5.3 Reading Functions of Financial Markets and Financial Intermediaries

F inancial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. This function is shown schematically in Figure 1. Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow funds to finance their spending, the borrower-spenders, are at the right. The principal lender-savers are households, but business enterprises and the government, as well as foreigners and their governments, sometimes also find themselves with excess funds and so lend them out. The most important borrower-spenders are businesses and the government, but households and foreigners also borrow to finance their purchases of cars, furniture, and houses. The arrows show that funds flow from lender-savers to borrower-spenders via two routes.

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FINANCIAL MARKETS

n direct finance, borrowers borrow funds directly from lenders in financial markets by selling them securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but they are liabilities for the individual or firm that sells (issues) them. Financial markets are very important to the economy because in the absence of them, borrowers and savers might never get together. Financial markets are essential to promoting economic efficiency because they transfer funds from a person who has no investment opportunities to one who has them. Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy. Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better. Financial markets that are operating efficiently improve the economic welfare of everyone in the society.

Now that we understand the basic function of financial markets, let’s look at their structure. There are several categorizations of financial markets:

• debt and equity markets,

• primary and secondary markets,

• exchanges and over-the-counter markets,

• money and capital markets.

A firm or an individual can obtain funds in a financial market in two ways. The most common method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of the business. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. The size of the debt market is often substantially larger than the size of the equity market: The value of debt instruments in the US debt market was $43.4 trillion at the end of 2006, while the value of equities was $19.3 trillion at the end of 2006.

A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing funds. A secondary market is a financial market in which securities that have been previously issued can be resold.

Secondary markets can be organized in two ways. One method is to organize exchanges, where buyers and sellers of securities meet in one central location to conduct trades. The New York and American Stock Exchanges for stocks are examples of organized exchanges. The other method is to have an over-the-counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices. Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange.

Another way of distinguishing between markets is on the basis of the maturity of securities traded in each market. The money market is a financial market in which only short-term (less than one year maturity) debt instruments are traded. The capital market is the market in which longer-term debt and equity instruments are traded.

As shown in Fig.1, funds also can move from lenders to borrowers by a second route called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. A financial intermediary does this by borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders. Financial intermediation is the primary route for moving funds from lenders to borrowers. Transaction costs, risk sharing, and information costs in financial markets are very important. Financial intermediaries can substantially reduce transaction costs, investors’ exposure to risk and eliminate problems caused by asymmetric information which is in fact a lack of information about contracting parties in financial markets. Financial intermediaries can be classified into:

• depositary institutions (banks) which include commercial banks and thrifts;

• contractual savings institutions (insurance companies and pension funds);

• investment intermediaries (finance companies, mutual funds, money market mutual funds, investment banks).