Purpose of the Financial System to facilitate the transfer of funds from savers to borrowers Savers Lenders supply the funds to borrowers who promise to pay back the money with interest in the future These promises are financial liabilities for the borrower Assets for the savers Ex Car loans are assets use of funds for the bank a liability source of funds for consumers Financial Markets such as stock or bond markets issue claims on individual borrowers directly to savers Financial Intermediaries Institutions such as banks mutual funds and insurance companies act as go betweens by holding a portfolio of assets and issuing claims based on that portfolio to savers Shadow Banking Form of financial intermediaries that are not regulated by the government This is because they deal with large institutional investors not common people An example would include hedge funds Financial Regulations Regulation occurs for three reasons 1 Governments want to ensure all participants have access to information 2 Regulate to ensure financial stability in the system 3 Government can advance economic policy by interacting with the system The third reason can cause instruments and services to change over time The Financial System provides 3 services to borrowers and savers 1 Risk sharing Risk is that the value of a financial asset will change relative to what s expected The financial system provides risk sharing by allowing savers to hold many assets at one time 2 Liquidity Ease in which an asset can be exchanged for money For example Holding a stock 3 in a company is more liquid than owning all the machines in their factories because it can more readily be turned into cash Information Banks do research on what borrowers intend to do with funds from savers Asymmetric information means borrowers possess more info than lenders about the purpose of loaned funds Risk Return Investments in decisions of higher risk are going to offer higher returns For example a bank will be more likely to loan money to someone with a large net worth because its less risky Since the bank is taking less of a risk on this loan they can charge a lower rate for money Compare this to someone with less net worth money will be more expensive to loan because it s risker Debt Is a type of claim which requires the borrower to pay back the principal amount borrowed plus a rental fee interest Equity Another type of claim which entitles the holder to ownership in the company and thus a share of profits assets Primary Markets Where newly issued claims are sold to buyers investors by the borrowers typically businesses or governments Businesses use these markets to raise money for new ventures These deals are negotiated prices behind closed doors and shares are sold to an investment bank The bank then takes these shares and sells them for a profit on the secondary markets Secondary Markets Most widely reported this is where already issued equities are traded Ex NYSE Money Markets Where financial instruments with a maturity of less than 1 year are traded When governments or businesses need cash to satisfy short term needs they issue money market instruments Capital Markets Where debt instruments with expirations of greater than 1 year and no fixed maturities are traded Competition In finance refers to the different avenues savers borrowers can put their monies each with pros and cons Example picking a single security vs a diversified mutual fund Moral Hazard The issue that arises when borrowers use their lent monies for things other than what they promised This happens when borrowers are incentivized to commit moral hazard Example using your financial aid money to invest in the stock market instead of paying for books Principal Agent Problem This shareholders are owners of companies and are called Principals Managers control the firm and are called Agents Principal agent problem is a form of moral hazard and occurs when managers agents don t own much equity in the company and aren t as concerned about maximizing shareholders wealth as they should be Ex If managers feel shareholders would be happy with a 3 return and returns for the year were 5 spending that extra 2 on a private plane instead of paying a dividend would be a principal agent problem Free Riding Occurs when people try to piggy back on others information that they did not pay for Example This can occur when investors mock or copy notable investors actions Reducing Information costs and how intermediaries play a role Because there are transaction information costs money costs interest for borrowers to cover these expenses Information costs are reduced by lenders when many people borrow and the per borrower share of the info cost is reduced Commercial Banks Financial Intermediaries take money as deposits and extend loans Also provide the big 3 services of banks risk share liquidity info services Face fierce competition when there are better places to put money with better returns Heavily regulated due to the fact they take common peoples money and are limited in the risks they are allowed to take in their investments Investment Banks Help firms raise new capital Two ways to do this 1 Stock issue which passes some ownership to the public 2 debt contracts Hedge Funds Are not regulated by the government They carry more risk for this reason Hedge funds are part of the shadow banking industry that helped cause the 2008 credit crisis Also unlike traditional funds managers are not required to disclose what they re investing in Mutual Funds Pool a large number of investors money to invest in a diversified portfolio of investments Mutual funds reduce transaction costs for savers Savers can buy into all the investments in the portfolio w one purchase Managers are typically more skilled at information gathering which could benefit savers as well Finance companies Are intermediaries who raise money by selling securities Then they take the money earned to extend loans to households and firms Three different types 1 Consumer Finance extend credit for people to buy cars furniture household improvements 2 Business Finance Help businesses with cash flow problems For example a company might sell a business finance company 10000 of accounts receivable for 9000 earning 1000 in the process The company likes this because they need cash to stay operational and the finance company gets to earn interest on extra money they had lying around 3 Sales Finance is associated with buying large priced goods such
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