Financial Assets, Money, Financial Transactions, and Financial Institutions

By Rose, P.S., Marquis, M.H.

Edited by Paul Ducham


Financial assets do not provide a continuing stream of services to their owners as a home, an automobile, or a washing machine would do. These assets are sought after because they promise future returns to their owners and serve as a store of value (purchasing power). Their value rests on faith that their issuer will honor his or her contractual promise to pay.

A number of other features make financial assets unique. They cannot be depreciated because they do not wear out like physical goods. Moreover, their physical condition or form usually is not relevant in determining their market value (price). A stock certificate is not more or less valuable, for example, because of the size or quality of paper it may be printed on, because it may be frayed around the edges, or because of the type and format of the computer file in which it may appear.

Because financial assets are generally represented by a piece of paper (certificate or contract) or by information stored in a computer, they have little or no value as a commodity and their cost of transportation and storage is low. Indeed, the cost of the storage and transfer of funds and other bits of financial information declined sharply as the twenty-first century began due to rapid advances in computer and electronic technology, causing financial assets to grow faster than world trade and faster than the economy as a whole. Finally, financial assets are fungible —they can be easily changed in form and substituted for other assets. Thus, a bond or share of stock often can be quickly converted into any other asset the holder desires.


Although there are thousands of different financial assets, they generally fall into four categories: money, equities, debt securities, and derivatives.

Any financial asset that is generally accepted in payment for purchases of goods and services is money. Thus, checkable accounts and currency are financial assets serving as payment media and, therefore, are forms of money. In the modern world, money— even the forms of money issued by the government—depends for its value only upon the issuer’s pledge to pay as promised. Equities (more commonly known as stock ) represent ownership shares in a business firm and, as such, are claims against the firm’s profits and against proceeds from the sale of its assets. We usually further subdivide equities into common stock, which entitles its holder to vote for the members of a firm’s board of directors and, therefore, determine company policy, and preferred stock, which normally carries no voting privileges but does entitle its holder to a fixed share of the firm’s net earnings ahead of its common stockholders.

Debt securities include such familiar instruments as bonds, notes, accounts payable, and savings deposits. Legally, these financial assets entitle their holders to a priority claim over the holders of equities to the assets and income of an individual, business firm, or unit of government. Usually, that claim is fixed in amount and time (maturity) and, depending on the terms of the indenture (contract) that accompanies most debt securities, may be backed up by the pledge of specific assets as collateral. Financial analysts usually divide debt securities into two broad classes: (1) negotiable, which can easily be transferred from holder to holder as a marketable security, and (2) nonnegotiable, which cannot legally be transferred to another party. Passbook savings accounts and U.S. savings bonds are good examples of nonnegotiable debt securities.

Finally, derivatives are among the newest kinds of financial instruments that are closely linked to financial assets. These unique financial claims have a market value that is tied to or influenced by the value or return on a financial asset, such as stocks (equities) and bonds, notes, and other loans (debt securities). Examples include futures contracts, options, and swaps. These particular instruments are often employed to manage risk in the assets to which they are tied or related.


The most important financial asset in the economy is money —one of the oldest and most useful inventions in the history of the world. Metallic coins served as money for many centuries until paper notes (currency) first appeared in China during the Tang Dynasty over a thousand years ago (618–907 c.e. ) and in Sweden in 1661. The federal government of the United States did not issue paper money until 1861 in the form of “greenbacks,” named for the green ink on the back of each note. Many other assets besides currency and coin have served as money in earlier periods, including beads, seashells, cigarettes, and even playing cards.

All financial assets are valued in terms of money, and flows of funds between lenders and borrowers occur through the medium of money. Money itself is a financial asset, because all forms of money in use today are claims against some institution, public or private. For example, one of the largest components of the money supply today is the checking account, which is the debt of a depository institution (although today check-writing volume is declining relative to electronic payments). Another important component of the money supply is the sum of all currency and coin—pocket money—held by the public. The bulk of currency in use today in the United States, for example, consists of Federal Reserve notes, representing debt obligations of the 12 Federal Reserve banks. In fact, if the Federal Reserve ever closed its doors (a highly unlikely event!), Federal Reserve notes held by the public would be a first claim against the assets of the Federal Reserve banks. Other forms of money that are growing rapidly in popularity include credit and debit cards to allow instant borrowing or the withdrawal of funds from a bank deposit; stored-value (“smart”) cards that are encoded via computer with a fixed amount of money available for spending; and digital cash available through the Internet computer network from a variety of financialservice providers. As we will see in the accompanying box on alternative definitions of the money supply, some concepts of what money is today include savings accounts at banks, credit unions, and money market funds—all forms of debt to their issuers, giving rise to financial assets.


Money performs a wide variety of important services. It serves as a standard of value (or unit of account ) for all the goods and services we might wish to trade. Without money, the price of every good or service would have to be expressed in terms of exchange ratios with all other goods and services—an enormous information burden for both buyers and sellers. We would need to know, for example, how many loaves of bread would be required to purchase a quart of milk, or what quantity of firewood might be exchanged for a suit of clothes. To trade just 12 different goods and services, we would have to remember 66 different exchange ratios! In contrast, the existence of money as a common standard of value permits us to express the prices of all goods and services in terms of only one item—the monetary unit. In the United States and Canada that unit is the dollar; in Japan, the yen; in China, the yuan; and in Europe, the euro. But whatever the monetary unit is called, it always has a constant price in terms of itself (e.g., a dollar always exchanges for a dollar). The prices of all other goods and services are expressed in multiples of the monetary unit.

Money also serves as a medium of exchange. It is usually the only financial asset that virtually every business, household, and unit of government will accept in payment for goods and services. By itself, money typically has little or no use as a commodity (except when gold or silver, for example, is used as the medium of exchange). People accept money only because they know they can exchange it at a later date for something else. This is why modern governments have been able to separate the monetary unit from precious metals (such as gold and silver) and successfully issue fiat money (i.e., pieces of paper or data stored in a computer file or on a plastic card) not tied to any particular commodity. Money’s service as a medium of exchange frees us from the terrible constraints of barter, allowing us to separate the act of selling goods and services from the act of buying goods and services. With a medium of exchange, buyers and sellers no longer need to have an exact coincidence of wants in terms of quality, quantity, time, and location.

Money serves also as a store of value —a reserve of future purchasing power. Purchasing power can be stored in currency and coin, in a checking account, on a plastic card, or in a computer file until the time is right to buy. Of course, money is not always a good store of value. The value of money, measured by its purchasing power, can experience marked fluctuations. For example, the prices of consumer goods represented in the U.S. cost-of-living index rose more than five times over between 1960 and 2006 and jumped almost a third during the most recent decade, on average. Individuals and families purchasing the identical market basket of goods represented in the cost-of-living index would have experienced a steep decline in their purchasing power unless their incomes rose rapidly enough to keep up with inflation.

Money functions as the only perfectly liquid asset in the financial system. An asset is liquid if it can be converted into cash quickly with little or no loss in value. A liquid asset possesses three essential characteristics: price stability, ready marketability, and reversibility. An asset must be considered liquid if its price tends to be relatively stable over time, if it has an active resale market, and if it is reversible so investors can recover their original investment without loss. All assets—real and financial—differ in their degrees of liquidity. Generally, financial assets, especially bank deposits and stocks and bonds issued by major corporations, tend to be highly liquid; on the other hand, real assets, such as a home or an automobile, may be difficult to sell in a hurry without taking a substantial loss. Money is the most liquid of all assets because it need not be converted into any other form to be spent. Unfortunately, the most liquid assets, including money, tend to carry the lowest rates of return. One measure of the “cost” of holding money is the income forgone by the owner who fails to convert his or her money balances into more profitable investments in real or financial assets. The rate of interest determined by the financial system is a measure of the penalty suffered by an investor for not converting money into income-earning assets.


The value of money—its purchasing power —changes due to inflation, defined as a rise in the average price level of all goods and services. Inflation lowers the value or purchasing power of money and is a special problem in the money and capital markets because it can damage the value of financial contracts (such as a bond or a deposit). Financial loss due to inflation is particularly likely where the amount of price inflation has not been fully anticipated or if the people and institutions who agreed to a financial contract were simply not able to adjust fully to the inflation that subsequently occurred. The opposite of inflation is deflation, where the average level of prices for goods and services actually declines. Less common than inflation, deflation benefits those whose income doesn’t also decline with prices and, therefore, can buy more goods and services than they could in the past. Unfortunately, deflation may be accompanied by a troubled economy and loss of jobs so that, even though living costs are less, many people may still find themselves with sharply reduced income (purchasing power). Today most economists measure inflation using popular price indexes, such as the Consumer Price Index (CPI) or the Gross Domestic Product (GDP) Deflator Index. The CPI, a cost of living index, measures the cost of a market basket of goods and services normally purchased by an urban family of four people. To determine this measure of the cost of living, the actual prices of designated items are collected from thousands of stores in cities across the United States each month, averaged, and combined into one index number. The U.S. CPI is widely used to make cost-of-living adjustments (COLAs) in labor contract, Social Security payments, and in other government and private programs. A number of other nations, especially in Europe, have begun in recent years to compile their own CPIs in order to monitor the effects of inflation on their economies. An even broader price index is the GDP deflator series, which gathers both business and consumer prices on goods and services produced each year by labor and property inside the United States. We can use the foregoing indexes to measure percentage changes in price levels (and inflation) relative to some base year employing the following relationship:


over the five-year period we are studying. Unless the value of our incomes and our investments in financial assets and other forms of wealth has also gone up at least 25 percent during the same time period, we would have suffered a decline in purchasing power and in the true value of our wealth in terms of the goods and services we can now buy. What else can a price index tell us? In 2006 the U.S. Consumer Price Index (CPI) averaged just over 200. This index value was based on the base period 1982–84 when the CPI was set at 100. This means that between 1982–84 and 2006 consumer prices in U.S. urban communities climbed an average of about 100 percent [that is, (200– 100)/100 times 100 percent]. We can use numbers such as these to help figure out what has happened recently to the purchasing power of the basic monetary unit. For example, suppose we wish to know what has happened to the purchasing power of the U.S. dollar recently. We could use this relationship:


between 1982–84 and 2006. In other words, in 2006, one dollar bought only about 50 percent of what it would have purchased just over two decades earlier. These dramatic changes in the purchasing power of money, even in the United States where inflation is relatively modest, give us a stern warning. We should get into the habit of thinking in terms of the real (“purchasing power adjusted”) values of things—incomes, goods, services, financial assets such as bonds, stocks, bank deposits, and so on—rather than only in terms of their nominal (or face) values, which can be highly misleading (sometimes referred to as a “money illusion”) in periods of significant inflation or deflation.


With the direct financing technique, borrower and lender meet each other and exchange funds in return for financial assets without the help of a third party to bring them together. You engage in direct finance when you borrow money from a friend and give him or her your IOU or when you purchase stocks or bonds directly from the company issuing them. We usually call the claims arising from direct finance primary securities because they flow directly from the borrower to the ultimate lender of funds. ( Exhibit 2.5 illustrates the process of direct financing.)

Direct finance is the simplest method of carrying out financial transactions and probably the most efficient if conditions are right. Indeed, most financial systems in history started out using direct finance. However, it has a number of serious limitations. For one thing, both borrower and lender must desire to exchange the same amount of funds at the same time. More important, the lender must be willing to accept the borrower’s IOU, which may be quite risky or slow to mature. Clearly, there must be a coincidence of wants between surplus- and deficit-budget units in terms of the amount and form of a loan. Without that fundamental coincidence, direct finance breaks down.

Another problem is that both lender and borrower must frequently incur substantial information costs simply to find each other. The borrower may have to contact many lenders before finding the one surplus-budget unit (SBU) with just the right amount of funds and a willingness to take on the borrower’s IOU. Not surprisingly, direct finance soon is joined by other methods of carrying out financial transactions as money and capital markets develop.



Early in the history of most financial systems, a new form of financial transaction called semidirect finance appears. Some individuals and business firms become securities brokers and dealers whose essential function is to bring surplus-budget (SBU) and deficit-budget (DBU) units together, thereby reducing information costs (see Exhibit 2.6 ).

We must distinguish here between a broker and a dealer in securities. A broker is merely an individual or financial institution who provides information concerning possible purchases and sales of securities. Either a buyer or a seller of securities may contact a broker, whose job is simply to bring buyers and sellers together. A dealer also serves as a service channel between buyers and sellers, but the dealer actually acquires the seller’s securities in the hope of marketing them to buyers at a later time at a favorable price. Dealers take a “position of risk” because, by purchasing securities outright for their own portfolios, they are subject to losses if those securities decline in value.

Semidirect finance may have some advantages over direct finance if conditions are right. It lowers the search (information) costs for participants in the financial markets. Frequently, a dealer will split up a large issue of primary securities into smaller units affordable by even buyers of modest means and, thereby, expand the flow of savings into investment. In addition, brokers and dealers facilitate the development of secondary markets in which securities can be offered for resale.

Despite the important contribution of brokers and dealers to the functioning of the global financial system, the semidirect finance approach is not without its limitations. The ultimate lender still winds up holding the borrower’s securities, and, therefore, the lender must be willing to accept the risk and maturity characteristics of the borrower’s IOUs. There still must be a coincidence of wants and needs between surplus-and deficit-budget units for semidirect financial transactions to take place.



The limitations of direct and semidirect finance under certain conditions stimulated the development of indirect finance carried out with the help of financial intermediaries. Financial intermediaries include commercial banks, insurance companies, credit unions, finance companies, savings and loan associations, savings banks, pension funds, mutual funds, and similar organizations. (See Exhibit 2.7. ) Their fundamental role in the financial system is to serve both ultimate lenders and borrowers but in a different way than brokers and dealers do. Financial intermediaries issue securities of their own—often called secondary securities —to ultimate lenders and at the same time accept IOUs from ultimate borrowers— primary securities (see Exhibit 2.8 ).

The secondary securities issued by financial intermediaries include such familiar instruments as checking and savings accounts, life insurance policies, annuities, and shares in a mutual fund. For the most part, these securities share several common characteristics. They generally carry low risk of default. For example, most deposits held in banks and credit unions are insured by an agency of government (in the United States, for amounts up to $100,000). Moreover, the majority of secondary securities can be acquired in small denominations, affordable by savers of limited means. For the most part, secondary securities are liquid and, therefore, can be converted quickly into cash with little risk of significant loss. Financial intermediaries in recent years have tried to make savings as convenient as possible through the mail and by plastic card, computer terminal, and telephone in order to reduce transactions costs to the saver.

Financial intermediaries accept primary securities from those who need credit and, in doing so, take on financial assets that many savers, especially those with limited funds and limited knowledge of the market, would find unacceptable. For example, many large corporations require billions of dollars in credit financing each year—sums that would make it impractical to deal directly with thousands of small savers. By pooling the resources of scores of small savings accounts, however, a large financial intermediary frequently can service the credit needs of several large firms simultaneously. In addition, many primary securities are not readily marketable and carry sizable risk of borrower default—a situation usually not acceptable to the small saver. By issuing its own securities attractive to ultimate lenders (SBUs), and accepting primary securities from ultimate borrowers (DBUs), the financial intermediary acts to satisfy the financial needs of both surplus-and deficit-budget units in the economy.

One of the benefits of the development of efficient financial intermediation (indirect finance) has been to smooth out consumption spending by households and investment spending by businesses over time, despite variations in income, because intermediation makes saving and borrowing easier and safer. Financial intermediation permits a given amount of saving in the global economy to finance a greater amount of investment than probably would have occurred without intermediation.

Interestingly enough, finance theory suggests that in a perfect world with perfect competition and where the public has access to information at little or no cost, financial intermediaries probably would not exist. Rather, it is imperfections in the financial system (where, for example, some groups do not have access to relevant financial information or face prohibitive information costs) that help explain why there are financial intermediaries and why they have grown to be such huge and important institutions within the financial system. Financial intermediaries overcome inefficiencies in the financial marketplace and reduce the cost to society of moving information and wealth among households, businesses, and governments, thereby providing access to economies of scale (information cost savings) that would otherwise not be available to smaller units in the economy. Financial intermediaries improve the real world efficiency of the money and capital markets in allocating the daily flow of capital toward its best possible uses. How well financial intermediaries work is a key determinant of which countries have the largest and strongest economies.




Financial intermediaries and other financial institutions differ greatly in their relative importance within any nation’s financial system. Measured by total financial assets, for example, commercial banks dominate the United States’s financial system (as shown in Exhibit 2.9 ) and most other financial systems around the globe. The more than $9.5 trillion in financial assets held by U.S. banks represent about one-quarter of the total resources of all U.S. financial institutions. By some measures banks appear to have lost some of their market share to some nonbank financial institutions (such as mutual funds and credit unions), which may be less regulated or offer more flexible service options. In most countries, however, banks still represent the dominant financial institution.

Lagging well behind banks are savings and loans associations —another deposit-type financial intermediary active primarily in the U.S. mortgage market, financing the building and purchase of new homes. Very similar in sources and uses of funds to savings and loans are savings banks, which attract small savings deposits from individuals and families and make a wide variety of household loans. The fourth major kind of deposittype financial intermediary, the credit union, was also created to attract small savings deposits from individuals and families and make loans to credit union members.

When the assets of all four deposit-type intermediaries—commercial banks, savings and loans, savings banks, and credit unions—are combined, they make up about one-third of the total financial assets of all U.S. financial institutions. The remainder of the sector’s financial assets are held by a highly diverse group of nondeposit financial institutions. Life insurance companies, which protect policyholders against the risks of premature death and disability, are among the most important nondeposit institutions and rank fourth behind commercial banks in total assets. The other type of insurance firm— property-casualty insurers —offers a wider array of policies to reduce the risk of loss associated with crime, weather damage, and personal negligence. Among the most specialized financial institutions are pension funds, which protect their customers against the risk of outliving their sources of income in the retirement years. Private pensions now rank third behind banks and mutual funds in total assets held within the U.S. financial system. (See again Exhibit 2.9. )

Other important financial institutions include finance companies, investment companies (mutual funds), and real estate investment trusts. Finance companies lend money to businesses and consumers to meet short-term working capital and long-term investment needs. Investment companies pool the funds contributed by thousands of savers by selling shares and then investing in securities sold in the open market and are particularly important in holding and investing the public’s retirement savings. A specialized type of investment company is the money market fund, which accepts savings (share) accounts from businesses and individuals and places those funds in high-quality, short-term (money market) securities. Also related to investment companies are real estate investment trusts, one of the smallest members of the financial institutions sector, which invest mainly in commercial and residential properties. Finally, near the bottom of the list, size-wise, are mortgage banks, which facilitate the raising of credit to construct new businesses and homes.



Financial institutions may be grouped in a variety of different ways. One of the most important distinctions is between depository institutions (commercial banks, savings and loan associations, savings banks, and credit unions); contractual institutions (insurance companies and pension funds); and investment institutions (mutual funds and real estate investment trusts). Depository institutions derive the bulk of their loanable funds from deposit accounts sold to the public. Contractual institutions attract funds by offering legal contracts to protect the saver against risk (such as an insurance policy or retirement account). Some investment institutions, particularly mutual funds, sell shares to the public and invest the proceeds in stocks, bonds, and other assets in the hope of providing higher returns to their shareholders. Other investment institutions facilitate the buying and selling of securities and other assets as in the case of brokers and dealers.


The management of a financial institution is called on daily to make portfolio decisions —that is, deciding what financial assets to buy or sell. A number of factors affect these critical decisions. For example, the relative rate of return and risk attached to different financial assets will affect the composition of each financial institution’s portfolio. Obviously, if management is interested in maximizing profits and has minimal aversion to risk, it will tend to pursue the highest yielding financial assets available, such as corporate bonds and stocks. A more risk-averse institution, on the other hand, is likely to surrender some yield in return for the greater safety available from acquiring government bonds and high-quality money market instruments.

The cost, volatility, and maturity of incoming funds provided by surplus-budget units (ultimate savers) also have a significant impact on the financial assets acquired by financial institutions. Banks, for example, derive a substantial portion of their funds from checkable deposits, which are relatively inexpensive but highly volatile. Such an institution will tend to concentrate its lending activities in short- and medium-term loans to avoid an embarrassing shortage of cash (liquidity). On the other hand, a financial institution such as a pension fund, which receives a stable and predictable inflow of savings, is largely freed from concern over short-term liquidity needs. It is able to invest heavily in long-term financial assets. Thus, the hedging principle —the approximate matching of the maturity of financial assets held with liabilities taken on—is an important guide for choosing those financial assets that a financial institution wants to hold in its portfolio.

Decisions on what financial assets to acquire and what financial assets to issue to the public are also influenced by the size of the individual financial institution. Larger institutions frequently can take advantage of greater diversification in their sources and uses of funds. This means that the overall risk of a portfolio of financial assets can be reduced by acquiring financial assets from many different deficit-budget units (DBUs or ultimate borrowers). Similarly, a larger financial institution can contact a broader range of surplus-budget units (SBUs or ultimate savers) and achieve greater stability in its incoming flows of funds. At the same time, through economies of scale (size), larger financial institutions can often sell financial services at a lower cost per unit and pass those cost savings along to their customers.

Finally, regulations and competition, two external forces, play major roles in shaping the financial assets acquired and issued by financial institutions. Because they hold the bulk of the public’s savings and are so crucial to economic growth, financial intermediaries are among the most heavily regulated of all business firms. Commercial banks are prohibited from investing in low-quality or highly volatile loans and securities in many countries. Insurance companies and pension funds must restrict asset purchases to those a “prudent person” would most likely choose. Most government regulations in this sector pertain to the assets that can be acquired, the adequacy of net worth, and the services that can be offered to the public. Such regulations are designed primarily to ensure the safety of the public’s funds.


Some authorities argue that new forms of disintermediation have appeared in recent years, some initiated by financial intermediaries themselves and some by their borrowing customers. For example, some banks in recent years have sold off some of their loans because of difficulties in raising enough capital. At the same time, some of their largest borrowing customers have learned how to raise funds directly from the open market (i.e., through direct and semidirect finance) rather than borrowing from a bank or other traditional financial intermediary.

In recent years many traditional financial intermediaries, such as banks and credit unions, have been challenged by nonfinancial retail and industrial firms attempting to draw financial-service customers away. Prominent examples include General Electric, General Motors, Target, and Toyota which recently set up industrial loan companies (ILCs) that offer services similar to those provided by smaller banks and finance companies. Recently the world’s largest retailer, Wal-Mart, submitted an application for a charter to the state of Utah and to the FDIC for deposit insurance (later withdrawn) in an effort to set up their own ILC, creating a storm of controversy that such a step might weaken public confidence in the financial system and drive many traditional financial intermediaries out of business.

These new forms of disintermediation have tended not only to slow the growth of some financial institutions but also to gradually reduce the overall importance of traditional financial intermediaries within the global financial system. A substantial volume of funds today flow around traditional financial intermediaries toward other financialservice providers and through direct and semidirect financial market channels.