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

Last Updated: 24 January 2011
Latest Course Offering: Spring 2011

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

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.


                SAVINGS                INVESTMENT
    HOUSEHOLD  --------->  BUSINESS   ------------>   PROJECTS
     SECTOR                 SECTOR

There are two central mechanisms for the transfer of funds from savers to borrowers to facilitate new acts of borrowing: indirect finance; and direct finance.

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."

             INTEREST                     INTEREST
             ON SAVINGS                   ON LOANS
   SAVERS  <------------   FINANCIAL    <----------   FIRMS
                          INTERMEDIARY

             "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 amounts.

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 return.

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)
      ASSET           |
      PORTFOLIO   ---->-------------------- ASSET B (ISSUED BY
      OF AN           |                     A ROW CORPORATION)
      HC SAVER        |
                       -------------------- ASSET C (ISSUED BY
                      |                     THE HC GOVERNMENT)
                      |
                        ETC.


      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) burden.

                                    ------------  SAVER A
                                   |
                                   |
      FINANCIAL ASSET       ------->------------  SAVER B
      ISSUED BY CORPORATION        |
                                   |
                                   | -----------  SAVER C
                                   |
                                    etc.


      ONE BORROWER ---------------->  MANY DIFFERENT SAVERS


5. Liquidity

The liquidity of an asset refers to the ease with which that asset can be converted into a means of payment for goods and services.

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.


6. Efficiency

Financial markets reduce transactions and information costs.

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

In 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 mortgage.

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 another country.

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 assets).

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 concrete illustration.

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 is 6%.

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 opportunities.

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 the signing of a purchase agreement between the buyer and seller of a good, service, or financial asset:

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 FSLIC insurance.

Potential solutions to moral hazard problems will be taken up in later parts of the course.

Financial Regulation

As noted by Mishkin, government regulates financial markets for three main reasons:

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 financial markets.

Securities Markets:

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) information.

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 default-prone borrowers.

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 intermediaries:

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
Risk Sharing
Risk Pooling
Liquidity
Primary Market
Secondary Market
Debt Market
Equity Market
Money Market
Capital Market
Negotiable (i.e., can be resold without penalty)
Eurocurrency
Eurodollar
International bond
Foreign bond
Eurobond
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.