Chapter 17 The Financial System Overview Understanding the Financial System Financial system process by which funds are transferred from those having excess funds savers to those needing addt l funds users Savers do not spend all of their income and have a surplus Users spend more than they make and have a deficit Net savers save more than they use households Net spenders use more than they save businesses gov t Net worth difference between what you owe and what you own grows with age Direct Transfer user raises needed funds directly from savers Indirect transfer funds transferred thru financial institutions Types of Securities Money Market Instruments Securities obligations of issuers to provide purchasers with returns on funds invested stocks bonds Money market instruments short term debt securities issued by gov ts institutions and corporations Investors are paid interest by the issuer for the use of their funds within 1 year treasury bills commercial paper CD Treasury bills issued by Treasury backed by US gov t risk free Commercial paper issued by corporations low risk Bonds Government bonds sold by the Treasury risk free Municipal bonds issued by state local gov t o Revenue bond proceeds are used to pay for project that will produce revenue toll road o General obligation bond proceeds are used to pay for project that does not produce revenue Corporate bonds diverse group based on collateral that backs them o Secured bond backed by a specific pledge of company assets home is collateral for mortgage o Unsecured bonds debentures backed only by the financial reputation of the issuing corporation Mortgage pass through security backed by a pool of mortgage loans purchased from lenders o Subprime mortgages loans made to borrowers with poor credit Investment grade bonds bonds with a rating of BBB low risk Speculative junk bonds BB and lower offer high interest rats in exchange for greater risk Call provision allows the issuer to redeem the bond before its maturity at a specified price Stock Preferred stock stockholders receive preference in the payment of dividends Common stock ownership claims in corporations vote on decisions Convertible securities bondholder has right to exchange the bond preferred stock for common stock Financial Markets Financial market market in which securities are bought and sold Primary market financial market in which new security issues are first sold o Securities sold in 2 ways open auctions gov t thru investment bankers corporate municipal o Underwriting investment bankers by securities at a discounted rate resell them Initial public offering IPO when a company offers stock for sale to the general public for the first time Tombstone announcements of new stock and bond offerings Secondary market financial market in which already issued securities are traded between investors NYSE Understanding Stock Markets Stock market where stocks are traded NYSE firms apply for listing and meet certain requirements trading takes place face to face on a trading floor NASDAQ completely computerized trading features smaller firms than NYSE trading thru intranet AMEX focuses on stocks of small firms Regional stock exchanges are located in certain cities London Stock Exchange most internat l stock market Forth market direct trading of stocks off the floor of the NYSE or NASDAQ Electronic communications networks ECNs buyers sellers meet in a virtual stock market trade directly with one another INET Archipelago Brokerage firms intermediaries that buy sell securities thru stock exchanges on behalf of most investors Market order instructs the broker to obtain the best possible price highest when selling lowest when buying Limit order sets a price ceiling when buying or price floor when selling Financial Institutions Financial institutions intermediary between savers borrowers collecting funds from savers and then lending funds to individuals businesses and gov ts Depository Institutions institutions that accept deposits that customers can withdraw on demand o Commercial Banks largest FDIC gov t agency that insures deposits at commercial and savings banks o Savings Bank and Credit Unions o Electronic Funds Transfers Systems computerized systems for conducting transactions over links o Online Banks Internet only banks ING Direct and brick and mortar banks CitiBank JPMorgan Non Depository Institutions accept funds from businesses households Insurance companies sell premiums and reinvest profit o o Pension funds retirement benefits o Finance companies offer short term loans o Mutual Funds financial intermediaries that raise money from investors by selling shares The Role of the Federal Reserve Organization of the Fed Purposes of Fed Federal reserve system US central bank regulate banks and set monetary policies 4 responsibilities regulating commercial banks performing banking activities for treasury providing services for banks setting monetary policy Nation divided into 12 districts each with own federal reserve bank 9 member board of directors with a president Governing board consists of 7 members on 14 year terms appointed by P confirmed by Senate Federal Open Markets Committee sets most policies concerning monetary policy and interest rates 12 members Fed facilitates in clearing of billions of checks each year Controlling supply of money and credit thru monetary policy that promotes economic growth Monetary Policy Fed has 4 major policy tools Regulation of the Financial System o Reserve requirements change in percentage of deposits held as reserves o Discount rate change in the rate the fed charges banks for loans o Open market operations buying and selling gov t securities to increase decrease bank reserves o Term auction facility loans fed auctions 28 day loans to banks Federally Chartered commercial banks regulated by Fed FDIC Comptroller of Currency State Chartered banks are subject to FDIC regulation SEC s mission is to administer securities laws and protect investors in public securities transactions Bank regulation purpose is to ensure public confidence in banking system Market Reform Act of 1990 gave SEC authority to halt trading and restrict practices such as program trading Insider trading use of material nonpublic info to make investment profits Self regulation rules of conduct established by organizations NASD and market surveillance audit trail
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