- 1. Financial InstitutionsAn OverviewChapter 8 Unit III
Financial Institutions
2. Fundamental Issues
- Why do financial intermediaries exist, and what accounts for
international financial intermediation?
- What do securities market institutions do, and how does the
government regulate these institutions?
- What do insurance companies do, and who regulates their
activities?
- How are pension funds structured, and why have they grown?
3. Fundamental Issues (contd)
- How do mutual funds and hedge funds differ?
- What financial institutions specialize in lending directly to
individuals and businesses?
4. Domestic and International Financial Intermediation
-
- Providing investment capital directly to a firm (e.g.,
purchasing shares of stock or corporate bond).
- Financial intermediation:
-
- 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.
5. Indirect Finance through Financial Intermediaries Figure 8 1
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. Why do we use financial intermediaries ( and also problems
faced by such intermediaries?
- One reason is Asymmetric information:
-
- Information possessed by one party to a financial transaction
but not by the other party.
-
- The problem that those who desire to issue financial
instruments are most likely to use the funds they receive for
unworthy, high-risk projects.
-
- The possibility that a borrower may engage in more risky
behavior after a loan has been made.
8. Benefits of Financial Intermediation
-
- Financial intermediaries collect information on behalf of
savers so that they will not have to incur these direct and
opportunity costs.
-
- Reducing the average cost of fund management by pooling savings
and spreading management costs across many people.
- International financial diversification:
-
- Spreading portfolio risk by holding both U.S.-issued and
foreign-issued financial instruments.
9. The Worlds Largest Banking Institutions Table 8 1 SOURCE:The
Banker , July 2004. 10. Megabanks
- Many of these large financial institutions are spread around
the world
- Since so many firms are multinational now, banks may need to be
also to take advantage of economies of scale in information
processing.
11. Investment Banks
- Even with direct finance, some institutions exist to try to
minimize information and moral hazard problems.
- Investment banks as intermediaries:
-
- Firm commitment underwriting
-
- Standby commitment underwriting
12. Investment Banks as Intermediaries
-
- 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.
- Firm commitment underwriting:
-
- An arrangement in which the investment bank purchases and
distributes to dealers and other purchasers all securities offered
by a business.
13. Investment Banks (contd)
- Standby commitment underwriting:
-
- 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.
-
- An arrangement in which the investment bank has an option to
buy a portion of the issuing firms securities but is not required
to do so.
-
- Some firms now decide to bypass the services of investment
banks:see the box dealing with Google on page 167.
14. Types Of Brokers
-
- 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 .
-
- An agent whose services are limited to making securities trades
for clients.
15. Types Of Brokers (contd)
-
- A discount broker which bases its commission charges on the
volume of shares that it trades on a customers behalf.
-
- A discount broker which charges commissions that are a
percentage of the dollar value each transaction.
16. Securities Brokers and Dealers
- Over-the-counter (OTC) broker-dealer:
-
- A broker-dealer that trades shares of stock that are not listed
on organized stock exchanges.
-
- Stock exchange members that are charged with trading on their
own accounts to prevent dramatic movements in stock prices.
-
- Instructions from other stock exchange members to specialists
to execute stock trades at specific prices.
17. Regulation of Securities Market Institutions
- Securities and Exchange Commission (SEC):
-
- Created in the Securities Exchange Act of 1934 to regulate all
securities market institutions.
-
- The SEC is composed of five presidentially appointed
commissioners whose mandate is to enforce rules governing
securities trading.
-
- A formal written offer to sell securities.
18. Insurance Institutions
- Types of insurance companies
-
-
- Issue policies that insure people against the financial
consequences associated with death.
-
-
- Issue annuities that guarantee the holder fixed or variable
payments at some future date.
-
- Property and casualty insurers
-
-
- 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.
19. Dealing with Asymmetric-Information Problems in
Insurance
- Limiting adverse selection
-
- Restricting the availability and quantity of insurance.
- Limiting moral hazard in insurance
-
- Policy cancellation:in some cases, certain behavior can lead to
cancellation of policies.
-
- Deductible: A fixed amount of an insured loss that a
policyholder must pay before the insurer is obliged to make
payments.
-
- Coinsurance: A policy feature that requires a policyholder to
pay a fixed percentage of a loss above a deductible.
20. Determining Policy Premiums
-
- An individual who specializes in using mathematical and
statistical principles to calculate insurance premiums and to
estimate an insurance companys net worth.
-
- Insurance premiums often vary inversely with interest rates:low
interest rates thus often lead to higher premiums charged to
customers, and vice versa:why?
21. Life Insurance
-
- A policy whose benefits are payable to a beneficiary whenever
the insured persons death occurs and that accumulates a cash value
that the policyholder may acquire prior to his or her death.
-
- A whole life insurance policy under which an insurance company
charges fixed premium payments throughout the life of the insured
individual.
22. Life Insurance (contd)
-
- 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.
-
- 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.
23. The Distribution of Life Insurance Policies Figure 8 4
SOURCE: A.M. Best, 2005. The Distribution of Property-Casualty
Premiumsby Line of Business Figure 8 3 SOURCE: Insurance
Information Institute, 2005. 24. Annuities
-
- A financial instrument, typically issued by an insurance
company, that pays regular, constant installments to the owner
beginning at a specific future date.
-
- 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.
25. Insurance
- 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?
26. Types of Pensions
- Pension funds:created annuities like life insurance companies,
but annuities that can only be collected at retirement.
-
- rapid growth since the 1950s:partly due to baby boom generation
and also many pension funds are tax deferred savings vehicles.
-
- Pensions funded by both employer and employee
contributions.
27. Types of Pensions
- Noncontributory pensions:
-
- Pensions funded solely by employers.
- Defined-contribution plan:
-
- Pension benefits (undefined) are based on total pension
contributions during working years.
-
- Pension benefits are set in advance key issue is certainty of
funding of benefits at retirement.
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. Alternative Pension Funding
Arrangements
- Terminally funded pensions:
-
- Pensions that must be fully funded by the date that an employee
retires.
-
- Pensions not fully funded when employees retire.
-
- 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.
30. Transferability Of Pension Funds
- Single-employer pensions:
-
- Pensions that are established by an employer only for its own
employees and are nontransferable to other employers.
-
- Pensions whose accumulations and benefit rights may be
transferred from one employer to another, in other words, the
pension is said to be portable
31. Pension Fund Insurance and Regulation
- Employment Retirement Income Security Act (ERISA) of 1974:
-
- Established Federal rules for disclosure of pension
information, funding arrangements, and vesting provisions.
-
- Also created the Pension Benefit Guaranty Corporation (PBGC),
which provides federal insurance guaranteeing solvency for all
pensions with tax-deferred benefits.
32. Pension Funding at Standard & Poors 500 Companies.
Figure 8 6 SOURCES: Simon Kwan, Underfunding of Private Pension
Plans, Federal Reserve Bank of San FranciscoEconomic Letter,No.
2003-16, June 13, 2003; Congressional Budget Office. 33. Types of
Mutual Funds
-
- A mix of financial instruments managed on behalf of
shareholders by investment companies that charge fees for their
services.
-
- Mutual funds marketed by brokers who receive commissions based
on the returns of the funds.
-
- Mutual funds that investment companies market directly to the
public and that charge management fees instead of brokerage
commissions.
34. Mutual Fund Growth Figure 8 7 SOURCE:Flow-of-Funds Accounts
, Board of Governors of the Federal Reserve System, various issues.
35. Types of Mutual Funds (contd)
-
- 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.
-
- 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.
36. Hedge Funds
-
- 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.
-
- Earn profits by speculating within particular bond markets or
making bets on changes in exchange rates.
-
- Read about the LTCM collapse:
-
- http://en.wikipedia.org/wiki/Long-Term_Capital_Management
37. Depository Financial Institutions
-
- Issue checking deposits and specialize in making commercial
loans.
- Savings and loan associations:
-
- Traditionally have specialized in mortgage lending.
-
- Have specialized in mortgage lending.
-
- Accept deposits from and make loans to only individuals who are
eligible for membership.
38. Finance Companies
-
- Specialize in loans to relatively high-risk individuals and
businesses.
-
- Business finance companies:
-
-
- Loan to small businesses.
-
- Consumer finance companies:
-
-
- Loan to individuals for the purchase of durable goods or for
home improvements.
-
-
- Loan to individuals for the purchase of items from specific
retailers or manufacturers.
39. Government-Sponsored Credit Agencies and Institutions
- Federal Intermediate Credit Banks
- Federal Land Banks Federal National Mortgage Association
- General National Mortgage Association
- Federal Home Loan Banks (FHLBs)
- Federal Home Loan Mortgage Corporation