Not surprisingly, given the similarity of the economic system here and in Japan, Canada, and the nations of western Europe, financial regulation in these countries is similar to that in the United States. Provision of information is improved by
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requiring corporations issuing securities to report details about assets and liabilities, earnings, and sales of stock, and by prohibiting insider trading. The soundness of intermediaries is ensured by licensing, periodic inspection of financial intermediar- ies’ books, and provision of deposit insurance (although its coverage is smaller than that in the United States and its existence is often intentionally not advertised).
The major differences between financial regulation in the United States and that found abroad relate to bank regulation. In the past, the United States was the only industrialized country to subject banks to restrictions on branching, which limited their size and confined them to certain geographic regions. (These restrictions were abolished by legislation in 1994.) U.S. banks are also the most restricted in the range of assets they may hold. Banks abroad frequently hold shares in commercial firms;
in Japan and Germany, those stakes can be sizable.
S U M M A R Y
1. The basic function of financial markets is to chan- nel funds from savers who have an excess of funds to spenders who have a shortage of funds. Financial markets can do this either through direct finance, in which borrowers borrow funds directly from lend- ers by selling them securities, or through indirect finance, which involves a financial intermediary that stands between the lender-savers and the borrower- spenders and helps transfer funds from one to the other. This channeling of funds improves the eco- nomic welfare of everyone in society. Because they allow funds to move from people who have no pro- ductive investment opportunities to those who have such opportunities, financial markets contribute to economic efficiency. In addition, channeling of funds directly benefits consumers by allowing them to make purchases when they need them most.
2. Financial markets can be classified as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets.
3. An important trend in recent years is the growing internationalization of financial markets. Eurobonds, which are denominated in a currency other than that of the country in which they are sold, are now the dominant security in the international bond market and have surpassed U.S. corporate bonds as a source of new funds. Eurodollars, which are U.S. dollars deposited in foreign banks, are an important source of funds for American banks.
4. Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn, use
those funds to acquire assets by purchasing securi- ties or making loans. Financial intermediaries play an important role in the financial system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral haz- ard. As a result, financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets, thereby increasing the efficiency of the economy. However, the economies of scope that help make financial intermediaries successful can lead to conflicts of interest that make the financial system less efficient.
5. The principal financial intermediaries fall into three categories: (a) banks—commercial banks, savings and loan associations, mutual savings banks, and credit unions; (b) contractual savings institutions—
life insurance companies, fire and casualty insurance companies, and pension funds; and (c) investment intermediaries—finance companies, mutual funds, money market mutual funds, hedge funds, and investment banks.
6. The government regulates financial markets and financial intermediaries for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system.
Regulations include requiring disclosure of informa- tion to the public, restrictions on who can set up a financial intermediary, restrictions on the assets financial intermediaries can hold, the provision of deposit insurance, limits on competition, and restric- tions on interest rates.
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adverse selection, p. 65 asset transformation, p. 64 asymmetric information, p. 65 brokers, p. 59
capital, p. 57 capital market, p. 60 conflicts of interest, p. 67 dealers, p. 59
diversification, p. 64 dividends, p. 58
economies of scale, p. 64 economies of scope, p. 66 equities, p. 58
Eurobond, p. 60
Eurocurrencies, p. 61 Eurodollars, p. 61 exchanges, p. 59
financial intermediation, p. 62 financial panic, p. 72
foreign bonds, p. 60 intermediate-term, p. 58 investment bank, p. 59 liabilities, p. 56 liquid, p. 59
liquidity services, p. 64 long-term, p. 58 maturity, p. 58 money market, p. 60
moral hazard, p. 65
over-the-counter (OTC) market, p. 59
portfolio, p. 64 primary market, p. 58 risk, p. 64
risk sharing, p. 64 secondary market, p. 58 short-term, p. 58
thrift institutions (thrifts), p. 67 transaction costs, p. 63
underwriting, p. 59
K E Y T E R M S
Q U E S T I O N S
1. What is the main function of financial markets? Who is usually better off in case of well-functioning mar- kets? Explain your answer.
2. If I can buy a car today for $5,000 and it is worth
$10,000 in extra income next year to me because it enables me to get a job as a traveling anvil seller, should I take out a loan from Larry the loan shark at a 90% interest rate if no one else will give me a loan?
Will I be better or worse off as a result of taking out this loan? Can you make a case for legalizing loan sharking?
3. Compare the performance of the emerging mar- kets in Southeast Asia and the developed markets in Western Europe in light of the recent global eco- nomic downturn.
4. In May 2017, the world’s first bond linked to the U.N.
Sustainable Development Goals (SDG) had been issued by the World Bank, which helped it raise €163 million from investors in France and Italy and will be used in projects aimed to eliminate extreme poverty.
Why do you think debt instruments are important?
5. How are Eurodollars similar to Eurobonds? How are these related to Eurocurrencies?
6. What are the risks and rewards of investing in the stock market as compared to the bond market?
7. Explain the problem of adverse selection created by asymmetric flow of information. Use an example to illustrate your answer.
8. Lisa is planning to purchase a new house and is looking for a home loan that will give her the low- est interest rate. Discuss how she can be affected by asymmetric information and adverse selection.
9. Why do loan sharks worry less bout moral hazard in connection with their borrowers than some other lenders do?
10. How does the presence of asymmetric information in the direct selling market lead to consumers not buying the products?
11. What is an adverse selection? How is it usually cre- ated in financial markets?
12. “Financial intermediaries play a crucial role in an economic crisis–they are responsible for both caus- ing the market to crash and then helping it recover from the crisis.” Is this statement true? Discuss with an example.
13. How do financial intermediaries solve the problem of adverse selection?
14. What is a main function of investment banks? Do such banks accept deposits and provide loans?
15. What is the main purpose of financial regulation?
What kind of instruments may a government use to protect the economy and country from financial panic?
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W E B E X E R C I S E S
The Financial System
1. One of the best sources of information about financial institutions is the U.S. Flow of Funds report produced by the Federal Reserve. This document contains data on most financial intermediaries. Go to www .federalreserve.gov/releases/Z1/. Go to the most current release. You may have to install Acrobat Reader if your computer does not already have it;
the site has a link to download it for free. Go to the Level Tables and answer the following questions.
a. What percentage of assets do commercial banks hold in loans? What percentage of assets are held in mortgage loans?
b. What percentage of assets do savings and loans hold in mortgage loans?
c. What percentage of assets do credit unions hold in mortgage loans and in consumer loans?
2. The most famous financial market in the world is the New York Stock Exchange. Go to www.nyse.com.
a. What is the mission of the NYSE?
b. Firms must pay a fee to list their shares for sale on the NYSE. What would be the fee for a firm with 5 million common shares outstanding?
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77 they use the term interest rate. We discuss how the yield to maturity is measured on credit market instruments and how it is used to value these instru- ments. We also see that a bond’s interest rate does not necessarily indicate how good an investment the bond is because what it earns (its rate of return) does not necessarily equal its interest rate. Finally, we explore the distinction between real interest rates, which are adjusted for changes in the price level, and nominal interest rates, which are not.
Although learning definitions is not always the most exciting of pursuits, it is important to read carefully and understand the concepts presented in this chapter. Not only are they continually used throughout the remainder of this text, but a firm grasp of these terms will give you a clearer under- standing of the role that interest rates play in your life as well as in the general economy.
PREVIEW
Interest rates are among the most closely watched variables in the economy. Their movements are reported almost daily by the news media because they directly affect our everyday lives and have important consequences for the health of the econ- omy. They affect personal decisions such as whether to consume or save, whether to buy a house, and whether to purchase bonds or put funds into a sav- ings account. Interest rates also affect the economic decisions of businesses and households, such as whether to use their funds to invest in new equip- ment for factories or to save their money in a bank.
Before we can go on with the study of finan- cial markets, we must understand exactly what the phrase interest rates means. In this chapter, we see that a concept known as the yield to maturity is the most accurate measure of interest rates; the yield to maturity is what financial economists mean when