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Summary Banking
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Samenvatting Banking 2020-2021Lecture 1
1. Some introductory concepts
Money market vs capital market
- Money market: short term (< 1y)
- Capital market: medium and long term (stocks and bonds)
Primary market vs secondary market
- Primary market: where securities are issued (ex. IPO)
- Secondary market: where securities are traded
Bond market vs stock market
- Bond market: fixed income + creditor
- Stock market: income not fixed + owner
Derivative markets
- Cf options, futures, forwards…
Official exchange or over the counter
2. Functions of financial markets
Why do financial markets exist?
“The primary role of the capital market is the allocation of ownership of the economy’s
capital stock. In general terms, the ideal is a market in which prices provide accurate signals
for resource allocation.
That is, a market in which firms can make production-investment decisions, and investors can
choose among the securities that represent ownership of firms’ activities under the
assumption that securities prices at any time “fully reflect” all available information”
– Eugene Fama
Notes:
→ Capital market is there to make sure money goes to the right place: allocating the
ownership of capital
→ By knowing the price of capital it helps you allocating where your money should go
→ Assumption: refers to efficient market hypothesis
The seven main functions of financial markets
Function 1: transfer funds
- Financial markets make it easier to transfer funds required for consumption or
investments
- The transfer of money from sectors with surpluses to sectors with deficits
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,Function 2: accumulation
- Financial markets allow people to build up wealth
Function 3: risk-sharing
- Financial markets transfer risk to parties interested in taking risk
Function 4: liquidity
- Financial markets allow people to sell financial assets: ideally on the short term and
without loss of value (i.e. liquid markets)
Function 5: pricing
- Financial markets provide information about the price of financial assets
Function 6: aggregation of information
- Financial markets aggregate information of many parties
→ Trading means many people can offer a price for it so a lot of people’s
information is in the price of the stock, might give better price result
Function 7: efficiency
- Financial markets reduce transaction and information costs
Financial markets are promises
- Bonds
→ Promises a (coupon) payment on fixed times
- Stocks
→ Promises a share of future profits
- Pension fund
→ Promises an income stream when people retire
- Life insurance
→ Promises to pay out after a certain period of time, or in case of death
- Mutual fund
→ Promises to distribute profits gained by investing in bonds and stocks
3. Size of financial markets
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,4. Asymmetric information
Asymmetric information: the one making a promise (i.e. selling financial assets) knows more
about the future than the one buying the promise
This leads to:
- Adverse selection
- Moral hazard
Adverse selection
- Agents on one side of the transaction have more information than agents at the
other side
- Is a problem of asymmetric information before the transaction occurs
- Can lead to the market unraveling
- Ex: secondhand cars, CDO’s
→ Secondhand cars: you’re trying to sell your car, you know what your car is
worth but the buyer doesn’t so he will pay you an average price; if you have a
good car you get less than you deserve and if you have a bad car you get
more than you deserve so in the end people with good cars will leave the
market and only the bad cars stay
→ CDO = Collateralized Debt Obligations: collections of mortgages
Moral hazard
= the risk that one initiates uncareful or risky activities because he or she is insured against
losses
- By (hidden) actions of the contractors, the risk of the transaction changes
- People who are initially planning on keeping their promises might receive an
incentive to break them
- Is a problem of asymmetric information after the transaction occurs
- Ex: car insurance, deposit insurance
→ Let’s say you drive a car without insurance so you will be carefull; but when
having an omnium insurance you might drive more risky because you know if
something happens you can get money back
Solutions?
Gathering more information, but…
- Costly to the one gathering the information
- If multiple people want the same information, we have inefficient duplication
- Free-rider problem: when the information becomes public
- Rational ignorance: when uninformed parties follow others because they think they
are better informed, herding occurs (bubbles, inefficient allocation, …)
Collateral, but…
- Only if you have something, you can give something as colleteral
- Assumes a correct legal system
- Not always high quality collateral available?
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, 5. Allocation of funds
Three types of financing
1) Direct financing
2) Semi-direct financing
3) Indirect financing
Direct financing
Surplus sectors = sectors with too much money
Deficit sectors = sectors with not enough money
Direct financing means households’ savings go directly to bonds or stocks issued by firms
- In an economy with only direct financing, there is a risk of a low level of financing,
because of several problems
Problems
- High transaction and information costs
→ Costly (time intensive, make sure it’s good info… ) to find out in which project
to invest, or to find out more about the project (avoiding adverse selection)
→ Monitoring: make sure that funds invested are used as promised, make sure
things are going well after you invested (avoiding moral hazard)
- Maturity
→ Often long term investment
→ Not all investors are looking to invest in the long term (i.e. maturity
transformation)
- Amount
→ Investments often require large amounts, leads to diversification problem for
the investor
Conclusion
- Using direct financing, investments are usually confined to friends, family and fools
- Every investor has to make his homework (which is inefficient)
Semi-direct financing
Important difference: financial intermediary = for ex. stockbroker ≠ bank
- Same assets and same money moving (no transformation)
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