An Overview

of the
Financial
System

Chapter 2
 Function of Financial Markets
To bring
lenders and borrowers together to
make both of them better-off.
Efficient
allocation of capital, which increases
production
Improve the well-being of consumers by
allowing them to time purchases better

2
Flows of Funds Through the
Financial System

3
Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets (D&E)
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Exchanges (D&E)
NYSE, NYBE, CBOT
Over-the-Counter (OTC) Markets
FX, Fed funds
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and
equity instruments

4
Principal Money Market
Instruments

5
Principal Capital Market
Instruments

6
 Internationalization of
Financial Markets
ForeignBonds: sold in a foreign country and
denominated in that countrys 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: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks

7
 World
Stock
Markets

8
 Function of Financial
Intermediaries: Indirect Finance
Lower transaction costs (time and money
spent in carrying out financial transactions).
Economies of scale
Liquidity services (checking account)

Reduce the exposure of investors to risk

Risk Sharing (Asset Transformation: packaging
risky assets into safer ones for investors)
Diversification by pooling and issuing new
assets
9
 Function of Financial
Intermediaries: Indirect Finance
Dealwith asymmetric information
problems
(before the transaction) Adverse Selection: try
to avoid selecting the risky borrower.
Gather information about potential borrower.
(after
the transaction) Moral Hazard: ensure
borrower will not engage in activities that will
prevent him/her to repay the loan.
Sign a contract with restrictive covenants.

10
Primary Assets and Liabilities of
Financial Intermediaries

11
Principal Financial Intermediaries
and Value of Their Assets

12
Regulation of the Financial System
To increase the information available to
investors
To ensure the soundness of financial
intermediaries
A report on upcoming regulation:
http://www.bos.frb.org/economic/conf/conf54/pape
rs/blinder.pdf

13
 Increasing Information
Reduce adverse selection and moral
hazard problems
Reduce insider trading (SEC).

14
 Ensuring the Soundness of
Intermediaries
Restrictions on entry (chartering process).
Disclosure of information.
Restrictions on Assets and Activities
(control holding of risky assets).
Deposit Insurance (avoid bank runs).
Limits on Competition (mostly in the past):
Branching
Restrictions on Interest Rates
15
Principal Regulatory Agencies of
the U.S. Financial System

16