Lecture1-Money and Finance

Reading for this presentation
Introduction
The Financial System and Its Role
Lenders and Borrowers
Wealth arrangement
Roles of Financial Markets
Classi…cation of …nancial markets
Financial Intermediaries
Summary
ES20070 Money and Finance

Financial System
A. H. Ahmad
University of Bath
Department of Economics
Room 3E4.10, Ext 6705
A.H.Ahmad@bath.ac.uk
Ahmad Financial System

Introduction
Wealth arrangement
Summary
Reading for this lecture
Howells and Bain, EMBF, Ch. 1

Howells and Bain, FMI, Ch. 1
Pilbeam, FFM, Ch. 2
Blake, FMA, Ch. 1

Introduction
Wealth arrangement
Summary
Introduction
In this lecture, we shall see:

- What a …nancial system consists of
- Who uses it and for what purposes
- The distinctive features of …nancial institutions
- Why the performance of the …nancial system is
relevant to the rest of the economy
- How …nancial systems may be classi…ed

Introduction
Wealth arrangement The Financial System
Summary
What is a …nancial system?

A …nancial system consist of:
- A set of …nancial institutions (banks, insurance,
etc.)
- A set of …nancial markets (equities, bonds, etc.)
- The regulatory bodies (central bank, Financial
Services Authority, etc.)
- the end users:
. de…cits’units (borrowers)
. surplus’units (lenders)

Introduction
Wealth arrangement The Financial System
Summary
The Financial System

The …nancial system provides:
1. ‘Intermediation’between surplus and de…cit
units
2. Range of services like insurance, pensions, fund
management
3. A payments mechanism
4. Portfolio adjustment facilities.
Financial markets are mainly concerned with 1 + 4, in other
words:
- They facilitate borrowing and lending and
- They help savers to achieve their optimum
wealth ‘portfolios’.
Introduction The options for lenders and borrowers
The Financial System and Its Role Contrasting interests of lenders and borrowers
Lenders and Borrowers How do markets help?
Wealth arrangement Primary and Secondary Markets
Roles of Financial Markets If No Secondary Markets Exist
Classi…cation of …nancial markets Securities in secondary markets exceeds value of new issues in prima
Financial Intermediaries Without well-functioning markets
Summary
Table 1 summarises who constitute borrowers and lenders

within the economy.
Table 1: Lenders and Borrowers

Lenders-savers Borrowers
1. Households Business …rms
2. Business …rms Government
3. Government Households
4. Foreigners Foreigners

Summary

The options for lenders and borrowers
Figure 1.
The options for lenders and borrowers

Summary

The options for lenders and borrowers: An Example
Suppose you have £ 500 to lend. Would you prefer:

1. To lend to someone who replied to your
advertisement on the notice board, or
2. Put it in a building society account, and why?
Most people would prefer (2) because:
i. It saves advertising
ii. There is very little risk
iii. They can get the £ 500 back on demand.

Summary
Borrowing and lending: Borrowers and lenders have

con‡icting requirements
Borrowers and lenders have con‡icting requirements.
Borrowers prefer:
Long loan
Minimum cost
Minimum risk
Lenders prefer:
Liquidity (ability to retrieve funds quickly for a
known value)
Maximum return
Minimum risk
Summary
Borrowing and lending
It is often said that lenders are:

- rational
- risk-averse
- wealth maximisers
Therefore, they want:
- The maximum return for any given level of risk,
or
- The minimum risk for any given rate of return
A portfolio which meets these conditions is an e¢ cient
portfolio
Summary
Table 1 summarizes the contrasting interests of lenders and

borrowers.
A (+) indicates a desire to maximize and a (-) shows a desire
to minimize.
Table 2: Lenders and Borrowers

Lenders Borrowers
Return + Cost -
Risk - Length of loan +
Liquidity +

Summary

The main con‡ict arises over the length of a loan.
Note the role of uncertainty for both parties:
- A borrower may wish to borrow for a period that
is su¢ ciently long to ensure that his investment
project will be earning a pro…t with which to
repay the loan. E.g. a …rm borrowing to build a
new factory, which is estimated to take two
years, will try to arrange a loan for three years in
case of delays.
- A lender may feel that she has funds which she
will not need for a year, but circumstances could
change and she could need them sooner.
Summary
Borrowing and lending: How do markets help?
How do markets help?

An active market for securities means that borrowers can have
a long-term liability while lenders can hold a relatively liquid
asset.
A new loan results from a new issue of securities
A …rm borrows when it issues new:
- Ordinary shares (equities)
- Corporate bonds
- Commercial bills
- Eurobonds etc.

Summary
Borrowing and lending: Primary and Secondary Markets

These issues take place in the primary market.
The buyer is the lender (beware – sometimes called an
‘investor’).
But, having bought, the buyers can sell. . .
Markets enable the buyer of a security to sell it later, if
necessary – quickly and cheaply.
This buying and selling takes place in the secondary market.
Without this escape route, there would be few buyers in the
primary market.
How would the lack of an active secondary market a¤ect the
primary market?
Summary
Borrowing and lending: if no secondary markets Exist
This will lead to

- Securities being very illiquid.
- This would make them unattractive.
- There would be few buyers and they would
demand a high rate of return.
- There would be little borrowing/lending and it
would be very expensive.

Summary
As a rule, trading of existing securities in secondary markets

exceeds the value of new issues in primary markets by a large
multiple.
On the next slide, the LH diagram compares the quantity and
cost of lending/borrowing in a …nancial system with highly
developed markets with one without.
The RH diagram translates this into a likely e¤ect on real
investment.

Summary
Figure 2
Summary
Without well-functioning markets, both the supply of loans

and the demand for them would be very limited and the price
would be high (S, D and i).
With well-functioning markets, there will be more lending and
borrowing and at a lower cost (S’, D’and I ’). This should
encourage higher levels of investment.
We have just seen that primary markets allow new borrowing
to take place and secondary markets encourage primary buyers
because they know they can sell if necessary.
Why might holders of securities wish to sell?

Introduction
Wealth arrangement
Summary
Wealth arrangement
The reasons could be due to the followings:

1 They may need to retrieve the money they lent (a ‘liquidity
crisis’)
2 Their circumstances may change in other ways: they want to
take on more/less risk
3 The circumstances of the borrower may change: the …rm may
become more or less pro…table; the …rm may become more or
less risky
4 The circumstances of third parties may change: other …rms
may become more pro…table or less risky etc.

Introduction
Wealth arrangement
Summary
Wealth arrangement
Any of 2, 3 or 4 will cause lenders to re-arrange their wealth.

Recall that:
- Rational, risk-averse investors are seeking to
maximise return for a given level of risk.
- There are thousands of assets that can be
combined to create portfolios that meet this
condition.
Which portfolio an investor will choose depends upon his
particular ‘taste’for risk.

Introduction
Wealth arrangement
Summary
Wealth arrangement
A particularly risk-averse investor will want a low-risk portfolio

and will be happy with a low return (provided that it is the
best he can get).
A less risk-averse investor will want a higher-risk portfolio but
will also want the highest return he can get.
The next slide shows a hypothetical investor whose choice is
portfolio A.

Introduction
Wealth arrangement
Summary
Wealth arrangement
Figure 3
Introduction
Wealth arrangement
Summary
Wealth arrangement
In the …gure, the curve P P 0 shows all those portfolios of

assets that yield the highest return for a given level of risk
(‘e¢ cient portfolios’).
I0 I2 are indi¤erence curves tracing out the combinations of
risk and return that give our investor equal satisfaction.
Our investor chooses A since this lies on the highest
attainable indi¤erence curve, I1

Introduction
Wealth arrangement
Summary
Wealth arrangement
Figure 4
Introduction
Wealth arrangement
Summary
Wealth arrangement
But now suppose that circumstances change.

Fig. 2 can be read as showing either that our investor has
become more risk-averse or that portfolio A has become
riskier.
Either way, portfolio A is no longer acceptable to our investor
who sells the assets in A and buys the assets that comprise
portfolio B.

Introduction
Wealth arrangement
Summary
Wealth arrangement
In order to move from portfolio A to portfolio B our investor
will wish to buy and sell shares, bonds, bills, certi…cates of
deposit and/or many other types of …nancial assets.
He will want to do this in markets where
1. transactions are low
2. where the price of the assets represents ‘fair
value’and
3. where he knows that his instructions will be
carried out:
- assets delivered and
- payments made with a high degree
of security.
Introduction
Adverse Selection
Wealth arrangement
Moral Hazard
Summary
Notice that most of this activity will involve existing assets –

i.e. it will be carried out in ‘secondary’markets.
This is why trading in secondary markets exceeds the value of
new issues in primary markets many times over.
Financial markets facilitates:
1 Risk reduction;
2 Minimisation of transaction costs
3 Transformation of maturities- to a greater or lesser extent

Introduction
Adverse Selection
Wealth arrangement
Moral Hazard
Summary

In other words, …nancial markets create assets and liabilities
for lenders and borrowers, which are more attractive than they
would be if lenders and borrowers dealt directly with each
other.
An asset:
- Any piece of property whose ownership provides
a ‡ow of bene…ts over time.
A liability:
- A debt (or obligation) owed to someone else.
Financial markets also help by providing the means for
individuals and businesses to diversify their asset holdings.
Introduction
Adverse Selection
Wealth arrangement
Moral Hazard
Summary
Low transaction costs allow them to buy a range of assets,

pool them, and then sell rights to the diversi…ed pool to
individuals
Another reason FIs exist is to reduce the impact of
asymmetric information.
One party lacks crucial information about another party,
impacting decision-making.
We usually discuss this problem along two fronts:
- adverse selection and
- moral hazard

Introduction
Adverse Selection
Wealth arrangement
Moral Hazard
Summary
Adverse Selection and Moral Hazard
Adverse Selection
- Before transaction occurs
- Potential borrowers most likely to produce
adverse outcome are ones most likely to seek a
loan
- Similar problems occur with insurance where
unhealthy people want their known medical
problems covered

Introduction
Adverse Selection
Wealth arrangement
Moral Hazard
Summary
Adverse Selection and Moral Hazard
Moral Hazard
- After transaction occurs
- Hazard that borrower has incentives to engage
in undesirable (immoral) activities making it
more likely that won’t pay loan back
- Again, with insurance, people may engage in
risky activities only after being insured
- Another view is a con‡ict of interest

Introduction
Money vs capital markets
Wealth arrangement
Call vs continuous markets
Summary

We have already seen that markets can be divided between
Primary markets and secondary markets.
Primary markets
- are where new issues of securities are made. An
issue of new securities results in new
borrowing/lending.
Secondary markets
- are where existing securities can be bought and
sold. A sale of existing securities simply
transfers the ownership of an existing debt. No
new lending/borrowing takes place.
Introduction
Wealth arrangement
Summary
Money vs capital markets;

- Money markets are markets for securities with
less than one year to maturity. They are markets
for short-term assets.
- Capital markets are markets for long-term
securities – with more than a year to maturity.

Introduction
Wealth arrangement
Summary
Call vs continuous markets; In most markets, it is possible to

trade at any time that the market is open. These are
continuous markets.
However, in some markets trades are ‘called’at set times. In
between the set times, potential orders to buy and sell
accumulate. Call markets are often associated with
‘auctioneer’or ‘order-driven’trading.
Auctioneer vs quote-driven markets; In an auctioneer market
(sometimes called ‘order-driven’) orders to sell are matched
with orders to buy.

Introduction
Wealth arrangement
Summary
To make this possible, orders are often left to accumulate

until they are su¢ cient to make matching probable. Buyers
and sellers may not be able to trade if they insist on a speci…c
price.
In a ‘quote-driven’market, makers hold inventories of
securities and quote continuous prices at which they are
willing to buy and sell.

Introduction
Lenders and Borrowers Financial Intermediaries
Wealth arrangement Deposit-takers
Roles of Financial Markets Non–deposit-takers
Summary
Intermediation creates assets and liabilities
Figure 5
Introduction
Summary
An interesting consequence follows:

- An increase in lending and borrowing must
involve:
a. An increase in liabilities and assets
b. An increase in the size of the
intermediary’s balance sheet
And so:
- Changes in intermediaries’output are often
re‡ected in their balance sheets. (Why does this
di¤er from other …rms?)
Introduction
Summary
Intermediaries also do other things too that include:

1. Create liquidity and money
2. Operate a payments mechanism
3. Provide …nancial services like pensions and
insurance
4. O¤er ‘portfolio adjustment facilities’

Introduction
Summary
These ‘other things’form the basis of a distinction between

types of intermediary.
Financial intermediaries can be classi…ed as deposit-takers and
non-deposit-takers.
Deposit-takers:
1. Banks
- retail
- corporate
- investment
2. Building societies
Introduction
Summary
Non–deposit-takers:
1. Pension funds
2. Insurance companies
3. Unit trusts
4. Investment trusts

Introduction
Wealth arrangement
Summary
Summary
A …nancial system consists of a set of markets, institutions,

their users and regulators.
A modern …nancial system is required to carry out a wide
range of functions.
Financial markets, in particular, facilitate lending and
borrowing through new issues in primary markets.
Secondary markets provide liquidity which makes new issues
more attractive than they would otherwise be; they provide
mechanism whereby investors can adjust their wealth
portfolios to provide the optimum trade-o¤ between risk and
return.
Introduction
Wealth arrangement
Summary
Summary
Financial intermediaries make it easier to borrow and lend

In doing this, they create assets and liabilities which appear on
their balance sheets
They also provide a variety of other …nancial services
This enables us to make a distinction between DTIs and
non-DTIs.

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Reading for this presentation

ES20070 Money and Finance

Ahmad Financial System

Reading for this lecture

Howells and Bain, EMBF, Ch. 1

Ahmad Financial System

In this lecture, we shall see:

Ahmad Financial System

The Financial System and Its Role

What is a …nancial system?

Ahmad Financial System

The Financial System

Lenders and Borrowers

Table 1 summarises who constitute borrowers and lenders

Table 1: Lenders and Borrowers

Ahmad Financial System

The Financial System

Ahmad Financial System

The Financial System

Suppose you have £ 500 to lend. Would you prefer:

Ahmad Financial System

Borrowing and lending: Borrowers and lenders have

Borrowing and lending

It is often said that lenders are:

Borrowing and lending

Table 1 summarizes the contrasting interests of lenders and

Table 2: Lenders and Borrowers

Ahmad Financial System

Borrowing and lending

Borrowing and lending: How do markets help?

How do markets help?

Ahmad Financial System

Borrowing and lending: Primary and Secondary Markets

Borrowing and lending: if no secondary markets Exist

This will lead to

Ahmad Financial System

Borrowing and lending

As a rule, trading of existing securities in secondary markets

Ahmad Financial System

Borrowing and lending

Borrowing and lending

Without well-functioning markets, both the supply of loans

Ahmad Financial System

The reasons could be due to the followings:

Ahmad Financial System

Any of 2, 3 or 4 will cause lenders to re-arrange their wealth.

Ahmad Financial System

A particularly risk-averse investor will want a low-risk portfolio

Ahmad Financial System

In the …gure, the curve P P 0 shows all those portfolios of

Ahmad Financial System

But now suppose that circumstances change.

Ahmad Financial System

Roles of Financial Markets

Notice that most of this activity will involve existing assets –

Ahmad Financial System

Roles of Financial Markets

Roles of Financial Markets

Low transaction costs allow them to buy a range of assets,

Ahmad Financial System

Adverse Selection and Moral Hazard

Ahmad Financial System

Adverse Selection and Moral Hazard