 Defining key terms
• There exist two different forms of exchange in financial
markets. The first one is direct finance, in which lenders and
borrowers meet directly to exchange securities.

• The second type of financial trade occurs with the help of

financial intermediaries and is known as indirect finance. In
this situation borrowers and lenders never meet directly, but
lenders provide funds to a financial intermediary such as a
bank or others institutions (Mutual funds, money managers,
…).

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Function of Financial Markets
(source: Mishkin, 2015)
1. Allows transfers of funds from
person or business without
investment opportunities to one
who has them.
2. Improves economic efficiency

2-19
 Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs
– Economies of scale
– Liquidity services

• Reduce the exposure of investors to risk

– Risk Sharing (Asset Transformation)
– Diversification
 Function of Financial
Intermediaries
Risk Sharing
1. Create and sell assets with low risk
characteristics and then use the funds to buy
assets with more risk (called asset
transformation).
2. Lower risk by helping people to diversify
portfolios (diversification)
 Asymmetric Information:
Adverse Selection and Moral Hazard

Financial intermediaries reduce adverse selection and moral

hazard problems.
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes
are ones most likely to seek loans
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage an immoral
activities making it more likely that won’t pay loan back
 Moral Hazard
• Moral hazard occurs when individual are likely
to take greater risks, knowing that a claim will
be paid for by other.

• Information known to one party but not the

other — makes it difficult for potential trading
partners to distinguish between high-risk and
low-risk transactions.

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 Adverse selection
• Making a decision without having all the
information.
• A good example of adverse selection is in the
health insurance market. People most likely to
purchase health insurance are those who are
most likely to use it, i.e. smokers/drinkers/those
with underlying health issues.
• This risks pricing healthy consumers out of the
market, meaning that only high risk individuals
gain insurance – this is clearly a market failure.
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 Defining key terms (cont.)
• Asset: Any possession that has value in an exchange.
– Tangible assets: Its value depends on particular physical
properties: Ex. buildings, land, machinery,…

– Intangible assets: Legal claims to some future benefit:

Financial assets

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 Defining key terms (cont.)
• Globally we can identify 2 types of Financial
instruments:

1. Debt instrument: The issuer agrees to pay

interest and repay the amount borrowed; Ex: Bonds.

2. Equity instrument: Obligates the issuer of the

financial instrument to pay the holder an amount
based on earnings, if any, after the holders of the
debt instruments have been paid.
Ex: common stock, a partnership share in a
business.
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 Examples of financial instruments
Context Issuer Investor Terms of the loan
A loan by BNP The individual Commercial Specified payments over time=
who buys a car bank repayment of the loan+ interest
A bond issued by the French Buyer of the Interest payments every six
French government government bond month till maturity date ->
amount borrowed
A bond issued by Total Corporation Same as above!
Inc.
A bond issued by the A central Same as above!
government of Australia government

A share of common Corporation Receive dividends + a claim to a

stock issued by L’Oréal pro rata share of the net asset
value in case of liquidation

A share of common The Japanese Same as above!

stock issued by Toyota Corporation
Motor Corporation
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Characteristics of debt instruments
• Debt instruments include: loans, money market instruments,
bonds, mortgage-backed securities and asset-backed
securities.
• Maturity: The number of years over which the issuer has
promised to meet the conditions of the obligation
• Money market instrument  Maturity < 1 year
• Capital market debt instrument  Maturity > 1 year

• Value/ principal/ face value/ maturity value: The amount that

the issuer agrees to pay by the maturity date.

• Coupon rate/ nominal rate/ contract rate: The interest rate the
issuer agrees to pay each year. The frequency of interest
payments varies by the type of the debt instrument.
• Zero-coupon bonds: debt instruments that are not contracted to make
periodic coupon payments
• Floating rate securities: coupon payments reset periodically according to
some reference rate
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 Defining key terms (cont.)
• Financial markets: place where financial instruments
are exchanged

3 major economic functions

• Interaction of buyer and sellers determine the price of
traded asset (price discovery process)
• A mechanism for an investor to sell a financial
instrument (offering liquidity)
• Reducing the transaction costs

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 Classification of financial markets
1. Type of financial claim
• Debt markets
• Equity markets
2. Maturity of the claim
• Money market
• Capital markets
3. Issuance:
• Primary market (newly issued)
• Secondary market (previously issued)
4. Time of the transaction:
• Cash market
• Derivatives market (The contract holder buys or sells a financial
instrument at some future time)
5. Organizational structure:
• Auction market /organized Exchange
• Over-the-counter market 30
 Debt vs. Equity
• The most common equity title is stock

• An equity instruments makes its buyer (lender) an owner of

the borrower’s enterprise

• Equity holders earn a share of the borrower’s enterprise’s,

some firms pay (more or less) payments to their equity holders
known as dividends.

• Equity titles do not expire and their maturity is, thus, infinite,
they are considered long term securities

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 Debt vs. Equity (cont.)
Two forms of equity market:

1) Public equity market (share markets/ stock exchanges):

Where companies list their shares for trading purposes. Total value
of the company’s outstanding shares  Market Capitalization

2) Private equity : Shares are not listed on a public market,

they are sold directly to the investors

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Money markets vs. capital markets

• Money markets are markets in which only short term debt

titles are traded
Ex: commercial paper, government bills with short maturities

• Capital markets are markets in which longer term debt and

equity instruments are traded.

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 Primary market vs. secondary markets
• Primary markets are markets in which financial instruments
are newly issued
– They are not very known to the public (selling behind closed doors)
 An important institution: investment banks

• Secondary markets are markets in which financial instruments

already in existence are traded among lenders
 Ex: The New York Stock Exchange
 Ex: NASDAQ

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 Cash vs. Derivatives market
Time of the transaction !
Derivatives markets:
2 types of basic instruments:
» Futures/forward contract: transaction of a
financial instrument at a predetermined price at
a specified future.
» Option contract: Owner of the contract has the
right but not the obligation to buy/sell a
financial instrument at a specific price from
another party.

• Tools for handling of financial risk: Derivatives can be used for

a number of purposes, including insuring against price
movements (hedging), increasing exposure to price
movements for speculation.
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Exchange vs. over-the-counter markets
• Secondary markets can be organized as:
 Organized Exchange, in which buyers and sellers of
securities meet in one central location, such as a stock
exchange (A visible marketplace for secondary market
transactions )
Over-the-counter (OTC) markets in which dealers at
different locations who have an inventory of securities
stand ready to buy & sell securities to anyone who
comes to them.
Titles are exchanged in several locations

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 National or international?

• Capital and money markets National

• Forex and derivatives markets International

• Internationalization of the financial markets
 important trend

FX markets: (Foreign exchange market/ Forex)

A market for trading currencies internationally

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 International Bond Market
• Foreign bonds: are sold in a foreign country and
denominated in that country’s currency
Ex: if Porsche sells a bond in US denominated in $ 
foreign bond

• Foreign bond have been an important instrument for

centuries: a large percentage of US railroads built is
the 19th century were financed by sales of foreign
bonds in Britain

• An innovation in the international bond market:

Eurobond 38
• Eurobonds: A bond issued in a currency other than
the currency of the country or market in which it is
issued
Ex: A bond that is denominated in U.S. dollars and
issued in Japan by an Australian company
A bond denominated in euros is called a Eurobond only if it is sold outside the
countries that have adopted the euro

• A variant of the Eurobond Eurocurrencies:

foreign currencies deposited in banks outside the
home country
• The most important Eurocurrencies are Eurodollars :
US$ deposited in foreign banks outside the US 39
 Commercial financial institutions
• Commercial banks:
• Investment banks:
• Universal banks:
• Mortgage banks:
• Contractual savings:
• Asset management companies:
• Private equity companies:

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 Commercial financial institutions
• Commercial banks: Take deposit from public and lend to
individuals and corporate borrowers.
 Difference between the interest rate paid to savers and that charged to
borrowers Spread
 These banks transform short term liabilities into long term assets
• Investment banks: Financial services that are generally related
to the businesses (finding and structuring various forms of
finance, issuance of corporate bonds, arrangement of mergers
and acquisitions, …)
• Universal banks: Combine functions of commercial and
investment banks

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• Mortgage banks: Provide finance for the purchase of
property.
• Contractual savings: Institutions such as pension
funds and insurance companies.
• Asset management companies: provide “Portfolio
management” services by accessing public and
private financial markets
• Venture capitalists/ Private equity companies:
Provide capital for new or expanding business
In the last 2 decades, we have seen a considerable destruction of the
‘functional boundaries’ between different types of bank and non-bank
financial institutions.

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Quasi-commercial financial institutions
• State development banks: Owned by governments,
direct credit to priorities of the government.
• Mutual cooperative banks: Collectively owned by
their members. (higher interest, lower charges)
• Post office savings banks: Basic financial services
(low income)
• Credit unions: Owned by their members, credit
granted to members on low incomes
• Microfinance institutions: Providing the poor with
access to financial services, in form of bank,
cooperative, credit union etc.
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Governmental financial institutions
• Central banks: Have the monopoly of fiat money
issuance.
– Provide liquidity (control money supply)
– LOLR: act as a lender-of-last resort to the domestic banking
system
Main features:
 National payments and settlement system
 Prudential regulation/ supervision
 Insurance for deposits
 Execute monetary policy  inflation targeting
 Exchange rate policy
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 Types of financial Intermediaries

1. Depository institutions:
Financial intermediaries that accept deposits from
individuals and institutions and make loans.

2. Contractual savings institutions:

Financial intermediaries that acquire funds at
periodic intervals on a contractual basis.

3. Investment intermediaries
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 Commercial Bank

Savings and Loans Associations (S&L)

Depository
Institutions Mutual Saving Banks

Credit Unions

Specialized Banks

Contractual
Financial
Intermediaries savings Insurance Companies
Institutions
Pension Funds

Finance Companies
Investment
Intermedaries Mutual Funds (Investment Funds)

Money market Mutual Funds 46

 How do financial markets differ
from other markets?
• Delivery in future, future is uncertain  Risky  interest
payment (time value of a money);
• Transfers across time: smoothing consumption and
investment;
• Risk management:
• Credit risk: the risk of default on a debt that may arise
from a borrower could not make required payments.
• Market risk: loss by changes in asset prices
• Liquidity risk: it may not be possible to sell an
investment quickly without loss.
• Systemic risk: severe instability or collapse in the
industry and/or in the economy.
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 Main roles of the financial system
(Levine, 2005)
1. Producing information and allocating capital:

 Improve resource allocation

 Leads to a more efficient allocation of capital

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2. Risk amelioration:
 Cross-sectional risk diversification: high-return
projects tend to be riskier than low-return
projects financial markets make it easier for
people to diversify risk and shift portfolios towards
higher expected returns.

 Intertemporal risk sharing: Some risks cannot be

diversified at a particular point in time, such as
macroeconomic shocks, they can be diversified
across generations.
Long intermediaries can facilitate intergenerational
risk sharing by investing with a long-run
perspective. 49
 Hicks 1969: the products manufactured
during the first decades of the Industrial
revolution had been invented much earlier,
the critical innovation that ignited growth
in 18th century was capital market
liquidity  savors can hold liquid assets
like equities, bonds etc. that they can
quickly and easily sell if they seek to access
credit and capital markets can transform
these liquid assets to long-term
investments.

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3. Mobilize savings and Invest

 Savings from individuals, investment in a

diversified portfolio, reallocation of investment
toward higher return activities  positive effects
on economic growth.

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4. Ease the exchange of goods and services

 Financial arrangements lower transaction cost

 More specialization requires more transactions,

since each transaction is costly  financial
development leads to more specialization 
positive impact on growth

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 Market efficiency
• The efficient market hypothesis (EMH)
formulated by Eugene Fama in 1970.
• Suggests at any given time, prices fully reflect
all available information about stock and/or
market.
• According to the EMH, no investor has an
advantage in predicting a return on a stock
price because no one has access to
information not already available to everyone.
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 Market efficiency
• In the real world of investment, there are
arguments against the EMH.

• There are investors who beat the market,

there are portfolio managers who have better
track records than others.

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 Evidence on Efficient Markets Hypothesis
Evidence: confirm +++++
1. Investment analysts and mutual funds don’t beat the market
2. Stock prices reflect publicly available information
3. Technical analysis does not outperform market

Evidence: opposite -------

1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Week-end effect: stock return tend to be lower than those preceding
Friday
4. Market overreaction
5. Excessive volatility
6. New information is not always immediately incorporated into stock prices
 Different types of the financial
system
• Bank-based: banks play the key role (in mobilizing
savings, allocating capital, etc.)
a bank-based financial system finds the economy
dependent on how well or poorly the banking
industry is doing.
Banks in these systems focus their attention on
loans. The stock market in these areas has little or
no power over economic trends.

• Market-based: The majority of financial power is

held by the stock market

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 Bank-based vs. market-based
• Bank Based:
Germany and Japan

• Market-Based:
UK and the United States

• As country grow richer, financial markets play

a more important role relative to banks.
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 Bank-based vs. market-based

• Exposure to risk?
• Market-based system expose households to
more risk than do institutions based on the
bank-based system.
• This risk is eliminated through inter-temporal
smoothing, and thus providing insurance to
investors who otherwise would be forced to
liquidate assets at disadvantageous prices
(Allen and Gale, 2000).
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 Bank-based vs. market-based
• Market based financial systems are
characterized by dispersion of information
(public companies are required to publish
more information than private ones).

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 Bank-based vs. market-based
• Countries with a Common Law tradition,
strong protection of shareholders rights, good
tax and accounting regulations and low level of
corruption, tend to be market orientated.
• Countries with low protection of shareholders
rights, high level of corruption, poor
accounting standards, restrictive banking
regulations and high inflation level, tend to
have underdeveloped financial systems.
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 Risks in the financial market
• Systematic risk is the risk that remains after no further
diversification benefits can be achieved.

• The systematic risk (market risk) of an asset cannot be

eliminated by holding the asset as part of a diversified
portfolio.

• Non-systematic risk is the part of total risk that is

unrelated to overall market movements and can be
diversified. Diversifiable/Idiosyncratic Risk.

• Investors are payed only for systematic risk.

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 Market Risk
• Market Risk: The risk associated with the co-
movements of the market.
• Market risk cannot be eliminated by diversification.
Holding the total market does not help if all companies
are falling together.
 Harry Markowitz’s “Portfolio
Selection”

• Portfolio variance (total risk) declines as the number of

securities included in the portfolio increases

• Harry Markowitz’s “Portfolio Selection” Journal of Finance

article (1952) set the stage for modern portfolio theory
– The first major publication indicating the importance of
security return correlation in the construction of assets
portfolios.
– Covariance and correlation matrices are required.

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 Chapter 5
Nonbank financial
institutions and financial
innovation
 Introduction
• The sector of NBFIs is defined as including
insurance, pension funds and other financial
intermediaries (OFIs).
• OFIs include financial institutions: securities
and derivatives dealers and specialised
financial institutions (e.g.: hedge funds).
• The sector of the non-bank financial
institutions (NBFIs) has increase in size and
highly inter-connected with banks.
 Introduction
• In the EU27, at the end of 2011, the assets
held by NBFIs exceeded the assets held by
monetary financial institutions (excluding
central banks) (MFIs) (source: European
commission):
– NBFIs held €32.6 tn of assets
– MFI-Monetary financial institutions held
€20.8 tn.
 Def.
• Non bank financial institution do not have a
full banking license, not supervised by a
national or international banking regulatory
agency.
• Functions: investment, risk pooling,
contractual savings, …
• The non-bank financial sector often
referring to the sector as the shadow
banking sector (Noeth and Sengupta (2011),
Pozsar and Singh (2011), Pozsar et al.
(2012), Tobias and Shin (2009)).
• Estimates of the size of the non-bank
financial sector vary considerably (because
of different methodologies).
Evolution of the size of the bank and non-bank
financial sectors in the EU27
• Money market funds (MMFs) or mutual
funds: invest in a diversified portfolio of
money market instruments.

• Private equity firms: intermediate between

investors seeking to invest (indirectly) in
companies through private capital markets
and companies seeking external finance.
• Hedge funds are active investment vehicles
that are lightly regulated with great trading
flexibility (Fung et al., 2008).
• Pension fund is a pool of assets and a pool of
liabilities that are to be funded with assets.
– collect, invest funds.
– Set up by employers, unions to provide for the
employees' or members' retirement benefits.
– Long term investors.
• Insurance undertakings play a similar role to
pension funds in financial intermediation, acting
as large institutional investors.
 Characteristics: DB pension schemes (3)

• Schemes cover:
• Retirement
• Health
• Incapacity for employment
• Death by accident
• Disability due to accident or illness
 Insurance

• Insurers accumulate funds due to the time gap

between the receipt of premiums and
payment of claims;

• Invest and manage these funds to generate

investment income.
Total assets as % of GDP, in 2006 and 2016 (OECD)
Denmark
Netherlands
Canada
Iceland
United States
Switzerland
Weighted average
Australia
United Kingdom
Sweden
Chile
Finland
Israel
Simple average
Ireland
Japan
Korea
New Zealand
Mexico
Estonia
Spain
Latvia
Slovak Republic
Portugal
Norway
France
Italy
Poland
Czech Republic
Slovenia
Belgium
Germany
Austria
Turkey
Hungary
Luxembourg
Greece
0 40 80 120 160 200 240

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Total assets as % of GDP, in 2006 and 2016 (OECD)

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Pension funds Returns 2016 (source: OECD)
 Pension funds Returns
• Strong public equity returns helped.
• Sept. 30, 2017: the MSCI Emerging
Markets index returned 22.46%, the MSCI
EAFE index returned 19.1% and the Russell
3000 index returned 18.71%.
• Popularity of passive indexed equity assets.
 Portfolio Evolution:
• Use of derivative instruments to hedge
interest rate risk,
• Investment in alternative instruments, such
as private equity and hedge funds.
• Private equity is the investment in
companies that do not trade on a quoted
market.
2 - Financial innovation

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 Financial innovation
• Creation of new financial instruments,
financial technologies, institutions and
markets.

• It includes institutional, product and process

innovation.

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 Financial innovation
• Institutional innovations: the creation of new
types of financial firms such as specialist credit
card, internet banks.
• Product innovation: new products such as
derivatives, foreign currency mortgages.
• Process innovations: new ways of doing
financial business including online banking and
new ways of implementing information
technology.

82
 Financial innovation
• Financial innovation has been a central force
driving the financial system toward greater
economic efficiency (Zvi & Merton).
• The underlying force driving the development
of efficient institutional structures is Adam
Smith’s “invisible hand”—firms seeking to
maximize their profits in competitive product
markets.

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• Recent innovations include: hedge funds,
private equity, weather derivatives, exchange
traded funds, multi-family offices and Islamic
bonds (Sukuk), longevity bonds.
 How Financial Innovations improve
economic performance?
• Completing markets: expanding opportunities for
o risk-sharing
o risk-pooling
o hedging
o lowering transactions costs
o increasing liquidity
• reducing “agency” costs caused by
o asymmetric information between trading parties
 Financial System Functions
Pooling of funds
• Mechanism for the pooling of funds to create
large-scale indivisible enterprises.
– Creating a mechanism for pooling capital in a low-
cost way and/or minimizing related agency
problems.
• Example: hedge funds, mutual funds, private
equity funds.
 Financial System Functions
Risk Management
• Reducing the risk by selling the source of it.

– In general, adjusting a portfolio by moving from

risky assets to a riskless asset to reduce risk is called
hedging; this can be done, for example, in a futures
or forward market.
 The dynamic of financial
innovation
• Sophisticated hedging and risk management will
become an integrated part of the financial
management process.
• Households will continue to move away from
direct, individual financial market participation
such as trading in individual stocks or bonds and
move to aggregate bundles of securities, such as
mutual funds and index securities designed by
intermediaries.