Lecture 1: Money, Banking & Financial Markets Why Study Financial Markets?

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Lecture 1: Money, Banking & Financial Markets Why Study Financial Markets? 1.Channel funds from savers to investors, thereby promoting economic efficiency 2.Affect personal wealth and behavior of business firms Bond Market - where corporations and governments borrow funds - PowerPoint PPT Presentation


  • Copyright 2007 Pearson Addison-Wesley. All rights reserved.

  • Lecture 1: Money, Banking & Financial Markets Why Study Financial Markets? 1.Channel funds from savers to investors, thereby promoting economic efficiency2.Affect personal wealth and behavior of business firms

    Bond Market- where corporations and governments borrow funds- where interest rates are determined- affects consumers willingness to spend & save- affects business spending decisions

    Stock Market- affects personal wealth- affects business investment decisions

    Foreign Exchange Market- used for transfer of funds between countries- affects costs of imports & exports for domestic and foreign consumers- affects competitiveness of domestic versus foreign businesses

  • The Circular Flow Diagram

  • Financial SystemFlow of FundsLenders/SaversFirmsHouseholdsGovernmentForeignersFinancial IntermediariesBanksS&LsCUsFinancial MarketsStock MarketBond MarketFX MarketBorrowers/SpendersFirmsHouseholdsGovernmentForeigners$$$$DepositsSecuritiesSecuritiesSecurities$$$$Direct FinanceIndirect FinanceProfit search is to moneywhat gravity is to water

  • The Heart Vs Bank AnalogyHow the Heart Works: Blood Flow Diagram How Blood Flows Through a Healthy Heart.

  • Copyright 2007 Pearson Addison-Wesley. All rights reserved.

  • Euro/$Euro/$$/Euro$/Euro

  • Recession Factors:Loose monetary policyPoor regulationLax bank supervisionOpaque derivativesShadow banking systemLax investor diligencePoor governanceMisaligned incentivesfraud

    Copyright 2007 Pearson Addison-Wesley. All rights reserved.

  • 2.5% Target

  • Federal Reserve Balance Sheet (January 2010 vs July 2009 vs July 2008) ($ Billions, H.4.1 Release, Table 10)Assets Liabilities + Capital

    T-Bills (18/18/22) Federal Reserve Notes (879/870/793)T-Notes/Bonds (708/618/402) TIPS (47/48/40) Depository Institution Deposits (1,135/809/23)Federal Agency Debt (161/102/0)Mortgage-Backed Securities (969/526/0) Repurchase Agreements (0/0/117) Reverse Repurchase Agreements (64/66/43)

    Term Auction Credit (76/274/150) U.S. Treasury, General Account (124/65/4) Primary Credit (18/34/14) U.S. Treasury, Supplementary Financing (5/200/0)Secondary Credit (1/0/0)Seasonal Credit (0/1/1)

    Asset-backed CP MMMF Liquidity Facility (0/8/0)AIG Credit (25/43/0)Term Asset-back Security loan Facility ((298/26/0) Foreign Official Deposits (3/2/2)

    Commercial Paper Funding LLC (14/111/0)Money Market Investor Funding (0/0/0)

    Maiden Lane I, II, III LLC (64/60/29) Capital Paid In (26/25/5) Surplus (25/21/3)Central Bank Liquidity Swaps (6/112/62) Other Capital (1/4/1)

    Total Assets (2,295/2,074/913) Total Liabilities & Capital (2,295/2,074/913)Italicized accounts represent new policy tools

  • Money Multiplier = M1/MB = 1 + c = 1+0.83 = 0.84 r + e + c 0.1+1.25+0.83

  • DM/M + DV/V = DP/P + DY/YDM/M + 0 = DP/P + 3.0%CurrencyCheckingSavingsMMAMMMFCD

  • Bank stock purchases (TARP)Stimulus planMortgage bailout planIncome-support programsRecession-induced falling revenues

  • Function of Financial IntermediariesFinancial IntermediariesEngage in process of indirect finance borrow funds from savers, then lend funds to borrowersissue liabilities, then acquire assetstake deposits, then make loans

    More important source of finance than securities markets

    Needed because ofrisk sharingasymmetric informationtransactions costs

  • Copyright 2007 Pearson Addison-Wesley. All rights reserved.

  • UWCU Balance SheetAssets Liabilities + NW Cash (7.5%) Deposits (88%) Share Draft (15%)Investments (6%) Regular Share (15%) MMA (29%)Loans (82%) CDs (25%)Consumer (20%) IRAs (4%)Mortgage (46%) Student (16%) Borrowings (2.5%) Building (4.5%) Net Worth (9.5%) YOA - COF = NIM + Fee/Other Income - Operating Expense- PLL = Net Income

    *Required ROA = Asset Growth Rate x Capital Ratio (dependent variable) (choice variable) (current)

  • FundingSpreadInterest RateRisk SpreadCredit Spread1-year CD @ 3.0%5-year loan@ 7.5%

  • Asymmetric Information: A situation where one party lacks sufficient information about the other party to make accurate decisions

    Adverse Selection1.Asymmetric information before transaction occursPotential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Adverse Selection => bankers willingness to lend

    Moral Hazard1.Asymmetric information after transaction occursHazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that wont pay loan back Moral hazard => bankers willingness to lendReputation: Declining social stigma regarding bankruptcy => M.H.

  • Asymmetric InformationAdverse SelectionMoral HazardStopping bad credit risks from becoming borrowersStopping borrowers frombecoming bad credit risksScreening processMonitoring processLoan applicantsApproveDenyLoan signingdatePerformingNon-performingA situation where 1 partyhas more infothan the other party Loan departmentCollections departmentpotential bad credit risks are the ones who most actively seek out loansthe lender runs the risk that the borrowerwill engage in risky activities that makeit less likely that the loan will be paid backThe business of bankingis the business of collecting informationGood C.R.Bad C.R.2 types

  • Financial Intermediaries make Ps by Transactions costsExperts on loan contractsExperts with screening processExperts with monitoring borrowersDevelop high level of lending expertiseTake advantage of economies of scale (lower average costs) number of transactions (reduce average costs by spreading fixed costs over many transactions) scale of transactions (make a few large loans instead of many small loans => variable costs) scope of operations (offering many products and services => variable costs)

  • Regulation of the Financial SystemTwo Main Reasons for Regulation1.Increase information to investorsDecreases adverse selection and moral hazard problemsSEC forces corporations to disclose informationSEC prohibits insider trading2.Ensuring the soundness of financial intermediariesPrevents financial panicsSix types of regulation:1.Chartering restrictions on entry 2.reporting requirements disclosure of appropriate financial statements3.restrictions on assets and activities4.deposit insurance up to $250,000 per personanti-competitive measures limits on branching (abolished by 1994 legislation)Restrictions on interest rates

  • Econ 330 Homework 1 Due Friday, September 13

    Chapter 2, pages 49-50.Questions 2, 4, 7, 12, 17, 22



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