Chapter 2

Financial Assets, Money, Financial Transactions, and Financial Institutions

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Introduction: The Role of Financial Assets

The financial system is the mechanism through which loanable funds reach borrowers. Through the operation of the financial markets, money is exchanged for financial claims in the form of stocks, bonds, and other securities, thereby transforming savings into investment so that the economy can grow.

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The Creation of Financial Assets

A financial asset is a claim against the income or wealth of a business firm, household, or unit of government, represented usually by a certificate, receipt, computer record file, or other legal document, and usually created by or related to the lending of money.

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Characteristics of Financial Assets

Financial assets are sought after because they promise future returns to their owners and serve as a store of value (purchasing power).

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Characteristics of Financial Assets

They do not depreciate like physical goods, and their physical condition or form is usually not relevant in determining their market value. They have little or no value as a commodity and their cost of transportation and storage is low. Financial assets are fungible they can easily be changed in form and substituted for other assets.

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Different Kinds of Financial Assets

Generally financial assets fall into four categories Money, Equities, Debt securities, and Derivatives. Any financial asset that is generally accepted in payment for purchases of goods and services is money. Currency and checking accounts are forms of money. Equities represent ownership shares in a business firm and are claims against the firms profits and against proceeds from the sale of its assets. Common stock and preferred stock are equities.

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Different Kinds of Financial Assets

Debt securities entitle their holders to a priority claim over the holders of equities to the assets and income of an economic unit. They can be negotiable or nonnegotiable. Examples include bonds, notes, accounts payable, and savings deposits. Derivatives have a market value that is tied to or influenced by the value or return on a financial asset. Examples include futures contracts and options.

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How Financial Assets Are Born

To acquire assets, households and business firms may use current income and accumulated savings internal financing. An economic unit may also raise funds by issuing financial liabilities (debt) or stock (equities), provided that a buyer can be found external financing.

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Balance Sheets of Units in a Simple Financial System

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Unit Balance Sheets Following the Purchase of Equipment and the Issuance of a Debt Security

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Unit Balance Sheets Following the Purchase of Equipment and the Issuance of Stock

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Financial Assets and the Financial System

The act of borrowing or of issuing new stock simultaneously gives rise to the creation of an equal volume of financial assets. All financial assets are recorded as a liability or claim on some other economic units balance sheet.

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Financial Assets and the Financial System

So, society increases its wealth only by saving and increasing the quantity of its real assets, for these assets enable the economy to produce more goods and services in the future. However, the financial system provides the essential channel necessary for the creation and exchange of financial assets between savers and borrowers so that real assets can be acquired.

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Lending and Borrowing in the Financial System

Economists John Gurley and Edward Shaw pointed out that each business firm, household, or unit of government active in the financial system must conform to: R E = (FA (D
where R E (FA (D = = = = Current income receipts Expenditures out of current income Change in holdings of financial assets Change in debt and equity outstanding

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Lending and Borrowing in the Financial System

So, for any given time period, each economic unit must fall into one of three groups: Deficit-budget unit (DBU):
E > R, so (D > (FA (net borrower of funds)

Surplus-budget unit (SBU):

R > E, so (FA > (D (net lender of funds)

Balanced-budget unit (BBU):

R = E, so (D = (FA (neither net lender nor borrower)

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Lending and Borrowing in the Financial System

The global financial system permits businesses, households, and governments to adjust their financial position from that of net borrower (DBU) to net lender (SBU) and back again, smoothly and efficiently.

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What is Money?

All financial assets are valued in terms of money, and flows of funds between lenders and borrowers occur through the medium of money.

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The Functions of Money

Money serves as a standard of value (or unit of account) for all goods and services. Money serves as a medium of exchange, such that buyers and sellers no longer need to have an exact coincidence of wants in terms of quality, quantity, time, and location. Money serves as a store of value a reserve of future purchasing power. However, the value of money can experience marked fluctuations.

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The Functions of Money

Money functions as the only perfectly liquid asset in the financial system. It exhibits price stability, ready marketability, and reversibility.

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The Value of Money and Other Financial Assets and Inflation

Inflation refers to a rise in the average price level of all goods and services. Inflation lowers the value or purchasing power of money and is a special problem in the money and capital markets because it can damage the value of financial contracts. The opposite of inflation is deflation, where the average level of prices for goods and services actually declines.

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The Evolution of Financial Transactions

Financial systems change constantly in response to shifting demands from the public, the development of new technology, and changes in laws and regulations. Over time, the ways of carrying out financial transactions have evolved in complexity. In particular, the transfer of funds from savers to borrowers can be accomplished in at least three different ways.

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The Evolution of Financial Transactions

Direct Finance Direct lending gives rise to direct claims against borrowers. Flow of funds Borrowers (DBUs)
(loans of spending power for an agreed-upon period of time)

Lenders (SBUs)

Primary Securities
(stocks, bonds, notes, etc., evidencing direct claims against borrowers)

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The Evolution of Financial Transactions

Semidirect Finance Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers. Primary Securities Borrowers (DBUs)
(direct claims against borrowers)

Primary Securities
(direct claims against borrowers)

(less fees and commissions)

Proceeds of security sales

Security brokers, dealers, & investment bankers Flow of funds

Lenders (SBUs)

(loans of spending power)

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The Evolution of Financial Transactions

Indirect Finance Financial intermediation of funds. Secondary Securities Primary Securities (indirect claims against ultimate
(direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes, etc.)

borrowers issued by financial intermediaries in the form of deposits, insurance policies, retirement savings accounts, etc.)

Ultimate borrowers (DBUs)

Financial intermediaries
(banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies, pension funds)

Ultimate lenders (SBUs)

Flow of funds
(loans of spending power)
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Flow of funds
(loans of spending power)

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Classification of Financial Institutions

Depository institutions derive the bulk of their loanable funds from deposit accounts sold to the public.
- Commercial banks, savings and loan associations, savings banks, credit unions.

Contractual institutions attract funds by offering legal contracts to protect the saver against risk.
- Insurance companies, pension funds.

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Classification of Financial Institutions

Investment institutions sell shares to the public and invest the proceeds in stocks, bonds, and other assets.
- Mutual funds, money market funds, real estate investment trusts.

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Portfolio (Financial-Asset) Decisions by Financial Institutions

Portfolio decisions deciding what financial assets to buy or sell are affected by: The relative rate of return and risk attached to different financial assets. The cost, volatility, and maturity of incoming funds provided by surplus-budget units.

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Portfolio (Financial-Asset) Decisions by Financial Institutions

The size of the individual financial institution.

- Larger financial institutions tend to have greater diversification in their sources and uses of funds and economies of scale.

Regulations and competition.

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Disintermediation of Funds

Disintermediation refers to the withdrawal of funds from a financial intermediary by the ultimate lenders (SBUs) and the lending of those funds directly to the ultimate borrowers (DBUs). Disintermediation involves the shifting of funds from indirect finance to direct and semidirect finance.

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Disintermediation of Funds
Financial Disintermediation
Primary Securities Ultimate borrowers (DBUs) Ultimate lenders (SBUs)

Financial intermediaries

Loanable funds
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Bank-Dominated Versus Security-Dominated Financial Systems

Lesser-developed financial systems are often bank-dominated financial systems, in which banks and other similar institutions dominate in supplying credit and attracting savings. The more mature systems today are becoming securitydominated financial systems, in which traditional intermediaries play lesser roles and growing numbers of borrowers sell securities to the public to raise the funds they need.

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Chapter Review

Introduction: The Role of Financial Assets The Creation of Financial Assets Characteristics of Financial Assets Different Kinds of Financial Assets How Financial Assets Are Born Financial Assets and the Financial System

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Chapter Review

Lending and Borrowing in the Financial System Money as a Financial Asset

- What is Money? - The Functions of Money

The Value of Money and Other Financial Assets and Inflation

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Chapter Review

The Evolution of Financial Transactions

- Direct Finance - Semidirect Finance - Indirect Finance and Financial Intermediation

Relative Size and Importance of Major Financial Institutions Classification of Financial Institutions

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Chapter Review

Portfolio (Financial-Asset) Decisions by Financial Intermediaries and Other Financial Institutions Disintermediation of Funds
- New Types of Disintermediation

Bank-Dominated Versus Security-Dominated Financial Systems

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