Chapter 2: The Financial System

Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley 1

Objective

Understanding the workings of the financial system Determining rates of return

Chapter 2 Contents • 1 What is a Financial System • 2 The Flow of Funds • 3 The Functional Perspective • 4 Financial Innovation & the “Invisible Hand” • 5 Financial Markets • 6 Financial Market Rates • 7 Financial Intermediaries • 8 Financial Infrastructure and Regulation • 9 Governmental & Quasi Governmental Organizations 2

The Financial System • Financial decisions are made within the context of a financial system • The financial system both constrains and enables the decision maker • This chapter provides a framework for understanding how financial systems work 3

2.1 What is the Financial System?

• A Financial System is comprised of – markets, intermediaries, service firms and other institutions used to carry out the financial decisions of households, business firms, and governments 4

Geography of the Markets – some markets for a particular market instrument may have a well defined geographic location such as the New York Stock Exchange or the Osaka Options and Futures Exchange – other market instruments are traded on over-the-counter or off-exchange markets for bonds, stocks, and foreign exchange 5

Contractual Jurisdictions • The jurisdiction governing a trade needs to be clearly established before making significant investments, particularly when trading over a computer network • Jurisdictional conflicts are too frequent, and have significant economic consequences because legal principles vary significantly between jurisdictions 6

2.2 The Flow of Funds – Funds may flow from the surplus unit to the deficit unit • Directly • Through markets • Through intermediaries 7

Financial Intermediary – a firm whose primary business is to provide financial services and financial products – Examples: • bank (checking accounts, loans, CDs …) • investment company (mutual funds …) • insurance company (term life insurance …) 8

The Flow of Funds Diagram Markets Surplus Units Deficit Units Intermediaries 9

The Flow of Funds Diagram • We shall examine various pathways from the surplus unit to the deficit unit 10

Fund Flows via Market • A household with surplus funds invests them in government bonds 11

Fund Flows via Market Markets Surplus Units Deficit Units Intermediaries 12

Fund Flows via Intermediary • Holders of surplus funds may use an intermediary, such as a bank, to invest them. The bank receives the surplus funds, say as 90-day deposits, and adds them to the bank’s assets (creating a bank liability). Money is fungible, so the corresponding loan can not be identified 13

Fund Flows via Intermediary Markets Surplus Units Deficit Units Intermediaries 14

Fund Flows via Intermediary and Market • Sometimes the intermediary itself has surplus funds, and invests them in the market or another intermediary • A bank that borrows and invests in the money market can increase its flexibility, reduce its risks, and turn a profit • Eventually, the surplus funds are consumed by a deficit unit 15

Fund Flows via Intermediary and Market Markets Surplus Units Deficit Units Intermediaries 16

Fund Flow via Markets and Intermediaries • Intermediaries such as Acceptance Corporation General Motors issue commercial paper to finance car loans and leases made to households needing a car • In this case, the paper has a shorter maturity than the loan, leading to a risk 17

Funds Flow via Markets and Intermediaries Markets Surplus Units Deficit Units Intermediaries 18

Funds Flow: Disintermediation • Sometimes the cost of using markets and intermediaries cannot be justified, and surplus units and deficit units contract directly • at its discretion, the deficit unit may repurchase contracts before their maturity, (at a proper discount), to avoid disrupting secondary markets, and to add liquidity 19

Funds Flow: Disintermediation 20

Funds Flow: Secured Credit • Poor credit risks sometimes receive credit card applications from banks offering a $1,000 credit limit, if $1,000 is deposited into a savings account as collateral • 19.56% is charged on the card balance, while 3.5% is paid on deposits. A high annual fee is also charged 21

Funds Flow: Secured Credit Surplus Units Markets Poor Credit Risk Deficit Units Intermediaries 22

2.3 Functional Perspective – A U.S. banks today differs from a 1928 U.S. bank, and a Saudi bank today. A credit union in the U.S. today shares many of the same functions as a U.S. bank – Analyzing institutions from a functional perspective helps us to understand why institutions differ over time and jurisdiction 23

Six Key Financial Functions: – Transferring Resources Across Time & Space – Managing Risk – Clearing and Settling Payments – Pooling Resources and Subdividing Shares – Providing Information – Dealing with Incentive Problems 24

Transferring Resources Across Time and Space • A financial system provides ways to transfer economic resources through time, across geographic regions, and amongst industries 25

Transferring Resources Across Time and Space (Illustration) – A Dutch household currently has excess funds needed in ten years – A Chinese business would become more profitable with new investment funds • Financial markets make this match 26

Managing Risk • A financial system provides ways to manage Risk 27

Managing Risk • Future flows have associated risks. Like flows, risks may be unbundle and repackaged by a financial system using portfolios, financial derivatives, and guarantees • Many financial contracts target risks rather than flows 28

Managing Risk • A fund manager may increases risk (and expected returns) of a fund by issuing bonds secured against the funds assets, writing put options, buying call options, and going “long” market index futures • Another fund manager may decrease risk by investing in the money market, put options, and short index futures 29

Clearing and Settling Payments • A financial system provides ways of clearing and settling payments to facilitate the exchange of goods, services, and assets 30

Clearing and Settling Payments • Barter (Levi jeans, old stamps & coins) • Gold (requires purity assay, heavy) • Paper money (restricted geographically) • Credit cards (not universally accepted) • Personal, cashier's or traveler’s checks (acceptability varies, denomination) 31

Pooling Resources and Dividing Ownership in Large Assets • A financial system provides a mechanism for the pooling of funds to undertake large-scale indivisible enterprise or for the subdividing of shares in large enterprises with many owners 32

Pooling Resources and Dividing Ownership in Large Assets • T-bills have a minimum face value of $10,000, but have very low risk (Solution: money market mutual fund) • Developing a promising technology would expose a single firm to too much capital risk (Solution: joint venture) • A household wishes to divest itself of its ownership in a chain of restaurants (Solution: Form a corporation, and sell its stock 33

Providing Information • A financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy 34

Providing Information • Investors need current prices to evaluate their portfolios of quoted securities • Quoted prices may be used to estimate the value of similar non-quoted securities • Option prices may be used to determine the market’s assessment of a stock’s risk 35

Family Loans: Advantages • Favorable information about you that’s available to your family may not be available to commercial lenders • This aberration leads to an opportunity – You may be able to obtain a family loan at a lower interest rate – Your family member may make a higher return on a similar risk 36

Family Loans: Disadvantages • Family loans tend to be harder to collect, because collection may threaten family ties • Family members are often naive when evaluating the credit risk of loved ones • Commercially available investments are liquid, and offer more appropriate cash flows and risk-reward tradeoffs • The family lender is exposed to individual risk that is diversified away (without significant cost) in a commercial investment 37

Dealing with Incentive Problems • A financial system provides ways to deal with the incentive problems that occur when one party to a financial transaction has information that the other party does not, or when one party is an agent and makes decisions for another 38

• Moral-Hazard – Adam enters into an insurance contract with Carmel. Adam pays Carmel a premium of $10,000. Camel will reimburse Adam’s costs should a fire damage his business during the next year, but pay nothing otherwise. Adam believes he can reduce the probability of fire by installing a cheap sprinkler. Without the contract he would certainly install the unit, but he gains nothing by installing the unit with the insurance contract in force. – Adam is exposed to a moral hazard. Adam is now taking less care of his assets now that Carmel has assumed the risk of their loss 39

• Adverse Selection – Carmel has identified 100 businesses that fall into the category of having a flood on average once every 200-years. Based on this estimate, Carmel sets a premium based on 1% of the insured amount. – Adam’s business is one of the 100, and he accepts the contract believing that his business premises are subject to flood about every 50-years. – Dillip’s business is another of the 100, but he does not accept the contract because he believes that there is almost no chance of flood damaging his business 40

• Principal-Agent Problems – Adam is the real-estate agent marketing Carmel’s house that’s worth $200,000 for a 6% commission – Adam’s agency has a multiple-listing agreement with other agencies, whereby listing agents receive 2.5%, and selling agents receive 3.5% – Bernadette wishes to buy the home for only 90% of its market value, $180,000. – Adam urges Carmel to accept the offer. Why?

• the agency will receive only $5,000 if it is sold by another agency at full value • the agency makes $10,800 if Adam can persuade Carmel to sell at the lower price 41

Insure and Burn • A business has a warehouse full of unfashionable clothes • The owner arranges for insurance at above true market value for the warehouse, its content, and loss of business • A fire is then set to collect the insurance 42

Insure and Burn: Solutions • Moral risk increases with [market value - insured value], so: – understand the business of insured companies – insist the insured assumes some risk of loss – avoid “unlucky” owners with dubious morality – gain a reputation for aggressive forensic investigations – require the use of modern surveillance, detection and protective equipment 43

Insure and Burn: Consequences • Insurance becomes over-priced, given the risks, leading to reduced use • Insurance companies are exposed to more claims during recessions • The economy loses assets that it would have had • A barrier to entry is created for new (honest) businesses that lack a claims track-record • Increased administrative costs • Longer verification delays when settling claims 44

Small Business • As a small business owner, your level of effort may depend on the source of borrowing – If money was borrowed from a friend, rather than a bank, you may work harder. It is hard to let down a friend – If the money was borrowed from a bank, rather than a friend, you may work harder. Banks are less forgiving than friends • If your behavior depends upon the source of a loan, then you are the victim of moral hazard 45

Adverse Selection • You have a pain in your chest, obtain life insurance, and then visit your doctor • The insurance company has fraudulently assumed a high risk • Knowing that you will die soon, you won’t now purchase that life annuity, leading to a non-fraudulent adverse selection • Asymmetrical information has resulted in adverse selection • Insurance companies adjust their premiums for adverse selection 46

Adverse Selection • Some insurance companies exploit rules designed to protect them against fraudulent adverse selection – You visit the doctor with the usual spectrum of medical complaints, the doctor takes notes, and neither of you are concerned – You obtain $1,000,000 in life insurance in good faith – Later, a car mounts the sidewalk, killing you – The insurance company refuses to pay your estate, claiming a preexisting condition found in your records that would have caused them to refuse the risk 47

Principal-Agent Problem • Your are still dead. Your spouse dials: 1-555-SUE-THEM, and agrees to the lawyer’s 33.33% contingency • The insurance company offers to settle the $1,000,000 claim for $300,000 – Acceptance of the offer earns the lawyer a risk-less $100,000 for two hours work – Rejecting the offer leads to higher risk and expected reward, but at the expense of considerable trial preparation • The lawyer advises her vulnerable client to settle • Some insurance companies “size” their settlement to be attractive primarily to the lawyer, who will then “sell” it to their client 48

Principal-Agent Examples • An employee selects an airline, hotel or car rental company to obtain free flight mileage for personal use – The decision has been made in interest of the employee, rather than the company – The company may lose time, or pay a higher price for service 49

Principal-Agent Examples • A supplier gives gifts to its customers’ employees having influence over purchase decisions • Traditionally, these gifts include Caribbean sweepstakes, gift vouchers, entertainment, and outright bribes • The supplier is attempting to subvert employee loyalty by creating an principal-agent conflict – In some industries there is a tradition, tolerated by higher management, of accepting “adult entertainment” from suppliers – In addition to perpetuating an principal-agent conflict, both companies expose themselves to large sexual discrimination suits from female buyers and salespeople 50

2.4 Financial Innovation & the “Invisible Hand” • Financial innovation occurs spontaneously from the individual actions of entrepreneurs and firms, and not from the actions of a central authority. • Example: Credit cards 51

2.5 Financial Markets: By Basic Financial Assets • Debt (Also called fixed income securities, Bonds and Loans) • Fixed Income Instruments promising fixed future payments • Equities (Common Stock/Shares) • Residual claim on assets. Limited liability • Derivatives (Options, Forwards, Futures) • Securities that derive their value from other securities 52

Markets: By Maturity • Money Market – Mostly debt instruments issued by governments and secure large corporations – Highly liquid: Quickly convertible to cash – Globally integrated • Capital Market – Equities, and debt instruments with a life greater than a year 53

2.6 Financial Market Rates • Interest rates • Exchange rates • Stock-market indicators 54

Financial Market Rates • Interest Rates – The Promised rate of return. Examples: • Mortgage rate • Commercial Rate – Depend upon: • Unit of account • Maturity • Default Risk 55

Unit of Account • The medium in which the payments are denominated – Usually a currency, but may be a commodity such as gold, silver, a standard “basket” of goods and services 56

Exchange-Rate Risk on T-Bills • A bond issued by a central government is risk-free only in that country – The bond’s return in a foreign investor’s currency is uncertain because exchange rates fluctuate, and future cash flows are denominated in the domestic country’s unit of account 57

Other Risks on T-Bills • T-Bills are default-free, but not risk-less • You observe that the 12-month T-Bill has a higher yield than the 6-month T-Bill. You plan to take advantage of this by buying a T-Bill with a maturity of 12 months, and plan to sell it after 6 months to pay college fees. Interest rate fluctuations result in a slightly higher (or lower) than expected capital return • Occasionally, the 3-month rate may be higher than the 6 month rate, but rolling-over a 3-month bill results in risk, too • Even a 6-month bill is not risk-less to you if inflation is uncertain. This college may increase fees by 20% 58

Example: Exchange Rate Risk • Suppose: – You are a Japanese Investor wishing to make a 1-year investment – Current exchange rate (Spot) of 150 Japanese yen/pound sterling – Japanese bonds yield 3% – British bonds yield 9% – Investment 15,000 ¥ – Crystal ball: Spot 1-year from now 140 ¥/£ 59

Time Exchange Rate Example Japan U.K.

15000 ¥ •150 ¥/£ £100 3% ¥/¥ (direct) 1.73% ¥/£/£/¥ 9%£/£ 15260 ¥ 15450 ¥ 140 ¥/£ £109 60

Exchange Rate Example • The currency speculation doesn’t pay-off under this scenario. It returns only 1.73%, which is below the 3% offered by a direct Japanese investment – A new crystal ball indicates that the correct exchange rate one-year from now is not 140, but 149, Yen per Pound • Observe that the currency speculation the 3% offered by a direct investment does pay-off under this scenario. It returns 8.27%, which is above 61

Time Exchange Rate Example Japan U.K.

15000 ¥ 150 ¥/£ £100 3% ¥/¥ (direct) 8.27% ¥/£/£/¥ 9%£/£ 16241 ¥ 15450 ¥ 149 ¥/£ £109 62

Exchange Rate Example • Our Japanese speculator now sees a business opportunity • She will offer financially sound Japanese companies doing business in London a contract that obligates both herself and them to buy or sell pounds for Yen at a fixed exchange rate one year from now 63

Exchange Rate Example • Her idea is to issue, or purchase, risk-free 1-year bonds (She has a superb credit rating) in Yen, and invest the proceeds in 1-year British bonds • Doing this she is creating a derivative security that she calls a Forward Exchange Rate Contract 64

Time Exchange Rate Example Japan U.K.

15000 ¥ (borrowed) 150 ¥/£ £100 Invested 3% ¥/¥ (direct) 3% ¥/£/£/¥ 9%£/£ 15450 ¥ 15450 ¥ Repaid Forward ¥/£ £109 Matures 65

Exchange Rate Example 1 Yen 1 * Spot Rate Forward Forward Rate Rate *  1 

r

UK  * Forward Rate   1  1 

r

Japan

r

UK 1  0 .

03 1  * Spot 0 .

09 * 1 50  Rate 141 .

74  1 *  1 

r

Japan 

Yen

•Note: This is for 1 year, but the analysis is easy to generalize 66

Maturity • The maturity of a fixed-income instrument is the date of, or period to, its final cash flow – The interest rate on short-term instruments may be higher, lower or the same as long term instruments 67

US Treasury Yiled Curve, Jan 97

7.50

7.00

6.50

6.00

5.50

5.00

4.50

0 5 10 15

Years to Maturity

20 68 25 30

Default Risk • The possibility that some portion of the interest or the principal on a fixed income security will not be paid in full – The greater the perceived default risk, the higher the interest rate the issuer must promise to give – Yield Spread (See next Table) 69

Yield Comparisons A p ril '9 5 1 - 10 Y e a rs 1 0 ++ Y e ars US Tre as ury 6. 9 2% 7. 6 5% Co rpo rat e Hig h Q u alit y 7. 57 % 8. 15 % Co rp o ra t e M ed Q u alit y 7 . 86 % 8 . 55 % 70

Financial Market Rates • Rates of Return on Risky Assets – Many assets do not promise • Real Estate a rate of return • Equity Securities • Works of Art – Return comes from: • Any Cash Flows from the Asset • Capital Gains 71

Holding Period Return • Assume: – Purchase price of Share was $100 – Selling price 1-year later was $105 – Cash dividends paid in year were $5 72

Computation of Return

Return Return

 (

EndPrice

 

StartPrice

) 

CashDivide

($ 105  $ 100 ) 

StartPrice

$ 5  0 .

10 $ 100  10 %

nd

73

Financial Market Rates • Market Indexes and Market Indexing – Overall level of stock prices, A benchmark • US: DJI, SP500 • Japan: Nikkei, Topix • UK: FT-30, FT-100 • Germany: DAX • France: CAC 40 • Switzerland: Credit Suisse • Europe, Australia, Far East: MSCI, EAFE 74

Financial Market Rates • Rates of Return in Historical Perspective – The following graphs show the returns of selected securities and inflation • The first shows annual returns • The second shows affects on $1 invested in 1925. The scale is logarithmic in order to show all the graphs on the same chart 75

Security Returns

60.00

40.00

20.00

0.00

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 -20.00

-40.00

Bills Bonds Stocks Inflation -60.00

Year

76

1000.0000

Consolidated Indicies

Bills_Index Bonds_Index Stocks_Index Inflation_Index 100.0000

10.0000

1.0000

1925 1930 1935 1940 1945 1950 1955 1960

Year

1965 77 1970 1975 1980 1985 1990 1995

Frequency of Returns

70 60 50 40 Freq_Bills Freq_Bonds Freq_Stock Freq_Inflation 30 20 10 -50 -40 -30 -20 -10 0 0

Percent

10 78 20 30 40 50

Financial Market Rates • Inflation and Real Interest Rates – Nominal Prices & Rates • Prices and rates expressed in terms of currency – Real Prices & Rates • Prices and rates expressed in terms of purchasing power 79

Nominal to Real ( 1 

NominalRat e

)  ( 1 

RealRate

) * ( 1 

InflationR ate

) 

RealRate



NominalRat e

 1 

InflationR InflationR ate ate

80

Financial Market Rates • Interest Rate Equalization – Interest Rate Arbitrage 81

Financial Market Rates • The Fundamental Determinates of Rates of Return – Expected Productivity of Capital Goods – Capital Goods Productivity Uncertainty – Time Preferences of People – Risk Aversion 82

Banks (Commercial) • Traditional Role: – Clearing and settling payment • Contemporary Role: – Take Deposits – Make Loans • Limited by the Glass Steagall Act, 1933, from acting as an investment bank 83

Other Depository Savings Institutions • Depository savings institutions, thrift institutions: – Savings Banks – Savings and Loans Associations – Credit Unions • Compete with Commercial Banks 84

Insurance Companies • Purpose is to shed specific risks – Property and Causality Insurance – Health and Disability Insurance – Life Insurance • Payments are Called Premiums, and these are invested in real estate, Stock and bonds 85

Pension and Retirement Funds • Defined-Contribution Pension Plan • Defined-Benefit Pension Plan 86

Mutual Funds • A portfolio of stocks, bonds, or other assets purchased in the name of a group of investors, and managed by a professional investment company or financial association • Open ended – Closed ended 87

Investment Banks • Assist businesses and governments raise funds by issuing securities • Facilitate mergers and acquisitions • Underwrite security issues • See: Commercial Banks, Glass Steagall Act, 1933 88

Venture Capital Firms • Similar to investment banks, but corporate clientele are usually start-up companies • Help manage company until ready to go public 89

Asset / Investment Management Firms • Advise, and often administer: mutual funds, pension funds, and other asset pools on behalf of individuals, firms, and governments 90

Information Services • Firms that specialize in providing financial information – Standard and Poor’s; Moody’s – Best (Insurance) – Bloomberg; Reuters – Lipper, Morningstar, SEI 91

2.8 Financial Infrastructure and Regulation • Rules for Trading • Accounting Systems 92

2.9 Government and Quasi Government Organizations • Central Banks • Special Purpose Intermediaries • Regional and World Organizations 93