The Financial Cornerstones: Debt and Equity Claims

Financial claims come into two basic forms: debt and equity. These two instruments are the financial cornerstones of capital markets and firms’ balance sheets. A fixed or variable dollar claim is called a debt instrument (e.g., a fixed- or floating-rate loan); a residual claim on the earnings of an enterprise represents equity (e.g., common stock). Hybrid claims such as preferred stock and convertible bonds have characteristics of both debt and equity.

Because all other financial contracts derive their values from either debt or equity, we use the term derivatives to describe such innovations as futures, options, and swaps. The development of these innovative contracts has been described as financial engineering and is referred to as innovations in contracting technologies. Because of these developments, financial claims can have many distinguishing traits. Nevertheless, four common characteristics for distinguishing among financial claims are the following:

• Risk;

• Liquidity;

• Maturity;

• Denomination (size).

These four factors provide key insights into why commercial banks are the kingpins of the FSI. First, they provide credit-risk diversification and other risk-management services. Second, they are the major providers of liquidity to the economy. Third, they provide maturity flexibility in terms of checking accounts, CDs, lines of credit, short-term loans. Fourth, they provide denomination divisibility in terms of savings accounts, large CDs, small loans, and large syndicated loans.

The pricing of Financial Assets

A fundamental principle of financial economics is that the price of any financial asset equals the present value of its expected future cash flows. Because the cash flows are expected, they are uncertain and therefore risky. The size, timing, and riskiness of cash flows determine the value of financial assets. In pricing financial assets, an inverse relation exists between risk and value. Risky assets have relatively low values, whereas safe assets have relatively high values. The basic risks associated with bank financial assets are default or credit risk, interest-rate risk, and liquidity (or resale) risk.

The Role and Function of Financial Markets and Securitization

Financial markets perform two .basic economic functions: (1) They transfer fundsfrom those economic units that have surplus funds to those that need them (usually to buy tangible assets), and (2) they transfer funds in such a way as to redistribute or shift risk among those seeking and those providing funds. In short, the two principal functions of financial markets are funds transfer and risk shifting. As intermediaries, banks also perform these two functions. These functions, whether performed by financial institutions or markets, provide three important economic services: (1) They determine the prices of financial assets through the interaction of buyers and sellers; (2) they provide liquidity by offering investors the opportunity to sell (liquidate) their financial assets; and (3) they reduce search and information costs, or transactions costs.

Financial markets also provide a mechanism for trading financial assets. Somefinancial assets are created and subsequently traded on organized financial marketsor exchanges. The more developed an economy is, the more organized its financialmarkets tend to be. Assets that are not bought and sold on organized exchangestrade in over-the-counter (OTC) markets. Most bank loans share three characteristicsthat make them similar to OTC-type contracts:

• They are customized;

• They are privately negotiated;

• They lack liquidity and transparency.

These traits make bank loans rather difficult to quantify and manage, which createsthe potential for the mispricing of bank stocks. Securitization. pooling and packaging bank loans for sale as securities, and the development of secondary markets for bank loans have made bank loans more liquid and less opaque and reduced the potential for mispricing bank equities. Both of these innovations shift risk from loan originators to investors. Another risk-shifting technique is the floating-rate loan, which requires borrowers to bear some of the risk of rising interest rates. lfinterest rates decline, borrowers receive the benefits.