Introduction to the

Financial System
In this section, you will learn:
 about securities, such as stocks and bonds
 the economic functions of financial markets
 how asymmetric information can disrupt financial
markets
 how banks compare to financial markets, and how
they combat problems from asymmetric
information
 the financial system’s role in economic growth
Financial Markets
 Financial markets:
where people and firms trade two kinds of
assets
 Currencies
 Securities – claims on future income flows,
e.g. stocks and bonds
Bonds
 issued by corporations to raise funds for
investment, or by the government
 promise predetermined payments to buyers at
specified times in the future
 also called fixed-income securities
 represent debt: the buyers are lending to the
issuers
Bond jargon
 Face value: the amount bond pays when it matures
 Coupon payment: a payment that buyers of certain
bonds receive prior to maturity
 Bonds that mature in under a year:
 commercial paper – issued by corporations
 Treasury Bills – issued by U.S. govt
 Zero-coupon bonds: buyers get no payments until
bond matures
 Default: When a bond issuer fails to pay
Stocks
 also called equities
 shares of ownership in corporations,
who sell them to raise funds for investment
 riskier than stocks, because the income comes
from corporate profits, which are unpredictable
Economic Functions of Financial Markets
1. Matching savers and investors
 the loanable funds model
 mutually beneficial transactions
 Savers earn income by loaning funds to
investors
 Investors get funds they need to finance
investment projects
(recall economics definition of investment –
spending on capital goods)
Economic Functions of Financial Markets
2. Risk sharing
 allows for diversification, the distribution of
wealth among many assets
 losses or low returns on some assets
offset by higher returns on others
 An easy way to diversify:
buy shares of mutual funds, financial firms that
buy and hold many different stocks and bonds
CASE STUDY
The Perils of Employee Stock Ownership
 401(k): a retirement savings fund administered by
a firm for its workers, contributions not taxed
 Most 401(k) plans let workers choose among a set
of mutual funds and their company’s own stock.
 Before Enron went bankrupt in 2001, most of its
employees’ 401(k) assets were Enron stock.
 After an accounting scandal, the price of Enron
stock dropped to near zero, wiping out the
retirement savings of most of its workers.
 Enron illustrates the danger of not diversifying.
Asymmetric Information
 Asymmetric information:
when one party in a transaction has more
information than the other party
e.g., a firm selling securities knows more about
its prospects than the buyers
 Two types of asymmetric information:
 adverse selection
 moral hazard
Asymmetric Information
 Adverse selection:
when the people or firms most eager to make a
transaction are the least desirable to the parties
on the other side of the transaction
 Firms with poor prospects are the most eager to
sell their securities; Savers lacking information
risk overpaying for a security that will produce low
returns.
 Savers understand this risk and may opt not to
buy securities. Then firms with good prospects
do not get the funding they need.
Asymmetric Information
 Moral hazard:
the risk that one party will act in a way that harms
the other
 If the buyer of a security cannot observe the
issuer’s behavior, the issuer may use the funds for
different purposes than promised (e.g. gambling
on risky ventures), letting the buyer incur the
losses if the venture fails.
 Savers understand this risk and may opt not to
buy securities. Then responsible borrowers do not
get the funding they need.
NOW YOU TRY:
Asymmetric information
Suppose banks could not check loan applicants’
credit histories.
a. Which type of asymmetric information problem
would result?
b. How would this problem affect the market for
loans?
ANSWERS:
Asymmetric information
a. Adverse selection
Riskier borrowers would be more eager to take
out a loan at a given interest rate than
responsible borrowers.
b. Banks would expect most loan applicants to be
risky, so they would charge higher interest
rates on all loans. Result: responsible
borrowers pay high rates and get fewer loans.
Banks
 Financial institutions (financial intermediaries):
firms that help channel funds from savers to
investors
 Banks: financial institutions that accept deposits
and make loans
 Deregulation has allowed banks to engage in
other activities, such as trading securities
 Indirect finance channels funds from savers to
investors through banks. Direct finance channels
funds through financial markets.
Banks and Asymmetric Information
 Banks reduce adverse selection by screening
potential borrowers.
 Banks combat moral hazard by using loan
contracts with covenants, provisions on the
borrowers’ behavior which protect the bank.
The Financial System & Economic Growth
 A well-functioning financial system promotes
economic growth by channeling saving to the
most productive investment projects.
 In countries with underdeveloped financial
systems, it’s hard for firms to raise funds for
investment, so aggregate investment and growth
are lower.
 Government policies can help, e.g.:
 regulations to reduce information asymmetries
 federal deposit insurance
 Two indicators of financial development
by income level, 1996-2007
90%

80% Stock Market Capitalization

Bank Loans
Percent of GDP

70%

60%

50%

40%

30%

20%

10%

0%
Low income Lower middle Upper middle High income
countries income countries income countries countries
Markets vs. central planning
 Centrally planned (or command) economy:
Govt decides what goods will be produced, who
receives them, and what investment projects will
be undertaken.
 Lesson from Microeconomics:
Free markets much better than command
economies at allocating resources.
 This lesson holds true in financial markets,
where stock prices and interest rates channel
funds to the most productive investments.
SECTION SUMMARY
 The financial system has two central parts:
financial markets and banks.
 Stocks and bonds are securities traded in financial
markets.
 Corporations and governments that issue bonds
are borrowing from those who buy the bonds; in
return, the issuers make predetermined
payments at specified times to the bond holders.
 A stock is an ownership share in a corporation,
and the stockholder receives a share of the
corporation’s earnings.
SECTION SUMMARY
 Financial markets channel funds from
savers to investors with productive uses
for the saved funds. Financial markets also help
people reduce risk by diversifying their asset
holdings.
 Financial markets can malfunction because of
asymmetric information: issuers of securities
know more than buyers. The two types of
asymmetric information problems are adverse
selection and moral hazard.
SECTION SUMMARY
 Banks raise funds by accepting deposits
and use the funds to make private loans.
They reduce asymmetric information problems by
screening loan applicants, including covenants in
loan agreements, and monitoring borrower
behavior.
 A well-functioning financial system promotes
economic growth by channeling savings into
productive investment. Bad government policies
can hinder this function and reduce growth.