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  1. 1. Financial Institutions—An Overview Chapter 8 Unit III Financial Institutions
  2. 2. Fundamental Issues <ul><li>Why do financial intermediaries exist, and what accounts for international financial intermediation? </li></ul><ul><li>What do securities market institutions do, and how does the government regulate these institutions? </li></ul><ul><li>What do insurance companies do, and who regulates their activities? </li></ul><ul><li>How are pension funds structured, and why have they grown? </li></ul>
  3. 3. Fundamental Issues (cont’d) <ul><li>How do mutual funds and hedge funds differ? </li></ul><ul><li>What financial institutions specialize in lending directly to individuals and businesses? </li></ul>
  4. 4. Domestic and International Financial Intermediation <ul><li>Direct financing </li></ul><ul><ul><li>Providing investment capital directly to a firm (e.g., purchasing shares of stock or corporate bond). </li></ul></ul><ul><li>Financial intermediation: </li></ul><ul><ul><li>Indirect finance through the services of an institutional “middleman” that channels funds from savers to those who ultimately make capital investments. Banks and many other institutions act as such intermediaries. </li></ul></ul>
  5. 5. Indirect Finance through Financial Intermediaries Figure 8 –1
  6. 6. Financial Intermediaries’ Share of Total Financial Assets in Selected Nations Figure 8 –2 SOURCE: Asli Demirguc-Kunt and Ross Levine, “Bank-Based and Market-Based Financial Systems: Cross-Country Comparisons,” World Bank and University of Minnesota, 2003.
  7. 7. Why do we use financial intermediaries ( and also problems faced by such intermediaries? <ul><li>One reason is Asymmetric information: </li></ul><ul><ul><li>Information possessed by one party to a financial transaction but not by the other party. </li></ul></ul><ul><li>Adverse selection: </li></ul><ul><ul><li>The problem that those who desire to issue financial instruments are most likely to use the funds they receive for unworthy, high-risk projects. </li></ul></ul><ul><li>Moral hazard: </li></ul><ul><ul><li>The possibility that a borrower may engage in more risky behavior after a loan has been made. </li></ul></ul>
  8. 8. Benefits of Financial Intermediation <ul><li>Cost reduction: </li></ul><ul><ul><li>Financial intermediaries collect information on behalf of savers so that they will not have to incur these direct and opportunity costs. </li></ul></ul><ul><li>Economies of scale: </li></ul><ul><ul><li>Reducing the average cost of fund management by pooling savings and spreading management costs across many people. </li></ul></ul><ul><li>International financial diversification: </li></ul><ul><ul><li>Spreading portfolio risk by holding both U.S.-issued and foreign-issued financial instruments. </li></ul></ul>
  9. 9. The World’s Largest Banking Institutions Table 8 –1 SOURCE: The Banker , July 2004.
  10. 10. Megabanks <ul><li>Many of these large financial institutions are spread around the world </li></ul><ul><li>Since so many firms are multinational now, banks may need to be also to take advantage of economies of scale in information processing. </li></ul>
  11. 11. Investment Banks <ul><li>Even with direct finance, some institutions exist to try to minimize information and moral hazard problems. </li></ul><ul><li>Investment banks as intermediaries: </li></ul><ul><ul><li>Securities underwriting </li></ul></ul><ul><ul><li>Firm commitment underwriting </li></ul></ul><ul><ul><li>Standby commitment underwriting </li></ul></ul><ul><ul><li>Best Efforts Deals </li></ul></ul>
  12. 12. Investment Banks as Intermediaries <ul><li>Securities underwriting: </li></ul><ul><ul><li>A guarantee by an investment bank that a firm that issues new stocks or bonds will receive a specified minimum price per share of stock or per bond. </li></ul></ul><ul><li>Firm commitment underwriting: </li></ul><ul><ul><li>An arrangement in which the investment bank purchases and distributes to dealers and other purchasers all securities offered by a business. </li></ul></ul>
  13. 13. Investment Banks… (cont’d) <ul><li>Standby commitment underwriting: </li></ul><ul><ul><li>An arrangement in which the investment bank earns commissions for helping the issuing firm sell its securities under the guarantee that the investment bank will purchase for resale any initially unsold securities. </li></ul></ul><ul><li>Best efforts deal: </li></ul><ul><ul><li>An arrangement in which the investment bank has an option to buy a portion of the issuing firm’s securities but is not required to do so. </li></ul></ul><ul><ul><li>Some firms now decide to bypass the services of investment banks: see the box dealing with Google on page 167. </li></ul></ul>
  14. 14. Types Of Brokers <ul><li>Full-service broker: </li></ul><ul><ul><li>An agent who offers a range of financial services, including consultations about what financial instruments to buy or sell and other financial planning advice, in addition to making securities trades for clients . </li></ul></ul><ul><li>Discount broker: </li></ul><ul><ul><li>An agent whose services are limited to making securities trades for clients. </li></ul></ul>
  15. 15. Types Of Brokers (cont’d) <ul><li>Share broker: </li></ul><ul><ul><li>A discount broker which bases its commission charges on the volume of shares that it trades on a customer’s behalf. </li></ul></ul><ul><li>Value broker: </li></ul><ul><ul><li>A discount broker which charges commissions that are a percentage of the dollar value each transaction. </li></ul></ul>
  16. 16. Securities Brokers and Dealers <ul><li>Over-the-counter (OTC) broker-dealer: </li></ul><ul><ul><li>A broker-dealer that trades shares of stock that are not listed on organized stock exchanges. </li></ul></ul><ul><li>Specialists: </li></ul><ul><ul><li>Stock exchange members that are charged with trading on their own accounts to prevent dramatic movements in stock prices. </li></ul></ul><ul><li>Limit orders: </li></ul><ul><ul><li>Instructions from other stock exchange members to specialists to execute stock trades at specific prices. </li></ul></ul>
  17. 17. Regulation of Securities Market Institutions <ul><li>Securities and Exchange Commission (SEC): </li></ul><ul><ul><li>Created in the Securities Exchange Act of 1934 to regulate all securities market institutions. </li></ul></ul><ul><ul><li>The SEC is composed of five presidentially appointed commissioners whose mandate is to enforce rules governing securities trading. </li></ul></ul><ul><ul><li>http:// www.sec.gov / </li></ul></ul><ul><li>Prospectus: </li></ul><ul><ul><li>A formal written offer to sell securities. </li></ul></ul>
  18. 18. Insurance Institutions <ul><li>Types of insurance companies </li></ul><ul><ul><li>Life insurance companies </li></ul></ul><ul><ul><ul><li>Issue policies that insure people against the financial consequences associated with death. </li></ul></ul></ul><ul><ul><ul><li>Issue annuities that guarantee the holder fixed or variable payments at some future date. </li></ul></ul></ul><ul><ul><li>Property and casualty insurers </li></ul></ul><ul><ul><ul><li>issue policies to individuals and businesses that insure risks relating to property damage and liabilities arising from injuries or deaths caused by accidents or adverse natural events. </li></ul></ul></ul>
  19. 19. Dealing with Asymmetric-Information Problems in Insurance <ul><li>Limiting adverse selection </li></ul><ul><ul><li>Restricting the availability and quantity of insurance. </li></ul></ul><ul><li>Limiting moral hazard in insurance </li></ul><ul><ul><li>Policy cancellation: in some cases, certain behavior can lead to cancellation of policies. </li></ul></ul><ul><ul><li>Deductible: A fixed amount of an insured loss that a policyholder must pay before the insurer is obliged to make payments. </li></ul></ul><ul><ul><li>Coinsurance: A policy feature that requires a policyholder to pay a fixed percentage of a loss above a deductible. </li></ul></ul>
  20. 20. Determining Policy Premiums <ul><li>Actuary: </li></ul><ul><ul><li>An individual who specializes in using mathematical and statistical principles to calculate insurance premiums and to estimate an insurance company’s net worth. </li></ul></ul><ul><ul><li>Insurance premiums often vary inversely with interest rates: low interest rates thus often lead to higher premiums charged to customers, and vice versa: why? </li></ul></ul>
  21. 21. Life Insurance <ul><li>Whole life policy: </li></ul><ul><ul><li>A policy whose benefits are payable to a beneficiary whenever the insured person’s death occurs and that accumulates a cash value that the policyholder may acquire prior to his or her death. </li></ul></ul><ul><li>Level premium policy: </li></ul><ul><ul><li>A whole life insurance policy under which an insurance company charges fixed premium payments throughout the life of the insured individual. </li></ul></ul>
  22. 22. Life Insurance (cont’d) <ul><li>Limited payment policy: </li></ul><ul><ul><li>A whole life insurance policy under which an insured individual pays premiums only for a fixed number of years and is insured during and after the payment period. </li></ul></ul><ul><li>Term life policy: </li></ul><ul><ul><li>A policy under which an individual is insured only during a limited period that the policy is in effect. There is no cash surrender value as with whole life, but the premiums are much lower. </li></ul></ul>
  23. 23. The Distribution of Life Insurance Policies Figure 8 –4 SOURCE: A.M. Best, 2005. The Distribution of Property-Casualty Premiums by Line of Business Figure 8 –3 SOURCE: Insurance Information Institute, 2005.
  24. 24. Annuities <ul><li>Fixed annuity: </li></ul><ul><ul><li>A financial instrument, typically issued by an insurance company, that pays regular, constant installments to the owner beginning at a specific future date. </li></ul></ul><ul><li>Variable annuity: </li></ul><ul><ul><li>A financial instrument, typically issued by an insurance company, that beginning on a specific future date pays the owner a stream of returns that depends on the value of an underlying portfolio of assets. </li></ul></ul>
  25. 25. Insurance <ul><li>Generally life insurance companies can hold a greater percentage of longer term financial instruments, like bonds and stocks as compared to property and casualty companies. Why? </li></ul>
  26. 26. Types of Pensions <ul><li>Pension funds: created annuities like life insurance companies, but annuities that can only be collected at retirement. </li></ul><ul><ul><li>rapid growth since the 1950’s: partly due to baby boom generation and also many pension funds are tax deferred savings vehicles. </li></ul></ul><ul><li>Contributory pensions: </li></ul><ul><ul><li>Pensions funded by both employer and employee contributions. </li></ul></ul>
  27. 27. Types of Pensions <ul><li>Noncontributory pensions: </li></ul><ul><ul><li>Pensions funded solely by employers. </li></ul></ul><ul><li>Defined-contribution plan: </li></ul><ul><ul><li>Pension benefits (undefined) are based on total pension contributions during working years. </li></ul></ul><ul><li>Defined-benefits plan: </li></ul><ul><ul><li>Pension benefits are set in advance — key issue is certainty of funding of benefits at retirement. </li></ul></ul>
  28. 28. Pension Funds’ Share of Financial Institution Assets Figure 8 –5 SOURCE: Flow-of-Funds Accounts , Board of Governors of the Federal Reserve System, various issues.
  29. 29. Alternative Pension Funding Arrangements <ul><li>Terminally funded pensions: </li></ul><ul><ul><li>Pensions that must be fully funded by the date that an employee retires. </li></ul></ul><ul><li>Pay-as-you-go pensions: </li></ul><ul><ul><li>Pensions not fully funded when employees retire. </li></ul></ul><ul><li>Vesting: </li></ul><ul><ul><li>Occurs when a worker covered by a pension will receive retirement benefits from that employer even if the worker leaves the employer prior to the retirement date. </li></ul></ul>
  30. 30. Transferability Of Pension Funds <ul><li>Single-employer pensions: </li></ul><ul><ul><li>Pensions that are established by an employer only for its own employees and are nontransferable to other employers. </li></ul></ul><ul><li>Multi-employer pensions: </li></ul><ul><ul><li>Pensions whose accumulations and benefit rights may be transferred from one employer to another, in other words, the pension is said to be portable </li></ul></ul>
  31. 31. Pension Fund Insurance and Regulation <ul><li>Employment Retirement Income Security Act (ERISA) of 1974: </li></ul><ul><ul><li>Established Federal rules for disclosure of pension information, funding arrangements, and vesting provisions. </li></ul></ul><ul><ul><li>Also created the Pension Benefit Guaranty Corporation (PBGC), which provides federal insurance guaranteeing solvency for all pensions with tax-deferred benefits. </li></ul></ul>
  32. 32. Pension Funding at Standard & Poor’s 500 Companies. Figure 8 –6 SOURCES: Simon Kwan, “Underfunding of Private Pension Plans,” Federal Reserve Bank of San Francisco Economic Letter, No. 2003-16, June 13, 2003; Congressional Budget Office.
  33. 33. Types of Mutual Funds <ul><li>Mutual fund: </li></ul><ul><ul><li>A mix of financial instruments managed on behalf of shareholders by investment companies that charge fees for their services. </li></ul></ul><ul><li>Load funds: </li></ul><ul><ul><li>Mutual funds marketed by brokers who receive commissions based on the returns of the funds. </li></ul></ul><ul><li>No-load funds: </li></ul><ul><ul><li>Mutual funds that investment companies market directly to the public and that charge management fees instead of brokerage commissions. </li></ul></ul>
  34. 34. Mutual Fund Growth Figure 8 –7 SOURCE: Flow-of-Funds Accounts , Board of Governors of the Federal Reserve System, various issues.
  35. 35. Types of Mutual Funds (cont’d) <ul><li>Closed-end funds: </li></ul><ul><ul><li>Mutual funds that sell nonredeemable shares whose market values vary with the market values of the underlying mix of financial instruments held by the mutual funds. </li></ul></ul><ul><li>Open-end funds: </li></ul><ul><ul><li>Mutual funds whose shares are redeemable at any time at prices based on the market values of the mix of financial instruments held by such funds. </li></ul></ul>
  36. 36. Hedge Funds <ul><li>Hedge funds: </li></ul><ul><ul><li>Limited partnerships that, like mutual funds, manage portfolios of assets on behalf of savers, but with very limited governmental oversight as compared with mutual funds. </li></ul></ul><ul><li>Macro funds </li></ul><ul><ul><li>Earn profits by speculating within particular bond markets or making bets on changes in exchange rates. </li></ul></ul><ul><ul><li>Read about the LTCM collapse: </li></ul></ul><ul><ul><li>http://en.wikipedia.org/wiki/Long-Term_Capital_Management </li></ul></ul>
  37. 37. Depository Financial Institutions <ul><li>Commercial banks: </li></ul><ul><ul><li>Issue checking deposits and specialize in making commercial loans. </li></ul></ul><ul><li>Savings and loan associations: </li></ul><ul><ul><li>Traditionally have specialized in mortgage lending. </li></ul></ul><ul><li>Savings banks: </li></ul><ul><ul><li>Have specialized in mortgage lending. </li></ul></ul><ul><li>Credit unions: </li></ul><ul><ul><li>Accept deposits from and make loans to only individuals who are eligible for membership. </li></ul></ul>
  38. 38. Finance Companies <ul><li>Finance company: </li></ul><ul><ul><li>Specialize in loans to relatively high-risk individuals and businesses. </li></ul></ul><ul><ul><li>Business finance companies: </li></ul></ul><ul><ul><ul><li>Loan to small businesses. </li></ul></ul></ul><ul><ul><li>Consumer finance companies: </li></ul></ul><ul><ul><ul><li>Loan to individuals for the purchase of durable goods or for home improvements. </li></ul></ul></ul><ul><ul><li>Sales finance companies: </li></ul></ul><ul><ul><ul><li>Loan to individuals for the purchase of items from specific retailers or manufacturers. </li></ul></ul></ul>
  39. 39. Government-Sponsored Credit Agencies and Institutions <ul><li>Federal Financing Bank </li></ul><ul><li>Banks for Cooperatives </li></ul><ul><li>Federal Intermediate Credit Banks </li></ul><ul><li>Federal Land Banks Federal National Mortgage Association </li></ul><ul><ul><li>(FNMA, or “Fannie Mae”) </li></ul></ul><ul><li>General National Mortgage Association </li></ul><ul><ul><li>(GNMA, or “Ginnie Mae”) </li></ul></ul><ul><li>Federal Home Loan Banks (FHLBs) </li></ul><ul><li>Federal Home Loan Mortgage Corporation </li></ul><ul><ul><li>(FHLMC, or “Freddie Mac”) </li></ul></ul>