Financial Institutions, Instruments, and Markets

Surplus and Deficit Units

Surplus units, or savers, give up consumption now to increase future consumption. Deficit units increase their consumption now but give up their consumption in the future.

Categories of Financial Institutions

1. Banks - Take savings from depositors and make loans.
2. Investment and Merchant Banks - Provide services to corporate and government clients to earn income fees.

Categories of Financial Instruments

1. Equity - An ownership interest in an asset.
2. Debt - A contractual claim to interest payments and payment of principal.
3. Derivatives - A financial instrument that derives its value from a physical market or commodity.

Money Market vs. Capital Market

• Money Market - Issuing and trading short-term securities (less than one year).
• Capital Market - The market for issuing and trading long-term securities (equity, corporate debt, and government debt). Securities have a maturity of greater than one year. The capital market is supported by the foreign exchange and derivatives markets.

Bank's Source of Funds

1. Current account deposits – funds held in a check account, highly liquid.
2. Negotiable CDs – paper issued by a bank in its own name at a discount to face value and can be sold.
3. Bill acceptance liabilities – securities issued in the money market at a discount to face value.
4. Debt liabilities – the bank sells medium to long-term debt instruments to investors.
5. Foreign currency liabilities – the bank sells debt instruments into the international capital market denominated in a foreign currency.
6. Loan capital and shareholders’ equity – bank can issue equity securities and subordinated debt.

Uses of Funds for a Bank

1. Personal and Housing Finance - Such as mortgages, fixed-term loans, and credit cards.
2. Commercial Lending - Lending to businesses and other financial institutions.
3. Lending to Government - Purchasing government securities such as Treasury notes and Treasury bonds.
4. Other Bank Assets - Such as electronic network infrastructure.

Off-Balance-Sheet (OBS) Business for a Bank

Off-balance-sheet (OBS) business for a bank are transactions that do not create an asset or liability on the bank's balance sheet.

OBS Business Categories

1. Direct credit substitutes.
2. Trade and performance-related items.
3. Commitments.
4. Foreign exchange, interest rates, and other market rate-related contracts.