The document provides an overview of the financial system including why it is studied, key components like financial markets and institutions, and economic analysis of its structure and regulation. It describes financial markets and the functions of intermediaries like banks. It also analyzes how adverse selection, moral hazard, and government safety nets influence financial structure and regulation. Capital requirements, supervision, and both micro and macroprudential regulation help address these issues.

1. An Overview
of the Financial System

2. Why Study Money, Banking, and
Financial Markets
• To examine how financial markets such as
bond and stock markets work
• To examine how banks, other financial
institutions and financial regulation work
• To examine the role of monetary policy in the
economy

3. Financial Markets
• Markets in which funds are transferred from
people who have an excess of available funds
to people who have a shortage of funds

4. The Bond Market and Interest Rates
• A security (financial instrument) is a claim on
the issuer’s future income or assets
• A bond is a debt security that promises to
make payments periodically for a specified
period of time (that is, IOU)
• An interest rate is the cost of borrowing or the
price paid for the rental of funds

5. FIGURE 1 Interest Rates on Selected Bonds,
1950–2008
Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

6. The Stock Market
• Common stock represents a share of ownership
in a corporation (IOBU)
• A share of stock is a claim on the earnings and
assets of the corporation
• Common stock holders are residual claimants.

7. Financial Institutions and Banking
• Financial Intermediaries: institutions that
borrow funds from people who have saved and
make loans to other people:
– Banks: accept deposits and make loans
– Other Financial Institutions: insurance companies,
finance companies, pension funds, mutual funds
and investment banks

8. Financial Crises
• Financial crises are major disruptions in
financial markets that are characterized by
sharp declines in asset prices and the failures
of many financial and nonfinancial firms.
• Severe financial crises typically spill over into
the real economy.

9. Outline of the lecture
• Financial Markets
• Financial Intermediaries
• Economic Analysis of Financial Structure
• Economic Analysis of Financial Regulation

10. Financial Markets
Function
Structure
Instruments

11. Function of Financial Markets
• Perform the essential function of channeling funds from
economic players that have saved surplus funds to those that
have a shortage of funds
• Direct finance: borrowers borrow funds directly from lenders
in financial markets by selling them securities
• Promotes economic efficiency by producing an efficient
allocation of capital, which increases production
• Directly improve the well-being of consumers by allowing
them to time purchases better

12. Flows of Funds
Through the Financial System

13. Structure of Financial Markets
• Debt and Equity Markets
– Debt instruments (maturity)
– Equities (dividends)
• Primary and Secondary Markets
– Investment Banks underwrite securities in primary
markets
– Brokers and dealers work in secondary markets

14. Structure of Financial Markets (cont’d)
• Exchanges and Over-the-Counter (OTC) Markets
– Exchanges: NYSE, Sofia Stock exchange, etc.
– OTC Markets: Foreign exchange, Federal funds
• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital markets deal in longer-term debt and
equity instruments

15. Internationalization
of Financial Markets
• Foreign Bonds: sold in a foreign country and denominated in
that country’s currency
• Eurobond: bond denominated in a currency other than that of
the country in which it is sold
• Eurocurrencies: foreign currencies deposited in banks outside
the home country
– Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or
in foreign branches of U.S. banks
• World Stock Markets
– Also help finance the federal government

16. Financial Markets Instruments
Money market instruments
– Treasury bills
– Negotiable Banks Certificates of Deposits
– Commercial papers
– Repurchase agreements

17. Financial Markets Instruments(cont’d)
Capital Market Instruments
– Stocks
– Mortgages
– Corporate bonds
– Government securities
– Local government bonds

18. Financial Intermediaries

19. Function of Financial Intermediaries:
Indirect Finance
• Lower transaction costs (time and money spent in carrying out financial
transactions)
– Economies of scale
– Liquidity services
• Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation)
– Diversification
• Deal with asymmetric information problems
– Adverse Selection: try to avoid selecting the risky borrower.
• Gather information about potential borrower.
– (after the transaction) Moral Hazard: ensure borrower will not engage in
activities that will prevent him/her to repay the loan.
• Sign a contract with restrictive covenants.

20. Function of Financial Intermediaries:
Indirect Finance (cont’d)
• Conclusion:
– Financial intermediaries allow “small” savers and
borrowers to benefit from the existence of
financial markets.

21. Types of Financial intermediaries
• Depository institutions
– Commercial banks
– Saving and loan associations and mutual saving
banks
– Credit unions

22. Types of Financial intermediaries (cont’d)
• Contractual Saving Institutions
– Life Insurance Companies
– Casualty Insurance Companies
– Pension Funds

23. Types of Financial intermediaries (cont’d)
• Investment Intermediaries
– Finance Companies
– Mutual Funds
– Money Market Mutual Funds
– Investment Banks

24. Regulation of the Financial System
• To increase the information available to investors:
– Reduce adverse selection and moral hazard problems
– Reduce insider trading .
• To ensure the soundness of financial intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control holding of
risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates

25. Economic Analysis
of Financial Structure

26. Basic Facts about Financial Structure
Throughout the World
How does the financial structure promote
economic efficiency?
• The bar chart in next slide shows how
American businesses financed their activities
using external funds (those obtained from
outside the business itself) in the period
1970–2000 and compares U.S. data to those
of Germany, Japan, and Canada

27. Sources of External Funds for Nonfinancial Businesses:
A Comparison of the United States with Germany, Japan, and
Canada

28. Eight Basic Facts
1. Stocks are not the most important sources of
external financing for businesses
2. Issuing marketable debt and equity securities
is not the primary way in which businesses
finance their operations
3. Indirect finance is many times more
important than direct finance
4. Financial intermediaries, particularly banks,
are the most important source of external
funds used to finance businesses.

29. Eight Basic Facts (cont’d)
5. The financial system is among the most
heavily regulated sectors of the economy
6. Only large, well-established corporations
have easy access to securities markets to
finance their activities
7. Collateral is a prevalent feature of debt
contracts for both households and
businesses.
8. Debt contracts are extremely complicated
legal documents that place substantial
restrictive covenants on borrowers

30. The Lemons Problem: How Adverse Selection
Influences Financial Structure
• If quality cannot be assessed, the buyer is willing
to pay at most a price that reflects the average
quality
• Sellers of good quality items will not want to sell
at the price for average quality
• The buyer will decide not to buy at all because all
that is left in the market is poor quality items
• This problem explains fact 2 and partially explains
fact 1

31. Tools to Help Solve Adverse Selection
Problems
• Private production and sale of information
– Free-rider problem
• Government regulation to increase information
– Not always works to solve the adverse selection problem,
explains Fact 5.
• Financial intermediation
– Explains facts 3, 4, & 6.
• Collateral and net worth
– Explains fact 7.

32. Tools to Help Solve the Principal-Agent
Problem
• Monitoring (Costly State Verification)
– Free-rider problem
– Fact 1
• Government regulation to increase information
– Fact 5
• Financial Intermediation
– Fact 3
• Debt Contracts
– Fact 1

33. Economic Analysis
of Financial Regulation

34. • Bank panics and the need for deposit insurance:
– FDIC: short circuits bank failures and contagion effect.
– Payoff method.
– Purchase and assumption method (typically more
costly for the FDIC).
• Other form of government safety net:
– Lending from the central bank to troubled institutions
(lender of last resort).
Asymmetric Information and Financial Regulation

35. Government Safety Net
• Moral Hazard
– Depositors do not impose discipline of
marketplace.
– Financial institutions have an incentive to take on
greater risk.
• Adverse Selection
– Risk-lovers find banking attractive.
– Depositors have little reason to monitor financial
institutions.

36. Government Safety Net:
“Too Big to Fail”
• Government provides guarantees of
repayment to large uninsured creditors of the
largest financial institutions even when they
are not entitled to this guarantee
• Uses the purchase and assumption method
• Increases moral hazard incentives for big
banks

37. Government Safety Net:
Financial Consolidation
• Larger and more complex financial
organizations challenge regulation
– Increased “too big to fail” problem
– Extends safety net to new activities, increasing
incentives for risk taking in these areas (as has
occurred during the global financial crisis)

38. Restrictions on Asset Holdings
• Attempts to restrict financial institutions from
too much risk taking
– Bank regulations
• Promote diversification
• Prohibit holdings of common stock
– Capital requirements
• Minimum leverage ratio (for banks)
• Basel Accord: risk-based capital requirements
• Regulatory arbitrage

39. Capital Requirements
• Government-imposed capital requirements
are another way of minimizing moral hazard at
financial institutions
• There are two forms:
– The first type is based on the leverage ratio, the amount of capital
divided by the bank’s total assets. To be classified as well capitalized, a
bank’s leverage ratio must exceed 5%; a lower leverage ratio,
especially one below 3%, triggers increased regulatory restrictions on
the bank
– The second type is risk-based capital requirements

40. Financial Supervision:
Chartering and Examination
• Chartering (screening of proposals to open new financial
institutions) to prevent adverse selection
• Examinations (scheduled and unscheduled) to monitor capital
requirements and restrictions on asset holding to prevent
moral hazard
– Capital adequacy
– Asset quality
– Management
– Earnings
– Liquidity
– Sensitivity to market risk
• Filing periodic ‘call reports’

41. Macroprudential Vs. Microprudential
Supervision
• Before the global financial crisis, the regulatory
authorities engaged in microprudential
supervision, which is focused on the safety and
soundness of individual financial institutions.
• The global financial crisis has made it clear that
there is a need for macroprudential supervision,
which focuses on the safety and soundness of the
financial system in the aggregate.