CAPITAL

MARKETS OVERVIEW OF MARKET PARTICIPANTS

AND FINANCIAL INNOVATION

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CONTENTS

• ISSUERS AND INVESTORS

• ROLE OF FINANCIAL INDERMEDIARIES

• OVERVIEW OF ASSET/LIABILITY

MANAGEMENT FOR FINANCIAL

INSTITUTIONS

• REGULATION OF FINANCIAL MARKETS

• FINANCIAL INNOVATION

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ISSUER AND INVESTORS

• We focus on one particular group of market

players,called financial intermediaries,because of

the key economic functions they perform in financial

markets.

• Regulators

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Cont’d

• Various entities issue financial assets,both debt

instruments and equity instruments and various

investors purchase these financial assets

• But these two groups are not mutually exclusive.

• It is common for an entity to both issue a financial

asset and at the same time invest in a different

financial asset.

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CLASSIFICATION OF ENTITIES

Central Governments

Agencies of Central Governments

Municipal Governments

Supranationals

Nonfinancial Businesses

Financial Enterprises

Households

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• Central governments borrow funds for a wide

variety of reasons.Debt obligations issued by

central governments carry the full faith and

credit of the borrowing government.

• Funds are raised by the issuance of debt

obligations called Treasury Securities.

• Two type of government agencies in the USA

are Federally Related Institutions and

Government Sponsored Enterprises.

• In most countries municipalities raise funds in

the capital market.

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• Supranational Institution:is an organization

formed by two or more central government

through international treaties.

• Two example of supranational institution are

International Bank for Reconstruction and

Development popularly referred to as World

Bank and American Development Bank

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• Businesses are classified into;

Nonfinancial

Financial Businesses

These entities borrow funds in the debt market and

raise funds in the equity market.

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Nonfinancial businesses are the form of three category;

Corporations

Farms

Nonfarms/Noncorporate Business

In the last category businesses produce same products

or provide the same services as corporations,but are

not incorporated.Financial businesses more popularly

referred to as financial institutions provide one or

more of the following services.

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Transform financial assets acquired through the market

constitute them into a different and more widely preferable

,type of asset,which becomes their liability.This function is

performed by financial intermediaries.(most important type of

financial institution)

Exchange financial assets on behalf of consumers.

Exchange financial assets on their own account.

Assist in the creation of financial assets for their customers and

then sell those financial assets to other market participants.

Provide investment advice to other market participants.

Manage the portfolios of other market participants.

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Cont’d

• Financial intermediaries include depository

institutions(commercial banks,savings and loan

associations) who acquire bulk of their funds by

offering their liabilities to the public mostly in form

of deposit.Others are discussed another chapters.

• Some subsidiaries of nonfinancial business provide

financial services.These financial institutions called

captive finance companies.

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• Examples of captive finance companies;

o General Motor Acceptance Corporations(a subsidiary

of General Motors)

o General Electric Credit(a subsidiary of General

Electric)

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Role of Financial Intermediaries

• Financial intermediaries play the basic role of the basic role of

transforming financial assets that are less desirable for a large

part of the public into other financial assets-their own

liabilities-which are more widely preferred by the public.This

transformation involves at least one of the four economic

functions;

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Cont’d

I. Providing maturity intermediation

II. Risk reduction via diversification

III. Reducing costs of contracting and information

processing

IV. Providing a payments mechanism

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I. Maturity intermediation:by issuing its own financial

claims the commercial commercial bank in essence

transforms a longer-term asset into a shorter –term

one by giving the borrower a loan for length of time

sought and the investors/depositor a financial asset

for the desired investment horizon.This is called

maturity intermediation.

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II. This economic function of financial intermediaries-

transforming more risky assets into less risky ones-is

called diversification.Even though individual investors

can do it on their own,they may not be able to to it as

cost effectively as a financial intermediary,depending

on the amount of funds they want to invest.Attaining

cost effective diversification in order to reduce risk by

purchasing the financial assets of a financial

intermediary is an important economic benefit for

financial markets.

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REDUCING THE COSTS OF CONTRACTING

AND INFORMATION PROCCESING

Investors purchasing financial assets must develop skills necessary to evaluate an investment.

Those skills are developed, investors can apply them when analyzing specific financial assets for purchase.

Investors who want to make a loan to a consumer or business need to write loan contract.

Although some people may enjoy devoting leisure time to this task, most of us find leisure time to be in short

supply and compensation for sacrificing it. The form of compensation could be a higher return obtained from

an investment.

In addition to the opportunity cost of time to process

the information about the financial asset, the cost of this

information must also be considered. All these costs are

information processing costs.

The costs of writing loan contracts are referred to as

contracting costs. Another dimension to contracting costs is

the cost of enforcing terms of loan agreement.

We have two examples of financial intermediaries as

commercial bank and investment company.

So that, economies of scale can be realized in

contracting and processing information because of amount of

funds managed by financial intermediaries.

The lower costs increase to the benefit of investor who

purchases asset and the issuer of financial assets.

PROVIDING A PAYMENTS MECHAISM

The previous three economic functions may not be

immediately obvious. This last one should be. Most

transactions made today are not with cash. Payments are made

using checks, credit cards, debit cards and electronic transfers

of funds. Financial intermediaries provide these methods for

making payments.

At one time, noncash payments were restricted to

checks. Payment by credit card was also at one time the

exclusive domain of commercial banks, but now other

depository institutions offer this service. Debit cards are offered

by various financial intermediaries.

A debit card differs from a credit card in that a bill

sent to credit cardholder periodically (usually once a month)

requests payment for transactions made in the past. With a

debit card, funds are immediately withdrawn from the

purchaser’s account at time transaction takes place.

The ability to make payments without cash is critical

for financial market. In short, depository institutions transform

assets that cannot be used to make payments into other assets.

OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL INSTITUTIONS

To understand why managers of financial

institutions invest in particular types of financial assets and

types of investment strategies employed. It is necessary to

have a general information of asset/liability problem.

For example, depository institutions seek to

generate income by difference between return that they earn

on assets and cost of their funds. This difference is referred

to as spread.

THE NATURE OF LIABILITIES

Liability Type Amount of Cash Outlay

Timing of Cash Outlay

Type I Known Known

Type II Known Uncertain

Type III Uncertain Known

Type IV Uncertain Uncertain

TYPE I LIABILITY

Both amount and timing are known. For example, depository institutions know amount that they are

committed to pay on maturity date of a fixed rate deposit, the depositor does not withdraw funds prior to the maturity

date.

TYPE II LIABILITY

The amount of cash outlay is known, but timing of cash outlay is uncertain. Life insurance policy can be an

example for this liability. The most of basic many types of life insurance policy provides that, for annual premium,

this company agrees to make a specified payment to beneficiaries upon the death of insured.

TYPE III LIABILITY

Timing is known, but amount is uncertain, such as

when a financial institution has issued an obligation in

which the interest rate adjust based on some interest rate

benchmark.

Depository institutions, for example, issue

liabilities called certificates of deposit with a stated

maturity. The interest rate paid need not to be fixed over

life of deposit but may fluctuate.

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TYPE IV LIABILITY

Both amount and timing are uncertain. Home

insurance policy is an example. Whenever damage is

done to an insured asset, the amount of payment that

must be made is uncertain.

LIQUIDITY NEEDS Because of uncertainty about the timing and the amount of the

cash outlays, a financial institution must be prepared with sufficent cash to satisfy its obligations.

Also keep in mind that our discussion of liabilities assumes that the entity that holds the obligation against the financial institution may exercise its right to change the nature of deposit, perhaps incurring some penalty.

For example;

In the case of a certificate of deposit,

the depositor may request the withdrawal

of funds prior to the maturity date.

• The deposit-accepting institution will grant this

request, but assess an early withdrawal penalty.

• Certain types of investment companies give

shareholders the right to redeem their shares at

any time.

• Some life insurance products provide a cash-

surrender value that allows the policyholder to

exchange the policy for a lump sum payment at

specified dates.

• Some life insurance products also offer a loan

value.

• In addition to uncertainty about the timing and amount of the cash outlays, and the potential for the depositor or policyholder to withdraw cash early or borrow against a policy, a financial institution is concerned with possible reduction in cash inflows.

• In the case of a depository institution, it means the inability to

obtain deposits.

• For insurance companies, it means reduced premiums because

of the cancellation of policies.

• For certain types of investment companies, it means not being

able to find new buyers for shares.

REGULATION OF FINANCIAL

MARKETS

• In their regulatory capacities,governments greatly influence

the development and evolution of financial markets and

institutions.

• It is important to realize that governments, issuers, and

investors tend to behave interactively and to affect one

another’s actions in certain ways.

JUSTIFICATION FOR

REGULATION • The standard explanation or justification for

govermental regulation of a market is that the market,

will not produce its particular goods or services in an

efficient manner and at the lowest possible cost.

• Efficiency and low-cost production are hallmarks of a

perfectly competitive at the time and that will not

gain that status by itself in the foreseeable future.

• Of course, it is possible that governments may regulate

markets that are viewed as competitive currently, but

unable to sustain competition, and low-cost

production, over the long run.

• A version of this justification for regulation is that the

government controls a feature of the economy that the

market mechanisms of competition and pricing could

not manage without help.

• A short hand expression used by economists to

describe the reasons for regulation is market failure.

The regulatory structure in the United States is largely the result of financial crises that have occurred at various times.Most regulatory mechanisms are the products of the stock market crash of 1929 and the Great Depression in the 1930s.

FORMS OF FEDERAL GOVERNMENT

REGULATION OF FINANCIAL MARKETS

1. Financial Activity Regulation

2. Disclosure Regulation

3. Regulation of Financial

Institutions

4. Regulation of Foreign

Participants

1. DISCLOSURE REGULATION: It requires issuers of

securities to make public a large amount of

financial information to actual and potential

investors.The standard justification for disclosure

rules is that the managers of the issuing firm have

more information about the financial health and

future of the firm. The cause of market failure here,

if indeed it occurs, is commonly described as

“asymmetric information,” it means investors and

managers are subject to uneven access to or

uneven possession of information.Also, the

problem is said to be one of “agency.”

• The United States is firmly committed to

disclosure regulation.The Securities Act of

1933 and the Securities Exchange Act of

1934 led to the creation of the Securities

and Exchange Commission (SEC).

• None of the SEC’s requirements or

actions constitutes a guarantee, a

certification, or an approval of the

securities being issued.

• Moreover, the government’s rules do not

represent an attempt to prevent the

issuance of risky assets.

2.FINANCIAL ACTIVITY REGULATION: It consists of

rules about traders of securities and trading on financial

markets. A prime example of this form of regulation is the

set of rules against trading by insiders who are corporate

officers and others in positions to know more about a firm’s

prospects than the general investing public. A second

example of this type of regulation would be rules regarding

the structure and operations of exchanges where securities

are traded.

3. REGULATION OF FINANCIAL INSTITUTIONS: Financial

institutions help households and firms to save; as depository institutions.

They also facilitate the complex payments among many elements of the

economy and they serve as conduits for the government’s monetary

policy. The U.S. Government imposed an extensive array of regulations

on financial institutions.

In recent years, expanded regulations restrict how financial institutions

manage their assets and liabilities, in the form of minimum capital

requirements for certain regulated institutions. These capital

requirements are based on the various types of risk faced by regulated

financial institutions and are referred to as risk-based capital

requirements.

4. REGULATION OF FOREIGN

PARTICIPANTS:

Government regulation of foreign participants limits the roles foreign firms can play in domestic markets and their ownership or control of financial institutions. Many countries regulate participation by foreign firms in domestic financial securities markets. Like most countries, the United States reviews and changes it policies regarding foreign firms’ activities in the U.S. financial markets on a regular basis.

FINANCIAL

Regulations that impede the free flow of capital and

competition among financial institutions (particularly

interest rates ceilings) motivate the development of

financial products and trading strategies to get around

these restirictions.

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Through technological advances and the reduction in

trade and capital bariers, surplus funds in one country

can be shifted more easily to those who need funds in

another country. As a result…

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CATEGORIZATIONS OF

FINANCIAL INNOVATION

Market-broadening instruments, which increase the

liquidity of markets and the availability of funds by

attracting new investors and offering new

opportunities for borrowers

Risk management instruments, which reallocate

financial risks to those who are less averse to them or

who have offsetting exposure, and who are

presumably better able to shoulder them

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Artbitraging instruments and processes ,which

enable investors and borrowers to take advantage of

differences in the perception of risks,as well as in

information, taxation, and regulations

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MOTIVATION FOR FINANCIAL

INNOVATION

Two extreme views seek to explain financial

innovation.At one extreme are those who believe that

the major impetus for innovation comes out of the

endeavor to circumvent (or “arbitrage”) regulations

and find loopholes in tax rules.At the other extreme

are those who hold that the essence of innovation is

the introduction of more efficient financial

instruments for redistributing risk among market

participants.

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MOTIVATION FOR FINANCIAL

INNOVATION

If we consider the ultimate causes of financial

innovation, the following emerge as the most

important:

1. Increased volatility of interest rates,inflation,equity

prices and exchange rates

2. Advances in computer and telecommunication

technologies

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3. Greater sophistication and educational training

among professional market participants

4. Financial intermediary competition

5. Incentives to get around existing regulations and tax

laws

6. Changing global patterns of financial wealth

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ASSET SECURITIZATION AS A

FINANCIAL INNOVATION

Asset securitization means that more than one

institution may be involved in lending capital.

Consider loans for the purchase of automobiles.A

lending scenario can look like this:

1. A commercial bank originates automobile loans

2. The commercial bank issues securities backed by

these loans.

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3. The commercial bank obtains credit risk insurance for

the pool of loans from a private insurance company

4. The commercial bank sells the right to service the

loans to another company that specializes in the

servicing of loans

5. The commercial bank uses the services of securities

firm to distribute the securities to individuals and

institutional investors.

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SUMMARY;

Financial innovation increased dramatically since the

1960s, particularly in the late1970s.Although

financial innovation can be result of arbitrary

regulations and tax rules, innovations that persist after

changes in regulations or tax rules, designed to

prevent exploitation, are frequently those that offer a

more efficient means for redistributing risk.

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