Financial System Overview and the Flow of Funds

Financial System Overview and the Flow of Funds Week 1 – August 24, 2005 J. K. Dietrich - FBE 524 – Fall 2005

The Financial System u What happened on August 9, 2005? – What was market reaction? – What are the linkages between those actions and business conditions? u What is occurring in financial markets? – Interest rates, mortgage borrowing, restructuring of financial firms? – New financial products? u What framework can be used to comprehend these important changes? J. K. Dietrich - FBE 524 – Fall 2005

Market Reaction – Summer 2005 J. K. Dietrich - FBE 524 – Fall 2005

This course u Overview of institutions and markets u Major institutions and their regulators u Interest rate determination u Risk. risk management, and risk premiums u Important financial markets in depth u Closer scrutiny of the money market and important factors influencing conditions u Detailed review of important credit markets and the market for equity J. K. Dietrich - FBE 524 – Fall 2005

Readings in text first two weeks u This evening will we cover Chapters 1 to 3 – Chapter 1 - Functions of financial system – Chapter 2 - Markets and funds flows – Chapter 3 - Efficient markets and information u Try to review these and raise any questions by next time, they are introductory u Next week, cover Chapters 14 and 15 – Chapter 14 – Banks – Chapter 15 – Non-bank thrift institutions J. K. Dietrich - FBE 524 – Fall 2005

Stages of financial systems u Each unit is independent, investments accumulate over time, e. g. a farm u Units can accumulate value in monetary asset (e. g. claim on government) in order to save for large investments u Units can borrow and lend individually u Financial intermediaries raise funds from saving units and lend to investing units J. K. Dietrich - FBE 524 – Fall 2005

J. K. Dietrich - FBE 524 – Fall 2005

Circular Flows u Goods and services – National product accounts, gross domestic product – Produced by Commerce Department u Income flows – National income accounts u These accounts do not reflect financial market activity u Flow of Funds Accounts of Federal Reserve system track financial flows J. K. Dietrich - FBE 524 – Fall 2005

J. K. Dietrich - FBE 524 – Fall 2005

Financial Markets u Money and capital markets u Open versus negotiated markets – Competitive market-based funding versus intermediated or bank-dominated funding markets u Primary versus secondary markets u Spot versus futures, forward, and option markets J. K. Dietrich - FBE 524 – Fall 2005

Balance Sheets and Flows J. K. Dietrich - FBE 524 – Fall 2005

Sources and uses = flows u Sources and uses are changes in balance sheets u We want to look at both u Balance sheets represents stocks, hence total size, at a point in time u Flows represent net changes in stocks (I. e. new issues minus repayments of financial assets or liabilities) J. K. Dietrich - FBE 524 – Fall 2005

Balance sheets and portfolios u Assets = Liabilities + (net worth = equity, common stock shares, etc. ) u Assets – Financial assets » Money, loans and bonds, equity investments – Real assets » Housing, consumer durables including autos » Inventory, plant and equipment J. K. Dietrich - FBE 524 – Fall 2005

Balance sheets/portfolios (cont’d) u Liabilities – Monetary liabilities (loans, mortgages) – Other financial liabilities u Net worth is composed of equity in real assets and net financial claims on others u Sectors are aggregate balance sheets of similar units – Households, business, government – Financial institutions J. K. Dietrich - FBE 524 – Fall 2005

Sectoral balance sheets u Balance sheets of Households and Nonprofit organizations – 2004 largest real and financial assets – 2004 largest liabilities – 2004 composition of real asset holdings – share of monetary assets u Compare 1980 balance sheets u Share changes = growth and change in portfolio composition J. K. Dietrich - FBE 524 – Fall 2005

Sectoral balance sheets (cont’d) u Farm + non-farm non-financial noncorporate + non-farm non-financial corporate business u Non-farm non-financial corporate balance sheet – 2004 largest assets – 2004 largest liabilities – 2004 composition of real asset holdings – share of monetary assets u Compare J. K. Dietrich - FBE 524 – Fall 2005 1980 balance sheets

Wealth and flow of funds u Primary sectors = households, business government u Financial sector – Financial claims - financial liabilities (small holdings of real assets) u Aggregate wealth is real assets since all financial claims cancel J. K. Dietrich - FBE 524 – Fall 2005

Wealth u Total wealth in 2004 is approximately (billions) $22, 566. 2 + $10, 479. 1 + 6, 407. 9 = $ 39. 5 trillion u 2004 GDP is $11, 734. 9 trillion, so income-capital ratio is approximately. 30 or capital-income ratio 3. 4 u 1980 wealth approximately $ 9, 729. 7 trillion, GDP $ 2, 789. 5 trillion, so capital-income ratio is also about 3. 5 (about the same) u GDP over assets in 1980 and 2004 around 30% u Has tangible wealth composition changed? J. K. Dietrich - FBE 524 – Fall 2005

Distribution of GDP u Employee compensation in 2004 was $6, 651, or 56. 7% of GDP u Business tangible assets were $ 16, 887. 0 or 40. 7% of “total” tangible assets u Roughly gross before tax return on business investment is: u Gross return illustrates top down approach J. K. Dietrich - FBE 524 – Fall 2005

Composition of wealth u Compare composition of tangible assets 1980 2004 Households Real Estate 78% 83% Durables 21% 16% Business (corporate + non-corporate) Real Estate 67% 68% P&E 22% 23% Inventories 11% 9% u Think of other economies J. K. Dietrich - FBE 524 – Fall 2005

The Financial System u Channels savings into investment u Financial institutions assist in this process u Financial institutions create value for primary surplus and deficit units through – Increasing economic efficiency – Providing financial servies u The value of flow of funds framework is that we can trace the changing roles of financial institutions J. K. Dietrich - FBE 524 – Fall 2005

Next time u Before next Wednesday, review Chapters 1 to 3 of Money and Capital Markets and identify any questions about this evening’s session u Read Chapters 14 and 15 of Money and Capital Markets u Bring a Wall Street Journal to class every Tuesday J. K. Dietrich - FBE 524 – Fall 2005