H1: The financial system Flashcards
Haves and have nots
The economy consists out of haves and havenots. Haves possess
capital and can lend it out (Lenders). Havenots have more needs than
money and they will have to raise capital (borrowers).
net wealth
When a single household owns a house of 100 but at the same time
has a remaining mortgage debt of 80, its net wealth is 20.
Net wealth = assets - liabilities
kinds of assets
> Tangible assets or real assets derive value from their physical
character and the utility they generate.
Intangible assets derive value from a legal claim to some future
benefit.
Financial assets are intangible assets that represent a claim to
future cash.
asset
An asset is a possession that has value in an exchange transaction.
traditional assets
Common stock
Bonds
Cash (and cash equivalents)
alternative assets
Real estate Commodities Private equity Hedge funds Venture capital Currencies (forex)
liabilities
Mortgage loans
Consumer loans
Tax debt
Growth Drivers in Net Wealth
> Value changes in assets and liabilities
Net-income from labour, capital or transfers (i.e. pensions, social
security based income)
Inheritances, gifts
Companies can be funded with
> shareholder funds (equity) consisting out of the original equity,
rights issues and the retained profit.
debt
company’s dept
When companies use debt to finance their operations, they use leverage.
Most companies use leverage to raise the ROE above the ROA.
ROE = return on equity i.e. profit/equity
ROA = return on assets i.e. profit/assets
Leverage can be measured in different ways:
> As a Debt/Equity ratio
V&M define the gearing ratio as the ratio between long-term
debt and equity.
The net gearing ratio is often defined as the ratio of the
financial debt and the equity. Net financial debt is defined as the
long term debt + short term debt - cash - short term financial
assets.
As a Assets/Equity ratio i.e. a leverage multiplier.
The famous Dupont scheme uses the latter:
ROE = ROA x LM
financial system
> Economic growth is linked to financial development.
The role of the financial system is to facilitate production, employment, and consumption.
Resources are funneled through the system so resources flow to
their most efficient uses.
(Semi-)Direct finance through financial markets
Borrowers sell securities directly to lenders in the primary market.
After issuance, these securities often can be traded in thesecondary market.
> Money markets
> Capital markets
Indirect finance through financial intermediaries
> An institution stands between lender and borrower.
> We get a loan from a bank or finance company to buy a car
Role of the Government in Financial Markets
Financial markets play a prominent role in the economy. This calls for
regulation if market failure (i.e. not producing services efficiently at the
lowest cost) may arise.
> Disclosure regulation in order to prevent issuers from defrauding
(actual or potential) investors by concealing relevant information.
> Market conduct regulation a.k.a. financial activity regulation
in order to prevent insider trading, in order to impose trading
rules, . . .
> Financial institution regulation in order to prevent the default
of financial intermediaries and in order to safeguard the payment
system.
> Restrictions on foreign participants in order to control
e.g. the money supply.
Other Potential Roles of the Government
> Act as financial intermediary (e.g. credit support through loans
and guarantees)
Influence the markets through monetary policy (i.e. government
sensu lato since this task is performed independently by the
central bank.)
Provide bail outs
The last potential role has been actively used in the past but is under
discussion.
> No bail out policies
> Systemically Important Financial Institutions (SIFIs)
