Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 PDF

Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 Econ 350: U.S. Financial Systems, Markets and Institutions Class 3: Overview of the financial system This class examines different ways of linking borrowers and lenders in financial markets. W...

Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 Econ 350: U.S. Financial Systems, Markets and Institutions Class 3: Overview of the financial system This class examines different ways of linking borrowers and lenders in financial markets. We explore many distinctions and definitions made in financial markets, such as direct vs. indirect finance or money vs. capital markets. We then describe different types of debt instruments, and we will discuss the differences between debt and equity. We then return to issues in financial intermediation that we first discussed in Class 2, and provide a brief overview of the Federal Reserve System. Class Objectives After today’s class, you should -- have a working knowledge of basic definitions and distinctions involved in financial markets. -- understand the difference between different types of debt and equity instruments. -- understand the difference between money and capital markets. -- learn about moral hazard and adverse selection. -- begin to acquaint yourself with the Federal Reserve System. Definitions and Distinctions This class we look at many distinctions made in financial market parlance, and then we provide definitions for these. It is not the most exciting endeavor, but it is necessary for the discussions that will take place in the rest of the course. We all need to be using the same words and definitions to communicate effectively. Some of the most important distinctions include: Direct vs. indirect finance Debt vs. equity markets Primary vs. secondary markets Dealers vs. brokers Exchanges vs. over the counter Short-term vs. long-term debt Money vs. capital markets Let’s take each of these in turn. Direct vs. indirect finance One distinction in the transactions between borrowers and lenders is whether or not a middleman is used. Indirect finance uses a middleman, while direct finance does not. Examples of direct finance include stocks, bonds, and commercial paper. These securities become assets for the purchaser and liabilities for the borrower. The best example of indirect finance is a bank loan. Here the bank acts as a middleman between depositors and borrowers. 15 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 Direct finance: The process of borrowing directly from lenders often by selling securities, such as stocks, bonds or commercial paper. Indirect finance: The process of borrowing that uses financial intermediaries such as banks or finance companies as middlemen to link borrowers and lenders in financial markets. Examples include commercial bank loans, mortgages, and insurance policies. The following diagram is adapted from Mishkin: Figure 3-1 Indirect finance FINANCIAL $ INTERMEDIARIES $ LENDERS/SAVERS BORROWERS/SPENDERS - households - households - firms $ FINANCIAL $ - firms - government MARKETS - government - foreigners - foreigners Direct finance Lenders/savers (those with excess funds) may not always have productive uses of their surplus funds. Without financial markets, they may not always be able to find profitable investment opportunities. As the stick figure model from last class showed, without financial markets borrowers/spenders may face high transactions costs in obtaining loans. Since they reduce transaction costs, financial institutions are essential for economic efficiency. For example, each of you is holding $50 in ClassCash, but up until the Series A market there are no profitable investment opportunities for the funds so your money just sits there. After the Series A bonds mature on Friday, some of you will be successful in purchasing bonds and find more productive uses of your money. When bonds are sold, the purchaser finds a more productive use of excess funds, while the seller of bonds receives funds that can be used for profitable investment opportunities. Again, in this way wealth is created and economic efficiency is increased. Unfortunately, no one else is willing to accept my electronic money! 16 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 We first turn our attention to the concepts and tools of direct finance, and then we examine issues in indirect finance. Direct Finance Debt vs. equity markets Debt and equity can both be instruments of direct finance. Debt includes such instruments as bonds and mortgages, while equity is primarily common stocks and derivatives such as options, futures and mortgage-backed securities. Debt markets: Markets consisting of contractual agreements by the borrowers to pay the holders of security instruments fixed payments at regular intervals until a specified date, when a final payment is made. Maturity: Time to expiration date or when final payment is made. Maturities can be short- (less than one year), intermediate- (one to ten years) or long-term (over ten years). See below. Equity markets: Markets consisting of claims to shares in the net income or assets of businesses. Dividends: Periodic equity payments. Common stock is the most predominant form of equity securities. For example, if you own X% of a company’s stock, then you are entitled to X% of that firm’s net income and assets. Other examples of equity instruments are preferred stock, options, futures, asset- backed securities, collateralized debt obligations, and credit default swaps. We discussed the difference between stocks and bonds in Class 2. Equity holders are residual claimants, since a company is legally obligated to pay debt holders first. Debt payments are fixed and never increase, while equity payments may increase if the firm becomes more profitable. Once again, we see the tradeoff between risk and return. Figure 3.2 shows the debt and equity holdings of US households and nonprofit institutions from 1988 - 2023. Equity holdings declined during the 2001 recession increased substantially through the stock boom from 2003-2007, and the market has declined dramatically since October 2007, with equities losing 24% of their value for households from the third quarter of 2007 to 2011. The graph also shows the decline in stock values during the pandemic and increases since then. Figure 3-2 also shows the trade-off between risk and return. While debt holdings never saw a large increase among households, they also did not see a large decline in value unlike equity holdings. Figure 3-3 shows debt and equity for US non-financial businesses. The table shows a slight shift from equity to debt holdings in 2008 as the value of stocks fell and debt instruments become more attractive investments. Since the pandemic the opposite trend has occurred, with the value of equity holdings increasing and debt holdings declining. 17 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 Figure 3-2 Debt and equity holdings: US households 1988 - 2023 (in millions) Figure 3-3 Debt and equity holdings: US non-financial corporations 1988 - 2023 (in millions) source Federal Reserve release Z.1, FRED Primary vs. secondary markets An important distinction is that between primary and secondary markets. Primary markets: Markets where new issues of a security are sold to initial buyers Secondary markets: Markets where previously issued securities are resold 18 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 Primary markets are equivalent to new car markets, while secondary markets are like used car markets. For example, the Treasury sells bonds in primary markets to initial buyers in order to finance the federal government deficit. The Fed, on the other hand, buys and sells previously issued bonds in secondary markets in order to control the level of bank reserves and the money supply. Corporations obtain funds from primary stock sales known as IPOs (Initial Public Offerings), but not from sales of stock in the secondary market which only transfer assets from one set of investors to another. Common types of primary security markets are Treasury sales, corporate bond sales, commercial paper, and IPOs. Secondary markets include stock markets such as the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ). The “AQ” stands for Average Quotient, a measure of stock prices traded in the market. I am not sure why it is stuck on there, probably just by convention. Other common measures of stock prices include the Dow Jones Industrial Average and Standard and Poor’s 500. Other secondary markets include bond markets and Fed open market operations, negotiable CDs, mortgages, commodities markets such as the Chicago Mercantile Exchange, futures markets, and options markets. Secondary markets help to increase the liquidity of securities because the security can be sold before maturity. This makes it easier to sell in the primary market to begin with. Also, secondary markets help to determine the price of securities in primary markets. Why? IPOs (Initial Public Offerings): The initial sale of stock in a primary market, underwritten by an investment bank which guarantees to purchase the IPO at a minimum price. Investment Banks: Financial institutions that purchase securities in primary markets by underwriting stocks. They guarantee a minimum price to the issuing company and then sell the shares to the public, in return for hefty fees. As mentioned in Class 2, the five major investment banks, Bear Stearns, Lehman Brothers, Merrill lynch, Goldman Sachs, and Morgan Stanley, all disappeared in 2008 as a result of the predatory lending scandals. They either went bankrupt (Lehman Brothers), were purchased by commercial banks (Merrill Lynch, Bear Stearns), or became bank holding companies themselves (Goldman Sachs, Morgan Stanley). Dealers vs. brokers Dealers: link buyers and sellers by purchasing and selling securities from their own portfolios at stated prices. Brokers: Agents of investors who match buyers and sellers of securities, often on a trading floor such as the NYSE. Dealers trade from their own portfolios by buying at the “bid price” and selling at the “asked price.” Brokers do not buy and sell their own securities, but link buyers and sellers for a brokerage fee through exchanges or over-the-counter markets. Most dealer 19 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 and broker services were performed by investment banks, but these services are increasingly offered through commercial bank divisions. Exchanges vs. over-the-counter markets Secondary markets can be either exchanges or over-the-counter markets. Exchanges: Markets where buyers and sellers meet in one central location Over-The-Counter Markets (OTC): Markets where dealers in different locations buy and sell to anyone willing to accept their prices. Examples of exchanges include the New York Stock Exchange, the London Stock Exchange, and the Chicago Mercantile Exchange. In the age of the internet, these are becoming less common. Examples of OTC markets include NASDAQ, Treasury bonds, negotiable CDs, federal funds, and foreign exchange. Recently there was a proposal for the NYSE to merge with Archipelago, an online trading company, so the days of actual physical face-to-face exchanges may be numbered. Short-term vs. long-term debt Short-term debt: debt securities with maturities less than one year Intermediate-term debt: debt securities with maturities between one and ten years Long-term debt: debt securities with maturities greater than 10 years. Treasury bills: short-term Treasury securities Treasury notes: intermediate-term Treasury securities Treasury bonds: long-term Treasury securities Money vs. capital markets An important distinction often made in the real financial world is that between money and capital markets. Money markets: markets where short-term debt securities are traded Capital markets: markets where intermediate and long-term debt and equities are traded Money Market Instruments Money market securities tend to be more liquid since they mature sooner. Since they have less price fluctuations, they are safer than capital instruments but generally pay lower interest rates. Once again, we see a tradeoff between risk and return. Money 20 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 instruments are generally used for short-term financing needs, and enable lenders to earn interest on money being held temporarily. Examples of money market instruments include U.S. Treasury bills Negotiable bank certificates of deposit (CDs) Commercial paper Banker acceptances Repurchase agreements Federal funds Make sure that you have an understanding of what each of these are and how they are related. Mishkin provides a good synopsis. Treasury bills are often thought to be the least risky type of debt or equity instrument since they are short-term obligations of the federal government with little likelihood of going bankrupt in the near future. In September and October of 2008, one of the important consequences of the credit crisis was a freeze in the commercial paper market as corporations were unwilling to lend to each other. Capital Market Instruments Capital market instruments are equity and debt securities with maturities greater than one year. Equity is always considered long-term because stocks do not mature. Since they tend to have wider price fluctuations than debt instruments, capital instruments are often riskier investments with higher returns. Examples of capital market instruments include Stocks Mortgages Corporate bonds Derivatives Treasury notes and bonds Government agency securities State and local (municipal) bonds consumer and bank commercial loans foreign bonds As we will see, even though stock markets receive most of the attention, the bulk of external financing for US firms comes from bonds and indirect finance, especially bank and other loans. Indirect finance A large part of the course covers issues and institutions involved in indirect finance, when a middleman is involved in connecting lender and borrower. A bank loan is the most common example of indirect finance. Other financial intermediaries include other depository institutions such as thrifts and credit unions, contractual savings institutions 21 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 such as finance companies, life insurance companies, pension funds and mutual funds, and fringe institutions such as pawn shops and rent-to-own centers. Many of these were discussed in Class 2. Many important issues in indirect finance center on the concepts of transactions costs and information asymmetries. We mentioned before that banks lower transactions costs. Specifically, banks lower transaction costs by developing tools such as expertise, knowledge and economies of scale. They can then use these tools to reduce the average costs of contract writing, monitoring loans, and searching for lenders and borrowers. Information asymmetries occur when one party to a transaction has more information then the other. There are two main types: adverse selection, which occurs before the transaction, and moral hazard, which occurs after the transaction. Adverse selection: occurs when high risk borrowers are the ones most likely to seek out loans. The safest borrowers do not need loans in the first place. Moral Hazard: occurs when a borrower engages in more risky activities which make it less likely that the loan will be repaid. Much more on these will follow later on in the course when we cover classes 8 and 9. Introduction to the Federal Reserve System While we will cover the Federal Reserve System (Fed) in extensive detail later on, it is useful to introduce ourselves to the Fed now since it plays such an important role in the United States financial system. if you have not done so yet, visit the Fed website (www.federalreserve.gov) and poke around for an introduction. The old website banner states that “The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.” In the book The Federal Reserve System, Purposes and Functions, the Fed provides a brief outline of its functions, goals, structure, and monetary tools. 22 Econ 350 U.S. Financial Systems, Markets and Institutions Class 3 Functions The functions of the Federal Reserve are divided into four major areas: 1. Conducting monetary policy 2. Supervision and regulation 3. Assuring financial stability 4. Operating the nation’s payments system Goals The goals of the Fed are listed above in the banner. More concretely, it tries to achieve these goals through maintaining a stable rate of GDP growth, with high employment, stable prices, and moderate long-term interest rates. These goals arise from The Full Employment and Stabilization Act of 1946 and The Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins). The Fed has always had a unique relationship with Congress. While it prides itself on its independence, it still must rely on Congress to delegate its powers to stabilize the economy and to coin money. Political independence is enhanced by the facts that the Fed is self-financing and its Governors have staggered, fourteen-year terms. Recently Janet Yellen and Jerome Powell have emphasized the Fed’s dual mandate of assuring price stability and high employment. Structure The structure of the Fed mimics that of the U.S. national government, with features such as the separation of powers and federalism. Rather than having one central bank located in New York City, the Fed consists of twelve regional banks spread out throughout the country, much the same way that state power is spread throughout the country. This is meant to avoid the concentration of political and economic power. The President selects the Board of Governors, but they are appointed to fourteen-year, staggered terms to provide a separation of powers and political insulation. Member commercial banks play a role by purchasing equity capital (stock) in the regional Federal Reserve Banks, providing reserve funds, and helping to select the Board of Directors of their regional Federal Reserve Banks. The Federal Open Market Committee (FOMC) guides the monetary policy decisions of the Fed, which are implemented by the Federal Reserve Bank of New York. (We New Yorkers love to brag. Personally, I’m proud that we get to do all of the bond operations.) That, in a nutshell, is the structure of the Federal Reserve. 23