1. Chapter 3 Financial Institutions
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

2. Learning Objectives
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

3. Central Bank Main Roles:
Best-known: Federal Reserve (USA), Bank of England, Bundesbank of Germany, European Central Bank (EU), Bank of Japan
Main Roles:
Implementation of monetary policy (open market operations – buy/sell Treasury bills)
Management of the national debt (the summation of all past borrowing requirements of central and local government)
Supervisory functions
capital adequacy (the amount of bank reserves should be related to the size and risk attached to their loan portfolio)
liquidity (maturity structure, volatility of assets and liabilities , demand for loans )
risk profile (monitoring of exposure to a particular firm/sector, control over off-balance-sheet exposure, riskiness of assets/liabilities)
Acting as a banker to the central government and the commercial banks
Acting as a lender of last resort
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

4. Financial Institutions Structure
deposit institutions
the banking sector
savings institutions
other financial intermediaries
insurance companies
mutual funds or unit trusts
investment companies or investment trusts
exchange traded funds
pension funds
hedge funds
private equity
specialist financial institutions
venture capital companies
finance companies or finance houses
factoring agencies
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

5. Deposit Institutions
Liabilities: deposits accepted from economic agents
Assets: direct loans and investments made from deposited funds
Profit: from “spread income”
Example: commercial banks, savings banks, building societies
Funding risk – the risk that the interest rate movements will adversely affect the profits
Default risk – the risk that governments, companies or individuals who owe money will default on their repayments of principal and/or interest
Regulatory risk – the risk that a change in regulations or the law will adversely impact upon the profitability of a financial institution or market participant
Liquidity risk – the risk that the market in a security will dry up such that it is difficult to turn it into cash without taking a substantial loss
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

6. The Banking Sector sources of profit:
- higher interest on loan less lower interest on deposits
- service commission fees
universal banks – banking that offers a broad range of financial services such as insurance, investment services in addition to basic banking services such as deposit taking and loan making
commercial or retail banks – typical banking, dealing with the taking in of deposits and making of loans in the form of personal, business and mortgage loans
(*) the way they raise funds is quite expensive
investment or merchant banks – banking dealing with the raising of funds in the wholesale money and capital markets; investment banks deal with takeovers, mergers, buyouts, corporate finance, advisory work, the issuance of new securities, underwriting, market-making and proprietary trading
(*) considerable expertise in foreign exchange due to trade finance experience
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

7. Savings Institutions UK example: building societies
very similar to banking however, historical origin, role and regulation may differ
the 18th century: - members paid periodic payments to finance local house building and could draw on the funds to finance house purchase
since 1986: allowed to issue cheque accounts and offer overdraft facilities
nowadays the distinction between building societies and banks is far less clear
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

8. Insurance Companies sources of profit:
- charge for assuming risks on behalf of their policy-holders
- investments made with the assets under their control
key variables that affect the insurance premium
the risk of claim being made
the payment to be made to the policy-holder in the event of a valid claim
Life Insurance
long-term insurance:
premiums are invested in government and corporate bonds and equities
examples:
term insurance policies
whole of life insurance policies
endowment policies
annuities
General Insurance
short-term insurance: premiums are invested in equities, property investments or government bonds
property insurance (personal vs commercial)
insurance against theft
general accident insurance
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

9. Bancassurance Phenomenon
first appeared during deregulation period in the 1980s and 1990s
European since US and Japanese regulation does not permit this kind of cross-selling activities
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

10. Mutual Funds Mutual Fund (US)/Unit Trust (UK)
a fund that pools funds from a variety of investors and invests them in shares (mostly UK) and/bonds (mostly US)
boom in the 1980s and 1990s
reasons of popularity:
increased incomes made alternative investments more attractive relative to traditional savings accounts
low-cost method to achieve portfolio diversification
benefits for the investors:
entitled to a share in the capital appreciation of the underlying assets
have a claim on the income generated by the underlying assets of the firm
funds are run by professional managers
different targets: high yield/risky, lower but more stable yields, income generation, capital growth
most of mutual funds are open ended – new investors can join at any time
there is no secondary market – investors can sell their holding back to the fund only
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

11. Investment Companies Investment Company (US)/Investment Trust (UK)
a company that holds stakes in the form of shares in other companies which can engage in takeovers and breakups; if it is publicly owned then its shares trade on the Stock Exchange.
investment companies are closed funds
the value of the company is determined by demand & supply for its shares
investment companies are subject to the legislation related to limited companies in the UK
are subject to corporation profit tax
have a board of directors who set the strategy and make investment decisions
earn income in the form of interest, dividends and capital gains a proportion of which is retained for new investment purposes
investment companies do not have to worry about attracting continuous inflows of capital hence do not have to maintain much of their funds in money market instruments
Are subject to corporate law and can be subjected to takeovers
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

12. Exchange Traded Funds Exchange Traded Fund [ETF]
an investment vehicle made up of assets such as shares, bonds, commodities or currencies that trade on an exchange on a continuous basis with the price of the ETF trading very close to the value of the underlying assets that make up the ETF
creation scheme:
a sponsor or ETF manager files a plan with a relevant body
following approval, an agreement is formed with an authorized participant, who borrows or buys shares from pension funds and other institutional investors (in large bundles)
the shares are divided to form creation units, which are subsequently repackaged into individual shares (ETFs) which are traded as on stock exchanges as ordinary shares
the shares that make up a creation unit can be bought and sold on a continuous basis – it is vital to know the composition of ETFs
benefits over mutual funds:
the transaction costs for ETFs are much lower
one ETF requires less capital commitment
it is possible to short an ETF
examples:
SPY (“spiders”) track the prices of shares in the S&P 500
DIA (“diamonds”) tracks Dow Jones Industrial Average index
QQQQ: tracks 100 of the most prominent NASDAQ shares
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

13. Pension Funds Pension Fund
a fund established by an employer which pools contributions from the company and its employees to be invested for the purposes of providing a pension to employees upon their retirement; pension funds in the USA and the UK are among the largest institutional investors in the financial markets
reasons of popularity: higher incomes, greater life expectancy, significant tax concessions compared to other savings products
run both state and private sector; the main difference is in that the state will always raise taxation or borrow on a sufficient scale to ensure that the obligation on pension schemes are fulfilled, whereas with private sector there are no such guarantees
pension funds are by definition long run investments, both pension fund obligations and contributions are relatively stable and predictable, the vast majority of funds are held in domestic and overseas equities, much of the remainder – in government securities
currently most funds receive contributions exceeding benefits paid a decline in working population relative to those retired will require revision of the strategy
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

14. Hedge Funds
hedge funds seek to make investors money regardless of the direction in which markets are moving
common characteristics include:
run by a number of partners that form the fund
typically seek to raise capital from wealthy individuals or institutional investors
partners put some capital into the fund, make an annual charge of 1-2% of money under management, take 15-25% share of profits (“2 and 20” is common !)
often use derivatives contracts to establish significantly leveraged speculative positions in addition to long and short positions:
if a particular equity market will rise – buy stock index futures or call options on that market
if that a market will fall – sell the stock-index futures or buy put options on that stock or stockmarket
depending on the type of strategy hedge funds are classified as macro funds, specialists in individual shares, bond prices, commodity prices and foreign exchange rates, others have a broad mandate to speculate in a whole range of markets and instruments
hedge funds differ greatly in risks as well as funds under management (majority between $100m and $1bn, some have tens of billions such as the Quantum Fund, Tiger Fund or Poulson and Co
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

15. Private Equity Private Equity
a privately owned partnership which invests capital raised from individuals and institutions; usually used to purchase majority stakes in a variety of companies
the capital raised is used to finance a range of investments including buying privately owned companies, management buyouts, leveraged buy outs, buying distressed debt and distressed companies, taking stakes in young and newly emerging companies, etc.
it is a relatively illiquid investment with average time horizon of 5-12 years
requires a substantial amount of capital say $20m minimum
investor has no real control over the decisions made by the management
possible entry strategy
leveraged buyout – the takeover of a company primarily financed by the issuance of debt in the form of bonds or bank loans by the acquiring company; often the assets of the acquired company are used to finance debt/loans
possible exit strategy
initial public offering [IPO] – in the USA, the floating of the company on the stock market for the first time
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

16. Venture Capital Companies
independent companies set up by professional venture capitalists with funds obtained from private investors or other financial institutions
invest for a limited period of time (5-10 years)
provide managerial expertise in return for a share in the business
aim to make a substantial capital gain from its investment via a flotation or sell off
for new companies
venture capital – private capital used to finance the growth of small companies that are generally risky and lack long-term trading records, making it difficult to secure finance from banks or capital markets.
for existing companies
management buyout – managers and directors of the company buy a controlling interest in the company from the existing shareholders; often the buyout is financed by the issuance of debt
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

17. Other Specialist Financial Institutions
Finance Houses
raise funds on the wholesale money markets for the purposes of lending to businesses and consumers and for the leasing of equipment, plant, machinery, etc
services include:
loans
finance leasing (the finance house purchases the investment asset and then leases it to the firm, while the ownership of the asset remains within the finance house)
hire purchase (enables the consumer or business to purchase goods in return for an initial deposit and monthly payments, the good is legally owned by the finance house until the final payment is settled)
Factoring Agencies
usually subsidiaries of banks or finance houses
buys up overdue invoices from a firm at a discount and then proceed to raise the face value of the invoice from the customer to which it was sent
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

18. The Role of Financial Institutions
financial institutions are distinguished by the type of liabilities they create and the type of assets they invest in
managers of financial institutions are expected to take reasonable precautions to protect funds under management, for instance by spreading financial institutions’ risks
an important allocative efficiency role
financial institutions ensure that the costs and risks are lower than if the surplus and deficit agents dealt directly with each other and stimulate a greater flow
Criticisms include:
too short-term in their investment strategies
lack of attention to new and small businesses
focus on exciting projects with quick payoffs rather than on the long term and future production
Keith Pilbeam ©: Finance and Financial Markets 4th Edition