ABM Business Finance: Financial Institutions and Capital Structure

Fundamental Roles and Purposes of Financial Institutions

• Financial institutions are entities that provide products and services related to financial transactions, serving as essential channels in the financial system.

• These intermediaries facilitate the flow of funds from savings to lending and investments, specifically ensuring that funds from net savers (creditors) reach net spenders (debtors).

• The functions of financial institutions include:

  • Assisting individual entities by investing and lending on their behalf.

  • Accepting deposits and donations.

  • Offering various types of loans.

  • Proposing and managing investment plans.

  • Pooling excess funds to finance business activities and overall economic development.

• Money is a vital part of daily life used to earn, spend, and save for survival in society. Managing finances and setting specific financial goals involves setting aside income, depositing it into bank accounts, and earning income through interest.

• Depositing money into a bank account constitutes a form of indirect lending. Banks pool funds from individuals, households, and companies to offer loans to those in need. Lenders then grow their capital through the interest payments made by borrowers.

Capital Structure: Trade-Off Theory vs. Pecking Order Theory

Corporate finance frameworks explain how companies decide to fund their operations and growth through two primary theories.

Trade-Off Theory: Balancing Risk and Reward

• This theory proposes that firms reach an optimal mix of debt and equity by balancing the tax advantages of debt against the costs of potential financial distress.

• Core Concepts:

  • The Tax Shield Benefit: Interest paid on bank loans or corporate bonds is tax-deductible. Borrowing money effectively lowers a company’s tax bill.

  • Financial Distress Costs: Borrowing excessively creates high monthly debt payments. If revenue drops, the business faces risks such as default, legal fees, or bankruptcy.

• The foundational value of a levered firm ($V_L$) relative to an unlevered firm ($V_U$) is calculated as:

  $V_L = V_U + PV(\text{Tax Shield Benefits}) - PV(\text{Bankruptcy Cost}) - PV(\text{Agency Cost})$

• The optimal capital structure is achieved at the debt ratio where the firm's value is maximized before the present value ($PV$) of bankruptcy and agency costs begins to outweigh the tax shield benefits.

Pecking Order Theory: The Path of Least Resistance

• This theory is based on Information Asymmetry, where company managers possess more information about the business's health than outside investors or banks. Because issuing new stock can signal that a stock is overvalued, companies follow a strict hierarchy of preference for funding.

• The Hierarchy of Preference (Pecking Order):

  1. Internal Equity (Retained Earnings): Saved profits are used first because they involve no fees and require no outside permission.

  2. Debt (Bank Loans & Financial Institutions): If internal savings are exhausted, firms seek loans. Banks perform private credit checks, avoiding public stock market panic.

  3. External Equity (Issuing New Shares): This is the last resort, used only when the capacity to borrow from banks is completely exhausted.

• This is a behavioral hierarchy model rather than a single target equilibrium formula. A firm’s net debt issuance ($\Delta D$) in a given period is modeled as its financial deficit:

  $\Delta D = \text{Dividend Payments} + \text{Capital Expenditures} + \text{Working Capital Needs} - \text{Operating Cash Flow}$

Categories of Financial Institutions

Financial institutions are broadly classified into depository and non-depository categories based on how they acquire funds and generate income.

Depository Financial Institutions

These institutions accept deposits and savings, offer loans, and earn primarily through interest payments.

• Central Banks: These govern all other banks, set monetary policies, and maintain price stability.

• Retail and Commercial Banks: These accept deposits and provide various loans (personal, car, home, business) and services such as savings accounts, checking accounts, time deposits, and credit cards.

• Internet Banks: A modern type of institution that accepts deposits and operates through purely online transactions.

• Credit Unions: These are formed by particular groups to pool contributions from members and provide loans with interest back to those members.

• Savings and Loan Associations: These accept deposits and offer loans and mortgages specifically to their members.

Non-Depository Financial Institutions

These do not accept deposits but offer other financial services such as investments and insurance, earning primarily through commissions.

• Investment Banks and Companies: They facilitate transactions on long-term securities, manage mutual funds, and buy bonds to offer them to investors.

• Brokerage Firms: These connect individual traders and investors by facilitating the buying and selling of short-term and medium-term securities.

• Insurance Companies: They collect premium payments to cover possible financial losses and other risks for the policyholder.

• Mortgage Companies: These focus specifically on home loans and lending money through real property mortgages.

Loans, Interest, and Regulatory Bodies

• Banks finance several loan types, including personal, home, car, and business loans.

• Example: Applying for a car loan payable over $5$ years with an interest rate of $8.14\%$. This interest constitutes the bank's income.

• Regulatory Bodies in the Philippines:

  • Bangko Sentral ng Pilipinas (BSP): The authorized body that regulates interest rates and sets monetary policies for all local banks.

  • Philippine Deposit Insurance Corporation (PDIC): This entity insures deposits made in Philippine commercial banks to protect depositors.

Case Study: The Federal Reserve Response to 9-11

• Background: The September 11, 2001, terrorist attacks on the World Trade Center in Manhattan resulted in $3,000$ deaths and massive infrastructure destruction. Economically, the event paralyzed the global financial system, interrupting bank transactions and stopping trade in various financial markets.

• Leadership and Action: The interruption challenged the Federal Reserve (the U.S. central bank). Roger Ferguson, Vice-Chairperson of the Fed’s Board of Governors, took charge as the only member available to make immediate decisions.

• Outcome: Despite a lack of specific legislative provisions for a single governor to act alone, Ferguson led the Federal Reserve to make a series of decisions aimed at providing confidence and increasing liquidity in the damaged financial system. These actions are credited as the ultimate solutions to that specific financial crisis.

Specific Financial Products and Applications

• Variable Universal Life (VUL) Insurance: Often recommended to full-time employees, VUL provides lifetime insurance coverage while also acting as an investment that accumulates value over time. If the policyholder dies, beneficiaries receive the insured amount. Companies offering VUL are examples of non-depository financial institutions.

• Mutual Funds: Managed by investment companies, these involve pooling money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities.

Questions & Discussion

• What are the common reasons for keeping personal savings in banks?

  • Common reasons include safety, earning interest, and the insurance provided by bodies like the PDIC.

• Do you think that people should invest their money?

  • People in the accumulation phase often invest to secure future income, provide for family needs, and attain financial freedom. Investment options include time deposits, stocks, and life insurance.

• How do depository and non-depository financial institutions act as financial intermediaries?

  • Depository institutions act as a medium by taking deposits and lending them out, while non-depository institutions facilitate specialized financial transactions like insurance or securities trading.

• In what ways can financial institutions help individuals during a crisis such as a pandemic?

  • They can provide access to personal savings, offer emergency loans, or provide insurance payouts in cases of health crises or job loss.

Practice Scenarios

• Scenario 1: A public school teacher has a percentage of her salary automatically transferred to a cooperative association every 15th and 30th of the month. She applies for loans from this association every June for tuition.

  • Financial Institution: Credit Union or Cooperative (Depository), as it is formed by a particular group and pools member contributions for member loans.

• Scenario 2: Marie established a grocery business and wants to protect her assets from losses due to calamities or natural disasters.

  • Financial Institution: Insurance Company (Non-Depository). It can help by providing a policy that covers financial loss and risks in exchange for premium payments.

• Scenario 3: A family has $Php\,550,000$ in savings, but the father was laid off due to the pandemic. They need to cover expenses for a year.

  • Financial Institution: Commercial Banks (to access savings) or potentially Social Security/Insurance if applicable. They might also seek personal loans from depository institutions.

• Scenario 4: A contractual worker earns $Php\,30,000$ a month with no dependents and wants to diversify income.

  • Financial Institution Recommendation: Investment banks (for mutual funds) or brokerage firms (for stocks/securities) to grow her wealth over time.