Chapter

3
FINANCIAL INSTITUTIONS

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
•Review of Financial markets and Securities traded
in financial markets
•Role of financial institutions in financial markets
•Types of financial institutions
•Financial regulation

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Overview of Financial Markets

A financial market is a market in which financial assets

(securities) can be purchased or sold
Financial markets facilitate financing and investing by
households, firms, and government agencies
Participants that provide funds are called surplus units
◦ e.g., households

Participants that enter markets to obtain funds are deficit

units
◦ e.g., the government

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 Types of Financial Markets
Financial markets can be distinguished by the maturity structure
and trading structure of its securities
Money versus capital markets
◦ The flow of short-term funds is facilitated by money markets
◦ The flow of long-term funds is facilitated by capital markets

Primary versus secondary markets

◦ Primary markets facilitate the issuance of new securities
◦ e.g., the sale of new corporate stock or new Treasury securities
◦ Secondary markets facilitate the trading of existing securities
◦ e.g., the sale of existing stock
◦ Securities traded in secondary markets should be liquid

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Types of Financial Markets (cont’d)
Organized versus over-the-counter markets
◦ A visible marketplace for secondary market transactions is an
organized exchange
◦ Some transactions occur in the over-the-counter (OTC) market (a
telecommunications network)

Knowledge of financial markets is power

◦ Decide which markets to use to achieve our investment goals or
financing needs
◦ Decide which markets to use as part of your job
◦ Avoid common mistakes in investing and borrowing

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Securities Traded in Financial Markets

•Money market securities

• Money market securities are debt securities
with a maturity of one year or less
• Characteristics:
• Liquid
• Low expected return
• Low degree of risk

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Securities Traded in Financial Markets
(cont’d)

•Capital market securities

• Capital market securities are those with a
maturity of more than one year
• Bonds and mortgages
• Stocks
• Capital market securities have a higher expected
return and more risk than money market
securities

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Securities Traded in Financial Markets
(cont’d)
•Bonds and mortgages
• Bonds are long-term debt obligations issued by
corporations and government agencies
• Mortgages are long-term debt obligations created
to finance the purchase of real estate
• Bonds and mortgages specify the amount and
timing of interest and principal payments

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Securities Traded in Financial Markets
(cont’d)

•Stocks
• Stocks (equity) are certificates representing partial
ownership in corporations
• Investors may earn a return by receiving dividends
and capital gains
• Stocks have a higher expected return and higher risk
than long-term debt securities

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Securities Traded in Financial Markets
(cont’d)
•Derivative securities
• Derivative securities are financial contracts whose
values are derived from the values of underlying
assets
• Speculating with derivatives allow investors to
benefit from increases or decreases in the
underlying asset
• Risk management with derivatives generates gains
if the value of the underlying security declines

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Function of Financial Institutions
•In a perfect market:
• All information about any securities for sale in primary and
secondary markets would be continuously and freely
available to all investors
• All information identifying investors interested in purchasing
securities as well as investors planning to sell securities
would be freely available
• All securities are infinitely divisible
•Markets are imperfect
• Financial institutions are needed to resolve problems created
by market imperfections

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Function of Financial Institutions
(cont’d)
•Lower transaction costs (time and money spent in
carrying out financial transactions).
• Economies of scale
• Liquidity services

•Reduce the exposure of investors to risk

• Risk Sharing (Asset Transformation)
• Diversification

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Function of Financial Institutions
(cont’d)
•Deal with asymmetric information problems
• Adverse Selection (before the transaction): try to avoid
selecting the risky borrower.
• Gather information about potential borrower.
• Moral Hazard (after the transaction): ensure borrower
will not engage in activities that will prevent him/her to
repay the loan.
• Sign a contract with restrictive covenants.

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Adverse Selection
◦ If quality cannot be assessed, the buyer is willing to pay at
most a price that reflects the average quality
◦ Sellers of good quality items will not want to sell at the
price for average quality
◦ The buyer will decide not to buy at all because all that is
left in the market is poor quality items

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Solutions to Adverse Selection
• Private production and sale of information:
• In the United States, companies such as Standard and
Poor’s, Moody’s, and Value Line gather information on
firms’ balance sheet positions and investment activities,
publish these data, and sell them to subscribers
(individuals, libraries, and financial intermediaries
involved in purchasing securities).

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Solutions to Adverse Selection (cont’d)
• Government regulation to increase information:
• Government regulation to increase information for
investors is needed to reduce the adverse selection
problem, which interferes with the efficient functioning of
securities (stock and bond) markets.
• Although government regulation lessens the adverse
selection problem, it does not eliminate it. Even when
firms provide information to the public about their sales,
assets, or earnings, they still have more information than
investors

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Solutions to Adverse Selection (cont’d)
• Financial intermediation
• Collateral and net worth

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Moral Hazard in Equity Contracts
•Called the Principal-Agent Problem
• Principal: less information (stockholder)
• Agent: more information (manager)

•Separation of ownership and control

of the firm
• Managers pursue personal benefits and power rather
than the profitability of the firm

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Principal-Agent Problem: Solutions
•Monitoring (Costly State Verification)
• Free-rider problem
•Government regulation to increase information
•Financial Intermediation
•Debt Contracts

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Moral Hazard in Debt Markets
•Borrowers have incentives to take on projects that
are riskier than the lenders would like.
• This prevents the borrower from paying back
the loan.

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Moral Hazard: Solutions
•Net worth and collateral
• Incentive compatible
•Monitoring and Enforcement of Restrictive Covenants
• Discourage undesirable behavior
• Encourage desirable behavior
• Keep collateral valuable
• Provide information
•Financial Intermediation

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 What are Financial Institutions ?
• Financial intermediaries are firms that collect the funds from lenders and
channel those funds to borrowers (Mishkin)
• Financial intermediaries are firms whose primary business is to provide
customers with financial products and services that can not be obtained
more efficiently by transacting directly in securities markets (Z.Bodie
&Merton)
• Any classification of financial institutions is ultimately somewhat
arbitrary, since financial markets are subject to high dynamics and
frequent innovation. Thus, we roughly use four categories:
• Brokers
Engage in trade in
• Dealers securities (direct finance)
• Investment banks
Engage in financial asset
transformation (indirect
• Financial intermediaries => finance)

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Brokers
◦ Brokers are agents who match buyers with sellers
for a desired transaction.
◦ A broker does not take position in the assets she/he
trades (i.e. does not maintain inventories of those assets)
◦ Brokers charge commissions on buyers and/or sellers
using their services
◦ Examples: Real estate brokers, stock brokers

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Dealers
◦ Like brokers, dealers match sellers and buyers of financial
assets.
◦ Dealers, however, take position in their assets, their trading.
◦ As opposed to charging commission, dealers obtain their profits
from buying assets at low prices and selling them at high prices.
◦ A dealer’s profit margin, the so-called bid-ask spread is the
difference between the price at which a dealer offers to sell an asset
(the asked price) and the price at which a dealer offers to buy an
asset (the bid price)
◦ Examples: Dealers in U.S. government bonds, Nasdaq stock dealers

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Investment Banks
•Investment banks assist in the initial sale of newly issued
securities (e.g. IPOs)
•Investment banks are involved in a variety of services for
their customers, such as advice, sales assistance and
underwriting of issuances
• Examples: Morgan-Stanley, Goldman Sachs, ...Lehman
Brothers ..(Before Crisis 2008)

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 Financial Intermediaries
•Financial intermediaries match sellers and buyers indirectly through the
process of financial asset transformation.
•As opposed to three above mentioned institutions. they buy a specific kind
of asset from borrowers –usually a long term loan contract – and sell a
different financial asset to savers –usually some sort of highly-liquid short-
run claim.
•Although securities markets receive a lot of media attention, financial
intermediaries are still the primary source of funding for businesses.
•Even in the United States and Canada, enterprises tend to obtain funds
through financial intermediaries rather than through securities markets.
•Other than historic reasons, this prevalence results from a variety of
factors.

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Types of Financial Intermediaries

Three classes of financial intermediaries:

◦ Depository institutions accept deposits from savers and
transform them into loans (Commercial banks, savings and loan
associations, mutual savings banks and credit unions)
◦ Contractual savings institutions acquire funds at periodic
intervals on a contractual basis (insurance and pension funds)
◦ Investment intermediaries serve different forms of finance.
They include finance companies, mutual funds and money
market mutual funds.

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 Commercial Bank

Savings and Loans Associations (S&L)

Depository
Institutions Mutual Saving Banks

Credit Unions

Specialized Banks

Financial Contractual
Intermed savings Insurance Companies
iaries Institutions
Pension Funds

Finance Companies
Investment
Intermedarie
s Mutual Funds (Investment Funds)

Money market Mutual Funds

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Depository Institutions
Commercial banks
◦ Are the most dominant depository institution
◦ Offer a wide variety of deposit accounts
◦ Transfer deposited funds by providing direct loans
or purchasing debt securities
◦ Serve both the public and the private sector

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Depository Institutions (cont’d)
Savings institutions
◦ Include savings and loan associations (S&Ls) and mutual
savings banks
◦ Are mostly owned by depositors (mutual)
◦ Concentrate on residential mortgage loans

Credit unions
◦ Are nonprofit organizations
◦ Restrict their business to credit union members
◦ Tend to be much smaller than other depository institutions

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Contractual Savings Institutions
Insurance companies
◦ Provide insurance policies to individuals and firms for
death, illness, and damage to property
◦ Charge premiums
◦ Invest in stocks or bonds issued by corporations

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Contractual Savings Institutions (cont’d)
Pension funds
◦ Offered by most corporations and government
agencies
◦ Manage funds until they are withdrawn from the
retirement account
◦ Invest in stocks or bonds issued by corporations or in
bonds issued by the government

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Investment Intermediaries
•Finance companies
• Obtain funds by issuing securities
• Lend funds to individuals and small businesses
•Mutual funds
• Sell shares to surplus units
• Use funds to purchase a portfolio of securities
• Some focus on capital market securities (e.g., stocks or
bonds)
• Money market mutual funds concentrate on money market
securities

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Financial Regulation
1. Increasing Information available to Investors
2. Ensuring the soundness of Financial intermediaries
3. Solutions for ensuring the soundness of Financial
Intermediaries

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Increasing Information available to Investors
•As mentioned above, asymmetric information can cause
severe problems in financial markets (Risk behavior, insider
trades,....)
•Certain regulations are supposed to prohibit agents with
superior information from exploiting less informed agents.
•In the U.S. the stock-market crash of 1929 led to the
establishment of the Securities and Exchange Commission
(SEC), which requires companies involved in the issuance of
securities to disclose certain information relevant to their
stockholders. The SEC further prohibits insider trades

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Ensuring the soundness of financial
intermediaries
•Even more devastating consequences from asymmetric information
manifest themselves in collapses of the entire financial system – so
called financial panics.

•Financial panics occur if providers of funds on a large scale withdraw

their funds in a brief period of time from the financial system leading to
a collapse of the system. These panics can produce enormous damage to
an economy.

•Examples of some recent panics are the crises in the Asian Tiger states,
Argentina or Russia. The United States, while spared for most of the
second half of 20th century, has a long tradition of financial crises
throughout the 19th century up to the Great Depression.

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Solutions for ensuring the soundness of
financial intermediaries
•Restrictions on entry
•Disclosure
•Restrictions on Assets and Activities
•Deposit Insurance
•Limits on Competition
•Restrictions on Interest Rates

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