Question

Discuss the history of the financial system. Why did stock and financial markets develop? Define direct finance and indirect finance

Answer 1

HISTORY OF FINANCIAL SYSTEM

The Crises Era (1782–1930)

The history of the U.S. banking system arguably began with the very first chartered bank of the United States, the Bank of North America. Founded by the national government toward the end of the American Revolution, the Bank of North America opened in 1782 in Philadelphia and provided credit to the newly formed government. The creation of the bank came at a time of extreme economic uncertainty, however, as the war's disruption of commerce and the nation's increased debt load caused concerns about government's ability to meet its debt obligations.

The post–Revolutionary War period was also marked with multiple economic recessions and banking crises. Attempts to establish a permanent central bank failed after the First, and then the Second, Bank of the United States charters were allowed to expire. This period was known as the Free Banking Era, a time of extremely loose banking regulations where a formal banking charter was unnecessary to establish a bank (banks also issued currency/notes typically secured by bonds issued by the state in which the bank was located).

During this time, bank data were very sparse. Beginning in the early 1800s, banks were required to provide a one-time report on certain balance sheet items. By 1832, Congress passed a resolution that allowed the Treasury to collect an annual state of condition from banks. Many states were already collecting this data on an annual basis as the states were majority stakeholders of the banks.

The Free Banking Era ended with the National Banking Act of 1864, which established the Office of the Comptroller of the Currency (OCC). With the OCC, bank reporting starts to evolve as national banks begin reporting assets, liabilities, and income on a quarterly basis. Additionally, the OCC begins to conduct regular exams of both national and state banks. Although the establishment of the OCC was a positive step in creating a more stable banking system, it occurred during the end of the Civil War (1861–65), which presented sizable obstacles to achieving banking and economic security.

The banking panic of 1907 led to the creation of Federal Reserve in 1913 and the beginning of what we will call the Regulatory Era. In addition to its central bank duties, the Federal Reserve was charged with supervising state member banks. The combined requirements of the OCC and the Fed led to a more consistent reporting across banks of different charters. The Federal Reserve also created the Federal Reserve Bulletin which was an aggregated report of banking industry performance.

Finally, the last event of the Crisis Era—and arguably one of the most severe events—was Black Thursday (1929), which led to the Great Depression. In all, there were 79 quarterly recessions between the years 1854 and 1932, representing almost 75 percent of all recorded U.S. recessions (see the chart). With so many recessions and banking crises, in addition to the fact that for a part of that time the United States was engaged in, or recovering from, wars on its own soil, the term “Crisis Era” seems particularly fitting.

The Regulatory Era (1913–80)

Following the Federal Reserve Act, the next significant banking law was the Banking Act of 1933, also known as the Glass-Steagall Act. Glass-Steagall accomplished many things, including giving the Federal Reserve additional regulatory powers and prohibiting banks from engaging in investment banking activities. It also created the Federal Deposit Insurance Corporation (FDIC), which received authority to provide deposit insurance to commercial banks and supervisory oversight of state nonmember banks. In 1935, the Federal Credit Union Act, which established federal credit unions, and the Banking Act, which permanently established the FDIC as a governmental agency, were passed.

The next major set of banking laws was designed to address more consumer-oriented issues. The Truth in Lending Act (1968), for example, was established to help protect consumers from unfair credit practices. The 1970s saw passage of the Housing & Community Development Act, the Home Mortgage Disclosure Act (HMDA), and the Community Reinvestment Act (CRA), with all three laws aimed at expanding credit to potentially underserved communities.

During this time, there were many important developments in bank reporting that laid the groundwork for the growth in bank data to come. In 1959, the more modern version of the Call Report was established. (Machine-readable data also began in 1959.) In 1966, the FDIC began reporting its annual Summary of Deposits, which lists the location of a bank's branches along with branches' deposit levels. The FR Y-9C—the Call Report for bank holding companies—began in 1978. In 1980, as a result of the passage of HMDA, home mortgage disclosure data is made available.

To be sure, some recessions occurred after the Great Depression and between 1950 and 1980, but they were generally less severe, and often of shorter duration, than those witnessed during the Crisis Era. Banking panics were also essentially eliminated, primarily as a result of FDIC deposit insurance, and bank failures overall during this time averaged only five a year.

The Bank Data Era (1980–present)

The period roughly beginning in 1980 can be referred to as the Bank Data Era, and it's easy to see why. Although significant banking legislation has passed since 1980, this is a period marked by advances in bank data. Most of the light blue, unlabeled markers in the above timeline during this period represent major changes to the Call Report (typically of 100 items or more). From a bank analysis perspective, one of the more notable developments was the creation of the Uniform Bank Performance Report (UBPR) in 1984. Supervisors still commonly use the UBPR to help assess bank performance. In addition to providing a consistent and repeatable platform for analysis, another benefit of the UBPR is its public availability.

The Bank Data Era is also a time where the connection between regulatory and economic events, and bank reporting, becomes more obvious. Examples of these relationships include the establishment of Basel I in 1988 and the subsequent addition of risk-based capital items to the Call Report in 1990. The savings and loan crisis of the 1980s and early 1990s resulted in the second-largest number of bank failures since the Great Depression, and because of concerns over bank exposure to mortgage lending, in 1991 the Call Report was amended to include additional details on real estate lending. More recently, the Dodd-Frank Act of 2010 led to possibly one of the largest data collection efforts by the Federal Reserve through the collection of FR Y-14 Comprehensive Capital Analysis and Review (CCAR), FR Y-16 Dodd-Frank Act (DFA), and FR 2052 Liquidity Monitoring Report data.

Next Phase: The Data-Driven Era

As we have discussed, bank data have evolved alongside both the U.S. economy and banking system. What is also interesting is that the growth in banking data is similar to the growth associated with technology and global data overall. Given this growth and the increased use of technological tools and techniques, regulators have become increasingly focused on the inclusion of data-driven analysis in supervision.

This increased attention to the role of data in the supervisory process by the Federal Reserve is highlighted in two recent SR letters. SR 12-17, Consolidated Supervision Framework for Large Financial Institutions, lays out a framework for large institution supervision. Part B.4 describes using various bank data to identify risks to a firm and overall systemic risk analysis. More recently, and directly, in SR 15-16, Enhancements to the Federal Reserve System’s Surveillance Program, the Federal Reserve provides a brief description of its surveillance program, which uses forward-looking methodologies to help assess bank risk.

Examples of data-driven models

So what does a data-driven supervisory or bank risk model look like? The answer to that varies depending on what risk, or risks, are being evaluated. As described in SR 15-16, the Fed's SR-SABR model is a logistic regression that predicts the probability of an overall downgrade in a CAMELS (Capital, Asset Quality, Management, Earnings, Liquidity) rating. It also produces a probability of firm failure through its Viability score. Other examples of bank health models that are available in the marketplace include credit ratings from firms like S&P, Moody's, and Fitch, and other CAMELS-type assessment models from IDC, Veribanc, BauerFinancial, and Kroll.

Along with an assessment of the overall health of a bank, data-driven models can be focused on a particular area of banking risk. One such set of risk measures is the OCC's Canary Report, which seeks to identify risks related specifically to credit risk, interest rate risk, and liquidity risk. Concerning interest rate risk, just as bank management implement various interest rate risk models to manage market and repricing risk, supervisors use similar models to help with their assessment of these risks. Typically based on a bank's Call Report data, supervisors have used internally developed Earnings at Risk (EAR) and Economic Value of Equity (EVE) models for years. The growth in and availability of loan, deposit, and interest rate data have improved the performance of these models by providing model developers with better details on rate-sensitive product volumes and pricing. Additionally, improved computing power has enabled the creation of more econometric-based models that can generate a prediction of net interest margin performance based on interest rates, asset yields, and deposit costs.

The next frontier of data-driven bank analysis will certainly use big data technologies and analytics. For example, the Federal Reserve Bank of Philadelphia hosts the Risk Assessment, Data Analysis and Research (RADAR) data warehouse, which stores a wide array of data on various credit-related products. The Kansas City Fed has the Center for the Advancement of Data and Research in Economics, which hosts the High-Performance Computing cluster. Together with the current systems, all these data set up a foundation for big data analysis, and tools such as SAS, R, and Python are starting to help researchers mine that data for bank-specific risks and industry trends.

Summing it up

Bank data have evolved from being a one-time reporting of bank capital to being intricately integrated into bank supervision and economic analysis. The type and purpose of bank data have also historically reflected the state of the banking system, regulatory environment, and economy. If this trend continues, as we believe it will, then the tools and techniques of data-driven bank analysis will start to more closely mirror those being used for other big data analysis and will hopefully be able to mitigate risks—both at the bank level and systemically—and provide useful insight into how the banking system works.

DEVELOPMENT OF STOCK AND FINANCIAL MARKETS

Origins of Stock

Stock markets were started when countries in the New World began trading with each other. While many pioneer merchants wanted to start huge businesses, this required substantial amounts of capital that no single merchant could raise alone. As a result, groups of investors pooled their savings and became business partners and co-owners with individual shares in their businesses to form joint-stock companies. Originated by the Dutch, joint-stock companies became a viable business model for many struggling businesses. In 1602, the Dutch East India Co. issued the first paper shares. This exchangeable medium allowed shareholders to conveniently buy, sell and trade their stock with other shareholders and investors.

Significance

The idea was so successful that the selling of shares spread to other maritime powers such as Portugal, Spain and France. Eventually, the practice found its way to England. Trade with the New World was big business so trading ventures were initiated. Other industries during the Industrial Revolution began using the idea as a way to generate start up capital. This influx of capital allowed for the discovery and development of the New World and for the growth of modern industrialized manufacturing.

History of the Stock Market

As the volume of shares increased, the need for an organized marketplace to exchange these shares became necessary. As a result, stock traders decided to meet at a London coffeehouse, which they used as a marketplace. Eventually, they took over the coffeehouse and, in 1773, changed its name to the "stock exchange." Thus, the first exchange, the London Stock Exchange, was founded. The idea made its way to the American colonies with an exchange started in Philadelphia in 1790.

Beginnings of Wall Street

To most people, the name Wall Street is synonymous with stock exchange. The market on Wall Street opened May 17, 1792 on the corner of Wall Street and Broadway. Twenty-four supply brokers signed the Buttonwood Agreement outside 68 Wall St. in New York, underneath a buttonwood tree. On March 8, 1817 the group renamed itself the New York Stock and Exchange Board and moved off the street into 40 Wall St. The organization that would define the world's economic future was born.

The first stock market bubble

Nobody really understood the importance of the stock market in those early days. People realized it was powerful and valuable, but nobody truly understood exactly what it would become.

That’s why the early days of the stock market were like the Wild West. In London, businesses would open up overnight and issue stocks and shares of some crazy new venture. In many cases, companies were able to make thousands of pounds before a single ship had ever left harbor.

There was no regulation and few ways to distinguish legitimate companies from illegitimate companies. As a result, the bubble quickly burst. Companies stopped paying dividends to investors and the government of England banned the issuing of shares until 1825.

The first stock exchange

Despite the ban on issuing shares, the London Stock Exchange was officially formed in 1801. Since companies were not allowed to issue shares until 1825, this was an extremely limited exchange. This prevented the London Stock Exchange from preventing a true global superpower.

That’s why the creation of the New York Stock Exchange (NYSE) in 1817 was such an important moment in history.

The NYSE has traded stocks since its very first day. Contrary to what some may think, the NYSE wasn’t the first stock exchange in the United States. The Philadelphia Stock Exchange holds that title. However, the NYSE soon became the most powerful stock exchange in the country due to the lack of any type of domestic competition and its positioning at the center of U.S. trade and economics in New York.

The London Stock Exchange was the main stock market for Europe, while the New York Stock Exchange was the main exchange for America and the world.

Modern stock markets

Today, virtually every country in the world has its own stock market. In the developed world, major stock markets typically emerged in the 19^th and 20^thcenturies soon after the London Stock Exchange and New York Stock Exchange were first created. From Switzerland to Japan, all of the world’s major economic powers have highly-developed stock markets which are still active today.

Canada, for example, developed its first stock exchange in 1861. That stock exchange is the largest in Canada and the third largest in North America by market capitalization. It includes businesses based in Canada and the rest of the world. The TSX, as it is known, hosts more oil and gas companies than any other stock exchange in the world, which is one major reason why it has such a high market cap.

Even war-torn countries like Iraq have their own stock markets. The Iraq Stock Exchange doesn’t have a lot of publicly-traded companies, but it is available to foreign investors. It was also one of the few stock markets unaffected by the economic crisis of 2008.

Stock markets can be found around the world and there’s no denying the global importance of stock markets. Every day, trillions of dollars are traded on stock markets around the world and they’re truly the engine of the capitalist world.

After dominating the world economy for nearly three centuries, the New York Stock Exchange faced its first legitimate challenger in the 1970s. In 1971, two organizations – the National Association of Securities Dealers and Financial Industry Regulatory Authority – created the NASDAQ stock exchange.

NASDAQ has always been organized differently from traditional stock exchanges. Instead of having a physical location, for example, NASDAQ is held entirely on a network of computers and all trades are performed electronically.

Electronic trading gave the NASDAQ a few major advantages over the competition. First and most importantly, it reduced the bid-ask spread. Over the years, competition between Nasdaq and the NYSE has encouraged both exchanges to innovate and expand. In 2007, for example, the NYSE merged with Euronext to create NYSE Euronext – the first transatlantic stock exchange in the world.

Impact

Today, there are many stock exchanges worldwide, each supplying the capital necessary to support industry growth. Without these vital funds, many revolutionary ideas would never become a reality, nor would fundamental improvements be made to existing products. In addition, the stock market creates personal wealth and financial stability through private investment, allowing individuals to fund their retirement and or other ventures.

DIRECT AND INDIRECT FINANCE

Direct finance is a method of financing where borrowers borrow funds directly from the financial market without using a third party service, such as a financial intermediary. This is different from indirect financing where a financial intermediary takes the money from the lender with an interest rate and lends it to a borrower with a higher interest rate. Direct financing is usually done by borrowers that sell securities and/or shares to raise money and circumvent the high interest rate of financial intermediary(banks). We may regard transactions as direct finance, even when a financial intermediary is included, in case no asset transformation has taken place. An example is a household which buys a newly issued government bond through the services of a broker, when the bond is sold by the broker in its original state. Another good example for direct finance is a business which directly buys newly issued commercial papers from another business entity.

Indirect finance is where borrowers borrow funds from the financial market through indirect means, such as through a financial intermediary. This is different from direct financing where there is a direct connection to the financial markets as indicated by the borrower issuing securities directly on the market. Common methods for direct financing include a financial auction (where price of the security is bid upon) or an initial public offering(where the security is sold for a set initial price).

This is where the government gives privilege, in the form of reduced tax burdens, as a means of supporting a particular interest rather than collecting and redistributing tax revenue (which would be considered as a direct financing method by the government). For example, a reduced tax burden on financiers provides focused monetary benefits and helps to effectively lower bond prices (provided that tax savings has a tangible effect on bond pricing and that the aforementioned would pass these tax savings to their respective clientele). This could be applied in a number of applications from infrastructural investment to education or military spending.