Chapter 2
Overview of Market Participants and Financial Innovation
Players
• Governments
– Federal government
– Government-sponsored enterprises
– State governments
– Local governments
• Nonfinancial Corporations
– Ford
– General Electric
• Depository Institutions
– Commercial banks
– Savings and loan associations
– Savings banks
– Credit unions
• Insurance Companies
Life Insurance
Property and Casualty Insurance
• Asset Management Firms
– Pension Funds
– Regulated investment companies
– Exchange-traded funds
– Hedge funds
– Real estate investment trusts
– Collateralized debt obligations
– Structured finance operating companies
• Investment Banks
– Assistance in obtaining funds
– For investors, act as broker and dealer
– May be a subsidiary of
• Commercial banks
• Insurance companies
• Nonprofit Organizations
– Classified as
• Commercial enterprises
• Not-for-profit organizations
• Foundations
• endowments
• Foreign Investors
– Individuals
– Nonfinancial businesses
– Financial entities
– Supranational institutions
• Two or more central governments through treaties
Role of Financial Intermediaries
• Transform financial assets and re-constitute them into different types of assets.
• Exchange financial assets on behalf of customers.
• Exchange financial assets for their own account.
• Assist in the creation of financial assets for their customers and then sell those financial
assets to other market participants.
• Provide investment advice to other market participants.
• Manage the portfolios of other market participants.
• Maturity Intermediation
• commercial bank in essence transforms a longer-term asset into a shorter-term asset
• Risk Reduction via Diversification
• transforming more risky assets into less risky ones
• Reducing the Costs of Contracting and Information Processing
• Cost of the acquisition and analysis of the information about the financial asset and
its issuer
• Cost of writing the loan contract
• Cost of enforcing the contract terms
• Providing a Payment Mechanism
• Credit cards, debit cards, electronic transfers
Overview of Asset/Liability Management for Financial Institutions
• Type I Liabilities
– Guaranteed Investment Contracts, Bonds
• Type II Liabilities
– Life Insurance Policy
• Type III Liabilities
– Certificates of Deposits (CD’s)
• Type IV Liabilities
– Property and Casualty Insurance
Regulation of Financial markets
• Justification for Regulation
– the market, left to itself, will not produce its particular goods or services in an efficient
manner and at the lowest possible cost
– The regulatory structure in the United States is largely the result of financial crises
that have occurred at various times
• Forms of Federal Government Regulation of Financial Market
– Disclosure Regulation
– Financial Activity Regulation
– Financial Institution Regulation
– Foreign Participant Regulation
Financial Innovation
• Market-broadening instruments
– increase the liquidity of markets and the availability of funds
• Risk-management instruments
– reallocate financial risks
• Arbitraging instruments and processes
– take advantage of differences in costs and returns between markets
• Price-risk-transferring innovations
• Credit-risk-transferring instruments
• Liquidity-generating innovations
• Credit-generating instruments
• Equity-generating instruments
Motivation for Financial Innovation
– Increased volatility of interest rates, inflation, equity prices, and exchange rates
– Advances in computer and telecommunication technologies
– Greater sophistication and educational training among professional market
participants
– Financial intermediary competition
– Incentives to get around existing regulation and tax laws
– Changing global patterns of financial wealth
Securitization and Financial Innovation
• securitization is a process by which a financial relationship is converted into a financial
transaction
– Loans
– Stocks
– Corporate bonds