The Financial System – Study Notes

Central Banks

• Role: Control money supply + interest rates; enforce monetary policy.

• Objectives: Price stability, full employment, economic prosperity.

• Tools:

  • Expansionary policy: cut interest rates, print money, quantitative easing (QE).

  • Contractionary policy: raise interest rates, quantitative tightening (QT).

• Mechanism: Buy/sell government bonds to inject or withdraw money.

• Examples: US Federal Reserve, Bank of England, People’s Bank of China.

Commercial Banks

• Role: Intermediaries between savers (surplus units) and borrowers (deficit units).

• Examples: JPMorgan, Wells Fargo, Bank of America.

• Key Point: When banks lend, they create new money (credit creation).

• Regulation: Reserve requirements (now ~0% in major economies), capital rules, credit checks.

• Functions: Deposits, loans, mortgages, payments.

Pension Funds

• Size: Largest financial institutions ($60+ trillion).

• Purpose: Provide income after retirement.

• Investments: Diversified (stocks, bonds, real estate, private equity, venture capital).

• Importance: Biggest backers of PE and VC firms.

• Examples: Ontario Municipal Employees Retirement System (owns Hudson Yards, major hotels).

Mutual Funds

• Role: Pool money from many small investors for diversified investments.

• Types:

  • Active funds: try to beat market → higher fees.

  • Passive funds: track index (e.g., S&P 500) → low fees.

• Examples: Vanguard, Fidelity, BlackRock.

• Access: Open to everyone; liquid (can withdraw anytime).

Hedge Funds

• Access: Only for accredited investors (wealthy, institutions).

• Strategy: High-risk, high-reward bets on anything (stocks, currencies, commodities, elections).

• Tactics: Leverage, derivatives, short selling, AI trading.

• Fees: “2 and 20” → 2% management + 20% profits.

• Examples: Bridgewater, Citadel, Jane Street.

Investment Banks

• Role: Corporate dealmakers + fundraisers.

• Core Functions:

  1. IPOs (taking companies public).

  2. Mergers & Acquisitions (valuation, negotiation, due diligence).

  3. Raising capital (corporate bonds, massive loans, equity sales).

• Examples: Goldman Sachs, Morgan Stanley, Citi.

• Note: Can also be involved in scandals (e.g., 1MDB).

Private Equity (PE)

• Role: Buy companies, restructure, and sell for profit (like house-flipping).

• Model: Leveraged buyouts (LBOs) → borrow heavily, load debt on target company.

• Tactics: Cut costs, flip in 3–5 years.

• Winners: Hilton Hotels (Blackstone → $14B profit).

• Losers: Toys R Us (collapsed under $5B debt).

• Examples: Blackstone, Apollo, KKR.

Insurance Companies

• Role: Spread risk across large groups.

• Products: Health, life, property, auto, pet insurance.

• Business model: Collect premiums → invest reserves (bonds, stocks, PE, VC).

• Examples: State Farm, Geico, Allstate.

Venture Capital (VC)

• Role: Fund startups (high risk, high reward).

• Model: “Power Law” → most fail, a few deliver massive returns.

• Example: Peter Thiel’s $500K into Facebook → $1B+ return.

• Backers: Pension funds, endowments, insurance companies.

• Examples: Sequoia Capital, Andreessen Horowitz.

Big Picture

• Central banks = control the money supply.

• Commercial banks = move money between savers & borrowers.

• Pension funds = safeguard retirements, fuel PE/VC.

• Mutual funds = give small investors diversification.

• Hedge funds = high-risk playground for the rich.

• Investment banks = handle IPOs, M&A, capital raising.

• Private equity = flip companies with debt leverage.

• Insurance companies = spread risk + invest premiums.

• Venture capital = gamble on startups with big upside.

Together: they create, multiply, and circulate money, powering (and sometimes breaking) the global economy.