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Chapter 2 Financial Assets, Money, Financial Transactions, and Financial Institutions McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved. Learning Objectives To learn about the important channels through which funds flow from lenders and borrowers and back again within the global system of money and capital markets. To discover the nature and characteristics of financial assets – how they are created and destroyed by decision makers within the financial system. 2-3 Learning Objectives To explore the critical roles played by money within the financial system and the linkages between money and inflation in the prices of goods and services. To examine the important jobs carried out by financial intermediaries in lending and borrowing and in creating and destroying financial assets. 2-4 The Role of Financial Assets The financial system is the mechanism through which loanable funds reach borrowers Operation of the financial market Money exchanged for financial claims Stocks Bonds Other securities Transforms savings into investment Permits the economy to grow 2-5 The Nature and Characteristics of Financial Assets A financial asset A claim against the income or wealth of a business firm, household, or unit of government Represented usually by a certificate receipt, computer record file, or other legal document Usually related to the lending of money Examples include stocks, bonds, deposits, and others 2-6 Characteristics of Financial Assets Financial assets are sought after because they promise future returns to their owners and serve as a store of value (purchasing power). 2-7 Characteristics of Financial Assets Financial asset value based on faith that issuer honors contractual promise to pay Financial assets characteristics Do not depreciate like physical goods Physical condition or form usually not relevant in determining market value Have little or no value as a commodity Cost of transportation and storage is low Financial assets are fungible – can easily be changed in form and substituted for other assets 2-8 Types of Financial Assets Money Financial asset accepted in payment for purchases of goods and services Examples are currency and checking Equities Ownership shares in a business firm Claims against the firm’s profits Claims against proceeds from the sale of its assets Examples are common stock and preferred stock 2-9 Types of Financial Assets Debt Securities Priority claim over the holders of equities to the assets and income of an economic unit Can be negotiable or nonnegotiable Examples include bonds, notes, accounts payable, and savings deposits Derivatives Market value tied to or influenced by the value or return on a financial asset Examples include futures contracts, options, and swaps 2-10 How Financial Assets Are Created Internal financing to acquire assets Use current income Use accumulated savings External financing to acquire assets Raise funds by issuing financial liabilities (debt) Raise funds by issuing stock (equities) 2-11 Balance Sheets of Units in a Simple Financial System 2-12 Unit Balance Sheets Following the Equipment Purchase and Debt Issuance 2-13 Unit Balance Sheets Following Equipment Purchase and Stock Issuance 2-14 Financial Assets and the Financial System The act of borrowing or of issuing new stock simultaneously gives rise to the creation of an equal volume of financial assets. All financial assets are recorded as a liability or claim on some other economic unit’s balance sheet. Volume of financial assets for lenders = Volume of liabilities issued by borrowers 2-15 Financial Assets and the Financial System For the balance sheet of any economic unit, Total assets = Total liabilities + Net Worth Where Assets = Real assets + Financial assets For the whole economy and financial system, Total financial assets = Total liabilities So, for the economy as a whole, Total real assets = Total net worth 2-16 Financial Assets and the Financial System Society can increase its wealth Saving and increasing the quantity of its real assets Real assets enable the economy to produce more goods and services The financial system provides the essential channel Necessary for the creation and exchange of financial assets Exchange is between savers and borrowers so that real assets can be acquired 2-17 Financial System Matters Strong financial system helps society Reducing barriers to external financing Lowering cost of capital Accelerating economic growth Nations with more fully developed financial systems Tends to grow faster Tends to enjoy a higher standard of living 2-18 Lending and Borrowing in the Financial System Economists John Gurley and Edward Shaw pointed out that each business firm, household, or unit of government active in the financial system must conform to: R - E = FA - D where R = Current income receipts E = Expenditures out of current income FA = Change in holdings of financial assets D = Change in debt and equity outstanding 2-19 Lending and Borrowing in the Financial System So, for any given time period, each economic unit must fall into one of three groups: Deficit-budget unit (DBU): E > R, so D > FA (net borrower of funds) Surplus-budget unit (SBU): R > E, so FA > D (net lender of funds) Balanced-budget unit (BBU): R = E, so D = FA (neither net lender nor borrower) 2-20 Lending and Borrowing in the Financial System The U.S. Economy in 2006 ($ Billions) Major Sectors of the Economy Households Net Acquisitions Net Net Lender (+) of Financial Increase in or Net Assets Liabilities Borrower (-) $865.1 $1,411.1 $ - 546.0 Nonfinancial business firms State and local governments Federal government International sector: foreign investors and borrowers 599.0 680.5 + 87.5 80.0 144.0 - 64.0 - 13.6 634.6 - 648.2 1491.9 545.3 + 946.6 Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts 2-21 Lending and Borrowing in the Financial System The global financial system permits businesses, households, and governments to adjust their financial position from that of net borrower (DBU) to net lender (SBU) and back again, smoothly and efficiently. 2-22 What is Money? All financial assets are valued in terms of money, and flows of funds between lenders and borrowers occur through the medium of money. Money itself is a financial asset, because all forms of money in use today are claims against some public or private institution. 2-23 Alternative Definitions of Money M1 Currency and coin held by the public outside bank vaults Various kinds of payment accounts at depository institutions M2 takes M1 and adjusts Add small savings and time deposits Add share accounts at retail money market mutual funds MZM takes M2 and adjusts Subtract small-denomination time deposits Add institutional money market funds 2-24 Historic Volume of Money 8000 7000 6000 5000 4000 3000 2000 1000 0 2000 2001 2002 2003 M1 2004 2005 2006 2007 M2 Source: http://www.federalreserve.org/releases/H6/hist/h6hist1.txt 2-25 The Functions of Money Money serves as a standard of value (or unit of account) Money serves as a store of value Reserve of future purchasing power Value of money can fluctuate with inflation Money serves as a medium of exchange Buyers and sellers no longer need to have an exact coincidence of wants 2-26 The Value of Money and Other Financial Assets and Inflation Inflation Rise in the average price level of all goods and services Lowers purchasing power of money Can damage value of financial contracts Deflation The opposite of inflation Fall in the average price level of all goods and services 2-27 The Value of Money and Other Financial Assets and Inflation Inflation is commonly measured using price indices, such as: the Consumer Price Index (CPI), the Producer Price Index (PPI), or the Gross Domestic Product (GDP) deflator Index. 2-28 The Value of Money and Other Financial Assets and Inflation Suppose the U.S. CPI rises from 100 to 125 over a five-year period. Over the five-year period, the cost-of-living index climbed 125 100 0.25 or 25% ... 100 and the U.S. dollar’s relative purchasing power fell 1 100 0.8 . 125 2-29 Impact on Purchasing Power Changes in purchasing power can be dramatic Due to inflation Even in the United States Provides a warning about measuring value Need to think in terms of real values Purchasing power adjusted Nominal values can be misleading 2-30 The Evolution of Financial Transactions Financial systems change constantly Shifting demands from the public Development of new technology Changes in laws and regulations The ways of carrying out financial transactions have evolved In particular, the transfer of funds from savers to borrowers can be accomplished in at least three different ways 2-31 The Evolution of Financial Transactions Direct Finance – Direct lending gives rise to direct claims against borrowers Flow of funds and other financial services (loans of spending power for an agreed-upon period of time) Borrowers (DBUs) Lenders (SBUs) Primary Securities (stocks, bonds, notes, etc., evidencing direct claims against borrowers) Simple Difficult to match & risky 2-32 The Evolution of Financial Transactions Semidirect Finance – Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers Primary Securities (direct claims against borrowers) Borrowers (DBUs) Proceeds of security sales and other financial services (less fees and commissions) Primary Securities Security brokers, dealers, & investment bankers (direct claims against borrowers) Lenders (SBUs) Flow of funds and other financial services (loans of spending power) Lower search (information) costs Risky & matching is still required 2-33 Major Financial Institutions 2-34 The Evolution of Financial Transactions Indirect Finance – Financial intermediation of funds Primary Securities (direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes, etc.) Ultimate borrowers (DBUs) Secondary Securities (indirect claims against ultimate borrowers issued by financial intermediaries in the form of deposits, insurance policies, retirement savings accounts, etc.) Financial intermediaries (banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies, pension funds) Ultimate lenders (SBUs) Flow of funds and other financial services Flow of funds and other financial services (loans of spending power) (loans of spending power) Low risk & affordable 2-35 Total Financial Assets Held by U.S. Financial Institutions ($ billions at year-end) 1970 1980 Financial intermediaries: Commercial banks $489 $1,248 S&L assoc. and savings banks 252 794 Life insurance companies 201 464 Private pension funds 110 413 Investment co. (mutual funds) 47 64 State & local gov’t pension funds 60 198 Finance companies 63 199 Property-casualty insurance co. 50 174 Money market funds –– 74 Credit unions 18 72 Mortgage companies –– 16 Real estate investment trusts 4 6 Other financial institutions: Security brokers and dealers 16 36 1990 2000 2006 $3,340 1,358 1,357 1,629 602 820 611 534 498 202 49 13 $6,488 1,219 3,204 4,587 4,457 2,290 1,138 872 1,812 441 36 62 $9,528 1,829 4,479 4,876 6,473 2,791 1,300 1,280 2,014 703 32 385 262 1,221 2,296 Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts 2-36 Classifying Financial Institutions Depository institutions Bulk of their loanable funds from deposit accounts sold to the public Commercial banks, savings and loan associations, savings banks, credit unions Contractual institutions Funds from offering legal contracts to protect the saver against risk Insurance companies, pension funds 2-37 Classifying Financial Institutions Investment institutions Sell shares to the public Invest the proceeds in stocks, bonds, and other assets Mutual funds, money market funds, real estate investment trusts 2-38 Portfolio (Financial-Asset) Decisions by Financial Institutions Deciding what financial assets to buy or sell Depends on various asset factors Different financial assets relative rate of return Different financial assets risk Cost of incoming funds Volatility of incoming funds Maturity of incoming funds 2-39 Portfolio (Financial-Asset) Decisions by Financial Institutions Also depends on financial institution size Larger financial institutions tend to have more diversified sources and uses Larger financial institutions also enjoy economies of scale. Regulations and competition 2-40 The Disintermediation of Funds Disintemediation process Withdrawal of funds from a financial intermediary by the ultimate lenders (SBUs) Lending of those funds to ultimate borrowers (DBUs) Disintermediation shifts funds Away from indirect finance To direct finance 2-41 The Disintermediation of Funds Financial Disintermediation Primary Securities Ultimate borrowers (DBUs) Financial intermediaries Ultimate lenders (SBUs) Loanable funds 2-42 The Disintermediation of Funds Disintermediation is not a foregone conclusion Reintermediation Reversal of flow of funds Back to a “safe haven” of financial intermediaries Interest rates are low or declining Or riskiness of financial instruments appear to be rising 2-43 New Forms of Disintermediation Initiation by financial intermediaries Banks sell off loans Difficulty in raising capital Initiation by borrowing customers Customer learn alternate financing conduits Nonfinancial retail and industrial firms attempting to draw financial services customers Raise funds in the open market 2-44 Bank-Dominated Versus SecurityDominated Financial Systems Bank-dominated financial systems Banks and other similar institutions dominate Supply of credit Attracting savings Common in economies with less protection of investor rights or less welldefined rules 2-45 Bank-Dominated Versus SecurityDominated Financial Systems Security-dominated financial systems Traditional intermediaries are less important More borrowers sell securities to the public Many economies are gradually moving toward a more security-dominated financial system 2-46 Markets on the Net Answers.com at http://www.answers.com/topic/disinter mediation Bondsonline at www.bondsonline.com Encarta at encarta.msn.com Encyclopedia.com at encyclopedia.com Federal Reserve Bank of Atlanta at www.frbatlanta.org Federal Reserve Bank of New York at www.ny.frb.org 2-47 Markets on the Net Federal Reserve Bank of St. Louis at research.stlouisfed.org/fred2 Moody’s Investor Service at www.moodys.com Money Magazine at money.cnn.com New York Stock Exchange at www.nyse.com RePEc at ideas.repec.org 2-48 Markets on the Net Standard & Poor’s Corporation at www.standardandpoor.com The Bond Market Association at www.investinginbonds.com U.S. Bureau of Economic Analysis at www.bea.gov U.S. Bureau of Labor Statistics at www.stats.bls.gov Wikipedia at en.wikipedia.org 2-49 Chapter Review Introduction: The role of financial assets The creation of financial assets Characteristics of financial assets Different kinds of financial assets How financial assets are born Financial assets and the financial system 2-50 Chapter Review Lending and borrowing in the financial system Money as a financial asset What is money? The functions of money The value of money and other financial assets and inflation 2-51 Chapter Review The evolution of financial transactions Direct finance Semidirect finance Indirect finance and financial intermediation Relative size and importance of major financial institutions Classification of financial institutions 2-52 Chapter Review Portfolio (financial-asset) decisions by financial intermediaries and other financial institutions Disintermediation of funds New types of disintermediation Bank-dominated versus securitydominated financial systems 2-53