Function of Financial Markets
Channel funds from economic agents that have saved surplus funds to those that have a shortage of funds
Promote economic efficiency by producing an efficient allocation of capital
Directly improve the well-being of consumers by allowing them to time purchases better (e.g., spend now against future income)
Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Exchanges and Over-the-Counter (OTC) Markets
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and equity instruments
Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and denominated in that country’s currency
Eurobond—bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies—foreign currencies deposited in banks outside the home country
Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
World Stock Markets
Function of Financial Intermediaries: Indirect Finance
Lower transaction costs
Economies of scale
Liquidity services
Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Address Asymmetric Information problems
Adverse Selection (before the transaction)—more likely to select risky borrower
Moral Hazard (after the transaction)—less likely borrower will repay loan
Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
Reduce insider trading
To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
Introduction to Money, Banking, and Financial Market
Why Study Money, Banking, and Financial Markets
To examine:
how financial markets work (bond, stock and foreign exchange markets)
how financial institutions work (banks and insurance companies
the role of money in the economy
Financial Market
What is a financial market?
These are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds
The Bond Market and Interest Rates
Securities or Financial Instruments: A security (financial instrument) is a claim on the issuer’s future income or assets
A bond is a debt security that promises to make payments periodically for a specified period of time
An interest rate is the cost of borrowing or the price paid for the rental of funds
The Stock Market
Common stock represents a share of ownership in a corporation
A share of stock is a claim on the earnings and assets of the corporation
The Foreign Exchange Market
The foreign exchange market is where funds are converted from one currency into another
The foreign exchange rate is the price of one currency in terms of another currency
The foreign exchange market determines the foreign exchange rate
Banking and Financial Institutions
Financial Intermediaries—institutions that borrow funds from people who have saved and make loans to other people
Banks—institutions that accept deposits and make loans
Other Financial Institutions—insurance companies, finance companies, pension funds, mutual funds and investment banks
Financial Innovation—in particular, the advent of the information age and e-finance
Money and Business Cycles
Evidence suggests that money plays an important role in generating business cycles
Recessions (unemployment) and booms (inflation) affect all of us
Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level
Money and Inflation
The aggregate price level is the average price of goods and services in an economy
A continual rise in the price level (inflation) affects all economic players
Data shows a connection between the money supply and the price level
Money and Interest Rates
Interest rates are the price of money
Prior to 1980, the rate of money growth and the interest rate on long-term Treasure bonds were closely tied
Since then, the relationship is less clear but still an important determinant of interest rates
Monetary and Fiscal Policy
Monetary policy is the management of the money supply and interest rates
Conducted in the U.S. by the Federal Reserve Bank (Fed)
Fiscal policy is government spending and taxation
Budget deficit is the excess of expenditures over revenues for a particular year
Budget surplus is the excess of revenues over expenditures for a particular year
Any deficit must be financed by borrowing
To examine:
how financial markets work (bond, stock and foreign exchange markets)
how financial institutions work (banks and insurance companies
the role of money in the economy
Financial Market
What is a financial market?
These are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds
The Bond Market and Interest Rates
Securities or Financial Instruments: A security (financial instrument) is a claim on the issuer’s future income or assets
A bond is a debt security that promises to make payments periodically for a specified period of time
An interest rate is the cost of borrowing or the price paid for the rental of funds
The Stock Market
Common stock represents a share of ownership in a corporation
A share of stock is a claim on the earnings and assets of the corporation
The Foreign Exchange Market
The foreign exchange market is where funds are converted from one currency into another
The foreign exchange rate is the price of one currency in terms of another currency
The foreign exchange market determines the foreign exchange rate
Banking and Financial Institutions
Financial Intermediaries—institutions that borrow funds from people who have saved and make loans to other people
Banks—institutions that accept deposits and make loans
Other Financial Institutions—insurance companies, finance companies, pension funds, mutual funds and investment banks
Financial Innovation—in particular, the advent of the information age and e-finance
Money and Business Cycles
Evidence suggests that money plays an important role in generating business cycles
Recessions (unemployment) and booms (inflation) affect all of us
Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level
Money and Inflation
The aggregate price level is the average price of goods and services in an economy
A continual rise in the price level (inflation) affects all economic players
Data shows a connection between the money supply and the price level
Money and Interest Rates
Interest rates are the price of money
Prior to 1980, the rate of money growth and the interest rate on long-term Treasure bonds were closely tied
Since then, the relationship is less clear but still an important determinant of interest rates
Monetary and Fiscal Policy
Monetary policy is the management of the money supply and interest rates
Conducted in the U.S. by the Federal Reserve Bank (Fed)
Fiscal policy is government spending and taxation
Budget deficit is the excess of expenditures over revenues for a particular year
Budget surplus is the excess of revenues over expenditures for a particular year
Any deficit must be financed by borrowing
Banking Basics
What's bank?
How do people start Banks ?
How did banking begin ?
Why are there so many different types of banks ?
How do I choose a bank ?
What types of accounts do banks offer ?
Is it difficult to open a bank account ?
What happens to money after you deposit it ?
What happens when you apply for a loan ?
What are checks, and how do they work ?
What's electronic banking ?
Credit cards, debit cards, stored value cards: What's the difference ?
Do banks keep large amounts of gold and silver in their vaults ?
Why do banks fail ?
Do you lose money if your bank fails ?
How does the Federal Reserve fit into the U.S. banking system ?
How do people start Banks ?
How did banking begin ?
Why are there so many different types of banks ?
How do I choose a bank ?
What types of accounts do banks offer ?
Is it difficult to open a bank account ?
What happens to money after you deposit it ?
What happens when you apply for a loan ?
What are checks, and how do they work ?
What's electronic banking ?
Credit cards, debit cards, stored value cards: What's the difference ?
Do banks keep large amounts of gold and silver in their vaults ?
Why do banks fail ?
Do you lose money if your bank fails ?
How does the Federal Reserve fit into the U.S. banking system ?
How does the Federal Reserve fit into the U.S. banking system?
Although the Federal Reserve is often in the news, not everyone understands what it is and what it does. Perhaps the best way to clear things up is to have a Federal Reserve “Q & A” to cover some of the most common questions that people ask.
What is the Federal Reserve?
It is the central banking system of the United States.
What does it do?
The short answer is that the Federal Reserve is:
• a bank for other banks,
• a bank for the U.S. government, and
• responsible for U.S. monetary policy, which influences
how much money and credit will be available to the U.S. economy.
It also helps to:
• supervise and regulate banking institutions to ensure the safety
and soundness of the nation’s banking and financial system
• protect the credit rights of consumers, and
• maintain the stability of the financial system by helping to
contain risks that may arise in financial markets.
When was the Federal Reserve established? Congress created the Federal Reserve System in 1913 to help make the U.S. banking system safer and more efficient.
How many Federal Reserve Banks are there?
There are twelve Federal Reserve Banks. Each of the twelve Reserve Banks serves its own Federal Reserve District.
Where is the headquarters for the Federal Reserve?
The System’s headquarters is in Washington, D.C. It is called the Board of Governors of the Federal Reserve System.
Does the Federal Reserve lend money to businesses and consumers?
No. The Federal Reserve does not lend money to private borrowers, but it sometimes lends money to banks when the need arises.
Does the Federal Reserve print U.S. paper money?
No. Although Federal Reserve Notes account for almost 100 percent of the U.S. paper money in circulation, the notes are actually printed by the Bureau of Engraving and Printing, which
is part of the U.S. Treasury Department. The paper money is then shipped to the Federal Reserve Banks and their branches. When banks need cash for their customers’ needs, they order it from the Federal Reserve Bank in their District. Also, since money gradually wears out, the Federal Reserve Banks process cash in order to determine its fitness. Worn out bills are
shredded; new bills are introduced into the system to replace the old ones.
Do all Federal Reserve Banks store gold bars in their vaults?
Only the Federal Reserve Bank of New York has a working gold vault, and almost all of the gold in its vault is foreign-owned. The U.S. government’s gold is held at Fort Knox, Kentucky, the U.S. Mints in Denver and Philadelphia, the San Francisco Assay Office of the U.S. Mint, and the U.S. Bullion Depository in West Point, New York.
Does the Federal Reserve process all the checks Americans write?
No. The Federal Reserve Banks handle less than one-third of all U.S. checks. Private entities process the rest.
Is the Federal Reserve responsible for regulating and supervising the entire U.S.
banking system?
No. It shares this responsibility with other federal and state regulatory agencies.
Does the Federal Reserve set interest rates?
The Federal Reserve is responsible for U.S. monetary policy. This means it makes policies that influence how much money and credit will be available to the U.S. economy. Interest rates often go up or down in response to the Federal Reserve’s monetary policy decisions, but only the discount rate is set directly by the Federal Reserve. The discount rate is the rate banks pay when they borrow from the Federal Reserve.
What is the Federal Reserve?
It is the central banking system of the United States.
What does it do?
The short answer is that the Federal Reserve is:
• a bank for other banks,
• a bank for the U.S. government, and
• responsible for U.S. monetary policy, which influences
how much money and credit will be available to the U.S. economy.
It also helps to:
• supervise and regulate banking institutions to ensure the safety
and soundness of the nation’s banking and financial system
• protect the credit rights of consumers, and
• maintain the stability of the financial system by helping to
contain risks that may arise in financial markets.
When was the Federal Reserve established? Congress created the Federal Reserve System in 1913 to help make the U.S. banking system safer and more efficient.
How many Federal Reserve Banks are there?
There are twelve Federal Reserve Banks. Each of the twelve Reserve Banks serves its own Federal Reserve District.
Where is the headquarters for the Federal Reserve?
The System’s headquarters is in Washington, D.C. It is called the Board of Governors of the Federal Reserve System.
Does the Federal Reserve lend money to businesses and consumers?
No. The Federal Reserve does not lend money to private borrowers, but it sometimes lends money to banks when the need arises.
Does the Federal Reserve print U.S. paper money?
No. Although Federal Reserve Notes account for almost 100 percent of the U.S. paper money in circulation, the notes are actually printed by the Bureau of Engraving and Printing, which
is part of the U.S. Treasury Department. The paper money is then shipped to the Federal Reserve Banks and their branches. When banks need cash for their customers’ needs, they order it from the Federal Reserve Bank in their District. Also, since money gradually wears out, the Federal Reserve Banks process cash in order to determine its fitness. Worn out bills are
shredded; new bills are introduced into the system to replace the old ones.
Do all Federal Reserve Banks store gold bars in their vaults?
Only the Federal Reserve Bank of New York has a working gold vault, and almost all of the gold in its vault is foreign-owned. The U.S. government’s gold is held at Fort Knox, Kentucky, the U.S. Mints in Denver and Philadelphia, the San Francisco Assay Office of the U.S. Mint, and the U.S. Bullion Depository in West Point, New York.
Does the Federal Reserve process all the checks Americans write?
No. The Federal Reserve Banks handle less than one-third of all U.S. checks. Private entities process the rest.
Is the Federal Reserve responsible for regulating and supervising the entire U.S.
banking system?
No. It shares this responsibility with other federal and state regulatory agencies.
Does the Federal Reserve set interest rates?
The Federal Reserve is responsible for U.S. monetary policy. This means it makes policies that influence how much money and credit will be available to the U.S. economy. Interest rates often go up or down in response to the Federal Reserve’s monetary policy decisions, but only the discount rate is set directly by the Federal Reserve. The discount rate is the rate banks pay when they borrow from the Federal Reserve.
Do you lose money if your bank is robbed?
No. Nearly all banks have private insurance that covers them if they are robbed. (It is not the same as federal deposit insurance.)
In addition, most banks take elaborate measures to safeguard the cash and other valuable items left in their care. Bank vaults have long been protected by reinforced concrete walls, time locks, and metal alloy doors that resist drilling and explosions. At one time, armed security guards stood watch over banks, but today most banks seem to have decided (wisely) that they would rather not expose their customers and employees to gunplay. Shotguns and revolvers have been replaced by closed-circuit television cameras that maintain a constant watch over everyone who enters or exits the bank.
Another innovation is the exploding dye pack. In certain cases, bank employees are able to place a package of red dye in with the robber’s stash of stolen cash. Later, when the crook opens the stash, the concealed dye pack explodes, covering the robber and the ill-gotten money with dye that won’t wash off.
In addition, most banks take elaborate measures to safeguard the cash and other valuable items left in their care. Bank vaults have long been protected by reinforced concrete walls, time locks, and metal alloy doors that resist drilling and explosions. At one time, armed security guards stood watch over banks, but today most banks seem to have decided (wisely) that they would rather not expose their customers and employees to gunplay. Shotguns and revolvers have been replaced by closed-circuit television cameras that maintain a constant watch over everyone who enters or exits the bank.
Another innovation is the exploding dye pack. In certain cases, bank employees are able to place a package of red dye in with the robber’s stash of stolen cash. Later, when the crook opens the stash, the concealed dye pack explodes, covering the robber and the ill-gotten money with dye that won’t wash off.
Do you lose money if your bank fails?
The Federal Deposit Insurance Corporation (FDIC) has protected bank deposits since 1934. In all that time, no one has lost money that was FDIC-insured. Federal deposit insurance covers most types of deposits, including savings deposits, checking deposits, and certificates of deposit.
The basic insured amount is $100,000.
In the days before federal deposit insurance, the U.S. banking system was plagued by bank “runs” or “panics.” At the slightest hint of trouble, depositors would run to the bank and line up to withdraw their money. All too often, only the first few people in line had any hope of ever seeing their money again; others lost everything. Even healthy banks sometimes failed after rumors caused depositors to panic and withdraw their money. For many years, the public seemed willing to accept the losses. But then came the Great Depression of the 1930s, and financial pressures forced thousands of banks to close their doors forever. Losses ran into the hundreds of millions of dollars, and many people lost their life savings.
The wave of bank failures shattered public confidence in the banking system, and Americans looked to the federal government for help. Congress responded by establishing the FDIC, which provided deposit insurance coverage of up to $2,500 per depositor. Public confidence rebounded, and bank failures declined from approximately 4,000 in 1933 to 62 in 1934. Over the years, the federal deposit insurance limit has increased, and federal deposit insurance has helped to maintain public confidence in the U.S. banking system. Bank failures have not been eliminated, but long lines of panic-stricken depositors have become an uncommon sight.
The basic insured amount is $100,000.
In the days before federal deposit insurance, the U.S. banking system was plagued by bank “runs” or “panics.” At the slightest hint of trouble, depositors would run to the bank and line up to withdraw their money. All too often, only the first few people in line had any hope of ever seeing their money again; others lost everything. Even healthy banks sometimes failed after rumors caused depositors to panic and withdraw their money. For many years, the public seemed willing to accept the losses. But then came the Great Depression of the 1930s, and financial pressures forced thousands of banks to close their doors forever. Losses ran into the hundreds of millions of dollars, and many people lost their life savings.
The wave of bank failures shattered public confidence in the banking system, and Americans looked to the federal government for help. Congress responded by establishing the FDIC, which provided deposit insurance coverage of up to $2,500 per depositor. Public confidence rebounded, and bank failures declined from approximately 4,000 in 1933 to 62 in 1934. Over the years, the federal deposit insurance limit has increased, and federal deposit insurance has helped to maintain public confidence in the U.S. banking system. Bank failures have not been eliminated, but long lines of panic-stricken depositors have become an uncommon sight.
Why do banks fail?
A bank is a business, and like other businesses, they can fail. Sometimes they fail because the people who run them make poor business decisions such as expanding too quickly or putting too much money into one type of loan.
Sometimes they fail because of fraud. Maybe the president makes questionable loans to friends or hires unqualified relatives and pays them huge salaries. But banks also go out of business because changing economic conditions make it difficult or impossible for borrowers to repay their loans. Here’s an example.
Gusher National Bank Slips on Falling Oil Prices Falling energy prices mean cheaper gasoline and lower home heating bills. So, falling oil prices must be good, right?
Not for everyone! Take the case of Gusher National Bank. Gusher was very aggressive in making loans to oil and natural gas companies that had no problem repaying their loans when energy prices were high. The loans spelled big profits for Gusher, and everyone agreed that Gusher’s executives were smart business people who really knew how to make money.
Then the economy slowed down, and the demand for energy fell. Factories burned less oil and natural gas. Truck drivers, commuters, and vacationers drove fewer miles and burned less fuel. As a result, energy prices dropped sharply, and many energy companies fell behind on their loan payments. Some even stopped making payments altogether. Months passed, oil prices remained low, and more energy companies fell
behind on their payments. Finally, Gusher lost so much money to bad loans that government regulators had to step in and close the bank. Gusher had fallen victim to changing economic conditions—falling energy prices and a high concentration of loans to energy companies.
Or take the case of Bedrock Bank . . . Bedrock Bank Gets Too Big Too Fast Bedrock Bank’s new president was determined to turn his bank into the region’s biggest lender. Bedrock’s loan officers got the message and started making as many loans as they could for condominium developments, shopping centers, office buildings, and high-priced suburban
housing developments. Loan applications were not always checked as closely as they had been in the past, and some of the loans were approved more quickly than they had been in the old days. But nobody seemed concerned because the local economy was strong and real estate values were rising rapidly.
Everything seemed fine; everyone was making money. But then the economy slowed down, and things took a turn for the worse. The weak economy forced many businesses to close, leaving lots of vacant office space. Real estate values plummeted, and many developers fell behind on their loan payments.
In the end, Bedrock Bank was losing so much money on bad real estate loans that government regulators were forced to step in and close it. The regulators tried to find a buyer for Bedrock, but no other bank wanted to get stuck with all the loans that had gone bad. Eventually, another bank agreed to buy Bedrock if the federal government would agree to keep many of the problem loans.
Sometimes they fail because of fraud. Maybe the president makes questionable loans to friends or hires unqualified relatives and pays them huge salaries. But banks also go out of business because changing economic conditions make it difficult or impossible for borrowers to repay their loans. Here’s an example.
Gusher National Bank Slips on Falling Oil Prices Falling energy prices mean cheaper gasoline and lower home heating bills. So, falling oil prices must be good, right?
Not for everyone! Take the case of Gusher National Bank. Gusher was very aggressive in making loans to oil and natural gas companies that had no problem repaying their loans when energy prices were high. The loans spelled big profits for Gusher, and everyone agreed that Gusher’s executives were smart business people who really knew how to make money.
Then the economy slowed down, and the demand for energy fell. Factories burned less oil and natural gas. Truck drivers, commuters, and vacationers drove fewer miles and burned less fuel. As a result, energy prices dropped sharply, and many energy companies fell behind on their loan payments. Some even stopped making payments altogether. Months passed, oil prices remained low, and more energy companies fell
behind on their payments. Finally, Gusher lost so much money to bad loans that government regulators had to step in and close the bank. Gusher had fallen victim to changing economic conditions—falling energy prices and a high concentration of loans to energy companies.
Or take the case of Bedrock Bank . . . Bedrock Bank Gets Too Big Too Fast Bedrock Bank’s new president was determined to turn his bank into the region’s biggest lender. Bedrock’s loan officers got the message and started making as many loans as they could for condominium developments, shopping centers, office buildings, and high-priced suburban
housing developments. Loan applications were not always checked as closely as they had been in the past, and some of the loans were approved more quickly than they had been in the old days. But nobody seemed concerned because the local economy was strong and real estate values were rising rapidly.
Everything seemed fine; everyone was making money. But then the economy slowed down, and things took a turn for the worse. The weak economy forced many businesses to close, leaving lots of vacant office space. Real estate values plummeted, and many developers fell behind on their loan payments.
In the end, Bedrock Bank was losing so much money on bad real estate loans that government regulators were forced to step in and close it. The regulators tried to find a buyer for Bedrock, but no other bank wanted to get stuck with all the loans that had gone bad. Eventually, another bank agreed to buy Bedrock if the federal government would agree to keep many of the problem loans.
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