Lecture Notes: Global Financial System PDF

GLOBAL FINANCIAL Dr. Marco Conti SYSTEM  Concept of the financial system & global financial system Evolution of the global financial system Institutions of global financial system Contents Concept of bank and its role Banking and inf...

GLOBAL FINANCIAL Dr. Marco Conti SYSTEM  Concept of the financial system & global financial system Evolution of the global financial system Institutions of global financial system Contents Concept of bank and its role Banking and information Economic imbalances, interdependence and their role in financial crisis The bread and butter of banks: credit intermediation The nature of financial intermediation To understand how banks work, it is necessary to understand the role of financial intermediaries in an economy. This will help us to answer the question about why we need banks. Financial intermediaries and financial markets’ main role is to provide a mechanism by which funds are transferred and allocated to their most productive opportunities. What does financial system mean? A Financial System is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals. Financial systems exist on firm, regional, and global levels.  What Is the Financial Sector? The financial sector is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers. This sector comprises a broad range of industries including banks, investment companies, insurance companies, and real estate firms.  What Is the Financial Sector? The financial sector plays a vital role in the economy because it helps money be efficiently channeled from savers to prospective borrowers, making it much easier for firms to obtain financing for profitable investment in new capital and for individuals to borrow against their future income (e.g., to pay for college, to buy a house or car). Financial markets Financial markets involve borrowers, lenders, and investors negotiating loans and other transactions. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. Assignment #2 Design the financial system by including these elements: FED NYSE APPLE INC JPM BANK SIMPSON FAMILY SEC An Overview on Financial System Without financial markets and institutions, borrowers would have to borrow directly from savers. Probably not much borrowing would take place at all, borrowers would tend to have a hard time finding individuals able and willing to loan them Il Banco dei Medici, 1400 An overview on Financial System Without much borrowing, the economy would be a lot less developed, as few businesses would be able to raises funds to invest in new plant and equipment. Likewise, relatively few individuals would be able to own their homes. A well-functioning financial sector is necessary for a well-functioning economy. Direct vs Indirect Finance Funds can raised directly (direct finance) or indirectly (indirect finance):  Direct finance refers to funds that flow directly from the lender/saver to the borrowers/investors in financial market.  Indirect finance refers to funds that flow from the lender/saver to a financial intermediary who then channels the funds to the borrower/investor. Financial intermediaries (indirect finance) are the major source of funds for corporations. Financial markets There are many kinds of financial markets, and the most relevant for what follows are: Stock markets: where listed shares are traded Bond markets: where government or other bonds are traded Currency markets: where currencies are bought and sold Commodity markets: where physical assets as oil, metals, agricultural, or electricity are traded Futures and option markets: on which derivatives, the object of the present notes, are traded. Function of Financial Markets Financial markets have important function in the economy because they: 1. Allow transfer of funds from person or business without investment opportunities to ones who have them. In the absence of financial markets, lenders-savers and borrower-spenders may not get together and it becomes hard to transfer funds from a person who has no investment opportunities to one who has them. 2. Enhance economic efficiency by allocating productive resources efficiently, which increases production. Function of Financial Markets 3. Improve the economic welfare because they allow consumers to time their purchases better. 4. Increase returns on investment and increase business profit 5. Set firm value 6. Buy and sell risk: allow you to transfer certain financial risks (arising from accidents, theft, illness, early death, etc.) to another party (in this case, the insurance company). A breakdown of financial markets can result in political instability. What is a global Financial System? The Global Financial System refers to those financial institutions and regulations that act on the international level, as opposed to those that act on a national or regional level. This is the interplay of financial companies, regulators and institutions operating on a supranational level. The global financial system can be divided into:  Regulated entities (international banks and insurance companies)  Regulators  Supervisors  Institutions When the Global Financial System has emerged? Birth of the global financial system is directly connected to the growth of international economic relations. International trade in a global scale started in the late 19th century. International trade is complicated by the fact that most nations have their own currency, and that the rules and regulations governing financial transactions vary widely between countries. Evolution of the global Financial System 1. Late 19th – early 20th centuries – little coordination of international finances  Gold standard – financial obligations were settled in currencies redeemable in gold 2. World War I involved vastly larger international capital flows than ever before  European nations such as Britain and Germany went deeply in debt, borrowing heavily from other nations, especially the United States Evolution of the global Financial System 3. The Great Depression of the 1930s resulted partially from sharply declining international trade caused, in part, by high tariffs 4. World War II disrupted world trade and led to international cooperative arrangements to facilitate economic stability and growth Evolution of the global Financial System 5. 1944 – Bretton Woods Conference: The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) were created. 6. Dollar was established as a main reserve currency (Keynes had argued against the dollar having such a central role in the monetary system, and suggested an international currency called Bancor used instead). Evolution of the global Financial System 7. 1947 – General Agreement on Tariffs and Trade (GATT - WTO)  Dramatic reductions in barriers to international trade  Led to the creation of a system of international financial arrangements and deeper economic / financial integration (especially EU, NAFTA) 8. 1971 – Dollar’s convertibility into gold was suspended 9. 1973 – Abandonment of fixed exchange rates Nixon Ends Bretton Woods International Monetary System https://www.youtube.com/watch?v=iRzr1QU6K1o 15 minutes to rearrange notes Types of Financial Institutions  Depository institutions: (banks, credit unions, savings & loan associations): Accept (issue) deposits, which then become their liabilities (sources of funds) Make loans, which then become their assets  Insurance companies: They collect premiums (regular payments) from policy-holders and pay compensation to policy-holders if certain events occur (e.g., fire, theft, sickness, and life). They invest the premiums in securities and real estate. Types of Financial Institutions  Pension funds: They collect contributions from current. Workers and make payments to retired workers. Like insurance companies, they invest the contributions in securities and real estate, and these are their main assets.  Finance companies: Like banks, they use people's savings to make loans to businesses and households they raise the cash to make these loans by selling bonds and commercial paper. They tend to specialize in certain types of loans, e.g., automobile or mortgage loans. Types of Financial Institutions  Securities firms: Thy provide firms and individuals with access to financial markets. This category covers a wide range of financial institutions such as investment banks.  Government-sponsored enterprises: Some of these provide loans directly, such as to farmers and home buyers. Some guarantee or buy up private loans, notably mortgage and student loans. Some administer social insurance programs. Institutions of Global Financial System  International Institutions IMF - keep account of international balance of payment of members states, also acts as lender of last resort World Bank - provide funding, take up credit risk and offer financial favorable terms to development projects in developing countries  Government institutions Financial ministries, tax authorities, central banks, securities and exchange commissions, etc. Institutions of global Financial System  Private participants  Commercial banks, pension funds, hedge funds, etc.  Regional institutions  Eurozone, NAFTA (The North American Free Trade Agreement) 20-minute coffee break Banks A bank is a financial intermediary whose core activity is to provide loans to borrowers and to collect deposits from savers. They act as intermediaries between borrowers and savers. They channel funds from savers to borrowers thereby increasing economic efficiency by promoting a better allocation of resources. Banks  Borrowers are generally referred to as deficit units.  Lenders are known as surplus units.  Financial claims can take the form of any financial asset, such as money, bank deposit accounts, bonds, shares, loans, life insurance policies, etc.  The issuer of the claim (borrower) is said to have financial liability. Banks Lenders’ requirements:  The minimization of risk. (risk of default and the risk of the assets dropping in value).  The minimization of cost. Lenders aim to minimize their costs.  Liquidity. Lenders value the ease of converting a financial claim into cash without loss of capital value; therefore they prefer holding assets that are more easily converted into cash. One reason for this is the lack of knowledge of future events, which results in lenders preferring short-term lending to long-term. Banks Borrowers’ requirements:  Funds for a specific period of time; preferably long-term (company borrowing to purchase capital equipment which will only achieve positive returns in the longer term or an individual borrowing to purchase a house).  Funds at the lowest possible cost (interest rate)  The majority of lenders want to lend their assets for short periods of time and for the highest possible return.  The majority of borrowers demand liabilities that are cheap and for long periods. Banks  The majority of lenders want to lend their assets for short periods of time and for the highest possible return.  The majority of borrowers demand liabilities that are cheap and for long periods. Bank unites these divergent needs Banks  Financial intermediaries help minimize the costs associated with direct lending – particularly transactions costs and those derived from information asymmetries. Transactions costs: costs of searching for a counterparty to a financial transaction; the costs of obtaining information about them; the costs of negotiating the contract; the costs of monitoring the borrowers and etc. The Role of banks Size transformation:  Savers/depositors are willing to lend smaller amounts of money than the amounts required by borrowers.  Banks collect funds from savers in the form of small-size deposits and repackage them into larger size loans.  Banks perform this size transformation function exploiting economies of scale associated with the lending/borrowing function, because they have access to a larger number of depositors than any individual borrower The Role of banks Maturity transformation:  Banks transform funds lent for a short period of time into medium and long- term loans.  Banks are said to be ‘borrowing short and lending long’ and in this process they are said to ‘mismatch’ their assets and liabilities.  This mismatch can create problems in terms of liquidity risk, which is the risk of not having enough liquid funds to meet one’s liabilities. The Role of banks Risk transformation:  Individual borrowers carry a risk of default (known as credit risk) that is the risk that they might not be able to repay the amount of money they borrowed.  Savers, on the other hand, wish to minimize risk and prefer their money to be safe.  Banks are able to minimize the risk of individual loans by diversifying their investments, pooling risks, screening and monitoring borrowers and holding capital and reserves as a buffer for unexpected losses. Asymmetric information Information is at the heart of all financial transactions and contracts. Three problems are relevant: Not everyone has the same information Everyone has less than perfect information Some parties to a transaction have ‘inside’ information which is not made available to both sides of the transaction. Asymmetric information Information asymmetries, or the imperfect distribution of information among parties, can generate adverse selection and moral hazard problems.  Adverse Selection is a transaction in which one party has relevant information that the other does not have. Financial intermediaries can help reduce the problem of adverse selection by gathering information about potential borrowers and screening out bad credit risks. Asymmetric information  Moral hazard (or hidden action): Superior information may enable one party to work against the interests of another. Financial intermediaries can help reduce the problem of moral hazard by monitoring borrowers’ activities. Economic imbalances, interdependence and their role in financial crisis Economic imbalances: is lack of balance/equilibrium between two or more economic parameters. (e.g. a country’s Imports are significantly lower than its exports) Global imbalances refers to the situation where some countries have more assets than the other countries. In theory, when the current account is in balance, it has a zero value: inflows and outflows of capital will be cancelled by each other. Hence, if the current account is persistently showing deficits for certain period it is said to show an in equilibrium. Since, by definition, all current accounts and net foreign assets of the countries in the world must become zero, then other countries become indebted with the other nations. Economic Interdependence Economic interdependency exists everywhere. Organizations, industries and nations are all deeply dependent on each other. Every company is economically dependent on many other firms thus creating a large and complex network of interdependent entities. Economic Interdependence This condition means that the entire network is affected in some degree if one of the entities is impacted by an event or suffers a substantial change. Such interdependency happens because every firm tends to be a kind of specialist, producing only a narrow range of goods or services. Specialization often results in higher efficiency and quality so firms prefer to focus on just some products. Economic Interdependence Example: Top management must be aware of economic interdependence and identify which are the highest risks associated to that. For example, depending on only one tested supplier of a key raw material can be risky because this supplier could increase prices too much or simply fail in its supply capacity. A strategy to diminish the risk might be searching for a second supplier. In other cases, the company prefers to lower some dimensions of the interdependence. A manufacturing firm with numerous machines may decide to eliminate the dependence on external maintenance and therefore to create its own technical maintenance department. Economic imbalances, interdependence and their role in financial crisis The presence of economic imbalances both in the public and private sector, along with the close ties existing between all economies, gave rise to a global scale crisis. The crisis began in the USA in 2008 and rapidly expanded to other countries, showing longstanding structural problems affecting banks, companies and states. Economic imbalances, interdependence and their role in financial crisis Intermediation involves the "matching" of lenders with savings to borrowers who need money by an agent or third party, such as a bank. Banks and institutions that perform credit intermediation essentially move funds from depositors to borrowers. In performing these intermediation activities, banks also perform services, such as the processing of checks or electronic funds transfers, bookkeeping, protection of deposited funds, and investment services. 15 minutes to rearrange notes A Little History International Banking is invented here in Florence Banco dei Medici The Medici bank was started by Giovanni di Bicci Medici in 1397 in Florence, and business flourished under his son, Cosimo de Medici, called the Elder, with branches in Venice, Rome, (later in London, Bruges, Avignon, Milan, and Lyon) The Medici bank was the largest in Europe and contributed in a major way to the development of the banking system, inventing the general ledger system of debits and credits, the birth of the double entry accounting system. Home Assignment #3 What were the causes that led to the decline of the Banco dei Medici?