The Role of Finance and Financial Markets

Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have surplus funds (from spending less than their income) to those with a shortage of funds (because they wish to spend more than their income).

Finance can be either direct or indirect. In direct finance, borrowers borrow funds directly from lenders by selling them securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the lender but are liabilities for the borrower. Securities take the form of either bonds or stocks.

Bonds (and mortgages) are contractual agreements that require the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of periods (the term) until the instrument’s expiration date. A debt instrument is considered short term if its maturity term is less than a year, and long term if its maturity term is 10 years or longer. Debt instruments with a maturity term between 1 and 10 years are said to be intermediate term. The yield of longer-term securities is characterized by higher interest rate risk, resulting in a maturity premium. The longer the maturity of a security is, the higher will be the average yield (return) of a security, even if the other risk characteristics of the borrower are the same.

Stocks are securities that entitle the owner to a share of a company’s profits or assets. Equities often make periodic payments (dividends) to their holders and are considered long-term securities, because they do not have a maturity date.

The disadvantage of being an equity holder is that you are a residual claimant (i.e., the corporation must satisfy debt holders before equity holders). As an equity holder, one benefits from an increase in the firms profitability, but one also loses from a decrease in the firms profitability. Bond holders receive fixed amounts. In the United States, the bond market is almost twice as large as the equity market.

Financial markets are organized in one of two ways: The first is through exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York Stock Exchange (NYSE) and the Chicago Board of Trade for commodities are examples of such organized exchanges. The second is over the counter (OTC) markets, where dealers in different locations stand ready to buy and sell securities. OTC markets rely on electronic communication systems, trades and prices are known to everybody, and such markets are thus very competitive.

Many stocks are traded OTC, but the majority of the large corporations have their shares traded at organized stock exchanges. However, the US government bond market, with a trading volume larger than that of the NYSE, is entirely OTC. There are about 40 dealers who establish the market in US government securities, standing ready to buy or sell. Other types of securities (such as negotiable securities of deposit, federal funds, and foreign exchange) are also traded in OTC markets.

By allowing funds to move from those who have no use for them to those who have, financial markets thus contribute to an efficient allocation of resources that increases economic welfare.

In indirect finance, financial intermediaries stand between lenders-savers and borrowers-spenders and help transfer funds from one group to the other.

19.1.1 Financial Frictions and Financial Intermediation

Financial intermediation implies lower transaction costs because of specialization, economies of scale, and the provision of liquidity services. In addition, because of the scale of their operations, financial intermediaries can reduce the risk of lending by pooling different types of risk. Thus, they can transform individually risky assets into safer composite assets, through diversification. By holding a larger and safer portfolio of risky assets, financial intermediaries are thus able to offer savers a safer menu of assets at a lower cost than if savers tried to do the same on a smaller scale.

Another reason for the importance of financial intermediation is asymmetric information. Borrowers usually have better information than do lenders about the risk and return of the project they are about to undertake. In addition, lenders cannot usually monitor the behavior of borrowers after they have lent them the funds. Asymmetric information creates two types of problems: Adverse selection and moral hazard.

Adverse selection is the problem created by asymmetric information before the transaction takes place. Adverse selection occurs when the riskier borrowers (those more likely to produce an adverse outcome) are the ones more actively trying to secure a loan.

Moral hazard is the problem created by asymmetric information after the transaction occurs. It is the risk (hazard) that the borrower might ex post engage in activities that are undesirable (immoral) from the view point of the lender, because they reduce the probability that the loan will be repaid. Hence borrowing and lending may break down because of this risk.

With financial intermediation, small savers can deposit their funds with the financial intermediary who, because of the specialization and the scale of their operations, have better means to address problems of asymmetric information by screening aspiring borrowers and monitoring the behavior of borrowers ex post. Thus, financial intermediaries can mitigate the problems of asymmetric information and thus expand the market. Yet the problems of adverse selection and moral hazard remain, although they may perhaps be less serious than in the case of direct finance.¹

Most financial intermediaries provide a range of financial services to their customers. Banks take in deposits, offer loans, provide liquidity services through checking accounts, provide insurance services to their customers, and so on. Thus, financial intermediation also implies economies of scope.

Economies of scope create the potential for conflicts of interest, a type of moral hazard problem that arises when an agent has multiple objectives (interests), some of which conflict with one another. Conflicts of interest are more likely to occur when a financial institution provides multiple services.²

19.1.2 The Risks of Financial Intermediation, Leverage, and the External Finance Premium

Financial intermediation increases the efficiency of the financial system but is not without risks. For a start, the problems of asymmetric information remain. Intermediaries have better information about risks than do their lenders but worse information than their borrowers have.

In addition, financial markets are vulnerable to systemic risks. A negative systemic shock can destabilize them, especially as financial intermediaries are usually highly leveraged, and there is a discrepancy between the maturity structure of the liabilities and the assets of financial intermediaries.

Leverage is defined as the ratio of assets to own capital. Leverage is simply the inverse of the capital ratio of a firm or a bank. Higher leverage increases the expected profitability of a bank, providing incentives for banks to be highly leveraged. Bank assets typically yield more than the cost of bank liabilities, like deposits, exactly because they are associated with longer maturities and higher risk. However, higher leverage increases the risk of losses for the bank, which may lower the value of its assets below the value of its liabilities and make the bank insolvent. The higher the leverage ratio is, the higher the risk of insolvency for banks will be. These risks apply in case there is a shock that reduces the return of their assets and at the same time shakes the confidence of lenders-savers, leading them to withdraw their deposits. In such a case, financial intermediaries may run into liquidity or solvency problems. Again, the possibility of such systemic risks creates the need for regulation, because in the absence of effective regulation, adverse shocks may lead to a destabilization of the financial system and a full-blown financial crisis.³

A common way to introduce financial market frictions in theoretical models is to assume an agency problem between borrowers and lenders. There are two basic approaches: postulating some type of informational asymmetry that leads creditors to be more informed than borrowers, or assuming that it is costly for creditors to enforce certain contractual commitments made by borrowers.

Key to the behavior of the external finance premium is the behavior of the borrower’s balance sheet–chiefly, its leverage ratio. A stronger balance sheet, in the form of lower leverage, enables the borrower either to self-finance a greater fraction of a project or to provide more collateral to guarantee debt. This basic prediction that credit access improves with the strength of the borrowers’ balance sheet is characteristic of many real-world financial arrangements, including restrictions that borrowers post down payments, post collateral, and meet certain financial ratios. In many of these cases, a borrower who is able to take a larger stake in the outcome of the project being financed will have a reduced level of agency conflict with the lender. The external finance premium declines as a consequence.

19.1.3 The Links between the Financial Sector and Real Activity in the Presence of Frictions

The link between borrower balance sheets and the external finance premium leads to mutual feedback between the financial sector and real activity. A weakening of balance sheets raises the external finance premium, reducing borrowing, spending, and real activity. The decline in real activity reduces cash flows and asset prices, which weakens borrower balance sheets, and so on.

This adverse feedback loop between the financial sector and real activity was first alluded to by Fisher [1933] in his debt-deflation theory of the Great Depression. It also played a key role in the Bernanke [1983] explanation of the Great Depression. Subsequent models include the financial accelerator model of Bernanke and Gertler [1989] and Bernanke et al. [1999], the model of bank runs of Diamond and Dybvig [1983], the credit cycle model of Kiyotaki and Moore [1997], and the leverage cycle model of Geanakoplos [2010]. Many derivative models of financial crises have evolved from these approaches to modeling financial frictions.

This earlier literature had focused largely on constraints faced by nonfinancial firms. In the crisis of 2008–2009, however, it was mainly highly leveraged households and banks that were initially vulnerable to financial distress. Following the crisis, Justiniano et al. [2010], Eggerstsson and Krugman [2012], and Guerrieri and Lorenzoni [2017] incorporated balance sheet constraints on households. The distress in financial markets induced other studies, like Gertler and Kiyotaki [2011], He and Krishnamurti [2013], and Brunnermeier and Sannikov [2014] to incorporate balance sheet constraints on banks. In these studies, the financial accelerator mechanism remains operative, but the transmission of the crisis through the different sectors of the economy is much closer to what actually occurred. In fact, this combination of weak balance sheets and high external finance premia is characteristic of major financial crises. In effect, through its liquidity effects and the rise in risk premia, a financial crisis causes a reduction in aggregate demand and may tilt an economy toward recession.⁴

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