Fundamentals of Financial Markets and Institutions Lecture Notes PDF

**Fundamentals of Financial Markets and Institutions** **08.01.2025 -- Lecture 1** On-balance-sheet: items directly recorded on banks financial statements - Assets(loans), liabilities (deposits), equity: deposits, loans, bonds, stocks - Represent the bank's core activities of borrowing a...

**Fundamentals of Financial Markets and Institutions** **08.01.2025 -- Lecture 1** On-balance-sheet: items directly recorded on banks financial statements - Assets(loans), liabilities (deposits), equity: deposits, loans, bonds, stocks - Represent the bank's core activities of borrowing and lending - What it owns and owes Off-balance-sheet: They do not represent actual assets or liabilities at time of reporting - Loan commitments, derivatives, letters of credits, securitizations - Can expose bank to risk Interest income is on-balance sheet banking because it is not what a bank owns or owes (stuff) but rather money earned, so it is put in the income statement. A diagram of financial funds Description automatically generated Lender-savers are those with excess funds and the borrower-spenders are those who need funding. Indirect funding: when funding flows through financial intermediaries like banks, mutual funds or insurance companies - *A household deposits money in a bank, the bank then borrows the money to businesses.* - The deposits (liabilities since it is money the bank "loaned" from depositor) and loans (assets since they expect to earn interest on it) are on-balance-sheet banking. Direct funding: funding flows directly through financial markets - *Businesses issuing bonds or stocks for investors to purchase* - Banks may facilitate this by underwriting bonds or providing guarantees but themselves do not hold the loan or security and therefore it is considered off-balance-sheet banking.  There are three main types of financial intermediaries: 1. Depository institutions (banks) Institutions that accept deposits and use these to make loans - *Commercial banks, credit unions, savings and loan associations* - Primary liability/source of funding: deposits - Primary assets/ use of funds: loans, mortgages, securities 2. Contractual saving institutions Institutions that collect funds through contracts like insurance policies or retirement contributions. - *Pension funds, life insurance companies* - Primary liability/source of funding: premiums for policies, employee and employer contributions. - Primary assets/ use of funds: Investments into bonds, stocks and mortgage to generate return 3. Investment intermediaries Institutions that pool funds from investors and allocate them across various investments - *Hedge funds, mutual funds, finance companies* - Primary liability/source of funding: money through shares, commercial paper - Primary assets/ use of funds: loans to consumers or businesses, investment in stocks, bonds and money market instruments. A close-up of a graph Description automatically generated - Banks are dominant institutions holding about 40% of global financial assets. - Non-banking financial institutions take up about half of the global financial assets and compliment banking offering alternative forms of financing and risk management. - However, this amount varies, for example in the US pension funds and insurance companies take up a larger amount. - This variation will depend on the reliance of market-based vs bank-based financing.  Banks collect funds from deposits, asset management, issued bonds. Banks use funds for loans, investments, and other assets. - Retail and corporate banking mainly use on-balance-sheet banking, so deposits and liabilities - Investment and asset management mainly use off-balance-sheet banking. So contingent liabilities or fee income. **The Finnish Financial Markets:** A screenshot of a report Description automatically generated Households in Finland hold a significant portion of their income in banks, so bank deposits are the primary financial assets. - Most money held in banks compared to investments in listed companies. - Reflects a saving-orientated culture, where stability and safety are prioritized. - Compared to countries like the US where households tend to have a larger share of their financial assets in stocks, or mutual funds.  There has been significant growth in the Finnish mutual fund market. - Increased investment interest. Finland has a mandatory pension system, where a part of each person's salary is automatically invested in pension funds -\> constant growth.  Public pension institutions: focus on fixed-income investments, like bonds to maintain stability. - Although they hold a large share of the pension funds, they are secondary to private pension funds. Private pension funds: Invest in equity of listed company shares - Due to this they are the biggest owners of Finnish companies. - If you look at the owners of companies you will often see *Ilmarinien, Varma, Elo.* [Why do financial markets and intermediaries exist?] 1. Consumption timing -\> consumption smoothing. 2. Allocation, management and pooling of risk - Allows for investors who are risk-seeking to bear the risk 3. Separation of ownership and control 4. Provide liquidity 5. Provide and process information - Credit rating, market pricing [The role of banks:] The core of the banking business is the three types of transformations: 1. Size transformation: banks pool money from small depositors to provide larger loans to borrowers 2. Maturity transformation: banks use short-term deposits to fund long-term loans 3. Risk transformation: banks manage and reduce risks associated with lending by diversifying across different industries and locations. These transformations cause mismatches in banks balance sheet, which causes risk. Managing this risk is the key role of banks. - *Borrow short term then lend long term mortgage loans -\> risk of default -\> need to management* There are three main risks to manage: 1. Credit risk: risk of default 2. Liquidity risk: banks may not have enough liquid funds to meet withdrawal demand 3. Interest rate risk: change in interest rates affects profitability of loans versus deposits. [Information asymmetries] Transaction is difficult because of private information - For banks issues of who to lend to? how to know if they will pay back capital and interest? - Issues of moral hazard caused by incentive to take more risk once money received - How do they manage this? -\> collateral, screening and monitoring. - By depositing, you are in a way "lending" to the bank -\> you take the risk - Deposit guarantee system - Best interest of society to have a trustworthy banking system, Finland up to 150,000 EUR, US up to 250,000 USD. [Banks incentives] Banks view deposits as a stable, guaranteed source of funding, often subject to little oversight from depositors. -\> incentivizes banks to invest in riskier assets in hopes to increase profits -\> this may exceed the risk tolerance of depositors if they were fully informed. - If risky investment fail, depositors may face loses, and government bailout may be required to prevent economic damage. Too large to fail: when financial institutions are so large and an integral part of the global or national economy that if they failed it would have severe consequences on the economy and financial system. - Issue of moral hazard if companies know this and know they will be bailed out.