Notes on Mishkin Chapter 2: Part A
Preliminary Definitions and Concepts
("Overview of the Financial System")
Econ 353: Money, Banking, and Financial Institutions

Last Updated: 28 March 2015
Latest Course Offering: Spring 2011

Course Instructor:
Professor Leigh Tesfatsion
tesfatsi AT iastate.edu
Econ 353 Web Site:
http://www2.econ.iastate.edu/classes/econ353/tesfatsion/

Overview:

In his text as a whole, Mishkin takes both a positive (descriptive) and normative (value judgment) approach to the study of financial markets and financial institutions. That is, he seeks to understand: (a) the structure and operation of financial markets and institutions as they have existed in the past and as they currently exist; and (b) the way in which these markets and institutions ought to be structured and operated in line with efficiency, stability, and welfare objectives.

In the first part of Chapter 2, Mishkin emphasizes description. He explains the key functions of financial markets, the key types of players in these markets, and the key types of financial market structures. The following notes focus on, and expand upon, these key issues from the first part of Mishkin Chapter 2. Other issues considered in Mishkin Chapter 2 are taken up in Notes on Mishkin Chapter 2: Part B.

Basic Terms:

An asset is anything of durable value, that is, anything that acts as a means to store value over time. Real assets are assets in physical form (e.g., land, equipment, houses,...), including "human capital" assets embodied in people (natural abilities, learned skills, knowledge,..). Financial assets are claims against real assets, either directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims to future income streams that originate ultimately from real assets).

Securities are financial assets exchanged in auction markets, over-the-counter markets, and/or organized exchanges (see below) whose distribution is subject to legal requirements and restrictions, such as information disclosure requirements.

Savers are people who have available funds in excess of their desired expenditures, and lenders are savers who make their excess funds available to others for their use. Borrowers are people who have a shortage of funds relative to their desired expenditures and who attempt to obtain these funds from lenders. Generally they obtain these funds from lenders by selling them newly issued claims ("IOU's") against their real assets, i.e., by selling the lenders newly issued financial assets.

A financial market is a market in which financial assets are traded. In addition to enabling exchange of previously issued financial assets, financial markets facilitate borrowing and lending by facilitating the sale by newly issued financial assets. Examples of financial markets include the New York Stock Exchange (resale of previously issued stock shares), the U.S. government bond market (resale of previously issued bonds), and the U.S. Treasury bills auction (sales of newly issued T-bills).

A financial institution is an institution whose primary source of profits is through financial asset transactions. Examples of such financial institutions include discount brokers (e.g., Charles Schwab and Associates), banks, insurance companies, and complex multi-function financial institutions such as Merrill Lynch.

Introduction to Financial Markets and Institutions:

Financial markets serve six essential functions. These functions, briefly listed below, are discussed in greater detail in Part B of these notes on Mishkin Chapter 2.

In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured.

Who are the Major Players in Financial Markets?

By definition, financial institutions are institutions that participate in financial markets, i.e., in the creation and/or exchange of financial assets. At present in the United States, financial institutions can be roughly classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."

BROKERS:

A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to complete the desired transaction. A broker does not take a position in the assets he or she trades -- that is, the broker does not maintain inventories in these assets. The profits of brokers are determined by the commissions they charge to the users of their services (either the buyers, the sellers, or both).

Examples of Brokers: Real estate brokers, stock brokers.

Diagrammatic Illustration of a Stock Broker:


           Payment     -----------------    Payment
         ------------>|                 |------------->
    Stock             |                 |                Stock
    Buyer             |  Stock Broker   |                Seller
        <-------------|<----------------|<-------------
            Stock     |  (Passed Thru)  |    Stock
            Shares     -----------------     Shares


DEALERS:

Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy.

Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy low - sell high). The price at which a dealer offers to sell an asset (the asked price) minus the price at which a dealer offers to buy an asset (the bid price) is called the bid-ask spread and represents the dealer's gross profit margin on the asset exchange.

Examples of Dealers: Used-car dealers, dealers in U.S. government bonds, and Nasdaq stock dealers.

Diagrammatic Illustration of a Bond Dealer:

           Payment     -----------------    Payment
         ------------>|                 |------------->
    Bond              |     Dealer      |                Bond
    Buyer             |                 |                Seller
        <-------------|  Bond Inventory |<-------------
            Bonds     |                 |    Bonds
                       -----------------


INVESTMENT BANKS:

Traditionally, investment banks have engaged in three basic types of activities:

Examples of Investment Banks: Some of the best-known U.S. investment banking firms are Morgan Stanley, Merrill Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs. The financial crisis 2007-2009 led in 2008 to the collapse of Bear Stearns and Lehman Brothers, the acquisition of Merrill Lynch by Bank of America, and major changes in the organization of Goldman Sachs and Morgan Stanley.

FINANCIAL INTERMEDIARIES:

Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from borrowers -- generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers, generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account).

In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on their investment portfolios, financial intermediaries make profits by charging relatively high interest rates to borrowers and paying relatively low interest rates to savers.

Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan associations, mutual savings banks, credit unions); Contractual Savings Institutions (life insurance companies, fire and casualty insurance companies, pension funds, government retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual funds, money market mutual funds).

Diagrammatic Example of a Financial Intermediary: A Commercial Bank

                 Lending by B             Borrowing by B

                                            deposited
        -------     funds       -------       funds       -------
       |       |<............. |       | <.............  |       |
       |   F   |.............> |   B   | ..............> |   H   |
        -------     loan        -------      deposit      -------
                  contracts                  accounts

              Loan contracts             Deposit accounts
             issued by F to B            issued by B to H
            are liabilities of F       are liabilities of B
             and assets of B              and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households


Important Caution: These four types of financial institutions are simplified idealized classifications, and many actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two or more of these classifications or even to some extent fall outside these classifications.
For example, as noted above, Merrill Lynch is an investment banker in the sense it is one of the key financial institutions that provides investment banking services both here in the United States and abroad. On the other hand, Merrill Lynch also engages heavily in brokering and dealership activities as well as providing money market accounts on which checks can be drawn. Thus, Merrill Lynch actually operates to some extent in all four of the above categories. The bottom line is that the ability to use the above four categories to distinguish among separate institutions (as opposed to the activities undertaken within institutions) is rapidly diminishing.

What Types of Financial Market Structures Exist?

The costs of collecting and aggregating information determine, to a large extent, the types of financial market structures that emerge. These structures take four basic forms:

Financial markets taking the first three forms are generally referred to as securities markets. Financial auction markets are often used for "initial public offerings" (new issues) of securities, while the second two financial market forms are used for "secondary markets" (resale of previously issued securities). Some real-world financial markets combine features from more than one of these three categories, so the categories constitute only rough empirical guidelines.

Note: Mishkin restricts the use of the term "financial markets" to include only securities markets for stocks and bonds, preferring not to refer to exchanges handled through financial intermediaries as any type of a "financial market." Other texts, however, generally refer to exchanges handled through financial intermediaries as an "intermediation financial market" or as an "intermediated financial market" or simply as an "indirect financial market." Since Mishkin's narrow usage makes exposition more awkward, we retain the more commonly accepted practice here of referring to exchanges of financial assets handled by financial intermediaries as constituting an intermediation financial market.

AUCTION MARKETS:

An auction market is some form of centralized facility (or clearing house) by which buyers and sellers, through their commissioned agents (brokers), execute trades in an open and competitive bidding process. The "centralized facility" is not necessarily a place where buyers and sellers physically meet. Rather, it is any institution that provides buyers and sellers with a centralized access to the bidding process. All of the needed information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No private exchanges between individual buyers and sellers are made outside of the centralized facility.

An auction market is typically a public market in the sense that it open to all agents who wish to participate. Auction markets can either be call markets -- such as art auctions -- for which bid and asked prices are all posted at one time, or continuous markets -- such as stock exchanges and real estate markets -- for which bid and asked prices can be posted at any time the market is open and exchanges take place on a continual basis. Experimental economists have devoted a tremendous amount of attention in recent years to auction markets.

Many auction markets trade in relatively homogeneous assets to cut down on information costs. Alternatively, some auction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to be sold prior to the opening of the actual bidding process. This inspection can take the form of a warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in televised auctions) a time during which assets are simply displayed one by one to viewers prior to bidding.

Auction markets depend on participation for any one type of asset not being too "thin." The costs of collecting information about any one type of asset are sunk costs independent of the volume of trading in that asset. Consequently, auction markets depend on volume to spread these costs over a wide number of participants.

A key example of a U.S. financial market organized as an auction is the primary market for newly issued U.S. Treasury bills, notes, and bonds.

OVER-THE-COUNTER MARKETS:

An Over-The-Counter (OTC) market has no centralized mechanism or facility for trading. Instead, the market is a public market consisting of a number of dealers spread across a region, a country, or indeed the world, who make the market in some type of asset. That is, the dealers themselves post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices. The dealers provide customers more flexibility in trading than brokers, because dealers can offset imbalances in the demand and supply of assets by trading out of their own accounts.

Many common stocks in the U.S. are traded on the Over-the-Counter Bulletin Board (OTCBB), for example "penny stocks." However, most larger corporations trade their stocks on organized exchanges. Although the Nasdaq stock market operates as an OTC (or "dealer market"), Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered to be a stock exchange. Nasdaq is an acronyym for "National Association of Securities Dealers' Automated Quotations."

As noted by Mishkin (Chapter 2), the U.S. government bond market, a secondary market with a larger trading market than the New York Stock Exchange, is set up as an OTC market. Other OTC markets include markets in negotiable certificates of deposit, federal funds, bankers' acceptances, and foreign exchange.

INTERMEDIATION FINANCIAL MARKETS:

An intermediation financial market is a financial market in which financial intermediaries help transfer funds from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of financial assets from borrowers. The financial assets issued to savers are claims against the financial intermediaries, hence liabilities of the financial intermediaries, whereas the financial assets received from borrowers are claims against the borrowers, hence assets of the financial intermediaries. Recall the following diagrammatic illustration of a financial intermediary presented earlier in these notes:

Example: Commercial Bank


                 Lending by B             Borrowing by B

                                            deposited
        -------     funds       -------       funds       -------
       |       |<............. |       | <.............  |       |
       |   F   |.............> |   B   | ..............> |   H   |
        -------     loan        -------      deposit      -------
                  contracts                  accounts

              Loan contracts             Deposit accounts
             issued by F to B            issued by B to H
            are liabilities of F       are liabilities of B
             and assets of B              and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households


Benefits of Financial Intermediaries Relative to Brokers and Dealers

What benefits are provided by financial intermediaries that cannot be provided as efficiently, or even more efficiently, by brokers or dealers? The conventional answer is that financial intermediaries provide six distinct types of services to their customers. These services, briefly summarized below, are more carefully examined in subsequent Mishkin chapters.

1. Risk reduction through portfolio diversification:

Intermediaries find it less costly than individuals to construct large well diversified asset portfolios---e.g., stock funds, bond funds, money market funds, etc. They can then sell small portions of these portfolios to individuals. Note that, unlike dealers, intermediaries hold these large portfolios to increase the efficiency and profit potential of their asset holdings. The asset holdings are not simply temporary inventories held as buffer stocks against unforeseen fluctuations in demand.

2. Maturity intermediation:

Financial intermediaries can purchase financial assets with long maturities ("lend long") while at the same time selling financial assets (acquiring liabilities) with short maturities ("borrow short"). Thus, illiquid long-maturity assets (e.g., mortgages) are transformed into a more liquid form (e.g., deposit accounts); and the buyers of the more liquid assets are charged a premium for this liquidity in the form of a lower rate of return. The gap between the average maturity of an intermediary's assets and the average maturity of its liabilities is referred to as the maturity gap of the intermediary.

Everything else equal, the larger the maturity gap, the more the intermediary bears the (nondiversifiable) risk of fluctuations in short-term interest rates. For example, suppose the intermediary is a savings and loan association which lends long in the form of mortgages and borrows short in the form of savings deposits paying a competitive rate of return, i.e., the short-term interest rate currently available in financial markets. If there is an increase in this market short-term interest rate, the intermediary must either match the rise in order to retain its customers, resulting in a decreased and possibly negative profit margin, or risk having a substantial portion of its customers close out their accounts and take their money elsewhere.

3. Reduction of transactions and information costs:

Intermediaries are able to reduce the transactions costs entailed during the process of matching borrowers with lenders. Intermediaries are also able to reduce the transactions costs associated with the writing and communicating of contract terms for borrowers and lenders, particularly in cases where the contract terms are highly specialized to the situation at hand.

In addition, information costs incurred as a result of monitoring and enforcement of contract terms are reduced by centralizing these functions in one agent with extensive experience. This is particularly important in cases in which would-be lenders are relatively unsophisticated compared to would-be borrowers. As long as the intermediary's own return is tied to the success of these monitoring and enforcement functions, it has an incentive to perform these functions in a reliable manner.

The transactions and information costs incurred by a financial intermediary are passed on to the pool of agents who lend to the intermediary in the form of lower interest rates and to borrowers in the form of higher interest rates. If the pools of agents lending funds to the intermediary and borrowing funds from the intermediary are large, these costs will be spread across large numbers of agents and hence will have only a small impact on each individual agent.

4. Information production:

Intermediaries expend considerable resources investigating the anticipated profitability of the projects they finance. Individual lenders in general have neither the resources nor the incentive to carry out such extensive investigations. Moreover, the information gathered by the intermediary about an investment project is generally not made public; it is used to construct investment opportunities (mutual funds, etc.) for those who supply the intermediary with loanable funds. This is to the advantage of both the borrowers (who wish to keep trade secrets secret) and the lenders (who wish to take advantage of "inside information" about investment opportunities).

In this way, the production of information is tied in with the management of customer accounts. The principal insurance which a supplier of funds has that an intermediary will perform reliably is the stake which the owners and/or managers of the intermediary themselves have in the investments they choose for their customers.

Supplying information about investments (investment advising) is nevertheless conceptually distinct from the supplying of investment opportunities. This is illustrated by the recent surge in the number of discount brokers, who offer investment funds but no investment advice, in contrast to the more traditional full-service brokers who offer both investment funds and investment advice, but at substantially higher fees.

5. Management of payments:

Another specialized service offered by some (but by no means all) financial intermediaries is bookkeeping. The intermediary keeps track of receipts and disbursements for their customers, paying particular attention to tax considerations: which disbursements are reportable to the IRS; which are to be treated as capital gains, as dividends, or as interest payments; and so forth. Some intermediaries (e.g., commercial banks, large brokerage firms such as Merrill Lynch, etc.) also provide checkable deposit accounts and/or credit cards with bookkeeping services to keep track of account and/or card transactions.

6. Insurance:

Many types of financial intermediaries supply insurance to their customers against losses of principal. Moreover, some intermediaries specialize in insurance: that is, they construct and sell insurance policies (contingent claims against the intermediary) funded by premiums collected from the holders of the policies. Premiums in excess of insurance claim payouts are typically invested. Consequently, insurance companies act as a lender just as other types of financial intermediaries do.

Basic Concepts and Key Issues from Mishkin Chapter 2: Part A

Basic Concepts: Mishkin Chapter 2 (Part A)

Asset (vs. Liability)
Real Asset
Financial Asset
Security (or Financial Instrument)
Financial Market
Financial Institution
Brokers
Dealers
Financial Intermediaries (FIs)
Investment Banks
Auction Markets
Over-the-Counter Markets
Intermediation Financial Markets
Portfolio Diversification
Maturity (Short, Intermediate, and Long Term)
Maturity Intermediation
Maturity Gap
Transaction Costs
Information Costs

Key Issues: Mishkin Chapter 2 (Part A)

The Economy as a Circular Flow (Hand-Out)
Financial versus Real Assets
Basic Functions of Financial Markets
Types of Players in Financial Markets
Types of Financial Market Structures
Relative Advantages/Disadvantages of FIs

Copyright © 2011 Leigh Tesfatsion. All Rights Reserved.