Role of Financial Markets and Institutions PDF

LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC ROLE OF FINANCIAL MARKETS AND INSTITUTIONS ▪​ delegated monitor- An economic agent appointed to act on behalf of smaller...

LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC ROLE OF FINANCIAL MARKETS AND INSTITUTIONS ▪​ delegated monitor- An economic agent appointed to act on behalf of smaller investors in collecting information and/or investing funds on their behalf. Chapter Objectives ▪​ asset transformers- Financial claims issued by an FI that are more attractive to 1.​ Describe the types of financial markets that facilitate the flow of funds. investors than are the claims directly issued by corporations. 2.​ Describe the types of securities traded within financial markets. ▪​ diversify- The ability of an economic agent to reduce risk by holding a number 3.​ Describe the role of financial institutions within financial markets. of securities in a portfolio 4.​ Explain how financial institutions were exposed to the credit crisis. ▪​ economies of scale- The concept that cost reduction in trading and other transaction services results from increased efficiency when FIs perform these Definition of Terms services. ▪​ financial markets- The arenas through which funds flow. ▪​ etrade- Buying and selling shares on the Internet. ▪​ primary markets- Markets in which corporations raise funds through new ▪​ commercial banks —depository institutions whose major assets are loans and issues of securities. whose major liabilities are deposits. Commercial banks’ loans are broader in ▪​ initial public offerings (IPOs)-The first public issue of financial instruments range, including consumer, commercial, and real estate loans, than are those of by a firm. other depository institutions. Commercial banks’ liabilities include more ▪​ secondary market- A market that trades financial instruments once they are nondeposit sources of funds, such as subordinate notes and debentures, than do issued. those of other depository institutions. ▪​ derivative security- A financial security whose payoffs are linked to other, ▪​ thrifts —depository institutions in the form of savings associations, savings previously issued securities. banks, and credit unions. Thrifts generally perform services similar to ▪​ money markets- Markets that trade debt securities or instruments with commercial banks, but they tend to concentrate their loans in one segment, such maturities of one year or less. as real estate loans or consumer loans. ▪​ over-the-counter (OTC) markets- Markets that do not operate in a specific ▪​ insurance companies —financial institutions that protect individuals and fixed location—rather, transactions occur via telephones, wire transfers, and corporations (policyholders) from adverse events. Life insurance companies computer trading. provide protection in the event of untimely death, illness, and retirement. ▪​ capital markets- Markets that trade debt (bonds) and equity (stocks) Property casualty insurance protects against personal injury and liability due to instruments with maturities of more than one year. accidents, theft, fire, and so on. ▪​ derivative security markets- The markets in which derivative securities trade. ▪​ securities firms and investment banks —financial institutions that help firms derivative security An agreement between two parties to exchange a standard issue securities and engage in related activities such as securities brokerage and quantity of an asset at a predetermined price on a specified date in the future. securities trading. ▪​ financial institutions- Institutions that perform the essential function of ▪​ finance companies —financial intermediaries that make loans to both channeling funds from those with surplus funds to those with shortages of individuals and businesses. Unlike depository institutions, finance companies funds. do not accept deposits but instead rely on short- and long-term debt for funding. ▪​ direct transfer- A corporation sells its stock or debt directly to investors ▪​ mutual funds —financial institutions that pool financial resources of without going through a financial institution. individuals and companies and invest those resources in diversified portfolios of ▪​ liquidity- The ease with which an asset can be converted into cash at its fair assets. market value. ▪​ hedge funds —financial institutions that pool funds from a limited number ▪​ price risk- The risk that an asset’s sale price will be lower than its purchase (e.g., less than 100) of wealthy (e.g., annual incomes of more than $200,000 or price. net worth exceeding $1 million) individuals and other investors (e.g., ▪​ indirect transfer- A transfer of funds between suppliers and users of funds commercial banks) and invest these funds on their behalf, usually keeping a through a financial intermediary. large proportion (commonly 20 percent) of any upside return and charging a fee (2%) on the amount invested.  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC ▪​ pension funds —financial institutions that offer savings plans through which debt securities when they need funds but might not be financially fund participants accumulate savings during their working years before capable of making the periodic interest payments required for debt withdrawing them during their retirement years. Funds originally invested in securities. and accumulated in a pension fund are exempt from current taxation. Accommodating Corporate Finance Needs: The financial markets serve as the mechanism whereby corporations (acting as deficit units) can obtain funds from Financial Market investors (acting as surplus units). A market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party Accommodating Investment Needs: Financial institutions serve as intermediaries purchases financial assets previously held by another party. to connect the investment management activity with the corporate finance activity. (Exhibit 1.1) Role of Financial Markets Financial markets transfer funds from those who have excess funds to those who need funds. ▪​ Surplus units: participants who receive more money than they spend, such as investors. ▪​ Deficit units: participants who spend more money than they receive, such as borrowers. ​ Example: College students are typically deficit units, as they often borrow from financial markets to support their education. After they obtain their degree, graduates may earn more income than they spend and become surplus units by investing their excess funds. A few years later, they may become deficit units again when they purchase a home. At this stage, they may provide funds to and access funds from financial markets simultaneously. That is, they may periodically deposit savings in a financial institution while also borrowing a large amount of money from a financial institution to buy a home. ▪​ Securities: represent a claim on the issuers o​ Debt securities - debt (also called credit, or borrowed funds) incurred by the issuer. The deficit unit shall issue debt securities in order to access funds from the financial markets. The surplus units that purchase debt securities are creditors, and they receive interest on a periodic basis. Debt securities have a maturity date, at which time the surplus units can redeem the securities and receive the principal (face value) from the deficit units that issued them. o​ Equity securities - (also called stocks) represent equity or ownership in the firm. Some businesses prefer to issue equity securities rather than  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Primary versus Secondary Markets ▪​ Primary markets - facilitate the issuance of new securities; such as stocks and bonds. o​ Primary market financial instruments include issues of equity by firms initially going public (e.g., allowing their equity—shares—to be publicly traded on stock markets for the first time). These first-time issues are usually referred to as initial public offerings (IPOs) ▪​ Secondary markets - facilitate the trading of existing securities, which allows for a change in the ownership of the securities; by selling securities that they own and buying other securities. o​ Once financial instruments such as stocks are issued in primary markets, they are then traded—that is, rebought and resold—in secondary markets. o​ Many types of debt securities have a secondary market, so that investors who initially purchased them in the primary market do not have to hold them until maturity. o​ An important characteristic of securities that are traded in secondary markets is liquidity, which is the degree to which securities can easily be liquidated (sold) without a loss of value o​ If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer.  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Securities Traded in Financial Markets corporations are subject to default (credit) risk because the issuer could Securities can be classified as money market securities, capital market securities, or default on its obligation to repay the debt. These bonds must offer a derivative securities. higher expected return than Treasury bonds to compensate investors for that default risk. (high risk, high return) 1.​ Money Market Securities- facilitate the sale of short-term debt securities by deficit units to surplus units. ▪​ Mortgages ▪​ Debt securities that have a maturity of one year or less −​ long-term debt obligations created to finance the purchase of real estate ▪​ Generally have a relatively high degree of liquidity −​ Prime mortgages are offered to borrowers who are assessed to have ▪​ Commonly have an active secondary market enough income to pay the mortgage ▪​ Tend to have a low expected return but also a low degree of credit (default) −​ Subprime mortgages are offered to some borrowers who do not have risk sufficient income to qualify for prime mortgages or who are unable to ▪​ Examples: Treasury bills (issued by the government), commercial paper make a down payment; carry a higher risk of default, so the lenders (issued by corporations), and negotiable certificates of deposit (issued by providing these mortgages charge a higher interest rate (and additional depository institutions) up-front fees) to compensate for that factor. (research about the 2008 financial crisis) MONEY MARKET INSTRUMENTS −​ Commercial mortgages are long-term debt obligations created to ▪​ Treasury bills —short-term obligations issued by the U.S. government. finance the purchase of commercial property. Real estate developers ▪​ Federal funds —short-term funds transferred between financial institutions rely on commercial mortgages so that they can build shopping centers, usually for no more than one day. office buildings, or other facilities. Financial institutions serve as ▪​ Repurchase agreements —agreements involving the sale of securities by lenders by providing commercial mortgages. one party to another with a promise by the seller to repurchase the same securities from the buyer at a specified date and price. ▪​ Mortgage-backed securities - debt obligations representing claims on a ▪​ Commercial paper —short-term unsecured promissory notes issued by a package of mortgages. company to raise short-term cash. Example: ▪​ Negotiable certificate of deposit —bank-issued time deposit that specifies Mountain Savings Bank originates 100 residential mortgages for an interest rate and maturity date and is negotiable, (i.e., can be sold by the home buyers and will service the mortgages by processing the holder to another party). monthly payments. However, the bank does not want to use its own ▪​ Banker’s acceptance —time draft payable to a seller of goods, with funds to finance the mortgages, so it issues mortgage-backed payment guaranteed by a bank. securities representing this package of mortgages to eight financial institutions that are willing to purchase all of these securities. Each 2.​ Capital Market Securities - facilitate the sale of long-term securities by deficit month, when Mountain Savings Bank receives interest and units to surplus units. These are commonly issued to finance the purchase of principal payments on the mortgages, it passes those payments on capital assets, such as buildings, equipment, or machinery. to the eight financial institutions that purchased the ▪​ Bonds mortgage-backed securities and thereby provided the financing to −​ long-term debt securities issued by the Treasury, government agencies, the homeowners. If some of the homeowners default on their and corporations to finance their operations; represent debt, they mortgages, the payments will be reduced, as will the return on specify the amount and timing of interest and principal payments to investment earned by the financial institutions that purchased the investors who purchase them. mortgage-backed securities. The securities they purchased are −​ Treasury bonds are perceived to be free from default risk because they backed (collateralized) by the mortgages. If Mountain Savings are issued by the U.S. Treasury. In contrast, bonds issued by Bank is not experienced at issuing mortgage-backed securities,  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC another financial institution may participate by bundling traded in the capital or foreign exchange markets. Derivative securities Mountain’s 100 mortgages with mortgages originated by other generally involve an agreement between two parties to exchange a standard insti-tutions. Then the financial institution issues mortgage-backed quantity of an asset or cash flow at a predetermined price and at a specified date securities that represent all the mortgages in the bundle. Any in the future. As the value of the underlying security to be exchanged changes, investor that purchases these mortgage-backed securities is the value of the derivative security changes. partially financing the 100 mortgages at Mountain Savings Bank ▪​ Speculation - allow an investor to speculate on movements in the value of and all the other mortgages in the bundle that are backing these the underlying assets without having to purchase those assets. securities. ▪​ Risk management - financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities. ▪​ Stocks ▪​ Derivative security markets are the markets in which derivative securities −​ represent partial ownership in the corporations that issued them; trade. −​ classified as capital market securities because they have no maturity; Valuation of Securities −​ secondary market is available (Investors who purchase stocks Each type of security generates a unique stream of expected cash flows to investors. (referred to as stockholders or shareholders) issued by a corporation Debt securities are easier to value than equity securities because they promise to in the primary market can sell the stocks to other investors at any provide investors with specific payments (interest and principal) until they mature. time in the secondary market) The stream of cash f lows generated by stocks is more difficult to estimate because −​ Some corporations provide income to their stockholders by some stocks do not pay dividends; instead, investors receive cash flows only when distributing a portion of their quarterly earnings in the form of they sell the stocks, which occurs at different times for different investors. dividends (current yield) −​ Other corporations retain and reinvest all of their earnings in their operations, which increases the company’s growth potential (capital ▪​ Impact of information on valuation gains yield) ▪​ Estimate future cash flows by obtaining information that may influence a stock’s future cash flows. (Exhibit 1.2) CAPITAL MARKET INSTRUMENTS ▪​ Use economic or industry information to value a security. ▪​ Corporate stock —the fundamental ownership claim in a public ▪​ Use published opinions about the firm’s management to value a security. corporation. ▪​ Mortgages —loans to individuals or businesses to purchase a home, land, ▪​ Impact of Behavioral Finance on Valuation or other real property. ▪​ Various conditions can affect investor psychology. Behavioral finance can ▪​ Corporate bonds —long-term bonds issued by corporations. sometimes explain the movements of a security’s price. ▪​ Treasury bonds —long-term bonds issued by the U.S. Treasury. ▪​ Behavioral Finance - the application of psychology to make financial ▪​ State and local government bonds —long-term bonds issued by state and decisions. local governments. ▪​ Example: When investors receive new information about a security that ▪​ Bank and consumer loans —loans to commercial banks and individuals. clearly indicates the likelihood of higher cash flows or less uncertainty surrounding the cash flows, they revise their valuations of that security upward, consequently increasing the demand for the security. 3.​ Derivative Securities - financial contracts whose values are derived from the o​ In addition, investors that previously purchased that security and values of underlying assets. A derivative security is a financial security (such as were planning to sell it in the secondary market may decide not to a futures contract, option contract, swap contract, or mortgage-backed security) sell. whose payoff is linked to another, previously issued security such as a security  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC ▪​ This results in a smaller supply of that security for sale (by Example: investors who had previously purchased it) in the secondary Nike stock provides cash flows to investors in the form of quarterly dividends and market. In turn, the market price of the security rises to a capital gains when an investor sells the stock. Both the future dividends and the new equilibrium level. future stock price are uncertain. Thus, the cash flows the Nike stock will provide to ▪​ In an efficient market, securities are rationally priced. If a security is investors over a future period are uncertain, which means the return from investing clearly under-valued based on public information, some investors will in Nike stock over that period is uncertain. Yet the cash flow provided by Nike’s capitalize on the discrepancy by purchasing that security. stock is less uncertain than that provided by a small, young, publicly traded o​ This strong demand for the security will push the security’s price technology company. Because the return on the technology stock over a particular higher until the discrepancy disappears. The investors who period is more uncertain than the return on Nike stock, the technology stock has recognized the discrepancy will be rewarded with higher returns on more risk. their investment. Their actions to capitalize on valuation discrepancies typically push security prices toward their proper International Financial Markets price levels, based on the information that is available. Financial markets vary across the world in terms of: ▪​ Degree of financial market development ▪​ Uncertainty Surrounding Valuation of Securities ▪​ Volume of funds transferred from surplus to deficit units ▪​ Limited information leads to uncertainty in the valuation of securities. ▪​ asymmetric information- firm’s managers may possess information about ▪​ International Integration of Financial Markets its financial condition that is not available to investors −​ Under favorable economic conditions, the international integration of ▪​ the higher the degree of uncertainty about a security’s proper valuation, the financial markets allows governments and corporations easier access to higher the risk is from investing in that security. From the perspective of an funding from creditors or investors in other countries to support their investor who purchases a security, risk represents the potential deviation of growth. the security’s actual return from what was expected. −​ Under unfavorable economic conditions, the international integration of financial markets allows one country’s financial problems to adversely Exhibit 1.2 Use of Information to Make Investment Decisions affect other countries. ▪​ Role of Foreign Exchange Market −​ International financial transactions normally require the exchange of currencies. The foreign exchange market facilitates this exchange. −​ Like securities, most currencies have a market-determined price (exchange rate) that changes in response to supply and demand. If the aggregate demand by corporations, government agencies, and individuals for a given currency shifts suddenly, or if the aggregate supply of that currency for sale (to be exchanged for another currency) changes abruptly, the price of the currency (exchange rate) will change. Financial Market Regulation ▪​ The Securities Act of 1933 o​ full and fair disclosure and securities registration ▪​ The Securities Exchange Act of 1934  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC o​ Securities and Exchange Commission (SEC) is the main regulator of securities markets o​ established on 26 Oct 1936 by virtue of the Commonwealth Act No. 83 or the Securities Act. o​ its establishment was prompted by the need to safeguard public interest in view of local stock market boom at that time. o​ operations began on 11 Nov 1936 under the leadership of Commissioner Ricardo Nepomuceno. o​ its major functions included registration of securities, analysis of every registered security, evaluation of the financial condition and operations of applicants for security issue, screening of applications for broker's or dealer's license and supervision of stock and bond brokers as well as the stock exchanges. o​ due to the changes in the business environment under Pres. Ferdinand Marcos, the agency was reorganized on 29 Sept 1975 as a collegial body with 3 commissioners and was given quasi-judicial powers under PD902-A. o​ In 1981, the Commission was expanded to include two (2) additional commissioners and two (2) departments, one for prosecution and enforcement and the other for supervision and monitoring. Then on 01 December 2000, the SEC was reorganized as mandated by R. A. 8799 also known as the Securities Regulation Code.  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Role of Financial Institutions ▪​ Because of the “common bond” characteristic, credit unions tend to be −​ Financial institutions are needed to resolve the limitations caused by market much smaller than other depository institutions. They use most of their imperfections such as limited information regarding the creditworthiness of funds to provide loans to their members. borrowers. Role of Non-depository Institutions −​ Without financial institutions, the information and transaction costs of financial Nondepository institutions generate funds from sources other than deposits but also market transactions would be excessive. (imagine the levels of analysis play a major role in financial intermediation. involved) ▪​ Finance companies - obtain funds by issuing securities and lend the funds to individuals and small businesses. −​ Financial institutions can be classified as depository and nondepository ▪​ Mutual funds - sell shares to surplus units and use the funds received to institutions. purchase a portfolio of securities. ▪​ Securities firms - provide a wide variety of functions in financial markets. Role of depository institutions o​ Broker- execute securities transactions between two parties for a Depository institutions accept deposits from surplus units and provide credit to commission (or markup) deficit units through loans and purchases of securities. o​ Underwriter and Advisory- commonly referred to as investment ▪​ Offer liquid deposit accounts to surplus units banking, and the securities firms that specialize in these services are ▪​ Provide loans of the size and maturity desired by deficit units sometimes referred to as investment banks. ▪​ Accept the risk on loans provided o​ Dealer- making a market in specific securities by maintaining an ▪​ Have more expertise in evaluating creditworthiness inventory of securities. A dealer’s income is influenced by the ▪​ Diversify their loans among numerous deficit units performance of the security portfolio maintained. Some dealers also provide brokerage services and therefore earn income from both 1.​ Commercial Banks types of activities ▪​ The most dominant type of depository institution ▪​ Insurance companies - provide insurance policies that reduce the financial ▪​ They serve surplus units by offering a wide variety of deposit accounts burden associated with death, illness, and damage to property. They charge ▪​ Then they transfer deposit funds to deficit units through loans or purchase fees or premiums and invest in financial markets. of debt securities ▪​ Pension funds – manage funds until they are withdrawn for retirement ▪​ Commercial banks serve both the private and public sectors; their deposit and lending services are utilized by households, businesses, and government agencies. ▪​ Commercial banks are subject to regulations that are intended to limit their exposure to the risk of failure. 2.​ Savings Institutions ▪​ Also called thrift institutions and include Savings and Loans (S&Ls) and Savings Banks ▪​ Concentrate on residential mortgage loans 3.​ Credit Unions ▪​ Nonprofit organizations ▪​ Restrict business to C U members with a common bond  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Services Performed by Financial Intermediaries 1.​ Services Benefiting Suppliers of Funds a.​ Monitoring costs —Aggregation of funds in an FI provides greater incentive to collect a firm’s information and monitor actions. The relatively large size of the FI allows this collection of information to be accomplished at a lower average cost (economies of scale). b.​ Liquidity and price risk —FIs provide financial claims to household savers with superior liquidity attributes and with lower price risk. c.​ Transaction cost services —Similar to economies of scale in information production costs, an FI’s size can result in economies of scale in transaction costs. d.​ Maturity intermediation —FIs can better bear the risk of mismatching the maturities of their assets and liabilities. e.​ Denomination intermediation —FIs such as mutual funds allow small investors to overcome constraints to buying assets imposed by large minimum denomination size. 2.​ Services Benefiting the Overall Economy a.​ Money supply transmission —Depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the economy in general. b.​ Credit allocation —FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy, such as farming and residential real estate. c.​ Intergenerational wealth transfers —FIs, especially life insurance companies and pension funds, provide savers with the ability to transfer wealth from one generation to the next. d.​ Payment services —The efficiency with which depository institutions provide payment services directly benefits the economy.  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Comparison of Roles among Financial Institutions ▪​ Financial institutions such as commercial banks, insurance companies, mutual ▪​ Financial institutions facilitate the flow of funds from individual surplus units funds, and pension funds take charge of investing funds that they have received (investors) to deficit units. (Exhibit 1.3) from surplus units, so they are often referred to as institutional investors. ▪​ Securities firms are not shown in Exhibit 1.3, but they play an important role in facilitating the flow of funds. Many of the transactions between the financial institutions and deficit units are executed by securities firms. Furthermore, some funds f low directly from surplus units to deficit units as a result of security transactions, with securities firms serving as brokers. Institutional Role as a Monitor of Publicly Traded Firms ▪​ Since insurance companies, pension funds, and some mutual funds are major investors in stocks, they can influence the management of publicly traded firms. ▪​ By serving as activist shareholders, they can help ensure that managers of publicly held corporations make appropriate decisions that are in the best interests of the shareholders. ▪​ One set of flows represents deposits from surplus units that are transformed by depository institutions into loans for deficit units. ▪​ A second set of flows represents purchases of securities (commercial paper) issued by finance companies that are transformed into finance company loans for deficit units. ▪​ A third set of flows reflects the purchases of shares issued by mutual funds, which are used by the mutual funds to purchase debt and equity securities of deficit units. ▪​ A fourth set of flows reflects transfer of surplus from policyholders to deficit units through premiums paid by the former to the insurance companies. Because insurance companies and pension funds purchase massive amounts of stocks and bonds, they finance much of the expenditures made by large deficit units, such as corporations and government agencies.  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Relative Importance of Financial Institutions (Exhibit 1.4) who prefer to obtain all of their financial services from a single financial ▪​ Households with savings are served by depository institutions. institution. ▪​ Households with deficient funds are served by depository institutions and −​ Global Consolidation of Financial Institutions - Many financial institutions have finance companies. expanded internationally to capitalize on their expertise. Notably, commercial ▪​ Several agencies regulate the various types of financial institutions, and the banks, insurance companies, and securities firms have all expanded through various regulations may give some financial institutions a comparative international mergers. advantage over others. Exhibit 1.5 Organizational Structure of a Financial Conglomerate FINANCIAL MAIN SOURCES OF MAIN USES OF FUNDS INSTITUTIONS FUNDS Commercial banks Deposits from households, Purchases of government and businesses, and government corporate securities; loans to agencies businesses and households Savings institutions Deposits from households, Purchases of government and businesses, and government corporate securities; mortgages and agencies other loans to households; some loans to businesses Credit unions Deposits from credit union Loans to credit union members members Finance companies Securities sold to Loans to households and businesses households and businesses Mutual funds Shares sold to households, Purchases of long-term government businesses, and government and corporate securities agencies Money market Shares sold to households, Purchases of short-term government funds businesses, and government and corporate securities agencies Insurance Insurance premiums and Purchases of long-term government companies earnings from investments and corporate securities Pension funds Employer/employee Purchases of long-term government contributions and corporate securities Consolidation of Financial Institutions −​ This is a strategy by the financial institutions for economies of scale. (optimizing profit by any given cost; also, a strategy for expansions; this then affects pricing hence services are offered to customers at a lower cost) −​ Exhibit 1.5 depicts the typical organizational structure of a financial conglomerate. The operations of each type of financial service are commonly managed separately, a financial conglomerate offers advantages to customers  LECTURE NOTES | ROLE OF FINANCIAL MARKETS AND INSTITUTIONS | GRC Systemic Risk among Financial Institutions Self-Assessment: ▪​ Systemic risk is defined as the spread of financial problems among financial 1.​ Differentiate between primary markets and secondary markets. institutions and across financial markets that could cause a collapse in the 2.​ Differentiate between money and capital markets. financial system. 3.​ Describe what foreign exchange markets are. ▪​ It exists because financial institutions invest their funds in similar types of 4.​ Distinguish between the different types of financial institutions and how each securities and therefore have similar exposure to large declines in the prices of facilitate the flow of funds. these securities. Further-more, they commonly engage in various loan and 5.​ Describe the types of securities traded within financial markets. guarantee arrangements that cause one financial institution to rely on others for 6.​ Describe the role of financial institutions within financial markets. payment. 7.​ Discuss the risks that financial institutions face. ▪​ During the credit crisis of 2008 and 2009, mortgage defaults affected financial 8.​ Explain how financial institutions are exposed to systemic risk. institutions in several ways. o​ First, many financial institutions that originated mortgages shortly before the crisis sold them to other financial institutions (i.e., commercial banks, savings institutions, mutual funds, insurance companies, securities firms, and pension funds). Therefore, even financial institutions that were not involved in the mortgage origination process experienced large losses because they purchased the mortgages originated by other financial institutions o​ Second, many other financial institutions that invested in mortgage-backed securities received lower payments as mortgage defaults occurred. o​ Third, some financial institutions (especially securities firms) relied heavily on short-term debt to finance their operations and used their holdings of mortgage-backed securities as collateral. o​ Fourth, as mortgage defaults increased, there was an excess of unoccupied housing. o​ Eventually, most financial institutions that invested heavily in equities experienced large losses on their investments during the credit crisis. Other risks faced by financial institutions ▪​ Credit ▪​ Foreign exchange ▪​ Country or sovereign ▪​ Interest rate ▪​ Market ▪​ Off-balance-sheet ▪​ Liquidity ▪​ Technology ▪​ Operational ▪​ Insolvency