Financial Markets, Banking, and Monetary Policy

CHAPTER 2 Overview of the Financial System

WHAT YOU WILL LEARN IN THIS CHAPTER

• Critical features of an effective financial system.
• A framework for understanding the various parts of a financial system.
• Direct versus indirect forms of finance.
• Debt versus equity.
• Money markets versus capital markets.
• The concepts of asymmetric information, moral hazard, and adverse selection.
• Primary- versus secondary-market trading.
• Different types of trading platforms.
• The role of brokers.

INTRODUCTION

Without a road map, the financial system can be a bewildering maze. There are bonds and stocks, underwriters, and commercial banks and other depository institutions, not to mention finance companies, insurance companies, pension funds, mutual funds, hedge funds, and private equity funds. Further, there are brokers and dealers, exchanges, and over-the-counter markets. Each handles huge amounts of funds that are entrusted to them. What are these pieces of the financial system, and what is it about what they do that makes them distinctive and a contributor to our economic well-being?

In this chapter, we develop a framework that will place these various parts of the financial system in perspective and answer these questions. Before we start, though, we examine some often overlooked features of a successful financial system.

FEATURES OF AN EFFECTIVE FINANCIAL SYSTEM

There are three features of a financial system that are critical for its success. First, the financial system is a fiduciary