Financial Markets and Institutions Lecture Notes

Interesting Facts
Why Study Financial Markets & Institutions?
Function of Financial Intermediaries
Direct vs Indirect Financing
Benefits of Financial Intermediation
- Solve Transactions Cost issues in the Financial System
- Provides liquidity benefits
- Risk sharing through diversification (asset transformation)
- Reduce asymmetric information

There is a total of RM93.3 billion in circulation as of 2018 in notes and coins.
Banks have around RM328 billion of deposits.
Government debt is around RM700 billion (unofficial) to RM1 trillion (official).
Household debt is at RM581 billion.
The Employees Provident Fund (EPF) has around RM600 billion worth of assets (unofficial).

Financial Institutions
- Banks
  - Central Bank
  - Commercial Banks
  - Investment Banks
- Other Institutions
  - Non-Banks
    - Insurance Companies
    - Investment Companies
    - Retirement Companies
    - Others
Financial Markets
- Equity Market
- Bonds Market
- Money Market
- Foreign Exchange

Financial Markets and Institutions are crucial in our economy, channeling funds from savers to spenders/borrowers, thereby promoting economic efficiency.
Funds flow from Savers (Lenders) to Spenders (Borrowers).

Direct Finance:
- Borrower-Spenders (Business firms, Government, Households, Foreigners) receive funds directly from Lender-Savers (Households, Business firms, Government, Foreigners) through financial markets.
Indirect Finance:
- Financial Intermediaries facilitate the flow of funds between Lender-Savers and Borrower-Spenders.

Direct Finance
- Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets.
Indirect Finance
- Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets.

Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) acts as the middleman.
- The intermediary obtains funds from savers.
- The intermediary then makes loans/investments with borrowers.
This process, called financial intermediation, is the primary means of moving funds from lenders to borrowers.
More important source of finance than securities markets (such as stocks).
Needed because of:
- Transactions costs
- Risk sharing
- Asymmetric information

Example 1:
- You lend your brother 1,000.
- You deposit 1,000 in Maybank. Maybank is the intermediary.
Example 2:
- You buy Nestle stocks directly from Bursa Exchange.
- You invest into unit trusts with Public Mutual. Public Mutual's fund managers buy Nestle stocks as part of their portfolio. Public Mutual is the intermediary.
Example 3:
- You buy Petronas bonds directly from Petronas through a broker.
- You buy an insurance product from Prudential. Prudential buys bonds from Petronas as part of their portfolio. Prudential is the intermediary.

Depository institutions (banks)
- Commercial banks:
  - Liabilities: Deposits
  - Assets: Business and consumer loans, mortgages, U.S. government securities, and municipal bonds
- Savings and loan associations:
  - Liabilities: Deposits
  - Assets: Mortgages
- Mutual savings banks:
  - Liabilities: Deposits
  - Assets: Mortgages
- Credit unions:
  - Liabilities: Deposits
  - Assets: Consumer loans
Contractual savings institutions
- Life insurance companies:
  - Liabilities: Premiums from policies
  - Assets: Municipal bonds, corporate bonds and stock, and U.S. government securities
- Fire and casualty insurance companies:
  - Liabilities: Premiums from policies
  - Assets: Corporate bonds and stock
- Pension funds, government retirement funds:
  - Liabilities: Employer and employee contributions
  - Assets: Corporate bonds and mortgages
Investment intermediaries
- Finance companies:
  - Liabilities: Commercial paper
  - Assets: Consumer and business loans
- Mutual funds:
  - Liabilities: Shares
  - Assets: Stocks, bonds
- Money market mutual funds:
  - Liabilities: Shares
  - Assets: Money market instruments

Bonds and money market instruments are traded in bundles of large quantities (Minimum RM1 million per transaction in Malaysia).
It is expensive for bond issuers to issue small amounts to many investors, especially for maturable assets. The translation of the cost to investors as returns on these instruments are low.
Financial institutions help investors group funds together in order to participate in the financial markets.
Banks also solve the transaction cost issue by having a central entity to process many savings and borrowings at the same time.
Reduce transaction costs by developing expertise and taking advantage of economies of scale.

A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions.
Banks provide depositors with checking accounts that enable them to pay their bills easily.
Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary.

Financial intermediaries (FIs) can reduce the exposure of investors to risk through risk sharing.
FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party.
This process is referred to as asset transformation, because risky assets are turned into safer assets for investors.

Financial intermediaries help by providing the means for individuals and businesses to diversify their asset holdings.
Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.
Efficient bank management, diligent loan approval processes, and government guarantees (PIDM) contribute to risk sharing.
Borrowing from many and lending to many diversifies risk.

Financial Intermediaries exist to reduce the impact of asymmetric information.
Asymmetric information occurs when one party lacks crucial information about another party, impacting decision-making.
This creates a problem when lenders lack crucial information about borrowers.

Why Study Financial Markets & Institutions?
Function of Financial Intermediaries
Direct vs Indirect financing
Benefits of financial intermediation
- Solve Transactions Cost issues in the Financial System
- Provides liquidity benefits
- Risk sharing through diversification (asset transformation)
- Reduce asymmetric information