Types of Finance
Direct Finance - Financial Indirect Finance - Financial Institutions
Markets
funds borrowed directly by funds borrowed indirectly - via nancial intermediaries (eg. bank) who play as a "middle man"
lenders in nancial markets -
by selling/issuing nancial used mostly by non- nancial businesses as a source of external funds
instruments (i.e. securities,
claims on borrowers future Financial Intermediaries (FI)
income or real assets)
function
- obtains funds from savers (households or rms)
- and then makes loans/investments (also to households or rms)
transaction costs
- intermediaries bene t from economies of scale: marginal transaction cost decreases as number
of transactions (or size of transaction) increases
- transaction costs are decreased due to gathered expertise (they provide liquidity services, such
why are as checking accounts allowing customers to pay bills easily)
they risk sharing
crucial? - they reduce exposure to uncertainty about investment returns
- help individuals diversify by investing into a portfolio with assets whose returns do not always
move together
- use returns from low-risk portfolios to make investments with higher risks (i.e. asset
transformation)
con ict of FI o er multiple nancial services (o er loans, sell bonds etc) —> they can use the same
interests information source to all of these services —> con ict of interest
Types of Financial Institutions (by asset value in the US)
depository commercial banks depository institutions (take deposits, make loans)
institutions
(banks) credit unions consumer loans organized around particular group (eg. union members)
insurance o er protection against adverse events (eg. death, illness, injury, re, theft)
companies
contractual pension funds invest money for retirement, taxation de ered
saving institutions
state and local
government
retirement funds
nance companies make loans (but are funded with debt), often organized by parent corporations (eg. Ford Motor)
investment mutual funds pool money and invest in diversi ed portfolios
intermediaries
,intermediaries
hedge funds pool money of small number of wealthy investors and invest on their behalf
not a depository investment banks help rms issue securities and engage in related activities (brokerage, trading), M&A
institution
Assymetric Information
there is asymmetric info when one counter-party lacks crucial information about another party, impacting decision-making
- the result of asymmetric information may be market failure (break-down of a market)
large, well established rms should have less asymmetric info with nancial markets (because they care about reputation),
hence, those rms can more easily issue bonds (it is more attractive for investors)
Adverse Selection Moral Hazard
one party that knows more about the transaction most likely a situation where one party has the incentive (hazard) to engage in
produce the undesirable (adverse) outcome undesirable (immoral) activities after the transaction has occurred
eg. once people get insurance, they become careless
hidden characteristics hidden action
information before a transaction occurs information problem after the transaction occur
solutions: Principal-Agent Problem (type of moral hazard)
1. private collection of information before transaction occur: issue - result of separation of ownership by stockholders (principals) from
with that is that later all those information becomes available to control by managers (agents)
public - problem: agents act in own rather than principals' interest
2. government regulation: reduces asymmetric info by having
company’s true information revealed solutions:
3. screening ex-ante from FI (especially banks): similar to private 1. monitoring (very costly): used by venture capitalists who actively
collection of information but those information are not revealed monitor startups they invested into
to public 2. government intervention: enforce the laws on fraudulent behavior
4. collateral and net worth: you may ask for collateral (property that (hiding & stealing pro ts)
will be taken from you in case you don’t pay back loan, 3. debt contracts (a way to reduce monitoring costs):
mortgage etc) or net worth (assets-liabilities) before making - principal needs to make sure no pro t is diverted away by the agent, by
transaction using debt contracts principal only needs to monitor in some states of
the world —> debt is an optimal security if moral hazard is present
- debt contracts often have collateral (eg. house for mortgage) and
covenants (to previous undesirable behavior)
consequences: consequences:
- borrowers who are most likely to produce adverse (bad) outcome - risk (“hazard”) that borrower engages in activities that are undesirable
are most likely to demand a loan (“immoral”) from lender’s perspective
- lenders know that borrowers have bad credit risk —> lenders - moral hazard increases default risk —> lenders increase interest rate or
increase interest rate (or even decide not to o er any loan) collateral (or do not o er any loan)
,adverse selection explains why small rms are shut out of capital moral hazard can explain why debt (bonds+loans) is much more prevalent
markets and use banks, and why bank loans are usually than equity (but debt itself is not immune from moral hazard)
collateralized
eg.
you should choose healthy lifestyle since 920>730
Why do Financial Institutions (FI) exist?
FI (indirect nance) are better equipped than nancial markets (direct) to solve problems of:
- transaction costs
- asymmetric information
FI engage in risk sharing (asset transformation, diversi cation)
- in uence the nancial structure
- for small transactions, transaction costs are a big part of investments —> small individual
investments are not well diversi ed
lower transaction
primary functions costs FI reduces transaction costs by
of FI (indirect - economies of scale: average cost of an investment decreases ass the size (scale) increases (this
nance is due to xed costs)
- economies of scope: average cost decreases as the number of products o ered increases
reduce asymmetric
information
Commercial Banking
def. commercial banks are institutions that accept deposits (liabilities) and make loans (assets)
- the largest FI by asset size
, a list of a bank’s assets and liabilities
total assets = total liabilities + capital (or equity or net worth)
balance sheet
book values (i.e. what you read on the balance sheet) are di erent from market values (i.e. as evaluated by the market using
prices)
from households and rms
two main types:
deposits (71%) - checking deposits: allow to withdraw at any time
- non-transaction deposits: savings accounts and time deposits (Certi cates of Deposits) (both have
limited withdrawals)
liabilities - fed funds (overnights from other banks)
other short-term - interbank o shore dollar deposits (Eurodollars)
borrowing (18%) - repurchase agreements
- funds borrowed from corporations
bank capital (11%) di erence between assets and liabilities (either raised by selling new equity or from retained earnings)
reserves and cash accounts held at the Federal Reserve plus physical cash in bank’s vault
(16%)
only debt (commercial banks not allowed to hold stock)
securities (22%)
assets (mostly US government debt and mortgage-backed securities)
loans (53%) mostly in Real Estate (household mortgages) and business loans to rms
other assets (9%) buildings, IT infrastructure etc
Direct Finance - Financial Indirect Finance - Financial Institutions
Markets
funds borrowed directly by funds borrowed indirectly - via nancial intermediaries (eg. bank) who play as a "middle man"
lenders in nancial markets -
by selling/issuing nancial used mostly by non- nancial businesses as a source of external funds
instruments (i.e. securities,
claims on borrowers future Financial Intermediaries (FI)
income or real assets)
function
- obtains funds from savers (households or rms)
- and then makes loans/investments (also to households or rms)
transaction costs
- intermediaries bene t from economies of scale: marginal transaction cost decreases as number
of transactions (or size of transaction) increases
- transaction costs are decreased due to gathered expertise (they provide liquidity services, such
why are as checking accounts allowing customers to pay bills easily)
they risk sharing
crucial? - they reduce exposure to uncertainty about investment returns
- help individuals diversify by investing into a portfolio with assets whose returns do not always
move together
- use returns from low-risk portfolios to make investments with higher risks (i.e. asset
transformation)
con ict of FI o er multiple nancial services (o er loans, sell bonds etc) —> they can use the same
interests information source to all of these services —> con ict of interest
Types of Financial Institutions (by asset value in the US)
depository commercial banks depository institutions (take deposits, make loans)
institutions
(banks) credit unions consumer loans organized around particular group (eg. union members)
insurance o er protection against adverse events (eg. death, illness, injury, re, theft)
companies
contractual pension funds invest money for retirement, taxation de ered
saving institutions
state and local
government
retirement funds
nance companies make loans (but are funded with debt), often organized by parent corporations (eg. Ford Motor)
investment mutual funds pool money and invest in diversi ed portfolios
intermediaries
,intermediaries
hedge funds pool money of small number of wealthy investors and invest on their behalf
not a depository investment banks help rms issue securities and engage in related activities (brokerage, trading), M&A
institution
Assymetric Information
there is asymmetric info when one counter-party lacks crucial information about another party, impacting decision-making
- the result of asymmetric information may be market failure (break-down of a market)
large, well established rms should have less asymmetric info with nancial markets (because they care about reputation),
hence, those rms can more easily issue bonds (it is more attractive for investors)
Adverse Selection Moral Hazard
one party that knows more about the transaction most likely a situation where one party has the incentive (hazard) to engage in
produce the undesirable (adverse) outcome undesirable (immoral) activities after the transaction has occurred
eg. once people get insurance, they become careless
hidden characteristics hidden action
information before a transaction occurs information problem after the transaction occur
solutions: Principal-Agent Problem (type of moral hazard)
1. private collection of information before transaction occur: issue - result of separation of ownership by stockholders (principals) from
with that is that later all those information becomes available to control by managers (agents)
public - problem: agents act in own rather than principals' interest
2. government regulation: reduces asymmetric info by having
company’s true information revealed solutions:
3. screening ex-ante from FI (especially banks): similar to private 1. monitoring (very costly): used by venture capitalists who actively
collection of information but those information are not revealed monitor startups they invested into
to public 2. government intervention: enforce the laws on fraudulent behavior
4. collateral and net worth: you may ask for collateral (property that (hiding & stealing pro ts)
will be taken from you in case you don’t pay back loan, 3. debt contracts (a way to reduce monitoring costs):
mortgage etc) or net worth (assets-liabilities) before making - principal needs to make sure no pro t is diverted away by the agent, by
transaction using debt contracts principal only needs to monitor in some states of
the world —> debt is an optimal security if moral hazard is present
- debt contracts often have collateral (eg. house for mortgage) and
covenants (to previous undesirable behavior)
consequences: consequences:
- borrowers who are most likely to produce adverse (bad) outcome - risk (“hazard”) that borrower engages in activities that are undesirable
are most likely to demand a loan (“immoral”) from lender’s perspective
- lenders know that borrowers have bad credit risk —> lenders - moral hazard increases default risk —> lenders increase interest rate or
increase interest rate (or even decide not to o er any loan) collateral (or do not o er any loan)
,adverse selection explains why small rms are shut out of capital moral hazard can explain why debt (bonds+loans) is much more prevalent
markets and use banks, and why bank loans are usually than equity (but debt itself is not immune from moral hazard)
collateralized
eg.
you should choose healthy lifestyle since 920>730
Why do Financial Institutions (FI) exist?
FI (indirect nance) are better equipped than nancial markets (direct) to solve problems of:
- transaction costs
- asymmetric information
FI engage in risk sharing (asset transformation, diversi cation)
- in uence the nancial structure
- for small transactions, transaction costs are a big part of investments —> small individual
investments are not well diversi ed
lower transaction
primary functions costs FI reduces transaction costs by
of FI (indirect - economies of scale: average cost of an investment decreases ass the size (scale) increases (this
nance is due to xed costs)
- economies of scope: average cost decreases as the number of products o ered increases
reduce asymmetric
information
Commercial Banking
def. commercial banks are institutions that accept deposits (liabilities) and make loans (assets)
- the largest FI by asset size
, a list of a bank’s assets and liabilities
total assets = total liabilities + capital (or equity or net worth)
balance sheet
book values (i.e. what you read on the balance sheet) are di erent from market values (i.e. as evaluated by the market using
prices)
from households and rms
two main types:
deposits (71%) - checking deposits: allow to withdraw at any time
- non-transaction deposits: savings accounts and time deposits (Certi cates of Deposits) (both have
limited withdrawals)
liabilities - fed funds (overnights from other banks)
other short-term - interbank o shore dollar deposits (Eurodollars)
borrowing (18%) - repurchase agreements
- funds borrowed from corporations
bank capital (11%) di erence between assets and liabilities (either raised by selling new equity or from retained earnings)
reserves and cash accounts held at the Federal Reserve plus physical cash in bank’s vault
(16%)
only debt (commercial banks not allowed to hold stock)
securities (22%)
assets (mostly US government debt and mortgage-backed securities)
loans (53%) mostly in Real Estate (household mortgages) and business loans to rms
other assets (9%) buildings, IT infrastructure etc
