Finance 305 Exam 2

Financial Intermediation

instead of savers lending/investing directly with borrowers, a financial intermediary plays the middleman

• even more important source of financing for corporations than securities markets

Are stocks the most important source of external financing for businesses?

no

is issuing marketable debt and equity securities the primary way for businesses to finacne their ops

no, stocks and bonds combined are still <50%

is indirect finance (From financial intermediaries) more important than direct finance

yes

most important source of external funds used to finance businesses

financial intermediaries, particularly banks

what type of corporations have easy access to securities market to finance their activities

only large, well established ones

prevalent feature of debt contracts for both households and businesses

collateral

are debt contracts complicated or simple

extremely complicated with substantial restrictions on behavior of borrowers

Why are financial institutions so important

• reduce trasnaction costs

• encourage risk sharing

• solve problems that arise from asymmetric information

Transaction costs

Time and money spent carrying out financial transactions

How do financial intstutions reudce transaction costs

• developing expertise

• exploiting economies of scale

Benefits of low trasnaction costs

• liquidity services for customers (sharing the benefits of economies of scale)

  • ex. checking accounts to easily pay bills

  • depositors earn interest on savings and checking accounts but cna stil convert them into goods and servies whenever necessary

  • Ability to write checks

  • ability to buy a range of assets, pool them, and sell rights to diversified pool of individuals (bank perspective)

Risk sharing

reducing investors’ exposure to risk

• provide means for invidivuals and businesses to diversify asset holdings

  • low assets

Asset transformation

• create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party

• risky assets are turned into safer assets for investors

asymmetric information

one party has more or better information than the other which can cause market failrues

adverse selection

affects people interested in doing the transaction before the transaction occurs

• lemons problem

How Can FIs mitigate adverse selection

• most cars are not bought and sold directly between individuals, who don’t have knowledge of each other, instead they’re bought and sold by car-dealers (intermediaries)

• intermediaries produce information by becoming experts to determine weather a car is a peach or a lemon, solving these asymmetric information problems

• FIs become expert in producing info about firms so they can sort good from bad credit

Principal-Agent Problem (morla hazard)

when one person (principal) hires another person (the agent) to make decisions/work on their behalf

• principal can’t monitor everything the agent does, so agent can pursue their best interest instead of principal

  • Voters + politicians

  • Stockholders + managers

  • investors + brokers

Moral Hazard in Financial markets

the risk that a borrower will engage in activities that are undesirable from the lendor/investor’s POV

• ex. moral hazard lowers prob. that loan will be repaid, lenders less likely to make the loan

  • fed ex going into the ground, gamble last $5k on roulette to try to save business

How od FIs reduce moral hazards

develop experitse in monitoring through creating large scale way to monitor firms directly

• writing contracts and stuff to enforce rules

Mitigate adverse selection problems

FIs better equipped than individuals to screen out bad credit borrowers from good ones

Reduce morla hazards concern

FIs can conduct more efficient and effective monitoring than borrowers

• FI can afford to pay lender-savers interest and provide substantial services, but still earn a profit

Most important FI activity

commercial banking

balance sheet

financial info on a bank’s assets, liabiliites, and equity

• 85-90% of financing comes from debt

• deposits and otehr short term borrowing are liabilities

• banks have very high leverage

Reserves and cash items

• vault cash

• deposits at Fed reserve

• deposits at other FIs

• Cash items in process of collection

Vault cash

currency and coins needd to meet customer withdrawals

deposits at federal reserve

used to meet legal reserve requirements, to assist in check clearing, wire transfers, and purchase or sale of treasury securities

• very very liquid

deposits at other FIs

used to purchase services from other FIs

• help execute transactions, make business partners

Cash items in process of collection

deposited checks written on account at antoehr bank whose funds have not yet been received/cleared

Reserve Requirement (asset)

regulation that for every dollar of checkable depoit at a bank, a certain fraction must be kept as reserves

• reserves = vault cash + deposits at fed + excess reserves

ensures banks maintain enough reserves to mmet obligations when funds are withdrawn

banks also hold excess reserves as a buffer

Investment securities (asset)

bank’s securities are an income-earning asset

• fed funds, repos

• treasury and agnecy securities

• MBS + debt-equity seurities

used for liquidity risk management purposes

• some are hihgly liquid

• sometimes called secondary reserves

Loans and leases (asset)

Loans

asset that generates the largest flow of revenue income

• least liquid

contra-asset accounts that are deducted from gross loans and leaes

unearned income

allowance (reserve) for loan and lease losses

unearned income

amount of income that bank received on a loan from a customer but hasn’t been recorded as income yet

Allowance for loan and lease losses

estimate of loans and leases that won’t be repaid to the bank

Deposits (liability)

Main liability in the bank balance sheet

• demand deposits nad NOW accounts

• Money Market deposits

• retail CDs

• Wholesale CDs

What accounts are transacion accounts that are subject to reserve requirements

Demand deposits and negotiable order of withdrawal (NOW) accounts

Who insured all domestic deposits

FDIC

NOW account backgroun

banks usedto not be able to pay nay interest on demand deposits

NOW accounts made in ‘74 as a loophole, bank can require 7+ days notice of withdrawal so they could pay some interest

demand deposit accounts

transaction account for non-interest beaing checkable deposits

NOW accounts

transaction account for interest bearing checkable deposits

BUT - demand deposit and now accounts after Regulation Q’s repealing cna both pay interest, eliminating any advatage that NOW accounts used to have

Borrowing in Various Markets (liability)

• banks fund assets through this as well

  • fed funds purchased, Repos

  • other borrowed funds

    • commercial paper, etc.

  • subordinated notes and debentures

Other liabilities

do not require interest to be paid

• accrued interest, deferred taxes, dividends payable, etc.

Bank Capitla (Equity)

bank’s net worth

= assets - liabilities

mainly preferred and common stock, surplus and additional paid in capitla, and retained earnings

Off-Balance Sheet Items

continegents assets and laibilities that MAY affect the bank’s balance sheet and/or income statement

• loan commitment

• loan sale

• derivative securities

at the moment, it doesn’t represent an asset or liabilitym could be one in the future, like if we agree to loan max $10 mil to someone, but they only take out $5 mil, but they could take the other $5 mil later on

OBS activities: loan commitment

commitment by a bank to loan a cutomer a certain max amount at a given interest rate terms

• the example i just gave before

when bank makes committment, nothing shows on B/S, and if they take out $8 mil, it’ll show $8 mil loan (not 10)

Loans sold

loans originated by a bank then sold to other investors

• can be sold with or without recourse

No recourse

loan sales have no OBS contingent liability implications for the bank

• the buyer of the lean must bear the full risk of loss

With recourse

loans may be returned to the bank if the credit quality of the loans deteriorate

• bank may do this to keep customer happy

• makes the bank buy it back and take on credit risk

loan buyer has option to put the loan back to the seller, which buyer can do if credit quality turns shit

OBS Activities: Derivative Contracts

Futures, forward, swap, option, and other derivatives positions taken by bank for hedging or other purpses

Depository Insitutions

FIs that are allowed to accept deposits from customers

Types of DIs

• commercial banks

• thrift institutions

Types of thrift institutions

savings institutions

• savings and loans association (S&L)

• savings banks

Credit Unions

Types of Commercial Banks

• community banks

• regional or super-regional banks

• money center banks

Community banks

assets < $10 billion

• local markets

• larger portion of assets in consumer and real estate loans

• less assets in commercial and industrial loans

• eavily rely on local deposits andl ess on borrowed and int’l funds

Regional or Super-regional banks

several billion ot serveral hudnred billion $

• HQ in large regional cities with branches all around

• multiple states/regions

wholesale commercial banking activites

deposits for dunding and large corporate customer and int’ money centers

Money center banks

Rely heavily on NON-deposited / BORROWED sources of funds

compete with large regional banks

JP Margon, Citi, etc.

Why has the # of commercial banks decreased so mcuh

M&As which were possible due to a series of financial deregulations

Riegle-Neal Act

eased branching by banks across state lines

Effect of consoldiation of banking

reduced asset shares of community banks dramatically

• way more banks with > $10 billion today vs 1984 (34% vs 84%) more banks are bigger

Dual Banking System

banks can be nationally (Federally) or state chartered

Who charters national banks

Office of the comptroller of the Currency (OCC)

• regulated by federal law

Who charters state banks

state ageniceis

regulated under state laws

FDIC

Created by Glass-Steagall Act

protects bank deposits up to $250,000

levies insurance premiums ob banks, manages the deposit insurance fund, and does bank examinations

acts as receiver and liquidator when bank closes

Now manages unsurance for both commercial banks and savings institutions

Federal reserve System

concerned with conduct of monetary policy

• has regulatory power over some banks

all nationally cahrtered banks automatically member of FRS

some state chartered banks can choose to be members

Advatage of FRS membership

direct access to fed funds wire transfer network for nationwide borrowing and lending of reserves

4 major regulators of commercial banks

OCC

State bank regulators

FDIC

Federal Reserve System

Primary Federal regulator

FDIC-insured banks are subject to at least one fedral regulator (state and national level)

Primary feferal regulatory for national banks

OCC

Primary feferal regulatory for state-chartered banks

FRS members: FRS

FRS non-members: FDIC

FRS also 1º regulator for bank holding companies

Savings Institutions

Savings and Loan Associations (S&Ls)

Savings banks

• both are DIs

both have slight structural differences but no real difference in sort of loans or investments they make

What do Savings institutions do

specialize in long-term residential mortgaes, financed with short term deposits of small savers

Mutual Organizations

depositors are owners of the institution, no stock issued

member deposits represent ownership stake

no stock holders, managers can concentrate on low-risk investments and prevention of failure

historically, most savings institutions are this

% of mortgage loans compared to commercial bank

larger

high reliance on Mortgages and MBS’s

% of MBS compared to commercial bank

larger

% of Commercial loans compared to commercial bank

lower

% of total deposits compared to commercial bank

larger

% of fed fudns and repos compared to commercial bank

smaller

% of other borrowed money compared to commercial bank

smaller

S&L Crisis

Phase 1:

deregulations from Regulation Q, opened up speculative lending

war caused price of oil to drop, hitting texas real estate prices hard, causing mortgage defaulting

Phase 2: FSILC chose not to close capital-depleted and insolvent savings institutions and allowed them to operate (regulatory forebearance)

• this incentivized excessive risk taking and pretty much gambling for redemption

large number of failed savings institutions caused the FSILC to be insolvent itslef

FIRREA passed in 1989 by congress to save this

• created Savings Association Insurance Fund (SAIF) and was put under managment of FDIC

OCC role for savings institutions

charters and examines federal savings institutions

doesn’t regulate state-chartered savings inst.

Credit Unions

Nonprofit DIs mutually organized and owned by their members (Depositors)

prohibited from serving general public

primary objective is the satisfy depository and borrowing needs of members

Are Credit Unions Tax exempt

Yes, their earnings are untaxed because

• nonprofit, mutual organizations

• don’t raise capital from large investors from wall street

• use member deposits to providel oans for other memebrs

• profits are distributed back to memebrs in form of better rates on dpeosits and loans + lower + fewer service fees

Most numerous depository institution

Credit Unions

Consumer loans of Crediut Unions

larger % than other DIs

hold >40% of assets in small consumer loans funded mainly by member deposits

also hold fewer mortgages than Savings Institutions

Credit Union Business Loans

Smaller % then other DIs

Regulator of NATIONAL Crediut Unions

National Credit Union Administration (NCUA)

• like FDIC but for CUs

• covers deposits through NCUSIF

State chartered credit unions are regulated by state agencies

Contractual Savings Institutions

FIs that acquire funds periodically under contractual agreements

• predict how much they’ll have to pay out in benefits in coming years

  • don’t have to worry as much as DIs about losing funds quickly

• Liquidity of assets is not as important a consideration as it is for DIs

What kind of funds do Contractual Savings Inst. tend to invest in: Long or short

long-term securities

Benefits of Diversfiication

Insuance companies enjoy this by poolinga large number of individual policies together

• idiosyncratic or customer-specific risks are diversified away

• this allows them to offer unsrance services at a cost lower than nay individual could achieve on their own

Two groups of insurance

life insurance

propoerty-casualty insurance

life insurance

portects agaisnt untimely deathm illness, adn retirement

P&C insurance

protects agaisnt property damage, personal injury, and liability due to accidents, theft, fire, and other bad stuff

Why is Law of Large numbers helpful

helkps establish correct insurance premium and reduce risks asscoaited with underwriting

• insurance companies accept (underwrite) risk that a pre-specified event will occur in return for insurance preimums

  • underwriting decsison determine which risks are accepeted and which are not and how much to charge for accepted risks

Three Classes of life insurance

Ordinary life

Group life

credit life

Ordinary Life

marketed on an individual basis

Types of ordinary life policies

Term life

Whole life

Endowment life

Term life

pure life insurance

contract expires if you live long enough

beneficiary receives payout if you die before coverage ends

Whole life

protects individual over entire lifetime

• beneficiary will receive payout no matter what