The Financial System

Chapter

16

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.

Describe the characteristics of the major stock exchanges.

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Learning Objectives

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.

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

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.

Understanding the Financial System

Securities Financial instruments Obligations on the part of the issuer

Businesses and governments

Provide rate of return to purchasers

Types of Securities

Money market instruments

Bonds

Stock

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

Money Market Instruments

Government Bonds Bonds sold by the U.S. Department of the Treasury

Municipal Bonds Bonds issued by state or local governments

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

Bonds

Types of Bonds

Price is determined by risk and interest rate.

Several firms rate bonds Standard & Poor’s (S&P) Moody’s

Investment-grade Speculative/Junk

Bond Ratings

Bond Ratings

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

Stocks

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

Convertible Securities

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

Financial Markets

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

Understanding Stock Markets

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

Stock Exchanges

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

ECNs and the Future of Stock Markets

Investors use brokerage firms to:1. Establish an account2. Enter orders3. Trade stock

The brokerage firm executes the trade on behalf of the investor, charging a fee for the order.

Market order Limit order

Investor Participation in the Stock Market

Commercial Banks

Savings Banks and Credit Unions

Non-depository Institutions

Financial Institutions

Financial Institutions

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.

Electronic Banking

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

Federal Deposit Insurance Corporation

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

Savings Banks and Credit Unions

Insurance Companies

Pension Funds

Finance Companies

Mutual Funds

Nondepository Financial Institutions

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

The Role 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

Organization of the Federal Reserve

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.

Check Clearing and the Fed

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

Monetary Policy

M1 & M2

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

Regulation of the Financial System

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.

The Financial System: A Global Perspective