hi I'm Thomas welcome to the first lecture for financial institutions and markets today we're going to work through our PowerPoint lecture we'll do some activities on the whiteboard and at the end you'll be ready to complete the case study that I'll provide to you so let's get started first we want to understand the financial system what is the financial system this consists of markets such as the New York Stock Exchange and that's one of the topics that we're discussing in our course institutions perhaps a bank that's an example of an institution and today we're gonna look at banking in a little more detail individuals investors who are buying and selling in investments and regulators the government usually gets involved generally this is to protect investors and make sure that their interests are taken into consideration so that the markets and institutions aren't taking advantage of the individuals markets and intermediaries an intermediary is someone or something that comes between two parties so how do markets and intermediaries provide benefits in the financial system first they connect buyers and investors if I'm interested in investing in a technology company I might have a difficult time just going out and finding a technology company looking for capital but if I go to a market I can find several technology companies who are listed on the stock exchange for example who are looking for capital and I can buy their shares put my capital into the system and then through that process the technology company accesses capital without having to find me individually this would be a primary market transaction when the issuer the company either issuing equity or borrowing money which is issuing bonds works directly with the investor that's when I buy shares from a company or I buy bonds from a company the secondary market is when an investor no longer wants to be an investor and is looking for another party to buy their investment so one investor will sell their investment to another and the issuer the company who originally issued the securities isn't involved in the secondary market transaction another benefit is an increase in liquidity if I want to invest in as we can do in the secondary market later sell my investment it might be difficult for me on my own to find a buyer for those securities I can go to a market or an intermediary someone in between me and the new investor and that facilitates that eases that transaction and finally markets and intermediaries will decrease transaction costs fees are lower because they're professionals they do the same thing in volume over and over that keeps fees down and it also decreases the interest rate and required dividends to the issuers it creates a competitive market and the issuers the companies who are looking for capital can work with the investors who are willing to accept the lowest cost from the company's perspective in other words the lowest interest rate possible or the lowest dividend payment possible an example of an institution banks let's look at banks in a little more detail how do banks work banks receive deposits which is a short term type of financing they receive deposits from customers who might want to come in the next week next month maybe the next day and remove their money what the banks do with those funds is they make loans and generally loans are a long term a year two years three years maybe ten years so a good question is how does this maturity imbalance function in other words how is it that a bank can take in money that they might have to pay back in the next week or the next day and they lend it out for years of time well there are a few factors that make this system work one is the bank has equity capital before opening for deposits and activity they have investors who provide capital to fund the bank and this is a source of money for the initial loans before a significant amount of deposits has been collected by the bank second factor is deposits are coming in going out coming in going out so yes somebody might come one day and say I need to get my money out but maybe the same day or the day before the day after another depositor comes and says here's my money I'm going to put it with you so there's consistent cash flow from deposits and the loans the bank has made are generating interest income so interest payments are coming in from the borrower's and then eventually loan payoffs begin to balance out new loan issuance and that creates sort of an equilibrium of cash flow so let's go to the whiteboard and let's look at an example of diagram of how cash flow works at a bank we're going to look at the concept of time and create a line going out let's say three years one two three and we're going to look at deposits and we're going to look at loans and deposits are increasing and decreasing the banks cash flow deposits are continually coming in and going out same in year two cash flow goes up and down because of deposits on into year three in the future now what's happening with loans in year one all the cash flow is an outflow the bank is making loans and probably not collecting much in repayment they're collecting some interest income but not much in the way of repayment in year two a similar situation and in year three let's assume the banks average loan has a three year life and so what's going to happen in year three is the bank will make new loans but they're also going to begin to collect the loans that were made in years one and two so here in year three we've reached an equilibrium deposits coming in and out loans go in and out and those work to offset each other what happened here in years 1 & 2 how did the bank cover the situation loans outflow outflow without loans coming back in probably this is the equity capital that the company originally started with from the owners of the bank that was an injection of cash equity capital that the bank can use to operate make loans cover its expenses until the time it hits the equilibrium point in year 3 this is a simplified example there's some other more advanced factors that are involved in actual banking but it gives you a good sense of how banking functions the final point let me just move my bar down a bit the final point is that multiple loans offer banks diversification what that means is they're lowering their risk instead of lending all of their money to one customer they're making loans to many different customers that lowers their risk because if one customer has a financial problem and can't pay the loan back the other let's say nine customers who have loans if they can pay then the bank's loss is minimized this allows the bank to offer lower interest rates they have lower risk through diversification which means multiple loans at the same time and their clients benefit their customers benefit because the bank can offer lower interest rate loans reflecting the lower risk that the banks realize due to diversification how does the lender borrower relationship work we know deposits are coming in from customers and loans are going out to customers usually not the same customer but sometimes they are what is the lender one lender wants short-term loans the sooner the loan comes back the lower the uncertainty and the lower the risk for the bank and the lender wants high interest rates the higher the rate the more interest income for the lender and logically the borrower wants the opposite of to those they want more time to pay longer-term loans and they would like to have a lower interest rate if possible so there's to some extent a conflict of interest in the goals of the lender and the goals of the borrower now as an analysis exercise a thought exercise here's a question I mentioned that in some cases a bank might have the same client who makes a deposit and who borrows money from the bank here's the question here's the scenario the bank client has a bank balance of $5,000 that's their deposit the interest rate is 1% in addition to that the same client has borrowed $50,000 from the bank at an interest rate of 6% question why does the client not use the low rate bank balance to reduce the high rate loan balance let's look at the whiteboard again for a minute this additional five or this deposit of $5,000 is available to pay the loan down and if the borrower paid the loan down let's look again at the interest rate differential our cost is 6% and our income is 1% so the difference point zero six - point zero 1 would be the interest savings if we were to pay down the loan by $5,000 so how much would we save in one year if we were to use that $5,000 to pay down the loan 5,000 times point zero five it's 250 dollars a year so the cost for keeping that money in the deposit account instead of using it to pay down the loan is 250 dollars a year so the question I want you to think about pause the video take a minute or two or five get online make a phone call see if you can determine the answer to this question why doesn't the client pay down the loan and save some interest expense when we come back I'll explain the reasoning okay welcome back maybe you found the solution either through odjick through a conversation through a web search the solution is that liquidity is an important factor for individuals and for companies we want the $5,000 available for daily or weekly or monthly expenditure needs so instead of paying the loan down and being in a cash flow crunch we keep it slightly higher loan balance and it has an expense this difference that we calculated of $250 a year that we calculated on the whiteboard but it also has a benefit and that benefit is that I'm able to maintain some liquidity to manage my cash flow over time that's the reason that the client keeps the bank balance at 5,000 and keeps the loan balance a little bit higher than it could be otherwise let's talk specifically about securities as a financial instrument securities are a form of a financial asset that means they're not real assets an example of a real asset is a building inventory computers financial assets or stocks and bonds the most common examples and those represent ownership in typically a corporation and the corporation owns the real assets so by owning by investing in financial assets you indirectly have an ownership stake in real assets but they are not the same thing this course is focused on the concept of financial type of assets financial transactions securities can be traded in the secondary market there's an investor to investor market as we mentioned earlier the primary market is when an issuer a company is dealing with a new investor in the secondary market which is available for securities an investor can sell their investment to another investor without the issuer without the company having any involvement and the two most common types of securities debt securities which are bonds bonds are a form of lending to a corporation equity securities which are stocks stocks are a form of ownership a few own stocks you're one of the owners of the company if you own bonds you're functioning like the bank of the company now we're going to conclude this video with this supply and demand of loans and security slide there's a question and in the next video we're going to answer that question the question is something is very unusual about the supply demand graph on the Left what is it well something isn't unusual about the supply demand graph on the right this is a typical supply demand graph that shows price on the y-axis quantity on the x-axis a supply curve going up and to the right a demand curve going down into the right now I'll make one comment about the curve on the left and I'm gonna leave it to you to give it some thought and we'll discuss further in the next video notice that the y-axis of the curve on of the chart on the left the graph on the Left isn't price it is yield and that's a very very important factor in why this graph the graph on the left is different there's another very important difference which is the one if you look closely will seem quite strange and we're going to discuss that when we continue in the next video
