Financial Intermediary

Financial Intermediary
Depository & Non Depository Financial Intermediary

DEPOSIT TAKING AND NON DEPOSIT TAKING INTERMEDIARIES
A bank can accept deposits. Such deposits of the customers can be withdrawn by cheque or otherwise (withdrawal slip, letter and voucher) on demand, or repayable on maturity to the customers. The bank lends or invests the funds collected from its customers,. Acceptance of deposits and lending the same are thus core functions of a bank. The above process is known as intermediation.

INTERMEDIATION The principle of intermediation is closely related to the core banking functions, taking of deposit and extending of credit. Banks are ‘financial intermediaries’ because they invest or lend the funds of depositors who themselves are unable to lend their funds to others due to risk and other factors involved in direct lending.

INTERMEDIATION….Cont’d
Banks assume the credit and other risks involved in direct lending to those who need funds (borrowers) because of their expertise and administrative abilities to manage such risks. Thus banks mediate between the depositors (savers of money) and borrowers (users of money) and earn interest spread as a reward for risk taking and also for meeting administrative expenses and making provision for some portions of loans that turn bad or difficult to recover (termed as ‘non-performing assets’ or NPAs).

DISINTERMEDIATION The term ‘disintermediation’ means the reversal of the intermediation process involved in banking. An investment by a person in certain stocks of a company is a direct exposure or risk taking by the investor in the particular company. In this example of dis-intermediation, the investor may or may not get back the capital invested in the company when he wants, as he has assumed the risk involved in direct investment.

DIAGRAM ON INTERMEDIATION

THE COMMON CHARACTERISTICS OF ALL FINANCIAL INTERMEDIARIES
First, they take money from those who seek to save, whether it be in exchange for a deposit account bearing interest or in exchange for a paper financial claim. Secondly, they lend the money provided by those savers to borrowers, who may issue a paper asset in return. Thirdly, in exchange for such lending they acquire a portfolio of paper assets (claims on borrowers) which will pay an income to the intermediary and which it may ‘manage’ by buying and selling the assets on financial markets in order to yield further profits for itself.

Financial Intermediary

Advantages of Financial Intermediaries
Financial consultancy, offered to the investors and capital users; The possibility of better gathering and valuing the existing information on the market; Additional facilities offered to the users and capital owners, a part of these being taken over by intermediation institutions. Pooling of small savings. Diversification of risks. Economies of scale in monitoring information and evaluating risks. Lower transactions costs.

The disadvantages of financial intermediation
− big transaction costs, due to collection of taxes, fees and commissions; − the loss of direct contact with the international financial market, therefore some investors aren’t sensitive anymore to the markets’ signs; − the existence of a routine in the relationship with the financial intermediary, many markets being led according to the solutions offered over the time by important intermediary firms.

Function of Financial Intermediaries (FIs)
Engage in process of indirect finance More important source of finance than securities markets Needed because of transactions costs and asymmetric information

Function of Financial Intermediaries
Transactions Costs Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale

A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions Banks provide depositors with checking accounts that enable them to pay their bills easily Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary.

Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors

Asymmetric Information: Adverse Selection and Moral Hazard
Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected

After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back

Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits.

Why have financial intermediaries grown so rapidly?
Financial intermediaries satisfy portfolio preferences of lenders and borrowers: For the lenders, they diversify the portfolio, particularly, the credit/ default risk. For the borrowers, they offer a much wider choice of (tailor-made) credit than the ultimate lender would have been able to provide. They get more choice in maturity, size of loan, interest rates. 2. Cost advantages: There is cost involved in a borrower locating a lender, in the lender getting information on the borrower. FIs specialize in these tasks. 3. Risk reduction: Particularly for the lender (diversification acts as a hedge).

Why have financial intermediaries grown so rapidly?
4. Liquidity intermediation: The lenders are able to withdraw their funds when required, at a small cost. 5. Government regulation: These include: Banking Act, capital adequacy requirements, reserve requirements, regulations regarding investment, auditing and examinations, lender of last resort privilege. These enhance the image of FIs in the eyes of the lenders. Further, there has been a more rapid expansion of unregulated FIs compared with regulated FIs. These (unregulated) FIs compensate the depositors for the higher risk with higher rates of return.

Two theories of financial intermediation:
Old theory: This holds that the services offered by financial intermediaries are primarily the transformation of assets. New theory: i) It isolates three types of financial intermediaries: broker, mutual fund and deposit-taking intermediary. ii) Financial intermediaries actively manage their portfolios through the application of resources to reduce costs. iii) Financial intermediaries play a more important role in developing economies than in developed ones.

THE ROLE OF FINANCIAL INTERMEDIARIES

Brokerage A broker is an intermediary who brings together lenders and borrowers who have complementary needs and does this by assessing and evaluating information. The lender may have neither the time nor the ability to undertake search activities in order to assess whether a potential borrower is trustworthy. Household avoids such information gathering, monitoring and evaluation costs,

Maturity Transformation
Intermediaries hold liabilities (e.g. deposits) that have a shorter term to maturity than their assets (e.g. loans), i.e. they borrow short and lend long. E.g., a building society will typically hold around 70% of its liabilities in the form of deposits repayable ‘on demand’, i.e. which can be withdrawn at any time without penalty. In contrast, around 75% of its assets are repayable only after five years or more. maturity transformation function in part because of the ‘law of large numbers’,.

Risk Transformation This involves the financial intermediaries in shifting the burden of risk from the lender to themselves. Their ability to do so depends largely on economies of scale in risk management. The large amounts of deposits (liabilities) the financial intermediaries collect allow them to diversify their assets across a wide variety of types and sectors. ‘Pooling’ risk and reward in this way means that no individual is exposed to a situation in which the default of one or more borrowers is likely to have a significant effect.

Collection and parcelling
Financial intermediaries also transform the nature of their assets through the collection of a large number of small amounts of funds from depositors and their parcelling into larger amounts required by borrowers. Often the financial intermediaries have relied on obtaining many small deposits from conveniently located branches of their operations. This process is known as ‘size intermediation’ and benefits borrowers because they obtain one large loan from one source, thus reducing transaction costs. Of course this loan is an asset to the financial intermediary and a liability to the borrower.

Financial Intermediaries

Chief sources and uses of funds by important intermediaries:
Intermediaries sources of funds uses of funds 1. commercial banks deposits loans, govt. bonds, mortgages etc. 2. savings and loan assoc. deposits mortgages 3. credit unions deposits mortgages 4. pension funds contributions stocks and bonds 5. mutual funds shares stocks and bonds 6. money market funds shares short term assets

Types of Financial Intermediaries
Depository Institutions (Banks) Commercial banks, Savings & Loan Associations (S&Ls), Mutual Savings Banks in US Three-tier system of deposit-taking institutions, namely, licensed banks, restricted licence banks, deposit-taking companies in Hong Kong (collectively known as AI: Authorized Institutions) Contractual Savings Institutions Life insurance companies Fire & casualty insurance companies Pension funds, government retirement funds (e.g. Mandatory Provident Fund Scheme in Hong Kong)

Investment Intermediaries Finance companies Mutual funds Money market mutual funds

Depository Institutions (Banks)

Commercial Banks Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios

Commercial Banks Most prominent financial institution
Range in size from huge (BankAmerica) to small (local banks) Major sources of funds used to be demand deposits of public now rely more on “other liabilities” also accept savings and time deposits Uses of funds short-term government securities long-term business loans home mortgages

NATIONAL SAVINGS Savings Institutions exist in the Country to complement the commercial banks and finance companies as the major deposit taking institutions. The main savings institutions are the National Savings and Credit Bank and cooperative Societies. These Savings institutions promote savings among middle and lower income groups in the rural areas that are not adequately served by the Commercial Banks and finance Companies. The national Saving Banks’s principal activity is to carry out the functions of a national savings bank, namely to accept deposits and to provide retail loans to small borrowers. The government guarantees all deposits. Funds raised through the premiums saving certificates are unique to this bank. Attractive prizes for lucky draw winners and payment of dividends contributed to the growth of these deposits. Other deposit products are savings deposits, fixed deposits and Giro deposits and save-as-you-earn deposits. The Giro savings scheme is attractive due to its features, which enable depositors to remit funds and make payments while earning an interest. Lending is channeled to housing, credit cards, hire-purchase and corporate loan.

Contractual Savings Institutions(CSIs)

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict

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

Life Insurance Companies
Insure against death Receive funds in form of premiums Use of funds is based on mortality statistics—predict when funds will be needed Invest in long-term securities—high yield Long-term corporate bonds Long-term commercial mortgages

Pension Funds 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 Cash Flows
Horizon Date 1 2 Time $ In C C $ Out Reinvestment

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.

Pension and Retirement Funds
Concerned with long run Receive funds from working individuals building “nest-egg” Accurate prediction of future use of funds Invest mainly in long-term corporate bonds and high-grade stock

Contractual Savings Institutions (CSIs)
All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities

Investment Financial Intermediary

Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations

FINANCE HOUSES Investment intermediaries provide a mechanism through which small savers pool funds to purchase a variety of financial assets rather than just one or two. An example of how pooling works can be seen by considering a mutual fund company, which is one type of investment intermediary. A finance Company is another type of investment intermediary. Finance Companies make loans to individuals and businesses, as do banks, but instead of holding deposits, as banks do, finance companies borrow the money they lend. They borrow from individuals by selling them bonds and commercial paper. Commercial paper is a short-term promissory note that a certain amount of money plus interest will be paid back on demand.

Investment Banking 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). The SEC was set up to ensure adequate disclosure of information to buyers of publicly offered securities. The main goal is to protect small investors, who may have limited knowledge and financial expertise, from possible exploitation by unscrupulous security issuers. Private placements are usually bonds sold to insurance companies. Since there’s typically only one buyer, they do not have to be registered with the SEC. However, they cannot be resold to the public. Private debt placements typically have higher interest rates because of their reduced liquidity.

Public Offerings 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.

Types of Public Offerings
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.

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. Many debt issues sold under Rule 144A are converted to public offerings at a future date.

Securities Firms and Investment Banks (IBs)
Investment banks (IBs) help corporations and governments raise capital through debt and equity security issues in the primary market underwriting is assisting in the issue of new securities IBs also advise on mergers and acquisitions (M&As) and corporate restructuring Securities firms assist in the trading of securities in secondary markets broker-dealers assist in the trading of existing securities 51

The size of the industry is usually measured by the equity capital of firms rather than total asset size the largest firm in 1987 had $3.2 billion in total capital the largest firm in 2007 had $114.2 billion in total capital The number of firms in the industry usually follows the overall condition of the economy 5,248 firms in 1980 9,515 firms in 1987 5,808 firms in 2007 As with commercial banks, consolidation has occurred through mergers and acquisitions McGraw-Hill/Irwin 16-52 52

The largest firms in the industry are diversified financial service firms or national full-service IBs service both retail and wholesale customers by acting as broker-dealers service corporate customers by underwriting security issues The second largest group of firms are full-service firms that specialize in corporate finance or primary market activity (i.e., focus less on secondary market activities) McGraw-Hill/Irwin 16-53 53

A third group of firms includes the rest of the industry and is further divided into five subgroups IB subsidiaries of commercial banks (i.e., Section 20 subsidiaries) discount brokers regional securities firms specialized electronic trading firms venture capital firms McGraw-Hill/Irwin 16-54 54

Investment banking first time debt and equity issues occur through initial public offerings (IPOs) new issues from a firm whose debt or equity is already traded are called seasoned equity offerings (SEOs) a private placement is a securities issue that is placed with one or a few large institutional investors public offerings are offered to the public at large IBs act only as an agent in best efforts underwriting IBs act as principals in firm commitments McGraw-Hill/Irwin 16-55 55

Market making involves the creation of secondary markets for an issue of securities agency transactions are two-way transactions on behalf of customers with principal transactions market makers seek to profit for their own accounts Trading involves taking an active net position in an asset position trading involves relatively long-term positions in assets McGraw-Hill/Irwin 16-56 56

pure arbitrage involves attempts to profit from price discrepancies risk arbitrage involves attempts to profit by forecasting information releases program trading is the simultaneous buying and selling of at least 15 different stocks valued at $1 million or more stock brokerage involves trading on behalf of customers electronic brokerage offers customers direct access, via the internet, to the trading floor McGraw-Hill/Irwin 16-57 57

Investing involves managing pools of assets such as closed- and open-end mutual funds as agents as principals Cash management involves deposit-like accounts such as money market mutual funds (MMMFs) that offer check writing privileges Merger and acquisition (M&A) assistance McGraw-Hill/Irwin 16-58 58

Venture capital (VC) is a professionally managed pool of money used to finance new (i.e., start-up) and often high-risk firms VC usually purchases an equity stake in the start-up usually become active in management of the start-up institutional venture capital firms find and fund the most promising new firms venture capital limited partnerships financial venture capital firms corporate venture capital firms McGraw-Hill/Irwin 16-59 59

Industry trends depend heavily on the state of the stock market commission income declined markedly after the 1987 stock market crash and the stock market decline improvements in the U.S. economy in the mid-2000s led to increases in commission income income fell with the stock market in because of rising oil prices and the subprime mortgage collapse 60

Balance Sheets of Securities Firms and Investment Banks (IBs) (2007)
Long positions in securities and commodities represent 24.1% of assets Securities purchased under agreement to resell represent 21.6% of total assets Securities sold under agreement to repurchase represent 41.5% of total liabilities and equity Equity capital amounted to 3.0% of total liabilities and equity compares to 10.1% for commercial banks SEC requires minimum net worth to assets of 2% McGraw-Hill/Irwin 16-61 61

Regulation of Securities Firms and Investment Banks (IBs)
The Securities and Exchange Commission (SEC) is the primary regulator of the securities industry The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed federal (over state) authority even so, state attorneys general intervene through securities-related investigations that have led to many highly publicized criminal cases McGraw-Hill/Irwin 16-62 62

The Sarbanes-Oxley Act (SOX) of 2002 created an independent auditing oversight board under the SEC increased penalties for corporate wrongdoers forced faster and more extensive financial disclosure created avenues of recourse for aggrieved shareholders McGraw-Hill/Irwin 16-63 63

The SEC sets rules governing underwriting and trading activity SEC Rule 144A defines boundaries between public offerings and private placements SEC Rule 415 allows shelf registration allows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement summarizing the firm’s financing plans for the period McGraw-Hill/Irwin 16-64 64

Two self-regulatory organizations oversee the day-to-day regulation of trading practices the New York Stock Exchange (NYSE) the National Association of Securities Dealers (NASD) The U.S.A. Patriot Act became effective in 2003 firms must verify identities of customers firms must maintain records of identities of customers firms must verify customers are not on suspected terrorist lists McGraw-Hill/Irwin 16-65 65

Industry is protected by the Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 due to securities firm failures (but not against poor investment decisions) created following passage of the Securities Investor Protection Act in 1970 McGraw-Hill/Irwin 16-66 66

Global Issues Securities firms and investment banks are by far the most global of any group of financial institutions U.S. firms are increasingly looking to expand their business abroad—particularly into China an India McGraw-Hill/Irwin 16-67 67

Investment Banking Services
Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal governments IBF’s serve both financing entities and investors: Serve as an intermediary buying securities (promise to pay) from issuing companies and selling them (securities) to investors Generate fees for services rather than interest income Sell investing services to institutional and other investors Advise companies on mergers and acquisitions Value companies for sale or purchase In recent years, loaned funds for mergers and acquisitions

Investment Banking Services
Distribution Origination Investment Banking Services Advising Underwriting

How IBFs Facilitate New Stock Issues
Origination Company wishes to issue additional stock or issue stock for the first time contacts IBF Gets advice on the amount to issue Helps determine stock price for first-time issues IBF assists with SEC filings Registration statement Prospectus—summary of registration statement given to prospective investors

Underwriting stock Issuer and investment bank negotiate the underwriting spread The difference between the net price given the company and the selling price to investors Incentive to under-price IPO’s The lead investment bank usually forms an underwriting syndicate Other IBFs underwrite a part of the security offering Helps spread the underwriting risk among IBFs

Distribution of stock Full underwriting vs. best efforts IBFs in the syndicate have retail brokerage operations Other IBF added as part of selling group Corporation incurs flotation costs Underwriting spread Direct issuance costs—accounting, legal fees, etc.

Advising The IBF acts as an advisor throughout the process Corporations do not have the in-house expertise Includes advice on: Timing Amount Terms Type of financing

How IBFs Facilitate New Bond Issues
Origination IBF may suggest a maximum amount of bonds that should be issued based on firm characteristics Decisions on coupon rate, maturity Benchmark with market prices of bonds of similar risk Credit rating Bond issuers must register with the SEC Registration Statement Prospectus

Underwriting bonds Public utilities often use competitive bids to select an IBF, versus….. Corporations typically select an IBF based on reputation and prior working experience The underwriting spread on bonds is lower than that for stocks Can place large blocks with institutional investors Less market risk

Distribution of bonds Prospectus Advertisements to public Flotation costs are typically in the range of 0.5 percent to 3 percent of face value

Private placement of bonds Avoids underwriting and SEC registration expenses Potential purchaser may buy the entire issue Insurance companies mutual funds commercial banks pension funds Demand may not be as strong, so price may be less, resulting in a higher cost for issuing firm Investment banks may be involved to provide advice and find potential purchasers

How IBFs Facilitate Leveraged Buyouts
IBFs facilitate LBOs in three ways: They assess the market value of the LBO firm They arrange financing Purchase outstanding stock held by public Often invest in the deal themselves Provide advice

How IBFs Facilitate Arbitrage
Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price IBFs work with arbitrage firms to search for undervalued firms Asset stripping A firm is acquired, and then its individual divisions are sold off Sum of the parts is greater than the whole Kohlberg, Kravis, and Roberts

IBFs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity IBFs also provide bridge loans When fund raising is not expected to be complete when the acquisition is initiated IBFs provide advice on takeover defense maneuvers

History of arbitrage activity Greenmail is when a target company buys back stock from arbitrage firm at a premium over market price Arbitrage activity has been criticized Results in excessive financial leverage and risk for corporations Restructuring sometimes results in layoffs Arbitrage helps remove managerial inefficiencies Target shareholders can benefit from higher share prices

Brokerage Services Full-service versus discount brokerage services
Full-service firms provide investment advice as well as executing transactions Discount brokerage firms only execute security transactions upon request Online brokerage firms

Allocation of Revenue Sources
Importance of brokerage commissions has declined in recent years Largest source of revenue has been trading and investment profits Underwriting and margin interest also make up a significant portion of revenue Revenue from fees earned on advising and executing acquisitions has increased over time

Regulation of Securities Firms
Regulated by the National Association of Securities Dealers (NASD) and securities exchanges The SEC regulates the issuance of securities and specifies disclosure rules for issuers Also regulates exchanges and brokerage firms SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory duties

The Federal Reserve determines the credit limits (margin requirements) on securities purchased The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts Insured up to $500,000 Brokers pay premiums to SIPC to maintain the fund Boosts investor confidence, increasing economic efficiency

Financial Services Modernization Act of 1999 Permitted banking, securities activities, and insurance to be offered by a single firm Varied financial services organized as subsidiaries under special holding company Financial holding companies regulated by the Federal Reserve

Risks of Securities Firms
Interest Rate Risk Market Risk Exchange Rate Risk Credit Risk

Market risk Securities firms’ activities are linked to stock market conditions When stock prices are rising: Greater volume of stock offerings Increased secondary market transactions More mutual fund activity Securities firms take equity positions which are bolstered when prices rise

Interest rate risk Performance of securities firms can be sensitive to interest rate movements because: Market values of bonds held as investments increase as interest rates fall Lower rates can encourage investors to withdraw money from banks and invest in stocks Exchange rate risk Operations in foreign countries Investments in securities denominated in foreign currency

Valuation of Securities Firms
Value of a securities firm depends on its expected cash flows and required rate of return V = f [E(CF),k] + Where: V = Change in value of the securities firm E(CF) = Change in expected cash flows k = Change in required rate or return

Factors that affect cash flows E(CF)= f (ECON, Rf , INDUS, MANAB) + ? + Where: E(CF) = Expected cash flow ECON = Economic growth Rf = Risk free interest rate INDUS = Prevailing industry conditions MANAB = The ability of the security firm’s management

Investors required rate of return k = f(Rf , RP) + + Where: Rf = Risk free interest rate RP = Risk premium

Interaction With Other Financial Institutions
Offer investment advice and execute security transactions for financial institutions that maintain security portfolios Compete against financial institutions that have brokerage subsidiaries Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms Financial Services Modernization Act of 1999 Effectively repealed Glass-Steagall Commercial banks, securities firms, and insurance companies will increasingly offer similar services

Globalization of Securities Firms
Securities firms have increased their presence in foreign countries Merrill Lynch has more than 500 offices spread across the world Allows them to place securities in various markets for corporations or governments International M&A Ability to handle transactions with foreign securities

Globalization of Securities Firms
Growth in international securities transactions Created more business for large securities firms International stock offerings Increased liquidity for issuing firm, avoiding downward price pressure Growth in Latin America Increased business due to NAFTA Growth in Japan Some barriers to foreign securities firms still exist

Mutual Funds Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds

Investment Intermediaries
Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments

Mutual Funds Stock or bond market related institutions
Pool funds from many people Invest in wide variety of securities—minimize risk

Money Market Mutual Funds
Individuals purchase shares in the fund Fund invests in highly liquid short-term money market instruments Large-size negotiable CD’s Treasury bills High-grade commercial paper

Mutual Funds 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.

Advantages of Mutual Funds
Information Economies. Diversification. Lower transactions costs.

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

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

Savings and Loan Associations (S&L’s)
Traditionally acquired funds through savings deposits Used funds to make home mortgage loans Now perform same functions as commercial banks issue checking accounts make consumer and business loans

Regulation Reason: Ensure Soundness of Financial Intermediaries
Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not, if they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions, with the possible outcome of a financial panic that produces large losses for the public and causes serious damage to the economy.

Regulation Reason: Ensure Soundness of Financial Intermediaries (cont
To protect the public and the economy from financial panics, the government has implemented six types of regulations: Restrictions on Entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

Regulation of Financial Markets
Three Main Reasons for Regulation Increase Information to Investors Ensure the Soundness of Financial Intermediaries Improve Monetary Control

FIN 444 Financial Institutions in Hong Kong
Week 1 Introduction: Financial System and Financial Intermediation Mishkin (2006): Chapter 2 Overview of the Financial System Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Segments of Financial Markets
Direct Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Classifications of Financial Markets
Debt Markets Short-Term (maturity < 1 year) Money Market Long-Term (maturity > 1 year) Capital Market Equity Markets Common Stock Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Characteristics of Debt Markets Instruments
Debt instruments Buyers of debt instruments are suppliers (of capital) to the firm, not owners of the firm Debt instruments have a finite life or maturity date Advantage is that the debt instrument is a contractual promise to pay with legal rights to enforce repayment Disadvantage is that return/profit is fixed or limited Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Characteristics of Equity Markets Instruments
Equity instruments (common stock is most prevalent equity instrument) Buyers of common stock are owners of the firm Common stock has no finite life or maturity date Advantage of common stock is potential high income since return is not fixed or limited Disadvantage is that debt payments must be made before equity payments can be made Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Exchanges Trades conducted in central locations (e.g., New York Stock Exchange, The Stock Exchange of Hong Kong) Over-the-Counter Markets Dealers at different locations buy and sell (e.g., The U.S. government bond market and Nasdaq OTC stock exchange in US; Notes issued by Hong Kong Mortgage Corporation in Hong Kong) NYSE home page Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Function of Financial Intermediaries (FIs)
Engage in process of indirect finance More important source of finance than securities markets Needed because of transactions costs and asymmetric information Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Transactions Costs Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions Banks provide depositors with checking accounts that enable them to pay their bills easily Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Depository Institutions (Banks) Commercial banks, Savings & Loan Associations (S&Ls), Mutual Savings Banks in US Three-tier system of deposit-taking institutions, namely, licensed banks, restricted licence banks, deposit-taking companies in Hong Kong (collectively known as AI: Authorized Institutions) Contractual Savings Institutions Life insurance companies Fire & casualty insurance companies Pension funds, government retirement funds (e.g. Mandatory Provident Fund Scheme in Hong Kong) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Depository Institutions (Banks)
Commercial banks Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Regulation of Financial Markets
Three Main Reasons for Regulation Increase Information to Investors Ensure the Soundness of Financial Intermediaries Improve Monetary Control Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Regulation Reason: Increase Investor Information
Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets and may also keep investors away from financial markets The Securities and Exchange Commission (SEC) (SEC in US; Securities and Futures Commission, SFC in Hong Kong) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation

Regulation Reason: Increase Investor Information
Such government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors

Regulation Reason: Ensure Soundness of Financial Intermediaries
Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not, if they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions, with the possible outcome of a financial panic that produces large losses for the public and causes serious damage to the economy Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Regulation Reason: Ensure Soundness of Financial Intermediaries (cont
To protect the public and the economy from financial panics, the government has implemented six types of regulations: Restrictions on Entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

Regulation: Deposit Insurance
The government can insure people providing funds to a financial intermediary from any financial loss if the financial intermediary should fail The Federal Deposit Insurance Corporation (FDIC in US; Deposit Protection Scheme, DPS managed by The Hong Kong Deposit Protection Board), insures each depositor at a commercial bank or mutual savings bank up to a loss of $100,000 per account (HK$100,000 per depositor per bank in Hong Kong) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Financial Intermediary

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Financial Intermediary

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