Financial Financial IntermediariesIntermediariesBears are people who do their arithmetic – Peter Bernstein– Peter Bernstein

FF 2005/06FF 2005/06 22

NES

Up to nowUp to now

What is traded?What is traded?– Basic securities: stocks and bondsBasic securities: stocks and bonds– DerivativesDerivatives

How is it traded?How is it traded?– Exchange vs OTC marketsExchange vs OTC markets

Who (helps to) trade(s)?Who (helps to) trade(s)?– Direct vs intermediated Direct vs intermediated

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NES

PlanPlan

Basis for financial intermediationBasis for financial intermediation– Solving agency problemSolving agency problem– Asset transformationAsset transformation

Main types and specifics of FIsMain types and specifics of FIs– Commercial / investment bankingCommercial / investment banking– Money management: mutual / pension / Money management: mutual / pension /

hedge fundshedge funds– Insurance Insurance – Rating agenciesRating agencies

Regulators and intl financial institutionsRegulators and intl financial institutions

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NES

Rationales for the Rationales for the existence of FIexistence of FI Transaction costs and economies of scaleTransaction costs and economies of scale

– Special human and technological skills Special human and technological skills – Cross-sectional and temporal reusability of Cross-sectional and temporal reusability of

informationinformation Information-based rationalesInformation-based rationales

– Market mechanisms may be unable to Market mechanisms may be unable to efficiently resolve information problemsefficiently resolve information problems

• Info asymmetry: ex ante prospects / ex post return Info asymmetry: ex ante prospects / ex post return of the borrowerof the borrower

• Free-rider problem among investorsFree-rider problem among investors

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NES

Rationales for the Rationales for the existence of FIexistence of FI (2)(2) Information-based rationalesInformation-based rationales

– FIs acquire information about the FIs acquire information about the borrowers and monitor their borrowers and monitor their performanceperformance

• Diversification benefitsDiversification benefits

– Who monitors the monitor?Who monitors the monitor?• Debt contract: bank depositsDebt contract: bank deposits• Equity claim (in case of easily priced Equity claim (in case of easily priced

assets): mutual fundsassets): mutual funds

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NES

Services of Financial Services of Financial IntermediariesIntermediaries BrokerageBrokerage: bringing together : bringing together

providers and users of capital providers and users of capital without modifying the claimwithout modifying the claim– Transactions servicesTransactions services– Financial advice Financial advice – Screening and sertification Screening and sertification

FF 2005/06FF 2005/06 77

NES

Services of Financial Services of Financial IntermediariesIntermediaries (2)(2) Qualitative asset transformationQualitative asset transformation: :

transforming the financial claims transforming the financial claims borrowers prefer into claims that borrowers prefer into claims that savers prefer to holdsavers prefer to hold– Liquidity / payment Liquidity / payment – Maturity Maturity – Denomination Denomination – Diversification Diversification – Information Information

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NES

Commercial banksCommercial banks

Long-term illiquid assets financed by Long-term illiquid assets financed by short-term liquid depositsshort-term liquid deposits– Interest rate riskInterest rate risk

• Refinancing / reinvestment riskRefinancing / reinvestment risk

– Credit riskCredit risk• Firm-specific / systematic / country riskFirm-specific / systematic / country risk

– Off balance sheet risk (e.g., letter of Off balance sheet risk (e.g., letter of credit)credit)

– Operational riskOperational risk– Liquidity riskLiquidity risk

FF 2005/06FF 2005/06 99

NES

Commercial banksCommercial banks (2)(2)

Danger of bank runsDanger of bank runs– Sequential service constraintSequential service constraint

Eliminating bank runsEliminating bank runs– Capital requirementsCapital requirements

• But: may induce more risksBut: may induce more risks

– Deposit insurance / lender of last resortDeposit insurance / lender of last resort• But: may induce excessive risk-taking by the But: may induce excessive risk-taking by the

banksbanks

– Interbank marketInterbank market• But: coordination problem among banksBut: coordination problem among banks

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NES

Commercial banksCommercial banks (3)(3)

Securitization: selling claims Securitization: selling claims against a specific part of the against a specific part of the bank’s assetsbank’s assets– Reducing info distortionsReducing info distortions– Better risk sharingBetter risk sharing– But: weaker monitoring incentivesBut: weaker monitoring incentives

Which types of loans are better Which types of loans are better suited for securitization?suited for securitization?

FF 2005/06FF 2005/06 1111

NES

Financing: Banks vs Financing: Banks vs Capital MarketsCapital Markets Banks Capital Markets

The intermediary charges an additional layer of costs

Lower interest, but larger initial (time / financial) costs

Tough info requirements

Close monitoring of the borrower Free-rider problem

Usually, not very large (except for syndicated loans)

Usually, large size

The form of credit may be very flexible and project-specific (e.g., credit line)

Usually, standard contract

May restructure the credit in the future Harsh budget constraint

May extract information rent

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NES

Do banks have a Do banks have a future?future? Only the largest firms have access to bond Only the largest firms have access to bond

marketsmarkets– Tough information requirements to Tough information requirements to

corporations issuing bondscorporations issuing bonds Large companies rely on syndicated bank Large companies rely on syndicated bank

loans to finance large projectsloans to finance large projects– Info requirement / greater controlInfo requirement / greater control

Banks are well-suited for the transfer of Banks are well-suited for the transfer of the control from shareholdersthe control from shareholders– Banks restructure and recapitalize firms in Banks restructure and recapitalize firms in

financial distressfinancial distress Banks provide sophisticated financial Banks provide sophisticated financial

productsproducts

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NES

Is more competition Is more competition always good?always good? Recent trends in banking:Recent trends in banking:

– EU: integration and cross-country competitionEU: integration and cross-country competition– USA: lifting restrictions on universal bankingUSA: lifting restrictions on universal banking– Russia: allowing entry of foreign banks?Russia: allowing entry of foreign banks?

Intensified competition in banking Intensified competition in banking regarded with suspicion:regarded with suspicion:– Lower rents => excessive risk taking and Lower rents => excessive risk taking and

failuresfailures– Larger winner’s curse in bidding for loans => Larger winner’s curse in bidding for loans =>

undue conservatismundue conservatism– Higher systemic risksHigher systemic risks

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NES

Investment banksInvestment banks

Securities intermediation:Securities intermediation:– Issuance by companies and Issuance by companies and

governmentsgovernments• E.g., IPOE.g., IPO

– Purchase by investorsPurchase by investors– Financial advice on M&A, project Financial advice on M&A, project

finance, structured products, etc.finance, structured products, etc. Cyclical nature of earningsCyclical nature of earnings

– Large profit in a strong marketLarge profit in a strong market

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NES

Insurance companiesInsurance companies

Transfer risks from clients to themselves Transfer risks from clients to themselves for a feefor a fee– Life / health / property and casualty insuranceLife / health / property and casualty insurance

Fixed liabilities: annuityFixed liabilities: annuity– Long-term investments: bonds, RE, etc.Long-term investments: bonds, RE, etc.

Rising demandRising demand– Aging of the populationAging of the population

Reinsurance: e.g., LloydsReinsurance: e.g., Lloyds Suffered from recent terror acts and Suffered from recent terror acts and

catastrophescatastrophes

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NES

Banking in the USBanking in the US

1927: the McFadden act1927: the McFadden act– Prohibiting interstate bankingProhibiting interstate banking

1933: the Glass-Steagall act1933: the Glass-Steagall act– Separation of cSeparation of commercial and investment ommercial and investment

bankingbanking– CBs cannot own voting equityCBs cannot own voting equity

1999: the Gramm-Leach-Bliley act1999: the Gramm-Leach-Bliley act– Allowed consolidation of commercial banks, Allowed consolidation of commercial banks,

investment banks, and insurance companiesinvestment banks, and insurance companies

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NES

Banking outside of the Banking outside of the USUS Large universal banksLarge universal banks

– Full range of financial servicesFull range of financial services– Nationwide branch networkNationwide branch network– E.g., Fuji, Sumitomo, Credit Lyonnais, E.g., Fuji, Sumitomo, Credit Lyonnais,

Deutsche, HSBC, ABN-AMRODeutsche, HSBC, ABN-AMRO Substantial stock (cross) ownershipSubstantial stock (cross) ownership

– Active role in corporate managementActive role in corporate management Smaller, but rising importance of Smaller, but rising importance of

security marketssecurity markets

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NES

Money managersMoney managers

Specific risk-return profileSpecific risk-return profile– Stocks vs bonds (vs derivatives)Stocks vs bonds (vs derivatives)– Conservative vs aggressiveConservative vs aggressive– Domestic vs intlDomestic vs intl

Nature of liabilitiesNature of liabilities Managerial compensation Managerial compensation Methods of distributionMethods of distribution RegulationRegulation

FF 2005/06FF 2005/06 1919

NES

Mutual fundsMutual funds

Role of the management Role of the management companycompany– Fund family (complex)Fund family (complex)

Management fee:Management fee:– Asset-based: proportional to TNAAsset-based: proportional to TNA– Performance-based: must be Performance-based: must be

symmetric around the benchmark symmetric around the benchmark in the USin the US

FF 2005/06FF 2005/06 2020

NES

Mutual fundsMutual funds (2)(2)

Open vs closed fundsOpen vs closed funds– Shares are “marked to market” Shares are “marked to market”

dailydaily Active vs passive (index) fundsActive vs passive (index) funds Load vs no-load funds (A/B/C)Load vs no-load funds (A/B/C)

– Sales loads: front-end / back-Sales loads: front-end / back-end / 12b-1 feeend / 12b-1 fee

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NES

Benefits of investing Benefits of investing via MFvia MF Low transaction costsLow transaction costs

– Easy way to buy a diversified Easy way to buy a diversified portfolioportfolio

Customer servicesCustomer services– Liquidity insuranceLiquidity insurance

Professional managementProfessional management– Selecting right stocks at right time?Selecting right stocks at right time?

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NES

Stylized facts about Stylized facts about MFsMFs Largest FI in the USLargest FI in the US There are over 8,000 MFs (more than There are over 8,000 MFs (more than

stocks)stocks) On average, MFs do not earn positive On average, MFs do not earn positive

performance adjusted for risk and expensesperformance adjusted for risk and expenses (Mostly bad) performance persists(Mostly bad) performance persists New money flows mostly in top performers,New money flows mostly in top performers,

– ……but does not really flow out from poor but does not really flow out from poor performersperformers

Many funds deviate from their stated Many funds deviate from their stated objectivesobjectives

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NES

Pension fundsPension funds

‘‘Fixed’ liabilitiesFixed’ liabilities– Defined contribution vs defined Defined contribution vs defined

benefit plansbenefit plans– Underfunded vs overfunded Underfunded vs overfunded

pensionspensions More conservative strategyMore conservative strategy US: 401(k) plansUS: 401(k) plans

– Investors themselves select PFsInvestors themselves select PFs

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NES

Hedge fundsHedge funds

More aggressive strategyMore aggressive strategy– Long-short / macro / event-drivenLong-short / macro / event-driven– High leverageHigh leverage– Usually, low systematic riskUsually, low systematic risk

Strict entrance restrictionsStrict entrance restrictions Management fee:Management fee:

– Typically, 20% of profit, with high Typically, 20% of profit, with high watermark provisionwatermark provision

High attrition rateHigh attrition rate

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NES

Wealth managementWealth management

Wealth management: mass segment Wealth management: mass segment ($100,000-$1mln)($100,000-$1mln)– Portfolio managementPortfolio management– E.g., Citibank, INGE.g., Citibank, ING

Private banking: for new richesPrivate banking: for new riches– Financial (e.g., tax and estate) planning, Financial (e.g., tax and estate) planning,

cash and asset managementcash and asset management– E.g., HSBC, UBSE.g., HSBC, UBS

Family office: for old wealthy familiesFamily office: for old wealthy families– E.g., Piktet, CourtzE.g., Piktet, Courtz

FF 2005/06FF 2005/06 2626

NES

Recent scandals with Recent scandals with FIsFIs Insider tradingInsider trading

– October 31, 2001: Goldman Sachs economist October 31, 2001: Goldman Sachs economist received info about 30y US Treasuries before the received info about 30y US Treasuries before the official release, traders earned $3.8 mln in 8 minutesofficial release, traders earned $3.8 mln in 8 minutes

– September September 2003: 2003: Goldman Sachs paid Goldman Sachs paid $9$9..3 3 mln to mln to SECSEC

Investment banks, 2002: analysts’ conflict of Investment banks, 2002: analysts’ conflict of interestsinterests– Analysts gave overoptimistic recommendations on IB Analysts gave overoptimistic recommendations on IB

clients’ stocksclients’ stocks– December 2002: top 10 banks paid $1.4 bln as December 2002: top 10 banks paid $1.4 bln as

compensationcompensation– NASD required to separate analytical and IB depts of NASD required to separate analytical and IB depts of

the same companythe same company

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NES

Recent scandals with Recent scandals with FIsFIs (2)(2) Mutual funds, 2003: late tradingMutual funds, 2003: late trading

– Some clients could trade at NAV fixed at Some clients could trade at NAV fixed at 4pm on the same day4pm on the same day

Brokers’ pre-emptive tradingBrokers’ pre-emptive trading– Brokers made own trades before executing Brokers made own trades before executing

their clients’ orderstheir clients’ orders– December 2004: 5 top NYSE market-December 2004: 5 top NYSE market-

makers paid $240 mln to settlemakers paid $240 mln to settle Independent consultants in the UK Independent consultants in the UK

were convicted in the insufficient were convicted in the insufficient disclosure of risks of structured disclosure of risks of structured products sold to their clientsproducts sold to their clients

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NES

Regulators in the US Regulators in the US and Russiaand Russia FRS / FRS / ЦБРФЦБРФ

– Bank regulationBank regulation– Monetary policyMonetary policy

FDIC / FDIC / АСВАСВ– Deposit insuranceDeposit insurance

SEC / SEC / ФСФРФСФР– Securities operationsSecurities operations

FF 2005/06FF 2005/06 2929

NES

Too big to fail?Too big to fail?

Continental Illinois Bank, a large US bankContinental Illinois Bank, a large US bank– 1983-84: many defaults on loans1983-84: many defaults on loans– May 1984: massive deposit withdrawalsMay 1984: massive deposit withdrawals

Help from regulatorsHelp from regulators– FRS: credits via the discount windowFRS: credits via the discount window– FDIC: guarantee on all deposits, even beyond FDIC: guarantee on all deposits, even beyond

$100,000$100,000– July 1984: FDIC purchased some loans and July 1984: FDIC purchased some loans and

provided over $5 bln in capitalprovided over $5 bln in capital Many smaller banks were not rescuedMany smaller banks were not rescued

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NES

Too big to fail (2)Too big to fail (2)

““The rescue effort was less expensive The rescue effort was less expensive than dealing with CIB’s failure”than dealing with CIB’s failure”

Arguments forArguments for– Direct costs of the bank’s failureDirect costs of the bank’s failure– Domino effect: chain reactionDomino effect: chain reaction

Arguments againstArguments against– Direct costs: FDIC recovered $1.1 bln of Direct costs: FDIC recovered $1.1 bln of

the $2.8 bln troubled loans it bought from the $2.8 bln troubled loans it bought from CIBCIB

– Unfair competitionUnfair competition– Incentive effectsIncentive effects

FF 2005/06FF 2005/06 3131

NES

Unification of intl Unification of intl banking regulationbanking regulation 1978: the Intl Banking Act in the US1978: the Intl Banking Act in the US

– Similar regulation for domestic and foreign Similar regulation for domestic and foreign banks operating in the USbanks operating in the US

1987: Single European Act 1987: Single European Act – Free capital flow and expansion across the Free capital flow and expansion across the

countriescountries– Similar regulations on competition, mergers, Similar regulations on competition, mergers,

taxes, etc. for European and foreign bankstaxes, etc. for European and foreign banks 1988: uniform capital adequacy guidelines 1988: uniform capital adequacy guidelines

for banks of 12 developed countries for banks of 12 developed countries – Similar regulation for domestic and foreign Similar regulation for domestic and foreign

banks operating in the USbanks operating in the US

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NES

Rating agenciesRating agencies

Independent Independent sertificationsertification– Credit qualityCredit quality– Corporate governanceCorporate governance

Major players:Major players:– S&P, Moody’s, FitchS&P, Moody’s, Fitch

FF 2005/06FF 2005/06 3333

NES

Global trendsGlobal trends

ConsolidationConsolidation Increase in competition => declining Increase in competition => declining

marginsmargins– Both intl and across different types of FIsBoth intl and across different types of FIs

Traditional banking is shrinkingTraditional banking is shrinking New financial services and products New financial services and products

growinggrowing Deregulation and unification of the Deregulation and unification of the

regulationregulation

ConclusionsConclusions

Today’s hero is often tomorrow’s Today’s hero is often tomorrow’s blockheadblockhead – Peter Bernstein– Peter Bernstein