Chapter 1 - Saunders PDF - Financial Markets Introduction

Introduction and Overview of Financial Markets part one Introduction chapter Learning Goals...

Introduction and Overview of Financial Markets part one Introduction chapter Learning Goals O U T L I N E LG - Differentiate between primary and secondary markets. Why Study Financial Markets and Institutions? Chapter LG - Differentiate between money and capital markets. Overview Overview of Financial Markets LG - Understand what foreign exchange markets are. Primary Markets versus Secondary Markets LG - Understand what derivative security markets are. Money Markets versus LG - Distinguish between the different types of financial institutions. Capital Markets Foreign Exchange Markets LG - Know the services financial institutions perform. Derivative Security Markets Financial Market Regulation LG - Know the risks financial institutions face. Overview of Financial LG - Appreciate why financial institutions are regulated. Institutions Unique Economic LG - Recognize that financial markets are becoming increasingly global. Functions Performed by Financial Institutions Additional Benefits FIs Provide to Suppliers of Funds Economic Functions FIs WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS? Provide to the Financial CHAPTER OVERVIEW System as a Whole In the 1990s, financial markets in the United States boomed. As seen in Figure 1–1, the Risks Incurred by Financial Dow Jones Industrial Index—a widely quoted index of the values of 30 large corporations Institutions (see Chapter 8)—rose from a level of 2,800 in January 1990 to more than 11,000 by the Regulation of Financial end of the decade; this compares to a move from 100 at its inception in 1906 to 2,800 Institutions eighty-four years later. In the early 2000s, as a result of an economic downturn in the United States and elsewhere, this index fell back below 10,000. The index rose to over Trends in the United States 14,000 in July 2007, but (because of an increasing mortgage market credit crunch, Globalization of Financial particularly the subprime mortgage market) fell back to below 13,000 within a month Markets and Institutions of hitting the all-time high. By 2008, problems in the subprime mortgage market esca- Appendix A: The Financial lated to a full-blown financial crisis and the worst recession in the United States since the Crisis: The Failure of Financial Great Depression. The Dow Jones Industrial Average (DJIA) fell to 6,547 in March 2009 Institutions’ Specialness before recovering, along with the economy, to over 11,000 in April 2010. However, it took (available through Connect or until March 5, 2013, for the DJIA to surpass its pre-crisis high of 14,164.53, closing at your course instructor) 14,253.77 for the day. The DJIA rose to over 27,300 in mid-2019 before falling to below 20,000 in March 2020 during the Coronavirus pandemic.  Part Introduction and Overview of Financial Markets Figure – The Dow Jones Industrial Average, – Index Value DJIA Index Values 30,000 25,000 20,000 15,000 10,000 5,000 0 Date Jan-89 Jan-05 Jan-07 Jan-09 Jan-15 Jan-17 Jan-19 Jan-13 Jan-93 Jan-95 Jan-97 Jan-99 Jan-03 Jan-91 Jan-11 Jan-01 During the financial crisis of 2008–2009, market swings seen in the United States quickly spread worldwide. Stock markets saw huge swings in value as investors tried to sort out who might survive and who would not (and markets from Russia to Europe were forced to suspend trading as stock prices plunged). As U.S. markets recovered in 2010–2013 and, as mentioned earlier, surpassed their pre-crisis highs, European stock markets struggled as Greece battled with a severe debt crisis that eventually spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. Even the growth in the robust Chinese economy slowed to 6.7 percent in 2016, the lowest level in seven years. A prolonged trade war with the United States saw growth in China drop even further, to 6.2 percent in 2019, the lowest level in 30 years. World markets were rocked again in June 2016 when the people of the United Kingdom voted to leave the European Union (EU) after 43 years (dubbed “Brexit”). The shock from the UK’s surprise vote to leave the EU swept across global markets, trig- gering steep drops in stock markets and the British pound and a flight into safe assets such as U.S. bonds and gold. The pound fell more than 11 percent to its lowest point since 1985. The DJIA dropped 610.32 points, or 3.4 percent. The Stoxx Europe 600 index fell 7 percent, its steepest drop since 2008, while Japan’s Nikkei Stock Average declined 7.9 percent. Bonds also sold off sharply, pushing UK government borrowing costs sharply higher, as traders and investors grappled with the market implications of Brexit. The UK had its credit rating outlook cut to “negative” by the ratings agency Moody’s. The UK’s vote to leave the European Union shook the region, precipitating an immedi- ate political crisis in Britain and shifting the path of a European project created to bind a continent torn by World War II. Britain’s decision, one of the most momentous by a Western country in the past 50 years, reverses the course of expansion for the EU. It had grown over decades to include most of Europe, absorbing former dictatorships in Greece, Spain, and Portugal, and the countries of the east, formerly under Soviet domination. The UK would be the first member nation to leave, a step some leaders warned beforehand would diminish the global influence of the UK and the EU and risk setting in motion the European bloc’s even- tual disintegration. Less than two weeks before the October 31, 2019, deadline, the UK still had no deal with the EU on how the exit would be structured. The most recent shock to world financial markets was the Coronavirus Pandemic in 2020. The pandemic resulted in a virtual shut down of world economies and resulted in a 32.5 percent drop in the DJIA in just over a month, from an all time high of 29,388.58 on February 6, 2020 to 19,830.01 March 19.  Chapter Introduction Originally the banking industry operated as a full-service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock invest- ing, insurance provision, etc.). In the early 1930s, the economic and industrial collapse resulted in the separation of some of these activities. In the 1970s and 1980s new, relatively unregulated financial services industries sprang up (e.g., mutual funds, broker- age funds) that separated the financial service functions even further. The last 35 years, however, have seen a reversal of these trends. In the 1990s and 2000s, regulatory barriers, technology, and financial innovation changes were such that a full set of financial services could again be offered by a single financial services firm under the umbrella of a financial services holding company. For example, JPMorgan Chase & Co. operates a commercial bank (JPMorgan Chase Bank), an investment bank (JPMorgan Securities, which also sells mutual funds), and an insurance company (JPMorgan Insurance Agency). Not only did the boundaries between traditional industry sectors change, but competition became global in nature as well. For example, JPMorgan Chase is the world’s sixth-largest bank holding company, operating in 60 countries. The financial crisis produced another reshaping of all financial institution (FI) sectors and the end of many major FIs (e.g., Bear Stearns and Lehman Brothers), with the two most prominent investment banks in the world, Goldman Sachs and Morgan Stanley, converting to bank holding company status. Indeed, as of 2010, all the major U.S. investment banks had either failed, been acquired by a commercial bank, or become bank holding companies. Further, legislation enacted as a result of the financial crisis represents an attempt to again separate FI activities. For example, the “Volcker Rule” provision of the Wall Street Reform and Consumer Protection Act prohibits the largest bank holding companies from engaging in proprietary trading and limits their investments in hedge funds, private equity, and related vehicles. Despite these most recent changes, many FIs operate in more than one FI sector. As economic and competitive environments change, attention to profit and, more than ever, risk becomes increasingly important. This book provides a detailed overview and analysis of the financial system in which financial managers and individual investors operate. Making investment and financing decisions requires managers and individuals to understand the flow of funds throughout the economy as well as the operation and struc- ture of domestic and international financial markets. In particular, this book offers a unique analysis of the risks faced by investors and savers, as well as strategies that can be adopted for controlling and managing these risks. Newer areas of operations such as asset securi- tization, derivative securities, and internationalization of financial services also receive special emphasis. Further, as the United States and the world continue to recover from the collapse of the financial markets, this book highlights and discusses the impact of this crisis on the various financial markets and the financial institutions that operate in them. This introductory chapter provides an overview of the structure and operations of various financial markets and financial institutions. Financial markets are differentiated by the characteristics (such as maturity) of the financial instruments or securities that are exchanged. Moreover, each financial market, in turn, depends in part or in whole on finan- cial institutions. Indeed, FIs play a special role in the functioning of financial markets. In particular, FIs often provide the least costly and most efficient way to channel funds to and from financial markets. As part of this discussion, we briefly examine how changes in the way FIs deliver services played a major part in the events leading up to the severe finan- cial crisis of the late 2000s. A more detailed discussion of the causes of, the major events during, and the regulatory and industry changes resulting from the financial crisis is pro- vided in Appendix 1A to the chapter (available through Connect or your course instructor). OVERVIEW OF FINANCIAL MARKETS financial markets Financial markets are structures through which funds flow. Table 1–1 summarizes the The arenas through which financial markets discussed in this section. Financial markets can be distinguished along funds flow. two major dimensions: (1) primary versus secondary markets and (2) money versus capital markets. The next sections discuss each of these dimensions.  Part Introduction and Overview of Financial Markets TABLE Types of Financial Markets Primary markets—markets in which corporations raise funds through new issues of securities. Secondary markets—markets that trade financial instruments once they are issued. Money markets—markets that trade debt securities or instruments with maturities of less than one year. Capital markets—markets that trade debt and equity instruments with maturities of more than one year. Foreign exchange markets—markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted. Derivative markets—markets in which derivative securities trade. LG Primary Markets versus Secondary Markets primary markets Primary Markets. Primary markets are markets in which users of funds (e.g., cor- Markets in which corpora- porations) raise funds through new issues of financial instruments, such as stocks and tions raise funds through bonds. Table 1–2 lists data on primary market sales of securities from 2000 through 2019. new issues of securities. Note the impact the financial crisis had on primary market sales by firms. New issues fell to $1,068.0 billion in 2008, during the worst of the crisis, from $2,389.1 billion in 2007, pre-crisis. As of 2018, primary market sales had still not recovered as only $1,725.2 billion new securities were issued for the year. Fund users have new projects or expanded production needs, but do not have sufficient internally generated funds (such as retained earnings) to support these needs. Thus, the fund users issue securities in the external primary markets to raise additional funds. New issues of financial instruments are sold to the initial suppliers of funds (e.g., households) in exchange for funds (money) that the issuer or user of funds needs.1 Most primary market transactions in the United States are arranged through financial institutions called investment banks—for example, Morgan Stanley or Bank of America Merrill Lynch—that serve as intermediaries between the issuing corporations (fund users) and investors (fund suppliers). For these public offerings, the investment bank provides the securities issuer (the funds user) with advice on the securities issue (such as the offer price and number of securities to issue) and attracts the initial public purchasers of the securi- ties for the funds user. By issuing primary market securities with the help of an investment bank, the funds user saves the risk and cost of creating a market for its securities on its own (see the following discussion). Figure 1–2 illustrates a time line for the primary market exchange of funds for a new issue of corporate bonds or equity. We discuss this process in initial public offering detail in Chapters 6 and 8. (IPO) Primary market financial instruments include issues of equity by firms initially going The first public issue of a public (e.g., allowing their equity—shares—to be publicly traded on stock markets for the financial instrument by a first time). These first-time issues are usually referred to as initial public offerings (IPOs). firm. For example, on May 10, 2019, Uber announced a $75 billion IPO of its common stock. TABLE Primary Market Sales of Securities (in billions of dollars) Security Type 2000 2005 2007 2008 2010 2015 2018 2019* All issues $1,256.7 $2,439.0 $2,389.1 $1,068.0 $1,024.7 $1,843.2 $1,725.2 $1,023.5 Bonds 944.8 2,323.7 2,220.3 861.2 893.7 1,611.3 1,526.3 905.9 Stocks 311.9 115.3 168.8 206.8 131.0 174.0 131.3 88.0 Private placements 196.5 24.6 20.1 16.2 22.2 28.8 33.4 n.a.† IPOs 97.0 36.7 46.3 26.4 37.0 29.1 34.2 29.6 1. We discuss the users and suppliers of funds in more detail in Chapter 2.  Chapter Introduction Figure – Primary and Secondary Market Transfer of Funds Time Line Primary Markets (Where new issues of financial instruments are o ered for sale) Users of Funds Initial Suppliers (Corporations Underwriting with of Funds issuing debt/equity Investment Bank (Investors) instruments) Secondary Markets (Where financial instruments, once issued, are traded) Economic Agents Economic Agents (Investors) Wanting Financial Markets (Investors) Wanting to Sell Securities to Buy Securities Financial instruments flow Funds flow The company’s stock was underwritten by 29 investment banks, including Morgan Stanley, Goldman Sachs, Citigroup, and Bank of America Merrill Lynch. Primary market securities also include the issue of additional equity or debt instruments of an already publicly traded firm. For example, on September 4, 2019, Appian Corp. announced the sale of an additional 1.825 million shares of common stock underwritten by one investment bank, Barclays. Secondary Markets. Once financial instruments such as stocks are issued in primary secondary market markets, they are then traded—that is, rebought and resold—in secondary markets. A market that trades finan- For example, on September 17, 2019, 14.5 million shares of ExxonMobil were traded cial instruments once they in the secondary stock market. Buyers of secondary market securities are economic agents are issued. (consumers, businesses, and governments) with excess funds. Sellers of secondary market financial instruments are economic agents in need of funds. Secondary markets provide a cen- tralized marketplace where economic agents know they can transact quickly and efficiently. These markets therefore save economic agents the search and other costs of seeking buyers or sellers on their own. Figure 1–2 illustrates a secondary market transfer of funds. When an economic agent buys a financial instrument in a secondary market, funds are exchanged, usually with the help of a securities broker such as Charles Schwab acting as an intermediary between the buyer and the seller of the instrument (see Chapter 8). The original issuer of the instrument (user of funds) is not involved in this transfer. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers derivative security Automated Quotation (NASDAQ) system are two well-known examples of secondary A financial security whose markets for trading stocks. We discuss the details of each of these markets in Chapter 8. payoffs are linked to other, In addition to stocks and bonds, secondary markets also exist for financial instruments previously issued securi- backed by mortgages and other assets (see Chapter 7), foreign exchange (see Chapter 9), ties or indices. and futures and options (i.e., derivative securities—financial securities whose payoffs  Part Introduction and Overview of Financial Markets are linked to other, previously issued [or underlying] primary securities or indexes of pri- mary securities) (see Chapter 10). As we will see in Chapter 10, derivative securities have existed for centuries, but the growth in derivative securities markets occurred mainly in the 1980s through 2000s. As major markets, therefore, derivative securities markets are among the newest of the financial security markets. Secondary markets offer benefits to both investors (suppliers of funds) and issuing corporations (users of funds). For investors, secondary markets provide the opportunity to trade securities at their market values quickly as well as to purchase securities with varying risk-return characteristics (see Chapter 2). Corporate security issuers are not directly involved in the transfer of funds or instruments in the secondary market. However, the issuer does obtain information about the current market value of its finan- cial instruments, and thus the value of the corporation as perceived by investors such as its stockholders, through tracking the prices at which its financial instruments are being traded on secondary markets. This price information allows issuers to evaluate how well they are using the funds generated from the financial instruments they have already issued and provides information on how well any subsequent offerings of debt or equity might do in terms of raising additional money (and at what cost). liquidity Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into The ease with which an cash quickly at its fair market value—as well as information about the prices or the value asset can be converted of their investments. Increased liquidity makes it more desirable and easier for the issuing into cash quickly and at firm to sell a security initially in the primary market. Further, the existence of central- fair market value. ized markets for buying and selling financial instruments allows investors to trade these instruments at low transaction costs. LG Money Markets versus Capital Markets money markets Money Markets. Money markets are markets that trade debt securities or instruments Markets that trade debt with maturities of one year or less (see Figure 1–3). In the money markets, economic securities or instruments agents with short-term excess supplies of funds can lend funds (i.e., buy money market with maturities of one year instruments) to economic agents who have short-term needs or shortages of funds or less. (i.e., they sell money market instruments). The short-term nature of these instruments means that fluctuations in their prices in the secondary markets in which they trade are usu- ally quite small (see Chapters 3 and 23 on interest rate risk). In the United States, money markets do not operate in a specific location—rather, transactions occur via telephones, wire transfers, and computer trading. Thus, most U.S. money markets are said to be over-the-counter over-the-counter (OTC) markets. (OTC) markets Markets that do not Money Market Instruments. A variety of money market securities are issued by operate in a specific fixed corporations and government units to obtain short-term funds. These securities include location—rather, transac- Treasury bills, federal funds, repurchase agreements, commercial paper, negotiable certifi- tions occur via telephones, cates of deposit, and banker’s acceptances. Table 1–3 lists and defines the major money wire transfers, and com- market securities. Figure 1–4 shows outstanding amounts of money market instruments puter trading. in the United States in 1990, 2000, 2010, and 2019. Notice that in 2019 federal funds and repurchase agreements, followed by Treasury bills, negotiable CDs, and commercial paper, had the largest amounts outstanding. Money market instruments and the operation of the money markets are described and discussed in detail in Chapter 5. Figure – Money versus Capital Market Maturities Capital Market Securities Money Market Securities Notes and Bonds Stocks (Equities) Maturity 0 1 year to 30 years to No specified maturity maturity maturity  Chapter Introduction TABLE Money and Capital Market Instruments MONEY MARKET INSTRUMENTS Treasury bills—short-term obligations issued by the U.S. government. Federal funds—short-term funds transferred between financial institutions usually for no more than one day. Repurchase agreements—agreements involving the sale of securities by one party to another with a promise by the seller to repurchase the same securities from the buyer at a specified date and price. Commercial paper—short-term unsecured promissory notes issued by a company to raise short-term cash. Negotiable certificates of deposit—bank-issued time deposits that specify an interest rate and maturity date and are negotiable (i.e., can be sold by the holder to another party). Banker’s acceptances—time drafts payable to a seller of goods, with payment guaranteed by a bank. CAPITAL MARKET INSTRUMENTS Corporate stock—the fundamental ownership claim in a public corporation. Mortgages—loans to individuals or businesses to purchase a home, land, or other real property. Corporate bonds—long-term bonds issued by corporations. Treasury bonds—long-term bonds issued by the U.S. government. State and local government bonds—long-term bonds issued by state and local governments. U.S. government agency bonds—long-term bonds collateralized by a pool of assets and issued by agencies of the U.S. government. Bank and consumer loans—loans to commercial banks and individuals. Figure – Money Market Instruments Outstanding 1990 2000 $2.06 trillion $4.51 trillion outstanding outstanding 18.1% 26.5% 27.1% 35.6% 2.6% 25.7% 14.4% 26.5% 23.3% 0.2% 2010 2019 $6.5 trillion $8.77 trillion outstanding outstanding 25.6% 46.0% 16.7% 12.2% Federal funds and repurchase 28.6% agreements 0.0% 0.0% 13.5% Commercial paper 29.1% 28.3% U.S. Treasury bills Negotiable CDs Banker’s acceptances  Part Introduction and Overview of Financial Markets capital markets Capital Markets. Capital markets are markets that trade equity (stocks) and debt Markets that trade debt (bonds) instruments with maturities of more than one year (see Figure 1–3). The major (bonds) and equity (stocks) suppliers of capital market securities (or users of funds) are corporations and governments. instruments with maturities Households are the major suppliers of funds for these securities. Given their longer of more than one year. maturity, these instruments experience wider price fluctuations in the secondary markets in which they trade than do money market instruments. For example, all else constant, long-term maturity debt instruments experience wider price fluctuations for a given change in interest rates than short-term maturity debt instruments (see Chapter 3). Capital Market Instruments. Table 1–3 lists and defines the major capital market securities. Figure 1–5 shows their outstanding amounts by dollar market value. Notice that in 2019, corporate stocks or equities represent the largest capital market instru- ment, followed by mortgages, Treasury securities, and corporate bonds. The relative size of the market value of capital market instruments outstanding depends on two Figure – Capital Market Instruments Outstanding 1990 2000 $14.93 trillion $40.6 trillion outstanding outstanding 3.7% 16.8% 25.5% 23.6% 10.6% 43.4% 7.9% 11.4% 7.7% 9.6% 11.1% 10.9% 12.1% 5.7% 2010 2019 $67.9 trillion $109.6 trillion outstanding outstanding 4.2% 3.7% 14.2% 20.9% 11.4% 8.3% 31.3% 43.8% 3.6% 6.4% 9.0% 14.1% 16.8% 12.3% Corporate stocks State and local government bonds Mortgages U.S. government agency bonds Corporate bonds Consumer loans Treasury securities  Chapter Introduction factors: the number of securities issued and their market prices.2 One reason for the sharp increase in the value of equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the early 2000s as the U.S. economy experienced a downturn—partly because of 9/11 and partly because interest rates began to rise—and stock prices fell. Stock prices in most sectors subsequently recovered and, by 2007, even surpassed their 1999 levels. Stock prices fell precipitously during the financial crisis of 2008–2009. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen 53.8 percent in value in less than 1½ years, larger than the decline during the market crash of 1929 when it fell 49 percent. However, stock prices recovered, along with the economy, in the last half of 2009, rising 71.1 percent between March 2009 and April 2010. Capital market instruments and their operations are discussed in detail in Chapters 6, 7, and 8. LG Foreign Exchange Markets In addition to understanding the operations of domestic financial markets, a financial man- ager must also understand the operations of foreign exchange markets and foreign capital markets. Today’s U.S.-based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. For example, ? Coca Cola’s global sales mean it is exposed to fluctuations in almost 70 different foreign currencies. The company reported that second quarter 2019 net sales in the Asia Pacific, Europe, Middle East, and Africa segments were flat for the quarter, and revenue in. The difference Latin America fell 6 percent largely due to the impact of a strong U.S. dollar. between primary and Cash flows from the sale of securities (or other assets) denominated in a foreign secondary markets? currency expose U.S. corporations and investors to risk regarding the value at which. The major distinction foreign currency cash flows can be converted into U.S. dollars. For example, the actual between money amount of U.S. dollars received on a foreign investment depends on the exchange markets and capital rate between the U.S. dollar and the foreign currency when the nondollar cash flow is markets? converted into U.S. dollars. If a foreign currency depreciates (declines in value) relative. What the major instruments traded in to the U.S. dollar over the investment period (i.e., the period between the time a foreign the capital markets investment is made and the time it is terminated), the dollar value of cash flows received are? will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar,. What happens to the the dollar value of cash flows received on the foreign investment will increase. dollar value of a U.S. While foreign currency exchange rates are often flexible—they vary day to day with investor’s holding of demand for and supply of a foreign currency for dollars—central governments sometimes British pounds if the intervene in foreign exchange markets directly or affect foreign exchange rates indirectly pound appreciates (rises) in value against by altering interest rates. We discuss the motivation and effects of these interventions the dollar? in Chapters 4 and 9. The sensitivity of the value of cash flows on foreign investments. What derivative to changes in the foreign currency’s price in terms of dollars is referred to as foreign security markets are? exchange risk and is discussed in more detail in Chapter 9. Techniques for managing, or “hedging,” foreign exchange risk, such as using derivative securities like foreign exchange (FX) futures, options, and swaps, are discussed in Chapter 24. LG Derivative Security Markets derivative security Derivative security markets are markets in which derivative securities trade. A derivative markets security is a financial security (such as a futures contract, option contract, swap contract, The markets in which or mortgage-backed security) whose payoff is linked to another, previously issued secu- derivative securities trade. rity such as a security traded in capital or foreign exchange markets. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of derivative security an asset or cash flow at a predetermined price and at a specified date in the future. An agreement between two parties to exchange a stan- dard quantity of an asset at 2. For example, the market value of equity is the product of the price of the equity times the number of shares that are a predetermined price at a issued. specified date in the future.  Part Introduction and Overview of Financial Markets As the value of the underlying security to be exchanged changes, the value of the deriva- tive security changes. While derivative securities have been in existence for centuries, the growth in derivative security markets occurred mainly in the 1990s and 2000s. Table 1–4 shows the dollar (or notional) value of derivatives held by commercial banks from 1992 through 2019. Note the tremendous growth in these securities between 1992 and 2013, and the large drop from 2013 to 2019. As we discuss in Chapter 10, part of the Wall Street Reform and Consumer Protection Act, passed in 2010 in response to the financial crisis, is the Volcker Rule which prohibits bank holding companies from engaging in proprietary trading (i.e., trading as a principal for the trading account of the financial institution). This included any transaction to purchase or sell derivatives. The Volcker Rule was implemented in April 2014 and banks had until July 21, 2015, to be in compliance. The result was a reduction in derivative securities held off-balance-sheet by these financial institutions. In 2018, however, changes to the Volcker Rule gave bank holding companies more freedom to conduct short-term trading of derivatives. The revision largely preserved the Volcker Rule intact but had two key ramifications. It exempted smaller banks from the full scope of the Volcker Rule. The amended rule also eliminated the presumption that positions held for fewer than 60 days violated the rule unless bankers could prove oth- erwise. This change made it easier for bank holding companies to trade for purposes of market making. The amount of trading done to hedge, or to offset risk, could also grow. The amended rule no longer requires banks to demonstrate how a trade is reducing a specific risk. And traders would no longer need to certify their intent on transactions. The amended Volcker Rule went into effect in 2019, and holdings of derivative securities by bank holding companies increased to $201.32 trillion by 2019. As major markets, derivative security markets are the newest of the financial security markets. Derivative securities, however, are also potentially the riskiest of the finan- cial securities. Indeed, at the center of the recent financial crisis were losses associated with off-balance-sheet mortgage-backed (derivative) securities created and held by FIs. Losses from the falling value of subprime mortgages and the derivative securities backed by these mortgages reached $700 billion worldwide by early 2009 and resulted in the failure, acquisition, or bailout of some of the largest FIs and the near collapse of the world’s financial and economic systems. We discuss derivative security activity in Chapter 10. Derivative security traders can be either users of derivative contracts for hedging (see Chapters 10 and 24) and other pur- poses or dealers (such as banks) that act as counterparties in trades with customers for a fee. www.sec.gov Financial Market Regulation Financial instruments are subject to regulations imposed by regulatory agencies such as the Securities and Exchange Commission (SEC)—the main regulator of securities markets since the passage of the Securities Act of 1934—as well as the exchanges (if any) on which the instruments are traded. The main emphasis of SEC regulations (as stated in the Securities Act of 1933) is on full and fair disclosure of information on securities issues TABLE Derivative Contracts Held by Commercial Banks, by Contract Product (in billions of dollars) 1992 2000 2008 2013 2016 2019 Futures and forwards $ 4,780 $ 9,877 $ 22,512 $ 45,599 $ 35,685 $ 46,165 Swaps 2,417 21,949 131,706 138,361 107,393 106,837 Options 1,568 8,292 30,267 33,760 30,909 44,134 Credit derivatives — 426 15,897 13,901 6,986 4,145 Total $ 8,765 $40,544 $200,382 $231,621 $180,973 $201,281  Chapter Introduction to actual and potential investors. Those firms planning to issue new stocks or bonds to be sold to the public at large (public issues) are required by the SEC to register their securities with the SEC and to fully describe the issue, and any risks associated with the issue, in a legal document called a prospectus. The SEC also monitors trading on the major exchanges (along with the exchanges themselves) to ensure that stockholders and managers do not trade on the basis of inside information about their own firms (i.e., information prior to its public release). SEC regu- lations are not intended to protect investors against poor investment choices, but rather to ensure that investors have full and accurate information available about corporate issuers when making their investment decisions. OVERVIEW OF FINANCIAL INSTITUTIONS LG Financial institutions (e.g., commercial and savings banks, credit unions, insurance companies, mutual funds) perform the essential function of channeling funds from those financial institutions with surplus funds (suppliers of funds) to those with shortages of funds (users of funds). Institutions that perform Chapters 11 through 19 discuss the various types of FIs in today’s economy, including the essential function of (1) the size, structure, and composition of each type; (2) their balance sheets and recent channeling funds from trends; (3) FI performance; and (4) the regulators who oversee each type. Table 1–5 lists those with surplus funds and summarizes the FIs discussed in detail in later chapters. to those with shortages of To understand the important economic function financial institutions play in the opera- funds. tion of financial markets, imagine a simple world in which FIs do not exist. In such a world, suppliers of funds (e.g., households), generating excess savings by consuming less than they earn, would have a basic choice: they could either hold cash as an asset or directly invest that cash in the securities issued by users of funds (e.g., corporations or households). In general, users of funds issue financial claims (e.g., equity and debt securities or mortgages) to finance the gap between their investment expenditures and their internally TABLE Types of Financial Institutions Commercial banks—depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than are those of other depository institutions. Commercial banks’ liabilities include more nondeposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions. Thrifts—depository institutions in the form of savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Insurance companies—financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, and so on. Securities firms and investment banks—financial institutions that help firms issue securities and engage in related activities such as securities brokerage and securities trading. Finance companies—financial intermediaries that make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding. Investment funds—financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets. Pension funds—financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation. Fintechs—institutions that use technology to deliver financial solutions in a manner that competes with traditional financial methods.  Part Introduction and Overview of Financial Markets Figure – Flow of Funds in a World without FIs Financial Claims (Equity and debt instruments) Users of Funds Suppliers of Funds Cash generated savings such as retained earnings. As shown in Figure 1–6, in such a world we direct transfer have a direct transfer of funds (money) from suppliers of funds to users of funds. In return, financial claims would flow directly from users of funds to suppliers of funds. A corporation sells its stock In this economy without financial institutions, the level of funds flowing between sup- or debt directly to investors without going through a pliers of funds (who want to maximize the return on their funds subject to risk) and users financial institution. of funds (who want to minimize their cost of borrowing subject to risk) is likely to be quite low. There are several reasons for this. First, once they have lent money in exchange for financial claims, suppliers of funds need to monitor continuously the use of their funds. They must be sure that the user of funds neither steals the funds outright nor wastes the funds on projects that have low or negative returns. Such monitoring is often extremely costly for any given fund supplier because it requires considerable time, expense, and effort to collect this information relative to the size of the average fund supplier’s investment. Given this, fund suppliers would likely prefer to leave, or delegate, the monitoring of fund borrowers to others. The resulting lack of monitoring increases the risk of directly investing in financial claims. Second, the relatively long-term nature of many financial claims (e.g., mortgages, corporate stock, and bonds) creates another disincentive for suppliers of funds to hold the direct financial claims issued by users of funds. Specifically, given the choice between holding cash and long-term securities, fund suppliers may well choose to hold cash for liquidity reasons, especially if they plan to use their savings to finance consumption expen- ditures in the near future and financial markets are not very developed, or deep, in terms of the number of active buyers and sellers in the market. Third, even though real-world financial markets provide some liquidity services, by allowing fund suppliers to trade financial securities among themselves, fund suppliers face price risk a price risk upon the sale of securities. That is, the price at which investors can sell a secu- The risk that an asset’s rity on secondary markets such as the New York Stock Exchange (NYSE) may well differ sale price will be lower from the price they initially paid for the security either because investors change their valu- than its purchase price. ation of the security between the time it was bought and when it was sold and/or because dealers, acting as intermediaries between buyers and sellers, charge transaction costs for completing a trade. Unique Economic Functions Performed by Financial Institutions Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average investor in a world without FIs would likely view direct investment in financial claims and markets as an unattractive proposition and prefer to hold cash. As a result, financial market activity (and therefore savings and investment) would likely remain quite low. However, the financial system has developed an alternative and indirect way for inves- indirect transfer tors (or fund suppliers) to channel funds to users of funds.3 This is the indirect transfer of A transfer of funds funds to the ultimate user of funds via FIs. Due to the costs of monitoring, liquidity risk, between suppliers and and price risk, as well as for other reasons explained later, fund suppliers often prefer to users of funds through a hold the financial claims issued by FIs rather than those directly issued by the ultimate financial intermediary. users of funds. Consider Figure 1–7, which is a closer representation than Figure 1–6 of the world in which we live and the way funds flow in the U.S. financial system. Notice 3. We describe and illustrate this flow of funds in Chapter 2.  Chapter Introduction Figure – Flow of Funds in a World with FIs Users of Funds FI Suppliers of Funds (Brokers) Cash FI Cash (Asset transformers) Financial Claims Financial Claims (Equity and debt securities) (Deposits and insurance policies) how financial intermediaries or institutions are standing, or intermediating between, the suppliers and users of funds—that is, channeling funds from ultimate suppliers to ultimate users of funds. How can a financial institution reduce the monitoring costs, liquidity risks, and price risks facing the suppliers of funds compared to when they directly invest in financial claims? We look at how FIs resolve these cost and risk issues next and summarize them in Table 1–6. LG Monitoring Costs. As mentioned previously, a supplier of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund user’s actions in a timely and complete fashion. One solution to this problem is for a large number of small investors to group their funds together by holding the claims issued by a finan- cial institution. The FI groups the fund suppliers’ funds together and invests them in the direct financial claims issued by fund users. This aggregation of funds by fund suppliers in a financial institution resolves a number of problems. First, the “large” FI now has a TABLE Services Performed by Financial Institutions Services Benefiting Suppliers of Funds: 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). Liquidity and price risk—FIs provide financial claims to household savers with superior liquidity attributes and with lower price risk. 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. Maturity intermediation—FIs can better bear the risk of mismatching the maturities of their assets and liabilities. Denomination intermediation—FIs such as mutual funds allow small investors to overcome constraints to buying assets imposed by large minimum denomination size. Services Benefiting the Overall Economy: 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. 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. 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. Payment services—the efficiency with which depository institutions provide payment services directly benefits the economy.  Part Introduction and Overview of Financial Markets much greater incentive to hire employees with superior skills and training in monitoring. This expertise can be used to collect information and monitor the ultimate fund user’s actions because the FI has far more at stake than any small individual fund supplier. Sec- ond, the monitoring function performed by the FI alleviates the “free-rider” problem that exists when small fund suppliers leave it to each other to collect information and monitor a fund user. In an economic sense, fund suppliers have appointed the financial institution delegated monitor as a delegated monitor to act on their behalf. For example, full-service securities firms An economic agent such as Morgan Stanley carry out investment research on new issues and make investment appointed to act on behalf recommendations for their retail clients (or investors), while commercial banks collect of smaller investors in col- deposits from fund suppliers and lend these funds to ultimate users such as corporations. lecting information and/ An important part of these FIs’ functions is their ability and incentive to monitor ultimate or investing funds on their fund users. behalf. Liquidity and Price Risk. In addition to improving the quality and quantity of infor- asset transformers mation, FIs provide further claims to fund suppliers, thus acting as asset transformers. Financial claims issued by Financial institutions purchase the financial claims issued by users of funds—primary an FI that are more attrac- securities such as mortgages, bonds, and stocks—and finance these purchases by selling tive to investors than are financial claims to household investors and other fund suppliers in the form of deposits, the claims directly issued insurance policies, or other secondary securities. Thus, in contrast to a world without FIs, by corporations. while funds are being transferred from suppliers of funds through FIs to users of funds, ownership of the financial claims is not directly transferred from users of funds to the suppliers of funds. For example, an individual investor in a mutual fund that purchases Apple stock is not a shareholder of Apple Inc. The mutual fund owns Apple shares and the individual investor owns shares of this mutual fund. Often claims issued by financial institutions have liquidity attributes that are superior to those of primary securities. For example, banks and thrift institutions (e.g., savings associations) issue transaction account deposit contracts with a fixed principal value and often a guaranteed interest rate that can be withdrawn immediately, on demand, by inves- tors. Money market mutual funds issue shares to household savers that allow them to enjoy almost fixed principal (depositlike) contracts while earning higher interest rates than on bank deposits, and that can be withdrawn immediately. Even life insurance companies allow policyholders to borrow against their policies held with the company at very short notice. Notice that in reducing the liquidity risk of investing funds for fund suppliers, the FI transfers this risk to its own balance sheet. That is, FIs such as depository institutions offer highly liquid, low price-risk securities to fund suppliers on the liability side of their balance sheets, while investing in relatively less liquid and higher price-risk securities— such as the debt and equity—issued by fund users on the asset side. Three questions arise here. First, how can FIs provide these liquidity services? Furthermore, how can FIs be confident enough to guarantee that they can provide liquidity services to fund suppliers when they themselves invest in risky assets? Finally, why should fund suppliers believe FIs’ promises regarding the liquidity and safety of their investments? diversify The answers to these three questions lie in financial institutions’ ability to diversify The ability of an economic away some, but not all, of their investment risk. The concept of diversification is familiar agent to reduce risk by to all students of finance. Basically, as long as the returns on different investments are not holding a number of differ- perfectly positively correlated, by spreading their investments across a number of assets, ent securities in a portfolio. FIs can diversify away significant amounts of their portfolio risk. (We discuss the mechan- ics of diversification in the loan portfolio in Chapter 21.) Thus, FIs can exploit the law of large numbers in making their investment decisions, whereas because of their smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI to predict more accurately its expected return and risk on its investment portfolio so that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little price risk. As long as an FI is large enough to gain from diversification and monitoring on the asset side of its balance sheet, its financial claims (its liabilities) are likely to be viewed as liquid and attractive to small savers—especially when compared to direct investments in the capital market.  Chapter Introduction Additional Benefits FIs Provide to Suppliers of Funds The indirect investing of funds through financial institutions is attractive to fund suppliers for other reasons as well. We discuss these below and summarize them in Table 1–6. Reduced Transaction Cost. Not only do financial institutions have a greater incentive to collect information, but also their average cost of collecting relevant information is economies of scale lower than for the individual investor (i.e., information collection enjoys economies of The concept that cost scale). For example, the cost to a small investor of buying a $100 broker’s report may reduction in trading and seem inordinately high for a $10,000 investment. For an FI with $10 billion of assets other transaction services under management, however, the cost seems trivial. Such economies of scale of informa- results in increased effi- tion production and collection tend to enhance the advantages to investors of investing ciency when FIs perform via FIs rather than directly investing themselves. Nevertheless, as a result of technologi- these services. cal advances, the costs of direct access to financial markets by savers are ever falling and the relative benefits to the individual savers of investing through FIs are narrowing. Maturity Intermediation. An additional dimension of financial institutions’ ability to reduce risk by diversification is their greater ability, compared to a small saver, to bear the risk of mismatching the maturities of their assets and liabilities. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, by maturity mismatching, FIs can produce long-term contracts such as long-term, fixed-rate mortgage loans to house- holds, while still raising funds with short-term liability contracts such as deposits. In addition, although such mismatches can subject an FI to interest rate risk (see Chapters 3 and 23), a large FI is better able than a small investor to manage this risk through its superior access to markets and instruments for hedging the risks of such loans (see Chapters 7, 10, 21, and 25). Denomination Intermediation. Some FIs, especially mutual funds, perform a unique service relating to denomination intermediation. Because many assets are sold in very large denominations, they are either out of reach of individual savers or would result in savers holding very undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000, while commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individual small savers may be unable to purchase such instruments directly. However, by pooling the funds of many small savers (such as by buying shares in a mutual fund with other small investors), small savers overcome constraints to buying assets imposed by large minimum denomination size. Such indirect access to these markets may allow small savers to generate higher returns (and lower risks) on their portfolios as well. Economic Functions FIs Provide to the Financial System as a Whole In addition to the services financial institutions provide to suppliers and users of funds in the financial markets, FIs perform services that improve the operation of the financial system as a whole. We discuss these next and summarize them in Table 1–6. The Transmission of Monetary Policy. The highly liquid nature of bank and thrift deposits has resulted in their acceptance by the public as the most widely used medium of exchange in the economy. Indeed, at the core of the most commonly used definitions of the money supply (see Chapter 4) are bank and/or thrift deposit contracts. Because deposits are a significant component of the money supply, which in turn directly impacts the rate of eco- nomic growth, depository institutions—particularly commercial banks—play a key role in the transmission of monetary policy from the central bank (the Federal Reserve) to the rest www.federalreserve.gov of the economy (see Chapter 4 for a detailed discussion of how the Federal Reserve imple- ments monetary policy through depository institutions).4 Because depository institutions 4. The Federal Reserve is the U.S. central bank charged with promoting economic growth in line with the economy’s potential to expand.  Part Introduction and Overview of Financial Markets ? are instrumental in determining the size and growth of the money supply, they have been designated as the primary conduit through which monetary policy actions by the Federal Reserve impact the rest of the financial sector and the economy in general.. The three major reasons that suppliers Credit Allocation. FIs provide a unique service to the economy in that they are the of funds would not major source of financing for particular sectors of the economy preidentified by society want to directly as being in special need of financing. For example, policymakers in the United States and purchase securities? a number of other countries such as the United Kingdom have identified residential real. What the asset transformation estate as needing special attention. This has enhanced the specialness of those FIs that function of FIs is? most commonly service the needs of that sector. In the United States, savings associations. What delegated and savings banks must emphasize mortgage lending. Sixty-five percent of their assets monitoring function must be mortgage related for these thrifts to maintain their charter status (see Chapter 14). FIs perform? In a similar fashion, farming is an especially important area of the economy in terms of. What the link is the overall social welfare of the population. Thus, the U.S. government has directly encour- between asset aged financial institutions to specialize in financing this area of activity through the diversification and creation of Federal Farm Credit Banks.5 the liquidity of deposit contracts? Intergenerational Wealth Transfers or Time Intermediation. The ability of savers. What maturity intermediation is? to transfer wealth from their youth to old age as well as across generations is also of great. Why the need importance to a country’s social well-being. Because of this, special taxation relief and for denomination other subsidy mechanisms encourage investments by savers in life insurance, annuities, intermediation arises? and pension funds. For example, pension funds offer savings plans through which fund. The two major sectors participants accumulate tax-exempt savings during their working years before withdrawing that society has them during their retirement years. identified as deserving special attention in Payment Services. Depository institutions such as banks and thrifts are also special credit allocation? in that the efficiency with which they provide payment services directly benefits the. Why monetary policy is transmitted through economy. Two important payment services are check-clearing and wire transfer services. the banking system? For example, on any given day, over $4.5 trillion of payments are directed through Fedwire. The payment services and CHIPS, the two largest wholesale payment wire network systems in the United States. that FIs perform? Any breakdowns in these systems would likely produce gridlock to the payment system, with resulting harmful effects to the economy. LG Risks Incurred by Financial Institutions As financial institutions perform the various services described previously, they face many types of risk. Specifically, all FIs hold some assets that are potentially subject to default or credit risk (such as loans, stocks, and bonds). As FIs expand their services to non-U.S. customers or even domestic customers with business outside the United States, they are exposed to both foreign exchange risk and country or sovereign risk as well. Further, FIs tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. If FIs actively trade these assets and liabilities rather than hold them for longer-term investments, they are further exposed to market risk or asset price risk. Increasingly, FIs hold contingent assets and liabilities off the balance sheet, which presents an additional risk called off- balance-sheet risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. All FIs are exposed to technology risk and operational risk because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services). Finally, the risk that an FI may not have enough capital reserves to offset a sudden loss incurred as a result of one or more of the risks it faces creates insolvency risk for the FI. Chapters 20 through 25 provide an analysis of how FIs measure and manage these risks. 5. The Farm Credit System was created by Congress in 1916 to provide American agriculture with a source of sound, dependable credit at low rates of interest.  Chapter Introduction LG Regulation of Financial Institutions The preceding section showed that financial institutions provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their efficient provi- sion, can be costly to both the ultimate suppliers of funds and users of funds as well as to the economy overall. The financial crisis of the late 2000s is a prime example of how such a breakdown in the provision of financial services can cripple financial markets world- wide and bring the world economy into a deep recession. For example, bank failures may destroy household savings and at the same time restrict a firm’s access to credit. Insurance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sudden drops in income upon retirement. In addition, indi- vidual FI failures may create doubts in savers’minds regarding the stability and solvency of FIs and the financial system in general and cause panics and even withdrawal runs on sound institutions. Indeed, this possibility provided the reasoning in 2008 for an increase in the deposit insurance cap to $250,000 per person per bank. At this time, the Federal Deposit Insurance Corporation (FDIC) was concerned about the possibility of contagious runs as a few major FIs (e.g., IndyMac and Washington Mutual) failed or nearly failed. The FDIC wanted to instill confidence in the banking system and made the change to avoid massive depositor runs from many of the troubled (and even safer) FIs, more FI failures, and an even larger collapse of the financial system. FIs are regulated in an attempt to prevent these types of market failures and the costs they would impose on the economy and society at large. Although regulation may be socially beneficial, it also imposes private costs, or a regulatory burden, on individual FI owners and managers. Consequently, regulation is an attempt to enhance the social welfare benefits and mitigate the costs of the provision of FI ser- vices. Chapter 13 describes regulations (past and present) that have been imposed on U.S. financial institutions. Trends in the United States In Table 1–7, we show the changing shares of total assets of financial institutions in the United States from 1948 to 2019. A number of important trends are clearly evident; most apparent is the decline in the total share of depository institutions—commercial banks and thrifts—since World War II. Specifically, while still the dominant sector of the finan- cial institutions industry, the share of depository institutions declined from 62.7 percent in 1948 to 30.9 percent in 2019. The effects of regulation imposed during the financial crisis (e.g., the Financial Institutions Reform and Recovery Act of 2010 and Basel 3 capital regulations discussed in Chapter 13) and historically low interest rates on bank deposits TABLE Percentage Shares of Assets of Financial Institutions in the United States, – 1948 1960 1970 1980 1990 2000 2010 2016 2019 Depository institutions 62.7% 54.5% 56.9% 57.9% 43.3% 27.9% 31.3% 32.5% 30.9% Insurance companies 23.4 22.6 18.1 15.7 16.2 14.4 14.2 14.1 13.8 Investment companies 1.1 3.7 3.8 3.8 9.9 24.0 24.7 28.5 31.0 Pension funds 9.1 13.0 13.3 13.7 15.3 14.3 12.5 13.4 13.2 Finance companies 2.5 4.7 5.1 5.2 5.3 4.1 3.5 2.3 2.0 Securities brokers and dealers 1.2 1.5 2.5 3.6 9.7 15.1 13.2 8.2 8.0 Real estate investment trusts — 0.0 0.3 0.1 0.3 0.2 0.6 1.0 1.1 Total (percentage) 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Total (trillions of dollars) $0.27 $0.63 $1.39 $4.10 $11.64 $29.91 $52.78 $67.18 $75.21 Part Introduction and Overview of Financial Markets (discussed in Chapter 2) reflect this relatively large decline.6 Similarly, insurance compa- nies also witnessed a decline in their share, from 23.4 to 13.8 percent. The most dramatic trend involves the increasing share of pension funds and invest- ment companies and securities brokers and dealers. Investment companies (mutual funds and money market mutual funds) increased their share from 1.1 to 31.0 percent, while pension funds increased from 9.1 to 13.2 percent over the 1948 to 2019 period. Investment companies and pension funds differ from banks and insurance companies in that they give savers cheaper access to the direct securities markets. They do so by exploiting the com- parative advantages of size and diversification, with the transformation of financial claims, such as maturity transformation, a lesser concern. Thus, open-ended mutual funds and pension funds buy stocks and bonds directly in financial markets and issue savers shares whose value is linked in a direct pro rata fashion to the value of the fund’s asset portfolio. Similarly, money market mutual funds invest in short-term financial assets such as com- mercial paper, CDs, and Treasury bills and issue shares linked directly to the value of the underlying portfolio. To the extent that these funds efficiently diversify, they also offer price risk protection and liquidity services. The Rise of Financial Services Holding Companies. To the extent that the financial services market is efficient and the data seen in Table 1–7 reflect the forces of demand and supply, these data indicate a current trend: savers increasingly prefer investments that closely mimic diversified investments in the direct securities markets over the transformed financial claims offered by traditional FIs. This trend may also indicate that the regulatory burden on traditional FIs—such as banks and insurance companies—is higher than that on pension funds, mutual funds, and investment companies. Indeed, traditional FIs are unable to produce their services as cost-efficiently as they previously could. Recognizing this changing trend, in 1999 the U.S. Congress passed the Financial Services Modernization (FSM) Act, which repealed the 1933 Glass-Steagall barriers between commercial banking, insurance, and investment banking. The bill, promoted as the biggest change in the regulation of financial institutions in 70 years, allowed for the creation of “financial services holding companies” that could engage in banking activities, insurance activities, and securities activities. After 70 years of partial or complete separa- tion between insurance, investment banking, and commercial banking, the FSM opened the door for the creation of full-service financial institutions in the United States simi- lar to those that existed before 1933 and that exist in many other countries. Thus, while Table 1–7 lists assets of financial institutions by functional area, the financial services holding company (which combines these activities in a single financial institution) has become the dominant form of financial institution in terms of total assets. The Shift Away from Risk Measurement and Management and the Financial Crisis. Certainly, the financial crisis of the late 2000s changed and reshaped today’s financial markets and institutions. As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in the systemic risk of the financial sys- tem, caused in large part by a shift in the banking model from that of “originate and hold” to “originate and distribute.” In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consum- ers. Banks typically hold these loans to maturity and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquid- ity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks have shifted to an underwriting model in which 6. Although depository institutions assets as a percentage of total assets in the financial sector may have declined in recent years, this does not necessarily mean that banking activity has decreased. Indeed, off-balance-sheet activities have replaced some of the more traditional on-balance-sheet activities of commercial banks (see Chapter 11). Further, as is discussed in Part Three of the text, banks are increasingly providing services (such as securities underwriting, insurance underwriting and sales, and mutual fund services) previously performed exclusively by other FIs.  Chapter Introduction Figure – Bank Loan Secondary Market Trading, – Trading Volume ($ billions) * *Through August they originate or warehouse loans and then quickly sell them. Figure 1–8 shows the growth in bank loan secondary market trading from 1991 through 2019. Note the huge growth in bank loan trading even during the financial crisis of 2008–2009. When loans trade, the secondary market produces information that can substitute for the information and monitoring of banks. Further, banks may have lower incentives to collect informa- tion and monitor borrowers if they sell loans rather than keep them as part of the bank’s portfolio of assets. Indeed, most large banks are organized as financial services holding companies to facilitate these new activities. More recently, activities of shadow banks, nonbank financial services firms (such as structured investment vehicles [SIVs] discussed in Chapter 25) that perform banking services, have facilitated the change from the originate-and-hold model of commercial banking to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutual and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers. However, instead of the bank serving as the intermediary, it is the nonbank financial services firm, or shadow bank, that intermediates. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking, they have little incentive to screen and monitor the  Part Introduction and Overview of Financial Markets activities of borrowers to whom they originated loans. Thus, FIs’ role as specialists in risk measurement and management has been reduced. Adding to FIs’ move away from risk measurement and management was the boom (“bubble”) in the housing markets, which began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term interest rate that banks and other financial institu- tions pay in the federal funds market. Perhaps not surprisingly, low interest rates and the increased liquidity provided by the central bank resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their