Financial Markets and Institutions

CATEGORIES OF ECONOMIC AGENTS

ELEMENTS OF A FINANCIAL SYSTEM 1) HOUSEHOLDS

1) CUSTOMERS 2) CORPORATIONS

2) FINANCIAL INSTRUMENTS 3) PUBLIC ADMINISTRATION

3) FINANCIAL MARKETS 4) REST OF THE WORLD

4) FINANCIAL INSTITUTIONS

5) REGULATIONS

Y – C = S Y = salaries, cash in, taxes

C = consumption, cash out, burocracy costs

S = savings, difference btw in and out

BALANCE SHEET

Real assets Financial liabilities

Financial assets Net worth

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

+ -

SURPLUS UNITS DEFICIT UNITS

S > I S < I

+ +

Δ Δ

increase of financial assets increase of financial liabilities

- -

Δ Δ

decrease of financial liabilities 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

We all make different economic choices based on:

RISK

• RETURN

• LIQUIDITY (attitude of a financial instrument to be transformed into cash, speed and cost)

• ETHICS

• have higher

Corporation bonds (BOT) is a short-term debt of

T-bill

risk and higher return but they’re the Government with a low risk,

difficult to liquid (sell) in order to actually zero, but it has a low

obtain money. Shares in listed return. It’s very liquidable, it can be

are the most difficult

companies sold anytime.

to sell in terms of cost and time.

> risk > return (direct relationship)

> liquid < return (inverse relationship)

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

risk

(⇾ future cash generating capacity)

→ PROBLEM OF FINANCIAL ASYMMETRIES

1) (traders with better private information about the quality of a product will

ADVERSE SELECTION

selectively participate in trades which benefits 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).

2) (due to the uneven distribution of information between parties, moral hazard occurs

MORAL HAZARD

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) .

a homeowner makes always sure his house is locked, protected, takes care of it but after he gets a house insurance he

Example

becomes reckless, he starts leaving the house unlocked, he unsubscribes the home security system, etc.

"The is a 1970 paper by the economist which

Market for Lemons: Quality Uncertainty and the Market Mechanism" George Akerlof

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 that is found to be defective only after it has been

bought. Suppose buyers can't distinguish between a quality car (a "peach") from a "lemon". Then they are only willing to pay a fixed

price for a car that averages the value of a "peach" and "lemon" together (p ). But sellers know whether they hold a peach or a lemon.

avg

Given the fixed price which buyers are willing to buy at, sellers are only willing to sell when they hold "lemons" (since p < p ) and

lemon avg

leave the market when they hold "peaches" (since p > p ). the buyer's best guess for a given car is that the car is of average

peach avg

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.

of cars on

owners of good cars will not place their cars on the used car market. The withdrawal of good cars reduces the average quality

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 which wants to be rated provide 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) can give protection in matter of information: CONSOB authorize a company to sollecit

people savings only if it publics a prospect 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 high protection, low taxes

Low regulation banks: example ⇾

Frankfurt, Tokyo high taxes, difficult to pursue illicits

High regulation banks: example ⇾

A bank may fail if takes too many risks. Bank of Italy prevent the other banks to do actions too risky. There’s

a public insurance agency that protects the deposits. If a bank fails another bigger one takes over and buys

it in order to maintain the deposits intact.

Banco Ambrosiano was owned by Catholic Church of Milan. It went in 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.

a bank is a financial institution that accepts savings of customers and makes loans with

st

1 Directive of EU:

this money. No discrimination for foreign banks (to prevent other cases like Banco Ambrosiano)

30 years ago: in US a department store issued a credit card for its customers (payments at the end of

month) then transformed it in debit card (deposit in order to make a payment) with an interest, which

become a credit on purchases. Also it made checks for other banks, so it was basically a bank and the case

has been judged in court.

a bank accepts money OR makes loans

nd

2 Directive of EU: if you have authorization to operate as a financial institution in one country, you have

rd Directive of EU:

3

the authorization in all the other EU countries to open branches

HOST HOME There are 64 banks in Italy, they’re not supervised by Banca d’Italia. The

country of origin supervises on them. Every bank has to protect all of its

country control country control branches. In off-shore tax heavens that’s not happening.

Banks’ branches have significal presence in retail

Categories / Size Households Corporations industry. Italian and Japanese households are the

of the Loan biggest savers.

Small & Medium

Retail

Small Enterprises Retail : no regulation problems, need of distribution to

be reached by people.

Private Big Corporations

Big Big corporations: no need of distribution, the banks

come to the customers.

Choosing a bank, 3 features are checked:

- stability

- efficiency

- competition

High degree of competition more efficiency less stability

Monopoly (ex. China): great stability less efficiency

How to regulate competition: + banking licences + competition

Primitive banks: •religious (catholic Church used to forbid loans; they were considered sins)

(if coins were deposited, once took back the same value were got, not the same

•fungible 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 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 have

been created.

The bank couldn’t issue more banknotes than the gold it had because in any moment people could ask for

their gold back.

Then, banknotes became unconvertable into gold, but after that there have been problems for exchanges

in foreign countries.

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 and the International Bank for Reconstruction and

International Monetary Fund (IMF)

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, of sorts, 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, meanwhile, assured

the rest of the world that its currency was dependable by linking the U.S. dollar to gold; $1 equaled 35 oz.

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.

=

IMF 188 countries working to foster global monetary cooperation, secure financial stability, facilitate international

trade, promote high employment and sustainable economic growth, and reduce poverty around the world. 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

During the war in Korea US Government adopted the “sequestorship”: they froze Korean deposits and investments in

US. Soviet and Chinese central banks were linked to Korea, so there were political risks.

Regulation Q forces down all interest rates in US, banks couldn’t pay interests on accounts and investments,

consequently even bonds interests were lower.

So, some investors started fearing political risks, all investors were unhappy for Regulation Q, borrowers found out US

gates were shut, those who owned a surplus of $ searched another market to invest , for its:

LONDON

• history (it always has been the financial centre in the world even if in the 50s lost some markets)

• geography nd biggest derivative market, etc.)

• infrastructure (biggest foreign exchange market, 2

• regulation

In continental European countries there were always written codes. Britain always had an aversion for that, they’d

prefer general principles, the courts decided for the particular. There were no rules for finance in commercial rules, no

banking law. British banking system was similar to the Italian one in size terms, 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, the oil importers had deficits

79: Poland default for a 27 billion $ debt, the government couldn’t repay it, so it was given some time.

81: Mexico had 90 billion $ of debts, banks stopped lending money to Brazil and Argentina which had to re-negotiate

their debts too.

A of the debt can imply:

re-negotiation

• a TRADE

• a PROJECT

• “CLEAN” option (the debt disappear)

1) a look at the international financial market to reconcile the necessity of the borrower and the necessity of the

BIG:

banks to diversify loans; there are many banks cooperating for 1 borrow -> SYNDICATES

2) a fixed rate expose the bank at a higher risk. The interest rate is not specified in the contract,

FLOATING RATE:

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 interest rate applied on deposits)

3) if I’m insolvent for one loan, I can be declared insolvent for

ABSENCE OF GUARANTEES – CROSS DEFAULT CLAUSE:

other creditors. All creditors are put on the same level.

primary - secondary

⇛ debt - equity

⇛ money - capital

⇛ official – OTC (over the counter = not reg