Chapter 2: The Financial System
In popular entertainment, financiers have long been portrayed as "evil and powerful monsters bent on destroying all that decent folk hold dear for the sake of a fast buck." It is not just a recent phenomenon, as it can be seen in literature all the way back to Shakespeare (the Merchant of Venice) and even literature of the ancient world demonized anyone who was a merchant or money-lender.
And in truth, some financiers have done very bad things, taking advantage of the ignorance of others to make profit and disregarding the negative consequences. But the same can be said of any occupation. To take a dim view of all people in a profession because of the negative behavior of a few is next of kin to blaming people of an entire race, religion, age, or any other arbitrary group. And as consumers, we tend to be very fickle in our loyalties. When a financier is helping us to get a loan to purchase something we want, he's our best friend. A month later when he shows up to collect the payment that we promised to make, he's our worst enemy.
Nor would it be correct to swing to the opposite extreme and attempt to glorify financiers. At times, they seem quite heroic when they are helping us obtain the credit for the things we want to buy (and cannot afford), managing our investments and winning a healthy return, enabling people to start new businesses and keep the doors open and the employees paid through tough times, and so on. In the end, most financiers are servants that do our bidding - they are middlemen between the people who have money and the people who need it.
The Complexity of Financial Systems
The basis of finance is lending, and an individual loan is easy enough to understand: one person borrows money from another and repays it in the future, with a little bit extra for interest. What makes financial systems complex is that it encompasses every loan - many borrowers, many lenders, large sums of money, and complicated repayment contracts.
He switches to the question of why is borrowing necessary at all. Society got along very well without it for many years, but progress would be very slow (and prevented) without it. On an individual level, we borrow money to buy a car to drive to work where we make the money to pay for the car - and if we weren't able to borrow the money to buy the car, it would be difficult or impossible for us to get to work. Commercial lending is much the same: the baker borrows money to buy the ingredients he needs to bake the bread, then pays back the loan with the money he makes from selling the bread once it's made.
Without financing, we could still likely get by - but not as well as we do in the modern age. The only people who could start businesses are those who are already wealthy enough to purchase a factory and materials. The only people who could go to college, own a car or a house, or do anything that costs a significant amount of money are those who already have wealth to purchase these things outright. Economic activity would be very low and most people would live lives of deprivation, much as they did in the middle ages.
If all of our needs were small, person-to-person lending without intermediaries would suffice - though everyone would likely need to have a rich friend with money to lend whenever we wanted to borrow it. The financial system serves to make those connections for us - the banker uses the savings of some to provide loans to others without them ever having to meet, to pool the savings of several people to make a large loan, to turn the loan into cash sooner than the borrower is able to repay it if the lenders need it back, etc.
And since the financial system has gone global, it connects buyers and sellers around the world. The savings account of a person in Ohio may be funding the construction of a bridge in India, or a person who gets a mortgage to buy a vacation home in Florida may be borrowing the finds of investors in Europe. The system allows money to flow from the hands of those who have it to those hands of those who need it, regardless of where they are.
Asymmetric Information
All exchanges or transactions involve asymmetric information: they buyer and the seller know different things and act accordingly. If the price of oil is going to rise, the buyer who knows this wants to purchase today to avoid paying a higher price in future - but to get this discount he must find a seller who does not know the price will rise and is still selling at the prices based on current supply. It is only natural that people will know different things and even make different predictions based on the same knowledge - but those who later discover information that would have helped them make more profit on a deal cry "unfair."
It is generally believed that the supply and demand in the marketplace will inevitably overcome informational asymmetries - that as more and more buyers find out the "secret" information, there will be greater demand that will drive up the price, regardless of whether sellers actually find out. The earlier buyers will enjoy the greatest discounts, which again is declaimed "unfair" by those who learn the secret later and get less of a discount for knowing it.
The author strays across a number of other topics here that seem a bit disjointed:
- Adverse Selection - The supplier who offers the lowest price (for goods, for credit, or whatever) attracts the worst kind of customer. Hence those who offer low-interest loans are often beset by un-creditworthy borrowers who attempt to hide information that would make lenders aware of their risk.
- Moral Hazard - When a person is protected from damage, they are prone to engage in riskier behavior. There is the argument that having car insurance makes a person more careless in their driving habits because someone else will pay for the damage they do.
- Liquidity - Is a state of having assets in a form that can easily be traded. Cash can be spent immediately, but a promissory note from a borrower locks up capital until the loan is repaid. The desire to be liquid influences the amount of money a person will lend and at what rate.
Financial Markets
When a lender has loaned capital to a borrower, he may opt to collect the payments to recover his investment and the interest he is owed. But there are various reasons he may wish to have his investment returned to him sooner so that he can spend it or invest it in something more profitable. To do this, the lender sells the loan - giving someone else the right to collect the payments from the borrower and earn the interest. He may arrange to sell the loan to a specific buyer, or he may put the loan up for sale on the financial markets.
A "primary market" is the market where debt instruments are sold - i.e. the buyer purchases the right to collect the loan. There is also a "secondary market" in which the holder of a debt instrument sells shares of the profit to others - the buyers of these derivatives do not hold the debt instrument itself, but are issued a contract promising them income from the collection of the debt. A derivative can be very complex, bundling many different debt instruments into a package and issuing shares. The buyers of these shares often have no sense of what are the actual debts upon which their shares are based.
There is another distinction made between a "money market" and a "capital market" in that the money market deals in instruments that are due to be repaid in the current year (and are perceived to have less risk of default) whereas a capital market deals in instruments that have a year or more to maturity (and it is believed that the longer the principal is outstanding, the greater the risk of default).
Then there is a bit of fussiness between the role of a broker (who helps other people to make trades but never takes possession of a security) and a dealer (who purchases a security with the intent to resell it to someone else). Naturally, the dealer makes more profit but takes on greater risk. It's also mentioned that a single firm may act as a broker in some trades and a dealer in others.
Then, there is some consideration of the various types of investment. An equity (such as a stock) implies a share of ownership in the assets of a corporation and in the income that the company produces. Bonds of various types are debt instruments that entitle the holder to collect the interest on a loan to a specific party (a company or a government entity) and to be returned the principal on the maturity date. Perpetuities are a special kind of bond that constantly earns interest but the principal is never repaid (until the instrument is retired).
There are other classes of investments called derivatives, as they derive value from the value of something else. A stock option is a derivative - it is the right to buy stock at a fixed price by a future date, so its value is derived from the difference between the strike value and the market value on any given day. A commodities future is a derivative that is based on the production of a farm, mine, or other operation and its value is based on the price that will be offered for the commodity on some future date.
Financial derivatives can be considerably more complex because their value is based on the repayment of many different debt instruments. Ideally, their value is based on the amount of interest that will be collected when those loans are repaid - but there is a default risk to be considered because some of the borrowers will default, which means the entire principal will be lost (though some may be recovered through the seizure and sale of the loan collateral). It is unknown how many of the borrowers of these loans will default.
It's noted that the notion of separate financial markets is a bit anachronistic. Originally, there was a financial market in each major commercial city where investment was made in the local market (the city itself and surrounding areas). These consolidated into larger markets, eventually becoming national markets. Today this distinction is largely academic, as an investment banker may deal in whatever market he cares to, so the stock (and debt) of a company in one nation may be traded in the exchange of another nation and most markets are connected electronically - so there is in effect one large international financial market - which is why a crisis in one nation affects markets around the globe.
Financial Intermediaries
Financial intermediaries are parties through which investors/lenders are linked to entrepreneurs/borrowers in a way that the two never have to meet. Intermediaries can specialize in a given kind of transaction or asset, and at one time regulations strictly separated firms that deal in different kinds of investments (e.g., banks could not engage in stock trading), but deregulation has largely reduced those barriers, though some still remain.
However, most financial services companies still tend to specialize: insurance, banking, and investments are often handled by different companies (or compartmentalized into subsidiaries of a parent corporation). Intermediaries may further specialize themselves - there are insurance companies that only offer life insurance and annuities, banks that only process commercial transactions, and the like.
In general, the financial services industry has exploded in the late twentieth century - with exponential growth in the number of firms, the kinds of financial instruments, and the amount of wealth involved in both daily transactions and capital reserves.
The author poses the question of why parties choose to work through intermediaries rather the participating directly in financial markets. Intermediaries are not necessary, and their profit is to the detriment of both parties (who could have made more or paid less if the intermediary were not involved). One reason is the same as that of retailers in any industry: it is much more convenient to buyers and sellers alike to have a middleman. Also, many intermediaries absorb some or all of the risk involved: those who place money in a bank account are shielded from the risk that borrowers from that bank will not repay their loans. So in exchange for decreased risk, investors/lenders are willing to accept a lower return.
For the entrepreneur/borrower who needs money from the investors/lenders, their effort in obtaining funding is greatly reduced by having an intermediary. A person who wishes to borrow money does not need to locate and negotiate the holders of funds, but may place their bid through an intermediary who attempts to match then with those who are willing to lend or invest.
(EN: that there are currently experiments on the internet and social media to disintermediate the markets - to allow individuals to borrow/loan directly from one another or to invest in businesses in a manner that is managed by a website. This site is acting as a market rather than an intermediary, as it bears none of the risk and places no effort, aside of providing search tools, to match demand and supply of capital. Thus far, it's still experimental, and too soon to tell whether this will be a passing fad or a major shift in the financial markets.)
Regulation
Throughout history, financial markets have experienced a number of catastrophic failures that have resulted from one fundamental cause: dishonesty. Because the financial services industry provides direct access to money, it is an attractive milieu for swindlers of all kinds - primarily borrowers and entrepreneurs who wish to misrepresent their ability or intent to repay the money the borrow cause havoc in financial markets because there are many instances in which one firm's ability to meet its obligation to others depends on others to meet their obligations to the firm: a bank cannot pay its depositors interest (or return their capital) if its borrowers do not repay their loans.
Each financial mishap of significant scale has been answered by a wave of regulation from government with an eye toward preventing the same thing from happening again in future - and as a result the financial services industry is the most heavily regulated industry. In many instances the regulations become so onerous that the system is unable to function properly, and there follows a period or incident of deregulation to unstuck the gears - and then the loopholes give swindlers the opportunity to abuse the system again, leading to another meltdown, leading to more regulation, and so on.
The Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC) are among the most well-known agencies (government or private) that work to ensure honesty between participants in the financial markets, but they are not by any means the only regulatory agencies.
The author suggest there are four major functions of regulators:
- To encourage honesty by means of transparency, requiring both financial markets and intermediaries to disclose accurate information to investors in a timely manner.
- To protect both investors/lenders and entrepreneurs/borrowers from being taken advantage of by dishonest parties and otherwise ensure that promises made are kept.
- To promote standardization and uniformity by licensing firms and registering financial instruments, such that both sellers and buyers have a "standard contract" by which to abide
- To ensure the perpetuity and function of the financial system by providing a stable foundation and reacting to financial crises in ways that minimize the damage to the system.
And all of this activity is done with an eye toward minimizing its impact on the system itself: heavy-handed regulation and bureaucracy can slow the flow of capital through the system - making it so difficult to obtain funding that borrowers and entrepreneurs seek to work outside the system, in risky and unregulated transactions.