Financial system

How do firms finance investments?

• Borrow

• Find investor / partner to provide funds in exchange for a share in ownership of the business

Financial system: the group of institutions that help match one person’s savings with another person’s investment.

• These financial institutions are typically regulated 

Financial intermediaries

• Banks

  • Banks take deposits from savers - borrow from savers

  • Use those deposits to make loans

  • How do they make money? By charging a higher interest from those they lend to and pay a lower interest to those they borrow from

• What functions do banks serve?

  • Pool savings from many savers (borrowers don't have to go to each saver to borrow)

  • Spread the risk of lending across many borrowers

  • Solve information problems (credit checks)

  • Provide payment services

  • Create long-term loans from short-term deposits

Financial markets: institutions through which savers can directly provide funds to borrowers

• Bond markets

• Stock markets

banks: middle man between the person who keeps the savings and those who borrow.

Bank reserves

• Share of deposits that is kept in the bank

• Banks dont keep all your money in the vault, they lend it to others

BANK RUN: when many bank customers try to withdraw their savings at the same time

• Bank runs can cause a bank to collapse

• What triggers a bank run:

  • Rumors 

  • Self-fulfilling prophecy

• Deposit insurance minimizes likelihood of bank runs

Shadow banks: financial firms that act like banks but since they arent actually banks, they do not have to follow the same rules as banks. They have no deposit insurance and are more susceptible to bank runs.

Bond market

Bond: IOU (“I owe you”). It’s a loan that in investor makes to a company or government, in return for which the issuer promises to pay interest and repay the principal (face value) at a specified future date (maturity date)

• Can be issued by private firms or governments

• The shorter the term of the bond, the lower the interest rate (all else equal)

Stock Market

• Stock: Represents partial ownership in a firm, claims to its profits

• Shareholders: owners of shares or stocks

• Equity finance: issuing stock to raise funds

  • Debt finance: issuing bonds to raise funds

• How can you benefit from owning stock?

  • Dividends: a share of profit that a company pays to shareholders

  • The value of your shares can rise

Functions of the stock market

• Channel funds from savers to investors

• Spread risk

  • If the company gains, all gain. If a company loses, you can lose the value of your shares. This is spread across all shareholders.

• Reallocate control

  • As the shares are traded, ownership changes

  • If a single individual has a large enough number of shares, they can have more power in shareholder meetings. 

• Create Liquidity

  • Stock market is a market for second-hand stock, i.e. trades existing stocks

Bonds vs. Stocks

Bonds

• Specified future interest payments

• First in line to get paid if the company goes bankrupt

• No rights to help control the company

Stocks

• Uncertain future dividends, depending on the company performance

• Last in line to get paid

• Shareholders have a vote in how the company is run

Efficient market hypothesis: The theory that at any point in time, stock prices reflect all publicly available information.

• It is tough to beat the market unless you have information that is not known by other people (insider information)

• Financial prices more unpredictably

Speculative bubble: when the price of an asset rises above what appears to be its fundamental value.

• Bubbles happen when the value of an asset is determined by people’s expectations about other people’s expectations.

• At some point the true value is revealed and the bubble bursts