Description
Prepare an (approximately) 250 word summary of the textbook material you have read this week on Chapter 6. This summary should be entered in your learning journal this week.The Financial System
CHAPTER OBJECTIVE S
By the end of this chapter, students should be able to:
1. Critique cultural stereotypes of financiers.
2. Describe the financial system and the work that it performs.
3. Define asymmetric information and sketch the problems that it causes.
4. List the major types of financial markets and describe what distinguishes them.
5. List the major types of financial instruments or securities and describe what distinguishes them.
6. List the major types of intermediaries and describe what distinguishes them.
7. Describe and explain the most important trade-offs facing investors.
8. Describe and explain borrowers’ major concerns.
9. Explain the functions of financial regulators.
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2.1 Evil and Brilliant Financiers?
L EARNING OBJECTIVE
1. Are bankers, insurers, and other financiers innately good or evil?
Ever notice that movies and books tend to portray financiers as evil and powerful monsters, bent on
destroying all that decent folks hold dear for the sake of a fast buck? In his best-selling 1987
novel Bonfire of the Vanities, [1] for example, Tom Wolfe depicts Wall Street bond trader Sherman
McCoy (played by Tom Hanks in the movie version) [2] as a slimy “Master of the Universe”: rich,
powerful, and a complete butthead. Bashing finance is not a passing fad; you may recall the unsavory
Shylock character from Shakespeare’s play The Merchant of Venice. [3] And who could forget Danny
DeVito [4] as the arrogant little donut-scarfing “Larry the Liquidator” juxtaposed against the adorable
old factory owner Andrew Jorgenson (played by Gregory Peck) [5] in Other People’s Money. [6] Even the
Christmas classic It’s a Wonderful Life [7] contains at best a dual message. In the film, viewers learn
that George Bailey, the lovable president of the local building and loan association (a type of
community bank) played by Jimmy Stewart, saved Bedford Falls from the clutches of a character
portrayed by Lionel Barrymore, actress Drew Barrymore’s grand-uncle, the ancient and evil financier
Henry F. Potter. (No relation to Harry, I’m sure.) That’s hardly a ringing endorsement of finance. [8]
Truth be told, some financiers have done bad things. Then again, so have members of every
occupational, geographical, racial, religious, and ethnic group on the planet. But most people, most of
the time, are pretty decent, so we should not malign entire groups for the misdeeds of a few, especially
when the group as a whole benefits others. Financiers and the financial systems they inhabit benefit
many people in wealthier countries. The financial system does so much good for the economy, in
fact, that some people believe that financiers are brilliant rocket scientists or at least “the smartest
guys in the room.” [9] This positive stereotype, however, is as flawed as the negative one. While some
investment bankers, insurance actuaries, and other fancy financiers could have worked for NASA,
they are far from infallible. The financial crisis that began in 2007 reminds us, once again, that
complex mathematical formulas are less useful in economics (and other social sciences) than in
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astrophysics. Financiers, like politicians, religious leaders, and, yes, college professors, have made
colossal mistakes in the past and will undoubtedly do so again in the future.
So rather than lean on stereotypes, this chapter will help you to form your own view of the financial
system. In the process, it will review the entire system. It’s well worth your time and effort to read this
chapter carefully because it contains a lot of descriptive information and definitions that will help you
later in the text.
KEY TAKEAWAYS
Financiers are not innately good or evil but rather, like other people, can be either, or can even be both
simultaneously.
While some financiers are brilliant, they are not infallible, and fancy math does not reality make.
Rather than follow prevalent stereotypes, students should form their own views of the financial system.
This important chapter will help students to do that, while also bringing them up to speed on key terms
and concepts that will be used throughout the book.
[1] www.amazon.com/Bonfire-Vanities-Tom-Wolfe/dp/0553275976
[2] www.imdb.com/title/tt0099165/
[3] http://www.bibliomania.com/0/6/3/1050/frameset.html
[4] www.imdb.com/name/nm0000362/
[5] www.imdb.com/name/nm0000060/
[6] www.imdb.com/title/tt0102609/
[7] www.nndb.com/films/309/000033210/
[8] video.google.com/videoplay?docid=4820768732160163488&pr=goog-sl
[9] en.wikipedia.org/wiki/The_Smartest_Guys_in_the_Room
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2.2 Financial Systems
L EARNING OBJECTIVE
1. What is a financial system and why do we need one?
A financial system is a densely interconnected network of financial intermediaries, facilitators, and
markets that serves three major purposes: allocating capital, sharing risks, and facilitating
intertemporal trade. That sounds mundane, even boring, but it isn’t once you understand how
important it is to human welfare. The material progress and technological breakthroughs of the last
two centuries, ranging from steam engines, cotton gins, and telegraphs, to automobiles, airplanes,
and telephones, to computers, DNA splicing, and cell phones, would not have been possible without
the financial system. Efficiently linking borrowers to lenders is the system’s main function.
Borrowers include inventors, entrepreneurs, and other economic agents, like domestic households,
governments, established businesses, and foreigners, with potentially profitable business ideas
(positive net present value projects) but limited financial resources (expenditures > revenues).
Lenders or savers include domestic households, businesses, governments, and foreigners with excess
funds (revenues > expenditures). The financial system also helps to link risk-averse entities called
hedgers to risk-loving ones known as speculators. As Figure 2.1 ““The financial system at work for
you”?” illustrates, you are probably already deeply imbedded in the financial system as both a
borrower and as a saver.
Figure 2.1 “The financial system at work for you”?
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Occasionally, people and companies, especially small businesses or ones that sell into rapidly
growing markets, have enough wealth (a stock) and income (a flow) to implement their ideas without
outside help by plowing back profits (aka internal finance). Most of the time, however, people and firms
with good ideas do not have the savings or cash needed to draw up blueprints, create prototypes, lease
office or production space, pay employees, obtain permits and licenses, or suffer the myriad risks of
bringing a new or improved good to market. Without savings, a rich uncle or close friend, or some
other form of external finance, people remain wannabe entrepreneurs and companies cannot
complete their projects. That should concern you because the world is a poorer place for it. [1]
Why do we need a financial system? Why can’t individuals and companies simply borrow from other
individuals and companies when they need to? Lending, like supplying many other types of goods, is
most efficiently and cheaply conducted by specialists, companies that do only one thing (or a couple of
related activities) very well because they have much practice doing it and because they tap economies of
scale. The fixed costs of making loans—advertising for borrowers, buying and maintaining
computers, leasing suitable office space, and the like—are fairly substantial. To recoup those fixed
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costs, to drive them toward insignificance, lenders have to do quite a volume of business. Little guys
usually just can’t be profitable. This is not to say, however, that bigger is always better, only that to be
efficient financial companies must exceed minimum efficient scale.
KEY TAKEAWAYS
The financial system is a dense network of interrelated markets and intermediaries that allocates capital
and shares risks by linking savers to spenders, investors to entrepreneurs, lenders to borrowers, and the
risk-averse to risk-takers.
It also increases gains from trade by providing payment services and facilitating intertemporal trade.
A financial system is necessary because few businesses can rely on internal finance alone.
Specialized financial firms that have achieved minimum efficient scale are better at connecting investors
to entrepreneurs than nonfinancial individuals and companies.
[1] www.innovation-america.org/archive.php?articleID=79
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2.3 Asymmetric Information: The Real Evil
L EARNING OBJECTIVE
1. What is asymmetric information, what problems does it cause, and what can mitigate it?
Finance also suffers from a peculiar problem that is not easily overcome by just anybody. Undoubtedly,
you’ve already encountered the concept of opportunity costs, the nasty fact that to obtain X you must
give up Y, that you can’t have your cake and eat it too. You may not have heard of asymmetric
information, another nasty fact that makes life much more complicated. Likescarcity, asymmetric
information inheres in nature, the devil incarnate. That is but a slight exaggeration. When a seller
(borrower, a seller of securities) knows more than a buyer (lender or investor, a buyer of securities),
only trouble can result. Like the devil in Dante’s Inferno, [1] this devil has two big ugly
heads, adverse selection, which raises Cain before a contract is signed, and moral hazard, which
entails sinning after contract consummation. (Later, we’ll learn about a third head, the principalagency
problem, a special type of moral hazard.)
Due to adverse selection, the fact that the riskiest borrowers are the ones who most strongly desire
loans, lenders attract sundry rogues, knaves, thieves, and ne’er-do-wells, like pollen-laden flowers
attract bees (Natty Light [2] attracts frat boys?). If they are unaware of that selection bias, lenders will
find themselves burned so often that they will prefer to keep their savings under their mattresses rather
than risk lending it. Unless recognized and effectively countered, moral hazard will lead to the same
suboptimal outcome. After a loan has been made, even good borrowers sometimes turn into thieves
because they realize that they can gamble with other people’s money. So instead of setting up a nice
little ice cream shop with the loan as they promised, a disturbing number decide instead to try to get
rich quick by taking a quick trip to Vegas or Atlantic City [3] for some potentially lucrative fun at the
blackjack table. If they lose, they think it is no biggie because it wasn’t their money.
One of the major functions of the financial system is to tangle with those devilish information
asymmetries. It never kills asymmetry, but it usually reduces its influence enough to let businesses
and other borrowers obtain funds cheaply enough to allow them to grow, become more efficient,
innovate, invent, and expand into new markets. By providing relatively inexpensive forms of external
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finance, financial systems make it possible for entrepreneurs and other firms to test their ideas in the
marketplace. They do so by eliminating, or at least reducing, two major constraints
on liquidity and capital, or the need for short-term cash and long-term dedicated funds. They reduce
those constraints in two major ways: directly (though often with the aid of facilitators) viamarkets and
indirectly via intermediaries. Another way to think about that is to realize that the financial system
makes it easy to trade intertemporally, or across time. Instead of immediately paying for supplies
with cash, companies can use the financial system to acquire what they need today and pay for it
tomorrow, next week, next month, or next year, giving them time to produce and distribute their
products.
Stop and Think Box
You might think that you would never stoop so low as to take advantage of a lender or insurer. That may
be true, but financial institutions are not worried about you per se; they are worried about the typical
reaction to asymmetric information. Besides, you may not be as pristine as you think. Have you ever done
any of the following?
Stolen anything from work?
Taken a longer break than allowed?
Deliberately slowed down at work?
Cheated on a paper or exam?
Lied to a friend or parent?
If so, you have taken advantage (or merely tried to, if you were caught) of asymmetric information.
KEY TAKEAWAYS
Asymmetric information occurs when one party knows more about an economic transaction or asset than
the other party does.
Adverse selection occurs before a transaction takes place. If unmitigated, lenders and insurers will attract
the worst risks.
Moral hazard occurs after a transaction takes place. If unmitigated, borrowers and the insured will take
advantage of lenders and insurers.
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Financial systems help to reduce the problems associated with both adverse selection and moral hazard.
[1] http://www.fullbooks.com/Dante-s-Inferno.html
[2] www.urbandictionary.com/define.php?term=natty+light
[3]www.pickeringchatto.com/index.php/pc_site/monographs/gambling_on_the_american_dream
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2.4 Financial Markets
L EARNING OBJECTIVE
1. In what ways can financial markets and instruments be grouped?
Financial markets come in a variety of flavors to accommodate the wide array of financial instruments
or securities that have been found beneficial to both borrowers and lenders over the years. Primary
markets are where newly created (issued) instruments are sold for the first time. Most securities are
negotiable. In other words, they can be sold to other investors at will in what are called secondary
markets. Stock exchanges, or secondary markets for ownership stakes in corporations called stocks
(aka shares or equities), are the most well-known type, but there are also secondary markets for debt,
including bonds (evidences of sums owed, IOUs), mortgages, and derivatives and other instruments.
Not all secondary markets are organized as exchanges, centralized locations, like the New York Stock
Exchange or the Chicago Board of Trade, for the sale of securities. Some are over-the-counter (OTC)
markets run by dealers connected via various telecom devices (first by post and semaphore [flag
signals], then by telegraph, then telephone, and now computer). Completely electronic stock markets
have gained much ground in recent years. [1]
Money markets are used to trade instruments with less than a year to maturity (repayment of
principal). Examples include the markets for T-bills (Treasury bills or short-term government
bonds), commercial paper (short-term corporate bonds), banker’s acceptances (guaranteed bank
funds, like a cashier’s check), negotiable certificates of deposit (large-denomination negotiable CDs,
called NCDs), Fed funds (overnight loans of reserves between banks), call loans (overnight loans on
the collateral of stock), repurchase agreements (short-term loans on the collateral of T-bills), and
foreign exchange (currencies of other countries).
Securities with a year or more to maturity trade in capital markets. Some capital market instruments,
called perpetuities, never mature or fall due. Equities (ownership claims on the assets and income of
corporations) and perpetual interest-only loans are prime examples. (Some interest-only loans
mature in fifteen or thirty years with a so-called balloon payment, in which the principal falls due all
at once at the end of the loan.) Most capital market instruments, including mortgages (loans on real
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estate collateral), corporate bonds, government bonds, and commercial and consumer loans, have
fixed maturities ranging from a year to several hundred years, though most capital market
instruments issued today have maturities of thirty years or less. Figure 2.3 “Types of financial
markets” briefly summarizes the differences between various types of financial markets.
Figure 2.3 Types of financial markets
Derivatives contracts trade in a third type of financial market. Derivatives allow investors to spread
and share a wide variety of risks, from changes in interest rates and stock market indices [2] to
undesirable weather conditions [3](too sunny for farmers, too rainy for amusement parks, too cold for
orange growers, too hot for ski resorts). Financial derivatives are in some ways even more
complicated than the derivatives in calculus, so they are usually discussed in detail only in more
specialized or advanced courses. (Here is a spot where your instructor might provide custom
content.)
Some call financial markets “direct finance,” though most admit the term is a misnomer because the
functioning of the markets is usually aided by one or more market facilitators, including brokers,
dealers, brokerages, and investment banks. Brokers facilitate secondary markets by linking sellers to
buyers of securities in exchange for a fee or a commission, a percentage of the sale price. Dealers
“make a market” by continuously buying and selling securities, profiting from the spread, or the
difference between the sale and purchase prices. (For example, a dealer might buy a certain type of
bond at, say, $99 and resell it at $99.125, ten thousand times a day.) Brokerages engage in both
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brokering and dealing and usually also providing their clients with advice and information.
Investment banks facilitate primary markets by underwriting stock and bond offerings, including
initial public offerings (IPOs) of stocks, and by arranging direct placements of bonds. Sometimes
investment banks act merely as brokers, introducing securities issuers to investors, usually
institutional investors like the financial intermediaries discussed below. Sometimes they act as
dealers, buying the securities themselves for later (hopefully soon!) resale to investors. And
sometimes they provide advice, usually regarding mergers and acquisitions. Investment banks took a
beating during the financial crisis that began in 2007. Most of the major ones went bankrupt or
merged with large commercial banks. Early reports of the death of investment banking turned out to
be premature, but the sector is depressed at present; two large ones and numerous small ones, niche
players called boutiques, remain. [4]
Stop and Think Box
In eighteenth-century Pennsylvania and Maryland, people could buy real estate, especially in urban areas,
on so-called ground rent, in which they obtained clear title and ownership of the land (and any buildings
or other improvements on it) in exchange for the promise to pay some percentage (usually 6) of the
purchase price forever. What portion of the financial system did ground rents (some of which are still
being paid) inhabit? How else might ground rents be described?
Ground rents were a form of market or direct finance. They were financial instruments or, more
specifically, perpetual mortgages akin to interest-only loans.
Financial markets are increasingly international in scope. Integration of transatlantic financial
markets began early in the nineteenth century and accelerated after the mid-nineteenth-century
introduction of the transoceanic telegraph systems. The process reversed early in the twentieth
century due to World Wars I and II and the cold war; the demise of the gold standard; [5] and the rise
of the Bretton Woods [6] system of fixed exchange rates, discretionary monetary policy, and capital
immobility. (We’ll explore these topics and a related matter, the so-called trilemma, or impossible
trinity, in Chapter 19 “International Monetary Regimes”.) With the end of the Bretton Woods
arrangement in the early 1970s and the cold war in the late 1980s/early 1990s, financial globalization
