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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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