Notes on Mishkin Chapter 2: Part B
("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:
Six Basic Functions of Financial Markets:
A More Detailed Consideration
1. Borrowing and Lending
One key function of financial markets is to facilitate the
financing of new borrowing. Financial markets bring savers (agents
with excess funds relative to their desired expenditures) together with
would-be borrowers (agents who are short of funds relative to their desired
expenditures). The borrowers issue new liabilities against themselves in
return for receiving the excess funds of savers.
In general, there is a mismatch of income and spending needs between
households and businesses in an economy that creates an opportunity for
borrowing and lending. In the aggregate, the household sector tends to have
on hand more funds than it currently wishes to consume (i.e., savings), and
the business sector tends to have fewer funds on hand than it wishes to
invest. Financial markets provide a mechanism by which the household sector
can lend its savings to the business sector for investment purposes.
HOUSEHOLD ---------> BUSINESS ------------> PROJECTS
There are two central mechanisms for the transfer of funds from savers
to borrowers to facilitate new acts of borrowing: indirect finance; and
- Indirect Finance:
- Funds are channeled indirectly from
savers to borrowers in intermediation
financial markets by means of financial
intermediaries (FIs). The FIs engage in asset transformation;
they acquire financial assets newly issued
by borrowers (e.g., residential mortgages), which the FIs
pay for (fund) by issuing to savers financial assets
newly issued by themselves (e.g., deposit accounts). Consequently, the FIs hold claims against the ultimate borrowers whereas the savers hold claims only against the FIs.
- Indirect Finance Examples: A bank XYZ provides loaned funds to a household under the terms of a residential mortgage loan contract (held by XYZ as a claim against the household) using monies collected from its depositors (i.e., holders of XYZ deposit account contracts); A defined-contribution pension fund HIRSK buys commercial paper newly issued by a corporation, paid for using the contributions collected from the participants in HIRSK.
- Direct Finance:
- Savers directly finance new acts of borrowing
by purchasing newly issued financial assets in the same form as originally issued by borrowers (no asset transformation). Consequently, the savers directly hold claims against these borrowers.
- Direct Finance Examples: A corporation directly buys newly issued commercial paper from another corporation; A household buys a newly issued government bond through the services of a broker (no asset transformation).
- Important Note: Transactions involving the purchase of
existing financial assets (e.g., households purchasing corporate stock shares from other households) do not involve any new borrowing. Such transactions simply reallocate among savers the existing volume of claims against borrowers without creating any new claims in net terms. Consequently, given any particular purchase of a financial asset, it can represent an instance of indirect finance, direct finance, or neither.
As pointed out by Mishkin, studies show that firms in major developed
countries have traditionally relied more on indirect than on direct financing
to obtain their borrowed funds. The reasons for this will be explored in
later parts of the course.
2. Price Determination
- Intermediation Financial Markets:
- Financial intermediaries pool the funds of many small savers to
lend money to individual borrowers.
- Interest is paid to savers in exchange for use of their funds
for lending, while borrowers pay interest on their loans.
- The difference between the rate paid by borrowers and the
(generally lower) rate paid to savers can be considered
a "price" for the services provided by the financial
intermediary to both the borrower and lender.
- The goal of intermediaries is generally to borrow funds from
savers at low rates and to lend funds to borrowers at high
rates -- "borrow low, lend high."
ON SAVINGS ON LOANS
SAVERS <------------ FINANCIAL <---------- FIRMS
"BORROW LOW" "LEND HIGH"
- Auction Securities Markets:
- In auction markets, brokers receive bid and asked prices from
buyers and sellers and facilitate exchange by matching received bid prices
with received asked prices of equal or lesser value so that exchanges can
take place. In some cases, only bids are received (so that effective
asked prices are zero) and items are simply sold to the highest bidders.
- Example: Treasury Auctions
- For example (see
Fedpoint 41: Treasury Auctions),
the U.S. Government regularly auctions newly issued Treasury bills, notes,
and bonds ("treasuries") to finance the Federal government debt. Most
newly issued treasuries are bought by "primary dealers" -- financial institutions that are
active in buying and selling U.S. government securities and that have
established business relations with the New York Fed. A much smaller volume
of newly issued securities is purchased by individual investors who buy them directly from
the Treasury Department at auction instead of in a secondary (resale) market.
- A modern auction process for bills, notes, and bonds begins with a
public announcement by the Treasury: e.g., "The Treasury will auction
$11,000 million of 91 day bills to refund $9,000 million of maturing
securities and to raise about $2,000 million in new cash."
- Bids are then accepted for up to thirty days in advance of the
auction. All bids are confidential and are kept sealed until the auction
date. Two types of bids can be submitted: non-competitive tenders (usually
submitted by small investors and individuals) submitted in dollar amounts
(e.g., $1 million); and competitive bids (usually submitted by primary
dealers for their own accounts) submitted in terms of both desired unit price
(equivalently, yield to maturity or discount rate) and desired dollar
- On the day of the auction, officials at the Treasury Department first
subtract from the public securities offering the total dollar amount of
securities bid by non-competitive bidders (who automatically receive
securities) in order to determine the total dollar amount of securities
available to competitive bidders. For example, if $1 billion in
non-competitive tenders is received in an $11 billion public offering of
securities, $1 billion in securities will be awarded to non-competitive
bidders and $10 billion in securities will be awarded to competitive bidders.
The Treasury officials then work their way down the list of
competitively bid unit prices, starting with the highest, accepting the
dollar-amount bids for securities submitted with these prices until all
securities available for competitive bidders (e.g., $10 billion) have been
awarded. Any remaining competitive bids are then rejected. For 2-year and
5-year notes, a single-price auction scheme is used to set the actual price
of each security: specifically, all non-competitive bidders and all accepted
competitive bidders are awarded their dollar-amount bids at a uniform unit
price equal to the unit price bid by the marginal (last) accepted competitive
bidder. For all other securities, a more complicated multiple-price auction
scheme is used -- see the Fedpoint 41 publication, cited above, for details.
- Over-the-Counter Securities Markets:
- In over-the-counter securities markets (e.g., Nasdaq), dealers make
the market for particular types of securities (e.g., stocks) by posting their
own bid prices (offers to buy) and asked prices (offers to sell) for units of
the security. The difference between any particular dealer's asked price and
bid price for units of a security -- called the dealer's bid-asked
spread -- constitutes the dealer's anticipated gross profit margin on
trades in this security. For obvious reasons, bid-asked spreads are always
positive. An individual (or institution) wishing to buy or sell a security
in an over-the-counter market generally makes use of a broker. The broker
seeks out the best available bid or asked price posted by the dealers making
a market in this security and then executes the individual's desired trade.
3. Information Aggregation and Coordination
- Intermediation Financial Markets:
- It is difficult to get information about the credit
worthiness of individuals or small businesses, as well as to seek
out potential borrowers or lenders.
- The specialized information gathering resources and skills
of financial intermediaries help to reduce the costs of acquiring
information about potential borrowers and lenders. In addition,
financial intermediaries act as a coordination device by providing a
centralized facility to which would-be lenders and borrowers can
direct their demands and supplies for funds.
- Securities Markets:
- Financial assets sold in securities markets (i.e., in auction
markets, over-the-counter markets, or organized exchanges) are financial
assets that have been transformed into relatively liquid marketable assets by
means of various legally enforceable guarantees provided either by the
original issuer of the asset or by other parties.
- Many investment advisory firms provide publicly attainable
ratings for securities based on the perceived trustworthiness of
these guarantees. For example, Moody's Investors Service and the
Standard and Poor's Corporation provide default risk information by
rating the quality of corporate and municipal bonds, and Merrill
Lynch continually announces buy and sell recommendations for various
stocks. These ratings reduce the need for participants in
securities markets to acquire detailed information, themselves,
about the original issuers of the assets.
4. Risk Sharing
Risk refers to the degree of uncertainty concerning an asset's
- Risk Diversification:
- Financial markets permit savers to diversify their asset
portfolios by purchasing financial assets from many different
borrowers who face separate types of risks.
- In this way, even if some assets in the portfolio generate
low rates of return, these low rates may be offset by high rates of
return earned by other assets in the portfolio.
------------------- ASSET A (ISSUED BY
| AN HC CORPORATION)
PORTFOLIO ---->-------------------- ASSET B (ISSUED BY
OF AN | A ROW CORPORATION)
HC SAVER |
-------------------- ASSET C (ISSUED BY
| THE HC GOVERNMENT)
ONE SAVER ------> MANY DIFFERENT BORROWERS
- Risk Pooling:
- Conversely, financial markets permit borrowers to transfer
their risk to lenders by issuing financial assets to a pool of
savers that then collectively shares the risk (e.g., default)
------------ SAVER A
FINANCIAL ASSET ------->------------ SAVER B
ISSUED BY CORPORATION |
| ----------- SAVER C
ONE BORROWER ----------------> MANY DIFFERENT SAVERS
The liquidity of an asset refers to the ease with which that
asset can be converted into a means of payment for goods and
Securities markets enhance the opportunity for savers to save their
assets in relatively liquid form while still generating a stream of returns.
If a saver were to lend to a personal acquaintence rather than lending
through a securities market, he or she would typically lose out on the
liquidity offered by lending through a securities market because personal
loan agreements are generally not liquid. That is, it would generally be
difficult to sell such a loan contract to a third party in return for cash in
advance of the maturity of the loan.
Financial markets reduce transactions and
Securities markets provide centralized or decentralized means
for individual savers to purchase financial assets from borrowers.
Since the financial assets sold in securities markets are subject to
general legal restrictions (e.g., information disclosure laws),
individual savers do not need to engage, themselves, in the design
and enforcement of contracts with individual borrowers.
The manner in which transactions and information
costs are reduced in intermediation financial markets is more
complicated, involving a consideration of asymmetric information,
monitoring, and enforcement. These issues are introduced in
preliminary fashion below and taken up in much greater detail in
later parts of the course.
Additional Distinctions Among Securities Markets
Notes on Mishkin Chapter 2: Part A,
financial markets were classified into four basic structural types: auction
markets; over-the-counter markets, organized exchanges, and intermediation
financial markets. It was also pointed out that the first three types of
markets are generally referred to as securities markets.
Mishkin points out several additional important ways to distinguish
among the structure of securities markets that primarily concern the
properties of the securities being exchanged.
Note on Terminology: Mishkin interchangeably uses the term
"security" and "financial instrument," and we will do likewise.
- Primary versus Secondary Markets:
Primary markets are securities markets in which newly
issued securities are offered for sale to buyers. Secondary markets
are securities markets in which existing securities that have
previously been issued are resold. The initial issuer raises funds
only through the primary market.
- Debt Versus Equity Markets:
- Debt instruments are particular types of securities that
require the issuer (the borrower) to pay the holder (the lender) certain
specied payments at regularly scheduled intervals until a specified time
(the maturity date) is reached, regardless of the success or failure of any
investment projects for which the borrowed funds are used.
Debt instrument holders do not normally participate in the management
of the debt instrument issuer. In cases of bankruptcy, holders of debt instruments have first
claim on any remaining assets of the debt instrument issuer. An example of a debt instrument is a 30-year
- In contrast, an equity is a security that confers on the
holder an ownership interest in the issuer. There are two general categories of equities: "preferred stock"
and "common stock."
- Common stock shares issued by a corporation are claims to
a share of the assets of a corporation as well as to a share of the
corporation's net income -- i.e., the corporation's income after subtraction
of taxes and other expenses, including the payment of any debt obligations.
Thus, the return that common stock shareholders receive depends on
the economic performance of the issuing corporation.
- Holders of a corporation's common stock shares participate in any
upside performance of the corporation in two possible ways: by receiving a share of
net income in the form of dividends; and/or by enjoying an appreciation in the
price of their stock shares.
However, the payment of dividends is not a
contractual or legal requirement. Even if net earnings are positive, a
corporation is not obliged to distribute dividends to shareholders. For
example, a corporation might instead choose to keep its profits as retained
earnings to be used for new capital investment (self-financing of investment
rather than debt or equity financing). Moreover, in case of
bankruptcy, the claims of common stock share holders against any remaining assets of the
company are subordinate to the claims of all debt instrument holders.
- On the other hand, corporations cannot charge losses to their
common stock shareholders. Consequently, these shareholders at most risk
losing the purchase price of their shares, a situation which arises if the
market price of their shares declines to zero for any reason. An example of
a common stock share is a share of IBM.
- In contrast, preferred stock shares are usually issued with a
par value (e.g., $100) and pay a fixed dividend expressed as a percentage of
par value. Preferred stock is a claim against a corporation's cash flow that
is prior to the claims of its common stock shareholders but is generally
subordinate to the claims of its debt instrument holders. In addition, like debt
holders but unlike common stock shareholders, preferred stock shareholders generally do
not participate in the management of issuers through voting or other
means unless the issuer is in extreme financial distress (e.g., insolvency).
Consequently, preferred stock combines some of the basic attributes of both
debt and common stock and is often referred to as a hybrid security.
- Money versus Capital Markets:
- The money market is the market for shorter-term securities,
generally those with one year or less remaining to maturity.
- Examples: U.S. Treasury bills; negotiable bank certificates
of deposit (CDs); commercial paper, Federal funds; Eurodollars.
- Remark: Although the maturity on certificates of deposit
(CDs) -- i.e., on large time deposits at depository institutions -- can run
anywhere from 30 days to over 5 years, most CDs have a maturity of less than
one year. Those with a maturity of more than one year are referred to as
term CDs. A CD that can be resold without penalty in a secondary
market prior to maturity is known as a negotiable CD.
- The capital market is the market for longer-term securities,
generally those with more than one year to maturity.
- Examples: Corporate stocks; residential mortgages; U.S.
government securities (marketable long-term); state and local government
bonds; bank commercial loans; consumer loans; commercial and farm mortgages.
- Remark: Corporate stocks are conventionally considered to be
long-term securities because they have no maturity date.
- Domestic Versus Global Financial Markets:
- As Mishkin notes in Chapter 2, financial markets are becoming
increasingly international in nature, in the sense that various types of
financial assets issued by one country may be purchased by nationals of
- Eurocurrencies are currencies deposited in banks outside the
country of issue. For example, eurodollars, a major form of
eurocurrency, are U.S. dollars deposited in foreign banks outside the U.S. or
in foreign branches of U.S. banks. That is, eurodollars are
dollar-denominated bank deposits held in banks outside the U.S.
- An international bond is a bond available for sale outside the
country of its issuer.
- Example of an International Bond: a bond issued by a U.S. firm
that is available for sale both in the U.S. and abroad.
- A foreign bond is an international bond issued by a country that
is denominated in a foreign currency and that is for sale exclusively in the
country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is
denominated in Japanese yen and that is for sale exclusively in Japan.
A Eurobond is an international bond denominated in a currency other
than that of the country in which it is sold. An example would be a bond issued
by a U.S. borrower, denominated in U.S. dollars, and
sold outside the U.S.
- Example of a Eurobond: Bonds sold by the U.S. government to
Japan that are denominated in U.S. dollars.
Asymmetric Information in Financial Markets
Asymmetric information in a market for goods, services, or financial
assets refers to differences ("asymmetries") between the information
available to buyers and the information available to sellers. For example,
in markets for financial assets, asymmetric information may arise between
lenders (buyers of financial assets) and borrowers (sellers of financial
Problems arising in markets due to asymmetric information are typically
divided into two basic types: "adverse selection;" and "moral hazard." This
section explains these two types of problems, using financial markets for
1. Adverse Selection
Adverse selection is a problem that arises for a buyer of a good,
service, or asset when the buyer has difficulty assessing the quality of
this item in advance of purchase. Buyers might then offer to buy the
item at a price equal to the average (expected) quality of the item.
But this encourages sellers of high-quality items to EXIT the market
and sellers of low-quality items to ENTER the market, lowering the
average quality of items for sale.
Consequently, adverse selection is a problem that arises because of
different ("asymmetric") information between a buyer and a seller
before any purchase agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
- In the context of a loan market, an adverse selection problem
can arise between lenders (i.e., buyers of newly issued financial assets)
and borrowers (i.e., sellers of newly issued financial assets).
In particular, if a lender sets contractual terms in advance in an
attempt to protect himself against the consequences of inadvertently
lending to high risk borrowers, these contractual terms might have
the perverse effect of
encouraging high risk borrowers to self-select INTO the lender's
loan applicant pool while at the same time encouraging low risk
borrowers to self-select OUT of this pool. In this case, the
lender's pool of loan applicants is adversely affected in the sense
that the average quality of borrowers in the pool decreases.
- Suppose, for example, that 50% of potential borrowers in the
population at large are high risk, in the sense that there is a high
probability they would default on their loan payments, and 50% are
low risk in the sense that there is a low probability they would
default on their loan payments. A banker is willing to loan to high
risk borrowers at an 11% interest rate and to low risk borrowers at
a 5% interest rate. Thus, the "risk premium" required by the bank
- Prior to making a loan to any individual, the bank has no way of
knowing whether the individual is a high risk or a low risk
borrower. However, the bank knows that the two types of individuals
(high risk and low risk) are equally represented in the population.
Consequently, prior to actually making any loans, the bank concludes
there is a 50-50 chance that any given would-be borrower is high
risk or low risk. It might therefore seem reasonable to the bank to
charge an interest rate that is an average of the rates for high and
low risk borrowers, so the bank sets its loan interest rate at 8%.
- Unfortunately for the bank, high risk borrowers will view 8% as
a great rate since they know the riskiness of their projects
actually warrants a higher rate -- indeed, they would be required to
pay 11% if the bank knew their true quality. Consequently, high risk
borrowers have an incentive to apply for loans from the bank. On
the other hand, low risk borrowers will view 8% as an unnecessarily
high and costly rate, and they might turn elsewhere for funds or
abandon their intended investment projects altogether.
- Consequently, although high risk and low risk borrowers are
equally represented in the population at large, when the bank offers a
loan rate of 8% the percentage of high risk borrowers attracted to
the bank's pool of loan applicants will tend to rise above 50%
and the percentage of low risk borrowers in this pool will tend to
fall below 50%.
- Being rational, the bank might be able to predict this
eventuality in advance, in which case the bank might conclude it
should set an interest rate higher than 8% to compensate for the
fact that more than 50% of its loan applicant pool will be high
risk. However, the effect of any such increase will only be to
further compound the adverse selection problem, because low risk
borrowers will have an additional incentive to select out of the
bank's loan applicant pool. Indeed, all low risk borrowers may
eventually be driven out of this pool altogether, leaving only high
risk borrowers who are each charged a rate of 11%. To the extent
that profits could also have been made on low risk borrowers at a
rate as low as 5%, the bank will then be missing out on good profit
Potential solutions to adverse selection problems in the context of
financial markets will be taken up in later parts of the course.
2. Moral Hazard
Moral hazard is said to exist in a market if, after
of a purchase agreement between the buyer and seller of a good, service, or
- the seller changes his or her behavior in such a way that
the probabilites (risk calculations) used by the buyer to determine
the terms of the purchase agreement are no longer accurate;
- the buyer is only imperfectly able to monitor (observe) this
change in the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases
a loan contract from a borrower, the borrower increases the risks originally
associated with the loan contract by investing his borrowed funds in more
risky projects than he originally reported to the lender.
This is precisely the type of moral hazard problem that arose in the
savings and loan debacle in the United Stated during the 1980s. In essence,
the government, through the agency of a regulatory body called the Federal
Savings and Loan Insurance Corporation (FSLIC), fully insured the majority of
the deposit accounts held by savings and loan (S and L) associations. When
the ceiling on depositor interest rates was lifted in the mid 1980's -- so that
S and L's now had to offer higher interest rates to depositors to compete for funds --
the S and L's then
had every incentive to move into riskier lending at higher charged interest
rates in an attempt to maintain their profit margins (borrow low-lend high).
This, in turn, significantly increased their probability of
bankruptcy, and hence the risk to taxpayers --- the ultimate underwriters of
Potential solutions to moral hazard problems will be taken up in later
parts of the course.
As noted by Mishkin, government regulates financial markets for three
Discussion of these forms of regulation will be taken up in later
sections of the course, particularly in Section 3. It may be useful,
however, to give a few preliminary remarks here on the specific types
of regulations imposed in securities markets and intermediation
- Efficiency: to increase the information available to investors;
- Stability: to ensure the soundness of the financial system;
- Optimality: and to improve the control of monetary policy.
A key problem in securities markets is that small investors cannot
easily judge the risks associated with the purchase of bonds and stock shares
issued by firms. As previously noted, various private investment advisory
firms have formed in response to this problem who collect information on the
quality of bonds and stock shares. Nevertheless, these private firms cannot
always collect truthful information, and the amount and type of information
they do collect is geared more to their own individual profitability than to
the welfare of society at large.
For these reasons, government policy makers have argued for the need for
government regulations requiring issuers of bonds and stock shares to
disclose information about their financial condition. For example, the
Securities and Exchange Commission (SEC), established by the Securities
Act of 1933, requires corporations issuing securities to represent these
securities truthfully and restricts "insider trading," i.e., trading by the
largest corporate shareholders on the basis of privileged (non-public)
Intermediation Financial Markets:
Adverse selection and moral hazard problems are endemic in
intermediation financial markets.
As noted above, the quality of loan application pools may be
degraded as a consequence of efforts by financial intermediaries
to protect themselves against the risk of making loans to
In addition, financial intermediaries are subject to two
different forms of moral hazard. On the one hand, the financial
intermediary has to worry about moral hazard problems arising from
changed behavior by its borrowers after loan contracts have been
made. On the other hand, the financial intermediary has to assure
its own creditors (e.g., depositors) that it will not engage in
behavior that endangers the soundness of the creditors' claims
against it. If creditors lose faith in the soundness of the
financial intermediary for any reason, valid or not, this can result
in a financial panic in which many creditors desperately attempt to
withdraw their funds from the financial intermediary all at the same
time, which could bankrupt the financial intermediary.
In an attempt to alleviate these and other problems perceived
to arise in intermediation financial markets, the government in the
past has imposed five basic types of regulations on financial
- Entry Restrictions: Restrictions on who is allowed
to set up a financial intermediary (i.e., chartering and
- Information Reporting: Restrictions regarding the
reporting requirements for financial intermediaries;
- Risk Reduction: Restrictions on participation in
activities perceived to be risky (e.g., stock purchases);
- Insurance Provision: Restrictions forcing financial
intermediaries to participate in government-backed
- Restrictions on Competition: For example, branching
restrictions imposed on banks to protect small banks from
competition, and ceiling restrictions on allowable
interest rates on deposit accounts in order to lessen
competition for funds on the basis of interest rates, etc.
The effectiveness of these and other forms of government
regulations, and the extent to which they have been successfully or
unsuccesfully challenged, will be taken up in Section 3 of the course.
Basic Concepts and Key Issues from Mishkin Chapter 2 (Part B)
- Basic Concepts: Mishkin Chapter 2 (Part B)
- Borrowing and Lending
- Direct Finance
- Indirect Finance
- Risk Sharing
- Risk Pooling
- Primary Market
- Secondary Market
- Debt Market
- Equity Market
- Money Market
- Capital Market
- Negotiable (i.e., can be resold without penalty)
- International bond
- Foreign bond
- Asymmetric Information
- Moral Hazard
- Adverse Selection
- Financial regulation
- Key Issues: Mishkin Chapter 2 (Part B)
- Financial Exchange vs. Instances of Finance
- Direct vs. Indirect Finance
- Distinctions Among Securities Markets by Asset Characteristics
- Moral Hazard Problems in Financial Markets
- Adverse Selection Problems in Financial Markets
- Reasons for Financial Regulations in Various Types of Financial Markets
Copyright © 2011 Leigh Tesfatsion. All Rights Reserved.