Financial Markets &
Institutions
FINN2021 Financial Markets
and Institutions
2023-2024
Financial Markets &
Institutions
Lecture 1
An Introduction to the Financial
System
Learning
Objectives
By the end of this session we will:
• Understand the main elements of the financial system;
• Outline and give details on the main goals of
institutions;
• Assess the links between institutions and
instruments;
• Analyse the role of the financial system within
an economy circular flow
• Learn about financial intermediation
``Price is what you pay. Value is what you get.'' -- Warren
Finance/Financial
System
The Financial System
Finance is
Saving about money
flow: managing
the process of
turning savings
Lenders Borrowers into cash-flow
generating
investments
Return
The Basic
Concept
Definition
A financial system is defined as a set of markets for
financial instruments, and the individuals and
institutions who trade in those markets, together with
the regulators and supervisors of the system.
The basic function of the financial system is to transfer
resources from those with excess funds for investment,
to those who require more funds for investment.
The
Participates
• Borrowers
•Firms
•Households
•The government (US $28.8 tril. as Oct 1st 21, $20.9 tril. in
2020)
•Foreigners Same people – but usually in a different
• Lenders
order
•Households
•The
government
•Firms
•Foreigners
Government Borrowing I: Percent
of GDP
Government Borrowing: in
Euros
Why Do Lenders
Lend?
• Lenders will worry about:
• the return that they can get
• the risk surrounding this return:
• default risk
• income risk
• inflation risk
• liquidity
If we wish to encourage more lending, one way is to
increase the return offered to lenders, the other is to
reduce the risk.
What Determines Borrowers’
Behaviour?
• Borrowers will worry about:
• the return that they must pay to get the funds;
• the terms of this return;
• for example, debt is not state-contingent
while equity is.
• the length and flexibility of the borrowing;
• firms will not wish to have debts which are
too
easily recalled.
How the Matches Occur?
Lending can be:
1. Completely direct
• lenders seeking out other agents who need to
borrow
2. Direct lending through a market
3. Through financial intermediation
• direct; or
• through a market.
The Basic
Concept
Direct Savin
Retur g
n
Lenders Borrower
s
Financial
Intermediation BANKS
Financial
Intermediation
•The process of transferring sums of money
from economic agents with surplus funds to
economic agents that would like to utilise
those funds.
•Financial intermediaries are institutions such as:
banks, mutual funds, hedge funds, pension
funds, insurance companies, etc…
Financial
Intermediaries
Financial
Intermediation
Why go through a financial
intermediary?
• Reduction of transaction costs
• Risk diversification
• Maturity transformation
• Reduction of asymmetric information
• Adverse selection
• Moral hazard
Financial
Intermediation
• Asymmetric Information
• Adverse selection
•Occurs before the transaction
•In the case of insurance, adverse selection is the tendency of those
in dangerous jobs or high-risk lifestyles to get life insurance.
•Only those who are most risky are willing to borrow
• Moral hazard
•Occurs after the transaction
•Moral hazard occurs when insuring against an event makes the
insured-against event itself more likely to occur.
•Once they have the service, their behaviour changes in undesirable
ways
Financial
Markets/System
The Different Types of
Market
•There are lots of different financial markets
for each different type of instruments (later)
• Primary versus secondary markets
• OTC versus exchange markets
• Dealers versus brokers in exchange markets
• Money-market versus capital market (maturity)
The different Types of
Instruments
The main instruments to distinguish are:
• Equity/stock
• May get an annual share of profits as
dividend
• Owns part of the company => voting right
• Price varies depending on supply and
demand
• Debt/bond
• Contractually fixed return
• Per period interests
• Principal at maturity date
• No voting right
The different Types of
Instruments
• Money-market instruments
• Treasury Bills
• Negotiable bank certificates of
deposit
• Repos
• Eurodollars
• Capital market instruments
• Stocks
• Corporate bonds
• Consumer loans
Regulation
•Financial services are regulated industry (and have
been like this for a long time). But why do we
regulate financial services?
• Bankingrelies on confidence of public
•Fractional reserves system
•Liquidity mismatch between assets and liabilities
• Contagion…
• Consumer protection…
Regulation
• Problems because of regulation
• Moral Hazard
• If governments guarantee investors’ money this may
encourage investors to place their money in institutions
offering the highest return, because, regardless of the
risks involved, investors know that their principal is safe.
• Costs of entry and exit are higher – more
monopoly
power
Functions of Financial Markets
• Consumption smoothing for investors
• Save for the future
• Allocate earnings over time
• Separation of ownership and management
• In seeking high returns, investors allocate capital to most productive
uses:
• Under some assumptions, capital will be efficiently allocated to projects.
• Only the ``marginal project'' (NPV = 0) or better will just be funded.
• Allow investors to manage and modify their risk exposures
• Market interest rates and securities prices convey investors'
information
and predictions about the future
• A stock price increase may reflect peoples' beliefs that the company’s earnings
will increase in the future.
A Well Functioning Financial
System I
•◼ (1) Transparency:
❑ Condition whereby all participants will have access to reliable and
• important information at the same time.
• ◼ Importance of financial services providers to
transparency in disseminating financial information.
❑ Dow Jones, Bloomberg, Reuters.
• ◼ Importance of reliable accounting data.
• ◼ Importance of trading platforms to transparency.
❑ How quickly is trading information made available?
❑ Do all potential traders have access to same trading
• information (bid and ask prices publicly displayed).
A Well Functioning Financial
System II
◼ (2) Adequate Regulation:
❑ Financial markets need to have regulation which ensures a level and fair
playing field and appropriate behavior.
◼ Regulation needs to:
❑ Encourage quick and full disclosure
❑ Provide appropriate reporting of financial information to markets
❑ Discourage unethical behavior: insider trading, price
manipulations.
❑ Issue for regulators:
◼ A what point does regulation become a burden (excessive) and/or
drive financial service providers to other markets?
◼ Perhaps regulators need to use a cost – benefit analysis
approach.
❑ Beginning with the Great Depression of the 1930s, the U.S. has gone
through a series of financial market regulatory changes.
A Well Functioning Financial
System III
◼ (3) Competition:
❑ Markets need to be structured and regulated so as to offer easy access
and exit.
◼ Not segmenting financial service providers.
◼ Not overly protecting (or rescuing) poorly run firms.
❑ Moral hazard issue (“too big to fail” or government guarantees).
❑ Competition applies to both domestic and foreign entities.
❑ Goal: To ensure best prices and services for end users.
◼ (4) Market Structure which Allows for Innovation:
❑ To provide needed new services and new product development.
◼ Allow financial service providers to respond to needs of end users.
❑ Development of derivative products in the 1970s through today.
Readin
gs
• Recent developments in financial
intermediation after the financial crisis
http://www.annualreviews.org/doi/abs/10.1146/an
nurev.economics.102308.124420
Further readings:
• Pilbeam (Chapter 1 & 2) *required
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