Money and banking

Lecture 1

 Financial markets are markets in which funds are

transferred from people and firms who have an excess of
available funds to people and firms who have a need of
funds.

 Financial markets crucial to promoting greater economic

efficiency. Three important financial markets are:

1) Bond market – where interest rates are determined.

2) Stock market – has major effect on individuals’ wealth and
firms’ investment decisions.
3) Foreign exchange market – fluctuations in the foreign
exchange rate have major consequences for an economy
e.g the UK.

The bond market and interest rates

 Security (financial instrument) is a claim on the issuer’s

future income or assets.
 Bond is a debt security that promises to make payments
periodically for a specified period of time.
  Interest rate. An interest rate is the cost of borrowing or
the price paid for the rental of funds.

The stock market

 Common stock represents a share of ownership in a

corporation.
 A share of stock is a claim on the residual earnings and
assets of the corporation.

Volatility on the stock market in shown

The foreign exchange markets

This is markets where funds are converted from one currency

into another. The foreign exchange market determines the
foreign exchange rate. The foreign exchange rate is the price of
one currency in terms of another currency.

Flow of funds through the financial system

Functions of financial markets:

1) Performs the essential function of channeling funds from

economic players that have saved surplus funds to those
that have a shortage of funds.

2) Direct finance: borrowers borrow funds directly from

lenders in financial markets by selling them securities.

3) Promotes economics efficiency by producing an efficient

allocation of capital, which increases production.

4) Directly improve the well-being of consumers by allowing

them to time purchases better.

Structure of financial markets

1) Debt and equity markets, where debts instruments

(maturity) and equities (dividends)

2) Primary and secondary markets, where investment banks

underwrite securities in primary markets. Brokers and.
Dealers work in secondary markets. Secondary markets
include: NYSE, LSE and FSE

Structure of financial markets

 Exchanges and over-the-counter (OTC) markets:

1) Exchanges: LSE, London metal exchange, NYSE.

2) OTC markets: Foreign exchange, US government bond
market.
  Money and capital markets:

1) Money markets deal in short-term debt instrument.

2) Capital markets deal in longer-term debt and equity
instruments.

Money market instruments: are treasury bills, negotiable bank

certificates of deposits (large dominations), commercial paper,
repurchase agreements.

Capital market instruments: corporate stocks (market value),

residential mortgages, commercial and farm mortgages, gilts or
government securities, corporate bonds, bank commercial
loans, consumer loans.

Internationalism of financial markets

Foreign bonds: sold in a foreign country and denominated in

that country’s currency.

Eurobond: bond denominated in a currency other than that of

the country in which it is sold.

Eurocurrencies: foreign currencies deposited in banks outside

the home country.

Eurodollars: US dollars deposited in foreign banks outside the

US or in foreign branches of US banks.

World stock markets: help finance corporations in the US and

the US federal government.
Why study financial institutions (FIs) and banking?

1) Financial intermediaries (FIs): institutions that borrow

funds from people who have saved and in turn make loans
to people who need funds.
 Banks: accept deposits and make loans.
 Other financial institutions: insurance companies, finance
companies, pension funds, mutual funds and investment
companies.

Function of financial intermediaries

 Lower transaction costs (time and money spent in

carrying out financial transactions): Economies of
scale are the cost advantages that enterprises obtain
due to their scale of operation (typically measured
by amount of output produced), with cost per unit of
output decreasing with increasing scale. Liquidity
services.

 Reduce the exposure of investors to risk: Risk sharing

(asset transformation), Diversification.

 Deal with asymmetric information problems:

Adverse selection (before the transaction): try to avoid
selecting the risky borrower by gathering information
about them.
 »  Moral hazard (after the transaction): ensure borrower
will not engage in activities that will prevent him or her to
repay the loan.

Sign a contract with restrictive covenants.

Why study financial institutions and banking?

2) Financial innovation: the development of new financial

products and services. Can be an important force for good
by making the financial systems more efficient. E-finance:
the ability to deliver financial services electronically.

3) Financial crises: major distributions in financial markets

that are characterized by sharp declines in asset prices and
failures of many financial and non-financial firms.

Regulation of the financial system

Regulated for two reasons

 To increase the information available to investors:

- Reduce adverse selection and moral hazard problems.
- Reduce insider trading – e.g. in the US done by the
Securities and Exchange Commission (SEC). Asymmetric
information can also lead to widespread collapse of
financial intermediaries, referred to as a financial panic.

Because providers of funds to financial intermediaries may

not be able to assess whether the institutions holding their
funds are sound, if they have doubts about the overall health
 of financial intermediaries, they may want to pull their funds
out of both sound and unsound institutions. The possible
outcome is a financial panic that produces large losses for
the public and causes serious damage to the economy.

 To ensure the soundness of financial intermediaries,

government implemented 6 types of regulations:

- Restriction to entry (chartering process). Tight regulations

governing who is allowed to set up a financial
intermediary.
- Disclosure of information. Books are subject of inspection
and certain information must be shared with public
- Restrictions on assets and activities (control holding of
risky assets).
- Deposit Insurance (avoid bank runs). Federal Deposit
Insurance Corporation (FDIC) insures each depositor for
100,000$
- Limits on competition (mostly in the past): There was an
evidence of competition between financial intermediaries
which led to public harm.
- Branching was previously restricted
- Restrictions on interest rates.

Monetary and Fiscal policy

Money is defined as anything that is generally accepted in

payment for goods or services or in repayment of debts.
Money plays important role in interest-rate fluctuations,
which are of great concern to businesses and consumers
Monetary policy is the management of the money supply and
interest rates. It is implemented because money can affect
many economic variables that are important to the well-being
of our economy

- Conducted in the UK by Bank of England (BoE), in the US

by the Fed and Eurozone by the European Central Bank
(ECB)/

Fiscal policy deals with government spending and taxation

- Budget deficit is the excess of government expenditures

over tax revenues for a particular year.
- Budget surplus is the excess of tax revenues over
government expenditures for a particular year.
- Government must finance any deficit by borrowing, while
a budget surplus leads to a lower government debt burden
- The UK’s government budget deficit narrowed to 2% of
GDP in 2017-18 fiscal year from 2.3%t of GDP in the
previous fiscal year.

Diagram of UK government budget as a percentage of gross

domestic product (GDP) from 2008 to 2018
Why study international finance?

- Financial markets have become increasingly integrated

throughout the world.
- The international financial system has tremendous impact
on domestic economies:
1)How a country’s choice of exchange rate policy
affects its monetary policy? Monetary policy may be
expansionary or contracting.
Expansionary policy refers to various ways and means
adopted by a central bank to infuse more money in an
economy. Expansionary policy is adopted mainly to cure
recession in an economy. Because of expansionary policy
supply of money in an economy increases leading to
decrease in cost of money i.e. interest rates reduces.
Now, because of reduced interest rates, the value of
interest yielding securities (debt securities) reduces.
If these securities are held by foreign investors (F.I.I), the
real value of such investments reduces. So, in order to
safeguard themselves, the foreign investors sell their
investments as early as possible. Since securities are sold
and proceeds are converted into foreign currency, the
demand for foreign currency increases therefore foreign
currency appreciates or domestic currency depreciates.
Thus, it takes more of domestic currency to buy foreign
currency.

How capital controls impact domestic financial systems and

therefore the performance of the economy? Capital control
represents any measure taken by a government, Central
bank or other regulatory bodies to limit the flow of
foreign capital in and out of the domestic economy.
These controls include taxes, tariffs, legislation, volume
restrictions, and market-based forces. Capital controls
can affect many asset classes such as equities, bonds,
and foreign exchange trades.

Which should be the role of the international financial

institutions like the IMF?

Summary

- Financial markets directly affect individuals’ wealth, firms’

behavior and efficiency of an economy.
- Three financial markets of importance are: bond markets,
stock market and foreign exchange rate market.
- Financial markets and financial intermediaries are crucial
to a well-functioning economy because they channel funds
 from those who do not have a productive use for them to
those who do.

Next lecture: Role of money in economy.