Chapter One

Money and Banking Sections FIN 3313.001 FIN 3313.002 ECO 3313.001 Dr. LoRusso Chapter One and Exam Review Chapter Learning Objective After studying the Chapter, you should be able to: Identify the key components of the Financial System, along with examples of each of the components Begin a timeline of the Financial Crisis and provide an overview of key events as well as a working understanding of the terms which describe the Crisis Explain the key issues concerning the Financial System The purpose of the Chapter is to present the framework of the Financial System, the key components with examples of each of the components, and the introduction of the division of the Financial System between financial intermediaries, and non-bank financial intermediaries. Know the characteristics of a financial institution that would be classified in either category. An understanding of this framework is important to understand the core concepts of the course material. 1.1 Key Components of the Financial System Learning Objective: Identify the key components of the Financial System There are three (3) major components of the Financial System. For each of these three major components you need to know the key categories and examples of each. Financial Assets Financial Institutions The Federal Reserve and other Financial Regulators I. Financial Assets To understand " what is a financial asset, " we start by understanding 'what is an asset' and how we classify assets. Definitions An asset is anything of value that is owned by a person or a business/firm. An example of an asset is a vehicle or building. In this example one is depreciating, the other is appreciating, respectively. A financial asset is an asset that represents a claim on someone else for payment. One key component of financial assets includes securities. A security Is a financial asset that can be bought and sold in a financial market A financial market is a place or channel for buying or selling securities. Examples of securities include stocks and bonds. There are five key categories of financial assets:
Money Stocks Bonds Foreign Exchange Securitized Loans For each of the five key categories of financial assets, you need to know what the asset is, how is it used in the Financial System and examples of each. Money Money is anything that is generally accepted in payment for a good or service or in discharge of a debt. Chapter Two is dedicated to the evolution of money, and how we used money in the payment system. The money supply is the total quantity of money in the economy. The Federal Reserve is responsible for tracking the money supply. Stocks A stock is an equity instrument commonly referred to as equities . These are financial securities that represent partial ownership of a firm or business. The income derived from a stock is called a dividend. This is what a corporation pays it shareholders for investing in the company. Ex. If you buy a share of sto ck let's say in Microsoft or Appl e, you become a shareholder, and you will be paid a dividend. Bond A bond is a debt instrument, it is a financial security issued by a corporation or a governmental entity that represents a promise to repay a fixed amount of money. The repayment is in the form of the principal amount, and the interest . You can think of a bond like a loan. You take out a loan to buy a car, you repay the principal and interest on the loan. When you buy a bond, you are buying a corporati on's debt. You receive interest payments every year until the bond matures, then you receive the principal or par value, or denomination of the bond. Interest is the cost of borrowing it is the reward for lending. You pay the interest on the principal amount you borrowed for the car, the bank or financial institution received the interest as a reward for lending you the money. Foreign Exchange Foreign Exchange refers to units of foreign currency. To buy foreign goods and services or foreign assets, a domestic, i.e. US, business or a domestic investor must first exchange domestic currency for foreign currency. U.S. banks are the largest buyers and sellers of foreign exchange, and engage in foreign currency transactions on behalf of investors and business firms. Securitized Loans Historically, banks made loans with the intention to collect interest payments for those loans. In the 1970's, the process of securitization was introduced into the Financial System whereby banks began to sell loans that they made into the financial markets. Securitization is the process of converting loans and other financial assets that are not tradeable into tradeable securities. The process of securitization evolved over time, and became the preferred way of doing business among banks in the aftermath of the market crash in 2001. This process of securitization is discussed in more detail in Chapter 12, The Financial Crisis.
A loan is a financial liability for the borrower. A financial liability is a financial claim owed by a person or a business. II. Financial Institutions The purpose of the Financial System is to match savers and borrowers through two channels: Banks and other financial intermediaries and Financial Markets IIA. Financial Intermediaries A financial intermediary is a financial firm that borrows funds from savers and lends them to borrowers, during this process increased capital is created in the system through the form of interest, and other mechanisms. A bank is an example of a financial intermediary, and the most important financial intermediary is a commercial bank. To be a bank, the financial institution must perform two functions: it must take deposits, and make loans. National Banks in the U.S. receive a 'charter' f rom the Comptroller of the Currency to function as a bank. Financial Markets are the place where buyers and sellers, lenders and borrowers come together to facilitate a transaction involving money. There are two types of cash flows, or flow of funds that are characteristic of financial markets: Indirect Finance and Direct Finance. Direct Finance is an easier concept to understand, so let's start there. Your author tells you that direct finance is where funds flow directly from savers to borrowers, but what does that really mean? Your next-door neighbor comes to you and asks to borrow money to start a landscaping business. Think of all the reason you should or should not lend your neighbor the money. In Finance, the biggest reason is risk - the uncertainty of the outcome. Will you get the money back? When? How much interest should you charge? Can you get more interest if you invested somewhere else? What happens if your neighbor defaults and does not pay you back? The risk of loss falls on you - are you able to bear that risk? In Indirect Finance you put the money in a bank or other financial intermediary, and you earn interest because you are lending money into the Financial System through an intermediary, a bank. The risk of loss if your next-door neighbor does not pay the money back remains with the bank. While the bank uses your money as a lender, and everyone else's money that is deposited in their bank to make the loan to your neighbor, the bank receives the interest, because they took the risk of loss, and your money is secure. Figure 1.1 Moving Funds through the Financial System illustrates the concepts of direct and indirect finance. Also, read the 'Making the Connection: The Rise of Peer to Peer Lending and Fintech' and ask yourself the question, who bear the risk of loss, and how do we as lenders identify the risks. IIB. Nonbank Financial Intermediaries Nonbank financial intermediaries are financial institutions that do not perform the two functions to be classified as a bank. Thrift institutions are an example of a nonbank financial intermediary, included in this category are savings and loan associations, savings bank, and credit unions. While thrift institutions appear
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