1. Lecture 10
Financial Markets
& Institutions
Introductory Finance for
Economics (ECN104)
Module Leader:
Farzad Javidanrad
Based on: Principle of Cooperate Finance by Brealey, Myers and Allen (2014)
(Spring 2013-2014)
Department of Economics
The University of Sheffield

2. Financial System & Financial Markets
• Financial system is a system that allows moneys to be transferred from the
individuals and companies with the surplus funds to those who have the
shortage of funds.
• The system can be defined at the global, regional or even specific firm level.
The regional financial systems is a set of banks and other financial
institutions, financial markets, financial services at a regional level.
• A healthy regional financial system directs funds to where that increase
productivity and promote economic stability and growth.
• At a global level, financial system comprises of the International Monetary
Fund (IMF), central banks, World Bank and major banks that work
internationally.
• Financial market is a market that money and financial securities (such as
stocks and bonds) and some commodities (such as some agricultural goods
and precious metals) are traded. Some financial markets are small in terms
of participants and number of transactions but some of them are very active
such as London Stock Exchange and New York Stock Exchange with over
trillion dollars trade in a day.

3. Financial Markets
• There are different types of financial markets:
1. Capital Markets; where money can be borrowed or lent for a long-period in
order to finance the projects of corporations through issuing bonds and
stocks. This market is subdivided to:
1.1 Bond Markets
1.2 Stock Markets
Each of them are subdivided to the Primary Market; where new issues are
first offered and the Secondary Market; where old issues are offered for
another trade.
2. Money Markets; where money is borrowed and
lent for a short-period of time (from several days up
to a year), mostly through interbanking lending.
Types of securities in this market are Certificates of
Deposits (CDs), government bonds,
commercial papers and etc.
Adopted from http://crackmba.com/financial-markets/

4. Financial Markets
3. Commodity Markets; where large amount of commodities such as gold,
silver, oil, wheat, coffee, sugar and etc. are being traded.
4. Insurance Markets; where buyers transfer risk of heavy loss to sellers in
exchange for payments.
5. Derivatives Markets; where financial instruments such as future contracts
and options are being traded.
6. Foreign Exchange Markets; where different currencies are exchanged. The
main participants of these markets are banks.
• Flow of funds through the financial system can happen in two ways:
a) Direct Finance: Funds move directly from lender/savers (investors) to
borrower/spenders via financial markets in exchange with financial
instruments (securities).
b) Indirect Finance: Funds moves first to the financial institutions (financial
intermediaries) and then lent to the borrowers.
 Graph in the next slide help to visualise these relations.

5. Flow of Fund Through the Financial System
Financial
Institutions
Financial
Market
Lenders/Savers:
• Households
• Firms
• Governments
• Foreign Investors
Borrowers/Spenders:
• Households
• Firms
• Governments
• Foreign Borrowers
Indirect Finance
Direct Finance

6. Types of Financial Institutions
• There are six types of financial institutions (intermediaries):
I. Commercial banks
II. Investment banks
III. Insurance companies
IV. Pension funds
V. Mutual funds
VI. Hedge funds
 Commercial banks accept deposits and offer loan to individual and
firms. They also serve as payment agents to facilitate the money
transfer between different individuals, companies and organisations.
 Investment banks do not take deposits and usually do not serve the
general public. They help companies to raise money, for example, by
underwriting companies' stocks and distributing (or reselling) them
to potential investors in the market. They also advice companies on
takeovers (purchase of one company by another), mergers
(combination of two or more companies) and acquisitions (buying
most, if not all, of another company's ownership)

7. Types of Financial Institutions
 Insurance companies make profit by insuring a large number of
people or companies at the same time. They are one of the
important sources of funds for corporations. They provide long-
term loans directly for companies through buying their bonds
and stocks.
 Pension funds are one of the largest fund providers around the
world and designed for long-term investments. They have tax
advantageous meaning the returns of their investment are not
taxed before the final withdrawn.
 Mutual funds are the professionally managed investment schemes
that raise money from different investors in order to invest in a
portfolio of securities. For many investors it is more efficient to buy
securities from a mutual fund than investing directly in individual
securities as these institutions try to find those stocks that generate
return better than the average returns.

8. Types of Financial Institutions
 Hedge funds like mutual funds pool money
from different investors to invest on their
behalf but they do not serve the general
public but the big investors such as pension
funds or very rich individuals. They have
limited liabilities and require a very large
level of minimum investment. Adopted from www.fca.org.uk/static/documents/hedge-fund-survey.pdf
• Failing or closing a very large hedge fund may put the financial system in the risk of instability either
through drying out the credit channel or through selling the collaterals simultaneously (needed for hedge
funds transactions).
• “Hedge funds use leverage to increase the size of the positions taken in financial markets. In some cases,
the use of leverage allows them to become large enough to suggest they could impact the wider financial
system in certain situations. Hedge funds obtain leverage either by borrowing money or securities from
counterparties (known as financial leverage) or by using derivative instruments such as options, futures
or swaps. …. the largest proportion of total leverage used by hedge funds in the UK is acquired using
derivatives. Derivative transactions allow hedge funds to acquire market/economic exposures (which
this report refers to as the Gross Notional Exposure) that are many times bigger than the capital of the
fund: for example a hedge fund may pay or receive USD 1m to buy or sell an option with an underlying
market exposure of USD 100m.”(Financial Conduct Authority, March 2014, Hedge Fund Survey, p.4)

9. Asymmetric Information & Free-Rider Problem
• A healthy financial system must overcome two problems:
A. Asymmetric information: A situation in which one side (party) of a
transaction (for example, seller) has more or better information compared
to another (here; the buyer) and causes imbalance of power. Asymmetric
information leads to two problems:
A.1. Adverse selection (before a transaction is completed) arises because
the party who is most eager to engage in a transaction is the one most likely
to produce an undesirable (adverse) outcome for another party.
For example, in the health insurance
market, buyers with health problems have
an incentive to hide their health problems
in order to pay lower insurance premium.
So, at any level of premium, there are
some buyers who are willing to be covered
as they know the cost of treatment is
higher than the cost of premium.
Adopted from http://dutchhealthcare.wordpress.com/2011/01/26/adverse-selection/

10. Asymmetric Information & Free-Rider Problem
A.2. Moral hazard (after a transaction
is completed) arises when one party is
engaged in activities that are undesirable
from other party’s point of view. For
example, when financial institutions
are bailed out by the state (in order to
protect people’s deposits) some financial
institutions carelessly enter into some
risky investments.
B. Free-rider problem: A situation when a party is benefited from something
but does not pay the price of that. For example, an individual who can get a
profit from a stock trade without using any of his or
her own money (Arbitrage Opportunity). Another
example is the people who get benefited from the
defence budget but do not pay their taxes.
Adopted from http://www.michaelwdean.com/
Adoptedfromhttp://mcjags.com/Page/10126

11. Financial Development & Economic Growth
• Financial institutions are important as they theoretically
1. Promote economic growth through facilitating trade and capital movement
2. Provide credit for individual and firms
3. Identify creditworthy firms
4. Pool the risks of the individual entities
5. Mobilise savings to investment projects
6. Reallocating capital with a low transactions costs
• “The relationship between financial development and economic growth has
received great attention during the last few decades. Many economists
have emphasised the significance of financial sector development in the
process of economic growth, whereas other economists believe that this
importance is over-stressed. However, the debate is not new in the
economics development literature and can be traced back to Bagehot
(1873) and Hicks (1969) which argued that financial development was an
important channel in the industrialisation of England, by helping the
movement of large amounts of funds for “immense” works.”(Javidanrad, Causal Relationship
between Financial Development & Economic Growth, p. 11)

12. Financial Development & Economic Growth
• How much are they good practically?
• It is naive to think that the private financial institutions are committed to
boost the economic growth. “Private financial institutions do not lend money to
create jobs or to facilitate transactions in economy but to make a bigger profit. They
have great interest to expand their business [through lending] … in order to have a
bigger share of the cake” (Javidanrad, The Impact of the Size of Financial Sector on Real Sector, (2013), P. 1)
Adopted from http://www.toonpool.com/cartoons/Stock%20Markets%20fall_100913

13. Financialisation of the Economy
• “In a modern economy real sector activities are heavily reliant on the
financial sector services. Even in a simple transaction between individual
buyers and sellers financial institutions and their instruments, such as
debit/credit cards and overdraft facilities, play a central and imperative
role. Many financial instruments have been created and encouraged to be
accepted by households and firms just to enable financial institutions to
have a bigger share of capital in economy. Some economists, such as
Stockhammer (2012), use the term “financialisation” to indicate on this
dominance.” (Ibid, p. 2)
• “He argues that financialisation has changed the non-financial actors’
perceptions about themselves and their motives and has led to the shift of
power from labour to capital in one hand and from company to
lenders/shareholders on the other hand. The main outcome of this shift is
the firms’ concentration on profit growth, in order to make lenders and
shareholders more satisfied, while the reinvestment of the profit shows a
slow growth.”(Ibid, p. 2)

14. Growth of the Financial Sector
• The financial sector’s share of aggregate income, which reflects the concept of
financialisation, has had a rapid growth compare to the same in the real part
of the economy.
• Data collected from the Blue Book (2013) in the UK shows that the
percentage share of GDP (income approach) has increased for financial
corporations from 1.96% in 1999 to 2.55% in 2012 while the same percentage
share has dropped for the private non-financial corporations in the UK from
19% in 1999 to 16.56% in 2012. The picture is more evident when the 8.58%
average of yearly growth rate of the financial corporations in 14 years (1999-
2012) is compared with 3.03% average yearly growth rate of non-financial
corporations.
0
20
40
60
80
100
120
140
160
180
1990 1995 2000 2005 2010 2015
Percentage
Years
UK's Net Debt as a % of GDP
Source : ONS
Increasing the number of profitable
financial institutions has no meaning
just the expansion of debt because
with the expansion of credit and
increasing debt they can survive.

15. Financial Crisis & Minsky Moment
• Most macroeconomists work with "equilibrium models" meaning the
economy is moving from one stable situation to another stable situation. So,
instability occurs when there is an external shock such as a disaster, war,
dramatic rise in oil prices or even something good such as technological
changes.
• Minsky believed that the economic system could generate shocks through its
own internal dynamics. Through his theory of financial instability
hypothesis he explains the formation of instability during the periods of
economic stability (when firm’s cash flow is more than the total amount of
their debt) when agents become less rational in their activities.
• They assume that the good times will continue and begin to take greater risks
in order to increase their profit. Financial institutions and big corporations
start to increase their speculative activities. The root of the future crisis starts
from here.
• He defines three types of financing that firms could choose according to their
risk tolerance : Hedge Finance, Speculative Finance and Ponzi Finance. The
terms hedge, speculative, and Ponzi finance are used to indicate the relative
difficulties that economic units have in repaying their debt.

16. Financial Crisis & Minsky Theory
• He believes that the accumulation of debt is the major element that
leads an economy towards a crisis. Hedge borrowers will be able to
repay their debt and interest. With the rise of speculative financing,
speculative borrowers know that profits will not cover all their liabilities,
however, they believe that more investment leads to more profits and there
will be no problem.
• lenders also start thinking that they will get back all the money they have lent
or alternatively they can use their acquisition rights to own the firm/house.
Therefore, they are ready to lend to firms, households or even other financial
institutions (perhaps more short term with higher level of interest) without
full guarantees of success. Lenders know that such borrowers might have
problems repaying but they still believe their borrowers will refinance from
elsewhere and repayment will continue. This is Ponzi financing where the
economy has entered into a very risky and unstable situation. Now it is only
a question of time before default of borrowers happen in an industrial scale.
Lenders stop giving credit so easily, so the financial institutions return to
hedge finance.

17. Financial Crisis & Minsky Theory
Hedge Finance
Lenders and borrowers are cautious
Less lending / less borrowing
Speculative Finance
Assuming good situation & continuation of
that
Starting risky borrowing /lending
Ponzi Finance
Too much risky borrowing / lending
Soaring asset prices / Forming bubbles
Start of the bankruptcy