Lecture 1
BEEM119 Economics of Banking
Jan Auerbach
Department of Economics University of Exeter
Contents
1 Financial Institutions and Key Concepts
1 Institutions and Concepts.
2 Understanding Interest Rates.
3 The Risk and Term Structure of Interest Rates.
4 The Efficient Markets Hypothesis.
2 Money
1 What is Money?
2 The Money Supply Process.
3 Quantitative Theory, Inflation, and the Demand for Money.
3 Banking and Financial Intermediation
1 An Economic Analysis of Financial Structure.
2 Banking Industry: Structure and Competition.
4 Banking and Policy
1 Economic Analysis of Financial Regulation.
2 Financial Crises.
Key Financial Concepts
(Mishkin, chapters 1 and 2)
Financial markets
Financial markets are markets in which funds are transferred
from people and firms who have excess funds available to people and firms who need funds.
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Bonds and Stocks
The Bond Market
A security (financial instrument) is a claim on the issuer’s future income or assets.
A bond is a debt security that promises to make payments periodically for a specified period of time.
That specified period of time ends at maturity, which is the number of years until the expiration date.
• Short-term: Maturity less than a year
• Intermediate-term: Maturity between one and ten years • Long-term: Maturity of ten years or longer
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Bonds and Stocks
The Stock Market
Common stock or Equity represents a share of ownership in a corporation
A share of stock is a claim on the residual earnings and assets of the corporation.
Stocks make periodic payments, called dividends.
Some stocks pay no dividends. How do they have any value?
Holding stock also gives the holder voting rights over company decisions.
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Function of Financial Markets
1 Channel funds: from those with a surplus to those with a shortage of funds
• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities
• Indirect finance: channels money through financial intermediaries
2 Promote economic efficiency: producing an efficient
allocation of capital increases production
Reduce the exposure of investors to risk through Risk Sharing (Asset Transformation) and Diversification
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Financial Intermediaries
Financial Intermediaries are institutions that
• borrow funds from people who want to save
• and make loans to other people who want to borrow. Examples:
• Banks: accept deposits and make loans
• Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds and investment companies
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Function of Financial Intermediaries
1 Reduce transaction costs (time/money spent on financial transactions): Economies of scale, Specialization, Liquidity services
2 Improve the well-being of consumers by allowing them to time their purchases better.
3 Deal with asymmetric information problems: Situation when one party (borrower) has more information than the other (lender).
Types of Asymmetric Information:
1 Adverse Selection (before the transaction): try to avoid selecting the risky borrower. Gather information about potential borrower.
2 Moral Hazard (after the transaction): ensure borrower will not engage in activities that will prevent him/her to repay the loan. Sign a contract with restrictive covenants.
Financial intermediaries allow “small” savers and borrowers to benefit from the existence of financial markets.
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Financial Innovation
Financial Innovation is the development of new financial products and services.
Potentially makes the financial system more efficient. E.g., mortgage backed security (MBS) as a vehicle to diversify risk.
Sometimes said to possibly contribute to troubled financial markets. E.g., MBS in the recent financial crisis.
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Flow of Funds in the Financial System
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Structure of Financial Markets
Debt and Equity Markets
• Debt instruments, e.g., bonds and mortgages: pay at maturity • Equities: pay dividends
Primary Markets
• Financial markets in which newly issued securities are sold.
• Investment Banks underwrite securities (guaranteeing a minimum
price) in an event called IPO (initial public offering).
Secondary Markets
• Financial markets in which previously issued securities are resold.
• Brokers: agents who will buy and sell securities on behalf of
their clients and usually receive instructions on how to trade.
• Dealers: person who trades on their own behalf and is more experienced than a broker, can decide what/how to trade.
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Structure of Financial Markets
Exchanges and Over-the-Counter (OTC) Markets
• Exchanges: centralized location. Top five stock exchanges (by market capitalization)
1 New York Stock Exchange, NYSE
2 NASDAQ (US)
3 Tokyo Stock Exchange
4 London Stock Exchange
5 Shanghai Stock Exchange
• OTC Markets: no centralized location. Foreign exchange, Federal
funds
Money and Capital Markets
• Money markets: deal in short-term debt instruments
• Capital markets: deal in longer-term debt and equity instruments
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Money Market Instruments
Sovereign Debt: Issued in one, three and sixmonth maturities to finance the federal government
Negotiable Bank Certificates of Deposit: sold by banks to depositors Commercial Paper: Short-term (about two months) debt instrument
issued by large banks and well-known corporations.
Repurchase Agreements: Short-term loans (less than 2 weeks) for which Treasury bills serve as collateral.
Federal Funds: Overnight loans between banks
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Principal Money Market Instruments
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Capital Market Instruments
Stocks
Mortgages
Corporate Bonds
Government Bonds: Most followed one is the 10-year t-bonds. Consumer and Bank Commercial Loans
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Principal Capital Market Instruments
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Internationalization of Financial Markets
Foreign Bonds: sold in a foreign country and denominated in that country’s currency
Eurobond: bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies: foreign currencies deposited in banks outside the home country
• Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
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Famous Stock Market Indexes
New York:
• The Dow Jones Industrial Average: Oldest (since 1892) and best known. Includes 30 large industrial companies.
Not a very a good (quite bad) indicator of the health of the market. Listen to this story on the Dow Jones: http://www.npr.org/blogs/money/2013/03/12/174139347/episode- 443-dont-believe-the-hype
• The S&P 500: Includes 500 large companies
• The NASDAQ Composite Index: More than 5000 companies
• The Wilshire 5000: Includes more than 7000 companies
• The Russell 2000: 2000 smallest stocks in the Russell 3000, the 3000 largest publicly traded companies on the US market
Tokyo: Nikkei 300 Average
London: Financial Times Stock Exchange (FTSE) 100-share Index: 100 largest companies on the London Stock Exchange
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Regulation of the Financial System
Goal: To increase the information available to investors:
• Reduce adverse selection and moral hazard problems • Reduce insider trading (SEC)
• To ensure the soundness of financial intermediaries:
• Restrictions on entry (chartering process).
• Disclosure of information.
• Restrictions on Assets and Activities (control holding of risky
assets).
• Deposit Insurance (avoid bank runs).
• Limits on Competition (mostly in the past): Branching,
Restrictions on Interest Rates
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Principal Regulatory Agencies in the US
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Principal Regulatory Agencies in the UK
In 2013, the Financial Services Authority was split in two:
• Financial Conduct Authority: Consumer protection agency
• Prudential Regulation Authority: Regulate banks (Recently in the news for the LIBOR manipulation case)
Panel on Takeover and Mergers
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Financial crises
Financial crises are
• major disruptions in financial markets that are
• characterized by sharp declines in asset prices and • failures of many financial and nonfinancial firms.
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Financial Crises
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Financial Crises
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Recent Crisis in the US
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Recent Crisis in the US
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