Banking
Understanding problems is the most important, memorizing is less important (book)
Aim exam: how well do you understand the course, he is not asking the 7 functions of financial
markets for example, but he does ask examples of stuff, not memorizing everything, he can give an
example and you need to understand the concepts
Chapter 1: Introduction to financial markets and banking (not really important)
1.1 Some introductory concepts
o Money market vs capital market
• Money market: short term (< 1y)
• Capital market: medium and long term (stocks and bonds)
o Primary market vs secondary market
• Primary market: where securities are issued (ex. IPO)
• Secondary market: where securities are traded
o Bond market vs stock market
• Bond market: fixed income + creditor
• Stock market: income not fixed + owner
o Derivative markets
• Cf options, futures, forwards…
o Official exchange or over the counter
1.2 Functions of financial markets
o Why do financial markets exist?
“The primary role of the capital market is the allocation of ownership of the economy’s capital stock.
In general terms, ideal is a market in which prices provide accurate signals for resource allocation.
That is, a market in which firms can make production-investment decisions, and investors can choose
among the securities that represent ownership of firms’ activities under the assumption that
securities prices at any time “fully reflect” all available information” - Eugene Fama
o Notes:
• Capital market is there to make sure money goes to the right place: allocating the
ownership of capital
• By knowing the price of capital it helps you allocating where your money should go
• Assumption: refers to efficient market hypothesis
o The seven main functions of financial markets:
• Function 1: transfer funds
- Financial markets make it easier to transfer funds required for consumption
or investments
- The transfer of money from sectors with surpluses to sectors with deficits
• Function 2: accumulation
- Financial markets allow people to build up wealth
• Function 3: risk-sharing
- Financial markets transfer risk to parties interested in taking risk
1
, • Function 4: liquidity
- Financial markets allow people to sell financial assets: ideally on the short
term and without loss of value (i.e. liquid markets)
• Function 5: pricing
- Financial markets provide information about the price of financial assets
• Function 6: aggregation of information
- Financial markets aggregate information of many parties
- Trading means many people can offer a price for it so a lot of people’s
information is in the price of the stock, might give better price result
• Function 7: efficiency
- Financial markets reduce transaction and information costs
o Financial markets are promises
• Bonds
- Promises a (coupon) payment on fixed times
• Stocks
- Promises a share of future profits
• Pension fund
- Promises an income stream when people retire
• Life insurance
- Promises to pay out after a certain period of time, or in case of death
• Mutual fund
- Promises to distribute profits gained by investing in bonds and stocks
1.3 Size of financial markets
1.4 Asymmetric information
o Asymmetric information: the one making a promise (i.e. selling financial assets) knows more
about the future than the one buying the promise
o This leads to:
• Adverse selection
• Moral hazard
2
, o Adverse selection
• Agents on one side of the transaction have more information than agents at the
other side
• Is a problem of asymmetric information before the transaction occurs
• Can lead to the market unraveling
• Ex: secondhand cars, CDO’s
- Secondhand cars: you’re trying to sell your car, you know what your car is
worth but the buyer doesn’t so he will pay you an average price; if you have
a good car you get less than you deserve and if you have a bad car you get
more than you deserve so in the end people with good cars will leave the
market and only the bad cars stay
- CDO = Collateralized Debt Obligations: collections of mortgages
o Moral hazard
• = The risk that one initiates uncareful or risky activities because he or she is insured
against losses
• By (hidden) actions of the contractors, the risk of the transaction changes
• People who are initially planning on keeping their promises might receive an
incentive to break them
• Is a problem of asymmetric information after the transaction occurs
• Ex: car insurance, deposit insurance
- Let’s say you drive a car without insurance so you will be careful; but when
having an omnium insurance, you might drive more risky because you know
if something happens you can get money back
o Solutions?
• Gathering more information, but…
• Costly to the one gathering the information
• If multiple people want the same information, we have inefficient duplication
• Free-rider problem: when the information becomes public
• Rational ignorance: when uninformed parties follow others because they think they
are better informed, herding occurs (bubbles, inefficient allocation, …)
o Collateral, but…
• Only if you have something, you can give something as collateral
• Assumes a correct legal system
• Not always high-quality collateral available?
1.5 Allocation of funds
o Three types of financing
• Direct financing
• Semi-direct financing
• Indirect financing
Direct financing
o Surplus sectors = sectors with too much money
o Deficit sectors = sectors with not enough money
3
, o Direct financing means households’ savings go directly to bonds or stocks issued by firms
• In an economy with only direct financing, there is a risk of a low level of financing,
because of several problems
o Problems
• High transaction and information costs
- Costly (time intensive, make sure it’s good info… ) to find out in which
project to invest, or find out more about project (avoiding adverse selection)
- Monitoring: make sure that funds invested are used as promised, make sure
things are going well after you invested (avoiding moral hazard)
• Maturity
- Often long term investment
- Not all investors are looking to invest in the long term (i.e., maturity
transformation)
• Amount
- Investments often require large amounts, leads to diversification problem for
the investor
o Conclusion
• Using direct financing, investments are usually confined to friends, family and fools
• Every investor has to do his homework (which is inefficient)
Semi-direct financing
o Important difference: financial intermediary = for ex. stockbroker ≠ bank
• Same assets and same money moving (no transformation)
o Using semi-direct financing, an intermediary or “broker” is used to invest directly into
o financial assets
o Broker (Longman online dictionary)
• = “Someone who buys and sells things such as shares in companies or foreign money
for other people”
• = “Someone who arranges sales or business agreements for other people”
o Advantages:
• Supply of information
- Broker has a big collection of data because of all the investors on the stock
market, so broker has more information than individual
• Setting a price
• Making markets more liquid
• Secondary markets
o Disadvantages:
• High costs for small amounts
• Asymmetric information
4
Understanding problems is the most important, memorizing is less important (book)
Aim exam: how well do you understand the course, he is not asking the 7 functions of financial
markets for example, but he does ask examples of stuff, not memorizing everything, he can give an
example and you need to understand the concepts
Chapter 1: Introduction to financial markets and banking (not really important)
1.1 Some introductory concepts
o Money market vs capital market
• Money market: short term (< 1y)
• Capital market: medium and long term (stocks and bonds)
o Primary market vs secondary market
• Primary market: where securities are issued (ex. IPO)
• Secondary market: where securities are traded
o Bond market vs stock market
• Bond market: fixed income + creditor
• Stock market: income not fixed + owner
o Derivative markets
• Cf options, futures, forwards…
o Official exchange or over the counter
1.2 Functions of financial markets
o Why do financial markets exist?
“The primary role of the capital market is the allocation of ownership of the economy’s capital stock.
In general terms, ideal is a market in which prices provide accurate signals for resource allocation.
That is, a market in which firms can make production-investment decisions, and investors can choose
among the securities that represent ownership of firms’ activities under the assumption that
securities prices at any time “fully reflect” all available information” - Eugene Fama
o Notes:
• Capital market is there to make sure money goes to the right place: allocating the
ownership of capital
• By knowing the price of capital it helps you allocating where your money should go
• Assumption: refers to efficient market hypothesis
o The seven main functions of financial markets:
• Function 1: transfer funds
- Financial markets make it easier to transfer funds required for consumption
or investments
- The transfer of money from sectors with surpluses to sectors with deficits
• Function 2: accumulation
- Financial markets allow people to build up wealth
• Function 3: risk-sharing
- Financial markets transfer risk to parties interested in taking risk
1
, • Function 4: liquidity
- Financial markets allow people to sell financial assets: ideally on the short
term and without loss of value (i.e. liquid markets)
• Function 5: pricing
- Financial markets provide information about the price of financial assets
• Function 6: aggregation of information
- Financial markets aggregate information of many parties
- Trading means many people can offer a price for it so a lot of people’s
information is in the price of the stock, might give better price result
• Function 7: efficiency
- Financial markets reduce transaction and information costs
o Financial markets are promises
• Bonds
- Promises a (coupon) payment on fixed times
• Stocks
- Promises a share of future profits
• Pension fund
- Promises an income stream when people retire
• Life insurance
- Promises to pay out after a certain period of time, or in case of death
• Mutual fund
- Promises to distribute profits gained by investing in bonds and stocks
1.3 Size of financial markets
1.4 Asymmetric information
o Asymmetric information: the one making a promise (i.e. selling financial assets) knows more
about the future than the one buying the promise
o This leads to:
• Adverse selection
• Moral hazard
2
, o Adverse selection
• Agents on one side of the transaction have more information than agents at the
other side
• Is a problem of asymmetric information before the transaction occurs
• Can lead to the market unraveling
• Ex: secondhand cars, CDO’s
- Secondhand cars: you’re trying to sell your car, you know what your car is
worth but the buyer doesn’t so he will pay you an average price; if you have
a good car you get less than you deserve and if you have a bad car you get
more than you deserve so in the end people with good cars will leave the
market and only the bad cars stay
- CDO = Collateralized Debt Obligations: collections of mortgages
o Moral hazard
• = The risk that one initiates uncareful or risky activities because he or she is insured
against losses
• By (hidden) actions of the contractors, the risk of the transaction changes
• People who are initially planning on keeping their promises might receive an
incentive to break them
• Is a problem of asymmetric information after the transaction occurs
• Ex: car insurance, deposit insurance
- Let’s say you drive a car without insurance so you will be careful; but when
having an omnium insurance, you might drive more risky because you know
if something happens you can get money back
o Solutions?
• Gathering more information, but…
• Costly to the one gathering the information
• If multiple people want the same information, we have inefficient duplication
• Free-rider problem: when the information becomes public
• Rational ignorance: when uninformed parties follow others because they think they
are better informed, herding occurs (bubbles, inefficient allocation, …)
o Collateral, but…
• Only if you have something, you can give something as collateral
• Assumes a correct legal system
• Not always high-quality collateral available?
1.5 Allocation of funds
o Three types of financing
• Direct financing
• Semi-direct financing
• Indirect financing
Direct financing
o Surplus sectors = sectors with too much money
o Deficit sectors = sectors with not enough money
3
, o Direct financing means households’ savings go directly to bonds or stocks issued by firms
• In an economy with only direct financing, there is a risk of a low level of financing,
because of several problems
o Problems
• High transaction and information costs
- Costly (time intensive, make sure it’s good info… ) to find out in which
project to invest, or find out more about project (avoiding adverse selection)
- Monitoring: make sure that funds invested are used as promised, make sure
things are going well after you invested (avoiding moral hazard)
• Maturity
- Often long term investment
- Not all investors are looking to invest in the long term (i.e., maturity
transformation)
• Amount
- Investments often require large amounts, leads to diversification problem for
the investor
o Conclusion
• Using direct financing, investments are usually confined to friends, family and fools
• Every investor has to do his homework (which is inefficient)
Semi-direct financing
o Important difference: financial intermediary = for ex. stockbroker ≠ bank
• Same assets and same money moving (no transformation)
o Using semi-direct financing, an intermediary or “broker” is used to invest directly into
o financial assets
o Broker (Longman online dictionary)
• = “Someone who buys and sells things such as shares in companies or foreign money
for other people”
• = “Someone who arranges sales or business agreements for other people”
o Advantages:
• Supply of information
- Broker has a big collection of data because of all the investors on the stock
market, so broker has more information than individual
• Setting a price
• Making markets more liquid
• Secondary markets
o Disadvantages:
• High costs for small amounts
• Asymmetric information
4
