978-0077861667 Chapter 1 Lecture Note Part 2

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1. Overview of Financial Institutions

Many savers today are willing to risk some of their funds in the capital markets, but not

all. For at least some of their wealth, savers typically desire a different type of claim than

the ultimate borrower wishes to offer. Asset transformers, such as banks, have evolved

to meet this need by offering low risk claims to savers while granting higher risk, more

illiquid investments (e.g., loans) to the funds demanders. Other types of institutions have

evolved to meet special needs of savers such as life insurance firms to eliminate certain

risks, pension funds to transfer wealth through time, money market mutual funds to pool

investors’ savings, etc.

Deposit-Type Institutions — Offer liquid, government insured claims to savers, such

as demand deposits, savings deposits, time deposits, and share accounts.

Commercial Banks — Make a variety of consumer and commercial loans (direct

claims) to borrowers.

Savings and Loan Associations — Make mortgage loans (direct claim) to borrowers.

Mutual Savings Banks — Purchase various securities and make loans — mortgages,

consumer loans, government bonds, etc.

Credit Unions — Receive share account deposits and make consumer loans.

Membership requires a common bond, such as a church or labor union.

Non-depository institutions:

Life Insurance Companies — Provide life insurance and long-term savings

opportunities for savers.

Casualty Insurance Companies — Provide auto, home insurance, purchase direct

financial securities with paid-in-advance premiums from insurance purchasers.

Pension Funds — issue claims to savers or provide investment plans that allow savers

to transfer wealth through time and to future generations.

Other Types of Financial Intermediaries:

Finance Companies — Borrow (issue liabilities) directly from banks and directly from

savers (commercial paper) and make/purchase riskier consumer and business loans.

Mutual Funds — Offer indirect mutual fund shares to savers and purchase direct

financial assets (e.g. stocks and bonds).

Money Market Mutual Funds — Offer (indirect) shares and purchase direct

(commercial paper) and indirect (bank CDs) money market financial assets.

Investment Bankers — Purchase securities from borrowers and repackage the payment

streams, creating new securities to sell to savers. Assist borrowers in selling direct

claims to savers.

E-brokers — E-brokers provide securities trading services over the Internet. Actually,

E-brokers are following one of four business models. A few, such as Schwab, seek to

be an online financial supermarket providing banking, insurance, portfolio

management and brokerage under one brand. Hybrids provide discount commissions

but provide some investment advice and research, some pure discount firms seek to

compete only on price and a few E-brokers are providing specialized services such as

access to special markets or extended credit.

a. Unique Economic Functions Performed by Financial Institutions

Relative to the choices available to many savers who invest directly in the markets, FIs

provide savers with very safe, liquid claims with fairly small denominations. FIs then in

turn lend money to funds demanders. The ultimate borrowers, say corporations, issue

risky claims (loans or bonds) held by FIs. The individual savers need not investigate the

riskiness of the corporate borrowers, the FI will do that. Consequently, FIs allocate

capital in an economy. FIs must then be able to accurately assess, price and monitor

risks of borrowers for an economy to achieve its potential growth rate. FIs must also

carefully manage their own risk since they are borrowing money from savers at low risk

and then investing the money in higher risk loans and securities in order to earn a profit.

By carefully evaluating the riskiness of potential investments and by diversifying their

loan and investment portfolios, lending institutions employ the law of large numbers to

reduce their risk exposure. The text argues that intermediaries failed in evaluating the

riskiness of mortgages and this failure resulted in the financial crisis. Actually, the causes

are more complex. Heavy government involvement in currency, mortgage and other

markets, lax regulation, failure of credit ratings agencies, political pressure to promote

affordable housing, failures of corporate governance and an extended period of very low

interest rates all contributed to the crisis. It is easy to blame it on ‘Wall Street’ or

capitalism but these simplistic arguments don’t hold up under scrutiny.

The instructor should note that both markets and institutions assess, price and monitor

risk. In some cases however, institutions can perform these functions better than the

markets. In this sense the institution is serving as a delegated monitor. For instance, in

situations where the borrower is reluctant to make information public or frequent

monitoring is needed or when special additional financing requirements may be

necessary, bank loans may be preferable to a public bond issue.

The federal government insures deposits of certain intermediaries. Because of deposit

insurance, depositors do not require a risk premium to place money in an insured

institution. In effect, government insurance subsidizes risk taking at depository

institutions. The government insurance liability requires that insured depository

institutions be regulated to limit the government’s liability and to limit imprudent risk

taking at these institutions.

b. Additional Benefits FIs Provide to Suppliers of Funds

Funds suppliers who place their money in a FI generally get the following benefits:

oReduced transaction costs due to economies of scale in information production1

oMaturity Intermediation (Intermediation is investing in a financial intermediary

(FI) and maturity intermediation is accomplished when a FI grants a saver a

different maturity investment than the maturity of the FI’s own claims on

borrowers)

oDenomination Intermediation

1Economies of scale (EOS) indicate that a firm’s unit profits grow as it becomes larger. Fixed costs lead to

EOS.

oImproved liquidity

oReduced default risk due to deposit insurance and/or the FI’s equity.

Note that a low rate of return is the cost of the safety and convenience of investing in a FI

as opposed to a capital market instrument.

c. Economic Functions FIs Provide to the Financial System as a Whole

Depository Institutions (DIs) also have a unique role in the transmission of monetary

policy because their claims are part of the money supply and because they assist in

providing large amounts of payments services such as check clearing and wire transfers

in the economy. As mentioned above, DIs allocate credit in an economy. If DIs perform

the credit allocation function poorly, long term economic growth will not be maximized.

Certain FIs are also granted special tax status to assist individuals in transferring wealth

through time or to the next generation.

d. Risks Incurred by Financial Institutions

All FIs face a variety of risks, but generally speaking all FIs face:

oDefault risk on at least a portion of their assets,

oMarket risk, or the risk that the value of FI investments may change,

oLiquidity risk, due to a mismatch in maturity of assets and liabilities,

oInterest rate risk due to the same mismatch above,

oForeign exchange risk due to foreign currency assets and liabilities or changing

competitive conditions with foreign FIs as currency values fluctuate,

oOperating cost risk because there are fixed costs involved in providing all

financial services,

oInsolvency risk, any of the stated risks may result in insolvency at a FI.

Some FIs face:

oSovereign risk on overseas investments,

oOff balance sheet risks due to contingent assets and liabilities,

oTechnology and Operational risk due to either overinvestment in a technology

relative to customer demand, or a failure of technology respectively.

e. Regulation of Financial Institutions

FIs hold savers’ funds. Should even one FI default many people’s wealth could be

destroyed unless the government intervenes. Government institutions such as the Federal

Deposit Insurance Corporation (FDIC) can handle a limited number of simultaneous

failures. Systemic risks or system wide failures, perhaps due to contagion, among any

group of FIs could not be handled by our existing regulatory structures at the current

funding levels. Contagion occurs when failure of one or a few institutions causes

widespread failures, at an extreme resulting in an economic crash similar to the

Depression of the 1930s. Part of the fear of contagion arises because most FIs are 1)

highly leveraged and 2) operate on the principle that the majority of claimants will not

seek to withdraw their funds at the same time as FIs don’t keep all of the savers’ funds in

the vault available for immediate withdrawal.

The government must regulate DIs because of the deposit insurance liability. Regulation

is also necessary to prevent fraud and discriminatory practices. Regulations impose a

cost on society by adding to the cost burden of FIs, which must be passed on to borrowers

in the form of higher costs, or as reduced rates of savings for investors in FIs. Prior to the

financial crisis, regulatory changes allowed FIs to engage in more activities and increased

the level of competition among institutions. As a result regulators have been forced to

develop more sophisticated measures of risk and incentives for institutions to limit risk.

The “Restoring American Financial Stability Act of 2010” was designed to promote the

financial stability of the United States by improving accountability and transparency in

the financial system, to eliminate the need for bailouts by getting rid of the “too big to

fail” problem, and to protect consumers from abusive financial services practices. Other

stated goals included helping create jobs by creating a solid economic foundation and to

prevent another crisis. An overarching theme in the bill was to create a regulatory

structure that restores America’s confidence in the financial system. The bill is divided

into 16 parts that address everything from hedge funds to insurance and accountability to

new regulations. I do not believe can eliminate the ‘too big to fail’ problem. What does

too big to fail mean? The only foolproof way to eliminate the government’s deposit

liability (short of rescinding insurance) is to ‘ring fence’ deposit funds. That is to prevent

deposits from being used for risky purposes. This seems unlikely. Moreover, the

government bailed out AIG, which did not take deposits.

f. Trends in U.S. Financial Institutions

The passage of the Financial Services Modernization Act (FSMA) of 1999 repealed the

last vestiges of the 1930s era Glass-Steagall Act that separated commercial and

investment banking and allowed financial service firms (FSFs) broader powers to engage

in financial activities. After passage, FSFs could simultaneously engage in banking,

insurance and securities activities.

The act was passed because technology had created large economies of scale and scope;

hence, FSFs were circumventing regulations to grow in size and to offer more financial

services. Increasing global competition from FSFs that were less tightly regulated also

provided impetus for passage of the bill along with a general trend towards

disintermediation by the public. The banking industry argued that they would be able to

provide financial services more cheaply by engaging in other less regulated activities.

Several other changes occurred after 1999. First, the addition of trading activities began

to change the culture of banking and the nature of the relationship between bankers and

customers. In a lending relationship there is a mutual partnership between the borrower

and the lender, in particular, the bank wants the borrower to do well so that the loan will

be repaid. In a trade deal however, the bank and the customer are in an adversarial

relationship. The bank does well at the customer’s expense. Customers who do not

realize this can easily be taken advantage of by their bank counterparty. Second, the

advent of securitization changed the nature of banking activity from primarily an ongoing

lending relationship with a customer to an ‘originate and resell the loan’ business, in other

words a volume based business. With securitization, the bank has an incentive to make

riskier loans since the loans will subsequently be sold. With Congressional urging,

mortgage lenders weakened credit standards and offered sophisticated mortgage types

such as adjustable rate and interest only mortgages that initially had low payments to

speculators and less sophisticated homebuyers. Banks and others took on too much

credit, liquidity and indeed insolvency risk as a result. Add to this a long period of low

interest rates which contributed to a housing price bubble along with government

involvement in mortgage securitization and insurance, and the resulting problems in the

mortgage markets should have been predictable. Indeed both former Federal Reserve

Chairmen Alan Greenspan and the Bush administration warned Congress of the growing

risks in mortgages. In 2006 with interest rates beginning to increase, home prices began

falling and the mortgage crisis began. By early 2007 about 10% of subprime mortgages

were 90 days behind on their payments. By August 2007 about 1/5 of subprime mortgage

holders were at least 60 days behind in their payments.

The subprime market only comprised a few percentage of the total mortgage industry. It

was not large enough to bring about the financial crisis that the U.S. and the world

endured. The problems in the subprime market revealed the overall bubble in housing

prices that resulted from an extended period of low interest rates. The housing market is

huge and fairly illiquid. The government has yet to pass a plan to reduce the risks posed

by The Federal National Mortgage Association and The Federal Home Loan Mortgage

Corporation. As of 2014 the housing market has not fully recovered although home prices

are rising once more.

As a percentage of total assets, banks, thrifts, insurers and private pension funds are all

declining with growth in investment companies and securities and broker dealers. Loan

sales have exhibited rapid growth, even throughout the financial crisis. In addition, many

FIs that did not traditionally provide bank credit now indirectly do so by purchase

securities collateralized by loans. This has given rise to the term ‘shadow banking

system’ because the ultimate financiers are not directly providing bank credit.

Securitization has been criticized as one source of the financial crisis and when

originators know they will sell the loans and that they will not bear the credit risk then

underwriting standards may decline. This apparently did happen with mortgages before

the crisis. Nevertheless, the additional supply of funds available from shadow banks

allows faster growth. Europe has recently begun encouraging securitization as a tool to

promote more rapid growth since their banks remain financially weak.

4. Globalization of Financial Markets and Institutions

1.1.1 Recent decades have witnessed the globalization of financial markets to an

unprecedented degree. At times trading in foreign equities exceeded

trading in U.S. equities and to a greater extent than ever, events ‘there’

affect markets ‘here’ and vice versa. Although the U.S. markets are still the

largest, the advent of the Euro (the common currency in Europe) has

already led to rapid growth in Euro financing. Eurobonds are a significant

source of financing for many U.S. firms and they represent an alternative to

a domestic bond issue. Eurobonds are bonds issued outside the home

country, but are in the home currency. The growth in foreign financial

markets has five ongoing causes:

1. Greater pool of savings in foreign countries.

2. Better investment prospects outside of countries with large savings.

3. The Internet has improved information availability on foreign markets and securities.

4. Low cost methods to invest in foreign securities have proliferated (such as ADRs).

5. Deregulation around the world has allowed investors to purchase more foreign

securities.

The financial crisis helped reveal how interconnected the world’s markets have become.

No country was unaffected by the crisis, though not all were affected equally. Countries

that did not have a housing boom, such as France and Germany, fared better.

Nevertheless, bank profits fell across the globe and global stock markets plunged in

unison during the crisis. The old adage that ‘the only thing that goes up in a crisis is

correlation’ proved dramatically true.

Europe underwent a sovereign debt crisis of its own. When weaker countries joined the

euro currency they found their borrowing costs were quite low, even when they borrowed

large amounts. In effect, countries such as Greece, Iceland, Ireland, Portugal and Spain

were able to borrow using Germany’s credit rating because of membership in the euro

currency. The results were predictable. These countries over-borrowed and did not use

the money to generate sufficient income growth to make the debt sustainable. Eventually

the debts incurred could not be repaid on and the markets began to charge higher interest

rate spreads over German bunds. The countries could not afford the higher interest rates

and bailouts ensued. The worst of the Euro area crisis appears to be over but Europe

contains to experience subpar growth and the threat of deflation.

Teaching Tip:

Ask your students how one could measure integration among economies. What variables

would you wish to consider?

How did the sub-prime mortgage market crisis reveal the extent of international

investing?

How did the recent financial crisis demonstrate how interconnected the world’s markets

have become?

Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’

Specialness

The financial crisis of 2008 and 2009 (FC) has likely changed the banking and

investment banking industries forever. There are now no major U.S. stand alone

investment banks. Most of the so called ‘Wall Street elite’ are either merged, bankrupt, or

in the case of Goldman Sachs and Morgan Stanley, converted to commercial bank

charters. Subprime losses also devastated one of the country’s largest thrift, IndyMac.

This failure alone cost the FDIC between $8.5 and $9.4 billion. The crisis resulted in the

forced sale or merger of other large institutions such as Wachovia, Countrywide and

Merrill Lynch and a bailout of Citigroup. Vaunted and time tested firms such as Bear

Stearns and Lehman Brothers lost all of their value due to excessive leverage and

overconcentration in mortgage backed investments. Both are now gone. As problems in

the major financial institutions began spreading other markets were affected. The

commercial paper market shut down until the Fed intervened and money market mutual

funds potentially faced runs when one fund ‘broke the buck’ due to its holdings of

Lehman investments. The country’s largest insurer, AIG, was saved from bankruptcy only

by government intervention, and even the ‘Big Three’ U.S. automakers faced insolvency

with GM and Chrysler receiving bailouts. U.S. unemployment peaked at over 10% and

the effects of the recession were felt worldwide. Countries that did not have housing

booms and had more conservative banking systems fared better during the crisis and

recovered more quickly. Canada is a good example as are France and Germany. China

was affected by the crisis but recovered quickly as the Chinese government quickly acted

to stimulate its economy.

The text appendix provides details of the government actions to stem the financial crisis

and a walkthrough of the major events. A brief outline of some of the major government

financial activities follows:

Troubled Asset Relief Program (TARP), up to $700 billion approved

Capital injections to troubled institutions (in exchange for preferred stock)

Purchase of poor quality loans and securities

Reducing preventable foreclosures

Funding for certain key markets

oThe Fed has greatly expanded its discount window lending facility to include

non-banks and to include much poorer collateral, lowered interest rates and began

‘quantitative easing.’

oThe Fed purchased commercial paper from high quality issuers for a time to offset

a lack of investors. Heavy mutual fund withdrawals limited the supply of funds

available to commercial paper markets during the crisis. Fed purchases of paper

allowed refunding to continue.

oThe Treasury and the Fed operated the Term Asset Backed Securities Lending

Facility to encourage securitization of loans.

Expanded FDIC backing

oThe FDIC first increased deposit insurance to $250,000 per account permanently

and temporarily increased insurance to 100% of the deposit amount (originally

until Dec 31, 2009, extended to June 30, 2010, the Dodd-Frank bill extended this

again until Dec 31, 2012). Currently the insurance limit is $250,000, but it is not

clear whether the government would force losses on uninsured amounts in the

event of a large bank failure.

oThe FDIC fully backed any newly issued senior unsecured debt that was sold

before June 30, 2009 for banks and bank holding companies.

The government also passed the controversial $789 billion stimulus package. It is

popular among many to deride the need for an economic stimulus bill. One has to

remember however that the U.S. financial system was indeed in severe trouble in this

time period and economic growth was falling at a record pace in the modern era. Had the

government taken the wrong steps, or even failed to act, I believe a far more serious

recession could have occurred. Was it reasonable to expect Congress to stand by and do

nothing in such a case, particularly if one recalls the effects of the Great Depression? In

an extreme situation such as presented by the crisis it seems likely that expansive fiscal

policy was called for. However, the stimulus bill that was actually passed did not seem to

contain enough elements that were focused on generating growth. Moreover, fiscal

spending is notoriously slow and ineffective in stimulating growth. The public sector

does not have a profit motive to promote efficiency and spending decisions are heavily

politicized. The elements of the stimulus bill should have been critically examined for

their ability to generate short term and long term economic growth. With the debt and

deficit levels the country now faces, more stimulus spending seems unwise unless a) one

can convincingly show sufficient growth would result to outweigh the risks of additional

spending and borrowing and b) one can provide a creditable plan to ensure debt reduction

through meaningful entitlement reform, including the new health care entitlement.

1.1.1.1 VI. Web Links

http://www.dowjones.com/ News service with business and market highlights

http://www.newsweek.com/ Weekly news magazine that covers business

http://www.economist.com/ Superb weekly magazine that covers U.S. and global

business and political news.

http://www.sec.gov/ Securities Exchange Commission homepage

http://www.nyse.com/ The New York Stock Exchange’s excellent website

http://www.wsj.com/ The Wall Street Journal has excellent coverage of the

many recent problems with ethics on Wall Street and

Main Street

http://www.federalreserve.gov The web page of the Federal Reserve Board of

Governors. This web site contains the Beige Book,

the Chairman’s testimony before Congress and flow

of funds data for the United States

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1.1.1.2 VII. Student Learning Activities

1. Identify a specific scenario where direct financing would be beneficial for both the funds

supply and the funds demander. Identify a second specific scenario where indirect financing

would be beneficial for both the funds supply and the funds demander.

2. Using the Internet find the flow of funds data at http://www.federalreserve.gov.

For each of the following intermediaries, identify the largest type of investment security

excluding loans (e.g., corporate bonds, equity, etc.). Explain why you believe each

intermediary has chosen this investment type:

Pension funds

Commercial Banks

Life insurers

Property & Casualty insurers

3. Find the most recent version of the Flow of Funds Matrix, Supplemental Table, Z.1 at the

Federal Reserve website. (You might try the following web address:

http://www.federalreserve.gov/releases/Z1/Current/z1r-3.pdf ). The Adobe Reader is

required.

Identify the financial assets and liabilities of each of the following sectors:

Financial Assets Financial Liabilities

Households and Non-profits

State & Local government

Financial sectors

Non-financial business

Federal government

Foreign sectors

In the current period, which categories are funds suppliers and which are funds

demanders?

4. Locate current promised interest rates on three money market instruments and promised rates

of return on two capital market instruments. Explain the differences in your findings.

5. A liquid asset is one that can be quickly converted to a spendable commodity such as cash

without incurring large transactions costs or uncertainty in value. Given this, rank the

following investments from most liquid to least liquid:

Cash, Common Stocks, Bonds, Real Estate, Savings Accounts, CD, Checking Accounts

During the financial crisis and afterwards gold prices skyrocketed. Discuss why gold prices

changed. Is gold always a good investment in uncertain times? Why has gold’s performance

changed now? Discuss

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