Notes de cours
[HBA02C] Financial Institutions and Markets: theory summary
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- Katholieke Universiteit Leuven (KU Leuven)
Summary for the theory part (Prof. Paepen) of Financial Institutions and Markets
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Overview of the financial systemThe function of financial markets
The financial markets channel funds from a person or business without investment
opportunities (called “lender-savers”) to one who has them (called “borrower-spenders”).
Households, governments, business firms and foreigners can both be categorized as lender-
savers and borrower-spenders.
There are two segments in financial markets: direct and indirect finance. In direct finance,
borrowers borrow directly from lenders in financial markets by selling financial instruments
(or securities), which are claims on the borrower’s future income or assets (ex bonds). In
indirect finance, borrowers borrow indirectly from lenders via financial intermediaries
(whose role is to source both loanable funds and loan opportunities) by issuing financial
instruments, which are claims on the borrower’s future income or assets.
Financial markets are critical for producing an efficient allocation of capital, allowing funds
to move from people lacking productive investment opportunities to people who have them.
They also improve the well-being of consumers, allowing them to time their purchases better.
Debt and equity markets
There are several categorizations of financial markets. In debt markets, a debt instrument is
issued (such as a bond or mortgage), which is an agreement by the borrower to pay the lender
a fixed amount at regular intervals (interest and principal payments) until a specified date (the
maturity date).
In equity markets, funds are raised by issuing equities such as common stock and the assets
of a business. Equities often make periodic payments called dividends to their holders and are
considered long-term securities because they have no maturity date.
Primary and secondary markets
A primary market is a financial market in which new issues of a security (such as bonds or
stocks) are sold to initial buyers through an investment bank who underwrites the offering
(they help companies find their customers). There is no risk for banks because these
securities are bought by them and they already know to whom they will be sold. In addition, a
primary market is a form of direct finance.
A secondary market is a financial market in which securities previously issued are bought and
sold; examples are the NYSE (New York Stock Exchange), NASDAQ (National Association
of Securities Dealers Automated Quotation System), foreign exchange markets, future
markets and options markets. This type of market involves both brokers and dealers. Brokers
are agents of investors who match buyers with sellers of securities, and get a (very small)
commission of the final transaction without any risk. On the other hand, dealers take a risk by
linking buyers and sellers by buying and selling securities at stated prices.
,The two functions of a secondary market are providing liquidity, making it easy to buy and
sell the securities of the companies, and establishing a price for the securities, useful for
company valuation.
Exchanges and over-the-counter markets
There are two other kinds of secondary markets: exchanges and over-the-counter markets. In
exchanges, trades are conducted in central locations such as the NYSE or CBT (Chicago
Board of Trade) where buyers and sellers of securities meet. In an over-the-counter (OTC)
market, dealers at different locations who have an inventory of securities are ready to buy and
sell securities to anyone who comes to them and is willing to accept their prices.
Money and capital markets
We can classify markets by the maturity of the securities. A money market is a financial
market in which short-term instruments (maturity of less than one year) are traded. A capital
market is a financial market in which long-term instruments (maturity of more than one year)
and equity instruments are traded.
Internationalization of financial markets
Foreign bonds are denominated in a foreign currency and targeted at a foreign market.
Eurobonds (have nothing to do with the Euro currency, but these bonds can indeed be issued
in Euros) are denominated in one currency but sold in a different market, therefore there’s no
correlation between the currency and the market targeted. Over 80% of new bonds are
Eurobonds. In the last 10 years, politicians in the European Parliament talk about Eurobonds
as bonds of a country that are issued by another (ex: Italian bonds that are assured by the
German government).
A Belgian company can issue bonds in Norwegian currency because either there’s a high
demand in that currency, or the company has activity in that country and therefore decides to
raise money in that specific country. If they have no activity in that country, they still can
issue bonds in their currency; if they realize it’s not profitable, they can switch to another
currency (cross-currency swap).
In the Eurocurrency market, foreign currency is deposited outside of the home country (ex:
Eurodollars are US dollars deposited, say, in London). This gives US borrowers an
alternative source for dollars.
World stock markets are worldwide stock markets; US stock markets are currently the
largest. There are many international stock market indexes, such as Dow Jones (USA), S&P
500 (USA), Nikkei 225, FTSE 100 (London Stock Exchange), NASDAQ Composite
(NASDAQ stock market), DAX (Frankfurt Stock Exchange), CAC 40 (Euronext Paris), Hang
Seng (Hong Kong stock markets), Strait Times (Singapore Exchange).
The US has lost its dominance in the stock markets. 4 reasons why the market has declined:
, 1. New and innovative technology in foreign markets.
2. Tighter regulations put in place after 9.11, which encourages off-shore transactions
and accounts in tax-friendly countries.
a. Example: a European company can choose to do a transaction either in
London or in the US. They’ll chose London because in the US they’ll need
more time to prepare documents and need many lawyers in case something
wrong will happen in the future.
3. Greater risk of lawsuit in the US.
4. Sarbanes-Oxley Act of 2002 has increased the cost of being a US-listed public
company because they’re required to provide higher quality financial statements. Both
CEOs and CFOs of each company are held accountable in case of fraud, and are at
risk of criminal prosecution.
Function of financial intermediaries (indirect finance)
As we saw previously, instead of savers investing directly with borrowers, a financial
intermediary (such as a bank) plays as the middleman: the intermediary obtains funds from
savers, then makes loans/investments with borrowers.
This process, called financial intermediation, is actually the primary means of moving funds
from lenders to borrowers. It’s a more important source of finance than security markets,
such as stocks. The intermediaries are needed because of transaction costs, risk sharing and
asymmetric information.
1. Financial intermediaries make profits by reducing transaction costs, by developing
expertise and taking advantage of economies of scale. Their low transaction costs
mean that they can provide their customers with liquidity services, making it easier
for customers to conduct transactions.
a. Banks provide depositors with checking accounts that enable them to pay their
bills easily.
b. Depositors can earn interest on checking and savings accounts and yet still
convert them into goods and services whenever necessary.
2. Another benefit made possible by financial intermediaries’ low transaction costs is
that they can help reduce the exposure of investors to risk, through a process called
risk sharing:
a. They create and sell assets with lesser risk to one party in order to buy assets
with greater risk from another party. This process is referred to as asset
transformation, because risky assets are turned into safe assets for investors.
3. Another reason financial intermediaries exist is to reduce the impact of asymmetric
information, where one party lacks crucial information about another party, therefore
impacting decision-making. We usually discuss this problem along two fronts:
adverse selection and moral hazard.
a. Adverse selection is the problem created by asymmetric information before
the transaction occurs. It occurs when potential borrowers who are the most
likely to produce an undesirable (adverse) outcome (the credit risks) are the
ones who most actively seek out a loan. For example, unhealthy people buy
health insurance and want their known medical problems covered: this isn’t
, right from an healthy person point of view, because they might require less
medical attention.
b. Moral hazard is the problem created by asymmetric information after the
transaction occurs. It’s the risk that the borrower might engage in activities
that are undesirable (immoral) for the lender because it will be less likely that
the loan will be paid back.
Financial intermediaries also help by providing the means for individuals and businesses to
diversify their assets holdings. Low transaction costs allow them to buy a range of assets,
pool them, and then sell rights to the diversified pool to individuals.
Financial intermediaries are able to lower the production cost of information by using the
information for multiple services: bank accounts, loans, retirement savings… This is called
economies of scope. For example, an investment bank can evaluate how good a credit risk a
corporation is when making a loan to the firm, which then helps the bank decide whether it
would be easy to sell the bonds of this corporation to the public.
However, providing multiple services may result in conflicts of interest, a type of moral
hazard problem. They may lead an individual or a firm to conceal information or disseminate
misleading information, which then results in less efficiency in financial markets and in the
economy as a whole.
Regulation of financial markets
There are two main reasons for regulation of the financial system:
1. Increase information to investors.
a. Because of asymmetric information, investors may be subject to adverse
selection and moral hazard problems that may obstruct the efficient operation
of financial markets and may also keep investors away from them. Therefore,
government regulation can reduce these two problems and enhance the
efficiency of the markets by increasing the amount of information available to
investors.
b. For example, in the USA the SEC (Securities and Exchange Commission)
requires corporations issuing securities to disclose certain information about
their sales, assets and earnings to the public, and restricts trading by the largest
stockholders (insiders) in the corporation, therefore discouraging insider
trading which could be used to manipulate security prices.
2. Ensure the soundness of financial intermediaries.
a. Asymmetric information can lead to the 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
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