1. Recent decades have witnessed the globalization of financial markets to an unprecedented degree. For instance, at times trading in foreign equities exceeded trading in U.S. equities and to a greater extent than ever, events ‘there’ affect us ‘here’ and vice versa. Although the U.S. markets are still the largest, the advent of the Euro (the common currency in Europe) has already led to rapid growth in Euro financing. For instance, Eurobonds are a significant source of financing for many U.S. firms and they represent an alternative to a domestic bond issue. Eurobonds are bonds issued outside the home country but are in the home currency. The growth in foreign financial markets has five ongoing causes:
        1. V. Web Links
        2. VI. Student Learning Activities

 
1.  Why Study Financial Markets and Institutions?
For an economy to achieve its potential growth rate, mechanisms must exist to effectively allocate capital (a scarce resource) to the best possible uses accounting for the riskiness of the opportunities available. Markets and institutions have been created to facilitate transfers of funds from economic agents with surplus funds to economic agents in need of funds. For an economy to maximize its growth potential it must create methods that attract savers’ excess funds and then put those funds to the best uses possible, otherwise idle cash is not used productively. The funds transfer should occur at as low a cost as possible to ensure maximum economic growth. Two competing alternative methods exist: direct and indirect financing. In direct financing the ultimate funds supplier purchases a claim from the funds demander with or without the help of an intermediary such as an underwriter. In this case, we rely on primary markets to initially price the issue and then secondary markets to update the prices, monitor any contractual conditions and provide liquidity. In indirect financing, the funds demander obtains financing from a financial intermediary. The intermediary and the borrower negotiate the terms and cost. The intermediary obtains funds by offering different claims to fund suppliers. In this case the intermediary is usually responsible for monitoring the contractual conditions of the financing agreement and perhaps updating the cost if needed or appropriate.
 
With the pace of globalization and increasing deregulation of financial institutions, managing risk and maintaining profits in a rapidly changing, increasingly competitive global market is of paramount importance. Institutions continue to merge within and across traditional financial product lines in an attempt to exploit perceived economies of scale and scope and to prevent others from gaining similar advantages over them. The pace of innovation of new technology, new financial products and services has not abated. In particular, we are on the cusp of many technological advances that may change traditional methods of offering financial services at the wholesale and perhaps eventually at the retail level. Job opportunities for finance students in markets and institutions are likely to be excellent in the next twenty years as managing risks at intermediaries in increasingly complex and competitive businesses will grow in importance thus highlighting the need to study the material in this book. The text provides an introductory examination of the functions and characteristics of markets and risk and profitability management at major financial institutions in order to help students understand the workings of the financial system in today’s global economy.
 
Fallout from corporate and Wall Street scandals continues, underscoring the failure of corporate governance and regulatory agencies to limit managerial misbehaviors as the pressure to hit short term earnings targets created need and opportunity for managers of corporations and financial institutions to act unethically. Measuring the cost of the resulting loss in investor confidence from managerial misdeeds (often aided by Wall Street’s elite banking and investment banking firms) is difficult at best, but must be several billions of dollars at least. The scandals and failure of corporate governance led to the passage of the Sarbanes-Oxley Act (S-O Act). The S-O Act is an attempt to

reduce conflicts of interest and increase management and board accountability for financial information disclosed by firms. Laws by themselves are insufficient to ensure proper behavior. Practitioners and academics also need to increase the emphasis placed on applications of corporate ethics and individual accountability.
 
2.  Overview of Financial Markets
a.  Primary Markets vs Secondary Markets
b.  Money Markets vs Capital Markets
The two alternative mechanisms of fund raising are direct financing, where the saver directly purchases a claim from the ultimate funds user in the primary market, or indirect financing where savers place their money in a FI and the FI lends money to the ultimate borrower. In the cases where savers desire to place their money directly in the markets, institutions such as investment bankers (asset brokers) have evolved to assist in this process. The first time a firm issues securities to the public is referred to as its initial public offering (IPO). Issuing additional stock of a firm that already has stock publicly traded is referred to as a seasoned offering. In some cases firms offer the issue to one or only a few institutional buyers. This is termed a private placement. Until recently secondary trading of private placements was restricted. Institutions may now trade privately placed securities among themselves and high net worth individuals.
 
The primary markets are the markets where firms (and other borrowers) create and sell new securities in order to raise cash to fund positive NPV projects (or to meet some other social goals in the case of non profit fund raisers).
 
Ethics Tip:
There have been serious breaches of ethics by investment bankers in allocating IPO business such as ‘There have been serious breaches of ethics by investment bankers in allocating IPO business such as ‘spinning’ and ‘laddering.’ Many IPOs are oversubscribed, allowing the investment banker to choose who will receive the issue. Spinning is allocating the new issue to firms or private accounts of the CEOs of client firms in exchange for IB business later on or some other perk. Laddering is allocating IPO shares to those who agree to buy more shares in the aftermarket, driving IPO prices up, which the buyers then dump shortly thereafter after the price run-up. Since the short term performance of IPOs is often quite good, the favored clients who receive the allocations often get abnormally high gains. Investment bankers were also apparently guilty of issuing overly optimistic stock research reports to help support the underwriting business. At some firms bonuses paid to research analysts were based on the level of underwriting business generated by the institution. According to the Wall Street Journal, Frank Quattrone was found guilty of obstructing justice in regulatory investigations of misallocating IPO shares. In 2004 Quattrone was sentenced to 18 months in prison, 2 years probation and a $90,000 fine. His firm paid millions in settlement payments. 1


Student Question:
One of the main results of recent scandals has been large fines paid by Wall Street firms. The sad fact is that most of the major investment bankers have paid fines to remedy ethical breaches.
 
One should emphasize that the secondary markets exist to provide liquidity and price information to investors. These functions make the primary market more attractive. Investors would be far less likely to invest in risky long term primary securities unless investors believe they can remain apprised of the current value of their claims and have the ability to sell these claims quickly at low cost if they choose. Hence the efficiency of operation of the secondary markets affects the growth rate in the overall economy through their effect on the primary markets. Secondary market trading volume has risen dramatically in the last several decades, particularly with the creation of wholesale and retail electronic trading mechanisms that have substantially reduced trading costs.
 
Money markets evolved to meet the short term investment needs (1 year or less) of corporations and institutions desiring to earn a small positive rate of return on cash that would be needed shortly, hence they have evolved with high denomination safe securities that have little risk of principle loss. Capital markets are markets where borrowers raise cash for long term investment needs. These are generally riskier than money markets and hence, capital market securities must promise to pay a higher rate of return to attract funds. Savers willing to take the associated risk are attracted to these markets.
 

Selected Money Market Instruments, billions of dollars, amounts outstanding
 
2000
% Total
3rd Qtr 2004
% Total
Fed Funds & Repos
$1,197.3
27%
$1,676.2
32%
Commercial Paper
$1,606.1
36%
$1,316.4
25%
T-bills
$ 646.0
14%
$ 961.0
19%
Banker’s Acceptances
$ 7.9
0%
$ 4.3
0%
Negotiable CDs
$1,052.6
23%
$1,221.8
24%
Totals
$4,509.9
100%
$5,179.7
100%
Sources: Federal Reserve Board, Flow of Funds Accounts, Levels Tables and The Bureau of the Public Debt, “Monthly Statement of the Public Debt of the United States,” various issues.
 
The amount of commercial paper outstanding has declined since 2000. This decline may be due to concerns about credit quality of issuers.

Selected Capital Market Instruments, billions of dollars, amounts outstanding
 
2000
% Total
3rd Qtr 2004
% Total
Common Equity
$ 17,627.0
53%
$ 15,627.1
41%
Corporate Bonds
$ 4,924.7
15%
$ 6,879.4
18%
Municipal Securities
$ 1,457.2
4%
$ 2,012.0
5%
Mortgages
$ 6,261.8
19%
$ 10,127.8
27%
Treasury Securities*
$ 2,711.8
8%
$ 3,308.2
9%
Totals
$ 32,982.5
100%
$ 37,954.5
100%
* Marketable, excluding T-bills
Sources: Federal Reserve Board, Flow of Funds Accounts, Levels Tables and The Bureau of the Public Debt, “Monthly Statement of the Public Debt of the United States,” various issues.
 
Mortgages have grown an astounding 62% over the given period, whereas corporate and municipal bonds grew at roughly equal rates (around 40%) and equity market values declined by 11%.
 
c.  Foreign Exchange Markets
The majority of the world’s business involves international business transactions. It is increasingly important for firms to recognize that the appropriate investment may be located in Europe, the lowest cost source of funds may be found in Britain instead of the U.S., or the highest potential growth rates for sales of a firm’s product may be in Asia. As corporations and institutions have increased their international transactions, foreign exchange risk has become a major source of risk for many firms today and much hedging with spot and forward foreign exchange trades occurs. In 2004 and 2005 there has been much speculation that the dollar would drop as the U.S. current account deficit reached record highs in absolute terms and as a percentage of GDP. Historically, when a nation’s current account deficit surpasses 5% of GDP a correction occurs in currency value. Foreign central banks continue to purchase dollars to keep local currencies down to foster their export sectors. Moreover, the U.S. economy and the dollar remain key generators of global growth; these factors help the dollar maintain its value in the global market.
 
d.  Derivative Security Markets
A derivative security is a contract which derives it value from some underlying asset or market condition. In general, the main purpose of the derivatives markets is to transfer risk between market participants. Some participants, called hedgers, enter derivatives contracts to reduce their risk exposure in the underlying cash market. Other participants, called speculators, use derivative contracts to bet on price movements. Derivatives are highly leveraged instruments. This allows hedgers to reduce risk with a low capital investment and the leverage also allows speculators to attempt to earn high rates of return with low capital investments. The two main types of derivatives markets are the market for exchange traded derivatives and the over the counter (OTC) derivatives markets. Exchange traded derivatives are generally liquid and involve no counterparty risk, whereas OTC contracts are custom contracts negotiated between two counterparties and have default risk.
 
 
 

e.  Financial Market Regulation
Financial markets are regulated by the SEC, the exchanges, the Commodity Futures Trading Commission (CFTC) and the National Association of Security Dealers (NASD). The primary purposes of regulations are to prevent fraud, to ensure performance as promised, and to ensure that the public has enough information to evaluate the riskiness of an investment. The regulators do not attempt to ensure investors earn a minimum rate of return. Recently, some specialists on the NYSE agreed to pay fines because of allegations of front running customer orders. In front running, specialists transact their own orders ahead of customer orders for the specialists’ advantage. Decimalization, automation and competition from electronic communications networks (ECNs) have reduced specialist profits creating temptations to find other ways to generate revenue.
 
3.  Overview of Financial Institutions
Many savers today are willing to risk some of their funds in the capital markets, but not all. For at least some of their wealth, savers typically desire a different type of claim than the ultimate borrower wishes to offer. Asset transformers, such as banks, have evolved to meet this need by offering low risk claims to savers while granting higher risk, more illiquid investments (e.g., loans) to the funds demanders. Other types of institutions have evolved to meet special needs of savers such as life insurance firms to eliminate certain risks, pension funds to transfer wealth through time, money market mutual funds to pool investors’ savings, etc.
Institution
Total Assets
(Bill $)
Number of Federally Insured
Institutions
Commercial Banks
$8,244
7,660
Savings Associations
$1,633
1,365
Credit Unions
$ 636
9,210
Insurance Companies
$5,119
 
Private Pension Funds
$4,146
 
Finance Companies
$1,397
 
Mutual Funds
$4,946
 
Money Market Mutual Funds
$1,866
 
Investment Bankers
$1,766
 		  
Data from 2003,   data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables, FDIC Stats at a Glance,” and NCUA. The mutual funds category excludes money market funds.
 

Deposit-Type Institutions -- Offer liquid, government insured claims to savers, such as demand deposits, savings deposits, time deposits, and share accounts.
  Commercial Banks -- Make a variety of consumer and commercial loans (direct claims) to borrowers.
  Savings and Loan Associations -- Make mortgage loans (direct claim) to borrowers.
  Mutual Savings Banks -- Purchase various securities and make loans -- mortgages, consumer loans, government bonds, etc.
  Credit Unions -- Receive share account deposits and make consumer loans. Membership requires a common bond, such as a church or labor union.
 
Non-depository institutions:
  Life Insurance Companies -- Provide life insurance and long-term savings opportunities for savers.
  Casualty Insurance Companies -- Provide auto, home insurance, purchase direct financial securities with paid-in-advance premiums from insurance purchasers.
  Pension Funds -- issue claims to savers or provide investment plans that allow savers to transfer wealth through time and to future generations.
 
Other Types of Financial Intermediaries:
  Finance Companies -- Borrow (issue liabilities) directly from banks and directly from savers (commercial paper) and make/purchase riskier consumer and business loans.
  Mutual Funds -- Offer indirect mutual fund shares to savers and purchase direct financial assets (e.g. stocks and bonds).
  Money Market Mutual Funds -- Offer (indirect) shares and purchase direct (commercial paper) and indirect (bank CDs) money market financial assets.
  Investment Bankers -- Purchase securities from borrowers and repackage the payment streams, creating new securities to sell to savers. Assist borrowers in selling direct claims to savers.
  E-brokers -- E-brokers provide securities trading services over the Internet. Actually, E-brokers are following one of four business models. A few, such as Schwab seek to be an online financial supermarket, providing banking, insurance, portfolio management and brokerage in one brand. Hybrids provide discount commissions but provide some investment advice and research, some pure discount firms seek to compete only on price and a few E-brokers are providing specialized services such as access to special markets or extended credit.
 
a.  Unique Economic Functions Performed by Financial Institutions (FIs)
Relative to the choices available to many savers who invest directly in the markets, FIs provide savers with very safe, liquid claims with fairly small denominations. FIs then in turn lend money to funds demanders. The ultimate borrowers, say corporations, issue risky claims (loans or bonds) held by FIs. The individual savers need not investigate the riskiness of the corporate borrowers, the FI will do that. Consequently, FIs allocate capital in an economy. FIs must then be able to accurately assess, price and monitor risks of borrowers for an economy to achieve its potential growth rate. FIs must also carefully manage their own risk since they are borrowing money from savers at low risk and then investing the money in higher risk loans and securities in order to earn a profit.

By carefully evaluating the riskiness of potential investments and by diversifying their loan and investment portfolios, lending institutions employ the law of large numbers to reduce their risk exposure.
 
One should note that both markets and institutions assess, price and monitor risk. In some cases however, institutions can perform these functions better than the markets. In this sense the institution is serving as a delegated monitor. For instance, in situations where the borrower is reluctant to make information public or frequent monitoring is needed or special additional financing requirements may be necessary, bank loans may be preferable to a public bond issue.
 
The federal government insures deposits of certain intermediaries. Because of deposit insurance, depositors do not require a risk premium to place money in an insured institution. In effect, government insurance subsidizes risk taking at depository institutions. The government insurance liability requires that insured depository institutions must be regulated to limit the government’s liability and to limit imprudent risk taking at these institutions.
 
b.  Additional Benefits FIs Provide to Suppliers of Funds
Funds suppliers who place their money in a FI generally get the following benefits:
Reduced transaction costs due to economies of scale in information production 2
o   Maturity Intermediation (Intermediation is investing in a financial intermediary (FI) and maturity intermediation is accomplished when a FI grants a saver a different maturity investment than the maturity of the FI’s own claims on borrowers)
o   Denomination Intermediation
o   Improved liquidity
o   Reduced default risk due to deposit insurance and/or the FI’s equity.
 
Be sure to note that the downside of all this safety and convenience is a low rate of return.
 
c.  Economic Functions FIs Provide to The Financial System as a Whole
Depository Institutions (DIs) also have a unique role in the transmission of monetary policy because their claims are part of the money supply and because they assist in providing large amounts of payments services such as check clearing and wire transfers in the economy. As mentioned above, DIs allocate credit in an economy. If DIs perform the credit allocation function poorly, long term economic growth will not be maximized. DIs also are granted special tax status to assist in transferring wealth through time or to the next generation.
 

d.  Risks Incurred by Financial Institutions
All FIs face a variety of risks, but generally speaking all FIs face
  Default risk on at least a portion of their assets
  Market risk changing the value of investments
  Liquidity risk, due to mismatch in maturity of assets and liabilities
  Interest rate risk due to the same mismatch above
  Foreign exchange risk due to foreign currency assets and liabilities or changing competitive conditions with foreign FIs as currency values fluctuate
  Operating cost risk because there are fixed costs involved in providing all financial services
  Insolvency risk, any of the stated risks may result in insolvency at a FI.
Some FIs face:
  Sovereign risk on overseas investments
  Off balance sheet risks due to contingent assets and liabilities
  Technology and Operational risk due to either overinvestment in a technology relative to customer demand, or a failure of technology respectively.
 
e.  Regulation of Financial Institutions
FIs hold savers’ funds. Should even one FI default many people’s wealth could be destroyed unless the government intervenes. Government institutions such as the Federal Deposit Insurance Corporation (FDIC) can handle a limited number of simultaneous failures. Systemic risks or system wide failures, perhaps due to contagion, among any group of FIs could not be handled by our existing regulatory structures. Contagion occurs when failure of one or a few institutions causes widespread failures, at an extreme resulting in an economic crash similar to the Depression of the 1930s. Part of the fear of contagion arises because most FIs are 1) highly leveraged and 2) operate on the principle that the majority of claimants will not seek to withdraw their funds at the same time as FIs don’t keep all of the savers’ funds in the vault available for immediate withdrawal. The government must regulate DIs because of the deposit insurance liability. Regulation is also necessary to prevent fraud and discriminatory practices. Regulations impose a cost on society by adding to the cost burden of FIs, which must be passed on to either borrowers in the form of higher costs, or as reduced rates of savings for investors in FIs. Recent regulatory changes have allowed FIs to engage in more activities and increased the level of competition among institutions. As a result regulators have been forced to develop more sophisticated measures of risk and incentives for institutions to limit risk.
 

4.  Globalization of Financial Markets and Institutions


Recent decades have witnessed the globalization of financial markets to an unprecedented degree. For instance, at times trading in foreign equities exceeded trading in U.S. equities and to a greater extent than ever, events ‘there’ affect us ‘here’ and vice versa. Although the U.S. markets are still the largest, the advent of the Euro (the common currency in Europe) has already led to rapid growth in Euro financing. For instance, Eurobonds are a significant source of financing for many U.S. firms and they represent an alternative to a domestic bond issue. Eurobonds are bonds issued outside the home country but are in the home currency. The growth in foreign financial markets has five ongoing causes:



Recent decades have witnessed the globalization of financial markets to an unprecedented degree. For instance, at times trading in foreign equities exceeded trading in U.S. equities and to a greater extent than ever, events ‘there’ affect us ‘here’ and vice versa. Although the U.S. markets are still the largest, the advent of the Euro (the common currency in Europe) has already led to rapid growth in Euro financing. For instance, Eurobonds are a significant source of financing for many U.S. firms and they represent an alternative to a domestic bond issue. Eurobonds are bonds issued outside the home country but are in the home currency. The growth in foreign financial markets has five ongoing causes:
1. Greater pool of savings in foreign countries.
2. Better investment prospects outside of countries with large savings.
3. The Internet has improved information availability on foreign markets and securities.
4. Low cost methods to invest in foreign securities have proliferated (such as ADRs).
5. Deregulation around the world has allowed investors to purchase more foreign securities.
 


V. Web Links



V. Web Links
 
http://www.dowjones.com/  News service with business and market highlights
 
http://www.newsweek.com/    Weekly news magazine that covers business
 
http://www.economist.com/  Superb weekly magazine that covers U.S. and global business and political news.
 
http://www.sec.gov/  Securities Exchange Commission homepage
 
http://www.nyse.com/     The New York Stock Exchange’s excellent website
 
http://www.wsj.com/  The Wall Street Journal has excellent coverage of the many recent problems with ethics on Wall Street and Main Street
 
http://www.federalreserve.gov  The web page of the Federal Reserve Board of Governors. This web site contains the Beige Book, the Chairman’s testimony before Congress and flow of funds data for the United States
 


VI. Student Learning Activities



VI. Student Learning Activities
 
1.  Identify a specific scenario where direct financing would be beneficial for both the funds supply and the funds demander. Identify a second specific scenario where indirect financing would be beneficial for both the funds supply and the funds demander.
2.  Using the Internet find the flow of funds data at http://www.federalreserve.gov .
For each of the following intermediaries, identify the largest type of investment security excluding loans (e.g., corporate bonds, equity, etc.). Explain why you believe each intermediary has chosen this investment type:
Pension funds
Commercial Banks
Life insurers
Property & Casualty insurers
3.  Find the most recent version of the Flow of Funds Matrix, Supplemental Table, Z.1 at the Federal Reserve website. (You might try the following web address: http://www.federalreserve.gov/releases/Z1/Current/z1r-3.pdf ). The Adobe Reader is required.
Identify the financial assets and liabilities of each of the following sectors:
  Financial Assets Financial Liabilities
Households and Non-profits    
State & Local government    
Financial sectors    
Non-financial business    
Federal government    
Foreign sectors    

 
In the current period, which categories are funds suppliers and which are funds demanders?
 
 
4.  Locate current promised interest rates on three money market instruments and promised rates of return on two capital market instruments. Explain the differences in your findings.
 

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