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Lecture 1: Overview of the Financial System (Chapters 1 and 2)

¾ Learning Outcomes: What is the role of the financial system in an economy? What are the needs it
serves? What are the obstacles it faces in serving those needs? What are the methods utilized to
overcome these obstacles?

¾ The key function of the financial system is to make it easier to trade.

¾ What are the obstacles to trade and why is there a need to make trade easier?

Nature of Trade

¾ Why do people trade?

Various Types of Trade

1. Trade in Goods and Services



Saving and Investment; Lending and Borrowing:

™ The basis for lending and borrowing is the following:

o Some people have purchasing power now, but want to transfer it to the future.
o Others expect to have purchasing power in the future, but want it now.

™ Life-Cycle Saving:

™ Borrowing and Investment:

o Potential borrowers are businesses and households who need purchasing power to now
in order to invest.
o Businesses need to borrow in order to finance their
ƒ Working Capital:

ƒ Fixed Capital:

o Households also make investments, such as buying a flat or a college education.

™ Savers and investors can fulfill each others needs and can hence gain from trade in the form of
lending and borrowing.

Trade in Risk

¾ The world we live in is an uncertain place where households and businesses face a variety of risks.

¾ Trade can reduce many of these risks significantly.

¾ There are two main forms of trade in risk:

1. Insurance

2. Forward Transactions

1. Insurance: Useful in dealing with risky and unpredictable events like accidents and illnesses.

(a) Reciprocal Insurance: An agreement whereby those facing a particular risk agree to share their
Example: Pearl Industry

• Historically, the best pearls in the world came from the Arabian Gulf.
• The ancient pearling industry provided the only real income for the people of what is
now the UAE (United Arab Emirates).
• Pearl-fishing was a very risky activity.
• Pearl-fishers needed capital to rent and equip a boat; they also needed money to support
their families for the several months that they were at sea. For these expenses, they had
to take a large loan at the beginning of the fishing season, which they needed to pay
back with interest at the close of the season.
• In addition, diving for pearls was also dangerous physically.
i. Perforated eardrums and bronchitis was a common problem among pearl-fishers.
ii. They were also at danger from the sawfish, the sting ray, the electric ray and

iii. The most devastating risk was that of becoming blind. Loss of sight meant that a
pearl-fisher’s means of earning had disappeared forever.
• An interesting custom among the pearl-fishers was the “blind-man’s share”.
• Of all the pearls collected every season, 1/3 went to the pearl-fishers and the crew, 1/3
went to the pearl-dealers, and 1/3 went to the blind pearl-fishers.
• Every pearl-fisher had complete confidence in this insurance system, which could one
day come to his rescue.
• The pearl industry of the Arabian gulf was destroyed in the early 1920’s as the Japanese
discovered how to make “cultured” pearls in large quantities. This led the UAE
countries to look for alternative resources, and they ended up finding vast quantities of
oil below their sands!
• Reciprocal Insurance has existed since ancient times in tribal societies (gift exchange)
and agricultural communities (mutual aid).

(b) External Insurance: Certain types of risks cannot be shared by reciprocal insurance. For
example, the risk that a ship will sink in the ocean or be looted by pirates may be difficult to
share since the number of ship owners is relatively small. In such cases, one may still be able to
use External Insurance.

• External Insurance refers to an agreement whereby those who do not face a particular
risk agree to share the losses of those who do in exchange for a premium.


¾ What is the “diversity” that leads to gains from trade in

o Reciprocal insurance:

o External Insurance:

2. Forward Transactions:

o Example: Fishermen in the European fish industry frequently undergo economic

hardship. They are also exposed to various kinds of risk and their income is very
volatile. Every time there is a fish crisis in the fishing industry, the European Union
tries to provide a subsidy to these fishermen to help them survive.

o One risk they face is related to the size of the catch – some days a fisherman catches a
lot of fish, other days very little.
¾ They reduce this quantity risk by participating in some form of reciprocal

o After the fish is caught, it is auctioned at the harbour. The fishermen’s income is thus
also subject to price risk. Fish prices are extremely volatile and their volatility causes
much suffering to these fishermen.
o When fish prices fall a lot, their income is reduced, but they still have pay back the
principal and interest on the loans financing their boats and business. If they can’t do so,
they can go bankrupt.
o The risk faced in this situation is called price risk and is common in business.

o How can the fishermen hedge the price risk they face?

o Price risk can be eliminated by a form of trade known as a Forward Transaction.

o The key feature of a forward transaction is that a price is set TODAY for delivery and
payment at a specified time in the FUTURE.

o Example: A tuna fisherman could sell his expected catch of 10000 pounds of tuna fish
forward at €2/pound to be delivered after one month. This removes the price
uncertainty so he can be assured of making a profit before going out to catch the tuna.

o Who might be willing to enter into a forward transaction with the fisherman for his tuna?

Diversity and Gains from Trade in Forward Transactions:

¾ Just like trade in goods and services, lending, and insurance, diversity forms the basis of gains from
trade in forward transactions.
¾ The fishermen are worried about falling prices; the tuna factory is worried about rising prices.

Obstacles to Trade

1. Problems Involved in Lending:

(a) The Need for Information

Example: Suppose you want to lend your money to SCUD, a promising new company that
manufactures batteries for mobile phones. Before you make the loan, you will need to know

something about the company. What are its future prospects? Has it ever defaulted on a loan in
the past? If it does default, does it own any assets that can be sold to pay your loan?

¾ Getting answers to all these questions is costly.

1. SCUD has to prepare financial statements and write a prospectus explaining its plans.
2. You may question the reliability of this financial information and want to verify it.
3. It may not be able to disclose its ideas for new products and services since it does not want its
competitors to know that information.

(b) Writing a Contract: Negotiating and writing a contract is expensive in terms of time and
lawyers fees.

(c) Incentive Effects of Contracts: The terms of the contract may change the incentives of the
owners of SCUD in a way that harm your interests.

Equity Contract: Contract representing a claim to a share in the net income and assets of a

o For example, you invest $1 million in SCUD in exchange for a 49% share of its profits. This
reduces the incentive of the owner to work as hard as before because she gets only 51% of
every extra dollar the company earns.

Debt Contract: Contract stating an agreement by the borrower to pay the lender fixed dollar

o For example, you provide $1 million to the owner of SCUD in exchange for a fixed payment
of $5 million 10 years from now. Does this also reduce her incentive to work as hard as

o Another incentive problem is created:

Probability Total Payoff Your Payoff Owner’s Payoff

½ $5 million
Strategy A
½ $6 million

½ $0 million
Strategy B
½ $12 million

(d) Liquidity: Refers to the ease with which an asset can be converted to the medium of exchange
of an economy. Lenders and borrowers have conflicting interests over liquidity.

o Suppose soon after you lend $1 million to SCUD, you need your money back to meet an
unexpected expenditure. But SCUD needs the money to buy equipment, and once the money
has been spent, it cannot be returned to you quickly.

(e) Transactions Costs: Dealing with all these obstacles to lending is costly.

o For example, both equity and debt contracts create undesirable incentives.
o These contracts usually include some provisions safeguarding the lender’s interests.
o For e.g., debt contracts include loan covenants, which are clauses in the contract that restrict
the borrower’s behavior in various ways.
o However, it is costly to monitor the borrower to ensure that s/he is following the terms of the
o A trade may be mutually beneficial, but if the transaction cost of implementing it is higher
than the gain from trade, it will not take place.

2. The Problems of Trade in Risk:

¾ The Problems of Insurance: Insurance creates incentive problems similar to lending. There
are two main problems -- Moral Hazard and Adverse Selection.
¾ Moral Hazard and Adverse Selection are very important concepts in finance and economics
and help us understand several different phenomena. They tend to arise when information
between two or more economic units is asymmetric, so that one unit has more information
than another.
¾ Moral Hazard: Refers to the risk of dishonest behavior when one person, called the Agent is
performing some task for another person, called the Principal. It is costly for the principal to
monitor the agent’s actions, so the agent may cheat and choose a low level of effort.

o Examples of Moral Hazard:

a. Baby Sitter:

b. Insurance: The tendency of the insured person to take more risk because s/he has insurance.

Example: A ship owner may face the choice between two routes: one safe but slow and the
other fast but risky. Without any insurance, which route would the ship owner choose?

With insurance, which route would he choose?

¾ Moral hazard occurs after the transaction takes place.

¾ Adverse Selection: Arises when one person knows more about the characteristics of a
good/service, so the uninformed person runs the risk of being sold a good/service of poor

¾ Examples of Adverse Selection:


2. Education: Does education maker workers more productive?

Assume education has no impact on workers’ productivity. Will firms still pay higher
wages to educated workers?

3. Insurance: The tendency of worse risks to buy insurance and better risks not to buy it.

Example: If the price of insurance is the same for all ships, then the owners of ships that are in
a poor condition are more likely to buy insurance than owners of ships that are in good

¾ Adverse Selection occurs before the transaction.

¾ Forward Transactions: In a forward transaction, one party promises to buy and the other to
sell at some specified time in the future. The danger is that one of the parties may fail to
keep its promise and default.
Example: You have entered into a forward transaction with Johnson Electric to sell them 1
million pounds of copper at $1.8 per pound. However, Johnson Electric goes out of business
and cannot accept delivery. What is your loss?

o Your loss from Johnson Electric’s default is generally NOT the full amount of $1.8
million it had promised to pay you.
o Your cost is the cost of finding a replacement for Johnson Electric as your trading
o The risk of default on a forward transaction is known as replacement risk or
counterparty risk.
o Thus each party to a forward transaction must take precautions to avoid this risk.
o These precautions are similar to those required in making a loan – i.e., gathering
information, contracting, and monitoring.

The Financial System and its Technology:

¾ The Financial System uses various mechanisms to overcome the obstacles to trade in lending
and trade in risk (insurance and forward transactions).

¾ Suppose you have $1 million you would like to save and SCUD would like to borrow this
amount to invest in a new project. If the obstacles to trade can be overcome, you can lend
this amount to SCUD.

¾ There are two ways in which you can lend the amount to SCUD.
I. Direct Finance: Lending by the ultimate lender to the ultimate borrower with no
II. Indirect Finance: Lending by ultimate lender to a financial intermediary which then relends
to the ultimate borrower.

Direct Finance and Financial Markets:

¾ Direct finance takes place in financial markets.

¾ Borrowers borrow money directly from lenders by selling them securities (financial
instruments like stocks or bonds).
¾ Various financial market institutions make it easier for you to lend to SCUD
¾ The first step in making a loan is gathering accurate information about the borrower.
¾ Several financial market institutions exist to satisfy your informational needs.
o Financial Press:
o Investment Information Services:
o Accounting Firms:

¾ The next step is to negotiate and write a loan contract.

¾ New securities are sold to the public through an underwriter, usually an investment bank.
¾ The underwriter purchases new securities from an issuer with the intention of reselling them.
¾ The underwriter negotiates the terms of the contract with the issuer and also appoints a
trustee to monitor compliance. The trustee is usually a commercial bank.
¾ These institutions – underwriters, trustees, accountants make it easy and cheap for you to
lend money to SCUD
¾ However, SCUD has to pay for these services, which are not cheap.

¾ Hence raising funds through selling new securities to the public (IPO or Initial Public Offer)
can be an expensive way of raising funds, so firms would use it only when the amount to
raised is very large.
¾ The market for new issues of securities is called the primary market.

¾ Once you have made your loan, SCUD has your $1 million and you have some securities
acknowledging its obligation to you.

¾ If the securities are bonds (debt securities), SCUD will pay interest periodically and repay
the original $1 million at a specified time (say in 10 years).

¾ If the securities are equities (stock), SCUD’s obligation is to pay you dividends; it has no
obligation to pay you the $1 million.

¾ What if circumstances change and you would like your money back immediately?

¾ SCUD is under no obligation to give your money back! What option do you have?

¾ Secondary Market: A financial market in which previously issued securities are traded.

¾ These markets help overcome the obstacle of liquidity that which hinders potential
borrowing and lending.

¾ Examples:

¾ The secondary market is created by brokers and dealers.

¾ Broker: Someone who arranges trades by bringing buyers and sellers together. S/he charges
a commission for her services.

¾ Dealer: Someone who stands ready to buy and sell at specified prices. You could sell your
SCUD shares immediately to a dealer at a specified price, and the dealer would hold onto
those shares until some buyer came along.

Indirect Finance and Financial Intermediaries:

¾ Indirect Finance: Lending by ultimate lender to a financial intermediary which then

relends to the ultimate borrower.

¾ Example: You lend your $1 million to HSBC bank, which then relends this amount to

¾ You are still the ultimate source of the loan: you are sacrificing current purchasing power
in exchange for a promise of purchasing power in the future.

¾ However, the promise is now from HSBC rather than SCUD. If SCUD defaults, that is
HSBC’s problem, not yours.

¾ SCUD’s creditworthiness is no longer your concern. The costs of making the loan are
passed on to the bank. However, the bank’s costs of making the loan are much lower than

o Informational Advantages: If SCUD is also HSBC’s client, HSBC can observe its
account transactions and will better know its cash flow and credit history. SCUD may
also be willing to provide more information to the bank in private because the risk of
information leaking to competitors is lower.

o Pooling to Make Large Loans: Many of the costs of making loans are fixed costs
(lawyer’s fees, accountant’s fees etc.). Banks can lower average costs by pooling
together the money received from several depositors.

o Gains From Specialization: Banks specialize in assessing the creditworthiness of

borrowers and in monitoring their performance, so they can do this better than the
typical small lender.

o Diversification: As a small lender, if you lend directly, you will not be able to lend to
more than a few borrowers. If your borrower defaults, you lose a large portion of
your wealth.

ƒ By pooling the deposits of thousands of people, the bank has a large amount to
lend, so it can lend to many different borrowers. (Diversification).
ƒ Even if some default, only a small part of the total will be lost.

o Liquidity: Banks also offer you superior liquidity. You can withdraw all or part of
your deposit any time you like.

ƒ Banks have a large number of depositors, and it is unlikely that all of them will
want to withdraw their deposits simultaneously.
ƒ However, banks are vulnerable to bank runs.

Direct and Indirect Lending Compared

Direct Lending Indirect Lending

Example Stock Market Bank

Gathering and evaluating

Negotiating and writing loan

¾ From the lenders point of view, indirect lending generally promises them less risk and more
liquidity. But this comes at a price.

¾ From the borrowers perspective, the bank’s comparative advantage in gathering information
and monitoring loans allows the borrower to avoid many of the costs associated with a public
o Indirect finance is usually cheaper for small or short-term loans.

¾ Which form of lending dominates in the real world?