Intermediaries 3 CHAPTER Depository Institutions Commercial Banks Thrifts Nondepository Institutions Insurance Companies Brokerage Firms Investment Companies Pension Funds Copyright © 1999 Addison Wesley Longman

2 Chapter 3: Intermediaries Depository Institutions  Banks  Thrifts  Credit Unions  15,000 of 30,000 Banks failed during the depression, resulting in the passage of banking reforms.

Copyright © 1999 Addison Wesley Longman 3 Chapter 3: Intermediaries Glass-Steagall Act  Separated commercial banking from investment banking  Introduced FDIC insurance

Copyright © 1999 Addison Wesley Longman 4 Chapter 3: Intermediaries FIGURE 3.1 Number of Banks Since 1920

Copyright © 1999 Addison Wesley Longman 5 Chapter 3: Intermediaries DIDMCA 1980  Removed interest rate ceilings  Established uniform reserve requirements  Authorized NOW accounts  Gave S & Ls increased lending power

Copyright © 1999 Addison Wesley Longman 6 Chapter 3: Intermediaries The U.S. has a dual banking system.  Early limits on intra- and interstate branching restricted bank growth. Recent reinterpretation of laws has relaxed restrictions.  Consolidation is now rapidly

Copyright © 1999 Addison Wesley Longman 7 Chapter 3: Intermediaries Savings and Loans  Original mandate was to provide mortgage loans  Thrift crisis occurred when interest rates rose in the late 1970s

Copyright © 1999 Addison Wesley Longman 8 Chapter 3: Intermediaries (a.) Thrift Crisis  Rising interest rates caused disintermediation  Thrift replaced lost deposits with expensive borrowed money  Loans earned less than cost of funds

Copyright © 1999 Addison Wesley Longman 9 Chapter 3: Intermediaries (b.) Thrift Crisis  Congress responded by deregulating industry  Fraud and a faltering economy led to losses

Copyright © 1999 Addison Wesley Longman 10 Chapter 3: Intermediaries (c.) Thrift Crisis  Congress re-regulated thrifts in 1989 (FIRREA)  Losses to taxpayers were $145 billion (about $580 per man, woman and child in the U.S.)

Copyright © 1999 Addison Wesley Longman 11 Chapter 3: Intermediaries Credit Unions  Enjoy non-profit tax status  Require common bond for membership

Copyright © 1999 Addison Wesley Longman 12 Chapter 3: Intermediaries Insurance Companies provide  Life insurance  Property and casualty insurance

Copyright © 1999 Addison Wesley Longman 13 Chapter 3: Intermediaries  People buy insurance because they are risk averse and prefer the certainty equivalent rather than take the risk of a major loss.

Copyright © 1999 Addison Wesley Longman 14 Chapter 3: Intermediaries  Tables help insurance companies accurately predict fund requirements

Copyright © 1999 Addison Wesley Longman 15 Chapter 3: Intermediaries Table 3.5Expectation of Life at Various Ages in the United States AgeMaleFemaleAverage

Copyright © 1999 Addison Wesley Longman 16 Chapter 3: Intermediaries Other Intermediaries  Brokerage Firms  Investment Companies

Copyright © 1999 Addison Wesley Longman 17 Chapter 3: Intermediaries Mutual Funds  Closed- vs. Open-End  Load vs. No-Load  Net Asset Value

Copyright © 1999 Addison Wesley Longman 18 Chapter 3: Intermediaries  An open-end investment company is commonly called a mutual fund.  A mutual fund has no limit on the size of the fund or the number of shares outstanding.  The value of a mutual fund share is called its net asset value.  Mutual fund shares are not sold in the traditional sense. Instead, they are redeemed by the fund management. Open-End Investment Companies

Copyright © 1999 Addison Wesley Longman 19 Chapter 3: Intermediaries  Upon opening an account with a mutual fund, the investor must select from among several options.  Some common options are : - automatic reinvestment option - automatic monthly investment plan - limit order option - periodic payment option - telephone redemption option - switching option Open-End Investment Companies

Copyright © 1999 Addison Wesley Longman 20 Chapter 3: Intermediaries  Load and No-Load Load funds have a salesforce and the shareholders have to pay a sales charge. If paid at the time of purchase, the fee is a front-end load. If levied when shares are sold, the fee is a back-end load, or contingent deferred sales charge. A no-load fund charges no sales commission. The Investment Company Industry : Fees  Most mutual funds separate their charges into a number of categories.

Copyright © 1999 Addison Wesley Longman 21 Chapter 3: Intermediaries The Investment Company Industry : Fees Prevalence of Load Charges by Type Source: Wiesenberger Mutual Funds Update, October 1999

Copyright © 1999 Addison Wesley Longman 22 Chapter 3: Intermediaries  Certain expenses such as the management fee are associated with operating a mutual fund. These fees are measured by the fund’s expense ratio, which is the fund’s total expenses expressed as a percentage of the fund’s assets.  Note that within the same fund, there may be several classes of shares with different fee combinations. Their relative merits depend on how long the investor anticipates keeping the investment. The Investment Company Industry : Fees

Copyright © 1999 Addison Wesley Longman 23 Chapter 3: Intermediaries  The annual 12b-1 fees permit the fund manager to pass certain advertising costs on to the accountholders.  A trailing commission is an annual fee paid to a broker, sometimes independent of the level of activity in the account or its size.  Other fees include fund transfer charges, custodian fees, low-balance fees, account opening or closing fees etc.  Studies indicate that the lower the expense ratio, the better the fund performance. The Investment Company Industry : Fees

Copyright © 1999 Addison Wesley Longman 24 Chapter 3: Intermediaries  Rationale : Mutual funds provide automatic diversification, professional management, and convenience.  Eligibility : One need only consider funds whose requirements, such as the minimum initial investment, are satisfied.  Interpreting Past Performance : Buying last year’s best performing mutual funds is seldom a winning strategy. Selecting A Mutual Fund

Copyright © 1999 Addison Wesley Longman 25 Chapter 3: Intermediaries  Money market funds invest in short-term government securities and sometimes in short-term corporate securities. They are used primarily as a temporary cash haven.  Bond funds invest in fixed income securities. They vary widely, and have no common maturity date to simultaneously return the components to their par value.  Stock funds vary widely in their risk and price behavior. They are classified as growth or value, and as large-cap or small-cap. Selecting A Mutual Fund : Types of Funds

Copyright © 1999 Addison Wesley Longman 26 Chapter 3: Intermediaries  A balanced fund is a mixture of stocks and fixed income securities. It forces discipline on the fund manager.  An international fund is limited to buying securities registered outside the country where it is sold, while a global fund can invest anywhere in the world.  Fund of funds invest only in other mutual funds. Their diversification is good, but their expense ratios tend to be higher than that of the typical mutual fund. Selecting A Mutual Fund : Types of Funds

Copyright © 1999 Addison Wesley Longman 27 Chapter 3: Intermediaries  Sector : Such funds invest in specific market sectors, such as physical commodities or stocks closely tied to natural resources e.g. oil, forest products, and gold.  An index fund may be a stock or bond fund that tries to behave exactly like the market. A stock index fund, for instance, may seek to mirror the performance of the Standard & Poor’s 500 stock index.  Investors should determine their investment objective first, and then choose an appropriate fund or group of funds. Selecting A Mutual Fund : Types of Funds

Copyright © 1999 Addison Wesley Longman 28 Chapter 3: Intermediaries  One important item in the prospectus is the fund’s portfolio turnover rate. A higher rate usually means higher expenses.  The Statement of Additional Information is required by the SEC, although it is generally only sent to accountholders upon their request. It is a more detailed version of the prospectus. Information Sources : Company Information  The prospectus is a legal document describing the operation of the fund, its management, and the fees accountholders must pay.

Copyright © 1999 Addison Wesley Longman 29 Chapter 3: Intermediaries Pension Funds  Private Plans  Public Plans –Social Security –Pay-as-You-Go