Chapter

16
The Financial System

Learning Objectives
1

Outline the structure and importance of the financial system. List the various types of securities. Define financial market, and distinguish between primary and secondary financial markets.

Discuss the organization and functioning of financial institutions. Explain the functions of the Federal Reserve System and the tools it uses to control the supply of money and credit. Evaluate the major features of regulations and laws affecting the financial system. Describe the global financial system.

2 3

7 4

Describe the characteristics of the major stock exchanges.

8

The Financial System

The financial system is the process by which money flows from savers to users.

Understanding the Financial System

Financial System

Savers Users Financial Institutions Financial Markets

Savings is a function of many variables. Funds can be transferred between users and savers directly or indirectly.

Types of Securities

Securities

Financial instruments
Obligations on the part of the issuer

Businesses and governments

Provide rate of return to purchasers

Money market instruments

Bonds Stock

Money Market Instruments

Short-term debt securities

Issued by governments, financial institutions, and corporations

Investors are paid interest for the use of their funds Generally low-risk U.S. Treasury bills, commercial paper, and bank certificates of deposit

Bonds

Government Bonds

Bonds sold by the U.S. Department of the Treasury Bonds issued by state or local governments

Municipal Bonds

Revenue bonds are used toward a project that will produce revenue, general obligation bonds are not

Corporate Bonds

A diverse group and often vary based on the collateral

Types of Bonds

Bond Ratings

Price is determined by risk and interest rate. Several firms rate bonds

Standard & Poors (S&P) Moodys

Investment-grade Speculative/Junk

Bond Ratings

Stocks

Common stock ownership claims in corporations

Vote on major company decisions Cash dividends Price appreciation

Preferred stock stockholders who receive preference in the payment of dividends

Convertible Securities

Stockholder has the right to exchange the bond or preferred stock for a fixed number of shares of common stock.

Financial Markets

Primary market firms and governments issue securities and sell them initially to the public

When a firm offers a stock for sale to the general public for the first time

Secondary market collection of financial markets in which previously issued securities are traded among investors

Understanding Stock Markets

Stock market (exchange) market in which shares are bought and sold by investors, such as the New York Stock Exchange.

Stock Exchanges

The New York Stock Exchange the Big Board is the most famous and one of the oldest stock markets in the world. More than 3,000 stocks are listed on the NYSE. The Nasdaq Stock Market the second largest stock market. Over 5,000 companies have their stocks listed on Nasdaq, but many are smaller firms. Other U.S. Stock Markets:

The American Stock Exchange/AMEX Regional stock exchanges Foreign markets

ECNs and the Future of Stock Markets

ECNs Electronic Communication Networks

The 4th market Buyers and sellers meet in a virtual market and exchange with one another Take place on INET or Archipelago

INET and Archipelago have been purchased by Nasdaq and the NYSE

Investor Participation in the Stock Market

Investors use brokerage firms to: 1. Establish an account 2. Enter orders 3. Trade stock The brokerage firm executes the trade on behalf of the investor, charging a fee for the order.
Market order Limit order

Financial Institutions

Commercial Banks
Savings Banks and Credit Unions Non-depository Institutions

Financial Institutions

Electronic Banking

An increasing amount of funds move through electronic funds transfers (EFTs). Millions of businesses and consumers now pay bills and receive payments electronically. Most employers directly deposit employee paychecks. Social Security and other federal payments are made each year electronically. Most banks now offer customers debit cards More than 1/3 of American households use some online banking.

Federal Deposit Insurance Corporation

Enacted by the Banking Act of 1933 Restored public confidence in the banking system Before deposit insurance, runs were common as people rushed to withdraw their money from the bank Deposit insurance shifts the risk of bank failures from individuals to the FDIC

Savings Banks and Credit Unions

Offer a variety of consumer services 80+% of their loans are real estate loans Credit unions are cooperative financial institutions owned by depositors/members Credit unions are created to serve consumers

Insured by National Credit Union Administration (NCUA), which functions the same as the FDIC

Nondepository Financial Institutions

Insurance Companies Pension Funds

Finance Companies
Mutual Funds

The Role of the Federal Reserve

The Federal Reserve Created In 1913 Central bank of the United States Regulates commercial banks Performs banking-related activities for the U.S. Department of Treasury Provides services for banks Sets monetary policy

Organization of the Federal Reserve

12 Federal reserve districts

Own federal reserve bank

District banks are run by a nine-member board of directors The board of governors is the governing body Politically independent Federal Open Markets Committee (FOMC) sets most policies concerning monetary policy and interest rates

Check Clearing and the Fed

Americans still write billions of paper checks. The process by which funds are transferred from the check writer to receiver is a multiple-step process managed and cleared by the Fed. The Check Clearing for the 21st Century Act is making this process more electronic.

Monetary Policy

Controlling supply of money and credit Measures of the money supply: M1 & M2 The Fed requires banks to maintain reserves Set the discount rate Open market operations

M1 & M2

Regulation of the Financial System

Bank regulation Government regulation of the financial markets (SEC) Industry self-regulation

Rules of conduct by professional organizations like National Association of Securities Dealers Market surveillance

The Financial System: A Global Perspective

The financial system is more connected. Financial institutions are more global. Only 3 of the 30 largest banks in the world are U.S. institutions. Most nations have a central bank.