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Chapter 11
Investment Banks, Mutual Funds, Hedge
Funds, and the Shadow Banking System
Brief Chapter Summary and Learning Objectives
11.1 Investment Banking (pages 314–327)
Explain how investment banks operate.
The central activities of investment banks include providing advice on new security issues,
underwriting new security issues, and providing advice and financing for mergers and acquisitions.
In recent years, investment banks have also engaged in activities such as financial engineering,
research, and proprietary trading.
Investment banks are often relatively highly leveraged because they borrow funds (such as
through repurchase agreements) to finance their investment activities.
Some policymakers and economists argue that the repeal of the Glass-Steagall Act in 1999, which
allowed commercial banks to engage in investment banking, helped contribute to the financial
crisis of 2007–2009.
11.2 Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies (pages 327–334)
Distinguish between mutual funds and hedge funds and describe their roles in the financial system.
Mutual funds are financial intermediaries that allow savers to purchase shares in a portfolio of
financial assets, helping to reduce transactions costs and risk sharing.
Modern hedge funds tend to speculate by selling stocks short or by pursing other investment
strategies rather than by engaging in hedging.
Finance companies are financial intermediaries that raise money through sales of commercial
paper and other securities and use the funds to make small loans to households and firms.
11.3 Contractual Savings Institutions: Pension Funds and Insurance Companies (pages 334–338)
Explain the roles that pension funds and insurance companies play in the financial system.
Employees may prefer to save through pension plans provided by employers rather than through
savings accounts for three reasons: 1) lower transactions costs for portfolio management, 2) the
availability of life annuities, and 3) favorable tax treatment.
Insurance companies are financial intermediaries that specialize in writing contracts to protect
their policyholders from the risks of financial loss associated with particular events.
11.4 Risk, Regulation, and the Shadow Banking System (pages 339–342)
Explain the connection between the shadow banking system and systemic risk.
Though deposit insurance reduces systemic risk in the traditional banking system, there is no
equivalent insurance for short-term lending in the shadow banking system.
Shadow banking firms have traditionally not been regulated. In 2010, Congress passed the
Dodd-Frank Act, which contained limited additional regulation of shadow banks.
Some shadow banks experienced runs during the 2007-2009 financial crisis and economists and
policymakers worry that shadow banks remain vulnerable to runs in a future crisis.
Key Terms and Concepts
Contractual saving institution A financial
intermediary such as a pension fund or an
insurance company that receives payments from
individuals as a result of a contract and uses the
funds to make investments.
Finance company A nonbank financial
intermediary that raises money through sales of
commercial paper and other securities and uses the
funds to make small loans to households and firms.
Hedge fund A financial firm organized as a
partnership of wealthy investors that make
relatively high-risk, speculative investments.
Initial public offering (IPO) The first time a
firm sells stock to the public.
Insurance company A financial intermediary
that specializes in writing contracts to protect
policyholders from the risk of financial loss
associated with particular events.
Investment banking Financial activities that
involve underwriting new security issues and
providing advice on mergers and acquisitions.
Investment institution A financial firm, such
as a mutual fund or a hedge fund, that raises
funds to invest in loans and securities.
Money market mutual fund A mutual fund that
invests exclusively in short-term assets, such as
Treasury bills, negotiable certificates of deposit,
and commercial paper.
Mutual fund A financial intermediary that raises
funds by selling shares to individual savers and
invests the funds in a portfolio of stocks, bonds,
mortgages, and money market securities.
Pension fund A financial intermediary that
invests contributions of workers and firms in
stocks, bonds, and mortgages to provide for
pension benefit payments during workers’
retirements.
Syndicate A group of investment banks that
jointly underwrite a security issue.
Systemic risk Risk to the entire financial system
rather than to individual firms or investors.
Underwriting An activity in which an
investment bank guarantees to the issuing
corporation the price of a new security and then
resells the security for a profit.
Chapter Outline
Teaching Tips
Until recently, the “banking” in most money and banking courses was exclusively commercial banking.
The financial crisis of 2007-2009 made it clear that so-called shadow banks have played an increasingly
important role in the financial system. This chapter provides a complete—but concise—overview of the
shadow banking system. One of the strengths of this chapter is that it has the most complete discussion of
investment banking available in any text. Although at one time this chapter would have seemed optional
to many instructors, today it provides material that gives students a good background on an important
sector of the financial system.
When is a bank not a bank? When it’s a shadow bank!
During the 2007–2009 financial crisis, it became clear that commercial banks no longer played the
dominant role in routing funds from savers to borrowers. Nonbank financial institutions–the “shadow
banking system”–were key players in the crisis.
11.1 Investment Banking (pages 314-327)
Learning Objective: Explain how investment banks operate.
A. What is an Investment Bank?
The central activities of investment banks include providing advice on new security issues;
underwriting new security issues; and providing advice and financing for mergers and
acquisitions. Because most firms lack expertise in financial markets, they turn to investment
banks for advice on how to raise funds. Investment banks underwrite new securities by
guaranteeing a price, selling the securities in financial markets, and retaining the difference.
Investment banks play an active role in mergers and acquisitions by taking the initiative on
contacting firms on potential purchases, sales, and mergers.
In recent years, investment banks have also engaged in activities such as financial engineering,
including risk management; research; and proprietary trading. Financial engineering typically
involves developing new financial securities or investment strategies using sophisticated
models. Critics state that some of the new financial securities increased risk instead of reducing
risk as intended. Investment banks conduct research on large firms or industries. This research
can be used for investing decisions as well as to help clients identify possible mergers and
acquisition targets. Beginning in the 1990s, investment banks began to engage in proprietary
trading, buying and selling securities for their own accounts rather than just for clients.
B. “Repo Financing,” Leverage and Funding Risk in Investment Banking
Investment banks borrow to finance their investments in securities and direct loans to firms. As
a result, these banks often have high leverage, which increases the volatility of their profits and
losses. One way that investment banks borrow is through repurchase agreements (repos), which
are short-term loans backed by collateral. Typically, repos involve selling a security to another
financial institution while agreeing to buy it back within the next few days at a slightly higher
price. In many cases, the borrowing is short term while the funds are used for purchasing
long-term assets, creating a maturity mismatch. In addition, a counterparty risk exists in that
there’s a possibility that the party on the other side of the financial transaction will not fulfill its
obligations.
Teaching Tips
Figure 11.1 on page 321 shows the differences in leverage ratios between major commercial and
investment banks. Have students discuss the role of leverage in exposing banks to risk. Note that the three
investment banks that didn’t survive the crisis–Lehman Brothers, Bear Stearns, and Merrill Lynch–had
leverage ratios of between 30 and 35 in 2007. In 1998, Lehman Brothers went bankrupt, Bear Stearns
was bought by JPMorgan, and Merrill Lynch was bought by Bank of America.
C. The Investment Banking Industry
Congress passed the Glass-Steagall Act during the Great Depression due to concerns about the
riskiness of investment banking. This Act separated commercial and investment banking. In
1999, Congress passed the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act. As
a result, many investment banks began to engage in commercial banking activities and many
commercial banks began to engage in investment banking. Some economists and policymakers
think that the repeal of Glass-Steagall was a mistake and that the repeal contributed to the
financial crisis of 2007–2009.
D. Where Did All the Investment Banks Go?
During the financial crisis of 2007–2009, firms that held large amounts of mortgage-backed
securities suffered significant losses. Standalone investment banks had a tough time weathering
the crisis. Only two large investment banks survived the crisis–Goldman Sachs and Morgan
Stanley–but they became financial holding companies so they could borrow from the Fed and
be eligible for the Troubled Asset Relief Program (TARP).
11.2 Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies
(pages 327–334)
Learning Objective: Distinguish between mutual funds and hedge funds and describe their roles in
the financial system.
A. Mutual Funds
Mutual funds are financial intermediaries that allow savers to purchase shares in a portfolio of
financial assets, which helps to reduce transactions costs and risk sharing. Open-end mutual
funds are the most common form of mutual fund. Other mutual funds are closed-end and
exchange-traded funds (ETFs). The greatest growth has come in money market mutual funds,
which hold high- quality, short-term assets.
B. Hedge Funds
Hedge funds are typically organized as partnerships of a small number of investors and are
largely unregulated. Modern hedge funds typically make investments that involve speculating
rather than hedging, so their name is misleading. Hedge funds are controversial: Some criticize
them for destabilizing markets through intensive use of short selling, while others think they
play a productive role in financial markets by forcing price changes that can correct market
inefficiencies.
C. Finance Companies
Finance companies are financial intermediaries that raise money through sales of commercial
paper and other securities and use the funds to make small loans to households and firms.
Consumer finance companies make loans to enable consumers to buy cars, furniture, and
appliances; to finance home improvements; and to refinance household debts. Finance
company customers have higher default risk than do good-quality bank customers and so may
be charged higher interest rates. Business finance companies engage in factoring—that is,
purchasing at a discount accounts receivables of small firms. Sales finance companies are
affiliated with companies that manufacture or sell big-ticket goods, such as automobiles.
11.3 Contractual Savings Institutions: Pension Funds and Insurance Companies
(pages 334–338)
Learning Objective: Explain the roles that pension funds and insurance companies play in the
financial system.
A. Pension Funds
Because retirements are predictable, pension funds can invest the contributions of workers and
firms in long-term assets. Employees may prefer to save through pension plans provided by
employers rather than through savings accounts for three reasons: 1) lower transactions cost
for portfolio management; 2) the availability of life annuities; and (3) favorable tax treatment.
Defined contribution plans, such as 401(k) plans, invest contributions but do not guarantee
values upon retirement. Defined benefit plans promise employees a particular dollar benefit
based on employee earnings and years of service.
B. Insurance Companies
Insurance companies are financial intermediaries that specialize in writing contracts to protect
their policyholders from the risks of financial loss associated with particular events. Insurance
companies attempt to reduce risk through:
1. Risk pooling
2. Reducing adverse selection through screening and risk-based premiums
3. Reducing moral hazard through deductibles, coinsurance, and restrictive covenants
Teaching Tips
Many people have heard of hedge funds without understanding them. The Making the Connection,
“Would You Invest in a Hedge Fund If You Could?” that begins on page 331 of the text explores various
aspects of hedge funds. The table on page 333 compares the benefits and drawbacks of hedge funds and
mutual funds. Have students read this Making the Connection and follow up by asking students if they
would invest in a hedge fund.
11.4 Risk, Regulation, and the Shadow Banking System (pages 339–342)
Learning Objective: Explain the connection between the shadow banking system and systemic risk.
A. Systemic Risk and the Shadow Banking System
In the shadow banking system, short-term loans take such forms as repurchase agreements,
purchases of commercial paper, and purchases of money market mutual fund shares rather than
the form of bank deposits. Though deposit insurance reduces systemic risk in the traditional
banking system, there is no equivalent in the shadow banking system.
B. Regulation and the Shadow Banking System
Shadow banking firms have traditionally not been regulated because policymakers thought that
they were not as important to the financial system as commercial banks and because these
financial firms dealt primarily with sophisticated investors who could look out for their own
interests. In 2010, Congress passed the Dodd-Frank Act, which contained limited additional
regulation of shadow banks.
C. The Fragility of the Shadow Banking System
Many firms in the shadow banking system borrow short term but lend long term. Investors
providing funds to shadow banks are not protected by deposit insurance, making these financial
firms more susceptible to runs. Due in part to lack of regulation, investment banks could invest
in risky assets and became highly leveraged. Many investment banks suffered heavy losses due
to investments in mortgage-backed securities.
D. Are Shadow Banks Still Vulnerable to Bank Runs Today?
Following the Financial Crisis of 2007-2009, many economists and policymakers called for
extensive
regulation of the shadow banking system. However, the Dodd-Frank Act, passed in 2010,
contained
limited regulation of the shadow banking system including the following:
1. Trading of some derivatives are to be carried out on exchanges
2. Large hedge funds must register with the SEC
3. Firms selling mortgage-backed securities and similar assets must hold 5% of the credit risk
However, the regulations did not address a basic problem the financial crisis revealed: Some
shadow banks borrow short term to make highly leveraged long-term investments, which makes
them vulnerable to runs.
