Chapter 1: Role of Financial Markets and Institutions

Chapter Objectives

Describe the types of financial markets that facilitate the flow of funds.
Describe the types of securities traded within financial markets.
Describe the role of financial institutions within financial markets.
Explain how financial institutions were exposed to the credit crisis.

Role of Financial Markets

Financial Market Defined: A market where financial assets (securities) like stocks and bonds are bought or sold. Funds are transferred when one party purchases assets previously held by another.
Primary Function: To transfer funds from those with excess funds (surplus units) to those who need funds (deficit units).
- Surplus Units: Participants who receive more money than they spend, e.g., investors.
- Deficit Units: Participants who spend more money than they receive, e.g., borrowers.
- Securities: Represent a claim on the issuers.
  - Debt Securities: Represent debt (also called credit or borrowed funds) incurred by the issuer.
  - Equity Securities: Also called stocks, represent equity or ownership in the firm.
Accommodating Corporate Finance Needs: Financial markets enable corporations (deficit units) to obtain funds from investors (surplus units).
Accommodating Investment Needs: Financial institutions act as intermediaries, connecting investment management activities with corporate finance activities.

Types of Financial Markets

Primary Markets: Facilitate the issuance of new securities. Funds are provided to the initial issuer of securities here.
Secondary Markets: Facilitate the trading of existing securities, allowing for a change in ownership. These markets enhance liquidity.
- Liquidity: The ease with which securities can be sold (liquidated) without a significant loss of value.
- Illiquid Securities: If a security is illiquid, investors may struggle to find a buyer in the secondary market and might have to sell at a large discount.

Securities Traded in Financial Markets

Securities are broadly classified into money market, capital market, or derivative securities.

Money Market Securities

Facilitate the sale of short-term debt securities by deficit units to surplus units.
Maturity of one year or less.
Example: Commercial paper.

Capital Market Securities

Facilitate the sale of long-term securities by deficit units to surplus units.
Types of Capital Market Securities:
- Bonds: Long-term debt securities issued by the Treasury, government agencies, and corporations to finance operations.
- Mortgages: Long-term debt obligations financing real estate purchases.
- Mortgage-backed Securities (MBS): Debt obligations representing claims on a package of mortgages.
- Stocks: Represent partial ownership in the issuing corporations.

Derivative Securities

Financial contracts whose values are derived from the values of underlying assets.
Purposes:
- Speculation: Allow investors to speculate on underlying asset value movements without directly purchasing the assets. This implies higher risk but potentially higher returns.
- Risk Management: Financial institutions and firms use derivatives to adjust the risk of their existing security investments.

Valuation of Securities

Impact of Information on Valuation:
- Investors estimate future cash flows by gathering information influencing a stock's future cash flows.
- Economic or industry information, and published opinions about a firm's management, are used to value a security.
Impact of the Internet on Valuation:
- Provides more timely pricing.
- Enables more accurate pricing.
- Offers more informative pricing.
Impact of Behavioral Finance on Valuation:
- Behavioral Finance: The application of psychology to financial decisions.
- Investor psychology can affect security prices, sometimes explaining movements not attributable to fundamental factors.
Uncertainty Surrounding Valuation: Limited information inevitably leads to uncertainty in the valuation of securities.

Securities Regulations

Required Disclosure:
- Securities Act of 1933: Mandated complete disclosure of relevant financial information for publicly offered securities and aimed to prevent fraudulent practices in their sale.
- Securities Exchange Act of 1934: Extended disclosure requirements to secondary market issues and established the Securities and Exchange Commission (SEC).
Regulatory Response to Financial Reporting Scandals:
- Sarbanes-Oxley Act (SOX): Required firms to provide more complete and accurate financial information in response to major financial reporting scandals.

International Securities Transactions

Financial markets globally vary in their degree of development and the volume of funds transferred.
Foreign Exchange Market (FOREX): Facilitates the exchange of currencies required for international financial transactions.

Government Intervention in Financial Markets

Governments have recently increased their role in financial markets, especially during crises.
During the Credit Crisis (2007-2009):
- The Federal Reserve purchased various debt securities to ensure more liquidity, thereby encouraging investors to purchase them.
- Government regulations altered how the credit risks of bonds were assessed.
- Increased monitoring of stock trading and prosecution of insider trading cases aimed to ensure fair play and prevent unfair investor advantages.

Role of Financial Institutions

Financial institutions are crucial for resolving market imperfections, such as limited information about borrowers' creditworthiness.

Depository Institutions

Accept deposits from surplus units and provide credit to deficit units via loans and security purchases.
Key Functions:
- Offer liquid deposit accounts to surplus units.
- Provide loans tailored to the size and maturity desired by deficit units.
- Assume the risk associated with loans.
- Possess expertise in evaluating creditworthiness.
- Diversify their loan portfolios across numerous deficit units.
Types of Depository Institutions:
- Commercial Banks: The most dominant type; transfer deposit funds to deficit units via loans or debt security purchases.
  - Federal Funds Market: Facilitates the flow of funds between depository institutions.
- Savings Institutions: Also known as Thrift Institutions (e.g., Savings and Loans (S&Ls) and Savings Banks); primarily focus on residential mortgage loans.
- Credit Unions: Nonprofit organizations that restrict business to members sharing a common bond.

Non-depository Institutions

Finance Companies: Obtain funds by issuing securities and then lend these funds to individuals and small businesses.
Mutual Funds: Sell shares to surplus units and use the proceeds to purchase a diversified portfolio of securities.
Securities Firms: Provide a wide range of functions including brokerage, underwriting, dealing, and advisory services.
Insurance Companies: Provide insurance policies (e.g., life, health, property/casualty) that reduce financial burdens. They charge premiums and invest the accumulated funds in financial markets.
Pension Funds: Manage funds until they are withdrawn by retirees.

Comparison and Consolidation of Financial Institutions

Institutional Role as Monitors: Financial institutions facilitate fund flows and also monitor publicly traded firms. As activist shareholders, they can ensure management decisions align with shareholder interests.
Internet's Impact: The internet has significantly improved the efficiency of financial institutions, leading to lower costs, reduced fees, and increased competition.
Relative Importance: Depository institutions primarily serve households with savings or deficient funds. Various regulatory agencies oversee these institutions, and regulations can create competitive advantages.
Consolidation of Financial Institutions:
- Typical Structure: Barriers to entry have been reduced, enabling firms specializing in one service to expand into others, forming financial conglomerates.
- Impact on Competition: Consolidation offers greater convenience to customers, allowing them access to multiple services from a single conglomerate.
- Global Consolidation: Many financial institutions have expanded internationally to leverage their expertise in broader markets.

Credit Crisis for Financial Institutions

Build-up to the Crisis: From 2004-2006, home prices surged, leading many financial institutions to dramatically increase their holdings of mortgages and mortgage-backed securities (MBS).
Crisis Onset (2007-2009): Mortgage defaults sharply increased, and home values plummeted substantially.
Systemic Risk Defined: The spread of financial problems among financial institutions and across financial markets, with the potential to cause a collapse of the entire financial system.
- How Mortgage Defaults Affected Firms:
  - Mortgage originators sold risky mortgages to other financial institutions just before the crisis.
  - Many financial institutions invested heavily in derivatives tied to these mortgages, increasing their exposure.
  - Some institutions relied on short-term funding and used MBS as collateral, making them vulnerable.
  - The decline in home building significantly reduced demand for related businesses, contributing to a weak economy.
Government Response to the Credit Crisis:
- Emergency Economic Stabilization Act (October 2008): Aimed to resolve liquidity issues within financial institutions and restore investor confidence.
- Federal Reserve Actions: Provided emergency loans to many securities firms, even those not traditionally under its direct regulation.
- Financial Reform Act of 2010 (Dodd-Frank Wall Street Reform and Consumer Protection Act): Required mortgage lenders to verify applicants' income, job status, and credit history before approving mortgage applications.
Conclusion on Government Response: The overall government response sought to enhance the safety of financial institutions. Tougher regulations were implemented to stabilize financial markets and encourage greater participation from both surplus and deficit units.