Money and Capital Markets

44C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

The Future of the Financial System and the Money and Capital MarketsThe Future of the Financial System and the Money and Capital Markets

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To understand the economic, demographic, social, and technological forces reshaping the financial system today.

To study where recent trends in the financial system appear to be leading us and how we may be affected.

To understand how the problems of the financial system today may influence the shape of the financial marketplace of the future.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Introduction

Powerful forces are reshaping the financial system today, as well as the public’s demand for financial services.

These forces for change include powerful new trends within the financial sector itself, major changes in the structure and functioning of the economy, and new social and demographic trends that are altering the public’s need for innovative financial services.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Financial ForcesReshaping the Financial System Today

Financial innovation - the development of new financial services and instruments

Service proliferation - the expansion of the menu of financial services offered

Competition - the intense struggle for the customer’s business

Homogenization - the blurring of the traditional distinctions among the different types of financial institutions

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Financial ForcesReshaping the Financial System Today

Consolidation and convergence - mergers and acquisitions across sectors have created financial giants and decreased the number of firms in the industry

Deregulation - the lightening or elimination of government rules

Globalization - the global expansion of operations and the falling of geographical barriers

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Financial ForcesReshaping the Financial System Today

Harmonization - the coordination of financial and economic policies

Market broadening - the expansion of traditionally local markets to become regional, national, or even international in scope

Securitization - the pooling of loans and the issuance of securities as claims against the loan pool

Greater emphasis on risk management

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Social, Economic, & Demographic Forces and TrendsReshaping the Financial System Today

Aging population - there is a greater need for retirement, tax and estate planning

Changing basic family unit - the rise in the proportion of single-parent households, parents and children living apart, immigrants, and well-educated working women will increase the demand for new forms of housing, daycare facilities, flexible work schedules, and less expensive medical care.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Social, Economic, & Demographic Forces and TrendsReshaping the Financial System Today

Displacement of the manufacturing industries by service industries in more developed economies

Technological innovation - the dissemination and storage of information today is broader, cheaper, faster, and more accurate

Internationalization of markets - such as the formation of the European Community

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Risk in the Financial System:The Challenges and Opportunities

The money and capital markets and the financial institutions that operate within them depend heavily on public confidence.

Ways to promote the strength and viability of financial institutions, and hence public confidence, include government insurance systems capital adequacy regulations market discipline risk-management tools

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Risk in the Financial System:The Challenges and Opportunities

However, the efforts made at promoting public confidence are limited by the information problem - capital market investors can only approximately price the securities of institutions that do not fully disclose their financial condition and prospects.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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New Technology:The Challenges and Opportunities

The technological revolution in information analysis, storage, and transfer is moving at an accelerating pace.

Global integrated electronic networks are changing the design and delivery of financial services: Internet or World Wide Web Cellular telephones and hand-held computers Smart cards

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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New Technology:The Challenges and Opportunities

However, the adjustment of the public to the unfolding technological revolution will probably be slower than the revolution itself.

The areas to watch include: friendliness of the user interface operating costs and service prices ease of technological upgrade data integrity and system security

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Homogenization of Financial-Service Suppliers:The Challenges and Opportunities

Financial-service firms will face increasingly intense competition and price-sensitive customers.

Financial institutions with extensive service delivery systems will have a competitive advantage.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Homogenization of Financial-Service Suppliers:The Challenges and Opportunities

The unfolding new markets will require new financial institutions and instruments, such as credit risk derivatives and additional secondary markets for loans.

New institutions will also be needed to facilitate the continuing trend of securitization, such as those that deal in mortgage-backed securities.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Consolidation and Convergence:The Challenges and Opportunities

Proponents argue that: The elimination of duplication will bring about

substantial savings in operational costs. The broadening of services and customer segments

will accelerate the growth in revenue. The greater diversification will reduce overall risk. The combination of expertise will result in higher-

quality products and services. The greater economies of scale will increase the

affordability of the latest technologies.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Consolidation and Convergence:The Challenges and Opportunities

Opponents point out that: The greater complexities of the firm may increase

its operating costs. The public’s demand for “one stop” financial

shopping may be overestimated. Smaller financial-service companies may have

their own competitive advantage. Smaller financial-service companies may compete

effectively in terms of the range of services available by outsourcing part of their operations.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Financial Services Regulation

The growing consolidation and convergence of financial-service companies poses major new challenges for the regulatory agencies charged with maintaining a competitive, yet safe and stable, financial system.

Different approaches to regulation are possible depending on the organizational structures that are allowed.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Financial Holding Company

InsuranceCompanies,

Underwritersand Agents

Security Brokers,

Dealers and Underwriters

BankingFirms

OtherFinancial-

ServiceCompanies

Financial Services Regulation

Financial Holding Company Model

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Banking or Other Controlling Firm

SecuritiesSubsidiary

InsuranceSubsidiary

Financial Services Regulation

Subsidiary Model

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Holding Company or Parent Firm

Affiliated and/or Subsidiary Companies

Financial Services Regulation

Single Regulator Model - One regulatory agency supervises the operations of the whole financial service firm.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Financial Services Regulation

Functional Regulator Model

Holding Company or Parent Firm

SecuritiesFirm

InsuranceCompanyBank

SecuritiesRegulator

InsuranceRegulator

Bank Regulator

Holding Company Regulator

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Management Coordination

The difficulties of coordination and control in larger and more diversified financial institutions call for: employees who are well trained in coordination

and control skills, strong internal auditing procedures and

management information systems, and continual evaluation of subsidiary firms, profit

centers, and service functions for their contributions to the goals of the financial firm.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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The Future of the Payments System

Tomorrow’s economy and financial marketplace will depend crucially upon the continuing ability of the world’s payments system to function efficiently, speedily, and accurately.

In the U.S., the retail payments system lags significantly behind the wholesale payments system in converting from expensive paper transactions to electronic systems.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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The Future Need forRegulation of Financial Institutions

The recent trend toward deregulation is likely to continue, leading to: reduced barriers to geographic diversification, reduced restrictions on the portfolio choices made

by financial institutions, reorganization of regulatory agencies, and reduced barriers to product-line diversification.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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The Future Need forRegulation of Financial Institutions

However, there are some regulations which will be maintained or even re-emphasized: financial disclosure regulations, privacy protection regulations, regulations pertaining to social responsibility, and regulations that promote a level playing field.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Money and Capital Markets in Cyberspace

A number of web sites are devoted to the changes and trends that are reshaping the money and capital markets. See, for example: http://www.goldmoney.com/ http://www.thebankingchannel.com/ http://www.financetech.com/ http://www.ex.ac.uk/~RDavies/arian/money.html

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Introduction Forces Reshaping the Financial System Today

Financial Forces Social, Economic, and Demographic Forces and

Trends

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

The Challenges and Opportunities Presented by Recent Trends Dealing with Risk in the Financial System:

Ensuring the Strength and Viability of Financial Institutions

The Effect of New Technology on the Design and Delivery of Financial Services

The Changing Mix of Financial-Service Suppliers Consolidation and Convergence Trends Within the

Financial System

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

A New Role for Financial Services Regulation in an Age of Financial-Service Consolidation and Convergence

Management Coordination within Diversified Financial Institutions

The Future of the Payments System The Future Need for Regulation of Financial

Institutions