Financial Markets and Institutions

Categories of economic agents

• Households
• Corporations
• Public administration
• Rest of the world

Elements of a financial system

• Customers
• Financial instruments
• Financial markets
• Financial institutions
• Regulations

Y - C = S

• Y = salaries, cash in, taxes
• C = consumption, cash out, bureaucracy costs
• S = savings, difference between in and out

Balance sheet

Savings (S) can be invested (I) in real assets.

Surplus units Deficit units

• S > I
• S < I

Δ increase of financial assets

Δ increase of financial liabilities

Δ decrease of financial liabilities

Δ decrease of financial assets

The parties agree on certain conditions for the financial instruments:

• Amount
• Currency
• Legal title maturity

Debt interest

Equity no maturity, no interest

Factors influencing economic choices

• Risk
• Return
• Liquidity (attitude of a financial instrument to be transformed into cash, speed, and cost)
• Ethics

Corporation bonds (BOT) is a short-term debt of the Government with low risk, but it has a low return. It’s very liquidable, it can be sold anytime. Shares in listed companies are the most difficult to sell in terms of cost and time.

> risk > return (direct relationship)

> liquid < return (inverse relationship)

Financial asymmetries

To estimate the risk, we need information; we need to estimate the possible future cash flows of the person:

• Adverse selection: Traders with better private information about the quality of a product will selectively participate in trades which benefit them the most, at the expense of the other trader. The asymmetry causes a lack of efficiency in the price and quantity of goods and services.
• Moral hazard: Due to the uneven distribution of information between parties, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Example: A homeowner makes sure his house is locked and protected but after he gets house insurance, he becomes reckless, starts leaving the house unlocked, and unsubscribes from the home security system.

The market for lemons

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist George Akerlof. It examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind. A lemon is an American slang term for a car found to be defective only after it has been bought. Suppose buyers can't distinguish between a quality car (a "peach") and a "lemon." Then they are only willing to pay a fixed price that averages the value of a "peach" and "lemon" together (p_avg). But sellers know whether they hold a peach or a lemon. Given the fixed price, which buyers are willing to buy, sellers are only willing to sell when they hold "lemons" (since p_lemon < p_avg) and leave the market when they hold "peaches" (since p_peach > p_avg). The buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a carefully maintained, never-abused, good used car will be unable to get a high enough price to make selling that car worthwhile. Owners of good cars will not place their cars on the used car market. The withdrawal of good cars reduces the average quality of cars on the market, causing buyers to revise downward their expectations for any given car. This, in turn, motivates the owners of moderately good cars not to sell, and so on.

Rating agencies

(Moody’s, Standard & Poor’s)

A company that wants to be rated provides information to the agency.

• 1% = 100 basis points
• Treasury risk-free = X
• AAA lowest risk = X + 150 basis points
• AA = X + 220 bp
• A = X + 350 bp
• BBB...

(Markets don’t price risks correctly, junk bonds have to promise an extra return)

Junk bond market

Financial systems are regulated because of:

• Monetary policy
• Protection of the investors

(In Italy) organizations like CONSOB can give protection in matters of information. They authorize a company to solicit people's savings only if it publishes a prospectus that has to be approved, with the details of the company and the financial instrument it wants to sell. A public offer with no trust consent is illegal.

There are many forms of regulations:

• Commercial law
• Labour law
• Local law
• Taxes
• Monetary policy
• Investor’s protection

Cayman Islands offer high protection and low taxes. Low regulation banks example: Frankfurt, Tokyo, with high taxes and difficult to pursue illicits. High regulation banks example: A bank may fail if it takes too many risks. Bank of Italy prevents other banks from taking actions that are too risky. There's a public insurance agency that protects the deposits. If a bank fails, another bigger one takes over and buys it to maintain the deposits intact.

Banco Ambrosiano was owned by the Catholic Church of Milan. It went into bankruptcy. Depositors found their money in the same amount though. There were depositors even in Luxembourg, but they didn’t have their money back because Banca d’Italia could regulate only for Italy.

Banking directives

• 1st Directive of EU: A bank is a financial institution that accepts savings of customers and makes loans with this money. No discrimination for foreign banks (to prevent other cases like Banco Ambrosiano).
• 30 years ago: In the US, a department store issued a credit card for its customers (payments at the end of the month) then transformed it into a debit card (deposit to make a payment) with interest, which become a credit on purchases. Also, it made checks for other banks, so it was basically a bank and the case was judged in court.
• A bank accepts money OR makes loans
• 2nd Directive of EU: If you have authorization to operate as a financial institution in one country, you have the authorization in all the other EU countries to open branches.
• 3rd Directive of EU: Host country control, home country control. There are 64 banks in Italy; they’re not supervised by Banca d’Italia. The country of origin supervises them. Every bank has to protect all of its branches. In offshore tax havens, that’s not happening.

Banks in the retail industry

Banks’ branches have significant presence in retail.

Categories/Size of the Loan

• Households: Italian and Japanese households are the biggest savers.
• Corporations: Small & Medium Enterprises (Retail: no regulation problems, need distribution to be reached by people). Private Big Corporations (Big corporations: no need for distribution, the banks come to the customers).

Choosing a bank, 3 features are checked:

• Stability
• Efficiency
• Competition

High degree of competition leads to more efficiency but less stability. In a monopoly (ex. China), there is great stability but less efficiency. How to regulate competition: + banking licenses + competition.

Primitive banks

• Religious (Catholic Church used to forbid loans; they were considered sins). If coins were deposited, once taken back the same value was got, not the same amount of coins.
• High liquidity function (I leave money in a bank to pay you and you have to go get them).
• Intermediate: Find an equilibrium between what’s lent and what’s available at the moment.

Problem: Industries were born, and the Church didn’t consider lending money a sin anymore. Make money function: instead of coins, the bank gives a piece of paper of a certain value for exchange (banknotes).

In 1500-1600, banknotes were only in monopoly banks (central banks) of public property (receive gold and give banknotes and vice versa). The other banks accepted deposits of banknotes and in exchange, people got an account. Also, checks were created. The bank couldn’t issue more banknotes than the gold it had because, at any moment, people could ask for their gold back. Then, banknotes became unconvertible into gold, but after that, there were problems for exchanges in foreign countries.

Bretton Woods system

Established in 1944 and named after the New Hampshire town where the agreements were drawn up, the Bretton Woods system created an international basis for exchanging one currency for another. It also led to the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, now known as the World Bank. The former was designed to monitor exchange rates and lend reserve currencies to nations with trade deficits, the latter to provide underdeveloped nations with needed capital—although each institution's role has changed over time. Each of the 44 nations who joined the discussions contributed a membership fee to fund these institutions; the amount of each contribution designated a country's economic ability and dictated its number of votes.

In an effort to free international trade and fund postwar reconstruction, the member states agreed to fix their exchange rates by tying their currencies to the U.S. dollar. American politicians assured the rest of the world that its currency was dependable by linking the U.S. dollar to gold; $1 equaled 35 ounces of bullion. Nations also agreed to buy and sell U.S. dollars to keep their currencies within 1% of the fixed rate. And thus the golden age of the U.S. dollar began.

For his part, legendary British economist John Maynard Keynes, who drafted much of the plan, called it "the exact opposite of the gold standard," saying the negotiated monetary system would be whatever the controlling nations wished to make of it. Keynes had even gone so far as to propose a single, global currency that wouldn't be tied to either gold or politics (he lost that argument).

Though it came on the heels of the Great Depression and the beginning of the end of World War II, the Bretton Woods system addressed global ills that began as early as the first World War when governments (including the U.S.) began controlling imports and exports to offset wartime blockades. This, in turn, led to the manipulation of currencies to shape foreign trade. Currency warfare and restrictive market practices helped spark the devaluation, deflation, and depression that defined the economy of the 1930s.

The Bretton Woods system itself collapsed in 1971 when President Richard Nixon cut off the link between the dollar and gold—a decision made to prevent a run on Fort Knox, which contained only a third of the gold bullion necessary to cover the amount of dollars in foreign hands. By 1973, most major world economies had allowed their currencies to float freely against the dollar. It was a rocky transition, characterized by plummeting stock prices, skyrocketing oil prices, bank failures, and inflation.

International Monetary Fund (IMF)

The IMF consists of 188 countries working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty worldwide. Formed in 1944 at the Bretton Woods Conference, it came into formal existence in 1945 with 29 member countries and the goal of reconstructing the international payment system. Countries contribute funds to a pool through a quota system from which countries with payment imbalances can borrow. Through this fund, and other activities such as statistics keeping and analysis, surveillance of its members' economies, and the demand for self-correcting policies, the IMF works to improve the economies of its member countries. The organization's objectives stated in the Articles of Agreement are: to promote international economic cooperation, international trade, employment, and exchange-rate stability, including by making financial resources available to member countries to meet balance-of-payments needs.

Gold is not an IMF monopoly. There were 2 markets:

• IMF (35$/oz)
• Private market in London

Political risks and Regulation Q

During the war in Korea, the US Government adopted the “sequestorship”: they froze Korean deposits and investments in the US. Soviet and Chinese central banks were linked to Korea, so there were political risks. Regulation Q forced down all interest rates in the US; banks couldn’t pay interests on accounts and investments, consequently even bond interests were lower. So, some investors started fearing political risks, all investors were unhappy with Regulation Q, borrowers found out US gates were shut, and those who owned a surplus of dollars searched for another market to invest in, for its:

London

• History (it always has been the financial center in the world even if in the 50s it lost some markets)
• Geography
• Infrastructure (biggest foreign exchange market, 2^nd biggest derivative market, etc.)
• Regulation

In continental European countries, there are always written codes. Britain always had an aversion for that; they’d prefer general principles, the courts decided on the particular. There were no rules for finance in commercial rules, no banking law. The British banking system was similar to the Italian one in size terms, with the same number of bank branches and employees and depositors; the difference was that there were 1200 banks in Italy and 4 in Britain. Also, the Bank of England “ignored” foreign banks, so it was paradise for them. So in the 60s, there were two markets:

• Domestic (US)
• Non-US investors in London (in the 60s this market grew extremely)

70s: Regulation Q is abolished. In these years the market is for borrowers, the banks compete on borrowing conditions, banks are less selective, the market is very liquid, and banks have more liquidity.

74: The oil exporters had dollar surpluses, and the oil importers had deficits. 79: Poland defaulted on a 27 billion dollar debt, and the government couldn’t repay it, so it was given some time. 81: Mexico had 90 billion dollars of debts, and banks stopped lending money to Brazil and Argentina, which had to renegotiate their debts too.

Debt renegotiations

A renegotiation of the debt can imply:

• A trade
• A project
• “Clean” option (the debt disappears)

Big: A look at the international financial market to reconcile the necessity of the borrower and the necessity of the banks to diversify loans; there are many banks cooperating for one borrower -> syndicates.

Floating rate: A fixed rate exposes the bank to higher risk. The interest rate is not specified in the contract; there’s a formula to compute them instead. The formula has 3 features:

• Roll over period (ex. 6 months: it means that every 6 months the bank and the borrower meet to recalculate the interest applying the formula)
• Reference rate (T-bill is very used, or London Inter Bank Offered Rate (LIBOR))
• Spread (difference between the interest rate applied on loans and the interest rate applied on deposits)

Absence of guarantees – cross default clause: If I’m insolvent for one loan, I can be declared insolvent for other creditors. All creditors are put on the same level.

Primary - Secondary

• Debt - Equity
• Money - Capital
• Official – OTC (over the counter = not regulated)