Financial markets and intermediaries provide financing for business. They channel savings to real investment. That much should be loud and clear. But other functions may not be quite so obvious. Financial intermediaries contribute in many ways to our individual well-being and the smooth functioning of the economy. Here are some examples.
1. The Payment Mechanism
Think how inconvenient life would be if all payments had to be made in cash. Fortunately, checking accounts, credit cards, and electronic transfers allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payments services, but they are not alone. For example, if you buy shares in a money
market mutual fund, your money is pooled with that of other investors and is used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit.
2. Borrowing and Lending
Financial institutions do not lend only to companies. They also channel savings toward those who can best use them. Thus, if Ms. Jones has more money than she needs now and wishes to save for a rainy day, she can put the money in a bank savings deposit. If Mr. Smith wants to buy a car now and pay for it later, he can borrow money from the bank. In other words, banks provide Jones and Smith with a time machine that allows them to transport their wealth backward and forward over time. Both are happier than if they were forced to spend cash as it arrived.
As we saw in Chapter 1, when individuals have access to borrowing and lending, companies do not have to worry that shareholders may have different time preferences. Companies can simply focus on maximizing firm value and investors can choose separately when they want to spend their wealth.
Notice that banks promise their checking account customers instant access to their money and at the same time make long-term loans to companies and individuals. This mismatch between the liquidity of the bank’s liabilities (the deposits) and most of its assets (the loans) is possible only because the number of depositors is sufficiently large that the bank can be fairly sure that they will not all want to withdraw their money simultaneously.
In principle, you don’t need financial institutions to provide borrowing and lending. Individuals with cash surpluses, for example, could take out newspaper advertisements to find those with cash shortages. But it can be cheaper and more convenient to use a financial intermediary, such as a bank, to link up the borrower and lender. For example, banks are equipped to check out the would-be borrower’s creditworthiness and to monitor the use of cash lent out.[1]
3. Pooling Risk
Financial markets and institutions allow firms and individuals to pool their risks. For instance, insurance companies make it possible to share the risk of an automobile accident or a household fire. Here is another example. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you would be wiped out if that company went belly-up. It is generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securities. In this case you are exposed only to the risk that security prices as a whole will fall.
4. Information Provided by Financial Markets
In well-functioning financial markets, you can see what securities and commodities are worth, and you can see—or at least estimate—the rates of return that investors can expect on their savings. The information financial markets provide is often essential to a financial manager’s job. Consider these scenarios.
In December, Catalytic Concepts, a manufacturer of catalytic converters, is planning production for the next April. The converters include platinum, which is traded on the New York
Mercantile Exchange. How much per ounce should the company budget for purchases of platinum in April? Easy: The company’s CFO looks up the market price of platinum on the New York Mercantile Exchange—$1,023 per ounce for delivery in April (this was the price for platinum in August 2017, for delivery the following April). The CFO can lock in that price if she wishes. We explain how in Chapter 26.
Now suppose the CFO of Catalytic Concepts needs to raise $400 million in new financing. She considers an issue of 30-year bonds. If the company’s bonds are rated Baa, what interest rate will it have to pay on the new issue? The CFO sees that existing Baa bonds yield 4.40%. The company should be able to sell its new bonds at a similar rate.
Finally, stock prices and company values summarize investors’ collective assessment of how well a company is doing, both its current performance and its future prospects. Thus an increase in stock price sends a positive signal from investors to managers.[2] That is why top management’s compensation is linked to stock prices. A manager who owns shares in his or her company will be motivated to increase the company’s market value. This reduces agency costs by aligning the interests of managers and stockholders. This is one important advantage of going public. A private company can’t use its stock price as a measure of performance. It can still compensate managers with shares, but the shares will not be valued in a financial market.
The basic functions of financial markets are the same the world over. So it is not surprising that similar institutions have emerged to perform these functions. In almost every country you will find banks accepting deposits, making loans, and looking after the payments system. You will also encounter insurance companies offering life insurance and protection against accident. If the country is relatively prosperous, other institutions, such as pension funds and mutual funds, will also have been established to help manage people’s savings. Of course there are differences in institutional structure. Take banks, for example. In many countries where securities markets are relatively undeveloped, banks play a much more dominant role in financing industry. Often the banks undertake a wider range of activities than they do in the United States. For example, they may take large equity stakes in industrial companies; this would not generally be allowed in the United States.
5. The Financial Crisis of 2007-2009
The financial crisis of 2007-2009 raised many questions, but it settled one question conclusively: Financial markets and institutions are important. When financial markets and institutions ceased to operate properly, the world was pushed deeper into a global recession.
The financial crisis had its roots in the easy-money policies that were pursued by the U.S. Federal Reserve and other central banks following the collapse of the Internet and telecom stock bubble in 2000. At the same time, large balance-of-payments surpluses in Asian economies were invested back into U.S. debt securities. This also helped to push down interest rates and contribute to the lax credit.
Banks took advantage of this cheap money to expand the supply of subprime mortgages to low-income borrowers. Many banks tempted would-be homeowners with low initial payments, offset by significantly higher payments later.[3] (Some home buyers were betting on escalating housing prices so that they could resell or refinance before the higher payments kicked in.) One lender is even said to have advertised what it dubbed its “NINJA” loan— NINJA standing for “No Income, No Job, and No Assets.”
Most subprime mortgages were then packaged together into mortgage-backed securities that could be resold. But, instead of selling these securities to investors who could best bear the risk, many banks kept large quantities of the loans on their own books or sold them to other banks.
The widespread availability of mortgage finance fueled a dramatic increase in house prices, which doubled in the five years ending June 2006. At that point, prices started to slide and homeowners began to default on their mortgages. A year later, Bear Stearns, a large investment bank, announced huge losses on the mortgage investments that were held in two of its hedge funds. By the spring of 2008, Bear Stearns was on the verge of bankruptcy, and the U.S. Federal Reserve arranged for it to be acquired by JPMorgan Chase.
The crisis peaked in September 2008, when the U.S. government was obliged to take over the giant federal mortgage agencies Fannie Mae and Freddie Mac, both of which had invested several hundred billion dollars in subprime mortgage-backed securities. Over the next few days, the financial system started to melt down. Both Merrill Lynch and Lehman Brothers were in danger of failing. On September 14, the government arranged for Bank of America to take over Merrill in return for financial guarantees. However, it did nothing to rescue Lehman Brothers, which filed for bankruptcy protection the next day. Two days later, the government reluctantly lent $85 billion to the giant insurance company AIG, which had insured huge volumes of mortgage-backed securities and other bonds against default. The following day, the Treasury unveiled its first proposal to spend $700 billion to purchase “toxic” mortgage- backed securities.
As the crisis unfolded throughout 2007 and 2008, uncertainty about which domino would be next to fall made banks reluctant to lend to one another, and the interest rate that they charged for such loans rose to 4.6% above the rate on U.S. Treasury debt. (Normally, this spread above Treasuries is less than .5%.) The bond market and the market for shortterm company borrowing effectively dried up. This had an immediate knock-on effect on the supply of credit to industry, and the economy suffered one of its worst setbacks since the Great Depression.
Few developed economies escaped the crisis. As well as suffering from a collapse in their own housing markets, many foreign banks had made large investments in U.S. subprime mortgages. A roll call of all the banks that had to be bailed out by their governments would fill several pages, but here are just a few members of that unhappy band: the Royal Bank of Scotland in the United Kingdom, UBS in Switzerland, Allied Irish Bank in Ireland, Fortis in Belgium, ING in Holland, Hypo Group in Austria, and WestLb in Germany.
Who was responsible for the financial crisis? In part, the U.S. Federal Reserve for its policy of easy money. The U.S. government also must take some of the blame for encouraging banks to expand credit for low-income housing.30 The rating agencies were at fault for providing triple-A ratings for many mortgage bonds that shortly afterward went into default. Last but not least, the bankers themselves were guilty of promoting and reselling the subprime mortgages.
The banking crisis and subsequent recession left many governments with huge mountains of debt. By 2010, investors were becoming increasingly concerned about the position of Greece, where for many years government spending had been running well ahead of revenues. Greece’s position was complicated by its membership in the single-currency euro club. Although much of the country’s borrowing was in euros, the government had no control over its currency and could not simply print more euros to service its debt. Investors began to contemplate the likelihood of a Greek government default and the country’s possible exit from the eurozone. The failure of eurozone governments to deal decisively with the Greek problem prompted investors to worry about the prospects for other heavily indebted eurozone countries, such as Ireland, Portugal, Italy, and Spain. After several rescue attempts, Greece finally defaulted in 2011. But it was not the end of the story, and four years later, after failing to get further assistance, Greece defaulted on a loan from the IMF.
At least with hindsight, we can see that the run-up to the financial crisis saw plenty of examples of foolishness and greed. Nearly a decade after the crisis, bankers remain at the bottom of everyone’s popularity list. That position has been reinforced by the revelations that several major banks had been rigging the interest rate and foreign exchange markets. But the lesson of the financial crisis and the subsequent scandals is not that we don’t need a financial system; it is that we need it to work honestly and well.
Financial markets in the United States and most developed countries work well most of the time, but just like the little girl in the poem, “when they are good, they are very good indeed, but when they are bad, they are horrid.” During the financial crisis, markets were very horrid indeed. Think of some of the problems that you would have faced as a financial manager:
- Many of the world’s largest banks teetered on the edge or had to be rescued so that there were few, or no, safe havens for cash.
- Stock and bond prices bounced around like Tigger on stimulants.
- Periodically, markets for some types of security dried up altogether, making it tough to raise cash.
- In the eurozone, investors could not even be confident that governments would be able to service their bonds or retain the euro as their currency.
- From the peak in 2006, manufacturing profits fell away sharply and the number of business bankruptcies tripled.
It must have seemed to financial managers as if they were being assailed from all sides.
We hope that these years were just a very unfortunate blip and that the world has not become permanently more complex and risky.
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