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Lecture 4: Financial instruments and regulation

Mishkin chapter 2 – part C

Page 28-32, 42-47

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Role in the financial system

Financial Intermediaries(e.g. bank)

Financial markets

Money

MoneyMoney

Indirect finance

Direct finance

Lender BorrowerRegulation

Financial instrument B(e.g. student loans)

Financial instrument A

(e.g. saving account)

Financial instruments (e.g. bond, stock)

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Financial instruments

A financial instrument (also called security) is a claim on the issuer’s future income or assets.

Financial assets vs. real assets Classification:

Money market instruments and capital market instruments

Bonds (debt instruments) and stocks (equity)

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Bank BorrowerLender

Money

Financial Instrument A:

e.g. Mortgage loan

Financial Instrument B: e.g. Deposit

Money

•Financial instrument A is ‘issued’ by the borrower and is essentially a claim on borrower’s future income or asset. Financial instrument B is ‘issued’ by the Bank and is essentially a claim on Bank’s future income or asset.After financial instrument A is issued and sold to the Bank, it becomes a financial asset of the Bank.After financial instrument B is issued and sold to the lender, it becomes a financial asset of the lender, the liability of the Bank.

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Financial asset vs. real asset Real assets: houses, equipments, human

resources, etc. Financial assets: claims against real

assets. Generally, borrowers obtain funds from

lenders by selling newly issued claims ("IOU's") against their (borrower’s) real assets.

IOUs are essentially financial assets. graph

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Money market instruments

Money market instrument is shorter-term security generally with one year or less remaining to maturity.

Treasury bill, commercial paper, CDs, etc. Many are held by institutions like banks,

insurance companies and mutual funds, less often by individuals.

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Capital market instruments

More than one year to maturity. Stock, residential mortgages, long-term

bonds, consumer loans, etc.

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Bonds

A bond is a debt security/instrument that promises to make payments periodically for a specified period of time.

Bond price is closely (negatively) related to interest rate.

Default risk: the possibility that the issuer (borrower) fail to pay back.

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Stocks A share of stock is a claim on the net

income and assets of the corporation. Holders of common stocks:

earn from price appreciation and dividends. have ownership interest in the company

proportional to shares owned:

1. ‘residual claimant’

2. have voting rights, or ‘vote with feet’. Stock prices are volatile.

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Regulation in the financial system

More regulation than in other industries. Why need regulation?

information (efficiency concern)bankruptcy (stability concern)control of monetary policy (optimality concern)

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How would regulations help? Increase the information available to investors:

SEC forces listed corporations to disclose information reduce insider trading

Ensure the soundness of financial intermediaries, fight against bankruptcy, prevent financial panics: Restrictions on entry (chartering), reporting

requirements, restrictions on assets and activities, deposit insurance, limits on competition, etc.

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Recap

Financial instrument Money market instrument vs. capital

market instrument Bonds vs. stocks Why is regulation in financial system so

important? How would regulation help?