Summary: International Financial Markets (master blok 1)
Book: Financial Markets and Institutions (a European perspective) – Haan et al.
Author: Kim Cornelissen
Chapter 1: Functions of the Financial System
1.1. Functions of a financial system
The financial system
Figure 1.1; page 5 – Working of the financial system
Financial system: includes all financial intermediaries and financial markets, and their
relations with respect to the flow of funds to and from households, governments,
business firms, and foreigners, as well as the financial infrastructure. Main task is to
channel funds from sectors that have a surplus to sectors that have a shortage of funds.
Financial infrastructure: the set of institutions that enables effective operation
of financial intermediaries and financial markets, including such elements as payment
systems, credit information bureaus and collateral registries.
Direct finance: occurs if a sector in need of funds borrows from another sector
via a financial market. Financial market: is a market where participants issue
and trade securities.
Indirect finance: a financial intermediary obtains funds from savers and uses
these savings to make loans to a sector in need of finance. financial
intermediaries: coalitions of agents that combine to provide financial services,
such as banks, insurance companies, finance companies, mutual funds, pension
funds etc.
Bank-based system: indirect finance is then the main route for moving funds from
lenders to borrowers in (most) countries.
Market-based system: countries that rely on financial markets (direct finance).
A well-functioning financial system in place that directs funds to their most productive
uses is a crucial prerequisite for economic development. At times, major disruptions
occur in the financial system which are characterized by sharp declines in asset prices
and the failure of financial intermediaries (financial crisis).
If sectors with surplus funds cannot channel their money to sectors with good
investment opportunities, many productive investments will never take place.
Functioning financial system economic growth/development
,Main functions (2)
Two main functions of the financial system:
1. Reducing information and transaction costs
2. Facilitating the trading, diversification, and management of risk, to explain why
the financial sector may stimulate capital formation and/or technological
innovation (two of the driving forces of economy)
1. Reducing information asymmetry and transaction costs
Financial system helps to overcome information asymmetry between borrowers and
lenders.
Information asymmetry:
Ex-ante: before a financial contract has been agreed upon. Arises because
borrowers generally know more about their investment projects than lenders
undesirable outcome for lender (adverse selection). Because it is difficult and
costly to evaluate potential borrowers.
this may keep funds from flowing to their highest productive use.
Financial intermediaries reduce the cost of getting information and may thereby
improve resource allocation.
Ex-post: after a financial contract has been agreed upon. Occurs when
borrowers, not investors, can observe actual behavior. Once a loan has been
granted, there is a risk that the borrower will engage in activities that are
undesirable from the perspective of the lender (moral hazard).
Financial markets also mitigate the information acquisition and enforcement
costs of monitoring borrowers.
Financial intermediaries can reduce the time and money spent in carrying out financial
transactions (transaction costs) by developing expertise and take advantage of
economics of scope and scale.
Reducing information and transaction costs leads to reduction of the cost of channeling
funds between borrowers and lenders, which leads to more resources available to invest.
2. Trading, diversification, and management of risk
High return projects tend to be riskier, so financial systems that make it easier to
diversify risk by offering a broad range of low- and high-risk investment opportunities
tend to have portfolios with higher expected returns (risk diversification= same return
lower risk or opposite).
Financial intermediaries and markets provide liquidity which reduces risk, because
long-term investment are seen as more risky. Transfers short-term (liquid) assets for
savers into long-term (less liquid) long-term capital investments.
Risk measurement and management is a key function of financial intermediaries.
Securitization is the packaging of particular assets and the redistribution of these
packages by selling securities, backed by these assets, to investors (example: mortgage-
backed securities, bundling mortgage loans and issue then bonds backed by those
mortgage loans). Converts illiquid assets into liquid (sellable) assets.
,Role of government
1. Government is needed to protect property rights and to enforce contracts.
2. Government regulation is needed to encourage proper information provision
(transparency) so that providers of funds can take better decisions on how to
allocate their money. reduces adverse selection and moral hazard problems.
3. Government should arrange for regulation and supervision of financials
institutions in order to ensure their soundness (gezondheid/soliditeit).
4. Governments are responsible for competition policy to ensure competition.
Example: overcome price fixing
Foreign participants
Financial liberalization: the opening up of domestic financial markets to foreign
capital and foreign financial intermediaries.
Increases availability of funds, stimulating investment and economic growth.
Competition may be stimulated, which lead to stimulation of efficiency of
domestic intermediaries.
Opening up to foreign capital and foreign financial institutions may support
institutional reforms that stimulate financial development.
1.2. Bank-based versus market-based financial systems
Figure 1.3; page 16- The financial system in the EU-15 and the NMS-12
Financing is almost exclusively provided by banks (bank-based system) and stock
markets (market-based system) in most countries.
Providing financial functions
Markets face a free-rider problem: investors do not have strong incentives to acquire
information as they cannot keep the benefits of this information consequently, some
innovative projects may not be identified. Banks have long-run relationships with firms
and keep the information they acquire.
If ownership is very concentrated in market, then free riding may be less.
Corporate governance
Corporate governance: the set of mechanisms arranging the relationship between
stakeholders of a firm, notably holders of equity and management of the firm.
Principal-agent theory: managers (agents) may not always act in the best
interest of the owners (principal). Investors/owners (outsiders) cannot perfectly
monitor managers acting on their behalf since managers (insiders) have inside
information about the performance of the firm.
There is need for mechanisms (corporate governance) that prevent
insiders of a company using the profits of their firm for their own benefit
rather than returning the money to the outside investors.
Tools that investors can use to ensure that the management of the firm acts in their
interest:
Appointment of the board of directors: shareholders have through this an
instrument to control managers and ensure that the firm is run in their interest.
, Executive compensation: by making manager’s compensation depend on the
firm’s performance, shareholders can provide incentives for the management of
the firm.
The market for corporate control:
o Proxy contests: shareholder tries to persuade other shareholders to act in
concert with him and force the management of the firm to change course
or even to unseat the board of directors
o Friendly mergers and takeovers: then management of both firms agree that
combining the firms would create additional value.
o Hostile takeover: buy enough shares and thereby gain control of the board
and through this gain control of the firm’s management.
Concentrated holdings:
Monitoring by financial intermediaries: proponents of a bank-based system
argue that monitoring by financial institutions may be more effective, because
market for corporate control may not always ensure that managers behave in
accordance with the interests of shareholders.
Pro market-based:
Dependence on influential banks in a bank-based system may have negative
effects. Bankers act in their own interest, not of all stakeholders.
Difficulties in governing banks themselves, information asymmetries between
bank insiders and outsiders may be larger than with non-financial corporations.
Markets provide a richer set of instruments to manage risks, but bank-based
systems may provide inexpensive, basic risk-management services.
Types of activity
There is considerable evidence that financial development is good for economic growth,
there is no clear evidence that one kind of financial system is better for growth than
another.
Other differences
In practice, financial systems are always a mixture of financial markets an financial
intermediaries. IMF classifies based on:
o Arm’s-length (more market based): parties do not have any special
knowledge about each other that is not available publicly.
o Direct (longer-term) relationship: usually a bank and customer, know
much about each that is not publicly available.
Figure 1.7; page 25 – Consumption-income correlations and the Financial Index
This figure shows that consumers in a country with a more arm’s-length financial
system are better able to smooth consumption in the face of changes in their income.
Complements
Some argue that financial markets and financial intermediaries may provide
complementary growth-enhancing financial services to the economy.
intermediaries may be necessary for the successful functioning of markets.
Some argue that financial intermediaries reduce participation costs: the costs of
learning about effectively using financial markets as well as participating in them on a
day-to-day basis.
,Legal systems
Some recent research suggests that legal system differences are key in explaining
international differences in financial structure.
in this approach: the financial system is a set of contracts that is defined and
made more or less effective by legal rights and enforcement mechanisms. A well-
functioning legal system facilitates the operation of both financial markets and
intermediaries.
1.3. Recent changes
In the years before the financial crisis the bank system in industrial countries saw two
major changes:
1. Traditional banking model (in which the issuing bank hold loans until they are
repaid) was increasingly replaced by the originate and distribute banking
model: in this model banks pool loans (like mortgages) and then tranch and sell
them via securitization (packaging). Banks created structured products, often
referred to as collateralized debt obligations (CDOs):
o First step is to form diversified portfolios of mortgages and other types of
loans.
o Next step is to slice these portfolios into different tranches and these are
then sold to investors.
Figure 1.9; page 31 – Securitisation
The safest tranche (super senior tranche) offers investors a relatively low
interest rate but it is the first to be paid out of the cash flows of the
portfolio.
1. Super senior tranche
2. Mezzanine tranches
3. Most junior tranche, equity tranche, toxic waste, stub (bear
loss first)
Buyers of securitized instruments can protect themselves by buying credit default
swaps (CDSs), which are contracts insuring default. Pays a fee each period in
exchange for a contingent payment in the event of credit default.
2. Figure 1.10; page 33 – Long intermediation chain
This securitization led to a non-regulated shadow banking system, which refers
to institutions that support bank style maturity transformation (funding long-
term assets with short-term debt) outside banks and without access to a central
bank liquidity backstop.
To facilitate securitization, banks set up off-balance sheet vehicles, like special
purpose vehicles (SPVs). Banks were not required to hold up equity capital for
these vehicles’ assets, so they could use it to reduce capital requirements
imposed by bank regulation.
1.4. Conclusions
Table 1.3; page 35 – Bank-based vs. market-based financial systems.
Page 33-35 gives short summary (read it!)
,Chapter 2: Financial Crises
2.1. Introduction
3 types of crises:
Banking crisis: a significant part of a country’s banking sector has become
insolvent after heavy investment losses, banking panics or both.
o Systemic banking crisis: a country’s corporate and financial sectors
experience a large number of defaults and financial firms face great
difficulties repaying contracts on time. As a result, non-performing loans
increase sharply and all or most of the aggregate banking system capital is
exhausted.
o Non-systemic banking crisis: not all capital is exhausted.
Sovereign debt crisis: involves outright default on payment of debt obligations.
This occurs when a government fails to meet interest or principal payments on
its debt obligations.
o External debt: loans issued under another country’s jurisdiction and is
often denominated in a foreign currency and held by foreign creditors.
o Domestic debt: is issued under a country’s own jurisdiction and is
typically denominated in the local currency and held by domestic
creditors.
In a default countries sometimes repudiate (verstoten) their debt, but it is more
common that a government restructures debt on terms less favourable to the
lender than in the original contract (like a longer maturity and lower interest rate.
Currency crisis: the value of a country’s currency falls precipitously. Countries
maintaining an (almost) fixed exchange rate regime are vulnerable to sudden
crises of confidence, leading to speculative attacks that can blow up the stable
regimes. They think it will depreciate and all go to other country: excess supply
depreciates even more can’t keep fixed exchange rate.
Box 2.1; page 41 – The EMS crisis (currency crisis happened in EMU)
Figure 2.1; page 42 – Incidence of financial crises
First figure shows 5 episodes with many external debt defaults. Second figure shows
that highest incidence was during the great depression (1930s).
Systemic banking crises are typically preceded by credit booms (growth of credit above
the trend of GDP growth) and asset price bubbles (a rise of asset prices above their
fundamental economic value).
Twin crises: many financial crises, especially those in countries with fixed exchange
rates, are so-called twin crises with currency depreciation exacerbating (verergeren)
banking sector problems through foreign currency exposures of borrowers or banks
themselves.
Banking crises often precede or accompany sovereign debt crises, because the aftermath
of a systemic banking crisis often involves protracted and pronounced contraction in
economic activity and put important strain on the government’s financial position.
, the indirect fiscal consequences of a banking crisis are much larger than the costs of
bank bailouts. Government debt increases 86% in the three years after systemic banking
crisis.
Table 2.1; page 46 – Debt and banking crises in European countries
Four crisis indicators for European countries in this table:
The share of years a country was in default since 1800 or the year in which it
became independent
The share of years with a banking crisis
The numbers of banking crises since 1800 and 1945
four conclusions out of table:
1. The share of years in default varies considerably among European countries
2. Several countries have been able to avoid a debt crisis, all countries have spent
some time in a banking crisis since 1800
3. The average length of time a country spends in a state of average default exceeds
the average amount of time spent in banking crisis.
4. The number of banking crises has dropped off markedly after WW II.
2.2. Theory
Theoretical models either focus on the asset or the liability side of the bank balance sheet
to explain banking crises.
Theories focusing on liability side
Banking problems arise from the liability side according to these theories.
Diamond and Dybvig model
Banks borrow in the form of short-term savings and demand deposits which can be
withdrawn at short notice and they lend at the same time at longer maturities in the form
of loans to firms and households.
should hold sufficient reserves to handle withdrawals of deposits, but during a run
lose depositors confidence in the bank and withdraw en masse
bank is forced to liquidate assets, typically against ‘fire sale’ prices, especially if
the assets are illiquid
as banks often hold broadly similar portfolios of asset the market can
dry up completely if all banks try to sell at once. This happens during a
systemic banking crisis.
assets that are liquid normally can become suddenly highly
illiquid at the time that banks need them most
even a bank that would be solvent in normal times may
see its balance sheet destroyed, so that the bank-run
becomes self-fulfilling:
If everyone expects a problem and acts as if one is about to
occur, then the run becomes a self-fulfilling prophecy and if
no one expects a bank to be in crisis no run occurs (also self-
fulfilling.
, Multiple eqiulibria model: a confidence shock can cause a jump from the good
equilibrium to the bad equilibrium. Agents have uncertain needs for consumption in an
environment in which long-term investments are costly to liquidate.
o Bad equilibrium: If depositors believe that other depositors will withdraw
then they all find it rational to redeem (terugwinnen) their claims and a
panic occurs.
o Good equilibrium: everybody believes no panic will occur and depositors
withdraw funds according to their consumption needs.
Theories focusing on asset side:
Banking problems arise then from a protracted deterioration in asset quality due to poor
fundamentals arising from the business cycle, like a collapse in real estate prices or
increased bankruptcies in the non-financial sector.
Allen and Gale model (box 2.4):
An economic downturn will reduce the value of bank assets (borrowers will have
difficulty repaying loans), raising the possibility that banks are unable to meet their
commitments. If depositors anticipate financial difficulties in the banking sector, they will
try to withdraw their bank deposits. same result as in panic story but different cause.
Box 2.4; page 49 – Bank runs and business cycle (see assignment)
They assume that depositors can observe a leading economic indicator that provides
public information about future bank asset returns.
if returns are high, depositors will want to keep their funds in the bank
if returns are low, depositors will withdraw their money in anticipation of low
returns and there is a crisis.
Minsky model:
The events leading up to the crisis start with a ‘displacement’ – some exogenous, outside
shock to the macroeconomic system- an invention or an abrupt change of economic
policy about which investors get excited.
Five stages to the boom and eventual bust:
1. Credit expansion, characterized by rising asset prices
2. Euphoria, characterized by overtrading
3. Distress, characterized by unexpected failures
4. Discredit, characterized by liquidation
5. Panic, characterized by the desire for cash
Deleveraging: financial institutions cut back on their lending.
Pro-cyclicality of the financial system (several factors contribute to this):
Role of risk assessment is important. Risk tends to be overestimated in bad times
(distress with ‘high risk’) and tends to be underestimated in good times (euphoria
with ‘low risk’).
The amount of debt (leverage) is a key factor. The more debt is built up in the
upswing, the more severe is the deleveraging in the downswing.
Capital requirements play a role. In good times, retained earnings boost capital,
which enables banks to increase lending. In bad times, capital shrinks through
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