EC102: CLASS 10 LTChristina Ammon

Financial Systems

Financial systems: the institutions in the economy that facilitate the flow of funds between and among households and firm

Financial markets vs. financial intermediaries• Bond & Stock markets vs. banks

What is the purpose of financial markets& intermediaries? 1. Financing investment

2. Sharing risk

What is the purpose of intermediaries• Overcoming asymmetric information

Quiz Question 1

Financial markets allow households to _____ provide resources for investment, while financial intermediaries allow households to _____ provide resources for investment.

A. directly; indirectly B. indirectly; directly  C. productively; unproductively D. unproductively; productively

Quiz Question 2

All of the following are examples of financial intermediaries except:

A. commercial banks.  B. stock exchanges. C. pension funds. D. insurance companies.

Essay 7

Basic setup:

A farmer’s harvest will be worth £200 if she can borrow £100 worth of fertilizer, and £0 otherwise.

The fertilizer needs to be applied now and harvest will take place in six months’ time. 

There are N>100 other people in the village, each of whom has saved £1.

Essay 7 Question aIs there a role for a financial system in this economy? Briefly describe a few types of financial arrangements that you might observe in this economy.

Without financial systems: Borrow (<)1$ from 100 (+) villagers

Possible, but costly

Financial system allows farmer easier access to savings of villagers

If financial markets present: Could issue bonds or stocks If financial intermediaries present: villagers deposit savings

and bank gives loan to farmer

Essay 7 Question b

Suppose an enterprising villager starts a new bank (with 0 capital), collects all of the villagers’ savings, and lends the £100 to the farmer. How will this bank’s balance sheet look like?

What does a balance sheet consist of? Assets = Liabilities (+equity)

Assets Liabilities+ Equity

Loans 100$ Deposits: N$

Reserves N$-100$ Equity

Essay 7 Question c

Suppose now that each of the savers faces some chance that there will be an emergency such as they will absolutely need access to their £1 three months from now. Is there still a role for a financial system?

Without financial markets - will the farmer be able to finance his investment?

What about if we only have financial markets?

Essay 7 Question d

Suppose that the probability that any investor faces the emergency is p. What is the minimum value of N such that the financial system can viably allow the farmer to buy the fertilizer?

Pool of savings: N*1$ But p*N*1$ will need to be withdrawn in expectation Hence the savings to reach the farmer will be (1-p)N$ Needs to be >=100$ => need N>100(1-p) Similar with financial intermediaries: need to keep p*N*1$ as

reserves

Essay 7 Question e

On the basis of this example, can you see what economists mean when they say banks are engaged in maturity transformation?

Depositors willing to provide short term debt Banks take short term debt and issue long term debt for

investment Can be problematic!

Quiz Question 5

Falling house prices generate widespread insolvency of financial institutions by:

A. reducing the value of collateral assets. B. reducing the value of liabilities. C. increasing the value of assets. D. increasing capital

Quiz Question 4

To the extent that mortgage defaults contributed to the financial crisis of 2008–2009, blame for these actions lies with: A. homebuyers who borrowed more than they could afford to

repay. B. mortgage brokers who encouraged households to borrow

excessively. C. financial intermediaries who held large positions in

mortgage-related assets D. all of the above

Quiz Question 3

A credit crunch reduces aggregate demand by:

A. increasing the exchange rate. B. increasing interest rates. C. reducing consumption and investment spending.  D. reducing the money supply.

Financial Crisis - Causes

Mistakes• Relying on prices going up• Over relying on diversification• Rating agencies issues

Bad incentives• On the level of the worker: asymmetric rewards• On the level of the bank: Originate and distribute• On the level of the financial system: Implicit bailouts

Bad “culture”?

Essay 8 Question a

Explain the meaning of the expression “originate and distribute” and explain how this practice may have contributed to the financial crisis.

= lenders generate loans with the intention of selling them immediately

Why is that a problem? Normally: monitor loans closely Now: the institution that issues the loans has no incentive to

monitor the loan as carries no more risk Issue a large amount of loans

Essay 8 Question bWhat are rating agencies and what role are they thought to have played in the crisis?

Rating agencies are institutions that evaluate the creditworthiness of a bond

i.e. how likely is the bond going to be repaid

Problem: • Bad ratings• Moral hazard – paid by issuer of bonds• Self-fulfilling prophecy?

Quiz Question 1

The Volcker rule restricts excessive risk taking by commercial banks by:

a. prohibiting banks from making certain kinds of speculative investments. 

b. increasing the amount of capital banks must hold. 

c. decreasing the deposit insurance coverage of depositors in commercial banks.

d. limiting the compensation that bank executives can be paid.

Quiz Question 2

What sort of changes to compensation in the financial sector is more likely to discourage excessive risk taking? 

a. Caps to the amounts that banks can pay in the form of bonuses.

b. Caps to the amount of stock options given to bankers

c. Caps to overall banker’s pay

d. Make pay conditional on long-term performance