1.4 Financial Markets and Financial Institutions

Let's think about all the economic activity in the world as a sea, an ocean with three kinds of players swimming around in that ocean.  First, there are the entrepreneurs, the creators, the doers. People and organizations with ideas, objectives, and dreams. They are swimming around out there in the economic sea.  There are also investors swimming around out there. These are entities, individuals, and companies who have saved money in the past and are now ready to lend it to or invest it in somebody else.  Finally, there are facilitators swimming around out there. These are specialized institutions that will match up the entrepreneurs, who have ideas but don't have money, with the investors, who've got the money.  So, in the economic environment outside of companies, we’ve got entrepreneurs, investors, and facilitators.

With respect to the entrepreneurs who are creating and operating companies, we've already talked about the financial issues inside companies… entrepreneurs need to decide what to buy, where to get the money to buy it, and how to manage it once they have it.  Let's think about the economic environment outside those companies in the rest of that economic sea.  

What about those investors and savers? What are they thinking about? They are looking at their investment opportunities. Under what conditions, under what circumstances, and with what contracts should they provide money to entrepreneurs?  Should they lend the money? Should they invest the money? What about their portfolio of investments? They probably don't want to risk everything they have in one big investment, so what different things should they invest in?

The facilitators, the financial institutions, bring together the entrepreneurs, who need money, with the investors, who have money. There are all kinds of facilitating financial institutions out there.  There are banks, there are mutual funds, there are private-equity funds, there are insurance companies, and there are investment banks.

There are all kinds of entities – entrepreneurs, investors, and facilitators -- swimming around out there in the economic sea.  Finance allows us to look at each of these entities and how they interact, one with another. Finance is identifying the necessary resources for an organization, determining how to get the money to buy those resources and then how to manage those resources efficiently once you have them. That's the broad definition of finance.

When we talk about finance, we often focus on just the second function: Determining the best way to get the money to buy necessary resources. Should I borrow the money? Should it be invested?  If I'm an outside investor, under what circumstances and under what conditions should I provide that money?  Finally, what about those financial institutions that bring savers and entrepreneurs together?

These financial institutions, and the financial markets in which they operate, are an important element of finance.