Two categories of contracts in financial markets for interactions between lenders and borrowers:
(1) Debt contracts: fixed contract
they specify the future payment from borrowers to lenders.
Lenders also are referred to as savers, creditors, investors. These people purchase the financial products.
Borrowers also are called debtors, sellers and issuers of financial products.
Debt contracts are not contingent at all about anything the business is doing. Lower uncertainty.
Great for debtors when extra gains are very generous. Great for lenders when gains are poor because they are promised something.
Types of debt contracts: bank loans, mortgage, treasury notes, bills, bonds, checking accounts, saving accounts, commodity paper, corporate bond, agency papers, etc
(2) Equity contracts: residual contract
borrowers buy purchasing powers, Uncertainty is higher,
Types: stocks
When contracts are traded, they are called securities.
Maturity: (mostly for bonds), bond with no maturity is perpetuity bond
Liquidity: how easily they can be converted into contract
(1) how difficult to liquidate the contract
(2) can be liquidated only by great discount
Some securities are structured to be illiquid: hedge funds,
Risk
Direct intermediary
Brokers match up buyers and sellers
Dealer buy securities out of their own accounts and sell it to the buyers
Full service provide research services
Indirect intermediation
middlemen. They participate in market transactions and put the contract on their balance sheets. When you need to invest money, what you end up doing is not investing in a particular firm, but rather buying a claim on the investment bank like JP Morgan investment bank.
(You lend JP Morgan money)
Two different economies at work:
Non-financial sector (Real economy) & Financial sector
--Households, entrepreneurs --banks
(save) (borrow) (match up)
Non-financial sector
Households are net savers, they care more about what happens on the assets sheets while net borrowers entrepreneurs pay more attention to liability sheets
Entrepreneurs issue securities that are risky and long term. Entrepreneurs want some stability in terms of borrowing because they don't want to be in short of fund in the process of doing the business.
But the households are risk-averse, that is they want to buy risk-free and short-term assets. So the problems are 1)risk-aversion asymmetry and 2)different timing preferences.
But financial sector can step in to accommodate that by issuing short-term riskless liability to households (checking account) and buying up long term risky assets (accommodate entrepreneurs). This is the importance of financial sector.
IN terms of non-financial sectors, households want to keep risk-free, short term assets. They wouldn't be very willing to buy those risky bonds. But entrepreneurs do need long term capital to investment their business. Also households tend to hoard money. Beyond that, entrepreneurs may be subject to animal spirits. So without financial intermediaries, entrepreneurs have to progressively persuade households to lend them money for a long time, which may turn out to be unsuccessful. Households won't do it unless they can get a very high return. As a result, there won't be many long term business.
Now suppose a banker steps in and opens a piggy bank. He issue short-term financial products like checking account to households for money and invest the money to the promising entrepreneurs. Based on law of large numbers, the banker doesn't have to hold all the cash. He only has to hold a fraction of it, what he has to do is make sure to households that the bank is safe to save money. Households put more money in the bank, and bank invests more in other companies.
Actually the households' money is more put in the entrepreneurs' business.
Why is this model possible? The law of large number
(1) diversification: if individual risks on something is not perfectly correlated, then as scales increases, the actual risk falls.
Two major risks in market: systematic and idiosyncratic (unsystematic) risk.
The reason why mutual fund is popular: it collects funds from many households and invest a large amount, decreasing the risk of the investment and benefiting every shareholders of the mutual fund.
Law of large number decreases the risk of entrepreneurs.
The supply of loanable funds shifts right because of the advent of the financial intermediaries
(2) underwriting/ customer selection
On the asset side of the balance sheet, we say underwriting; on the liability side, we say customer selection.
--Banks, before making the loan, will investigate whether the borrowers are able to repay. This is the underwriting process. (banks can pick out investment of better quality)
-- Banks want to know the types of households that loan the bank the money. Banks don't want people who withdraw from checking account frequently. Some banks offer interest rate in checking account to attract patient people to put money in the checking account. (Liability side)
(3) behavior modification
Bank can modify people's behavior on both sides of the balance sheet
On asset side: change entrepreneurs' decisions
On liability side: change households' decisions
Why would you put money in a bank which penalizes you from taking money out?
You are imposing negative externalities upon others. When you take money out for whatever reasons, it lowers the possibility that other people will get their money.
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