Modern Financial Systems: Theory and Applications (The Frank J. Fabozzi Series)

579 Pages·2009·2.8 MB·English

by  Edwin H. Neave

(continued from front flap) Praise for Neave THE FRANK J. FABOZZI SERIES $110.00 USA/$132.00 CAN
In order to benefit from the information found MODERN FINANCIAL SYSTEMS M
throughout these pages, it doesn’t matter whether The study of financial systems is worthwhile
you’re an experienced financial veteran or stu- O both for its own sake and because financial
dent aspiring to enter this field. All you need to “Modern financial systems play a vital role in our global economy and, given the rapid activity contributes to economic efficiency.
D
productively use the material here is a familiarity evolution of modern finance, it is vital that participants in this system have a thorough And while financial systems exhibit wide-ranging
with the principal concepts underlying the prac- understanding of the material in this text. This is an important and timely synthesis of the E differences in appearance, their structure and
tice of finance. theory that drives modern finance.” activities have greater commonality than is cus-
R
—Mike Durland, Co-CEO, Scotia Capital tomarily realized.
Following a non-technical approach, Modern N
Financial Systems’ focus on principles permits a “This book clearly presents all the material that is necessary to achieve a comprehensive With Modern Financial Systems, experienced

more integrated analysis, and a more concise understanding of modern financial systems. It’s an essential topic, more important now F financial expert Edwin Neave extensively develops
description, of financial systems than found than ever, yet many of the traditional approaches to teaching finance lack emphasis on these common themes. In it, he shares his
I
elsewhere. With this book as your guide, you it. This is unfortunate because the events of the past year underscore how important it N insights with you, providing both comprehensive
can gain a firm understanding of the foregoing is for financial professionals, regulators, and scholars to have a comprehensive under- coverage of the complex and changing organiza-
A
theory of financial system organization and how standing of modern financial systems as a set of constituent parts operating together as a tion of financial systems, and the applications of
the theory works in practice. complex whole. Professor Neave’s book is an essential tool for those wishing to achieve N theory to numerous practical situations.
that goal.”
EDWIN H. NEAVE, PhD, is a former depart- —Michael L. McIntyre, PhD, Associate Professor, Finance, C Divided into seven informative sections, Modern
mental editor of finance for Management Science. I Financial Systems aims to strengthen your under-
Sprott School of Business, Carleton University
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He has written more than fifty articles and fifteen standing of the economic forces shaping modern
books focusing on asset pricing, derivatives pric- “This impressive book by Professor E.H. Neave on financial systems is a good intro- L financial systems and how the markets and
ing, financial system theory, and financial system duction for anyone interested in how financial systems are organized. A book for the institutions in these systems interact with each

practice. Neave is the sole academic who is an present times!” S MODERN other. Filled with in-depth insights and practical
Honorary Fellow of the Institute of Canadian advice, this reliable resource develops a theoreti-
—A.M. Herzberg, Professor Emeritus, Queen’s University Y
Bankers, and his banking education programs cal survey of financial system activity, along with
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are currently used in more than forty countries. “Edwin Neave shows how classical, simple no-arbitrage arguments and common sense illustrations of how the theory applies in practice.
Neave has held positions as associate professor, models of decision-making on the lattice get results, and if you’re looking for more in- T The applications sections illustrate how the prin-
Northwestern University; Bank of Montreal depth, advanced treatment you can follow the references at the end of each chapter. He E FINANCIAL ciples affect financial transactions, as well as the
Professor of Business and Finance, School of explains exactly how financial systems are symbiotic; how various players depend on institutions and markets that carry them out. The
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Business, Queen’s University; as well as director, each other to survive and prosper—something that the entire world has come to real- theoretical sections outline the economic prin-

Queen’s Financial Economics, and professor of ize given the recent crisis. Contrary to what many had thought about the world markets ciples underlying the organization of financial
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economics, both at Queen’s University. being so large, infinitely liquid, and robust that it would be impossible to bring them systems, and show how a system’s component
down, we have seen first-hand that financial systems are not self-correcting. The author S institutions and markets complement each other.
T YSTEMS
Jacket Photograph: Jupiter Images shows that thoughtful regulation, skillful deal screening, and corporate governance struc- h
ture with proper rewards and penalties (i.e., not restrictions but rather good incentives eo Along the way, Modern Financial Systems:
r
management) are all extremely important to financial systems performing their intended y
a • Explains both static financial system organization
functions. This book will be useful to students of finance who want to learn about markets, n and the dynamics of financial system evolution
d
as well as seasoned practitioners who want to better understand microeconomic forces A • Discusses financial governance mechanisms—
that shape modern financial systems.” p
p Theory and Applications markets, intermediaries, and internal finance
l
—Serge Slavinsky, Associate Director, Scotia Capital i • Classifies currently available theoretical
c
a
t models and identifies where the theoretical
i
o
n models’ predictions need to be qualified
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• Examines the economics of intermediary
operations and the main policy issues faced
by intermediary management
EDWIN H. NEAVE, PHD
(continued on back flap)
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Modern
Financial Systems

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TheFrankJ.FabozziSeries
FixedIncomeSecurities,SecondEditionbyFrankJ.Fabozzi
ManagingaCorporateBondPortfoliobyLelandE.CrabbeandFrankJ.Fabozzi
RealOptionsandOption-EmbeddedSecuritiesbyWilliamT.Moore
CapitalBudgeting:TheoryandPracticebyPamelaP.PetersonandFrankJ.Fabozzi
TheExchange-TradedFundsManualbyGaryL.Gastineau
InvestinginEmergingFixedIncomeMarketseditedbyFrankJ.FabozziandEfstathiaPilarinu
HandbookofAlternativeAssetsbyMarkJ.P.Anson
TheGlobalMoneyMarketsbyFrankJ.Fabozzi,StevenV.Mann,andMooradChoudhry
TheHandbookofFinancialInstrumentseditedbyFrankJ.Fabozzi
InterestRate,TermStructure,andValuationModelingeditedbyFrankJ.Fabozzi
InvestmentPerformanceMeasurementbyBruceJ.Feibel
TheTheoryandPracticeofInvestmentManagementeditedbyFrankJ.FabozziandHarryM.Markowitz
FoundationsofEconomicValueAdded,SecondEditionbyJamesL.Grant
FinancialManagementandAnalysis,SecondEditionbyFrankJ.FabozziandPamelaP.Peterson
MeasuringandControllingInterestRateandCreditRisk,SecondEditionbyFrankJ.Fabozzi,StevenV.Mann,
andMooradChoudhry
TheHandbookofEuropeanFixedIncomeSecuritieseditedbyFrankJ.FabozziandMooradChoudhry
TheHandbookofEuropeanStructuredFinancialProductseditedbyFrankJ.FabozziandMooradChoudhry
TheMathematicsofFinancialModelingandInvestmentManagementbySergioM.FocardiandFrankJ.Fabozzi
ShortSelling:Strategies,Risks,andRewardseditedbyFrankJ.Fabozzi
TheRealEstateInvestmentHandbookbyG.TimothyHaightandDanielSinger
MarketNeutralStrategieseditedbyBruceI.JacobsandKennethN.Levy
SecuritiesFinance:SecuritiesLendingandRepurchaseAgreementseditedbyFrankJ.FabozziandStevenV.Mann
Fat-TailedandSkewedAssetReturnDistributionsbySvetlozarT.Rachev,ChristianMenn,andFrankJ.Fabozzi
FinancialModelingoftheEquityMarket:FromCAPMtoCointegrationbyFrankJ.Fabozzi,SergioM.Focardi,
andPetterN.Kolm
AdvancedBondPortfolioManagement:BestPracticesinModelingandStrategieseditedbyFrankJ.Fabozzi,Lionel
Martellini,andPhilippePriaulet
AnalysisofFinancialStatements,SecondEditionbyPamelaP.PetersonandFrankJ.Fabozzi
CollateralizedDebtObligations:StructuresandAnalysis,SecondEditionbyDouglasJ.Lucas,LaurieS.Goodman,
andFrankJ.Fabozzi
HandbookofAlternativeAssets,SecondEditionbyMarkJ.P.Anson
IntroductiontoStructuredFinancebyFrankJ.Fabozzi,HenryA.Davis,andMooradChoudhry
FinancialEconometricsbySvetlozarT.Rachev,StefanMittnik,FrankJ.Fabozzi,SergioM.Focardi,andTeoJasic
Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie S.
Goodman,FrankJ.Fabozzi,andRebeccaJ.Manning
RobustPortfolioOptimizationandManagementbyFrankJ.Fabozzi,PeterN.Kolm,DessislavaA.Pachamanova,
andSergioM.Focardi
AdvancedStochasticModels,RiskA ssessment,andPortfolioOptimizationsbySvetlozarT.Rachev,StoganV.
Stoyanov,andFrankJ.Fabozzi
HowtoSelectInvestmentManagersandEvaluatePerformancebyG.TimothyHaight,StephenO.Morrell,and
GlennE.Ross
BayesianMethodsinFinancebySvetlozarT.Rachev,JohnS.J.Hsu,BilianaS.Bagasheva,andFrankJ.Fabozzi
TheHandbookofMunicipalBondseditedbySylvanG.FeldsteinandFrankJ.Fabozzi
SubprimeMortgageCreditDerivativesbyLaurieS.Goodman,ShuminLi,DouglasJ.Lucas,ThomasAZimmerman,
andFrankJ.Fabozzi
IntroductiontoSecuritizationbyFrankJ.FabozziandVinodKothari
StructuredProductsandRelatedCreditDerivativeseditedbyBrianP.Lancaster,GlennM.Schultz,andFrankJ.
Fabozzi
HandbookofFinance:VolumeI:FinancialMarketsandInstrumentseditedbyFrankJ.Fabozzi
HandbookofFinance:VolumeII:FinancialManagementandAssetManagementeditedbyFrankJ.Fabozzi
Handbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by Frank J.
Fabozzi
Finance:CapitalMarkets,FinancialManagement,andInvestmentManagementbyPamelaPetersonDrakeand
FrankJ.Fabozzi
LeveragedFinance:Concepts,Methods,andTradingofHighYieldBonds,Loans,andDerivativesbyStephenJ.
Antczak,DouglasJ.Lucas,andFrankJ.Fabozzi
ModernFinancialSystems:TheoryandApplicationsbyEdwinH.Neave
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Modern
Financial Systems
Theory and Applications
EDWIN H. NEAVE

John Wiley & Sons, Inc.
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Copyright(cid:1)C 2009byJohnWiley&Sons,Inc.Allrightsreserved.
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LibraryofCongressCataloging-in-PublicationData

Neave,EdwinH.
Modernfinancialsystems:theoryandapplications/EdwinH.Neave.
p. cm.–(TheFrankJ.Fabozziseries)
Includesindex.
ISBN978-0-470-41973-1(cloth)
1.Finance. 2.Financialinstitutions. I.Title.
HG173.N3342010
332–dc22
2009014325
PrintedintheUnitedStatesofAmerica.
10 9 8 7 6 5 4 3 2 1
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This book is for Liz.

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Contents
Preface xv
PARTONE
TheoreticalOverview 1
CHAPTER1
Introduction 3
AimsandApproach 4
ImportanceofFinancialSystemAnalysis 5
DifferencesamongFinancialSystems:Overview 7
FunctionsandGovernance 9
FinancialSystemOrganization 10
FinancialSystemChange 11
References 12
Terms 12
CHAPTER2
FinancialSystemFunctions 15
Introduction 16
ClearingandSettling Payments 16
PoolingResources 18
TransferringResources 20
ManagingRisks 21
InformationProduction 24
ManagingIncentives 25
Functional–StructuralApproach 25
References 26
Terms 27
CHAPTER3
FinancialSystemGovernance 29
Introduction 30
GovernanceMechanisms 33
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viii CONTENTS
TypesofDeals 37
Alignment 42
FinancialSystemOrganization 49
References 53
Terms 54
CHAPTER4
FinancialSystemOrganizationandChange 57
TrendsinProvidingFinancialServices 58
ProfitOpportunitiesandChange 62
References 67
PARTTWO
MarketversusNonmarketGovernance 69
CHAPTER5
MarketGovernance 71
FunctionsofMarkets 72
DescriptiveandEconomicCharacteristics 74
MarketEfficiency 77
InformationProduction 79
Liquidity 80
SecuritizationofIlliquidAssetPortfolios 80
References 84
Terms 84

CHAPTER6
IntermediationandInternalGovernance 87
IntermediariesandValueCreation 88
IntermediariesandLiquidity 92
InformationSharing 99
DelegatedMonitoring 104
IntermediaryInformationProcessing 105
InternalGovernance 110
References 115
Appendix6A:IntermediaryInformationProcessing:
ResultDerivations 115
Appendix6B:FormalStatementofProblem 122