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8.1 Financial Environment: Institutions and Markets

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Describe the difference between a commercial bank and an investment bank.
  2. Explain why commercial banks and investment banks have been merging into “megabanks”.
  3. Describe markets, especially with regards to physical vs. electronic presence.

Institutions

The most visible of financial institutions to the majority of people are commercial banksA bank that provides checking and savings accounts for depositors and loans for borrowers. that provide checking and savings accounts for depositors and loans for borrowers. Banks can also provide services, such as currency exchange. Successful commercial banks traditionally inspire feelings of security (with thoughts of large vaults) and trust. The overly simplistic view of a bank is that depositors place their money at the bank and it sits there until it is withdrawn. A slightly more accurate view is that the bank takes these deposits and lends most of the money out to borrowers, who promise to pay the money back with interest. When the borrowers pay back the loans, the interest returned is shared by the depositors and the owners of the bank. In reality, there are many ways a bank can take deposits and even more ways to invest the funds.

In contrast, investment banksA bank that provides services geared to corporations and market operations. provide services geared to corporations and market operations. Investment banks have employees who specialize in evaluating, issuing and trading securities, conducting mergers and acquisitions, and raising capital for companies. From 1933 to 1999, the Glass-Steagall Act mandated a separation of the commercial and investment activities in the USA, under the premise that commercial deposits should be protected from the riskier investment activities.

In recent years, many commercial banks in the US have been merging with each other to form large chains, as customers demand greater flexibility and banks can make use of economies of scale. Additionally, mergers and acquisitions between commercial banks and investment banks have proliferated since the 1999 repeal of the Glass-Steagall provisions. Since the latest financial crisis, however, there has been some who suggest that this division be restored, as the new “megabanks” are so large and involved in the economy that they are “too big to fail”A label that means governments are pressured into supporting a company when it is in distress, as the alternative of letting the company become insolvent is perceived to be even worse.. As used by most commentators, this means that governments are pressured into supporting these companies when they are in distress, as the alternative of letting the company become insolvent is perceived to be even worse.

Markets

Markets exist for trading any product, financial or otherwise. One of the most famous of financial markets is the New York Stock Exchange (operated by NYSE Euronext). Here, various securities, particiularly shares of ownership in corporations, are traded. Through most of its history, these transactions involved representatives of institutions negotiating prices with each other face-to-face. In recent years, however, electronic systems have dominated the transaction volume. As technology and communications have improved, more transactions are occuring in non-traditional marketplaces, some specifically designed to mask the identities of the buyers and sellers, or to allow for transactions of large volume. The NASDAQ is an electronic market that has no physical location, but is an alternative exchange that many companies (especially technology companies) have chosen.

Markets used to be segmented by product (such as pork bellies vs. shares of IBM) and location (Tokyo vs. New York), but these barriers are rapidly falling away. Virtually every product is trading somewhere in the world at any point in a 24 hour day, and technology is allowing for linkages among the various markets. As a consequence, markets are broadening the variety of products with which they deal, and mergers among the exchanges are becoming more commonplace. Many “markets” have no physical location or formal recognition, as they are decentralized; for example, most corporate bonds are traded amongst representatives at the various financial institutions. These are called over-the-counter (OTC) marketsDecentralized market with no physical location or formal recognition.. We will discuss the various types of securities and financial products and where they are traded later in this chapter.

Key Takeaways

  • Commercial banks focus on retail customers and small businesses; investment banks focus on capital markets for larger businesses.
  • Since 1999, many commercial banks and investment banks have been merging after the elimination of government restrictions on the practice
  • Many markets still have a physical presence, but the bulk of volume is now electronic.

Exercises

  1. When a company is in distress, a government can choose to let it fail or attempt to rescue it (often termed a “bailout” by those against the move). When might it be in the best interest of the populace to “bail out” a company? If “bailouts” are common, would companies be more or less likely to engage in risky business activities?