The Players

From a bird's-eye view, there would appear to be three major players in the financial markets:

1. Firms are net borrowers. They raise capital now to pay for investments in plant and equipment. The income generated by those real assets provides the returns to investors who purchase the securities issued by the firm.

2. Households typically are net savers. They purchase the securities issued by firms that need to raise funds.

3. Governments can be borrowers or lenders, depending on the relationship between tax revenue and government expenditures. Since World War II, the U.S. government typically has run budget deficits, meaning that its tax receipts have been less than its expenditures. The government, therefore, has had to borrow funds to cover its budget deficit. Issuance of Treasury bills, notes, and bonds is the major way that the government borrows funds from the public. In contrast, in the latter part of the 1990s, the government enjoyed a budget surplus and was able to retire some outstanding debt.

Corporations and governments do not sell all or even most of their securities directly to individuals. For example, about half of all stock is held by large financial institutions such as pension funds, mutual funds, insurance companies, and banks. These financial institutions stand between the security issuer (the firm) and the ultimate owner of the security (the individual investor). For this reason, they are called financial intermediaries. Similarly, corporations do not market their own securities to the public. Instead, they hire agents, called investment bankers, to represent them to the investing public. Let's examine the roles of these intermediaries.

Financial Intermediaries

Households want desirable investments for their savings, yet the small (financial) size of most households makes direct investment difficult. A small investor seeking to lend money to businesses that need to finance investments doesn't advertise in the local newspaper to find a willing and desirable borrower. Moreover, an individual lender would not be able to diversify across borrowers to reduce risk. Finally, an individual lender is not equipped to assess and monitor the credit risk of borrowers.

For these reasons, financial intermediaries have evolved to bring lenders and borrowers together. These financial intermediaries include banks, investment companies, insurance companies, and credit unions. Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations.

For example, a bank raises funds by borrowing (taking deposits) and lending that money to other borrowers. The spread between the interest rates paid to depositors and the rates charged to borrowers is the source of the bank's profit. In this way, lenders and borrowers do not need to contact each other directly. Instead, each goes to the bank, which acts as an intermediary between the two. The problem of matching lenders with borrowers is solved when each comes independently to the common intermediary.

Financial intermediaries are distinguished from other businesses in that both their assets and their liabilities are overwhelmingly financial. Table 1.3 shows that the balance sheets of financial institutions include very small amounts of tangible assets. Compare Table 1.3 to the aggregated balance sheet of the nonfinancial corporate sector in Table 1.4. The contrast arises because intermediaries simply move funds from one sector to another. In fact, the primary social function of such intermediaries is to channel household savings to the business sector.

financial intermediaries

Institutions that "connect" borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.

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