Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.

A financial asset is a paper claim that entitles the buyer to future income from the seller. For example, when a saver lends funds to a company, the loan is a financial asset sold by the company that entitles the lender (the buyer) to future income from the company. A household can also invest its current savings or wealth by purchasing a physical asset, a claim on a tangible object, such as a preexisting house or a preexisting piece of equipment. It gives the owner the right to dispose of the object as he or she wishes (for example, rent it or sell it).

If you were to go to your local bank and get a loan—say, to buy a new car—you and the bank would be creating a financial asset: your loan. A loan is one important kind of financial asset in the real world, one that is owned by the lender—in this case, your local bank. In creating that loan, you and the bank would also be creating a liability, a requirement to pay money in the future. So, although your loan is a financial asset from the bank’s point of view, it is a liability from your point of view: a requirement that you repay the loan, including any interest. In addition to loans, there are three other important kinds of financial assets: stocks, bonds, and bank deposits. Because a financial asset is a claim to future income that someone has to pay, it is also someone else’s liability. Shortly, we’ll explain in detail who bears the liability for each type of financial asset.

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These four types of financial assets exist because the economy has developed a set of specialized markets, such as the stock market and the bond market, and specialized institutions, such as banks, that facilitate the flow of funds from lenders to borrowers. A well-functioning financial system is a critical ingredient in achieving long-run growth because it encourages greater savings and investment spending. It also ensures that savings and investment spending are undertaken efficiently. To understand how this occurs, we first need to know what tasks the financial system needs to accomplish. Then we can see how the job gets done.

There are three important problems facing borrowers and lenders: transaction costs, financial risk, and the desire for liquidity. The three tasks of a financial system are to reduce these problems in a cost-effective way. Doing so enhances the efficiency of financial markets: it makes it more likely that lenders and borrowers will make mutually beneficial trades—trades that make society as a whole richer.

Reducing Transaction Costs Transaction costs are the expenses of actually putting together and executing a deal. For example, arranging a loan requires spending time and money negotiating the terms of the deal, verifying the borrower’s ability to pay, drawing up and executing legal documents, and so on. Suppose a large business decided that it wanted to raise $1 billion for investment spending. No individual would be willing to lend that much. And negotiating individual loans from thousands of different people, each willing to lend a modest amount, would impose very large total costs because each individual transaction would incur a cost. Total costs would be so large that the entire deal would probably be unprofitable for the business.

Fortunately, that’s not necessary: when large businesses want to borrow money, they either get a loan from a bank or sell bonds in the bond market. Obtaining a loan from a bank avoids large transaction costs because it involves only a single borrower and a single lender. We’ll explain more about how bonds work in the next section. For now, it is enough to know that the principal reason there is a bond market is that it allows companies to borrow large sums of money without incurring large transaction costs.

Reducing Risk A second problem that real-world borrowers and lenders face is financial risk, uncertainty about future outcomes that involve financial losses or gains. Financial risk (which from now on we’ll simply call “risk”) is a problem because the future is uncertain; it holds the potential for losses as well as gains.

Most people are risk-averse, although to differing degrees. A well-functioning financial system helps people reduce their exposure to risk. Suppose the owner of a business expects to make a greater profit if she buys additional capital equipment but isn’t completely sure of this result. She could pay for the equipment by using her savings or selling her house. But if the profit is significantly less than expected, she will have lost her savings, or her house, or both. That is, she would be exposing herself to a lot of risk due to uncertainty about how well or poorly the business performs. So, being risk-averse, this business owner wants to share the risk of purchasing new capital equipment with someone, even if that requires sharing some of the profit if all goes well. How can she do this? By selling shares of her company to other people and using the money she receives from selling shares, rather than money from the sale of her other assets, to finance the equipment purchase. By selling shares in her company, she reduces her personal losses if the profit is less than expected: she won’t have lost her other assets. But if things go well, the shareholders earn a share of the profit as a return on their investment.

By selling a share of her business, the owner has been able to invest in several things in a way that lowers her total risk. She has maintained her investment in her bank account, a financial asset; in ownership of her house, a physical asset; and in ownership of the unsold portion of her business, also a physical asset. By engaging in diversification—investing in several assets with unrelated, or independent, risks—our business owner has lowered her total risk of loss. The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market.

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Providing Liquidity The third and final task of the financial system is to provide investors with liquidity, which—like risk—becomes relevant because the future is uncertain. Suppose that you want to start a new business at some point. Even if you have no concerns about the risk of the business failing, you probably won’t want to invest all of your savings into the business. This is because you might suddenly find yourself in need of cash—say, to pay for a medical emergency. Money invested in a business is not easily converted into cash in the event that it is needed for other purposes. For this reason, savvy investors like you are reluctant to lock up too much money in businesses among other large purchases.

An asset is liquid if, as with money deposited in a bank, it can be quickly converted into cash without much loss of value. An asset is illiquid if, as with a business, car, or home, it cannot. The reluctance to invest heavily in illiquid assets would deter business growth and many major purchases if financial systems offered no remedy. As we’ll see, however, the initial sale of stocks and bonds can resolve some liquidity problems by raising money for new and expanding projects. And, by taking deposits and lending them out, banks allow individuals to own liquid assets (their deposits) while financing investments in illiquid assets such as businesses and homes.

To help lenders and borrowers make mutually beneficial deals, then, the economy needs ways to reduce transaction costs, to reduce and manage risk through diversification, and to provide liquidity. How does it achieve these tasks? With a variety of financial assets.

In the modern economy there are four main types of financial assets: loans, bonds, stocks, and bank deposits. In addition, financial innovation has allowed the creation of a wide range of loan-backed securities. Each type of asset serves a somewhat different purpose. We’ll explain loans, bonds, stocks, and loan-backed securities first. Then we’ll turn to bank deposits when we explain the role banks play as financial intermediaries.

Loans A loan is a lending agreement between an individual lender and an individual borrower. Most people encounter loans in the form of bank loans to finance the purchase of a car or a house. And small businesses usually use bank loans to buy new equipment.

The good aspect of loans is that a given loan is usually tailored to the needs of the borrower. Before a small business can get a loan, it usually has to discuss its business plans, its profits, and so on with the lender. This results in a loan that meets the borrower’s needs and ability to repay.

The bad aspect of loans is that making a loan to an individual person or a business typically involves a lot of transaction costs, such as the cost of negotiating the terms of the loan, investigating the borrower’s credit history and ability to repay, and so on. To minimize these costs, large borrowers such as major corporations and governments often take a more streamlined approach: they sell (or issue) bonds.

Bonds A bond is an IOU issued by the borrower. Normally, the seller of the bond promises to pay a fixed sum of interest each year and to repay the principal—the value stated on the face of the bond—to the owner of the bond on a particular date. So a bond is a financial asset from its owner’s point of view and a liability from its issuer’s point of view. A bond issuer sells a number of bonds with a given interest rate and maturity date to whoever is willing to buy them, a process that avoids costly negotiation of the terms of a loan with many individual lenders.

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Bond purchasers can acquire information free of charge on the quality of the bond issuer, such as the bond issuer’s credit history, from bond-rating agencies rather than having to incur the expense of investigating it themselves. A particular concern for investors is the possibility of default, the risk that the bond issuer might fail to make payments as specified by the bond contract. Once a bond’s risk of default has been rated, it can be sold on the bond market as a more or less standardized product—a product with clearly defined terms and quality. In general, bonds with a higher default risk must pay a higher interest rate to attract investors.

Another important advantage of bonds is that they are easy to resell. This provides liquidity to bond purchasers. Indeed, a bond will often pass through many hands before it finally comes due. Loans, in contrast, are much more difficult to resell because, unlike bonds, they are not standardized: they differ in size, quality, terms, and so on. This makes them a lot less liquid than bonds.

Loan-backed Securities Loan-backed securities, assets created by pooling individual loans and selling shares in that pool (a process called securitization), have become extremely popular over the past two decades. Mortgage-backed securities, created by pooling thousands of individual home mortgage loans and selling shares to investors, are the best known example. Securitization has also been widely applied to student loans, credit card loans, and auto loans. These loan-backed securities trade on financial markets like bonds. They are appealing to investors because they provide more diversification and liquidity than individual loans. However, with so many loans packaged together, it can be difficult to assess the true quality of the asset. That difficulty came to haunt investors during the financial crisis of 2007–2008, when the bursting of the housing bubble led to widespread defaults on mortgages and large losses for holders of “supposedly safe” mortgage-backed securities, causing pain that spread throughout the entire financial system.

Stocks A stock is a share in the ownership of a company. A share of stock is a financial asset from its owner’s point of view and a liability from the company’s point of view. Not all companies sell shares of their stock; “privately held” companies are owned by an individual or a few partners, who get to keep all of the company’s profit. Most large companies, however, do sell stock. For example, as this book goes to press, Microsoft has more than 8 billion shares outstanding; if you buy one of those shares, you are entitled to about one-eight billionth of the company’s profit, as well as 1 of 8 billion votes on company decisions.

Why does Microsoft, historically a very profitable company, allow you to buy a share in its ownership? Why don’t Bill Gates and Paul Allen, the two founders of Microsoft, keep complete ownership for themselves and just sell bonds for their investment spending needs? The reason, as we have just learned, is risk: few individuals are risk-tolerant enough to face the risk involved in being the sole owner of a large company.

Reducing the risk that business owners face, however, is not the only way in which the existence of stocks improves society’s welfare: it also improves the welfare of investors who buy stocks (that is, shareowners, or shareholders). Shareowners are able to enjoy the higher returns over time that stocks generally offer in comparison to bonds. Over the past century, the average annual return on U.S. stocks has been about 7% after adjusting for inflation; for U.S. bonds the average annual return during the same time period has been only about 2%. But as investment companies warn you, “Past performance is no guarantee of future performance.” And there is a downside: owning the stock of a given company is riskier than owning a bond issued by the same company. Why? Loosely speaking, a bond is a promise while a stock is a hope: by law, a company must pay what it owes its lenders (bondholders) before it distributes any profit to its shareholders. And if the company should fail (that is, be unable to pay its interest obligations and declare bankruptcy), its physical and financial assets go to its bondholders—its lenders—while its shareholders typically receive nothing. So, although a stock generally provides a higher return to an investor than a bond, it also carries higher risk.

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The financial system has devised ways to help investors as well as business owners simultaneously manage risk and enjoy somewhat higher returns. It does that through the services of institutions known as financial intermediaries.

A financial intermediary is an institution that transforms funds gathered from many individuals into financial assets. The most important types of financial intermediaries are mutual funds, pension funds, life insurance companies, and banks. About three-quarters of the financial assets Americans own are held through these intermediaries rather than directly.

Mutual Funds As we’ve explained, owning shares of a company entails risk in return for a higher potential reward. But it should come as no surprise that stock investors can lower their total risk by engaging in diversification. By owning a diversified portfolio of stocks—a group of stocks in which risks are unrelated to, or offset, one another—rather than concentrating investment in the shares of a single company or a group of related companies, investors can reduce their risk. In addition, financial advisers, aware that most people are risk-averse, almost always advise their clients to diversify not only their stock portfolio but also their entire wealth by holding other assets in addition to stock—assets such as bonds, real estate, and cash. (And, for good measure, to have plenty of insurance in case of accidental losses!)

However, for individuals who don’t have a large amount of money to invest—say $1 million or more—building a diversified stock portfolio can incur high transaction costs (particularly fees paid to stockbrokers) because they are buying a few shares of a lot of companies. Fortunately for such investors, mutual funds help solve the problem of achieving diversification without high transaction costs. A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors. By buying these shares, investors with a relatively small amount of money to invest can indirectly hold a diversified portfolio, achieving a better return for any given level of risk than they could otherwise achieve.

The mutual fund industry represents a huge portion of the modern U.S. economy, not just of the U.S. financial system. In total, U.S. mutual funds had assets of $13 trillion at the end of 2012. The largest mutual fund company at the end of 2013 was Vanguard Group, Inc., which managed almost $2.4 trillion in funds.

We should mention, by the way, that mutual funds do charge fees for their services. These fees are quite small for mutual funds that simply hold a diversified portfolio of stocks, without trying to pick winners. But the fees charged by mutual funds that claim to have special expertise in investing your money can be quite high.

Pension Funds and Life Insurance Companies In addition to mutual funds, many Americans have holdings in pension funds, nonprofit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire. Although pension funds are subject to some special rules and receive special treatment for tax purposes, they function much like mutual funds. They invest in a diverse array of financial assets, allowing their members to achieve more cost-effective diversification and conduct more market research than they would be able to individually. At the end of 2013, pension funds in the United States held more than $18.9 trillion in assets.

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Americans also have substantial holdings in the policies of life insurance companies, which guarantee a payment to the policyholder’s beneficiaries (typically, the family) when the policyholder dies. By enabling policyholders to cushion their beneficiaries from financial hardship arising from their death, life insurance companies also improve welfare by reducing risk.

Banks Recall the problem of liquidity: other things equal, people want assets that can be readily converted into cash. Bonds and stocks are much more liquid than physical assets or loans, yet the transaction cost of selling bonds or stocks to meet a sudden expense can be large. Furthermore, for many small and moderate-sized companies, the cost of issuing bonds and stocks is too large, given the modest amount of money they seek to raise. A bank is an institution that helps resolve the conflict between lenders’ needs for liquidity and the financing needs of borrowers who don’t want to use the stock or bond markets.

A bank works by first accepting funds from depositors: when you put your money in a bank, you are essentially becoming a lender by lending the bank your money. In return, you receive credit for a bank deposit—a claim on the bank, which is obliged to give you your cash if and when you demand it. So a bank deposit is a financial asset owned by the depositor and a liability of the bank that holds it.

A bank, however, keeps only a fraction of its customers’ deposits in the form of ready cash. Most of its deposits are lent out to businesses, buyers of new homes, and other borrowers. These loans come with a long-term commitment by the bank to the borrower: as long as the borrower makes his or her payments on time, the loan cannot be recalled by the bank and converted into cash. So a bank enables those who wish to borrow for long lengths of time to use the funds of those who wish to lend but simultaneously want to maintain the ability to get their cash back on demand. More formally, a bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance borrowers’ investment spending on illiquid assets.

In essence, a bank is engaging in a kind of mismatch: lending for long periods of time but also subject to the condition that its depositors could demand their funds back at any time. How can it manage that?

The bank counts on the fact that, on average, only a small fraction of its depositors will want their cash at the same time. On any given day, some people will make withdrawals and others will make new deposits; these will roughly cancel each other out. So the bank needs to keep only a limited amount of cash on hand to satisfy its depositors. In addition, if a bank becomes financially incapable of paying its depositors, individual bank deposits are currently guaranteed to depositors up to $250,000 by the Federal Deposit Insurance Corporation, or FDIC, a federal agency. This reduces the risk to a depositor of holding a bank deposit, in turn reducing the incentive to withdraw funds if concerns about the financial state of the bank should arise. So, under normal conditions, banks need hold only a fraction of their depositors’ cash.

By reconciling the needs of savers for liquid assets with the needs of borrowers for long-term financing, banks play a key economic role.