II. Nondepository Institutions
A. Insurance Companies
1. Insurance companies began hundreds of years ago with long sea voyages.
2. The most famous insurance company, Lloyd’s of London, was established in 1688.
3. Two Types of Insurance Company: insurance companies offer life insurance or
property and casualty insurance.
a. Life insurance can be term life insurance (which makes a payment upon the death
of the insured) and whole life insurance (which accumulates a cash value).
b. As time passes, the emphasis of the whole life policy shifts from insurance to
savings.
c. Life insurance companies hold assets of longer maturity than property and
casualty insurers, since most of their payments will be made well into the future.
4. The Role of Insurance Companies: insurance companies pool risk to generate
predictable payouts.
a. Adverse selection and moral hazard create problems in the insurance
market that are worse than those in the stock and bond markets.
b. To deal with this, insurance companies carefully screen applicants
before issuing them policies.
c. Policies may also include restrictive covenants in order to reduce moral
hazard.
5. The future of insurance must be considered in the light of advances in medical
technology, particularly with regard to the decoding of the human genome. In the
future, people with inherited tendencies toward certain diseases may not be able to get
insurance.
B. Pension Funds
1. A pension fund offers people the ability to make premium payments today in
exchange for promised payments under certain future circumstances.
2. By pooling the savings of many small investors, pension funds spread risk, ensuring
that funds will be available to investors in their old age.
3. Nearly everyone who works for a large corporation in the United States has an
employer-administered pension plan, which may be a defined benefit (DB) pension
plan or a defined contribution (DC) pension plan.
a. Participants in defined benefit plans receive a lifetime retirement income
based on the number of years they worked at the company and their final salary.
b. Under defined contribution plans (called 401k or 403b accounts after
their tax designation) both the employee and the employer make contributions but
the amount of income upon retirement depends on the amount of funds in the
account.
C. Securities Firms: Brokers, Mutual Funds and Investment Banks
1. The broad class of securities firms includes brokerages, investment banks, and mutual
fund companies. In one way or another, these are all financial intermediaries.
2. The primary services of brokerage firms are accounting and the provision of access to
secondary markets. They also provide loans to customers who wish to purchase stock
on margin, and they provide liquidity by offering check-writing privileges and by
allowing investors to sell assets quickly.
3. All securities firms are very much in the business of producing information; but this
is truly at the heart of the investment banking business.
4. Investment banks are the conduits through which firms raise funds in the capital
markets.
5. Through their underwriting services, investment banks issue new stocks and a variety
of other debt instruments.
6. In underwriting, the investment bank guarantees the price of a new issue and then
sells it to investors at a higher price; however, this is not without risk, since the
selling price may not in fact be higher than the price guaranteed to the firm issuing
the security.
7. Information and reputation are central to the underwriting business; underwriters
collect information to determine the price of the new securities and then put their
reputations on the line when they go out to sell the issues.
8. In addition to underwriting, investment banks provide advice to firms that wish to
merge with or acquire other firms, for which advice they are paid a fee.
D. Finance Companies
1. Finance companies raise funds in the financial markets by issuing commercial paper
and securities and use the funds to make loans to individuals and corporations.
2. These companies are largely concerned with reducing the transactions and
information costs that are associated with intermediated finance, and because of their
narrow focus they are particularly good at screening potential borrowers’
creditworthiness, monitoring borrower performance over the life of the loan, and
seizing collateral in the event of a default.
3. Most finance companies specialize in one of three loan types: consumer loans,
business loans, and what are called sales loans (for example, the financing for a
consumer to purchase a large-ticket item like an appliance). Some also provide
commercial and home mortgages.
4. Business finance companies provide loans to businesses, for equipment leasing.
5. Business finance companies also provide short-term liquidity to firms by offering
inventory loans (so that firms can keep the shelves stocked) and accounts receivable
loans (which provide immediate resources against anticipated revenue streams).
E. Government-Sponsored Enterprises
1. The U.S. government is directly involved in the financial intermediation system
through loan guarantees and in the chartering of financial institutions to provide
specific types of financing.
2. When Congress wanted to make sure that low- and moderate-income families could
get mortgages it created private corporations called the Federal National Mortgage
Association (Fannie Mae) and the Federal National Mortgage Corporation (Freddie
Mac) and a corporation wholly owned by the federal government called the
Government National Mortgage Association (Ginnie Mae).
3. To provide student loans it chartered Sallie Mae, the Student Loan Marketing
Association.
4. All these government-sponsored enterprises have the same basic structure; they issue
short-term bonds and use the proceeds to provide loans.
5. Because of their relationship to the government, they can obtain lower-than-average
interest rates on their liabilities and pass those along to borrowers.
6. In recent years, Fannie Mae and Freddie Mac have been heavily criticized for
problems in their structure, particularly the large extent to which they are leveraged,
and contributed significantly to the financial crisis of 2007-2009.
7. Government officials predicted that dramatic decline in house prices could create
enough mortgage defaults to cause these institutions to fail.
Terms Introduced in Chapter 13
bank charter
bank holding company
defined-benefit pension plan
defined-contribution pension plan
dual banking system
economies of scale
economies of scope
eurodollars
Fannie Mae
financial holding company
hedge fund
London Interbank Offered Rate (LIBOR)
property and casualty insurance
term life insurance
underwriting
unit bank
universal bank
vesting
whole life insurance
Using FRED: Codes for Data this Chapter
Data Series FRED Data Code
Commercial banks USNUM
Banks with total assets over $20 billion FREQ5
Bank failures BKFTTLA641N
Return on equity USROE
Equity to assets ratio EQTA
Credit market assets held by domestic financial
sectors
TCMAHDFS
Held by commercial banks CBUSCCBTCMAHDFS
Held by private pension funds PPFTCMAHDFS
Held by brokers and dealers BDTCMAHDFS
Held by property & casualty insurers PCICTCMAHDFS
Held by life insurers LICTCMAHDFS
Held by money market mutual funds MMMFTCMAHDFS
Held by mutual funds MFTCMAHDFS
Held by government‐sponsored enterprises GSETCMAHDFS
Three‐month U.S. dollar LIBOR USD3MTD156N
Lessons of Chapter 13
1. The United States has a comparatively large but declining number of banks.
a. The large number of banks in the United States is explained by restrictions on branching,
both within and across state lines, that were imposed by the federal government in 1927.
b. The large number of banks in the United States is a sign of an anticompetitive legal
environment.
c. Since 1997, banks have been permitted to operate in more than one state. This change
has increased competition and driven many small, inefficient banks out of business.
d. Between 1933 and 1999, banks were prohibited from engaging in the securities and
insurance businesses.
e. Banking has been expanding not just across state boundaries but across international
boundaries.
i. Many U.S. banks operate abroad, and a large number of foreign banks do business
in the United States.
ii. Eurodollars—dollar deposits in foreign banks—play an important part in the
international financial system.
f. The financial industry is constantly evolving. With changes in regulations, financial
services can now be provided in two ways:
i. Through a large universal bank, which provides all the services anyone could
possibly need.
ii. Through small specialized firms, which supply a limited number of services at a
low price.
2. Nondepository institutions are playing an increasingly important role in the financial system.
Five types of financial intermediary may be classified as nondepository institutions.
a. Insurance companies:
i. Life insurance companies insure policyholders against death through term life
insurance and provide a vehicle for saving through whole life insurance.
ii. Property and casualty companies insure individuals and businesses against losses
arising from specific events, like accidents and fires.
iii. The two primary functions of insurance companies are to:
1) allow policyholders to transfer risk
2) screen and monitor policyholders to reduce adverse selection and moral
hazard.
b. Pension funds perform two basic services.
i. They allow employees and employers to make payments today so that employees
will receive an income after retirement.
ii. They spread risk by ensuring that those employees who live longer than others
will continue to receive an income. For this reason, pension funds may be
thought of as the opposite of life insurance.
c. Securities firms include three basic types of financial intermediary: brokers, mutual-fund
companies, and investment banks.
i. Brokers give customers access to the financial markets, allowing them to buy and
sell securities.
ii. Mutual-fund companies provide savers with small-denomination shares in large,
diversified investment pools.
iii. Investment banks screen and monitor firms before issuing their securities.
d. Finance companies specialize in making loans to consumers and businesses for the
purchase or lease of specific products, such as cars and business equipment.
e. Government-sponsored enterprises supply direct financing and provide loan guarantees
for low-interest mortgages, student loans, and agricultural loans.