Copyright-A.S. Cebenoyan- 2002 1 Review of Financial Institutions and Markets Finance 201 and Finance 101 Professor Sinan Cebenoyan Hofstra University
Dec 21, 2015
Copyright-A.S. Cebenoyan-2002 1
Review of Financial Institutions and Markets
Finance 201 and Finance 101
Professor Sinan Cebenoyan
Hofstra University
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US Depository Institutions
• Incentives, always incentives!
• Commercial Banks
Size, Structure, and Composition
Balance Sheet and Trends-Regulation
• Thrifts
S&L’s and Savings Banks
Credit Unions
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Commercial Banks
• 1985----->>> 14,416
• 1989----->>> 12,744
• 1994----->>> 10,384
• 1998----->>> around 9,000
• Why? Failures and M&A
• Community, Regional, Super Regional, and Money Center Banks
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Commercial Banks continued
• Assets: Business Loans (C and I)
Securities
Mortgages
Consumer Loans
Other (LDC)
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Commercial Banks continued
• Liabilities: Deposits
transactions
NOW
Savings and Time
Negotiable CD’s
Borrowings and Other
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Commercial Banks continued
• Off-Balance Sheet Activities
Fee-related activities
Letters of Credit
Derivatives
Swaps
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Regulation
• FDIC
• COC
• The Fed
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Thrifts
• Savings and Loans
Long-term mortgages backed by short-term
savings deposits (helped by the yield curve)
after 1979 different Fed targets:
Disintermediation
Regulation Q
DIDMCA
Regulatory Forbearance
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Thrifts continued
• FSLIC in trouble.>>>>FIRREA (1989)
SAIF under FDIC
RTC
strengthen capital requirements
QTL test
Number of S&Ls down sharply
• Balance Sheet and Recent Trends
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Thrifts continued
• Savings BanksNew England
mutual to stock
more diversified than S&Ls (assets)
more reliant on deposits >>less borrow
State regulators
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Thrifts continued
• Credit Unions65% of assets in small Consumer loans
hold large amount of Government Sec.’s
Residential mortgages very small
lending funded by savings deposits
NCUA and NCUIF
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Insurance Companies
• Life Insurance Companiesdeath, illnesses, and retirement
• Property-Casualty Insurancepersonal injury and liability
accidents, theft, fire...
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Life Insurance Companies
• Life Insurance
Ordinary Life (Term, Whole, Endowment
Variable, Universal, VariableUniversal) ---- 58%
Group Life --- 40%
Industrial Life ---- 0.2%
Credit Life ------ 2%
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• Other Life Insurer Activities
Annuities
Private Pension Funds
Accident and Health Insurance
• Balance Sheet
Assets>>15.9% Gov.Sec., 65% corp. Bonds and stock, 8% mortgs.,
balance policy and other loans
Liabilities>>53% net policy reserves
• Regulation >> McCarran-Ferguson Act ‘45
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Property-Casualty Insurance
• PC Insurance
Fire Insurance
Homeowners
Commercial
Marine
Auto liability+ PD, Liability other
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• Balance Sheet and Underwriting Risk
Loss Risk >>>Predictability:
Property(more) vs. liability(less predict.)
Severity vs. Frequency
Long tail(claims later) versus short tailLoss ratio (Losses/Premiums)
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Other Financial Institutions
• Securities Firms and Investment Banks
• Finance Companies
• Mutual Funds
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Securities Firms and Investment Banks
• Size, Structure, + Composition of IndustryNumber of firms
Sizes >>>Merrill Lynch to regionals
Activities: Investing, Investment Banking (IPO, PP)
Market Making, Trading (Position Trading,
Pure Arbitrage, Risk Arbitrage, Program
Trading), Back-Office and Other
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• Balance Sheet and Recent TrendsCommissions down after crashes, but up mostly in the 90’s. Underwriting and Holdings of Fixed income securities >>> Risk implications
Assets: Long Positions in Securities and Commodities (26%) and Reverse
repurchase agreements (35%).
Liabilities: Repurchase agreements (47%)
securities and comm. sold short +loans+equity
• Regulation: SEC, NYSE, NASD
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Finance Companies
• 2 Major Types:
1) Installment (auto) loans to consumers
2) Consumer+corporate loans, Factoring
• Commercial Paper used in Financing
• No Deposits -->>> Not much regulation
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Mutual Funds
• Diversification
• Lower Transaction Costs
• First in Boston, 1924,
360 in 1970
about 8,000 today
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Mutual Funds continued
• Short-term fundsTaxable or tax-exempt
Money market mutual funds
• Long Term FundsBond, income, and equity funds
Returns: income and dividends,
capital gains when sold, capital
appreciationMarked-to-Market daily
NAV
open versus closed-end
• REITs
• Balance Sheets:• MMMF 75% in short
term securities (foreign and domestic deposits, RP’s, CP, US gov.secs)
• Long term Funds 63% in stocks, US Treasuries and muni. bonds 23%.
• Regulated by the SEC, and States.
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Overview of the Federal Reserve System
• Today, Fed’s duties are:• Conducting the nation’s monetary policy…in
pursuit of full employment and stable prices
• Supervising and regulating Financial Inst.s…safety and soundness…credit rights of consumers
• Maintaining the stability of the fin’l system ...containing systemic risk
• Providing certain fin’l services…major role in operating the nation’s payment system
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Background• History of failures.
• December 23, 1913 Wilson signs into law the Federal Reserve Act
• To provide for the establishment of Federal Reserve Banks, to furnish an elastic currency,…,effective supervision…
• Other Acts followed to fill in other needs
Structure of the System•Board of Governors, Washington, D.C.
•12 Regional Federal Reserve Banks
•Federal Open Market Committee (FOMC)
•Board + President of NY Fed+ 4 rotating other presidents
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Three Major Tools Fed uses to conduct Monetary policy:
•Open Market Operations - FOMC
•Reserve Requirements - Board has sole authority
•The Discount Rate - Board approves any change by a Fed bank
Banking Supervision
•shared with OCC + FDIC
•All member banks + BHCs + Foreign activities of member banks, US activities of foreign banks, Edge Act corporations
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Federal Reserve Banks•12 regional feds with 25 branches: Operate the nationwide payments system, distribute the nation’s currency and coin, supervise, regulate member banks and BHCs, and serve as Banker to the US Treasury.
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Why are Financial Intermediaries Special?
• Flow of Funds in a world without FI’s
Householdsnet savers
Corporationsnet borrowers
Cash
Equity and debt claims
•Monitoring costs (covenants)
•Liquidity
•Price Risk
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• Flow of funds in a world with FI’s
HouseholdsFI
(brokers)
-----------FI
(asset-transformers)
Corporations
Cash
Deposits and insurance policies
Cash
Equity + Debt
… …
•Brokerage Function reduce transaction costs, imperfections etc..
•Asset transformer: purchase Primary Securities and sell deposits, insurance policies,etc.(Secondary securities)
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• Information Costs
FI does the monitoring to reduce agency costs
hence a delegated monitor
economies of scale
frequent monitoring in Bank Loans allows the FI to gather information constantly (insider?)
Reduction of imperfections and information asymmetries
• Liquidity and price risk
Through diversification, FI’s offer highly liquid and
low price -risk contracts on the liability side of their
B/S while investing in relatively illiquid and higher
price-risk securities of corporations on the asset side.
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• Reduced Transaction Costs
Bulk asset purchases reduce costs (mutual funds and pension funds)
Bid-ask spreads are lower in large quantity purchases
• Maturity Intermediation
Other Aspects• Transmission of Monetary Policy• Credit Allocation (residential mortgages, farming loans…)
• Intergenerational Wealth Transfers (Time Intermediation)
• Payment Services
check clearing and wire transfers
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Risks of Financial Intermediation• Interest Rate Risk: The risk incurred by an FI when the
maturity of its assets and liabilities are mismatched.
0 Liabilities 1
0 1 2
Assets
Suppose the cost of Funds (liabilities) is 9 %, and interest return on
assets is 10%. Profit spread of 1%. But there is Refinancing Risk -The Risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments.
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• Reinvestment Risk - The risk that the returns on funds to be reinvested will fall below the cost of funds
01
2 Liabilities
0 1 Assets
FI borrows at 9%, and invests in an asset yielding 10%. But at what rate will reinvestment take place?
Market Value Risk: As interest rates rise market value of assets or liabilities will fall. Moreover, mismatching maturities by holding longer term assets than liabilities implies when rates rise asset MVs fall more than liabilities. This could lead to economic loss and insolvency.
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• Market Risk - The Risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.
– Barings Bank lost $1.2 billion on its trading position (buying Futures on the Nikkei index and betting the index would rise)
• Credit Risk - The risk that the promised cash flows from loans and securities held by FIs may not be paid in full.
Virtually, all types of FIs face this risk. However, those that make loans or buy bonds with long-maturities are more exposed (banks, thrifts, and life insurance co.s). Default of a borrower puts both the principal and the interest payments at risk. – Diversification helps. Firm Specific Credit Risk is reduced, while
the FI is still exposed to Systematic Credit Risk
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• Off-Balance-Sheet Risk - The Risk incurred by an FI due to activities related to contingent assets. While all FIs, to some extent, engage in Off-Balance-Sheet activities, mostly larger banks have drawn attention.– For example: A letter of Credit which is a guaranty issued by an FI
for a fee (makes it attractive) on which payment is contingent on the default of the agent that purchases the letter of credit. Nothing appears on the B/S but the fee appears on the income statement.
• Technology and Operational Risk– Purpose of technology is to lower operating costs, increase profits
and capture new markets for the FI.– Economies of Scale: The degree to which an FI’s average unit costs
of producing financial services fall as its output of services increase– Economies of Scope:The degree to which an FI can generate cost
synergies by producing multiple financial service products.– Technology Risk occurs when technological investments do not
produce the anticipated cost savings.
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- Operational Risk : The risk that existing technology or support systems may malfunction or break down.
•Foreign Exchange Risk: The risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad. If a U.S. FI is net long in foreign currency denominated assets, any depreciation of the foreign currency against the US dollar would lead to a loss for the U.S. FI . If a net short position prevails, then an appreciation of the foreign currency would lead to a loss.
- Even if we match the amounts of the assets and liabilities, we would still not be fully hedged if we have exposure to foreign interest rate risk from a maturity mismatch (simple maturity matching does not lead to a good hedge either, we need to match durations, but more on that later).
•Country or Sovereign Risk: The risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments.
•Liquidity Risk : The risk that a sudden surge in liability withdrawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices. ( Fire-Sale ) (RUNRUN!)
•Insolvency Risk: Not having enough capital to offset a decline in asset values.