Chapter 2

FIN 324 Financial Institutions in Hong Kong and Global Banking Week 1 Introduction: Financial System and Financial Intermediation Mishkin (2012): Chapter 2 Overview of the Financial System Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-1 Chapter Preview In this chapter, we examine the role of the

financial system in an advanced economy. We study the effects of financial markets and institutions on the economy, and look at their general structure and operations. Topics include: Function of Financial Markets Structure of Financial Markets Internationalization of Financial Markets Function of Financial Intermediaries Financial Intermediaries

Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-2 Function of Financial Markets Channels funds from person or business without investment opportunities (i.e., Lender-Savers) to one who has them (i.e., Borrower-Spenders) Improves economic efficiency Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-3

Financial Markets Funds Transferees Lender-Savers Borrower-Spenders 1. Households 1. Business firms 2. Business firms 2. Government 3. Government

3. Households 4. Foreigners 4. Foreigners Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-4 Segments of Financial Markets 1. Direct Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments which are

claims on the borrowers future income or assets 2. Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrowers future income or assets Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-5 Function of Financial Markets

Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-6 Importance of Financial Markets Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the wellbeing of consumers, allowing them to time their purchases better. Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-7

Structure of Financial Markets 1. Debt Markets Short-Term (maturity < 1 year) Long-Term (maturity > 10 year) Intermediate term (maturity in-between)

2. Equity Markets Pay dividends, in theory forever Represents an ownership claim in the firm Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-8 Structure of Financial Markets 1. Primary Market

New security issues sold to initial buyers Typically involves an investment bank who underwrites the offering 2. Secondary Market Securities previously issued are bought and sold Examples include the New York Stock Exchange (NYSE) and Nasdaq Involves both brokers and dealers Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-9 Structure of Financial Markets

Even though firms dont get any money, per se, from the secondary market, it serves two important functions: Provide liquidity, making it easy to buy and sell the securities of the companies Establish a price for the securities Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-10 Structure of Financial Markets We can further classify secondary markets as follows: 1. Exchanges

Trades conducted in central locations (e.g., New York Stock Exchange, The Stock Exchange of Hong Kong) 2. Over-the-Counter Markets Dealers at different locations buy and sell Best example is the market for Treasury securities, Notes issued by Hong Kong Mortgage Corporation in Hong Kong.

Copyright 2009 Pearson Prentice Hall. All rights reserved. NYSE home page http://www.nyse.com 2-11 Classifications of Financial Markets We can also further classify markets by the maturity of the securities: 1. Money Market: Short-Term (maturity < 1 year) 2. Capital Market : Long-Term (maturity > 1 year) plus equities

Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-12 Internationalization of Financial Markets The internationalization of markets is an important trend. The U.S. no longer dominates the world stage. International Bond Market Foreign bonds Denominated in a foreign currency Eurobonds Denominated in one currency, but sold in a different market

Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-13 Internationalization of Financial Markets Eurocurrency Market Foreign currency deposited outside of home country Eurodollars are U.S. dollars deposited, say, London. Gives U.S. borrows an alternative source for dollars. Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-14 Internationalization of Financial Markets

The number of international stock market indexes is quite large. Dow ( ) S&P 500 ( 500 ) Nikkei 225 ( 225 ) FTSE 100 ( 100 ) Hang Seng Index ( ) Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-15 Function of Financial Intermediaries: Indirect Finance We now turn our attention to the top part of Figure 2.1 indirect finance.

Function of Financial Intermediaries : Indirect Finance Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: the intermediary obtains funds from savers the intermediary then makes

loans/investments with borrowers Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-17 Function of Financial Intermediaries : Indirect Finance This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers. More important source of finance than securities markets (such as stocks) Needed because of transactions costs, risk

sharing, and asymmetric information Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-18 Function of Financial Intermediaries : Indirect Finance Transactions Costs 1. Financial intermediaries make profits by reducing transactions costs 2. Reduce transactions costs by developing expertise and taking advantage of economies of scale Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-19 Function of Financial Intermediaries : Indirect Finance A financial intermediarys low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-20

Function of Financial Intermediaries : Indirect Finance Another benefit made possible by the FIs low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-21 Function of Financial Intermediaries : Indirect Finance Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings. Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals. Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-22

Function of Financial Intermediaries : Indirect Finance Another reason FIs exist is to reduce the impact of asymmetric information. One party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two fronts: adverse selection and moral hazard. Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-23 Function of Financial

Intermediaries : Indirect Finance Adverse Selection 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan 3. Similar problems occur with insurance where unhealthy people want their known medical problems covered Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-24 Asymmetric Information: Adverse Selection and Moral Hazard

Moral Hazard 1. After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back 3. Again, with insurance, people may engage in risky activities only after being insured 4. Another view is a conflict of interest Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-25 Types of Financial Intermediaries Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-26 Types of Financial Intermediaries Three-tier system of deposit-taking institutions, namely, licensed banks, restricted licence banks, deposit-taking companies in Hong Kong (collectively known as AI: Authorized Institutions) Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-27

Contractual Savings Institutions (CSIs) All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-28 Contractual Savings Institutions (CSIs) All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-29 Types of Financial Intermediaries Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-30 Types of Financial Intermediaries Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets. Copyright 2009 Pearson Prentice Hall. All rights reserved.

2-31 Regulation Reason: Increase Investor Information Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets and may also keep investors away from financial markets The Securities and Exchange Commission (SEC) (SEC in US; Securities and Futures Commission, SFC in Hong Kong) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation

Copyright 2009 Pearson Prentice Hall. All rights reserved. SEC home page http://www.sec.gov 2-32 Regulation Reason: Increase Investor Information Such government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors. Indeed, the SEC has been particularly active recently in pursuing illegal insider

trading. Copyright 2009 Pearson Prentice Hall. All rights reserved. SEC home page http://www.sec.gov 2-33 Regulation: Deposit Insurance The government can insure people depositors to a financial intermediary from any financial loss if the financial intermediary should fail The Federal Deposit Insurance Corporation in the United States (FDIC): depositors are paid off

in full on the first US$250,000 they have deposited in a bank if the bank fails Copyright 2009 Pearson Prentice Hall. All rights reserved. 2-34 Regulation: Deposit Insurance In Hong Kong, Deposit Protection Scheme (DPS) managed by The Hong Kong Deposit Protection Board insures HK$500,000 per depositor per bank in Hong Kong. Copyright 2009 Pearson Prentice Hall. All rights reserved.

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