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3-1 Chapter 3 Financial Intermediaries. 3-2 Deficit Sectors Financial Intermediaries Claims Surplus Sectors $ Claims $$

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Presentation on theme: "3-1 Chapter 3 Financial Intermediaries. 3-2 Deficit Sectors Financial Intermediaries Claims Surplus Sectors $ Claims $$"— Presentation transcript:

1 3-1 Chapter 3 Financial Intermediaries

2 3-2 Deficit Sectors Financial Intermediaries Claims Surplus Sectors $ Claims $$

3 3-3  Pooling of small savings.  Diversification of risks.  Economies of scale in monitoring information and evaluating risks.  Lower transactions costs.  Special reasons.  The above are not mutually exclusive. Advantages of Financial Intermediaries

4 3-4  The primary market for securities involves the initial sale.  The secondary market for securities involves the resale. Primary Market vs. Secondary Market

5 3-5  Investment banking is the marketing of securities when they are initially sold.  Some securities are sold to private buyers. Others are sold to the public. The exact difference is a technical legal issue.  Public offerings must be registered with the Securities and Exchange Commission (SEC). Investment Banking

6 3-6  Investment banking firms sell public offerings. They are essentially marketers of securities and charge a fee for their services. This is often called an underwriting fee.  Syndicates of investment banks are often involved in public offerings. This spreads the resale risk. Public Offerings

7 3-7  Firm Commitments. The investment banker purchases the security issue outright and bears the resale risk.  Best Efforts. The investment bankers sell whatever they’re able.  Fees for firm commitments are much higher. Most bond issues are sold by firm commitment. Types of Public Offerings

8 3-8  Shelf Registration.  Some securities are sold by shelf registration. This is essentially a pre- registration of a security issue. Anytime during the next two years the securities can be brought to market very rapidly.  Rule 144A.  They do not have to be registered with the SEC and can be resold to other qualified financial institutions.

9 3-9

10 3-10  Many securities are traded on organized exchanges such as the New York Stock Exchange or NASDAQ.  Most bonds are traded over-the- counter (OTC). The OTC market is a network of dealers located throughout the country.  Some securities are traded over anonymous electronic trading systems. Secondary Market

11 3-11  Dealers are marketmakers for securities. They maintain an inventory and buy and sell from that inventory. A dealer offers to buy at the bid price and offers to sell at the asked price.  The size of the bid-asked spread depends upon two major factors. Volume of trading. Inherent price risk. Security Dealers

12 3-12  Brokers are agents who carry out transactions for buyers or sellers. Brokers charge commissions for their services.  There are different types of brokers.  Full-service brokers provided execution and advice and charge the highest fees.  Discount brokers provided execution only. Security Brokers

13 3-13  Mutual funds represent a pooling of funds by many investors.  Open-end vs. closed-end funds.  Net Asset Value (NAV) = liquidating value.  For closed end funds, typically Price < NAV. Mutual Funds

14 3-14  Information Economies.  Diversification.  Lower transactions costs. Advantages of Mutual Funds

15 3-15 Mutual Fund Costs Sales Fees Front End Load Rear End Load 12b-1 Fees (Annual)

16 3-16 Mutual Fund Costs Expense ratio includes: Management fee. Administrative fee. Other fees. Additional Costs: Brokerage commissions.

17 3-17  Life insurance.  Casualty insurance.  Insurance companies are large investors in fixed income securities.  Adverse selection.  Moral hazard. Coinsurance. Insurance Companies

18 3-18  Defined benefit plans. Dollars paid out usually set by some formula, e.g., Pension = (# Years)(Average) (X%). Pension Benefit Guarantee Corporation. Employer bears the reinvestment risk.  Defined contribution plans. Dollars paid in are specified. Dollars paid out depend upon returns. Employee bears the reinvestment risk. Pension Funds

19 3-19 Reinvestment 012 Horizon Date Time $ In C C $ Out Pension Funds Cash Flows

20 3-20 Pension Benefit Guaranty Corporation  Insures pensions of private defined benefit plans.  Does not ensure government defined benefit plans.  Collects premiums from covered plans.  Underfunded.  Limited benefits.

21 3-21  Heavily regulated. Safety. Widespread effects. Competition.  Regulatory agencies. The Federal Reserve. The FDIC. The comptroller of the currency. State banking authorities.  Charters. Branches. Insurance. Capital. Failure. Commercial Banks and Thrifts

22 3-22 Important Regulations  Glass Steagall Act – separated commercial banking from investment banking, dealers, brokers, mutual funds, insurance.  Restrictions lifted beginning in 1980s and repealed in 1999.

23 3-23 Important Regulations  RESTRICTIONS ON BRANCHING  Banks used to be restricted to operating in one state.  Within states, there were three types of branching rules: one office, limited branching, unrestricted branching.

24 3-24 Bank Economies of Scale Cost per Dollar of Assets Size High Cost Low Cost Small Bank Large Bank  

25 3-25 Federal Deposit Insurance Corporation  FDIC has the power to close failing banks.  FDIC insurance covers depositors up to $250,000 for any shortfalls.

26 3-26 Bank Balance Sheet Assets Liabilities & Equity Book Value Market Value Book Value Market Value Cash20 Deposits150 Loans170100Bonds400 Building10 Equity100 200130200150

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