Question one: What is the importance of Financial Institutions?

▪ Business organizations obtain external sources of funds in different

ways:
1. Directly, through financial markets (equity & debt as direct
finance).
2. Indirectly, through a bank or other financial institution.
3. Through private placements.
Without FIs

Without financial markets :

1. The savers won’t earn return on their investment.
2. Business owners will suffer to get the enough resourses to fund their
operations, as the financial markets help borrowers use that
borrowed money to fund their expansion and to increase their
productivity, then paying back to lenders (savers) the interest as cost
of fund.
3. 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.
4. Financial markets improve the well-being of consumers, allowing
them to time their purchases better.
5. Lead to Low level of fund flows.
6. Lead to Less liquidity.

Page 1 of 12
 With Financial Institutions:

1. Financial institutions are intermediaries that channel the savings of

individuals, businesses, and governments into loans or investments.
2. The key suppliers and demanders of funds are individuals, businesses,
and governments.
3. In general, individuals are net suppliers of funds, while businesses and
governments are net demanders of funds.
4. Commercial banks make profits through asset transformation
(borrow short, lend long).
5. Investment banks make profits through acting as brokers of securities.

Question two: What are the functions of Financial Intermediaries:

Indirect Finance?
1. Financial intermediation and Brokerage
2. Reducing Transactions Costs
3. Risk sharing
4. Diversification
5. Asset transformer
6. Analyze and disseminate expensive financial information.

Page 2 of 12
 1. Financial intermediation and Brokerage
▪ Financial intermediation is the primary means of moving funds
from lenders to borrowers.
▪ 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.
Needed because of transaction costs, risk sharing, and asymmetric
information.
▪ Brokerage function
– FI Acts as an agent for investors: e.g. Merrill Lynch, Bank of
America
– Encourages higher rate of savings

Page 3 of 12
 2. Reducing Transactions Costs
▪ Financial intermediaries make profits by reducing transactions costs
▪ Reduce transactions costs by developing expertise and taking
advantage of economies of scale
3. Risk sharing
▪ FIs absorb Risk by issuing their own liabilities.
▪ A benefit made possible by the FI’s low transaction costs is that they can
help reduce the exposure of investors to risk, through a process known
as risk sharing.
4. Diversification
▪ Financial intermediaries also help by providing the means for
individuals and businesses to diversify their asset holdings.
Question Three: What is the importance of Financial Intermediaries Relative
to Securities Markets?
• Studies show that firms in the U.S., Canada, the U.K., and other
developed nations usually obtain funds from financial intermediaries,
not directly from capital markets.
• In Germany and Japan, financing from financial intermediaries
exceeds capital market financing 10-fold.
• However, the relative use of bonds versus equity does differ by
country.
Question four: Why Study Financial Institutions and Banking?
▪ The vital role of financial intermediaries: FIs borrow funds from
people who have saved and in turn make loans to other people.
– Banks: accept deposits and make loans

Page 4 of 12
 – Other financial institutions include insurance companies,
finance companies, pension funds, mutual funds and
investment companies.
– Financial innovation: the development of new financial
products and services.
– Financial crises: major disruptions in financial markets that
are characterized by sharp declines in asset prices and the
failures of many financial and nonfinancial firms.
Question five: Specialness and Regulation
▪ FIs receive special regulatory attention
Reasons:
1. Negative externalities of FI failure
2. Special services provided by FIs
3. Institution-specific functions such as money supply transmission
(banks), credit allocation (farm banks), payment services (banks), etc.
▪ Important features of the regulatory policy:
– Protect ultimate sources and users of savings
– Primary role is to ensure soundness of the overall system
Regulation
1- Safety and soundness regulation:
– Regulations to increase diversification
 No more than 10 percent of equity to single borrower
– Minimum capital requirements
2- Credit allocation regulation
Page 5 of 12
 – Supports socially important sectors such as housing and farming
 Requirements for minimum amounts of assets in a particular
sector or maximum interest rates or fees
3- Consumer protection regulation
Home Mortgage Disclosure Act (HMDA)
4- Investor protection regulation
– Protections against abuses such as insider trading, lack of
disclosure,
Changing Dynamics of Specialness
Trends in the United States
– Decline in share of depository institutions and insurance
companies
– Increases in investment companies
– May be attributable to net regulatory burden imposed on
depository FIs
Global Trends
▪ US FIs facing increased competition from foreign FIs
▪ Only 2 of the top ten banks are US banks
▪ Foreign bank assets in the US typically more than 10 percent

Page 6 of 12
 Chapter two
Question Six: What are the functions of Financial Markets?
• Financial markets provide a forum in which suppliers of funds and
demanders of funds can transact business directly.
• A main function of financial markets is to Channel funds from person
or business without investment opportunities (i.e., “Lender-Savers”) to
one who has them (i.e., “Borrower-Spenders”)
• Improves economic efficiency.
Financial Markets Funds Transferees
Lender-Savers Borrower-Spenders
1. Households 1. Households
2. Business firms 2. Business firms
3. Government 3. Government
4. Foreigners 4. Foreigners
Segments of Financial Markets
1. Direct Finance
– Borrowers borrow directly from lenders in financial markets by
selling financial instruments which are claims on the borrower’s
future income or assets
2. Indirect Finance
– Borrowers borrow indirectly from lenders via financial
intermediaries by issuing financial instruments which are claims
on the borrower’s future income or assets

Page 7 of 12
Question seven: What is the structure of Financial Markets?
1. Money market 2. Capital market
• Transactions in short term marketable securities take place in the money
market while transactions in long-term securities take place in the
capital market.
• Whether subsequently traded in the money or capital market, securities
are first issued through the primary market.
• The primary market is the only one in which a corporation or
government is directly involved in and receives the proceeds from the
transaction.
• Once issued, securities then trade on the secondary markets such as the
New York Stock Exchange or NASDAQ.
There are different classifications of financial markets:
1- Money Market - Capital Market
2- Primary Market - Secondary Market
3- Debt Markets - Equity Markets
1- Money Market - Capital Market
We can also classify financial 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 (no
maturity).
Money Market
- The money market exists as a result of the interaction between the
suppliers and demanders of short-term funds (those having
a maturity of a year or less).
Page 8 of 12
 - Money market transactions can be executed directly or through an
intermediary.
- Most money market transactions are made in marketable securities
which are short-term debt instruments such as T-bills and
commercial paper.
The Capital Market
- The capital market is a market that enables suppliers and demanders of
long-term funds to make transactions.
- The key capital market securities are bonds (long-term debt) and both
common and preferred stock (equity).
- Bonds are long-term debt instruments used by businesses and
governments to raise large sums of money or capital.
- Common stock are units of ownership interest or equity in a corporation.
2- Primary Market - Secondary Market
1. Primary Market
– New security issues sold to initial buyers
– Typically involves an investment bank who underwrites the offering
2. Secondary Market
• The Secondary Market for securities is the market for outstanding
securities and where most trading takes place.
– It includes securities that are previously issued, bought , sold
– Examples include the NYSE and NASDAQ
– Even though firms don’t get any money, per se, from the secondary
market, it serves two important functions:

Page 9 of 12
 1. Provides liquidity, making it easy to buy and sell the securities of the
companies
2. Establishes a price for the securities (useful for company valuation)We
can further classify secondary markets as follows:
We can further classify secondary markets as follows:
A- Organized Exchanges B- Over-the-Counter Exchange
A- Organized Exchanges
- Organized securities exchanges are tangible secondary markets where
outstanding securities are bought and sold.
- Only the largest and most profitable companies meet the requirements
necessary to be listed on the New York Stock Exchange.
- Trading is conducted through an auction process where specialists
“make a market” in selected securities.
B- Over-the-Counter Exchange
• The over-the-counter (OTC) market is an intangible market for securities
transactions. Best example is the market for Treasury Securities
• Unlike organized exchanges, the OTC is both a primary market and a
secondary market.
• Dealers at different locations buy and sell. The OTC is a computer-based
market where dealers make a market in selected securities and are
linked to buyers and sellers through the NASDAQ System.
3- Debt Markets - Equity Markets
1. Debt Markets
– Short-Term (maturity < 1 year)
– Long-Term (maturity > 10 year)
– Intermediate term (maturity in-between)

Page 10 of 12
 2. Equity Markets
– Pay dividends, in theory forever
– Represents an ownership claim in the firm
Internationalization of financial markets
• The Eurocurrency market is a market for short-term bank deposits
denominated in U.S. dollars or other marketable currencies.
• The international equivalent of the domestic (U.S.) money market is the
Eurocurrency market.
• The Eurocurrency market has grown rapidly mainly because it is
unregulated and because it meets the needs of international borrowers
and lenders.
International Capital Markets
• In the Eurobond market, corporations and governments typically issue
bonds denominated in dollars and sell them to investors located outside
the United States.
• The foreign bond market is a market for foreign bonds, which are bonds
issued by a foreign corporation or government that is denominated in
the investor’s home currency and sold in the investor’s home market.
Question eight, What are the functions of Financial Institutions and
Markets?
1. Collect, Analyze, and Disseminate Financial Information
– Risk of debt and equity issues and issuers
– Valuation of debts and equities
– Valuation of derivative securities
– Volume of debts and equities
Page 11 of 12
2- Intermediate between preferences of primary security issuers (deficit
units) and final asset holders (surplus units)
3. Distribute Primary Securities
- Investigate issuers of debts and equities as to their future performance.
- Underwrite Securities -- guarantee a price for a security issue and accept
the risk of selling the security issue.
- Wholesale Distribution of a security to underwriters and dealers
- Retail Distribution of securities through a sale to the open market via brokers
and dealers.
4. Provide for Secondary Markets for Primary, Secondary, and Derivative
Securities

Page 12 of 12