Over the past 35 years, the financial services industry has
Chapter Overview undergone major changes. In the 1990s and 2000s,
The Dow Jones Industrial Average (DJIA) experienced several regulatory shifts, advances in technology, and financial
major fluctuations tied to economic crises. In the early innovation allowed single firms to offer a full range of
2000s, it fell below 10,000 during a downturn. By July 2007, services under financial holding companies. For example,
it climbed above 13,200 but quickly dropped below 13,000 JPMorgan Chase & Co. operates both a commercial bank
due to the subprime mortgage credit crunch. The situation (JPMorgan Chase Bank) and an investment bank (JPMorgan
escalated into the 2008 financial crisis, the worst recession Securities, which also sells mutual funds). Traditional
since the Great Depression, driving the DJIA down to 7,600 boundaries between industry sectors blurred, and
in March 2009. Recovery followed, with the index surpassing competition became global. Today, JPMorgan Chase is the
11,000 in April 2010, though it did not exceed its pre-crisis world’s largest bank holding company, with operations in 60
high until March 2013, closing at 14,253.77. By mid-2019, the countries.
DJIA rose above 27,300 before plunging below 20,000 in
March 2020 during the Coronavirus pandemic. Summary:
The chapter highlights how global financial markets and the
In June 2016, the United Kingdom’s vote to leave the financial services industry have been shaped by major crises
European Union (Brexit) triggered sharp global market and structural changes. The Dow Jones Industrial Average
reactions. The British pound fell more than 11 percent to its (DJIA) saw sharp fluctuations during the early 2000s
lowest level since 1985, while the Dow Jones Industrial downturn, the 2008 financial crisis, Brexit in 2016, and the
Average dropped 610.32 points (3.4 percent). Europe’s Stoxx COVID-19 pandemic in 2020–2022, with each event causing
600 index plunged 7 percent, its steepest decline since 2008, steep declines followed by periods of recovery. Brexit also
and Japan’s Nikkei Stock Average fell 7.9 percent. Investors slowed UK economic growth, reduced business investment,
moved toward safer assets such as U.S. bonds and gold, UK and prompted international firms to shift operations out of
government borrowing costs rose, and Moody’s cut the UK’s London. Meanwhile, the financial services industry
credit rating outlook to “negative.” transformed over the past 35 years, with regulatory changes,
technology, and innovation enabling firms like JPMorgan
Brexit created significant economic uncertainty that slowed Chase to operate globally as both commercial and
the UK’s growth rate from 2.4 percent in 2015 to 1.6 percent investment banks under one holding company.
in 2019. Government estimates suggested growth could be
reduced by up to 6.7 percent over 15 years. London’s
financial center was hit especially hard, with growth at only
Overview of Financial Markets
1.4 percent in 2018 and nearly zero in 2019. Business Financial Markets – structures through which funds flow.
investment declined by 11 percent between 2016 and 2019. Financial markets can be distinguished along two major
International companies also began shifting operations away dimensions:
from London as an entry point into the EU economy: Barclays
1. Primary versus secondary markets
moved 5,000 clients to Ireland; Goldman Sachs, JPMorgan
2. Money versus capital markets
Chase, and Morgan Stanley transferred about 10 percent of
their clients; and Bank of America relocated 100 bankers to
Dublin and 400 to Paris. Types of Financial Markets:
➢ Primary markets – markets in which corporations raise
The COVID-19 pandemic in 2020 caused a sudden shock to funds through new issues of securities.
global financial markets, leading to a 32.5 percent drop in the ➢ Secondary markets – markets that trade financial
Dow Jones Industrial Average (DJIA) in just over a month, instruments once they are issued.
from a record 29,388.58 on February 6 to 19,830.01 on ➢ Money markets – markets that trade debt securities
March 19. After three of the largest single-day drops in or instruments with maturities of less than one year.
history that spring, the Dow rebounded, breaking 30,000 on ➢ Capital markets – markets that trade debt and equity
November 24 and ending 2020 at 30,606.48. It crossed instruments with maturities of more than one year.
31,000 on January 7, 2021, reaching 31,188.38 on January ➢ Foreign exchange markets – markets in which cash
20. Positive pandemic recovery news, including strong retail flows from the sale of products or assets denominated
sales and lower unemployment claims, pushed the index in a foreign currency are transacted.
higher, hitting 35,625.40 on August 16, 2021. The ➢ Derivative markets – markets in which derivative
momentum continued into 2022, with the Dow closing at an securities trade.
all-time high of 36,799.65 on January 4. However, markets
declined afterward due to tighter Federal Reserve monetary Primary Market VS. Secondary Markets
policy, Russia’s invasion of Ukraine, rising energy prices, and
Primary markets – markets in which users of funds (e.g.,
investor concerns about new COVID variants.
corporations) raise funds through new issues of financial
instruments, such as stocks and bonds.
Secondary markets – markets in which financial instruments Derivative Security Markets
such as stocks are traded (that is rebought and resold) after
being issued in primary markets. Also, it offers a centralized ➢ Definition – markets in which derivative securities
and efficient marketplace for transactions. trade.
➢ Derivative security – a financial security (futures,
• Buyers - economic agents with excess funds
options, swaps, mortgage-backed) whose payoff is
• Sellers - in need of funds linked to another, previously issued security.
• Benefits - liquidity (ability to turn assets into cash ➢ Agreement structure – involves two parties
quickly at fair value), price information (helps exchanging a standard quantity of an asset or cash
issuers and investors evaluate value), and low flow at a predetermined price and date in the
transaction costs. future.
➢ Value linkage – as the value of the underlying
Money Markets VS. Capital Markets security changes, the value of the derivative
changes.
Financial Market Regulation
Financial instruments are subject to regulations imposed by
regulatory agencies such as the Securities and Exchange
Commission (SEC)—the main regulator of securities markets
since the passage of the Securities Act of 1934—as well as
the exchanges (if any) on which the instruments are traded.
The main emphasis of SEC regulations (as stated in the
Securities Act of 1933) is on full and fair disclosure of
information on securities issues to actual and potential
investors.
Money Markets - markets that trade debt securities or
instruments with maturities of less than one year. Economic ➢ SEC – the main regulator of securities markets since
agents with short term excess supplies of funds can lend the Securities Act of 1934.
funds (buy money market instruments) to economic agents ➢ Disclosure – full and fair disclosure of information
who have short term needs or shortage of funds (they sell on securities issues to actual and potential investors
money market instruments). (Securities Act of 1933).
➢ Public issues – firms planning to issue new stocks or
bonds to be sold to the public at large are required
by the SEC to register their securities and fully
describe the issue, including risks, in a legal
document called a prospectus.
Capital Markets - markets that trade debt (stocks) and equity
(bonds) instruments with maturities of more than one year.
The major suppliers of capital market securities (or users of
Overview of Financial
funds) are corporations and government. Institutions
Foreign Exchange Markets Financial Institutions – (e.g., commercial and savings banks,
credit unions, insurance companies, and mutual funds)
Foreign exchange markets – markets in which cash flows
performs the essential function of channeling funds from
from the sale of products or assets denominated in a foreign
those with surplus funds (suppliers of funds) to those with
currency are transacted.
shortages of funds (users of funds.
Cash flows from the sale of securities or other assets
denominated in a foreign currency expose U.S. corporations
and investors to exchange rate risk. The amount of U.S. Types of Financial Institutions
dollars received depends on the exchange rate at the time ➢ Commercial banks - depository institutions; major
the nondollar cash flow is converted. assets are loans (consumer, commercial, real estate)
• Depreciation – if a foreign currency depreciates and major liabilities are deposits. They also use
relative to the U.S. dollar during the investment nondeposit sources like notes and debentures.
period, the dollar value of cash flows will fall. ➢ Thrifts – savings associations, savings banks, and
• Appreciation – if a foreign currency appreciates credit unions. Similar to commercial banks but loans
are concentrated in one segment (real estate or
relative to the U.S. dollar during the investment
consumer).
period, the dollar value of cash flows will increase.
➢ Insurance companies – protect individuals and
corporations from adverse events. Life insurance
covers death, illness, retirement; property casualty Monitoring Costs
covers accidents, theft, fire, liability. ➢ The Problem with Direct Investing: For individual
➢ Securities firms & Investment banks – help firms
investors, keeping a close eye on how their money is
issue securities and engage in brokerage and
being used by a borrower is both difficult and
trading.
expensive.
➢ Finance companies – make loans to individuals and
businesses; do not accept deposits, rely on short- ➢ The Power of Pooling: By collecting money from
and long-term debt for funding. many small investors, a Financial Institution (FI) gains
➢ Investment funds – pool financial resources of
the resources and a much larger financial stake, which
individuals/companies and invest in diversified
gives them a stronger incentive to monitor borrowers
portfolios of assets.
➢ Pension funds – offer savings plans for retirement; effectively.
contributions are tax-exempt until withdrawal. ➢ Professional Expertise: Because they operate on a
➢ Fintechs – use technology to deliver financial
large scale, FIs can hire highly skilled professionals to
solutions, competing with traditional methods.
handle the complex task of gathering information and
Flow of funds without financial institutions supervising fund users.
Flow of funds without financial institutions - the level of ➢ Delegated Monitoring: FIs act as "delegated
funds flowing between suppliers and users of funds would be monitors" for their clients. This solves the "free-rider"
low. There are several reasons for this: problem, where individual investors might otherwise
wait for someone else to do the hard work of
➢ Monitoring costs – the cost and effort of monitoring
monitoring while they reap the benefits
fund borrowers is high.
➢ Long-term nature – financial claims such as Liquidity & Risk
mortgages, corporate stock, and bonds are long-
term, discouraging suppliers of funds. ➢ Asset Transformation: FIs act as "asset
➢ Price risk – the presence of price risk in real-world transformers" by purchasing "primary" securities
financial markets creates uncertainty for suppliers (like mortgages or corporate bonds) and turning
and users of funds. them into "secondary" securities (like bank deposits
or insurance policies) that are more attractive to
Unique Economic Functions everyday investors.
➢ Enhanced Liquidity: FIs offer products that are
Performed by Financial Institutions much easier for investors to turn back into cash
Because of compared to direct investments. For example, a
bank deposit can be withdrawn immediately,
1. Monitoring cost whereas selling a complex bond might take time
2. Liquidity cost and involve more risk.
3. Price risk ➢ Risk Absorption: The FI takes on the risk of the long-
term, illiquid assets it buys, while providing safe,
liquid options to its customers.
➢ The Role of Diversification: FIs can safely offer
these liquid products because they diversify. By
spreading their investments across many different
areas that don't all behave the same way, they
reduce their overall risk and can more accurately
predict their returns. This makes their promise of
safety to small investors credible.
Additional Benefits FIs Provide to Suppliers
of Funds
➢ Reduced Transaction Cost: Financial institutions
(FIs) benefit from economies of scale, allowing
them to gather information and execute trades far
more cheaply than a single person could.
➢ Maturity Intermediation: FIs are better equipped
than individuals to manage the risk of having
mismatched timelines between their assets and
liabilities, such as using short-term deposits to fund
long-term mortgages.
➢ Denomination Intermediation: By pooling money merge, leading to the dominance of massive, full-
from many small investors, FIs allow people to service holding companies.
access expensive financial instruments—like large-
➢ Shift in Banking Models: Leading up to the 2008
scale corporate debt—that usually require high
crisis, banks moved from an "originate and hold"
minimum buy-ins.
model to "originate and distribute," where they
Economic Functions FIs Provide to the sold off loans rather than keeping them, which
reduced their incentive to monitor borrower risk
Financial System
➢ The Transmission of Monetary Policy: Banks and The Impact of Fintech
other depository institutions act as the primary ➢ Fintech: Technology-driven innovation is creating
channel for the Federal Reserve to control the new business models, such as mobile payments
money supply and influence national economic and real-time transfers, that compete directly with
growth. traditional banking.
➢ Credit Allocation: FIs are vital for funding specific ➢ Blockchain and Decentralization: Technologies like
sectors that society deems important, such as blockchain allow for the direct exchange of value
agriculture and housing, often with without needing a traditional middleman,
encouragement or specialized structures from the potentially making some current financial
government. structures redundant
➢ Intergenerational Wealth Transfers: These
institutions enable people to move wealth across
time, such as saving during their working years for Globalization of Financial
retirement through life insurance and pension
funds. Markets and Institutions
➢ Payment Services: FIs provide the essential
The Global Nature of Finance
infrastructure for moving money, including wire
transfers and check clearing, which are necessary Financial markets have shifted from being domestic-focused
for a functional economy. to being a tightly integrated global network.
• While the United States still holds the top spot in
Managing Risks and Regulation
terms of stock exchange size and debt market
➢ Risks Incurred by Financial Institutions: FIs are volume, international markets in regions like
exposed to a wide variety of dangers, including Europe, Japan, and Shanghai are expanding rapidly.
credit defaults, interest rate shifts, liquidity
shortages, and technological failures. • In the debt sector specifically, the United Kingdom
and the United States are the dominant forces,
➢ Regulation of Financial Institutions: Because FI collectively issuing a significant portion of the
failures can trigger global recessions, governments world's debt securities.
regulate them to ensure stability and protect
depositors, though this adds a "regulatory burden" The Surge in Cross-Border
to the institutions.
Investment
➢ Enterprise Risk Management (ERM): Modern FIs
have moved toward looking at risk as a unified There has been a massive expansion in foreign investment
portfolio rather than separate categories, activity within U.S. markets, and vice versa, over the past
emphasizing a firm-wide culture of risk awareness. thirty years.
• Between 1992 and 2021, the value of U.S. debt held
Evolution and Market Trends by foreign investors and foreign debt held by U.S.
➢ Trends in the United States: Since 1948, there investors grew by trillions of dollars.
has been a massive shift away from traditional
banks and toward investment companies and • This interconnectedness means the U.S. economy is
pension funds, which now hold a much larger share now reliant on the health of foreign economies.
of total financial assets. • Financial Institutions (FIs) are the essential
➢ Rise of Financial Services Holding Companies: "middlemen" that make this global integration
Following the 1999 Financial Services possible by managing high-level risks like liquidity,
Modernization Act, different types of financial firms monitoring costs, and price volatility.
(banking, insurance, and securities) were allowed to
• Competition has become global; for instance, while
four of the world's ten largest banks are American,
U.S. institutions must now compete directly with
powerful foreign banks for market share.
The Global Ripple Effect of Market
Volatility
Because markets are so connected, economic problems in
the United States now cause immediate "shocks" to
financial systems worldwide.
• The 2007 credit crisis serves as a primary example:
when U.S. mortgage lenders began to fail, it
triggered a domino effect that caused stock
markets to crash across Asia (Japan, Hong Kong,
South Korea) and Europe (UK, Germany) almost
instantly.
• This demonstrates that investor fear in one region
can lead to a global selloff, proving that local
financial stability is now tied to global economic
growth.