Lecture 1: Why Study Financial Markets and Institutions?

Why have intermediaries?

Funds can be moved from those with an excess to those with a shortage either directly or
indirectly. In direct financing the saver provides funds directly to the end user of the funds. More
frequently an intermediary brings the two parties together and minimizes transaction costs by
taking advantage of economies of scale. This is indirect financing. Because of economies of
scale and the ability of intermediaries to minimize search costs, both savers and spenders can
often earn more than when using direct financing. The presence of intermediaries and of
financial markets permits funds to move easily and efficiently from savers to spenders in a
manner that puts the funds to work where they will provide the greatest return.

Introduction to Financial Markets and Institutions:

Financial markets serve six basic functions. These functions, briefly listed below.

• Borrowing and Lending: Financial markets permit the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.
• Price Determination: Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.
• Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.
• Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
• Liquidity: Financial markets provide the holders of financial assets with a chance to resell
or liquidate these assets.
• Efficiency: Financial markets reduce transaction costs and information costs.

In attempting to characterize the way financial markets operate, one must consider both the
various types of financial institutions that participate in such markets and the various ways in
which these markets are structured.

Types of markets

A firm can obtain funds in financial markets in two ways. The most common method is to issue
debt; the other is to issue equity. Firms sell bonds on the debt markets and this represents
lending by a saver to a firm. The saver normally receives a contractually set interest payments
from the borrower for use of the loaned funds. Firms sell stocks in the equity markets and this
represents the transfer of partial ownership interest in a firm. Stock owners are not assured of any
contractual payments but are entitled to any residual funds remaining after all other claims are
paid. We can further describe the debt and equity markets as either primary or secondary
markets. In the primary market, the corporation or government agency that will ultimately use
the funds sells new issues of a security. An investment banker is commonly used to assist in the
process of a single borrower obtaining funds from many savers. The investment banker assists
by underwriting the debt or equity issue. Underwriting means that the investment banker first
provides the money to the borrower and will proceed to obtain the money from lenders by
issuing the stock or bond. In the secondary market, previously issued securities are resold. The
New York Stock Exchange is the best known of the secondary markets. Other important
secondary markets include the over-the-counter market, the American Stock Exchange, and the

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Chicago Board of Trade. One valuable service provided be the secondary market is to make
securities more liquid by establishing a ready market for the security when the holder wishes to
sell. This makes the security much more desirable. Brokers and dealers assist in the secondary
markets by matching buyers and sellers of the security. A final way that we can distinguish
between markets is on the basis of the maturity of the securities traded in that market. The
money market is for securities that have annual maturity of less than one year. Capital markets
are for securities with an initial maturity that exceeds one year. For example, stock will trade on
the capital markets since it has no maturity. Treasury bills will trade in the money market since
they mature in less than one year.

Intermediaries Help Remove Informational Asymmetries

In addition to minimizing transaction costs through economies of scale, intermediaries can

minimize the cost associated with asymmetric information. Asymmetric information occurs
when the borrower and the lender have different information about transaction. For example,
managers may know that the future of the firm is very shaky, but lenders continue lending to the
firm because they do not have this information. There two types of asymmetric information
costs, adverse selection and moral hazard. Adverse selection occurs when those firms most
likely to default are the ones most actively seeking loans. This occurs because the market interest
rate is the most attractive to high risk firms. Moral hazard occurs when the lender is subject to
the risk that the borrower will engage in risky activities that jeopardize repayment while seeking
high returns. In way we distinguish between adverse selection and moral hazard is to recognize
that adverse selection is a problem before transaction while moral hazard is a problem after
transaction has occurred.

Types of Financial Intermediaries

Financial economists categorize financial intermediaries as (1) depository institutions, (2)

contractual savings institutions, and (3) investment intermediaries. Depository institutions make
loans and accept deposits from individuals and institutions. Depository institutions include
commercial banks, savings and loan associations, mutual savings banks, and credit unions.
Contractual savings institutions acquire funds at periodic intervals on a contractual basis. Life
insurance companies, fire and casualty insurance companies, and pension funds are examples of
contractual savings institutions. Investment intermediaries invest funds on behalf of others. This
category includes finance companies, mutual funds, and money market mutual funds.

Who are the Major Players in Financial Markets?

By definition, financial institutions are institutions that participate in financial markets, i.e., in
the creation and/or exchange of financial assets. At present in the United States, financial
institutions can be roughly classified into the following four categories: "brokers;" "dealers;"
"investment bankers;" and "financial intermediaries."

Brokers:

A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller
(or buyer) to complete the desired transaction. A broker does not take a position in the assets he
or she trades -- that is, the broker does not maintain inventories in these assets. The profits of
brokers are determined by the commissions they charge to the users of their services (either the
buyers, the sellers, or both). Examples of brokers include real estate brokers and stock brokers.

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Diagrammatic Illustration of a Stock Broker:

Payment ----------------- Payment

------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares

Dealers:

Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions"
(i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of
inventory rather than always having to locate sellers to match every offer to buy. Also, unlike
brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets
at relatively low prices and reselling them at relatively high prices (buy low - sell high). The
price at which a dealer offers to sell an asset (the asked price) minus the price at which a dealer
offers to buy an asset (the bid price) is called the bid-ask spread and represents the dealer's profit
margin on the asset exchange. Real-world examples of dealers include car dealers, dealers in
U.S. government bonds, and Nasdaq stock dealers.

Diagrammatic Illustration of a Bond Dealer:

Payment ----------------- Payment

------------>| |------------->
Bond | Dealer | Bond
Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------

Investment Banks:

An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial
Public Offerings) by engaging in a number of different activities:

• Advice: Advising corporations on whether they should issue bonds or stock, and, for bond
issues, on the particular types of payment schedules these securities should offer;
• Underwriting: Guaranteeing corporations a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
• Sales Assistance: Assisting in the sale of these securities to the public.

Some of the best-known U.S. investment banking firms are Morgan Stanley, Merrill Lynch,
Salomon Brothers, First Boston Corporation, and Goldman Sachs.

Financial Intermediaries:

Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions
that engage in financial asset transformation. That is, financial intermediaries purchase one kind
of financial asset from borrowers -- generally some kind of long-term loan contract whose terms

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are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different
kind of financial asset to savers, generally some kind of relatively liquid claim against the
financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial
intermediaries typically hold financial assets as part of an investment portfolio rather than as an
inventory for resale. In addition to making profits on their investment portfolios, financial
intermediaries make profits by charging relatively high interest rates to borrowers and paying
relatively low interest rates to savers.

Types of financial intermediaries include: Depository Institutions (commercial banks, savings

and loan associations, mutual savings banks, credit unions); Contractual Savings Institutions
(life insurance companies, fire and casualty insurance companies, pension funds, government
retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual
funds, money market mutual funds).

Diagrammatic Example of a Financial Intermediary: A Commercial Bank

Lending by B Borrowing by B

deposited
------- funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- loan ------- deposit -------
contracts accounts

Loan contracts Deposit accounts

issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households

Important Caution: These four types of financial institutions are simplified idealized
classifications, and many actual financial institutions in the fast-changing financial landscape
today engage in activities that overlap two or more of these classifications or even to some extent
fall outside these classifications.

For example, as noted above, Merrill Lynch is an investment banker in the sense it is one of the
key financial institutions that provides investment banking services both here in the United
States and abroad. On the other hand, Merrill Lynch also engages heavily in brokering and
dealership activities as well as providing money market accounts on which checks can be drawn.
Thus, Merrill Lynch actually operates to some extent in all four of the above categories. The
bottom line is that the ability to use the above four categories to distinguish among separate
institutions (as opposed to the activities undertaken within institutions) is rapidly diminishing.

What Types of Financial Market Structures Exist?

The costs of collecting and aggregating information determine, to a large extent, the types of
financial market structures that emerge. These structures take four basic forms:

• Auction markets conducted through brokers;

• Over-the-counter (OTC) markets conducted through dealers;
• Organized Exchanges, such as the New York Stock Exchange, which combine
auction and OTC market features. Specifically, organized exchanges permit

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 buyers and sellers to trade with each other in a centralized location, like an
auction. However, securities are traded on the floor of the exchange with the help
of specialist traders who combine broker and dealer functions. The specialists
broker trades but also stand ready to buy and sell stocks from personal inventories
if buy and sell orders do not match up.
• Intermediation financial markets conducted through financial intermediaries;

Financial markets taking the first three forms are generally referred to as securities markets.
Some financial markets combine features from more than one of these categories, so the
categories constitute only rough guidelines.

Auction Markets:

An auction market is some form of centralized facility (or clearing house) by which buyers and
sellers, through their commissioned agents (brokers), execute trades in an open and competitive
bidding process. The "centralized facility" is not necessarily a place where buyers and sellers
physically meet. Rather, it is any institution that provides buyers and sellers with a centralized
access to the bidding process. All of the needed information about offers to buy (bid prices) and
offers to sell (asked prices) is centralized in one location which is readily accessible to all would-
be buyers and sellers, e.g., through a computer network. No private exchanges between
individual buyers and sellers are made outside of the centralized facility.

An auction market is typically a public market in the sense that it open to all agents who wish to
participate. Auction markets can either be call markets -- such as art auctions -- for which bid
and asked prices are all posted at one time, or continuous markets -- such as stock exchanges and
real estate markets -- for which bid and asked prices can be posted at any time the market is open
and exchanges take place on a continual basis. Experimental economists have devoted a
tremendous amount of attention in recent years to auction markets.

Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills, notes and
bonds) to cut down on information costs. Alternatively, some auction markets (e.g., in second-
hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to be sold
prior to the opening of the actual bidding process. This inspection can take the form of a
warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in
televised auctions) a time during which assets are simply displayed one by one to viewers prior
to bidding.

Auction markets depend on participation for any one type of asset not being too "thin." The costs
of collecting information about any one type of asset are sunk costs independent of the volume of
trading in that asset. Consequently, auction markets depend on volume to spread these costs over
a wide number of participants.

Over-the-Counter Markets:

An over-the-counter market has no centralized mechanism or facility for trading. Instead, the
market is a public market consisting of a number of dealers spread across a region, a country, or
indeed the world, who make the market in some type of asset. That is, the dealers themselves
post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with
anyone who chooses to trade at these posted prices. The dealers provide customers more
flexibility in trading than brokers, because dealers can offset imbalances in the demand and
supply of assets by trading out of their own accounts. Many well-known common stocks are

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traded over-the-counter in the United States through Nasdaq (National Association of Securies
Dealers' automated quotation system).

Intermediation Financial Markets:

An intermediation financial market is a financial market in which financial intermediaries help

transfer funds from savers to borrowers by issuing certain types of financial assets to savers and
receiving other types of financial assets from borrowers. The financial assets issued to savers are
claims against the financial intermediaries, hence liabilities of the financial intermediaries,
whereas the financial assets received from borrowers are claims against the borrowers, hence
assets of the financial intermediaries. Recall the following diagrammatic illustration of a
financial intermediary presented earlier in these notes:

Example: Commercial Bank

Lending by B Borrowing by B

deposited
------- funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- loan ------- deposit -------
contracts accounts

Loan contracts Deposit accounts

issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households

Benefits of Financial Intermediaries Relative to Brokers and Dealers

What benefits are provided by financial intermediaries that cannot be provided as efficiently, or
even more efficiently, by brokers or dealers? The conventional answer is that financial
intermediaries provide six distinct types of services to their customers. These services, briefly
summarized below, are more carefully examined in subsequent Mishkin chapters.

1. Risk reduction through portfolio diversification:

Intermediaries find it less costly than individuals to construct large well diversified asset
portfolios---e.g., stock funds, bond funds, money market funds, etc. They can then sell small
portions of these portfolios to individuals. Note that, unlike dealers, intermediaries hold these
large portfolios to increase the efficiency and profit potential of their asset holdings. The asset
holdings are not simply temporary inventories held as buffer stocks against unforeseen
fluctuations in demand.

2. Maturity intermediation:
Financial intermediaries can purchase financial assets with long maturities ("lend long") while at
the same time selling financial assets (acquiring liabilities) with short maturities ("borrow
short"). Thus, illiquid long-maturity assets (e.g., mortgages) are transformed into a more liquid
form (e.g., deposit accounts); and the buyers of the more liquid assets are charged a premium for
this liquidity in the form of a lower rate of return. The gap between the average maturity of an
intermediary's assets and the average maturity of its liabilities is referred to as the maturity gap
of the intermediary.

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Everything else equal, the larger the maturity gap, the more the intermediary bears the
(nondiversifiable) risk of fluctuations in short-term interest rates. For example, suppose the
intermediary is a savings and loan association which lends long in the form of mortgages and
borrows short in the form of savings deposits paying a competitive rate of return, i.e., the short-
term interest rate currently available in financial markets. If there is an increase in this market
short-term interest rate, the intermediary must either match the rise in order to retain its
customers, resulting in a decreased and possibly negative profit margin, or risk having a
substantial portion of its customers close out their accounts and take their money elsewhere.

3. Reduction of transactions and information costs:

Intermediaries are able to reduce the transactions costs entailed during the process of matching
borrowers with lenders. Intermediaries are also able to reduce the transactions costs associated
with the writing and communicating of contract terms for borrowers and lenders, particularly in
cases where the contract terms are highly specialized to the situation at hand.

In addition, information costs incurred as a result of monitoring and enforcement of contract

terms are reduced by centralizing these functions in one agent with extensive experience. This is
particularly important in cases in which would-be lenders are relatively unsophisticated
compared to would-be borrowers. As long as the intermediary's own return is tied to the success
of these monitoring and enforcement functions, it has an incentive to perform these functions in a
reliable manner.

The transactions and information costs incurred by a financial intermediary are passed on to the
pool of agents who lend to the intermediary in the form of lower interest rates and to borrowers
in the form of higher interest rates. If the pools of agents lending funds to the intermediary and
borrowing funds from the intermediary are large, these costs will be spread across large numbers
of agents and hence will have only a small impact on each individual agent.

4. Information production:
Intermediaries expend considerable resources investigating the anticipated profitability of the
projects they finance. Individual lenders in general have neither the resources nor the incentive to
carry out such extensive investigations. Moreover, the information gathered by the intermediary
about an investment project is generally not made public; it is used to construct investment
opportunities (mutual funds, etc.) for those who supply the intermediary with loan able funds.
This is to the advantage of both the borrowers (who wish to keep trade secrets secret) and the
lenders (who wish to take advantage of "inside information" about investment opportunities).

In this way, the production of information is tied in with the management of customer accounts.
The principal insurance which a supplier of funds has that an intermediary will perform reliably
is the stake which the owners and/or managers of the intermediary themselves have in the
investments they choose for their customers.

Supplying information about investments (investment advising) is nevertheless conceptually

distinct from the supplying of investment opportunities. This is illustrated by the recent surge in
the number of discount brokers, who offer investment funds but no investment advice, in contrast
to the more traditional full-service brokers who offer both investment funds and investment
advice, but at substantially higher fees.

5. Management of payments:
Another specialized service offered by some (but by no means all) financial intermediaries is
bookkeeping. The intermediary keeps track of receipts and disbursements for their customers,

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paying particular attention to tax considerations: which disbursements are reportable to the IRS;
which are to be treated as capital gains, as dividends, or as interest payments; and so forth. Some
intermediaries (e.g., commercial banks, large brokerage firms such as Merrill Lynch, etc.) also
provide checkable deposit accounts and/or credit cards with bookkeeping services to keep track
of account and/or card transactions.

6. Insurance:
Many types of financial intermediaries supply insurance to their customers against losses of
principal. Moreover, some intermediaries specialize in insurance: that is, they construct and sell
insurance policies (contingent claims against the intermediary) funded by premiums collected
from the holders of the policies. Premiums in excess of insurance claim payouts are typically
invested. Consequently, insurance companies act as a lender just as other types of financial
intermediaries do.

Regulation of the Financial System

Due to the importance of financial markets, state and federal governments have created volumes
of regulations to ensure these markets are not placed at excessive risk. Regulations are intended
to assist in three areas. The first area is to increase information availability to investors. Two of
the most important regulatory steps taken by the federal government to increase information
availability were the passage of the Securities Act of 1933, and the creation of the Securities
and Exchange Commission (SEC). The SEC is given primary regulatory authority over
different types of markets discussed above. The second area of regulation is intended to ensure
the soundness of the financial system. Soundness is accomplished through the control of who can
establish financial intermediaries, the separation of commercial banking and investment banking,
stringent reporting requirements, control of certain assets that the intermediary can own, and
through creation of deposit insurance through agencies such as the Federal Deposit Insurance
Corporation, the Savings Association Insurance Fund (for saving and loans) and the National
Credit Union Share Insurance Fund. The third area of regulation is to improve control of
monetary policy. To accomplish this task the Federal Reserve establishes reserve requirements,
which are minimum net deposits that financial intermediaries must have on deposit with the
Federal Reserve System.

An asset is anything of durable value, that is, anything that acts as a means to store value over
time. Real assets are assets in physical form (e.g., land, equipment, houses,...), including "human
capital" assets embodied in people (natural abilities, learned skills, knowledge,..). Financial
assets are claims against real assets, either directly (e.g., stock share equity claims) or indirectly
(e.g., money holdings, or claims to future income streams that originate ultimately from real
assets). Securities are financial assets exchanged in auction and over-the-counter markets (see
below) whose distribution is subject to legal requirements and restrictions (e.g., information
disclosure requirements).

Lenders (savers) are people who have available funds in excess of their desired expenditures,
and borrowers are people who have a shortage of funds relative to their desired expenditures.
Borrowers attempt to obtain funds from lenders by selling to lenders newly issued claims against
the borrowers' real assets, i.e., by selling the lenders newly issued financial assets.

A financial market is a market in which financial assets are traded. In addition to enabling
exchange of previously issued financial assets, financial markets facilitate borrowing and lending
by facilitating the sale by newly issued financial assets. Examples of financial markets include
the New York Stock Exchange (resale of previously issued stock shares), the U.S. government
bond market (resale of previously issued bonds), and the U.S. Treasury bills auction (sales of
newly issued T-bills). A financial institution is an institution whose primary source of profits is

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through financial asset transactions. Examples of such financial institutions include discount
brokers (e.g., Charles Schwab and Associates), banks, insurance companies, and complex multi-
function financial institutions such as Merrill Lynch.