Chapter 2

An Overview
of the Financial System

20-1 © 2016 Pearson Education Ltd. All rights reserved.

More realistically, when IBM invents a better
computer, it may need funds to bring it to market.
Similarly, when a local government needs to build
a road or a school, it may need more funds than
local property taxes provide. Well-functioning
financial markets and financial intermediaries are
crucial to economic health.
To answer these and other questions we need:
 In direct finance (the
route at the bottom of
Figure 1), 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.
Securities are assets
for the person who
buys them but liabilities
(IOUs or debts) for the
individual or firm that
sells (issues) them.

For example, if General Motors needs to borrow funds to pay for a new factory to
manufacture electric cars, it might borrow the funds from savers by selling them
bonds, debt securities that promise to make payments periodically for a specified
period of time
 Structure of Financial Market
Primary vs Secondary Markets

Primary Markets
 The corporation is the seller to raise money (financing)
(selling stock Shares or Bonds).

 When a company goes public, it sells new stocks and bonds

for the first time. Usually, that sale takes the form of an Initial
Public Offering. (IPO)
 Structure of Financial Market
Primary Markets
Two Types of Primary Markets:
1. Public offering : selling securities to general public

2. Private offering :
1.selling securities to privately to large financial institutions
such as life insurance companies or mutual fund.

2. In most cases selling of securities in primary markets take

place behind closed doors. Investment banks as an
important financial institution assists in the initial sale of
securities by underwriting securities and the prices and
finally sells them to public.
 Structure of Financial Market
Secondary Markets
 Secondary market
 is the financial market in which previously issued financial
instruments such as stock, bonds, options, and
futures are bought and sold.
 In the secondary market, investors trade securities among
themselves

 Secondary market would organized in two ways:

1. Exchanges:
• buyers and sellers of securities meet in one central location to
conduct trades. Such a New York stock Exchange (NYST) or
Tokyo Stock exchanges (TSE)
2. Over The Counter Market(OTC)
• Dealers of securities at different locations sell and buy
securities over the counter
For example, a bank might acquire
funds by issuing a liability to the
public (an asset for the public) in
the form of savings deposits. It
might then use the funds to
acquire an asset by making a loan
to General Motors or by buying a
GM bond in the financial market.
The ultimate result is that funds
have been transferred from the
public (the lender-savers) to GM
(the borrower-spender) with the
help of the financial intermediary
(the bank).
The process of indirect finance using financial intermediaries called financial
intermediation.
 To answer this question, we

need to understand the role of

transaction costs, risk sharing,
and information costs in
financial markets
 You have the cash and would like to lend him the money,
1. Lower Transaction but to protect your investment, you have to hire a lawyer to
write up the loan contract that specifies how much interest
Cost Carl will pay you, when he will make these interest
payments, and when he will repay you the $1,000.
Obtaining the contract will cost you $500. When you figure
in this transaction cost for making the loan, you realize that
you can’t earn enough from the deal (you spend $500 to
make perhaps $100) and reluctantly tell Carl that he will
have to look elsewhere.
2. Reduce the exposure of
investors to risk

 Risk Sharing (Asset

Transformation)
 Create and sell assets with
characteristics that people are
comfortable with and then use the
funds to buy assets with more
risk (also called asset
transformation).
- Diversification
• Also lower risk by helping people
to diversify portfolios
 3. asymmetric
information

 Deal with asymmetric information problems : arise when one party

often have more information than other party about a transaction
 Adverse Selection (before the transaction):
try to avoid selecting the risky borrower by gathering information about them.
 Moral Hazard (after the transaction): ensure borrower will not engage in activities that
will prevent him/her to repay the loan.
 Sign a contract with restrictive covenants.

 To understand why adverse selection occurs, suppose that you have two aunts to whom
you might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a conservative
type who borrows only when she has an investment she is quite sure will pay off. Aunt
Sheila, by contrast, is an inveterate gambler who has just come across a get-rich-quick
scheme that will make her a millionaire if she can just borrow $1,000 to invest in it.
 Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila, of course,
because she has so much to gain if the investment pays off. You, however, would not
want to make a loan to her because there is a high probability that her investment will
turn sour and she will be unable to pay you back.
Conclusion:
Financial intermediaries allow “small”
savers and borrowers to benefit from the
existence of financial markets.
TYPES OF FINANCIAL INTERMEDIARIES

1) Depository intermediary

2) Contractual savings institutions

3) Investment intermediators
TYPES OF FINANCIAL INTERMEDIARIES

1) Depository institutions (Banks)

 Are financial institutions that accept deposits from
individuals and institutions and make loans.

1-1) Commercial banks (thrifts)

1-2) Saving and loan associations
1-3) Mutual saving banks
1-4) Credit unions
 Types of Financial Intermediaries
2) Contractual Saving Institutions
 They are financial intermediaries that acquire funds at
periodic intervals on a contractual basis.
 As a result they tend to invest their funds in long-term
securities such as corporate bonds , stocks and so forth.

1) Life insurance companies

2) Fire and casualty insurance companies
3) Pension funds, Government retirement funds
Types of Financial Intermediaries

3) Investment intermediaries
1. Finance companies
2. Mutual funds
3. Money market mutual funds
 Finance companies
 Raise funds by selling commercial paper (a short-term debt instruments)
and by issuing stocks and bonds
 They lend these funds to consumers who make purchases of such items as
furniture, automobile and home improvements , and to small business.

 Mutual
 Acquire money by selling shares to many individuals and use the proceeds to
purchase diversified portfolios of stocks and bonds.

 Money market mutual funds

 They have the characteristics of mutual funds mixed to some extent as a
depository institutions
 These mutual funds sell shares to acquire funds and then buy money
market instruments that are safe and very liquid.
1. How can the adverse selection problem explain why you are
more likely to make a loan to a family member than to a
stranger?
2. “In a world without information and transaction costs, financial
intermediaries would not exist.” Is this statement true, false, or
uncertain? Explain your answer.
3. Some economists suspect that one of the reasons that economies
in developing countries grow so slowly is that they do not have
well-developed financial markets. Does this argument make
sense?
End of Chapter 2