Lecture 1: Introduction to Financial Institutions

Dr Lixiong Guo
Semester 2 ,2014

Part I

FINANCIAL INSTITUTIONS SPECIALNESS

The Role of Financial Institutions in the Economy

Flow of production goods and services

Flow of expenditures ($)

Producing Units
(Corporations)

Consuming Units
(Households)
Primary
Securities

Secondary
Securities

Flow of incomes ($)

Flow of productive services

Information Problems in Investing

Adverse selection (Hidden information problem)
The lender does not know the exact credit risk of the borrower.
Without screening, the lender is left with only high-credit-risk
borrowers for any level of interest rate they charge.

The solution to this problem is to sort out borrowers for different

credit risks before lending and charge them the appropriate
interest rates.

Mora hazard (Hidden action problem).

After obtaining the money, the borrower can take actions that
damage the interest of the lender. In the extreme case, the
borrower can abscond with the money.
The solution is to monitor, or check, the actions of the borrower.

Information Problems in Investing (cont.)

When household savers invest directly in corporations, they

duplicate each others effort in information collection and

monitoring.
These costs can be too high to justify the return on the
investment given the usually small stake each household saver
has in the borrower.
In addition, household savers usually lack the expertise to
effectively process information and monitor the borrower.

Liquidity Costs and Price Risk

Liquidity costs:
Household savers want to have ready access to their funds
whenever they need them. However, corporate equity and debt
are usually long-term in nature and sometimes lack a liquid
secondary market in which households can sell their securities.
Price risk:
The price of corporate equity and debt can change significantly
over even short period of time, i.e. they have high price risk.
However, household savers are usually more concerned with
preserving the value of their saving and thus dislike high price risk.
Because of (1) information costs, (2) Liquidity costs, and (3) price

risk, in a world without FIs, the level of fund flows between

household savers and the corporation sector is likely to be quite
low.

FIs Can Better Solve These Problems

An FI aggregate funds from a large number of households and

thus can have a much larger stake in a firm.

This results in economy of scale. The costs of information
collection and monitoring are significantly reduced per unit of
investment.
The FI has a much greater incentive to collect information and
monitor than individual households.

The FIs can offer household savers financial claims with high

liquidity and low price risk while themselves investing directly in

securities issued by corporations that are illiquid and have high
price risk.
e.g. Bank deposits are almost risk free and can have very short
maturities.

Asset Transformation
Primary securities: securities issued by corporations.
Secondary securities: securities issued by FIs.
One important function of FIs is asset transformation.

FI
(Brokers)

Households
Cash
Deposits/Insurance
Policies

FI
(Asset
Transformers)

Corporations
Equity & Debt
Cash

Asset Transformation (cont.)

Asset transformation is made possible by the following two

diversifications.
By investing in a portfolio of firms, the FI can diversify away
significant amount of firm-specific risk. This allows the FI to predict
more accurately its expected return on its asset portfolio.
By diversifying its source of funds, the FI can predict more
accurately its expected daily withdrawals and set aside cash to
meet these withdrawals without liquidating its entire long-term
investments.

Asset transformation leads to a mismatched balance sheet for

FIs, which expose FIs to certain risks.

Duration mismatch => Interest Rate Risk
Liquidity mismatch => Liquidity Risk

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FIs Function As Brokers

When functioning as brokers, FIs bring sellers and buyers of

securities together so that transactions can happen.

The FIs are involved as agents not principals and are usually
compensated with a fee for performing the services.
The FIs mainly provide information and transaction services.
The FIs can perform these services more efficiently than
individuals can because of economy of scale.

The main difference between brokers is whether they offer

advice or not, they are either

Full-service brokers: Offering advice on buying and selling
securities, make recommendations, provide research and compile
tailored investment plans.
Non-advisory brokers: Offering no recommendations or advice
regarding the appropriateness of your decision

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Types of FIs
There are many different types of FIs, each plays one or more

functions we just discussed.

Depository Institutions
In the U.S.: Commercial Banks, Savings Institutions, Credit Unions
In Australia: Banks, Building Societies, Credit Unions.

Finance Companies
Rely on short- and long-term debt and are not allowed to take deposits.

Securities Brokerage and Investment Banking

Investment Banks
Brokerages

Mutual Funds and Hedge Funds

Insurance Companies

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Regulations of FIs
FIs are special because the services they provide are crucial to

the economy. Failure to provide these services or a breakdown in

their efficient provision can be costly to both the ultimate sources
and users of the savings.
The negative externalities when something goes wrong in the
financial sector make a case for regulation.
Negative externality: Actions by an economic agent imposing
costs on other economic agents.

Safety and soundness regulations

Diversification requirement, Capital adequacy requirement
Investor protection regulations
Disclosure, Insider trading

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Financial Regulatory Framework in Australia

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Financial Regulators in Australia

APRA = Australian Prudential Regulation Authority.
Responsible for the prudential regulation and supervision of the
finance services industry.
ASIC = Australia Securities and Investments Commission
Responsible for market integrity and consumer protection across
the financial systems.
Set standards for financial market behavior with aim to protect
investor and consumer confidence.
Administers the Corporate Law to promote honesty and fairness in
companies and markets.

RBA = Reserve Bank of Australia

Responsible for the development and implementation of monetary
policy and for overall financial stability.

Part II

DEPOSITORY INSTITUTIONS

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How Do Commercial Banks Make Profits?

Lets list major items on a commercial banks balance sheet.
Assets

Liabilities

Shareholders Equity

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Yield Curve
At any point of time, interest rates on debt instruments of

different maturities (terms) are different.

The relation between terms of the debt instruments of identical
default risk and their market rates of interest is known as the
term structure of interest rates.
To display the term structure of interest rates, economists use a
diagram called yield curve.
The difference between the required yield on long- and shortterm securities is called the maturity premium (MP).

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Calculating Yield to Maturity

For example, a U.S. government zero coupon bond that

promises $100 in 1 year is currently trading at $94.56 and

another one that promises $100 in 2 year is currently trading at
$88.58. What are the yields to maturity of the two bonds?
94.56 =

100
(1+01 )

88.58 =

100
(1+02 )2

=> 01 = 5.75%
=> 02 = 6.25%

The relation between the yields and their maturity gives the term

structure of interest rates for risk-free bonds at that point of time.

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Net Interest Spread and Net Interest Margin

Net Interest Spread measures the difference between average

yield on earning assets and average costs of interest-bearing

liabilities.

Net Interest Spread measures the nominal average difference

between borrowing and lending rates, without compensating for
the fact that the amount of earning assets and borrowed funds
may be different.

Net Interest Margin measures the net return on the banks

earning assets.

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Off-Balance-Sheet Activities
The balance sheet itself does not reflect the total scope of bank

activities.
Banks conduct many activities off-balance-sheet.
Standby letter of credit (SLC): A guarantee by the issuing bank to
pay a third party should the buyer of SLC defaults on it payment.
Loan commitments: A contractual commitment to make a loan up
to a stated amount at a given interest rate in the future.
Derivatives transactions.

These items will move on the balance sheet as assets or

liabilities should certain contingencies occur and expose the

bank to various risks.
These activities are an important source of fee income for banks.

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Portfolio Shifts: U.S. Commercial Banks Assets

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Part III

SECURITIES BROKERAGE AND

INVESTMENT BANKING

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Key Activities of Security Firms and Investment Banks

Raising Funds
Public offering (underwriting) of debt and equity.
Private placement of securities
Securitization of assets

Advising
M&A, Restructuring
Broker and Dealer
Trading of securities
Trading and creation of derivative instruments
Prime brokerage

Asset Management
Managing pools of assets for clients.

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The Primary Assets Are Financial Market Securities

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Public Offering
In a public offering, securities are distributed directly to the public

at large.
In a private placement, securities are placed with a limited
number of institutional investors such as insurance companies,
pension funds and investment companies.
Public offerings must meet more stringent regulatory
requirements than private placements
The Securities Act of 1933 and the Securities and Exchange Act
of 1934 require that all public securities to be registered with the
SEC, unless there is a specific exemption.

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The Role of IB in Underwriting

The investment bank performs one or more of the following

functions
Advising the issuer on the terms and the timing of the offering.
Buying the securities from the issuer
Only in a firm-commitment underwriting

Distributing the issue to the public

The investment bank helps the issuer to reduce asymmetric

information and increase the proceeds that can be raised.

Conduct due-diligence and prepare prospectus

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The Typical Process of An IPO

Issuer contact an investment bank to form a underwriter

syndicate
The lead underwriter
Perform due diligence

Register the issue with the SEC

Advise the issuer on offer size and offer price
Road show
Specify a possible price range for the offering

When SEC approves the issue, the firm meets with the

underwriter syndicate and sets the final offer price.

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The Typical Process of An IPO

Public offering
If a issue is over-subscribed, the lead underwriter in general has
the power to allocate the hot issue to investors.
Lead underwriter provides price support.
Syndicate members commit to provide analyst coverage.

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Firm Commitment Underwriting

In the firm-commitment underwriting, the investment bank agrees

to buy the entire issue from the issuer at a negotiated price,

hoping to place them with the public investors at the (slightly
higher) offering price
The amount of money the issuer is going to receive is guaranteed.
However, the investment bank accepts the downside risk of selling
the securities to investors at a lower price than it paid to the issuer
To diversify this risk, the lead investment bank often assemble an
underwriting syndicate composed of other investment banks, referred
to as co-managers, that commit along with it to guarantee the
proceeds to the issuer and help with marketing the securities.

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Firm Commitment Underwriting (cont.)

The fee the investment bank earns is the difference between the

price it paid to the issuer and the price at which the investment
bank offers the security to the public.
This difference is called the gross spread, or underwriter
discount

The lead underwriter also commit to provide price support to

stabilize the market in the first few days of trading of an IPO.

Usually, firm commitment underwriting are only done for higher
qualify companies or where the investment bank is confident that
it will be able to resell the shares it is purchasing from the issuer.

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Clustering of IPO Gross Spread at 7%

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Best Effort Underwriting

In a best-efforts underwriting, the investment banker, acting as

an agent, agree to do its best to sell an issue to the public.

Instead of buying the securities outright, these agents have an
option to buy and an authority to sell the securities.
For the issuer, there is no guarantee of price and the amount of
money that can be raised.

The best efforts method is often used in issuing more

speculative securities of new and unseasoned companies.

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Example 4-1
An IB agrees to underwrite an issue of 20 million shares of stock

fro Murray Construction Corp. on a firm commitment basis. The

investment bank pays $15.50 per share to Murray for the 20
million shares of stock. It then sells those shares to the public for
$16.35 per share. How much money does Murray Construction
Corp. receive? What is the profit to the IB? If the IB can sell the
shares for only $14.75, how much money does Murray
Construction Corp. receive? What is the profit to the IB?
Suppose the IB agrees to underwrite the 20 million shares on a
best-effort basis. The IB is able to sell 18.4 million shares for
$15.50 per share, and it charges Murray $0.375 per share sold.
How much money does Murray raise? What is the profit to the
IB?

Part IV

RISKS OF FINANCIAL INSTITUTIONS

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Risks of FIs
Interest Rate Risk
In mismatching the maturities of assets and liabilities as part of the
asset transformation function, FIs potentially expose themselves
to interest rate risk.
Market Risk
The values of assets in the trading portfolio of a FI is affected by
changes in market variables, which expose FIs to market risk.
Credit Risk
This refers to the risk that promised cash flows are not paid in full.
Off-balance-sheet Risk
The risk incurred by FIs due to off-balance-sheet activities.

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Risks of FIs (cont.)

Foreign Exchange Risk
The risk that exchange rate changes can affect the value of an
FIs assets and liabilities denominated in foreign currencies.
Sovereign Risk
Sovereign risk is a different type of credit risk when an FI
purchases assets of foreign governments or corporations.
A foreign borrower may be unable to repay the loan even if it
would like to when the foreign government prohibits or limits such
payments.
The FI usually has little, if any, recourse to the local bankruptcy
courts or an international civil claims court in the event of default.
The major leverage available to an FI is its control over the future
supply of loans or funds to the country concerned.

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Risks of FIs (cont.)

Liquidity Risk
The risk that a sudden surge in liability withdrawals may leave an
FI in a position of having to liquidate assets in a very short period
of time and at low prices.
Example 7-3: Impact of liquidity risk on an FIs equity value

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Risks of FIs (cont.)

Operational Risk
The BIS definition: the risk of loss resulting from inadequate or
failed internal processes, people and systems or from external
events.
Employee fraud and errors constitute an important type of
operational risk.

Insolvency Risk
The risk that an FI has insufficient capital to offset sudden decline
in value of assets relative to liabilities.
A consequence or outcome of one or more of the risks described
above.