1.1 The Financial System
In this section, we provide an overview of the financial system, and in the two following sections we focus on financial markets. The financial systemThe system that transfers money between suppliers and users. It comprises financial intermediaries, markets, and instruments (securities)., as shown in Figure 1.1, transfers money from suppliers (such as individual households), to users, such as companies. Suppliers have savings that they want to invest to earn a return. Users need money to fund their activities. For example, individuals borrow to finance a home purchase, businesses expand their factories, and governments build roads. The financial markets are the places in which suppliers and users transact. They usually transact through intermediaries and seldom transact directly with each other. The intermediaries include (commercial) banks, investment banks, funds, and insurance companies.
Figure 1.1 The Financial System
Source: FlatWorld
Table 1.1 Definitions of Terms in Figure 1.1
| Individuals (Suppliers) | Individuals are the primary investors in the economy. Ultimately, they own every business asset. As individuals plan for retirement (or set aside money for other goals), they invest their savings in the financial system with the expectation of converting them into greater savings for the future. |
| Businesses (Suppliers) | Businesses supply funds in the form of retained earnings (money earned in prior periods that is not distributed to shareholders). |
| Individuals (Users) | Individuals borrow to finance homes, cars, and holidays. |
| Businesses (Users) | Businesses use money to start new projects. They borrow money and raise equity. |
| Governments (Users) | Governments borrow to pay for operating deficits and to fund capital improvement projects—like new highways. |
| Banks & Thrifts (Financial Intermediaries) | Banks and thrifts take deposits from savers and lend to individuals (i.e., mortgages) and businesses (i.e., lines of credit and commercial loans). They profit from spread between rate charged on loans and rate paid on deposits. |
| Investment Banks (Financial Intermediaries) | Investment banks help companies, municipalities, and states raise capital by selling securities to the public. They profit from spread between price paid to security issuer and price charged to investor. They provide financial consulting to companies. |
| Mutual and Hedge Funds (Financial Intermediaries) | Funds invest in private businesses and financial securities on behalf of individual savers. They profit from management fees charged to savers. |
| Insurance Companies (Financial Intermediaries) | Insurance companies collect premiums from individuals/businesses for life and property insurance. They invest premium income prior to paying out claims. They profit if premium plus investment income exceeds claims. |
| Money Markets (Financial Markets) | Assets that mature in less than one year, such as treasure bills. |
| Capital Markets (Financial Markets) | Assets that mature in more than one year, such as stock. |
To give you a sense of who the suppliers and users are, let’s look at two specific markets: the bond and equity markets. Figure 1.2 shows the users and suppliers of capital in the U.S. bond marketThe market for coupon and zero coupon bonds with maturities ranging from one to thirty years and includes bonds issued by governments and corporations..
Figure 1.2 U.S. Bond Market Suppliers and Users
Sources: Data from SIFMA; FlatWorld
Figure 1.2 shows that the largest user of capital in the bond market is the government. Federal, state, and local governments along with agencies and government-sponsored enterprises (e.g., Freddie Mac) account for 65% of bond issuance. Corporations only account for 14% of bond market issuance. On the supply side, the largest supplier are governments who buy 44% of all bonds, but you should note that households don’t generally buy bonds directly. Direct holdings account for only 10% of the market. It is more common for households to own bonds through mutual funds or through their retirement accounts. The bond markets are not retail markets in the sense that public investors buy the securities directly.
Figure 1.3 U.S. Equity Market Suppliers and Users
Source: Data from U.S. Equity Issuers; FlatWorld
As shown in Figure 1.3, it is not surprising that the largest issuer in the equity markets is publicly traded corporations. The equity market is much more of a retail market as shown by the fact that households directly account for 41% of the supply capital. Of course, households also supply capital to equity markets indirectly through mutual funds and retirement accounts.