Introduction to the Financial System

In this section, you will learn: about securities, such as stocks and bonds the economic functions of financial markets how asymmetric information can disrupt financial

markets how banks compare to financial markets, and how

they combat problems from asymmetric information

the financial system’s role in economic growth

Financial Markets Financial markets:

where people and firms trade two kinds of assets Currencies Securities – claims on future income flows,

e.g. stocks and bonds

Bonds issued by corporations to raise funds for

investment, or by the government promise predetermined payments to buyers at

specified times in the future also called fixed-income securities represent debt: the buyers are lending to the

issuers

Bond jargon Face value: the amount bond pays when it matures Coupon payment: a payment that buyers of certain

bonds receive prior to maturity Bonds that mature in under a year:

commercial paper – issued by corporations Treasury Bills – issued by U.S. govt

Zero-coupon bonds: buyers get no payments until bond matures

Default: When a bond issuer fails to pay

Stocks also called equities shares of ownership in corporations,

who sell them to raise funds for investment riskier than stocks, because the income comes

from corporate profits, which are unpredictable

Economic Functions of Financial Markets

1. Matching savers and investors the loanable funds model mutually beneficial transactions

Savers earn income by loaning funds to investors

Investors get funds they need to finance investment projects (recall economics definition of investment – spending on capital goods)

Economic Functions of Financial Markets

2. Risk sharing allows for diversification, the distribution of

wealth among many assets losses or low returns on some assets

offset by higher returns on others An easy way to diversify:

buy shares of mutual funds, financial firms that buy and hold many different stocks and bonds

CASE STUDYThe Perils of Employee Stock Ownership 401(k): a retirement savings fund administered by

a firm for its workers, contributions not taxed Most 401(k) plans let workers choose among a set

of mutual funds and their company’s own stock. Before Enron went bankrupt in 2001, most of its

employees’ 401(k) assets were Enron stock. After an accounting scandal, the price of Enron

stock dropped to near zero, wiping out the retirement savings of most of its workers.

Enron illustrates the danger of not diversifying.

Asymmetric Information Asymmetric information:

when one party in a transaction has more information than the other party e.g., a firm selling securities knows more about its prospects than the buyers

Two types of asymmetric information: adverse selection moral hazard

Asymmetric Information Adverse selection:

when the people or firms most eager to make a transaction are the least desirable to the parties on the other side of the transaction

Firms with poor prospects are the most eager to sell their securities; Savers lacking information risk overpaying for a security that will produce low returns.

Savers understand this risk and may opt not to buy securities. Then firms with good prospects do not get the funding they need.

Asymmetric Information Moral hazard:

the risk that one party will act in a way that harms the other

If the buyer of a security cannot observe the issuer’s behavior, the issuer may use the funds for different purposes than promised (e.g. gambling on risky ventures), letting the buyer incur the losses if the venture fails.

Savers understand this risk and may opt not to buy securities. Then responsible borrowers do not get the funding they need.

NOW YOU TRY:Asymmetric information

Suppose banks could not check loan applicants’ credit histories.

a. Which type of asymmetric information problem would result?

b. How would this problem affect the market for loans?

ANSWERS:Asymmetric information

a. Adverse selectionRiskier borrowers would be more eager to take out a loan at a given interest rate than responsible borrowers.

b. Banks would expect most loan applicants to be risky, so they would charge higher interest rates on all loans. Result: responsible borrowers pay high rates and get fewer loans.

Banks Financial institutions (financial intermediaries):

firms that help channel funds from savers to investors

Banks: financial institutions that accept deposits and make loans

Deregulation has allowed banks to engage in other activities, such as trading securities

Indirect finance channels funds from savers to investors through banks. Direct finance channels funds through financial markets.

Banks and Asymmetric Information Banks reduce adverse selection by screening

potential borrowers. Banks combat moral hazard by using loan

contracts with covenants, provisions on the borrowers’ behavior which protect the bank.

The Financial System & Economic Growth

A well-functioning financial system promotes economic growth by channeling saving to the most productive investment projects.

In countries with underdeveloped financial systems, it’s hard for firms to raise funds for investment, so aggregate investment and growth are lower.

Government policies can help, e.g.: regulations to reduce information asymmetries federal deposit insurance

Two indicators of financial development by income level, 1996-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Stock Market CapitalizationBank Loans

Per

cent

of G

DP

Markets vs. central planning Centrally planned (or command) economy:

Govt decides what goods will be produced, who receives them, and what investment projects will be undertaken.

Lesson from Microeconomics:Free markets much better than command economies at allocating resources.

This lesson holds true in financial markets, where stock prices and interest rates channel funds to the most productive investments.

SECTION SUMMARY The financial system has two central parts:

financial markets and banks. Stocks and bonds are securities traded in financial

markets. Corporations and governments that issue bonds

are borrowing from those who buy the bonds; in return, the issuers make predetermined payments at specified times to the bond holders.

A stock is an ownership share in a corporation, and the stockholder receives a share of the corporation’s earnings.

SECTION SUMMARY Financial markets channel funds from

savers to investors with productive uses for the saved funds. Financial markets also help people reduce risk by diversifying their asset holdings.

Financial markets can malfunction because of asymmetric information: issuers of securities know more than buyers. The two types of asymmetric information problems are adverse selection and moral hazard.

SECTION SUMMARY Banks raise funds by accepting deposits

and use the funds to make private loans. They reduce asymmetric information problems by screening loan applicants, including covenants in loan agreements, and monitoring borrower behavior.

A well-functioning financial system promotes economic growth by channeling savings into productive investment. Bad government policies can hinder this function and reduce growth.