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==Function of Financial Markets
• Channels funds from person or business without investment opportunities (i.e., “Lender-Savers” aka SURPLUS UNITS) to one who has them (i.e., “Borrower-Spenders” aka DEFICIT UNITS).
• Improves economic efficiency (costly to individually find out appropriate investment seekers).

Lender-Savers (SU)
1. Households
2. Business firms
3. Government
4. Foreigners

Borrower-Spenders (DU)
1. Business firms
2. Government
3. Households
4. Foreigners

==Segments of Financial Markets
1. Direct Finance
   • Borrowers borrow directly from lenders in financial markets by selling financial instruments (stocks/equity or bonds/debt) which are claims on the borrower’s future income or assets
2.Indirect Finance
  • Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets

==Importance of Financial Markets
Financial markets are critical for-
• Producing an efficient allocation of capital.
• Improving the well-being of consumers, allowing them to time their purchases better.

==Structure of Financial Markets
• Debt Markets
  a. Short-Term (maturity < 1 year)
  b. Long-Term (maturity > 10 year)
  c. Intermediate term (maturity in-between)
  d. Represented $41 trillion at the end of 2007

• Equity Markets
  a. Pay dividends, in theory forever
  b. Represents an ownership claim in the firm

• Primary Market
New security issues sold to initial buyers
Typically involves an investment bank who underwrites the offering

• Secondary Market
Securities previously issued are bought and sold
Examples include the NYSE and Nasdaq
Involves both brokers and dealers (do you know the difference?)

Even though firms don’t get any money, as such, from the secondary market, it serves two important functions:
• Provide liquidity, making it easy to buy and sell the securities of the companies
• Establish a price for the securities

We can further classify secondary markets as follows:
a) Exchanges
   • Trades conducted in central locations (e.g., New York Stock Exchange, Chicago Board of Trade)
b) Over-the-Counter Markets
   • Dealers at different locations buy and sell

== Classifications of Financial Markets
We can also further classify markets by the
maturity of the securities:
a) Money Market: Short-term (maturity < 1 year)
b) Capital Market : Long-term (maturity > 1 year) plus equities

==Internationalization of Financial Markets
The internationalization of markets is an important trend. The U.S. no longer dominates the world stage.

International Bond Market
• Foreign bonds
Denominated in a foreign currency
Targeted at a foreign market
• Eurobonds
Denominated in one currency, but sold in a different market
now larger than U.S. corporate bond market
Over 80% of new bonds are Eurobonds.

Eurocurrency Market
• Foreign currency deposited outside of home country
• Eurodollars which are U.S. dollars deposited in foreign banks outside the U. S. say, London.

World Stock Markets
• U.S. stock markets are no longer always the largest - at one point, Japan's was larger.

==Function of Financial Intermediaries: Indirect Finance
Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman:
• the intermediary obtains funds from savers
• the intermediary then makes loans/ investments with borrowers

==Function of Financial Intermediaries : Indirect Finance
• This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers.
• More important source of finance than securities markets (such as stocks)
• Needed because of transactions costs, risk sharing, and asymmetric information

 Transactions Costs
a. Financial intermediaries make profits by reducing transactions costs
b. Reduce transactions costs by developing expertise and taking advantage of economies of scale

A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions
1. Banks provide depositors with checking accounts that enable them to pay their bills easily
2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary

Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing
•  FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party
•  This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors

• Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings.
• Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.

==Regulation of Financial Markets
 Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial Intermediaries

==Regulation Reason: Increase Investor Information
• Asymmetric information in financial markets means one party lacks crucial information about another party, impacting decision-making.
• The Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation

==Regulation Reason: Ensure Soundness of Financial Intermediaries
• Providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not.
• If they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions, with the possible outcome of a financial panic.
• Such panics produces large losses for the public and causes serious damage to the economy.

==Regulation Reason: Ensure Soundness of Financial Intermediaries (cont.)
 To protect the public and the economy from financial panics, the government has implemented six types of regulations:
• Restrictions on Entry
• Disclosure
• Restrictions on Assets and Activities
• Deposit Insurance
• Limits on Competition
• Restrictions on Interest Rates

==Regulation: Restriction on Entry
  Restrictions on Entry
• Regulators have created very tight regulations as to who is allowed to set up a financial intermediary
• Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government
• Only if they are upstanding citizens with flawless credentials and a large amount of initial funds will they be given a charter.

==Regulation: Disclosure
 Disclosure Requirements:
There are stringent reporting requirements for financial intermediaries
• Their bookkeeping must follow certain strict principles,
• Their books are subject to periodic inspection,
• They must make certain information available to the public.

==Regulation: Restriction on Assets and Activities
 There are restrictions on what financial intermediaries are allowed to do and what assets they can hold
• One way of doing this is to restrict the financial intermediary from engaging in certain risky activities.
• Another way is to restrict financial intermediaries from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent.

==Regulation: Deposit Insurance
• The government can insure people depositors to a financial intermediary from any financial loss if the financial intermediary should fail
• In Bangladesh, a Deposit Insurance Trust Fund (DITF) has been created for providing limited protection (not exceeding Taka 1 lakh) to a small depositor in case of winding up of any bank.
• Commercial Banks (Private and State Owned) have to pay half yearly insurance premium to Bangladesh Bank based on the insured deposits- ranging from 0.08-0.10% depending on its CAMEL Rating.

==Regulation: Past Limits on Competition
• Although the evidence that unbridled competition among financial intermediaries promotes failures that will harm the public is extremely weak, it has not stopped the state and federal governments from imposing many restrictive regulations
• In the past, banks were not allowed to open up branches in other states, and in some states banks were restricted from opening additional locations

==Regulation: Past Restrictions onInterest Rates
• Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits.
• These regulations were instituted because of the widespread belief that unrestricted interest-rate competition helped encourage bank failures during the Great Depression.
• Later evidence does not seem to support this view, and restrictions on interest rates have been abolished.

==Regulation Reason: Improve Monetary Control
• Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy), much regulation of these financial intermediaries is intended to improve control over the money supply
• One such regulation is reserve requirements, which make it obligatory for all depository institutions to keep a certain fraction of their deposits in accounts with the Federal Reserve System (the Fed), the central bank in the United States
• Reserve requirements help the Fed exercise more precise control over the money supply

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==Facts of Financial Structure
1. Stocks are not the most important source of external financing for businesses.
2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.
3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.
5. The financial system is among the most heavily regulated sectors of economy.
6. Only large, well-established corporations have easy access to securities markets to finance their activities.
7. Collateral is a prevalent feature of debt contracts for both households and businesses.
8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

==Transactions Costs
Transaction costs refer to:
• A fee charged by a financial intermediary such as a bank, broker, or underwriter. Example: communication charges, legal fees, informational cost of finding the price, quality and durability, etc.
Transaction costs influence financial structure:
• E.g., a $5,000 investment only allows you to purchase 100 shares @ $50 / share (equity)
• No diversification
• Bonds even worse - most have a $1,000 size
In sum, transaction costs freeze many small savers and borrowers out of direct involvement with financial markets.

Financial intermediaries make profits by reducing transactions costs
1. Take advantage of economies of scale (example: mutual funds)
2. Develop expertise to lower transaction costs

==Information Asymmetries and Information Costs
• Information plays a central role in the structure of financial markets and financial institutions.
• Markets require sophisticated information to work well.
    If the cost of information is too high, markets cease to function.
• Issuers of financial instruments know more about their business prospects and willingness to work than potential lenders/investors.

Asymmetric information is a serious hindrance to the operation of financial markets.
It poses two important obstacles to the smooth flow of funds from savers to investors:
1. Adverse selection arises before the transaction occurs.
   • Lenders need to know how to distinguish good credit risks from bad.
2. Moral hazard occurs after the transaction.
   • Will borrowers use the money as they claim?

==Adverse Selection
The market for lemons:
• Used car buyers can’t tell good from bad cars.
• Buyers will at most pay an average expected value of good and bad cars.
• Sellers know if they have a good car, and won’t accept less than the true value.
• Good car sellers will withdraw cars from the market.
• Then the market has only the bad cars.

==Adverse Selection in Financial Markets
If you can’t tell good from bad companies
• Stocks of good companies are undervalued, and
• Owners will not want to sell them.

If you can’t tell good from bad bonds
• Owners of good companies will have to sell bonds for too low a price, so
• Owners won’t want to do it.

==Solving the Adverse Selection Problem
From a social perspective, the problems of adverse selection are not good.
• Some companies will pass up good investments.
• Economy will not grow as rapidly as it could.
We must find ways for investors and lenders to distinguish well-run firms from poorly run firms.

==Disclosure of Information
• An obvious way to solve the problem of asymmetric information is to provide more information.
• In most industrialized countries, public companies are required to disclose voluminous amounts of information.
   Public companies are those that issue stock and bonds that are bought and sold in pubic financial markets.

==Collateral and Net Worth
• Another solution for adverse selection is to make sure lenders are compensated even if borrowers default.
   • If a loan is insured in some way, then the borrower isn’t a bad credit risk.
• Collateral is something of value pledged by a borrower to the lender in the event of the borrower’s default.
   • It is said to back or secure a loan.
	Ex:  Cars, houses

• Collateral is very prevalent because adverse selection is less of a concern - the lender gets something of equal or greater value if the borrower defaults.
• Unsecured loans, like credit cards, are loans made without collateral.
  Because of this they generally have very high interest rates.

The net worth is the owner’s stake in a firm - the value of the firm’s assets minus the value of its liabilities.
• Net worth serves the same purpose as collateral
• If a firm defaults on a loan, the lender can make a claim against the firm’s net worth.

• The importance of net worth in reducing adverse selection is the reason owners of new businesses have so much difficulty borrowing money.
• Most small business owners must put up their homes and other property as collateral for their business loans.
    Only after establishing a successful business and built up net worth, can they borrow without personal property.

==Screening and Certifying to Reduce Adverse Selection
• Underwriters screen and certify firms seeking to raise funds directly in the financial markets.
     Underwriters are large investment banks like Goldman Sachs, JPMorgan Chase, and Morgan Stanley.
• Without certification by one of these firms, companies would find it difficult to raise funds.

==Moral Hazard: Problem and Solutions
• The phrase moral hazard originated when economists who were studying insurance noted that an insurance policy changes the behavior of the person who is insured.
• Moral hazard arises when we cannot observe people’s actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck.

• A second information asymmetry arises because the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project.
• Moral hazard  affects both equity and bond financing.
• How do we solve the problem?

==Moral Hazard in Equity Finance
• If you buy stock in a company, how do you know your money will be used in the way that is best for you, the stockholder?
• It is more likely that the manager will use the funds in a way that is most advantageous to them, not you.
• The separation of your ownership from their control creates what is called a principal-agent problem.

Solving the Moral Hazard Problem in Equity Financing
During the 1990’s, a concerted attempt was made to align managers’ interests with those of stockholders.
    Executives were given stock options that provided lucrative payoffs if a firm’s stock price rose above a certain level.
    This gave managers incentives to misrepresent companies’ profits.
At this time, there is no guaranteed way of ensuring managers will behave in the owner’s best interest.

==Moral Hazard in Debt Finance
• When the managers are the owners, moral hazard in equity finance disappears.
• Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking.
• Lenders need to find ways to make sure borrowers don’t take too many risks.
• People with risky projects are attracted to debt finance because they get the full benefit of the upside, while the downside is limited to their collateral.

==Solving the Moral Hazard Problem in Debt Finance
Legal contracts can solve the moral hazard problem inherent in debt finance.
   • Bonds and loans carry restrictive covenants that limit the amount of risk a borrower can assume.
   • The firm may have to maintain a certain level of net worth, a minimum credit rating, or a minimum bank balance.
	For example: home mortgages’ home insurance, fire
	insurance, etc.

==Monitoring to Reduce Moral Hazard
• In the financial world, intermediaries insure against this type of moral hazard by monitoring both the firms that issue bonds and those that issue stocks.
   • Many hold significant number of shares in individual firms.
   • They may place a representative on the company’s board of directors.

For new companies, a financial intermediary called a venture capital firm does the monitoring.
   • They specialize in investing in risky new ventures in return for a stake in the ownership and a share of the profits.
   • They keep a close watch on the managers’ actions.
Finally, the threat of a takeover helps to persuade managers to act in the interest of the stock and bondholders.



==Tools to solve Adverse selection:
• Private production and sale of information
• Government regulation to increase information
• Financial intermediation
• Collateral and net worth

Tools to solve Moral hazard in equity contracts (principal-agent problem):
• Production of infromation: monitoring
• Government regulation to increase information
• Financial intermediation
• Debt contracts

Tools to solve Moral hazard in debt contracts:
• Collateral and net worth
• Monitoring and enforcement of restrictive covenants
• Financial intermediation