I. Classifying Financial Markets
Well-functioning financial markets are an essential part of any modern healthy economy. It is through these markets that funds are offered by the lenders/savers who have excess funds and purchased by the borrowers/spenders who need those funds. These borrowers and lenders may meet directly (known as direct finance) or through financial intermediaries (known as indirect finance). (see the diagram on page 21)
Lenders and borrowers meet directly (the blue arrows at the bottom) or through a financial intermediary (the orange arrows at the top). Through these markets the funds flow that allow for the development of new products/ideas, the expansion of the production of existing products, and consumer spending on "big ticket" items like houses, cars, and college tuition. Without these markets, firms may be unable to expand production or invent new products and consumers will be unable to afford certain products.
There is not one financial market, but rather many markets, each dealing with a particular type of financial instrument. We can classify financial markets into narrower categories based on the type of assets traded, their characteristics, or even the location of markets.
A. Debt and Equity Markets
Recall that debt instruments, like a bond or a bank loan, involve a promise by the borrower (the seller/issuer of the debt instrument) to pay the lender (the owner/buyer of the debt instrument) fixed payments at specified intervals until a final date. The time until all payments are made is known as the maturity of a debt security. For example, most mortgages have a maturity of 30 years when first created. We can further classify the debt market by maturity:
Equity instruments, like shares of common
stock, are claims on the earnings and assets of a corporation. If you own
5% of the shares of a company, then you are entitles to 5% of the earnings
and assets of that company. Equity securities differ from debt in that
The primary market is like the new car market. The financial instruments sold in the primary market are brand new, or new issues. They are sold to the buyer by the issuer. The secondary market is like the used car market (or as car dealers like to say "previously-owned vehicle"). The securities sold in the secondary market are being resold by previous buyers for the second, tenth, or fortieth time.
Financial intermediaries play a role in both markets. In the primary market, investment banks assist a business in selling a new issue to the public. Investment banks underwrite new securities, meaning that they buy the new issue from the business and sell it to the public. Investment banks charge fees for this service, along with any profits from reselling the issue at a higher price. Underwriting is big business. The largest underwriters of new equity securities include Merril Lynch, Salomon Smith Barney, and Goldman Sachs.
Even in the secondary market, financial intermediaries are an important part of a well-functioning market. Securities brokers facilitate trade by match buyers with sellers. For this they charge a commission on each match (or trade).
Securities dealers act as the buyer and seller by continuously quoting a price at which they will buy a security (the bid price) and the price at which they will sell the security (the ask price). The bid price is lower than the ask price (the difference is known as the bid-ask spread), and this is how dealers make their money. Dealers own an inventory of the securities in which they deal. Since dealers stand ready to be the buyer or seller for a security, dealers are said to "make a market" in that security, and dealers are often referred to as "market-makers". If a buyer is looking for a seller, the dealer acts as the seller. If a seller is looking for a buyer, the dealer acts as a buyer. This way there is always a buyer and seller, so there is always a market.
Why have a secondary market? Keep in mind that the better the secondary market, the better the primary market. Why? Because if securities are easily bought and sold, then they will be more popular in the first place. The ease of which a security is converted to cash is known as its liquidity. High liquidity is considered a good feature. If, for example, Microsoft stock is easy to buy and sell in the secondary market (highly liquid) then it will be popular in the primary market.
C. Exchanges and OTC Markets
Secondary markets can be classified by where or how the trading of securities takes place. When buying and selling occurs in a central, physical location, then securities are traded on an exchange. The New York Stock Exchange is probably the best-known example. In the year 2000, the NYSE had an average daily volume of over 1 billion shares traded.
The alternative to an exchange is trading by geographically dispersed buyers and sellers, linked by computer. This is known as an over-the-counter (OTC) market. The name originated from pre-computer days when securities and money were literally exchanged over countertops by buyers and sellers. The OTC markets depend on dealers who make a market in various securities. Debt securities are traded in OTC markets (although some bond trading does occur on the NYSE), while stocks are traded on exchanges and large OTC markets, like the NASDAQ. The largest companies typically have their stocks trade on an exchange, but overall the NASDAQ has a larger transaction volume.
D. Money and Capital Markets
Securities markets may also be classified by maturity. The money market consists of short-term debt instruments (with less than one year original maturity). These securities are more liquid and thus more frequently traded. The short maturity also makes their prices more stable, so money market securities are considered to be low risk. Longer term debt and equity instruments make up the capital market. Prices fluctuate more widely in this market.
II. Financial Market Instruments
What types of securities trade in the money and capital markets? Familiarity with these instruments is important since some of them play a special role in monetary policy and are important indicators of the state of financial markets and the economy. For each market, the instruments are describing in order of the dollar amount of securities outstanding.
A. Money Market Instruments
All instruments in this market are short-term and considered low risk investments.
Commercial Paper is short-term debt issued by well-known companies and large financial institutions. Corporations are basically taking out a short-term loan without having to go through a bank. Commercial paper must have a maturity of less than 270 days to avoid being subject to substantial government regulation. The market for commercial paper has exploded over the past 20 years, with over $1.3 trillion in commercial paper outstanding in 2000.
Negotiable Bank Certificates of Deposit are a subcategory of CDs that are large (over $100,000) and as a result may be resold in the secondary market. (CDs consisting of smaller amounts may not be resold and are not in this category).
US. Treasury Bills (Tbills) are short-term debt instruments issued by the US government. They have maturities of 3, 6 or 12 months and pay a stated amount at maturity (the face value), but sell for less than that (at a discount), effectively paying some rate of interest. For example, a 3-month Tbill paying $10,000 at the end of September 2001 might originally sell for $9875, a discount of $125. All debt issued by the US. government are considered default-free. This means the probability of the US government not paying the promised amount on time is considered to be zero. Tbills are the most liquid and least risky debt securities in the world, and mostly held by financial institutions.
Repurchase Agreements (Repos) are short-term loans secured by Tbills. How does this work? The borrower sells the lender a Tbill with an explicit agreement to buy it back within a short period of time at a higher price. So the Tbill is collateral for the loan, and the higher buyback price implies some interest rate. The Federal Reserve uses repos to temporarily alter the money supply.
Eurodollars are US dollars deposited in banks outside the United States (not necessarily in Europe). American banks borrow these deposits on a short-term basis when they need the funds.
Federal Funds are very short-term (usually overnight) loans between banks. Although the term "federal funds" sounds official, this is an entirely private sector interbank lending market. The interest rate on these loans is called the federal funds rate. This interest rate is a very important indicator of the availability and cost of loans in the financial system.
Banker's Acceptances are probably the oldest of all money market instruments, dating back prior to the discovery of America. A banker's acceptance is an I.O.U from a borrower to a lender that is guaranteed by a bank in case the borrower defaults. These instruments are often used in international trade in payments for goods and services. It is like a really big check which a bank promises to cash, even if there is not enough money in the account. The bank is paid for giving this guarantee. These acceptances are then resold in financial markets.
B. Capital Market Instruments
Instruments traded in capital markets have maturities greater than one year, with varying degrees of risk. They include both debt and equity securities.
Stocks are by far the largest category, with over $30 trillion in stock outstanding in the United States in 2000. Half of all shares of stock are held by financial institutions and half are held by individuals. Stocks may pay dividends, but they are not required to do so. The US stock market is the largest in the world but stock exchanges in London and Tokyo are also important, along with growth stock exchanges in emerging markets in South America and Eastern Europe.
Mortgages are loans to purchase real estate, where the real estate serves as collateral for the loan. Mortgages are the largest debt market in the United States, with most of these being residential (used to purchase homes). Several government agencies play a big role in promoting liquidity in the mortgages market by creating a secondary market for financial institutions to buy and sell existing mortgages. This makes it easier for households to get a mortgage in the first place, which is one of the reasons why over 2/3 of all households in the US are homeowners. Mortgages are long-term debt. Over 75% of all single-family home mortgages originated in 2000 are for 30 years at a fixed interest rate, but adjustable rate mortgages of various terms are available.
US Treasury Securities are long-term debt securities issued by the federal government. US Treasury notes (Tnotes) have maturities of 2 to 10 years, while Treasury bonds (Tbonds) have maturities greater than 10 years. Again, Tnotes and Tbonds are highly liquid (although not as liquid as Tbills) because they are considered default-free and the market is large. Tnotes and Tbonds pay interest payments every 6 months in addition to the face value payment at maturity. A smaller market exists for US Government Agency debt. These are also long-term bonds backed by the US federal government, but they are issued by government agencies other than the US Treasury, usually for special projects. These securities are also default free, but the market for them is smaller and thus less liquid.
Corporate Bonds are long-term debt securities issued by corporations. The bonds typically pay interest semiannually and then a face value payment at maturity. Since the issuers here are private corporations, there is some risk of default; i.e. the bond owner may not receive all of the promised payments if a company goes bankrupt. Corporate bonds are rated so potential buyers can gauge the amount of default risk they will face. This rating system is discussed in chapter 6. Since the US has the largest capital markets in the world, firms located in other countries often issue dollar-denominated bonds to raise funds. These are known as Eurobonds.
Municipal Bonds are long-term debt securities issued by state and local governments. These bonds are typically used to finance construction and infrastructure improvements for roads, schools, buildings, sewer/water systems, etc. Municipal bonds are unique in that their interest payments are not subject to federal income tax or state income tax in the issuing state. Individuals and firms in high income tax brackets will be more likely to hold these securities.
Loans. This category consists of loans to consumers (but NOT mortgages) and firms, made by both banks and finance companies. Examples include auto loans by GMAC, or a small business loan made by Key Bank. There are few secondary markets for these loans (although it is growing), which makes them the least liquid category in capital markets.
III. Financial Intermediaries
So now we've covered the types of markets and instruments that make up the VERY broad term "financial markets." Now we take a closer look at the institutions that stand between buyers and sellers for indirect finance. Why have them? Who are they? What rules must they follow?
A. Why Do We Need Financial Intermediaries?
Advertisements bombard us with the notion that "cutting out the middleman" saves us time and money. If buyers and sellers just met directly in all financial markets, wouldn't that be more efficient? The answer is "not always." Certain realities about financial markets make the role of the intermediary not only desirable but in some cases essential.
Transactions Costs
Transactions costs can be thought of as the cost of carrying out buying/selling transactions in a market as well as the cost of enforcing agreements (like collecting on a loan). Borrowers and lenders do not automatically find each other, and when they do, they need to come to an agreement about the terms of a loan/security. These practical issues take time and money to resolve.
Financial intermediaries specialize in finding borrowers and lenders AND in writing and enforcing loan agreements. If you want to lend money and I want to borrow it, we have to spend time and money drawing up a contract with the loan's interest rate, fees, payment schedule, etc. And if I fall behind in payments later, you have to spend time and money enforcing the original contract. But if you go to a bank and open an account (lending the bank money), and I go to the bank to borrow money, there are two advantages:
Asymmetric Information
When there is uncertainty in markets about buyers and/or sellers, an intermediary may help markets function better. In financial markets, one party often has more information than the other about the transaction. This lop-sided structure is known as asymmetric information. For example, I have much better information about my likelihood of making my car payments on time than the bank making the loan. The lack of information on one side creates problems BEFORE the loan is made and AFTER the loan. To you or I, these problems are huge, but financial intermediaries use their size and expertise to minimize them.
Before a financial instrument is bought or sold, there is the problem of adverse selection. Basically, what happens is that the worst candidates (adverse) are more likely to be selected for the transaction. People who are bad credit risks are more likely to try and get a loan than those who are good credit risks. Thus, odds are that you might end up lending to someone with a bad credit risk. Knowing that, you just decide not to lend. Again, this problem occurs because of asymmetric information: You do not have good information about a stranger's credit risk, although that stranger knows his/her own creditworthiness quite well. Banks, however, are experts at assessing credit risk and can distinguish the good from the bad. So you lend to the bank, and the bank lends to those who are good credit risks.
After a the loan is made, there is the problem of moral hazard. Once you lend someone money, you risk (the hazard) that he/she does something stupid to blow the money (immoral) and would be unable to pay you back. Your brother in-law claims to be investing in a restaurant franchise and will repay you with the profits, but once you lend him $10,000 he goes and blows it in Las Vegas. Knowing about this risk, you tell your brother-in-law to get lost, even though the franchise might be a good idea. Again, this is from asymmetric information: Your brother-in-law knows what he will do with the money but you can only guess. Banks are experts in monitoring and enforcing lending contracts in order to minimize the moral hazard problem.
Note: adverse selection and moral hazard are important concepts that explain the structure and regulation of the financial sector as well as the major crises that have plagued the financial sector in the past 30 years, so take the time to understand these concepts.
B. Types of Financial Intermediaries
Financial intermediaries can be subdivided into three categories based on their liabilities (how they get their funds) and their assets (how they use their funds).
Depository Institutions
Your textbooks refers to these institutions as banks. All institutions in this category accept deposits and make loans. We will focus on this group because they play a large role in monetary policy.
Commercial banks' primary liabilities are deposits (checking accounts, savings accounts and CDs) and their primary assets include commercial loans, consumer loans, mortgages, U.S. government bonds, municipal bonds. They are the largest type of financial intermediary, as measured by the total value of their assets.
Savings and Loan Associations were created in the 1930s and originally restricted to offering savings accounts and CDs and making mortgage loans. In the 1980s these restrictions were relaxed to allow greater asset and liability choices, making S&Ls very similar to commercial banks. Mutual Savings banks are very similar to S&Ls, with the only distinction being that mutual savings banks are owned by the depositors.
Credit Unions are the smallest of the depository institutions. They take deposits and primarily make consumer loans. Credit unions are distinguished by two features: They are nonprofit and credit union membership is organized around a particular group, such as company employees, a union, or even a church parish.
Contractual Savings Institutions
These institutions do not accept deposits, but acquire their liabilities on a regular basis through contractual payments in return for obligations that are fairly predictable (much more so than the withdrawals of depositors). Compared to depository institutions, their assets are more long-term and less liquid.
Life insurance companies receive premiums in return for protection from the risk of death. Mortality rates are predictable, so the timing and size of payouts for these companies are also predictable. Life insurance companies also sell a variety of investment products as well, such as annuities and guaranteed investments contracts (GICs). Life insurance companies are the largest buyer of corporate bonds, and invest heavily in mortgages as well. They hold very little stock or municipal bonds.
Fire and casualty insurance companies receive premiums in return for protection from the risk of property damage/loss, liability, and disability. The size and time of their payouts are less predictable, since natural disasters such as a major earthquake or bad hurricane season can greatly affect the amount of property damage that occurs in a given year. Because of this, their assets are more liquid than life insurance companies. They hold municipal bonds, corporate bonds, stocks, and U.S. government bonds.
Pension funds may be privately-sponsored or government-sponsored, but in either case they provide retirement income in return for contributions from employees and employers during their working years. Pension funds receive very favorable tax treatment at the federal level. Again, the payouts are predictable, so assets are long term such as corporate bonds and stocks.
Investment intermediaries
These institutions are behind much of the explosion in indirect investment and the decline in traditional banking by providing alternatives for individuals and firms needing to save or borrow funds.
Finance companies have taken much of the consumer and commercial loan business away from depository institutions. These companies raise funds by issuing commercial paper (they do NOT accept deposits). They then use these funds to make business loans, construction loans, auto loans and other consumer loans. For example, all 3 major U.S. auto companies, GM, Ford, and Chrysler have finance companies to help consumers finance auto purchases. Other finance companies specialize in credit cards.
Mutual funds sell shares to individuals and use those funds to purchase and manage a diversified portfolio of stocks and/or bonds. The value of the shares fluctuates with the value of the underlying portfolio. Why not just buy stock directly? Because through mutual funds, investors can diversify with little initial capital, receive professional management of their investments, and save on transactions costs. These advantages explain why the number of mutual funds has grown from less than 500 in 1980 to over 6000 today. Mutual funds vary according to their investment objectives and the type of securities they hold. Some funds focus on a particular sector, like technology or health care, while some focus on U.S. government bonds or municipal bonds.
Money market mutual funds have features like both a mutual fund and a checking account. These funds sell shares, fixed at a price of $1, and use those shares to buy money market instruments. These funds then pay regular dividends in the form of additional shares. These funds also have restricted check writing privileges. They operate like an interest bearing checking account with a large minimum deposit. They have taken away funds from banks by competing for depositors.
C. Regulation of the Financial System
The financial sector is one of the most heavily regulated areas of the economy. Table 5 in your textbook summarizes the various institutions responsible for regulating financial markets and institutions. The regulations we look at this semester serve at least one of 3 purposes: (1) reduce the asymmetry of information, (2) promote the stability of the financial system, and (3) improve the Federal Reserve's control of the money supply.
Reducing the Asymmetry of Information
We have already discussed the problems caused
by asymmetric information. One way to minimize these problems is to require
the disclosure of information deemed to be valuable to investors. The government
does this in several ways, including
Some of the worst economic conditions in the history of the United States were triggered by a financial panic, where financial institutions and markets ceased to function. So it only makes sense for the government to ensure that financial institutions are sound. Most, but not all, of these regulations came about in response to the Great Depression and massive bank failures of the 1930s. These regulations include
Depository institutions play a central role in determining the supply of money in the economy (which in turn affects inflation and economic growth). The Federal Reserve, through the banking system, exercises a lot of control over the money supply. Two regulations help with this: