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Chapter 1
Introduction

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 Learning Goals
• Differentiate between primary and secondary markets.
• Differentiate between money and capital markets.
• Understand what foreign exchange markets are.
• Understand what derivative security markets are.
• Distinguish between the different types of financial
institutions.
• Know the services financial institutions perform.
• Know the risks financial institutions face.
• Appreciate why financial institutions are regulated.
• Recognize that financial markets are become increasingly
global.

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 Why Study Financial Markets and
Institutions?
Markets and institutions are primary channels through
which capital is allocated in our society.
• Investment and financing decisions require managers
and individual investors to understand the flow of
funds throughout the economy.
• Managers and individuals must also understand the
operation and structure of domestic and international
financial markets.

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 Financial Markets
• Financial markets are structures through which funds
flow.

Financial markets can be distinguished along two major

dimensions:
• Primary versus secondary markets.
• Money versus capital markets.

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 Primary versus Secondary Markets 1

Primary markets
• Markets in which users of funds (e.g., corporations)
raise funds through new issues of financial
instruments, such as stocks and bonds.
• Include issues of equity by firms initially going public,
referred to as initial public offerings (IPO’s).

Secondary markets
• Markets that trade financial instruments once they are
issued.

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 Primary and Secondary Market
Transfer of Funds Timeline

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 Primary versus Secondary Markets 2

• How were primary markets affected by the financial

crisis?
Secondary markets offer the following:
• Liquidity, or the ability to turn an asset into cash
quickly at its fair market value.
• Information about the prices or the value of
investments.
• Trading with low transaction costs.

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 Money versus Capital Markets
Money markets trade debt securities or instruments with
maturities of one year or less
• Most U.S. money markets are over-the-counter
(OTC) markets.
Capital markets trade debt (bonds) and equity (stocks)
instruments with maturities of more than one year
• Wider price fluctuations than money market
instruments.

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 Money Market Instruments
Outstanding

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 Capital Market Instruments
Outstanding

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 Foreign Exchange Markets
Foreign exchange risk is the sensitivity of the value of
cash flows on foreign investments to changes in the
foreign currency’s price in terms of dollars
• U.S. dollars received on a foreign investment depends
on the exchange rate between the U.S. dollar and the
foreign currency when the nondollar cash flow is
converted into U.S. dollars.

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 Derivative Security Markets 1

A derivative security is a financial security (e.g., future,

option, swap, or mortgage-backed security) whose
payoff FI's linked to another, previously issued security,
such as a security traded in capital or foreign exchange
markets
• Derivatives are traded in derivative security markets.
• Generally involves agreement between two parties to
exchange a standard quantity of an asset or cash flow
at a predetermined price and at a specified future
date.
• Derivative markets are the newest of financial security
markets and are also potentially the riskiest security.

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 Derivative Security Markets 2

Derivative activity:
• Tremendous growth between 1992-2013.
• Large drop from 2013 to 2019, due largely to the 2014
implementation of the Volcker Rule.
TABLE 1-4 Derivative Contracts Held by Commercial Banks, by Contract Product (in billion of dollars)

1992 2000 2008 2013 2016 2021

Futures and $ 4,780 $ 9,877 $ 22,512 $ 45,599 $ 31,685 $ 31,180
forwards
Swaps 2,417 21,949 131, 706 138, 361 107,393 109,290
Options 1,568 8,292 30, 267 33,760 30,999 33,453
Credit _ 426 15, 897 13,901 6,986 3,540
derivatives
Total $ 8,765 $ 40,544 $ 200,382 $ 231,621 $ 180,973 177,464

Note: EM dashes represent value that are too small to register.

Sources: Office of the Comptroller of the Currency website, various dates. www.occ.treas.gov

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 Financial Market Regulation
Financial instruments are subject to regulations imposed
by regulatory agencies, such as the Securities and
Exchange Commission (SEC)
• Main emphasis of SEC regulations is on full and fair
disclosure of information on securities issues to actual
and potential investors.
• SEC monitors trading on the major exchanges to
ensure stockholders and managers do not trade on
inside information about their own firms.

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 Overview of Financial Institutions
(FI's)
• Financial institutions perform the essential function
of channeling funds from those with surplus funds to
those with shortages of funds.

In a world without FI's, the level of funds flowing

between suppliers and users would likely be quite low
due to the following reasons:
• Monitoring costs.
• Liquidity costs.
• Price risk.

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 Types of Financial Institutions
Commercial banks —depository institutions whose major assets are loans and whose major liabilities are deposits.
Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than are those of
other depository institutions. Commercial banks’ liabilities include more non deposit sources of funds, such as subordinate
notes and debentures, than do those of other depository institutions.

Thrifts—depository institutions in the form of savings associations, savings banks, and credit unions. Thrifts generally
perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate
loans or consumer loans.

Insurance companies—financial institutions that protect individuals and corporations (policyholders) from adverse events.
Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty
insurance protects against personal injury and liability due to accidents, theft, fire, and so on.

Securities firms and investment banks—financial institutions that help firms issue securities and engage in related
activates such as securities brokerage and securities trading.

Finance companies—financial intermediaries that make loans to both individuals and businesses. Unlike depository
institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding.

Investment funds—financial institutions that pool financial resources of individuals and companies and invest those
resources in diversified portfolios of assets.

Pension funds—financial institutions that offer savings plans through which fund participants accumulate savings during
their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in
pension funds are exempt from current taxation.

FinTech's—institutions that use technology to deliver financial solutions in a manner that competes with traditional
financial methods.

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 Flow of Funds
Flow of Funds in a Flow of Funds in a
World without FI's World with FI's

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 Monitoring Costs
A supplier of funds who directly invests in a fund user’s
financial claims faces a high cost of monitoring the fund
user’s actions in a timely and complete fashion
• A solution is for many small investors to group their
funds together by holding the claims issued by a FI
(i.e., aggregation of funds).

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 Liquidity and Price Risk
• FI’s act as asset transformers, financial claims issued
by an FI that are more attractive to investors than are
the claims directly issued by corporations.
• Often, claims issued by FI’s have liquidity attributes
that are superior to those of primary securities.
• FI’s diversify away some, but not all, of their
investment risk.

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 Additional Benefits and Functions of
F I's
Additional benefits FI’s provide to suppliers of funds:
• Reduced transaction cost.
• Maturity intermediation.
• Denomination intermediation.

Economic functions FI’s provide to the financial system as a

whole:
• Transmission of monetary policy.
• Credit allocation.
• Intergenerational wealth transfers or time intermediation.
• Payment services.

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 Risks Incurred by Financial
Institutions
FI’s face various types of risks:
• Default risk (i.e., credit risk).
• Foreign exchange risk and country (i.e., sovereign) risk.
• Interest rate risk.
• Market risk, or asset price risk.
• Off-balance sheet risk.
• Liquidity risk.
• Technology and operational risk.
• Insolvency risk.

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 Regulation of Financial Institutions
Failures of FI’s can cause widespread panic and
withdrawal runs on institutions
• The 2008 increase in the deposit cap (to $250,000 per
person per bank) was intended to instill confidence in
the banking system.

• FI’s are regulated to prevent market failures, as well

as associated costs on the economy and society at
large.

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 Trends in the United States 1

The following trends are evident in the U.S. between

1948 to 2020:
• Share of depository institutions declined from 62.7%
to 29.7% .
• Insurance companies also witnessed a decline in their
share, from 23.4% to 15.6%.
• Investment companies increased their share from
1.1% to 31.1%, while pension funds increased from
9.1% to 15.4%.
• Overall assets increased from $0.27t to $79.08t.

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 Trends in the United States 2

Rise of financial services holding companies

• Savers increasingly prefer investments that closely
mimic diversified investments in the direct securities
markets over the transformed financial claims offered
by traditional FI’s.
Shift away from risk measurement and management
and the financial crisis
• Under the traditional originate-and-hold banking
model, banks may have been reluctant to so
aggressively pursue low-credit-quality borrowers for
fear of default.

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 Enterprise Risk Management

Enterprise risk management

• Recognizes the importance of managing the
combined impact of the full spectrum of risks as an
interrelated risk portfolio.
• Seeks to embed risk management as a component in
all critical decisions throughout FI.
• Popularity rose as a result of the failure of advanced
risk measurement and management systems to detect
exposures that led to the financial crisis.
• Stresses importance of building strong risk culture.

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 Fintech
Financial technology, or fintech, refers to the use of
technology to deliver financial solutions in a manner that
competes with traditional financial methods.
• Includes services such as cryptocurrencies (e.g.,
bitcoin) and blockchain.
• Fintech risk involves the risk that fintech firms could
disrupt business of financial services firms in the form
of lost customers and lost revenue.
• Supports models of peer-to-peer mass collaboration.

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 Globalization of Financial Markets
and Institutions 1

U.S. markets are the world’s largest, but international

markets have seen rapid growth in recent years as a
result of various factors:
1. Pool of savings in foreign countries has increased.
2. International investors have turned to U.S. and other
markets to expand their investment opportunities.
3. Information on foreign investments and markets is
now more accessible and thorough.
4. Some U.S. FI’s offer their customers opportunities to
invest in foreign securities and emerging markets at
relatively low transaction costs.

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 Globalization of Financial Markets
and Institutions 2

U.S. markets are the world’s largest, but international

markets have seen rapid growth in recent years as a
result of various factors:
5. The euro is having a notable impact on the global
financial system.
6. Economic growth in Pacific Basin countries, China,
and other emerging countries has resulted in
significant growth in their stock markets.
7. Deregulation in many foreign countries has allowed
international investors greater access and allowed
the deregulating countries to expand their investor
base.
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 Appendix 1A - The Financial Crisis:
The Failure of FI’s Specialness 1

Home prices plummeted in late 2006 and early 2007

• Defaults by subprime mortgage borrowers began to affect
the mortgage lending industry, as well as the rest of the
economy.
• Foreclosure filings jumped 93% in July 2007 over July
2006.
• FIs that held these mortgages and mortgage-backed
securities started announcing huge losses as borrowers
defaulted.
• Losses reached over $400b worldwide through 2007.
Bear Stearns failed and was bought by JPMorgan Chase for
$2 per share.
• Deal was assisted by Federal Reserve.
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 Appendix 1A - The Financial Crisis:
The Failure of FI’s Specialness 2

The Crisis Hits

• September 8, 2008: U.S. government seized Fannie Mae and

Freddie Mac.
• Recorded approximately $9b in losses in the last half of 2007
related to subprime mortgage-backed securities.
• Put under a conservatorship and continue to operate under
the control of Federal Housing Finance Agency (F HFA).

September 15, 2008:

• Lehman Brothers filed for bankruptcy.
• Merrill Lynch was bought by Bank of America.
• AIG met with federal regulators to raise cash.
• Washington Mutual was looking for a buyer.
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 The Dow Jones Industrial Average,
October 2007 to January 2010

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 Overnight LIBOR, 2001 to 2010

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 Appendix 1A - The Financial Crisis:
The Failure of FI’s Specialness 3

The Rescue Plan

• September 18, 2008: Federal Reserve and central banks
around the world invested $180b in global financial
markets to unfreeze credit markets.
• Treasury Secretary Henry Paulson met with
congressional leaders to devise a plan to get bad
mortgage loans and mortgage-backed securities off the
balance sheet of financial institutions.
• October 3, 2008: $700b rescue plan was based and
signed into law.
• Established the Troubled Asset Relief Program (TARP)
that gave the U.LS. Treasury funds to buy “toxic”
mortgages and other securities from FI’s.
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 Federal Funds Rate and Discount
Window Rate
Some positive events occurred
between September and
December 2008
• Oil dropped to below $40 in
late 2008, leading to falling gas
prices.
• Many banks restructured
delinquent mortgage loans
rather than foreclose.
• Fed announced it would drop
its target fed funds rate and
lower its discount window rate.

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 Major Items in the Stimulus Program
$116.1 For tax cuts and credits to low- and middle-income workers
$69.8 For middle-income taxpayers to get an exemption from the alternative
minimum tax
$87.0 In Medicaid provisions
$27.0 For jobless benefits extension to a total of 20 weeks in addition to regular
unemployment compensation
$17.2 For increases in student aid
$40.6 For aid to states
$30.0 For modernization of electric grid and energy efficiency
$19.0 For payments to hospitals and physicians who computerize medical record
systems
$29.0 For road and bridge infrastructure construction and modernization
$18.0 For grants and loans for water infrastructure, flood prevention, and
environmental cleanup.

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