1.4 Module 23: The Financial System

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Understanding the Financial System

A well-functioning financial system brings together the funds of investors with those looking to fund investment spending projects (making the rise of Facebook, as we saw in the section-opener, possible). Financial markets have been around for centuries. In fact, capital inflows financed the early economic development of the United States, through investment spending in mining, railroads, and canals. Let’s begin by understanding exactly what is traded in financial markets.

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 of the financial asset) to future income from the company.

A household can also invest its current savings or wealth by purchasing a physical asset, a tangible object that can be used to generate future income such as a preexisting house or 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 get a loan from your local bank—say, to buy a new car—you and the bank are 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 are also creating a liability, a requirement to pay income 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. We’ll explain in detail shortly who bears the liability for each type of financial asset.

The four types of financial assets—loans, stocks, bonds, and bank deposits—exist because the economy has developed a set of specialized markets, like the stock market and the bond market, and specialized institutions, like banks, that facilitate the flow of funds from lenders to borrowers.

Earlier, in the context of the circular-flow diagram, we defined the financial markets and institutions that make up the financial system. A well-functioning financial system encourages greater savings and investment spending and ensures that both are undertaken efficiently. To understand how these processes occur, we need to know what tasks the financial system needs to accomplish. Then we can see how the job gets done.

Three Tasks of a Financial System

Our earlier analysis of the loanable funds market ignored three important problems facing borrowers and lenders: transaction costs, 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, making it more likely that lenders and borrowers will make mutually beneficial trades that make society as a whole richer.

Task 1: Reducing Transaction CostsThe expenses involved in actually putting together and executing a deal are known as transaction costs. 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, with the result that the entire deal would probably be unprofitable.

Fortunately, there is another option: when large businesses want to borrow money, they either go to 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 shortly. 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.

Task 2: Reducing RiskAnother problem that real-world borrowers and lenders face is financial risk, or simply, risk, uncertainty about future outcomes that involve the potential for financial losses or gains. For example, owning and driving a car entails the financial risk of a costly accident.

Most people experience the loss in welfare from losing a given amount of money more intensely than they experience the increase in welfare from gaining the same amount of money. A person who is more sensitive to a loss than to a gain of an equal dollar amount is called risk-averse. Most people are risk-averse, although to differing degrees. For example, people who are wealthy are typically less risk-averse than those who are not so well-off.

A well-functioning financial system helps people reduce their exposure to risk, which risk-averse people prefer to do. Suppose the owner of a business expects to make a greater profit if she buys additional capital equipment, but she isn’t completely sure that this will indeed happen. 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.

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 also achieved diversification: she has been able to invest 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, a financial asset. These investments are likely to carry some risk of their own; for example, her bank may fail or her house may burn down (though in the United States it is likely that she is partly protected against these risks by insurance).

But even in the absence of insurance, she is better off having maintained investments in these different assets because their different risks are unrelated, or independent, events. This means that her house is no more likely to burn down if her business does poorly and that her bank is no more likely to fail if her house burns down. To put it another way, if one asset performs poorly, it is very likely that her other assets will be unaffected and, as a result, her total risk of loss has been reduced. But if she had invested all her wealth in her business, she would have faced the prospect of losing everything if the business had performed poorly. 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 to reduce total risk by engaging in diversification is why we have stocks and a stock market.

Task 3: Providing LiquidityFinancial systems also exist to provide investors with liquidity, a concern that—like risk—arises because the future is uncertain. Suppose that, having made a loan, a lender suddenly finds himself in need of cash—say, to meet a medical emergency. Unfortunately, if that loan was made to a business that used it to buy new equipment, the business cannot repay the loan on short notice to satisfy the lender’s need to recover his money. Knowing in advance that there is a danger of needing to get his money back before the term of the loan is up, our lender might be reluctant to lock up his money by lending it to a business.

An asset is liquid if it can be quickly converted into cash with relatively little loss of value, illiquid if it cannot. As we’ll see, stocks and bonds are a partial answer to the problem of liquidity. Banks provide an additional way for individuals to hold liquid assets and still finance illiquid investment spending projects.

Now that we’ve learned the three ways the financial system helps lenders and borrowers make mutually beneficial deals—by reducing transaction costs and risk, and by providing liquidity—we’ll look at how it goes about achieving these tasks.

Types of Financial Assets

A loan is a financial asset to the issuer but a liability to the person taking it out.

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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 serves a somewhat different purpose. We’ll examine loans, bonds, stocks, and loan-backed securities now. Then we’ll turn to the role played by bank deposits.

LoansA lending agreement made between an individual lender and an individual borrower is a loan. Individuals are likely to encounter loans in the form of a student loan or a bank loan to finance the purchase of a car or a house. Small businesses usually use bank loans to buy new equipment.

On the positive side, loans are typically 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 pay.

On the negative side, making a loan to an individual person or a business 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.

BondsAn IOU issued by a borrower is called a bond. 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 anyone willing to buy them, a process that avoids costly negotiation of the terms of a loan with many individual lenders.

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 will 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—one 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, making them a lot less liquid than bonds.

Loan-Backed SecuritiesLoan-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. While mortgage-backed securities, in which thousands of individual home mortgages are pooled and then shares are sold 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 are traded on financial markets like bonds; they are preferred by 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 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, creating pain that spread throughout the entire financial system.

StocksA 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, Microsoft has over 8 billion shares outstanding; if you buy one of those shares, you are entitled to one-eight-billionth of the company’s profit, as well as 1 of 8 billion votes on company decisions.

Selling stock reduces risk for business owners and benefits investors who buy the stock.

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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 is risk: few individuals are risk-tolerant enough to face the risk involved in being the sole owner of a large company.

But stocks do more than reduce the risk that business owners face. The existence of stocks improves society’s welfare and improves the welfare of investors who buy stocks. Shareowners are able to enjoy the higher returns over time that stocks generally offer in comparison to bonds. Over the past century, stocks have typically yielded about 7% after adjusting for inflation; bonds have yielded 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 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 generally receive nothing. So although a stock generally provides a higher return to an investor than a bond, it also carries higher risk.

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

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 FundsOwning shares of a company entails accepting 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.

Many mutual funds also perform market research on the companies they invest in. This is important because there are thousands of stock-issuing U.S. companies (not to mention foreign companies), each differing in terms of its likely profitability, dividend payments, and so on. It would be extremely time-consuming and costly for an individual investor to do adequate research on even a small number of companies. Mutual funds save transaction costs by doing this research for their customers.

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 $14.8 trillion at the end of 2013.

We should mention, by the way, that mutual funds 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 CompaniesIn 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 market research than they would be able to achieve on their own.

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.

BanksRecall that, 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 the illiquid investment spending needs of borrowers.

An increase in bank deposits in South Korea in the late 1960s allowed businesses to launch an investment spending boom that contributed to the country’s spectacular economic growth.

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In essence, a bank is engaging in a kind of mismatch: lending for long periods of time while 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 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.

Financial Fluctuations and Macroeconomic Policy

We’ve learned that the financial system is an essential part of the economy; without stock markets, bond markets, and banks, long-run economic growth would be hard to achieve. Yet the news isn’t entirely good: the financial system sometimes doesn’t function well and instead is a source of instability in the short run because of asset price fluctuations. We saw this in 2008 as the economy faced a severe slump resulting from a sharp reduction in home values (a situation that we examine in detail in the upcoming Economics in Action).

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How should economists and policy makers deal with the fact that asset prices fluctuate a lot and that these fluctuations can have important economic effects? This question has become one of the major problems for macroeconomic policy. On one side, policy makers are reluctant to assume that the market is wrong—that asset prices are either too high or too low. It’s hard to make the general case that government officials are better judges of appropriate prices than private investors who are putting their own money on the line.

On the other side, the past 15 years were marked by not one but two huge asset bubbles, each of which created major macroeconomic problems when it burst. In the late 1990s the prices of technology stocks, including but not limited to dot-com Internet firms, soared to hard-to-justify heights. When the bubble burst, these stocks lost, on average, two-thirds of their value in a short time, helping to cause the 2001 recession and a period of high unemployment. A few years later there was a major bubble in housing prices. The collapse of this bubble in 2008 triggered a severe financial crisis followed by a deep recession.

These events have led to a fierce debate among economists over whether policy makers should try to pop asset bubbles before they get too big.

THE GREAT AMERICAN HOUSING BUBBLE

Between 2000 and 2006, there was a huge increase in the price of houses in America. By the summer of 2006, home prices were well over twice as high as they had been in January 2000 in a number of major U.S. metropolitan areas, including Los Angeles, San Diego, San Francisco, Washington, Miami, Las Vegas, and New York. By 2004, as the increase in home prices accelerated, a number of economists (including the authors of this textbook) argued that this price increase was excessive—that it was a bubble, a rise in asset prices driven by unrealistic expectations about future prices.

It was certainly true that home prices rose much more than the cost of renting a comparable place to live. Panel (a) of Figure 23-1 compares a widely used index of U.S. housing prices with the U.S. government’s index of the cost of renting, both shown as index numbers with January 2000 = 100. Home prices shot up, even though rental rates grew only gradually.

Sources: Panel (a): Standard and Poor’s; Bureau of Labor Statistics. Panel (b): Federal Reserve Bank of St. Louis.

Yet there were also a number of economists who argued that the rise in housing prices was completely justified. They pointed, in particular, to interest rates that were unusually low in the years of rapid price increases, and they argued that low interest rates combined with other factors, such as growing population, explained the surge in prices. Alan Greenspan, then chairman of the Federal Reserve, conceded in 2005 that there might be some “froth” in the markets but denied that there was any national bubble.

Unfortunately, it turned out that the skeptics were right. Greenspan himself would later concede that there had, in fact, been a huge national bubble. In 2006, as home prices began to level off, it became apparent that many buyers had held unrealistic expectations about future prices. As home prices began to fall, expectations of future increases in home prices were revised downward, precipitating a sudden and dramatic collapse in prices. And with home prices falling, the demand for housing fell drastically, as illustrated by panel (b) of Figure 23-1.

The implosion in housing, in turn, created numerous economic difficulties, including severe stress on the banking system.

Module 23 Review

Check Your Understanding

List and describe the four most important types of financial intermediaries.