lOMoARcPSD|6389959

Lecture Notes

MANAGEMENT OF FINANCIAL INSTITUTIONS

May, 2022
FINANCIALINSTITUTIONS: ACTIVITIES AND FUNCTIONS
Financial Institutions and Changing Times For These Institutions
Financial institutions are looked at as “money specialists”; as opposed to
specialists in consumer or industrial products like soap or machinery.
Until recently little attention was paid to the fact that financial institutions
have their own financial management problems. Instead the common belief
was that finance institutions existed to solve the financial management
problems of others-not a surprising thought because most individuals have
relationships with several finance institutions, beginning at an early age. A
typical consumer might have a checking account at a local bank; a credit
card issued by a bank headquartered in another state, a home mortgage from
an area savings or loan association; an automobile loan from the credit union
at work; a life insurance policy from an insurer with offices in many states,
an automobile and home-owners insurance from a different firm; savings
from retirement entrusted to a mutual fund; and an account with the regional
office of the national brokerage firm.

Many financial institutions operate in many countries, and people are so

accustomed to them, that their existence, functions and their continued
operations are often taken for granted.

In the 20th Century, widespread concern emerged about the safety and
soundness of financial institutions that the state and legislators enacted laws
to ensure the public that the business to which its funds were entrusted were,
infact viable.
By law, the activities of most financial institutions were limited so that, for
several decades, their financial management was not a terribly complex
process. Managers engaged in specific activities and were legally
permissible, charging prices whose maximums are legally mandated, and
incurring costs as legally determined.
Regulators set prices and costs such that financial institutions were usually
profitable and relatively few failed.
With time, the perceived need for regulation of financial institutions also
diminished. In addition, as interest rates rose in the 1980’s and 1990’s,
depositors became dissatisfied with the low rates paid by financial
institutions and withdrew their funds in search for higher returns elsewhere.
Many financial institutions were unable to respond because the interest rates
they could offer were limited by the laws of the 1930’s forcing financial
markets to be liberalized. Government regulators responded to these
developments, and since 1992, in the Kenyan case, many restrictions on
financial institutions have been loosened or removed.
The deregulation coincided with, and was encouraged by, rapid
developments in technology and innovation in the products financial
institutions offer.
Notably, although virtually all financial institutions are still regulated,
regulations are less restrictive than in previous decades.
The turbulent environment meant that financial institutions and markets
were faced with managerial challenges. Thus due to dynamics in the
financial market environment, complexity of managing financial institutions
has increased dramatically.
There is the growing tendency to take the health and success of financial
institutions for granted. On the other hand events have made financial
success more difficult to achieve than any time in recent times.

Following failure of financial institutions customers tend to run for their

money; which has implications for management of financial institutions.
Failure of financial institutions leads to failure of the financial market which
translates to global financial crises because the effects of crises in one
financial institution is usually felt in other financial institutions in the same
country and even extended to other foreign financial markets.
Research does indicate that there are times financial institutions are allowed
to fail to give room to the regulator to come up with solutions and to review
the regulations where need be.
Financial Versus Real Assets
Assets include a broad range of both tangible and intangible items that
provide their owners with expected future benefits. An automobile, a
savings account, a favourable reputation among others provide future
benefits to an entity. A firm expects future benefits in the form of cash from
the sale of its products and services as well as from owning a recognizable
trademark or slogan, trademark or a patent.

Assets are numerous, thus it is convenient to divide them into real assets and
financial assets.
Real assets are those expected to provide benefits based on their
fundamental qualities. A corporation’s main computer provides benefits
based on its speed, the size of its memory, the case of its use, and the
frequency with which it needs repair.
Financial assets are on the other hand assets expected to provide benefits
based soley on another party’s performance. They are claims against others
for future benefits. Foe example; a bank savings account will provide future
 benefits only if the bank continues to operate and to pay interest on the
account, the account holder depends on the bank’s performance for any
benefits from the financial asset.
Notably one party’s financial asset is another party’s financial liability. The
latter has an obligation to provide future benefits to the owner of the
financial asset.
Financial Institutions Versus Nonfinancial Institutions
Most business firms exist to acquire and use real assets in a way that makes
the value of future benefits received greater than the cost of obtaining them.
Financial institutions on the other hand exist to acquire and use assets so that
the value of their benefits exceeds their costs.
Majority of financial institutions hold financial assets while other firms hold
real assets. Financial institutions use funds from their own creditors and
owners to acquire financial claims against others. They may extend loans, or
may purchase shares. The future benefits financial institutions expect to
receive thus depend upon the performance of the parties whose financial
liabilities they purchase.

1.1Primary Securities Versus Secondary Securities

Primary securities are direct financial claims against individuals,
governments and nonfinancial firms
Secondary securities are the financial liabilities of financial institutions

1.2 Direct Versus Indirect Investments

Direct investment involves the transfer of funds directly between parties. For
example; extending a loan to a friend, or an individual purchases stock in a
corporation.
Indirect investment on the other hand occurs when the transfer of funds is
 through a financial institution. The claim of the investor in this case is on the
financial institution.
1.3 Types of Financial Institutions
Financial institutions channel funds from those with surplus funds to those
with shortages of funds
6
Financial institutions are classified into various categories. The main types
of financial institutions are;
1.3.1 Depository institutions
These are further categorized into commercial banks and thrift institutions.
Commercial banks are depository institutions whose major assets are loans
and advances and whose major liabilities are customer deposits. Loans from
commercial banks are broader in range including consumer loans,
commercial loans and real estate loans.
Liabilities of commercial banks are majorly customer deposits.

Thrift institutions on the other hand are depository institutions in the form of
savings and loans, savings bank and credit unions. Thrifts generally perform
services similar to commercial banks, but they tend to concentrate their
loans in one segment such as real estate loans or consumer loans.
1.3.2 Insurance Companies
Are financial institutions that protect individuals and corporations
(policyholders) from adverse events. These main ones include; Life
Insurance, Property insurance and Composite insurance. Reinsurance is a
branch that deals with insurance of insurance companies.
1.3.3 Finance Companies
Financial intermediaries that make loans to both individuals and businesses.
Unlike depository institutions, finance companies do not accept deposits but
instead rely on short and long-term debt for funding.
1.3.4 Pensions Funds
Financial institutions that offer savings plans through which fund
participants accumulate savings during their working years before
withdrawing them during their retirement years. Funds originally invested in
and accumulated in a pension fund are exempt from current taxation.
1.3.5 Securities Firms and Investment Banks
Financial institutions that underwrite securities and engage in related
activities such as brokerage, credit rating agencies etc.
1.3.6 Pensions Funds
These are financial institutions that offer savings plans through which fund
participation accumulate savings during their working years before
withdrawing them during their retirement years.
1.6.7 Investment Companies
Provide a means through which small savers can pool funds to invest in a
variety of financial instrument. The resulting economies of scale offer
investors the benefits of professional portfolio management. Among the
investment companies include; Mutual Funds, Money Market Mutual Funds
These are financial institutions that pool financial resources of individuals
and companies and invest these resources in diversified portfolio of assets.

Intermediaries & Functions of Finance Intermediaries

Financial intermediaries and financial institutions exist to contribute towards
economic performance
Satisfying the needs of investors: To provide with new instrument that offer
a wider range of opportunities for risk management and transfer of
resources.
Transaction cost rationale:
Lowering transactions costs or increasing liquidity
Financial intermediaries can reduce such costs through brokerage and the
 creation of their own financial liabilities e.g banks – issuing loans.
Information processing and monitoring rationale
Reducing agency costs arising either from information asymmetry between
market participant or incomplete monitoring of their agents’ performances.
Other benefits Reduction include:
 Operator of the payment system rationale
 To complete the markets’
 Reduction of search costs, Portfolio selection costs and Minimization of
liquidity associated issues
 Reduces the cost of information asymmetry

2.1 REGULATING FINANCIAL INSTITUTIONS

2.1Goals of Financial Regulation
Key Principles of Regulation:
  To prevent market failure (financial collapse) due to externalities
 Promotion of competitive markets or constraints on competition for the
benefits of some suppliers
 Enhancement of consumer welfare including protection from fraud and
monetary (macro-economic) policy considerations
 Enhancing market power and addressing problems relating to information
The main objective should be to ensure stability of the financial system
while prohibiting competition to protect certain financial institutions.
2.2 Rationale of Financial Regulations
 Should be based on the recognition of the fact that monitoring
financial market is costly and necessarily imperfect.
 Legislators and government agencies usually provide a justification for
regulations.
 It is believed that unannounced motivations often guide the decisions of
regulators
Government through its Agencies, must
 Have its own control mechanism must have indirect control
mechanism encompassing:-
Incentives Restraints
 Set Regulatory Standards
 Recognition of its Limitation in risk assessment
Design cost effective regulations
Enforcing regulations – to ensure that regulations are adhered to.

Main Regulations:
 Banking Sector; Banking Act, Central Bank Act
Majorly stipulates the scope of banking business, capital adequacy, cash
ratio, liquidity and reserve requirements, disclosures and risk measures
 among others.
 Retirement Institutions; Pension Funds and Provident Funds; Retirement
Benefits Act
 Insurance Companies; Insurance Act
 Capital Markets; Capital Markets Act
All these regulations are reviewed occasionally to accommodate any
changes in the financial market, economy and global environments.

2.3 What is Regulated?

 Licensing restrictions
 Entry Barriers
 Nature of Activities undertaken
 Consumer Protection; the Deposit Protection Fund (DPF) and Investor
Compensation Fund (ICF)
 Solvency Requirements by stipulating capital levels
 Liquidity requirements
 Asset Structure; through investment guidelines and
portfolio composition

 Product regulation; Nature and types of financial instruments to be used

for facilitating financial transactions
 Management; Appointment of managers of financial institutions
 Interest rate ceilings; Open Market Operations or Mechanism such as
through use of Treasury Bills

2.4 Types and Challenges of Financial Regulation:

- Macroeconomic controls
- Allocation controls
- Structure controls
- Prudential controls
- Organizational controls
 - Protective controls

Challenges of Regulating Financial Institutions

 Regulatory avoidance; The relationship between the regulator and the
regulated is observed as that of a ‘cat and mouse’ game
 Where certain parties are disadvantaged, they will look for loopholes in the
regulation, leading to regulatory avoidance and evasion
 Innovations; Whereas regulations are imposed there is need to ensure that
new financial instruments, new financial institutions including their
regulatory institutions, and new methods of effecting transactions do
continuously evolve in the financial market.
 Technological changes calls for embracing new procedures, processes,
linkages and institutional restructuring. Regulations should therefore be
broad enough to accommodate technological innovations
 Economic uncertainties; This calls for regular review of regulations to
accommodate consumer needs which differ across financial institutions
 Regulations should be introduced gradually to avoid shocks in the
financial system as these could lead to financial market failure

2.5 Who are Regulated?

 Commercial Banks
 Thrift Institutions
 Credit Unions
 Insurance Companies
 Capital Market Institutions
 Retirement Benefits Institutions such as Pension Funds
 Other financial institutions

2.6 Areas of continued concern in regulations

 Risk control
  Investor or client protection,
 Stability and solvency of financial institutions
 Off-balance sheet activities and their disclosures
3.0 LEVEL OF INTEREST RATES
Interest rates are charges on financial instruments and denotes
prices of assets that are determined on the basis of market
conditions guided by the forces of demand and supply.
3.1 Why Interest Rates are Important to Managers
Managers majorly do focus on decisions that are critical to the future of their
institutions. Their decisions rely on often conflicting opinions about the
direction of the economy and interest rates.
Managers must be able to evaluate available data and forecasts so as to make
informed decisions. The evaluations in turn require knowledge of the
principles on which forecasts are based. Thus the managers expectations
about interest rate movements will certainly influence the decision
Often economists are unable to agree on the future direction of interest rates,
and managers must exercise judgment in evaluating available forecasts. The
theories of interest rates provide the foundation on which economic forecasts
base their expectations about interest rate changes, which in turn affect
managerial evaluation and decision making.
3.2 The General Level of Interest Rates
Theories of interest rates follow various conventions:
1. Models usually focus on determination of the equilibrium level of interest.
Notably, the financial markets are seldom if ever in equilibrium, but are in
the process of approaching equilibrium
as they respond to the numerous factors that cause an imbalance between
supply and demand
2. Economic models rely on a number of assumptions required to simplify the
 real world
3. Theories explaining the general level of interest rates do just that; they focus
on the rate of interest

3.3 The Main Theories of Interest Rates

There are may compatible theories that attempt to explain interest rate
movements, although they are not equally useful for forecasting changes in
interest rates.

3.3.1 Loanable Funds Theory

This theory focuses on the amount of funds available for investments
(supply of funds) and the amount of funds borrowers want (Demand for
funds).

Supply of Loanable Funds

The loanable funds theory categorizes borrowers and lenders into;
households or consumers, businesses, governments and the foreign sector.
Governments supply almost no loanable funds, but is important to
understand the forces affecting the savings decisions of individuals,
businesses and the foreign sector.
The expected Rate of return and the Decision to Save: Economic units
always have several choices for disposition of funds. They can spend money
on consumable goods; they can save money by investing in
financial assets, or they can choose to hold, or hoard money. But once the
amount of consumption has been determined, there is still a choice between
investing and holding money.

A key motivation for savings is the expected rate of return. Since investors
have a time preference for consumption, they will reduce current
consumption to save money only if they receive some reward for doing so.
That reward is the expected rate of interest, which must always be positive
to induce substantial postponement of consumption.
Economists have also identified several additional motivations for savings;
which suggest that some funds will be saved even if the expected rate of
interest is zero.

Holding or hoarding cash requires postphonement of consumption but,

unlike saving, does not provide a positive rate of return. Three motivations
have been identified for hoarding money; transaction demand, precautionary
demand and speculative demand. Because individuals and businesses cannot
always assume that the timing of cash inflows and cash expenditures will
coincide, they usually need to maintain ready cash to handle transactions. In
addition, some cash will be held as a precaution against unforeseen
contingencies. Neither of these motivation is tied to the expected rate of
interest.

Households: Most people virtually save for future needs either because they
recognize that illness or other emergencies could jeopardize their financial
position, or because they will need funds to support themselves after
retirement. Other people may be involved in involuntary savings
programmes. The income of a household is also significant. Low income
families often spend all available funds on the basic necessities of life,
leaving nothing for alternative uses. At the opposite side of the spectrum,
high-income families may be unable to consume all available funds even if
they want to, so they must invest regardless of the expected interest rate.

Businesses: Although businesses are usually demanders, they also supply

loanable funds. Expected interest rates may have some bearing on the
decisions of businesses to save by investing in financial assets, but other
important factors are potential real asset investments, the nature of the
business enterprise, and the philosophy of the firm’s managers and owners.
Money Supply: The supply of loanable funds is affected by changes in the
total money supply which are influenced by monetary policy. An increase in
money supply makes more money available for savings after consumption is
satisfied.

Foreign Sector: Funds available domestically are also influenced by the

behaviour of foreign investors. The key factor influencing funds provided by
the foreign sector is not simply the expected rate of interest but the
difference between that rate and the expected rate available in other
countries.

Demand for Loanable Funds

The forces determining the demand for loanable funds – the total funds
households, businesses, government units, and the foreign sector want to

17
borrow – is tied much more closely to expected interest rates than is the
supply.

The Effect of Expected Interest Rates on Borrowing: Most business

borrowing is sensitive to expected interest rates. The funds raised by
nonfinancial firms will depend upon their optimal budgets for investment in
real assets. An optimal capital budget reflects a firm’s investment
opportunities. It occurs at the point where the marginal returns from
investing in real assets are equal to the marginal costs of raising the funds,
and the net present value of incremental investments is zero. At lower rates
of interest, the capital budget will be larger, because a lower discount rate
will be used for calculating net present value. The investment opportunity
schedule and the resulting demand for loanable funds are inversely related
to expected interest rates.

Non-interest factors: As with the supply of loanable funds, non-interest

factors motivate the demand for borrowing. Government units at the local,
state, must borrow regardless of interest rates. Government units borrow
whenever they face budget deficits or when they need to finance major
construction of roads or government buildings. In fact, government demand
for money is relatively inelastic with respect to interest rates.

Foreign Sector: Foreign sector borrowers also seek funds in the domestic
credit markets. Foreign business borrowers are motivated by the same
factors affecting domestic firms.
The Rate of Interest

18
 The loanable funds theory follows classical supply/demand analysis and
explains the equilibrium rate of interest as the point of intersection of the
supply and demand schedules. Many analysts use the loanable funds
framework to explain and anticipate the movement of interest rates.

3.3.2 Loanable Funds Theory and Interest Rate Forecasting

Since the loanable funds theory explains the rate of interest as the point of
intersection between supply and demand curves, political, economic, or
behavioural factors shifting either curve are expected to result in a change in
interest rates.

Changes in Supply or Demand

Government policy as portrayed by the size of fiscal budget affects the
demand for loanable funds. Taxation has also the potential for shifting the
supply or demand curves. An increase in corporate taxes reduces after-tax
profits and thereby reduces the incentive for additional business spending.
Smaller capital budgets lower the demand for borrowed funds. Monetary
policy through its impact on the money supply also affects interest rates. An
increase in money supply relative to money demand leads to higher savings,
shifting the supply curve to the right. This subsequently leads to lower
interest rates, at least in the short-run.

3.3.3 Inflation and the Level of Interest Rates

The expected yield at the time of investment is the nominal return. If there is
no inflation, the real return is equal to the nominal return. But if inflation is

19
anticipated during the coming year, lenders will build in some
 protection against the decline in purchasing power of their dollars by
increasing their required ex ante rate of return. The size of the premium for
expected inflation and the way it is determined have been the subjects of
much theoretical and empirical investigation. The real rate of interest in the
rate of exchange between present and future goods, while the rate of
exchange between present and future dollars is the nominal rate of interest.

The Fisher Effect

The relationship is summarized as; the nominal rate of interest reflects the
real rate of interest and a premium based on the expected rate of inflation.
Rn = Rr + E(p) Where;
Rn is the nominal rate Rr is the real rate and
E(p) is the expected rate of inflation

4.0 THE TERM STRUCTURE OF INTEREST RATES

The term structure of interest rates is the relationship between security yields
and maturities, all else equal.

4.1 Unbiased (Pure) Expectations Theory

20
 This theory holds that observable long-term yields are the average of
expected, but directly unobservable, short-term yields, where short-term is
defined as a year.

Assumptions of the Unbiased Expectation theory

The pure expectations theory rests upon important assumptions about
investors and markets.

- Investors are indifferent between owning a single long-term security or a

series of short-term securities over the same period. Thus maturity alone
does not affect investor’s choice of investments.
- All investors hold common expectations about the course of short-term rates
- On average, investors are able to predict rates accurately. Their expectations
about future rates are unbiased in the statistical sense - they are neither
consistently low nor consistently high.
- There are no taxes, information costs, or transaction costs in the financial
markets. Investors are free to exchange securities of varying maturities
quickly and without penalty.
The main implication of the pure expectations theory from these
assumptions is that; for a given holding period, the average expected annual
yields on all combinations of maturities will be equal.

Criticisms of the Unbiased Expectation Theory

21
 -Investors assume indifference between short-tem and long-term securities
and ignores the fact that a long-term investment may be riskier than a series
of short-term investments.
-Investors are never certain that personal circumstances will allow them to
follow initial investment strategies throughout the holding period. If
emergencies arise, they may have to sell long-term securities at a loss when
forced to abandon their initial plans.
-Issuance of securities have no influence on the term structure appears to
contradict the negotiation process that actually occurs between borrowers
and lenders in many financial markets

4.2 The Liquidity Premium Hypothesis

According top this theory, today’s long-term rates reflect the geometric
average of intervening expected short-term rates, plus a premium investors
demand for holding long-term securities instead of a series of short-term,
less risky investments.

4.3 The Modified Expectation Theory

This theory contends that expectations of future rates do, in fact, determine
today’s yields. Thus if interest rates are expected to rise in the future, lenders
may wish to lend short-term to avoid locking in today’s lower spot rates.
Such a long-term commitment would not only prevent reinvestment of
principle at the expected higher rates but also would subject lenders to
capital losses should shell their investments before maturity. On the other
hand, borrowers will wish to borrow long-term to avoid expected higher
interest costs.

22
4.4 The Segmented Markets Theory
Argues that there are really is no term structure, and it has gained especially
strong support among market participants. The segmentation theory suggests
that different spot rates on long-term and short-term securities are explained
not by a liquidity premium to induce lenders to switch from short-term to
long-term securities, but rather by separate demand/supply interactions in
the financial markets.
According to theory, short-term yield result from interactions of individuals
and institutions in the short-term market segment, the same is true of yields
on long-term securities

4.5 The Preferred Habitat Theory

Assumes that although investors may strongly prefer particular market
segments of the market, they are not necessarily locked in to those segments.
Thus investors time preferences for spending versus saving influence their
choice among securities. They will lend in markets other than their preferred
one, but only if a premium exists to induce them to switch.

5.0 INTEREST RATE RISK

Risk is a fact of life. The potential variation in returns caused by unexpected
changes in interest rates is known as the interest rate risk.

5.1 The Price/Yield Relationship

Although unexpected changes in interest rates affect virtually all financial
instruments, they do not affect them equally. Differences in interest rate

23
 risk occur because of the type of instrument, the maturity, the size and
timing of cash inflows, and the planned holding period relative to the asset’s
maturity.

5.2 Fundamental Principles of Financial Assets

The following are the fundamental principles of financial asset prices:

Individual Investors Cannot Change Prices: Most financial markets are

characterized by many participants and much publicly available information.
An individual investors as only one of the many buyers and sellers is unable
to influence the prices of a financial asset.

Supply/Demand is important: Market prices of financial assets change

frequently. Thus knowing the price of a Treasury Bill in one day for
example, does not mean that one will know it the next day or even later in
the day. Thus managers must understand factors associated with price
changes.
Basic economic theory establishes the influence of supply and demand in
setting non-financial market prices. Financial assets tend to be affected by
these forces. Two supply/demand relationships are at work. One is the
supply and demand for a particular financial asset and generally, the larger
the quantity of a financial asset, relative to a similar assets, the lower the
price. A corporation’s sale of new stock therefore often results in a decline
in price as supply increases.
An increase in the total supply of loanable funds with no increase in the
demand for borrowing will result in higher financial asset prices as more
lenders bid for the right to hold the existing stock of financial assets

24
 instead of cash. Since new financial assets are always being created, and
existing ones eliminated as borrowers repay previous liabilities, prices
:often change as a result of changes in overall supply and demand.

Risk is important: There is more to the determination of prices than

supply/demand relationships. All else equal, the price of a riskier asset will
be lower than that of a less risky one because most financial market
participants are risk averse. Risk aversion causes investors to demand higher
expected rates of return from riskier investments.

The price/yield relationship is expressed as: n

Po = ∑ Ct
t
t=1 (1+y*)
Where Po is the price of the security, Ct are the cash flows associated with
the security, t is the time to maturity and y* is the market yield. This
relationship states that the price of an asset is equal to the present value of its
future cash benefits discounted at y*, the rate of return the financial markets
expect for the riskiness of the asset. The expression reveals the relationship
between price and yield.

Price and yield change simultaneously: Changes in both price and yield is
caused by underlying economic conditions. Notably, the supply of securities
is also the demand for loanable funds, just as the demand for securities
reflects the willingness to supply loanable funds. A decrease in the supply of
securities corresponds to a decrease in the demand for loanable funds.

25
Including risk in the relationship: Where risk increases, investors expect to
be compensated for bearing a high level of risk leading to an increase in the
market yield.

5.3 Estimating the Yield of a Bond Example:

Given two bonds the 3 7/8 per cent and 10 3/8 per cent, and assuming a par
value of $1000,annual interest payments , and exactly five years to maturity,
calculate their yields to maturity if the former was selling for 78.625% and
the later at 99.875%.

Bond 1;
n
$786.25 = ∑ $38.75 + $1000
t=1 (1+y*)t (1+y*)5 Yield approximately 9.43%

Bond 2:
n
$998.75 = ∑ $103.75 + $1000
t=1 (1+y*)t (1+y*)5 Yield approximately 10.41%

26
 Notably, when markets yields fall unexpectedly, the prices of existing
financial instruments rise; when market yields rise unexpectedly, the prices
of existing financial assets fall.

6.1 INTEREST RATE RISK MANAGEMENT

6.2 The Concept of Duration
Most scholarly on financial institutions mention the concept of duration.
Duration is defined as the weighted average time over which the cash flows
from an investment are expected, where the weights are the relative present
values of the cash flows. It is an alternative to maturity for expressing the
time dimension of an investment. Focusing on maturity ignores the fact that
for most securities, some cash benefits are received before the maturity date.
Benefits received before maturity is often substantial, especially for bonds
with relatively high coupon rates or annuities. Thus it is difficult to ignore
time dimension when estimating cash flows.
The basic expression for the market value of an investment takes into
account the aspect of duration:
N
Po = ∑ Ct
t=1 (1 + y*)t

Since the market value of an investment equals the present value of expected
benefits, and because discount factors (1+y*)t are exponential functions of
time, early payments are discounted less than those received later.
Differences in discounted value become more pronounced as t increases.
Thus the effective maturity; that is, the time period over which the investor
receives cash flows with relatively high present value- may differ from the
contractual or legally specified maturity. Duration is the measure of this
effective maturity.

ILLUSTRATION
A bond with a coupon rate of 37/8 percent matured in 1990 and was selling
for $800 on May 20 1985. The other bond had a coupon rate of 10 1/8
percent also matured in 1990 and was selling for $1,008.75 on May 20,
1985. Although they both had five years to maturity as of 1985, their coupon
rates differed substantially, so that a relatively greater proportion of the cash
flows from the 10 3/8 bond was expected earlier than from the 3 7/8 bond. In
other words, the effective maturity of the10 3/8 bond was less than the
effective maturity of the 3 7/8 bond. Duration is a measure of time that
captures this difference.

6.02 Estimating The Duration of a Bond

The Duration Equation is given by:

N
∑ Ct(t) DUR = t=1 (1 + y*)t
N
∑ Ct
t=1 (1 + y*)t

Duration of Bonds with Equal Contractual Maturities 3 7/8 of per cent

End of Cash flows Present Value Relative Weight Weighted
Year in 1985 (@9.02%) (% of Total Time Period
Present Value) (1) x (4)
28
 1 $ 38.75 $35.54 4.44% 0.0444 Years
2 38.75 32.60 4.08 0.0815
3 38.75 29.91 3.74 0.1121
4 38.75 27.43 3.43 0.1372
5 1038.75 674.52 84.31 4.2157
800.00 100.00 4.5910 Years

DUR = $35.54(1) + $32.60(2) + $29.91 (3) + $27.3(4) + $674.52 (5)

$800

= $3,672.79
$800

=4.5911Years

The equation above shows that the duration of a financial instrument is

based on a complex interaction of factors; cash flows, their timing, and the
current market yield. If any of these changes, the duration of the instrument
will change. One can also compare the duration of several investments even
if they have different yields, cash flows or contractual maturities. It is also
possible for two or more assets with very different characteristics to have the
same duration.

DURg = 1 + y*
Y* - g
The above expression indicates that the expected rate of return, y*, the
higher the anticipated growth in dividends the greater the stock’s estimated
duration.

6.3 General Properties about Duration

1. The duration of any instrument is positively related to maturity, except for
maturities in excess of 50 years .The duration of the bond at each market
yield increases with maturity.
2. There is an inverse relationship between duration and current market yield,
the discount rate in the duration equation. As y* increases, the present value
of distant cash flows gets exponentially smaller. Thus, the weight given to
distant time periods in the numerator of the duration equation also gets
smaller, lowering duration.
3. Duration is inversely related to coupon rate, because high coupon bonds
provide a greater proportion of their cash flows earlier than low coupon
bonds. The duration of a Zero coupon is equal to its maturity.
4. The duration of a stock paying no dividend is equal to the planned holding
period, because the cash inflow from the sale is the only one anticipated. In
addition the longer the planned holding period, the longer a stock’s duration.
Additionally, the duration of a stock increases with decreases in the current
expected yield and the higher the interim cash dividends, the lower a stock’s
duration.

6.4 The Relationship Between Duration and Price Change

Duration is important in assessing an institution’s interest rate risk because
for a given change in market yields, percentage changes in asset prices are
proportional to, but of opposite sign from the assets duration. Although the
bond theorems allow an analyst to anticipate price changes based on one
characteristic at a time, the relationship between duration and price changes
 considers all characteristics simultaneously.

6.5 Asset/ Liability Management

30
 Because financial institutions interact in the financial markets one critical
element is to manage the spread or the dollar difference between the interest
earned on assets and the interest cost on liabilities. The spread expressed as a
percentage of Total Assets gives the
Net Interest Margin or the NIM. Therefore;
NIM=Interest on Assets – Interest Cost on Liabilities
Total Assets
If the NIM is high enough, the institution may use it to offset the non-
interest costs of the intermediation and brokerage it provides.
Asset Liability Management is an integrated approach to financial
management requiring simultaneous decisions about the types and amounts
of financial assets and liabilities the institution holds

NOTE
The objectives of a financial institution will be affected by;
 Customer needs
 Ownership structure of financial institutions

7.1 RISK AND PERFORMANCE ANALYSIS OF

DEPOSITORY INSTITUTIONS
7.2 Performance Evaluation
The objective of performance evaluation and the information used in such
analysis vary depending on the evaluator’s perspective. Regulators may
focus on potential loan losses and capital adequacy ratios s while

31
investors may be more concerned about after-tax profits and depositors on
liquidity Many stakeholders with different motivations evaluate the
performance of depository institutions, however, all attempt to evaluate
accounting and other data to assess the financial position of an institution at
a point in time to determine how well it has been managed. Results of such
an analysis form a basis for projecting the institution’s future performance.
A thorough performance analysis may assist management in diagnosing
areas of greatest strengths and weaknesses and in formulating plans for
improvement of asset/liability decisions.

Differences in regulatory and accounting standards for reporting financial

data leave some discretion to managers of depository institutions in
evaluating performance. Accounting for tax purposes must follow somewhat
different guidelines than regulatory accounting and both differ from the
generally accepted accounting principles. In analyzing financial
performance and risk of commercial banks off-balance sheet items should
also be taken into account since they may have significant effect on these
variables.

It is often helpful to analyze depository institution managers based on

different aspects of their activities, including liquidity, investment, loan
portfolio, capital and interest rate sensitivity. Common Size Statements and
Trend Analysis
Apart from calculating financial ratios, an analyst can acquire useful
information by expressing balance sheet accounts as a percentage of total
 assets and income statement items as percentage of total revenues.
o find useful input in the patterns of financial rations over

32
time. Trend analysis thus reveals long-term patterns in financial measures,
indicating whether a firm’s performance improving or deteriorating.

Performance evaluation is more complicated than simply calculating ratios

and common-size statements. Interpreting the ratios is usually a more
difficult task. Ratios also give informative results only when compared
either with a standard for the industry or industry subgroup or with the
firm’s recent past performance.

Where can industry information be obtained?

To perform a careful analysis, an analyst needs information on trends and/or
comparative-benchmarks for similar-size peers. This information may be
obtained from the regulator or from the public domain where the regulator
requires the information to be publicly made available such as in the case of
banks or quoted companies.

7.02 Categories of Performance Evaluation

Ratios are categorized according to the area of performance with which they
are most closely connected. Ratios that can be used are various, thus it is the
analyst who determines which ratios are the best for informing the decision
at hand. Notably, data availability, sources of industry data or special
purposes for the analysis may lead to analyst choosing one measure as
opposed to another.

33
Before choosing among many possible ratios or common-size calculations,
an analyst is well-advised to select the industry standards to use for the
comparison.

Industry Structure
Commercial banks hold the most assets among depository institutions as
well as among non-depository financial institutions
Commercial banks facilitate most financial transactions in the financial
system of any economy. However commercial banks differ in terms of their
asset composition, in terms of size and in terms of their organization
structure.
Assets of commercial banks include;

Cash and deposits from Depositories: Includes coins and paper and cheques.
Also includes reserves with the Central bank, deposits with other banks

Securities Held: Include treasury bills, treasury bonds, corporate bonds and
other securities.

Loans and advances to customers: Loans are the single largest assets for
banks of all sizes, but within the general category, small and large banks
differ significantly. Real estate loans are loans secured by real property and
consist primarily of commercial and residential mortgages Commercial and
industrial loans are extended to industries and businesses. Consumer loans
are extended to households. The main challenge facing depository
institutions is managing the loan portfolio.

34
Other Assets: Property and equipment, plant and building, fixtures and
fittings and other tangible and intangible assets.

Liabilities of Commercial Banks

The main liability of commercial banks is customer deposits.
Deposits: Within this category are accounts with varying interest rates
transaction balances and maturity characteristics. The main accounts are
demand deposits and time and savings deposits.
Borrowings: This includes borrowings from other financial institutions or
issue of debt instruments such as corporate bonds.
Other Liabilities: Include accounts payable and accrued expenses

Equity Capital
This is equity of commercial banks including common stock and retained
earnings.

Income and Expenses of Commercial Banks

From the balance sheet of a commercial bank it follows that income and
expenses of large and small banks differ. Among the main incomes include;

Interest Income: Because loans are a larger proportion of assets in

commercial banks, interest and fees on loans are more important source of
their income.

35
Service charges on Deposits: Service charges are a small proportion of
operating income for banks of all sizes.

All Other Operating Income: This includes charges for expertise offered by
banks to other institutions.

Expenses of Commercial Banks

Small and large banks tend to have different expenses.

Interest Expenses: Interest on deposits dominates total expenses. Other

interest expenses include payment of interest on debt instrument issued by
the particular financial institution.

Provision for Loans and Advances: Loans that have the likelihood of being
repaid are provided for and the expense charge in the income statement.

Salaries, Wages and other employee benefits: this constitute a relatively

large amount of non interest expense. As commercial banks adopts new
technology, amounts paid to employees significantly reduce.

Other Non-interest Operating Expense: Includes expenses incurred for bank

premises such as depreciation, advertising and supplies expenses.

Profits of Commercial Banks

36
Net operating income is the difference between total operating income less
total operating expense. The net income reflects the impact of all managerial
activities on profits for the reporting period

Performance of Depositories
These can be analyses using composite analysis or financial ratio analysis.
Among the indicators are: Asset Growth
Profits Growth Equity growth

7.03 Performance Indicators of Commercial Banks

Financial ratios that can be used are categorized into the major categories;
namely, overall profitability, common size income statement to total assets,
common size balance sheet to total assets, liabilities to total assets and
average yields earned on different types of assets.

The following data relates to Very Firm Commercial Bank for Year X09 and
X10.The common size ratios and the ratios for the Peers are provided

Summary of Performance Ratios for The Very Firm Commercial Bank for
Years X09 and X10.

Overall profitability YearX09 Peers Year X10 Peers

Return on Equity 17.25% 19.20% 16.50% 19.32%
Return on Assets 1.12% 1.4% 1.23% 1.35%
Equity Multiplier 12.95 11.28 8.64 11.5

37
 Common Size Income
Statement to Assets
Interest Revenue 7.21% 7.61% 7.47% 7.79%
Interest Expense 1.34 1.37 1.01 1.49
Net Interest Margin (NIM)6.87 6.24 6.46 6.30

Noninterest Revenue 1.46 1.53 1.40 1.16

Noninterest Expense 4.84 5.17 4.55 6.29
Types of Noninterest
Expense
Personnel Expense 2.54 1.56 2.31 2.59
Occupancy Expense 0.54 0.21 0.49 0.26
Other Operating
Expense 1.76 3.4 1.75 3.44
Provision for Loan Losses 0.14 0.27 0.34 0.47
Net Income Before Gains
Taxes 1.04 1.14 1.28 1.37
Gains/Losses on securities 0.61 0.66 0.7 1.10
Net Income After Taxes 0.92 1.40 1.03 1.15

Common Size Balance Sheet to Assets Assets

Deposits at Other Banks 0.10 0.32 0.30 0.55

Repos 7.83 4.58 5.43 4.85
Securities 29.49 28.07 32.38 25.57
Gross Loans and Leases 50.24 45.51 48.44 57.40
Allowances for Loans
And Leases 1.67 1.40 1.87 1.65
NET Loans And Leases 48.57 40.11 26.57 55.75
Total Loans and Leases as a
Percentage of Gross Loans
Leases
38
 Real Estate Loans 43.31 45.70 48.00 44.52
Commercial Loans 26.14 22.70 32.10 22.95
Consumer Loans 6.97 21.27 5.55 29.20
Other Loans 16.98 13.45 17.52 15.45
Liabilities
Demand Deposits 24.46 15.94 22.51 17.10
Total Deposits 80.35 75.17 80.32 79.24
Core Deposits 56.78 54.95 66.90 56.45
Volatile Liabilities 21.45 22.56 20.65 23.54
Owners Equity to Total
Assets 8.98 3.31 6.32 9.13

A Summary of Risk Ratios for Bank Prestige for the period X09 and X10
X09 Peers X10 Peers
Credit Risk Measures
Net Loans and Leases to Assets 52.06% 59.22% 38.75% 59.99%
Loan Loss Provision to Average
Total Loans and Leases -1.27 0.25 0.52 0.61
Loan Loss Allowances to Total
Loans and Leases 5.65 2.30 5.30 2.90
Loan Loss Allowance to
Nonaccrual Loans 2.69 2.49 1.30 2.07
Loan Loss Allowance to Net Losses 18.08 8.50 19.75 5.11
Noncurrent Loans and Leases to
Gross Loans and Leases 2.42 1.26 4.11 1.52
Earnings Coverage to Net Losses 100.77 13.70 7.22 7.49
Net Loss to Average loans and Leases 0.03 0.31 0.26 0.53
Growth Rate in net Loans and Leases 518.81 9.91 -15.34 7.01
Liquidity Ratios
Net Loans and Leases to Total Assets 52.06 59.22 38.75 59.08

39
 Net Loans and Leases to Total
Deposits 74.42 86.49 49.09 80.53
Securities with Maturities Less
Than 1 Year to Total Assets 15.63 14.04 31.23 11.61
Volatile Liabilities to Assets 20.35 32.13 17.11 22.62
Core deposits to Assets(Securities
With Maturities less than 1 Year
Volatile Liabilities to Assets) 20.01 38.11 17.22 23.87
Standby Letters of Credit to Assets 3.67 5.37 3.82 2.07

Interest Rate Risk

(Rate Sensitive Assets – Rate
Sensitive Liabilities) to Assets
Within 3 Months 5.22 5.84 N/A N/A
Within 1 Year 6.64 8.79 N/A N/A
Rate sensitive Assets to Rate
Sensitive Liabilities

Within 3 Months 1.14 1.16 N/A N/A

Within 1 Year 1.15 1.15 N/A N/A

Capital Risk
Equity (Tier 1 Capital) to Average
Assets 8.78 6.95 6.12 7.39
Cash Dividends to Net Income 157.60 57.49 0.00 86.44
Tier 1 Capital to Risk-Weighted
Assets N/A N/A N/A N/A
Tier 1 and Tier 2 Capital to Risk
Weighted Assets N/A N/A N/A N/A
Growth Rate in Tier 1 Equity
Capital 501.31 10.37 4.06 14.91
Growth Rate in Assets 360.59 10.10 -2.61 7.81

40
Equity Growth Less Asset Growth
140.73 0.37 6.07 5.16
Rate

Operating Efficiency Measures

Average Personnel Expense Per
Employee ($000)
40.32 43.59 35.09 35.41
Assets Per Employee ($Million) 2.7 3.05 3.38 2.55
Total Overhead Expenses to Assets3.91 3.72 3.41 3.79
Personnel Expense to Average
Assets 1.50 1.50 1.05 1.49
Occupancy Expense to Average
Assets 0.51 0.50 0.39 0.46

Credit Risk: This is that likelihood that borrowers will not pay their loans in
full. This financial institution had lower credit risk than its peers. This is
indicated by the lower percentage of net loans and leases to assets and a
lower loan loss provision to average assets. Its loan loss allowance to total
loans, nonaccrual loans and net losses are much higher than those of its
peers. Its earnings coverage to net losses is also higher with a lower ratio of
net losses to loans. The bank has a smaller growth rate in loans than the
peers. Reviewing trends, loan loss allowances appear to have been rising,
nonrecurrent loans rose and earnings coverage rose in the period.

Interest Rate Risk: This is the risk associated with fluctuations in interest
rates. The bank appears to be more exposed to interest rate risk than the
peers. The analysis indicates that interest revenues decreased more than the
 41

interest expenses an indication that interest rate risk is higher for the bank
than its peers.
Liquidity Risk: is a measure of the ability of a financial institution to meet
its obligations as they fall due. The bank had a lower percentage of loans, a
larger percentage of securities and fewer volatile liabilities than its peers,
indicating less liquidity risk on both the asset and liability side. The bank
had a larger percentage of standby letters of credit relative to assets than the
peers. Trends indicate a rise in temporary securities. Otherwise, ratios are
pretty much the same in both years relative to peers.

Capital Risk: The risk that the capital requirement might fall below the
statutory ratio or fluctuate significantly. The bank had a lower equity to
assets ratio than its peers. However, it also had a lower dividend payout. The
bank’s risk-based capital ratios were all above the regulatory minimum but
lower than those of peers. Tier 1 and Tier 2 capital to risk-based assets was
lower than that of the peers. Trends further indicate an improvement in
capital ratios and a higher growth rate in equity.

Operating Efficiency : This measure of risk is associated with the ability of

the bank to manage its operating expenses. A profit generated from interest
income can be wiped away by huge operating costs. The operating ratios for
the bank are slightly better than the ones for the peers with exception of
assets per employee of the Year X10.

Overall Analysis Summary

The bank had lower liquidity and credit risk than the peers, but showed
somewhat more capital and interest rate risk. Its capital ratios however well
above regulatory minimum and its interest rate risk did not appear to be a

42
 threat. Risk ratios appear to have improved over time. The challenge of the
bank appears to be its high operating risk caused by poor efficiency relative
to the peers. The bank appears to be profitable with a relatively low overall
risk.

8.1 BANKS NON-INTEREST INCOME AND FEE

BASED ACTIVITIES
8.2 Shift From Traditional Activities
Banks have shifted from the traditional activities of accepting deposits to
engaging in activities that are traditionally associated with other financial
institutions such as securities business, merchant banking, asset management
and insurance business among others. In recent years banks have also
entered to new activities, that of generating income from non-interest based
activities commonly known as fee-based incomes. In this respect banks
desire that their employees in different areas would work together for a
common purpose, such as loan officers in the banking area referring
corporate customers to the corporate service and investment banking areas.

The challenges that arose included; occasional fights over who would
receive credit for a transaction that involved a referral. In addition,
developing a common incentive compensation scheme across the bank
became another challenge. Investment bankers in corporate finance are paid
higher salaries than commercial lenders to be able to attract quality
employees. Additionally, banks that have purchased securities firms and not
paid close attention to cultural differences have been less successful and
 have found themselves subject to serious defections on the part of valuable
employees.

8.3 Fee Income From Off-Balance Sheet Activities

Banks receive fee income from a number of off-balance sheet items
including; loan commitments, note issuance facilities, letters of credit,
foreign exchange and other derivative contract while many of these activities
are limited to very large banks, loan brokerage, including loan sales and
securitization have become more accessible to medium-sized and small
depository institutions as well.

Loan Commitments: These are legally binding agreements in banks

promising to guarantee that a certain amount of funds will be available for a
borrower over a given time period for a given rate. An additional fee is
usually charged for this guarantee.

Letters of credit: Letters of credit include standby and commercial letters of

credit. Standby letters of credit provide a promise by a bank that it will
perform a contract in the event that the buyer of the letter of credit defaults,
that is, a letter of credit substitutes a bank’s credit for that of the buyer of the
standby letter of credit. Standby letters of credit are bought by institutions
such as a company issuing commercial paper or other securities.
Commercial letters of credit are similar but guarantee the credit standing of a
buyer for an international trade transaction. These letters of credit make
importing/exporting easier by substituting the bank’s credit for that of an
importer.

44
 Note Issuance Facilities: Banks often facilitate private placement.
Transactions for foreign investors through note issuance facilities. If a
borrower has a problem obtaining financing at some time over the contract
period involved, often two to seven years, the bank will buy the short-term
notes. Thus, the bank has issued in effect a time loan commitment for a note
issuance contract.

Foreign Exchange Transactions: Large banks provide services in foreign

exchange markets by making currency exchanges and receiving brokerage
fees. They also make forward arrangements by promising to buy or sell
foreign currencies for a given price at a given future date, receiving a
brokerage fee for these services. Similarly, banks offer traveler check
services for a fee by selling traveler’s checks in different currencies. These
services facilitate transactions for businesses and individuals and in return
banks receive fees.

9.3 Loan Sales

Banks have been active in the past decade as loan brokers, negotiating large
loans and selling them or selling portions of them to other financial
institutions, including pension funds, insurance companies, and other
depository institutions. The sales help customers by allowing them to
maintain their relationship with their banks, which goes through the credit
analysis and loan approval process, but allowing much longer-term loans to
be made that can be sold to life insurance companies or pension funds,
which have long-term investment horizons than the bank. The bank benefits
 45

by allowing it to take longer-term loans off its balance sheet, reducing the
bank’s interest rate risk, yet at the same time satisfying customers who want
longer-term loans. Additionally, by selling the loan without recourse, legally,
the bank is no longer responsible for the loan and is no longer subject to the
credit risk associated with the loan. By acting as a broker, the bank also
receives fee income, and the loan that it has made has no effect on the
required capital it must hold assets if the loan is sold without recourse.

There are different types of loan sale, the most common of which is the
participation. With this loan sale, the originating bank continous to hold the
formal contract between the bank and the borrower. The originating bank
continous to serve the loan, collecting payments, overseeing the collateral,
and keeping the books. In the case of a silent participation, the borrower
may not be aware of the sale. A less common type is the assignment, in
which the debtor-creditor relationship is transferred to the loan buyer, which
gives the purchaser the right to take actions against the borrower if payments
are not made. The originating bank, however, may retain the lien on any
collateral backing the loan or some other obligations. The novation, the least
common type of arrangement, transfers all rights and obligations of the
selling bank to the buyer, and the originator is completely free from any
legal obligations to either the borrower or the loan buyer. Nonetheless,
selling a loan is generally less of a “clean break” than the sale of other types
of assets. Even if loans are sold without recourse, banks implicitly have
responsibilities to the buyer of the loan in terms of maintaining the
reputation of the bank. If a bank simply sold its worse loans to other
institutions, it would lose its reputation and goodwill with those institutions.
However, banks can sell troubled loans to investors at large discounts. This
would mean such banks would incur sometimes, significant losses.

46
9.4 Securitization
Loan securitization involves removing loans from the bank’s balance sheet
and selling them to investors. Before being sold, loans are packaged into
securities with characteristics that make them attractive in form of large or
small loans. The mechanics of securitization are subject to a variety of tax,
securities, regulatory and accounting laws. On a recourse basis, a depository
institution originating the loans sells a pool of loans and collateral values to
a limited purpose corporation. The limited purpose corporation, often a
subsidiary of an investment bank setting up the deal or a special subsidiary
of the originating bank, exists solely to act as an intermediary between the
buyer and seller to transfers assets as trusts. The trust purchases loans from
the limited-purpose company and package loans into certificates that can be
sold to investors. If the trust has no recourse with the originating bank for
loan losses, the bank can then remove the loans sold from its balance sheet.
To make the certificates that represent “fractional and undivided interests in
the pool of assets more attractive to investors, an insurance company surety
bond or a bank letter of credit is purchased to guarantee a portion of the loan
pool.

9.0 INSURANCE COMPANIES: PERFORMANCE

AND RISK ANALYSIS
9.1 Nature and Types of Insurance Companies
Insurance companies are financial intermediaries which underwrite policies
for their clients. Insurers receive income from premiums and from returns
earned on investments. Insurers make profits whenever premium and
investment income exceeds the amount needed to cover all expenses, claims
and proper provisions for liabilities to policy holders. The main types of
insurance companies are; property liability companies, life insurance
companies and general insurance companies. Property liability insurers
depend more on premium income because they have shorter-term
unexpected payoff contracts and thus cannot invest in higher yielding long-
term assets as life insurers with long-term contracts can. For life insurance
companies premiums come from life insurance premiums, health insurance
premiums and annuity considerations. Both life insurers and property
liability insurers hold the majority of their assets in fixed-income securities.,
notably bonds. Because property insurers have unexpected maturities on
their insurance contracts, they hold short-term and intermediate-term bonds.
In contrast life insurers have longterm contracts with more predictable
maturities and therefore can hold long-term higher-yielding bonds.

Expenses for property liability companies are loss expenses, operating

expenses including commissions, and policy holder dividends. For many
companies, total expenses are larger than revenues from premiums during
periods of major losses. Consequently profit liability (P/L) insurance
companies often depend on investment resources to make a profit.

Interpreting financial data for P/L insurers is somewhat more difficult than
for other financial institutions. Insurance companies are subject to two sets
of accounting rules: regulatory principles that insurers call statutory
accounting and generally accepted accounting principles (GAAP). Statutory
accounting is a combination of cash-based and accrual based accounting:
expenses are not recognized until incurred. In general it is a more

48
 conservative way of reporting financial results than GAAP. h differences
between statutory accounting and GAAP are greater for P/L insurers than
life insurers. Statutory accounting affects balance sheets and income
statements for all insurers, although. Virtually all data on life insurers are
consistent with GAAP: this is not true for P/L insurers. For example,
statutory accounting for P/Ls require unrealized gains or losses on stock
holdings to be reflected on the balance sheet, directly affecting both reported
asset holdings and insurers net worth. This is in contrast with GAAP which
requires the reporting of equity security holdings as the lower of either cost
or market value. In the case of statutory accounting P/L insurers may only
include admitted assets in “other assets” which are assets that could be
liquidated should the insurer face a financial emergency. This procedure
differs from GAAP in which “other assets” include cash but not premises.
Thus the reported net worth of P/L insurers is understated by nonadmitted
assets that do not appear in the balance sheet.

9.2 Balance Sheets of Insurance Companies

Items contained in the balance sheet of insurance companies include; policy
reserves, policy dividends, dividend reserves, policy dividend accumulation,
dividend obligation payable and surplus funds. Policy reserves are estimated
by taking the total present value of future financial obligations – that is, the
total present value of expected benefits that the company may be required to
pay to current policyholders. The amount determined actuarially considers ;
mortality and morbidity rates reflecting the reasons future claims will be
 49

made; the present value of future premium payments to be received from

those currently insured; the expected rate of return on the company’s
investments. The reserves of a life insurance company is basically the
present value of the expected claims, net of the present value of estimated
receipts of premiums and investment incomes. The largest percentage of
outstanding reserves is often for annuity contracts.

Life insurers have a policy dividend reserve for mutual life insurance
companies that provide refunds for participating insurance policies on
premiums paid during the year if the loss experience, operating expense and
investment income of the insurer are better than expected at the beginning of
the year. To maximize the probability that dividends can be paid regularly,
premiums on participating policies are higher than premiums on
nonparticipating policies that provide similar coverage but that are not
entitled to dividends. Policy dividend accumulation are past dividends that
policyholders have reinvested in interest-bearing accounts: dividend
obligations payable are policy dividends declared during the current year but
not yet paid to policyholders because policy dividends are considered
refunds of previous payments they are taxable to the insured when paid.

Other obligations include accrued expenses, prepaid premiums and

mandatory reserves for fluctuations in security values. Asset valuation
reserves are a type of reserve that makes provisions for credit-related losses
on fixed-income assets, default component as well as all types of equity
investments. The interest maintenance reserve is a reserve that captures all
realized interest related capital gains and losses on fixed income assets.
Surplus and common stock are the equity, or capital of the life insurance
industry. The surplus account is analogous of retained earnings. The book

50
 value of an insurer’s surplus to common stock shows how much the book
value of assets can shrink before estimated claims on the insurer exceed
asset values.

9.3 Operations of Insurance Companies

The major insurance company operations include:
-Product Design and development: The design of new products satisfies
customer needs and allows insurance companies with other financial
institutions. The nature and size of the market for the product, potential
competition expected losses, legal and regulatory factors, costs, advertising
and strategy planning need to be considered
-Production and distribution: Products are produced, distributed, promoted
and advertised
-Product management: Includes rate-making, underwriting and claims
adjustment and settlement
-Services: Legal, loss control, risk management and policyholder services
and educational services consumers and employees
-Administration: Includes general management, strategic planning,
personnel management, branch management, accounting and public relations
-Finance and investment: Includes; managing the company’s investment
portfolio and determinant investment strategy; the later id often subject to
regulatory supervision

9.4 Performance Evaluation of Insurance Companies

Similar to depository institutions main ratios can be calculated to help

51
analysts focus on critical aspects of an insurers financial performance and
risk. Net Underwriting Margin (NUM) is a ratio common to both types of
insurance companies, which encompasses the main source of an insurer’s
revenue and expenses.

NUM = Premium Income – Policy Expenses

Total Assets

Policy expenses include all benefits payments, additions to policy reserves

operating expenses for life insurers and all loss expenses and operating
expenses for P/L insurers. Policy expenses also include dividends to
policyholders.

Other performance indicators for Insurance Companies

In addition to NUM, P/L companies have other underwriting efficiency
ratios including:

Loss Ratio = Loss Expenses / Total Premiums Earned

Where Total Premiums Earned are premiums received and earned on

insurance contracts without a claim being filed (total premiums written less
unearned premiums) and loss expenses include losses and adjustment
expenses for settling losses.

Expense Ratio + Operating Expenses / Total Premium Written Combined

Ratio = Loss Ratio + Expense Ratio
Overall Profitability = 100% - (Combined Ratio + Investment Yield)
52
Where investment yield can be estimated as investment revenue/earning
assets. Loss and expense ratios reflect the two major expenses of P/L
insurers: Loss expenses and commissions and other operating expenses.

Note on Financial Analysis for Insurance Companies

Many insurance companies offer both life and property insurance. These
companies prepare combined financial statements which makes it necessary
to prepare financial ratios for the separate lines of business as well as
combined ratios for all business lines. Other issues relate to the special
accounts particular to different types of insurance companies as well as
complications with statutory versus GAAP accounting.

9.04 Factors Affecting Insurance Companies:

-Conflicting laws on reporting
-Conflicting opinions which has meant that many insurance companies have
come up with many institutions some of which have limited the services
which are offered by these companies.
-Demutualization of life and property insurance companies to convert them
to mutual holding companies or to stock-owned companies which would
make raising capital easier for firms
-Entry of many insurance firms to mutual fund business as well as either
acquiring or starting their own funds or selling funds as agents for other
fund companies.
-Many insurance companies are majority partners in joint ventures in which
a bank or insurer together establish a third company in which they both

53
have interests. The bank becomes the majority partner in a bancassurance
venture, the dealing in insurance products through bank distribution
channels, the insurance becomes the majority partner in an assurbanking
operation system of taking bank products and selling them through the
insurers distribution channels.
-Competition from banks as insurers face more competition from banks as
court rulings have allowed banks more product flexibility, particularly in
annuity and mutual fund business.
- Change in technology affects insurance companies

Regulatory Monitoring Solvency

Regulators use early earning systems to monitor insurance companies for
solvency risk. Indicators of risk such as capital levels, liquidity ratios,
portfolio composition guidelines etc are some of the indicators used to
assess the solvency of insurance companies.

10.0 PERFORMANCE AND RISK ANALYSIS OF

NON-DEPOSITORY FINANCIAL INSTITUTIONS
In addition to the insurance companies; other non-depository institutions
include; pension funds, investment companies and securities firms.

10.01 PENSION SCHEMES

Defined Contributions Schemes Versus Defined Benefits Schemes
Retirement benefits institutions distinguishes defined contribution schemes
from defined benefits schemes.
54
In a defined contributions plan, the per employee contributions made by the
employer are specified, but benefits paid during retirement are not promised
in advance. Instead, they depend on contributions and earnings accumulated
over time. Employees are not promised specific benefits thus the question of
funding adequacy does not arise.

A defined benefit plan promises in advance to pay employees a specified

level of benefits. The total amount of the fund’s liabilities and the date
incurred are not known with certainty and depend on the characteristics,
such as age and gender, of the company’s workforce. The fund’s liabilities
are estimated using actuarial methods, and the employer’s contributions are
based on those calculations. A major concern in the management and
regulation of defined benefit plans is whether an employer’s contribution to
the fund is sufficient to the fund is sufficient to meet future pension
liabilities.

Descriptive Data for Pension Funds

Asset Structure: Noninsured private pension funds invest the largest
proportion of their assets in corporate stock. Due to changing market
conditions however, other assets such as bonds continue to be included in
the portfolio of assets of pension funds. Therefore portfolio of assets more so
of private pension funds are not stable. Corporate equities, government
securities, corporate and foreign bonds are large asset categories. Smaller
holdings include deposits, mortgages, commercial paper and miscellaneous
assets form part of asset portfolios of many pension funds.
 55

Sources of Funds: Pension funds have no liabilities with face amounts or

maturity dates in the traditional sense. They have obligations to covered
employees, but most obligations are difficult to quantify and must be
estimated by actuaries. Instead of considering pension fund obligations in
the traditional balance sheet sense, the ensuing focus is on sources of funds
to private pension funds. Corporations with employees covered by pension
plans provide the majority of funds with which assets are purchased. While
employees may also contribute, in many cases they do not. Corporate
decisions thus determine whether the plan is adequately funded, overfunded,
or underfunded.
If a plan is overfunded the value of its assets are less than the value of
estimated obligations, and the fund accumulates net worth, or an excess of
assets over liabilities. When a fund is underfunded, it has negative net worth
because assets are less than the value of estimated obligations. Adequate
funded plans have no net worth, and asset values equal the value of
estimated future obligations. Corporate contributions to pension funds
reduce the corporation’s after-tax profits, therefore firms face conflicting
influences on the contribution decision.
The adequacy of contributions also depends on actuarial assumptions. Most
obligations depend on future occurrences, such as the retirement age of
covered employees and how long they live after retirement. For a pension
fund which is fully funded, its assets must equal the present value of future
obligations less the present value of future contributions, an amount known
as funding target. The funding target depends on actuarial assumptions about
future obligations and the yield on the fund’s assets over time. Like life
insurance actuaries, pension actuaries are cautious, preferring to err by
overestimating future obligations rather than by underestimating them.

56
Managing Pension Fund Assets
The assets and sources of funds for private pension funds suggest that their
management is more like tat of insurance firms than management of other
financial institutions. Among the important aspects include;
Liquidity: Pensions need not consider explicit reserve requirements, but as
insurers must protect cash flows to ensure payments to policyholders,
pension funds must have cash for benefit payments. Outflows for pension
funds and life insurers are much more, for new or growing plans, corporate
contributions usually exceed payments to covered employees in the same
period, so liquidity considerations are not managers foremost concern.
Taxability: Earnings on pension fund assets are subjected to various tax
regulations. Tax laws may mean that incomes are taxed at the funds level or
when received by the contributor. Tax laws are however occassionary
reviewed and incomes that were not subjected to tax may have subsequently
found their way into the tax net. Tax-exempt securities are removed from the
investment because of their inferior yields.
Corporate Sponsor Preferences: One of the unusual aspects of pension
fund management is the potential division of control among several parties.
The pension fund must operate in the best interests of covered employees
but depends upon the sponsoring firm for its sources of funds. The plan’s
administrators may make investment decisions themselves or they may
entrust the responsibility for investing all or a portion of fund assets to
professional portfolio managers. The sponsoring firm, the administrators and
the managers may at times have conflicting interests.
Investment Policy and Choice of Investment Managers: A pension fund’s
trustees set investment policies for the fund’s assets, including standards for
risk and return and selection of the investment manager. Many pension funds
are not managed by in-house managers but instead plan trustees designate
external professional managers to make investment decisions. Trust
departments of commercial banks are usually selected, other times securities
firms or other investment advisers may also be selected. Pension funds may
spread the management of assets among several external investment
advisers. Surveys indicate that the vast majority of plans use outside
management for at least part of plans use outside management for at least
part of the asset portfolio. The Employee Retirement Income Security Act
(ERISA), a law passed by congress has influenced pension plans trustees to
develop written statements of investment objectives and to establish formal
guidelines for investment managers.
Inflation: The main effects of inflation on pension funds are the impact of
inflation on benefit payments and on the return on fund assets.
Two methods are commonly used to determine a retiree’s benefit payments.
The career-average plan bases retirement income on an employee’s average
salary over his or her entire career. The final-average plan weighs income
just before retirement more heavily in computing benefits. Inflation strongly
affects pension obligations strongly in the case of final-average plan because
employees’ cost-of-living raises are directly translated into higher pension
fund obligations. In the case of career-average plan, even several years of

58
high inflation toward the end of an employee’s career may not increase
retirement benefits significantly.
The effect of inflation on interest rates is that nominal yields do not always
keep up with the rate of inflation. Pension fund managers are thus faced with
the challenge of protecting returns on their funds from inflation. It is argued
that even after adjusting for risk, most funds perform worse than the markets
in general and actively managed funds record the worst performance.
International diversification: Diversification is an additional technique for
modern portfolio management. One of the motives for venturing into
international diversification is the desire to reduce variability in total returns
by holding assets with low correlation in expected returns. Secondly, to
improve the risk-adjusted return on the portfolio by investing in rapidly
growing foreign firms with abundant raw materials and lower labor costs.
Risks that managers must be cautious about include; exchange rate
uncertainty, transfer risk, and limited access to market information.
Issues in Pension Fund Asset Management:
Real estate investment: Investments by many pension funds are regulated,
giving guidelines on portfolio composition.

Social responsibility: Pension funds at times receive pressure to avoid

investing in certain companies or countries. Managers argue that with this
inference most efficient portfolio for the pension fund may be unobtainable.
According to ERISA decisions of management of assets of pension funds
must clearly be in the best interests of the covered employees, must not
interfere with diversification, and must coincide with the fund’s investment
objectives.
Integrated Management Strategies
Pension funds as a whole lack identifiable net worth, thus is may seem
unusual to discuss integrated asset/liability approaches. At any one time, an
individual fund has assets and obligations with present values that may or
may not be equal. When they are not equal, the fund has either positive or
negative net worth that can be affected by changes in market yields.
Techniques of risk management of pension fund assets should focus more on
duration based techniques because of the long-term nature of pension fund
assets and liabilities.
Immunization
A pension fund is immunized if its net worth at the end of a holding period is
at least equal to its net worth at the beginning of the holding period. The
value of a pension fund’s assets as well as its liabilities is affected by the
discount rate which is an indicator of market conditions. The net worth of a
fund will change, for a given change in market yields, changes in asset
values differ from changes in the present value of future obligations.
The nature of pension fund liabilities introduces some unusual problems in
immunizing a fund’s net worth. The present value of liabilities is sensitive to
actuarial assumptions about mortality. In addition, whether liabilities should
include only those to employees with vested benefits or should consider
potential obligations for all employees is another point of controversy. The
lack of a maturity date for liabilities and the fact that new employees may be
60
regularly joining the sponsoring firm, mean that the fund’s obligation may
stretch far into the future. As a result, the duration of a fund’s liabilities will
be long. If plans are undefended, asset values are smaller than the present
value of liabilities and the duration of assts must be quite large to achieve
immunization
Performance Evaluation of Pension Funds
Performance of pension funds focus on the yields on a fund’s assets.
Ordinarily, evaluating the performance of pension fund managers is difficult
because appropriate comparative data are scarce and because responsibility
for managing the assets of a fund may be divided among several
management groups.
Evidence indicates that those funds managing a significant portion of assets
internally reported that the performance of internal managers, both in
equities and in bonds, exceeded the returns achieved by external professional
managers. They also reported that internal management was accompanied by
significant cost savings. Despite these findings, reliance on external
management is popular among many pension scheme management.
Desirability of Active Management: Regardless of whether a pension fund
chooses internal or external managers, a significant performance issue is
whether active portfolio management ca achieve greater returns than a
simple buy-and-hold strategy. Some studies have found that as pension funds
become larger, their portfolios inevitably mirror the market portfolio. Other
researchers argue that, ironically, as active management increases, the huge
volume of assets held by pension funds make it hard to find trades of
 comparable size except with other pension funds, and funds often simply
trade assets with one another. The implications of these findings is that
active management of pension funds is not worth-while, and that investment
in a portfolio that approximates a market index could offer results as good
as, if not superior to, those achieved by managers. The explanation offered
by many observers is that pension funds cannot beat the market because they
are the market.
Emerging Issues in Performance Measurement:
The accumulating evidence that it is difficult for pension fund managers o
“beat the market” has encouraged some state and local government sponsors
to change the way they compensate fund mangers. Instead of paying
managers a flat percentage of assets managed, performance fees tie
compensation to managers’ ability to outperform market indexes. If
managers are the reluctant to accept the challenge that performance fees
present, they are encouraged to manage the fund as an index fund. Many
observers believe the trend toward indexation and passive fund management
is towards the right direction.

10.2 INVESTMENT COMPANIES

Investment companies raise funds by selling ownership shares to investors,
mainly of whom are small savers. Professional managers then direct
investment of the funds in a variety of assets.
Operations of Investment Companies
62
Investment company shareholders obtain benefits unavailable from direct
investment or other financial intermediaries. They get greater diversification,
lower transactions costs, and expert investment opinion at a lower cost than
if they invested directly in the financial markets. Most investment
companies rely on the sale of shares and do not use financial leverage, so the
investor avoids the increased risk of owning stock in-an intermediary with
large liabilities. In contrast to depository institutions, investment companies
promise no guarantee return to savers. Returns depend upon managers
investment decision and market conditions, with no insurance to protect the
saver against loss of principle.
Investment companies are separate from management companies hired to
make investment decisions and to market new shares of the investment
company. Since management companies also have shareholders, investment
managers must earn profits for them and for the investment company.
Management fees must be disclosed in the prospectus and investment
companies’ annual reports give information about expenses. Public
disclosure is intended to ensure that fund managers price their services
competitively.
Open-End Companies: Mutual Funds
An open-end fund is always willing to sell new shares to prospective
investors, or even to redeem shares held by investors at the fund’s current
net asset value. The net asset value is the difference between the value of the
investment company’s assets and its liabilities, stated on a per share basis.
Open-end companies are better known as mutual funds; they are the most
popular type of investment company and as noted, control the vast majority
of industry assets.
Closed-End Companies: REITs and Unit Trusts
A closed-end investment company will not automatically redeem shares
when a current investor wants to liquidate them. Since the price of shares is
affected by supply and demand, as well as by fund performance, the seller
has no guarantee of receiving the net asset value. If market value is less than
net asset value, new shares cannot be issued without diluting the current
investors’ position, and the company is essentially closed to new investment.
Real Estate Investment Trusts (REITs) specialize in real estate related assets.
Unit Trusts are close-end fund specializing in one type of investment such as
real estate, equities, bonds etc. The assets chosen determine the return
potential and the ax benefits of the trust. A unit trust differs from other funds
because a portfolio of assets is purchased when the trust is formed. When
fixed-income securities are chose, they are held to maturity. Consequently,
there are no ongoing management fees, although large initial fees may be
charged when the trust is formed. Fixed income trusts offer low liquidity
because shares cannot be redeemed before the portfolio matures. Equity
trusts allow investors to redeem shares at market value before the trust
expires and are more liquid than fixed-income trusts.
Regulatory Influences of Investment Companies
Regulation impacts on asset structure, taxation and disclosure of information
among other aspects.
Managing Mutual Fund Assets:
The management of mutual fund assets is very much influenced by the
fund’s investment objectives. Taxability, inflation, and diversification are
64
important influences in investment company activities. Additional factors
that influence activities of investment companies include;
Timing and Security Selection: Timing refers to the coordination of
investment decisions with anticipated market movements. Industry observers
have debated the ability of mutual fund managers to time their decisions to
achieve superior investment returns. Fund managers indicate that the
identification of over or undervalued securities has a more significant impact
on fund performance than attempts to anticipate market changes and make
portfolio adjustments. Managers of money market funds place more
emphasis on timing.
Diversification: The measures of diversification such as correlation between
individual assets or portfolio variance. Many managers use guidelines such
as limiting the amount invested in a single industry, or limiting the
proportion of the portfolio invested in certain securities.
Fund Size: Researchers observe that a large fund cannot use the same
investment strategy as a small fund, but not that one is better than the other.
Notably, some mutual fund managers including those with excellent
performance records, have recently decided to control asset growth by
closing the funds to new investors after reaching a certain size. Large funds
may on the other hand provide more safety and diversification than those
with fewer assets. They may also be able to afford a larger and better trained
investment staff, and may command volume discounts to reduce transaction
costs. It is argued that the appropriate fund size is based on investment
objectives, and no general guidelines govern growth.
Specification: Mutual fund specialization in terms of investments is subject
to debate. Some funds choose goals more specific than “growth” or
“income”. Some investors have shown interest in a type of mutual fund at
the opposite end of the spectrum. Known as ‘fund of funds’ such a fund
affords the maximum degree of diversification by investing in the shares of
other mutual funds. A potential problem is excessive diversification which
increases management costs with little reduction in portfolio risk. Most
experts are that any large mutual fund provides sufficient diversification, and
little benefit is received from paying managers to select shares of other
mutual funds.
Managing REITs Assets
Taxation: Managers of REITs need to take into account tax matters when
managing the activities of the trust.
Flexibility: The investors can choose from among a wide array of assets. For
example; equity REITs specialize in owning real estate, and investors can
profit from increases in the value of the physical assets held. Other REITs
specialize in holding mortgages. Investor returns are generated by the
interest payments made by borrowers and are subject to the risk of borrower
default. Another type of REIT combines features of both equity and
mortgage REITs. Known as participating mortgage REITs, they hold
mortgages on real estate, but also have the right to a portion of the increase
in property value. Additional flexibility is offered through self-liquidating
funds. They are similar to unit trusts, but they specialize in real estate.
Investors are not forced to sell shares to terminate their interest in the fund,
because the funds themselves have a maturity date.

66
 Performance Evaluation of Investment Companies
Ratio analysis is inappropriate for evaluating performance of most
investment companies but other measures of industry performance
especially that of managing mutual funds is used. The main question in
evaluating investment companies is whether they offer shareholders a rate of
return higher than could be obtained through direct investment. For mutual
funds research has attempted to ascertain whether an investor could adopt a
simple buy-and-hold strategy and earn a better return than is achieved by the
typically active investment style of a mutual fund’s professional managers
and the associated costs. Risk-adjusted rates of return and relative
performance evaluation are used for evaluating performance of investment
companies.
Size and Performance: Some comparative studies have concluded that
small funds have outperformed large mutual funds. These results should not
be interpreted as blanker support for small funds, however, because smaller
funds have less diversification potential and may expose investors to higher
risk. Unless risk-adjusted returns are considered, one cannot conclude that
size is instrumental to fund performance.

10.3 SECURITIES FIRMS

Securities firms have experienced several changes such as mergers of
established securities firms, acquisitions of securities companies by firms
outside the industry, heightened competition, the development of creative
financial services and instruments, and more elusive profits. The services
offered by securities firms include; investment banking; brokerage services
and securities trading; merchant banking; and services such as asset
management account, financial advisory services and mutual fund
sponsorship.
Investment Banking
This has been defined as a business which has its function the floatation of
new securities, both debt and equity, to the general public for the purpose of
raising funds for clients. Their role in the issuance of securities makes
investment banks dominant in the primary securities markets.
Investment bankers assist both private firms and public entities in selecting
securities to issue and their characteristics. Investment banks have been
influential in adding new twists to financial instruments. The investor is
protected against interest rate risk because the bonds can be liquidated
without a loss even if interest rates have risen. Underwriting function is one
in which investment banks assume the risk of adverse price movements
immediately after the issuance of new securities. An underwriter purchases
new securities from a client for a price negotiated in advance, then resells
them. The difference between the price paid by the underwriter and the price
at which the securities are sold to the public (the spread) is a source of profit
in the underwriting business – and a source of risk as well.
The relationship between investment bankers and their clients depends on
the financial position of the client and the breadth of the market for its
securities. Investment banks are sometimes unwilling to bear the risk of
underwriting a new issue but sell it on a best efforts basis. In best efforts
deals, the investment banker does not buy the securities from the issuing
firm, but merely assists in distribution, profiting from fees for services. An

68
alternative that clients sometimes choose is private placement for which
investment bankers earn fees for bringing buyers and sellers together.

Brokers and Trading

Brokerage and trading services involve handling securities transactions for
individual or institutional customers and managing the firm’s own securities
inventory. Securities firms also act as investment advisers for mutual and
pension funds. Full-service brokerage firms conduct security analysis and
provide investment advice to clients, and both full-service and discount
brokers complete securities transactions.

Merchant Banking
This is the name given to a group of activities such as investing in real
estate, taking an equity position in new firms, providing financing for
mergers and acquisitions, or other endeavors those securities firms make on
their own behalf. Larger firms in the industry are diversifying into these
activities to smooth out the income variability inherent in investment
banking and brokerage.

Other Financial Services

As competition has heightened, securities firms have introduced a variety of
financial services to meet the needs of individual and institutional
customers. Some firms serve only institutional clients, selling their expertise
at arranging interest rate swaps and other hedging techniques. Other industry
members emphasize services to retail clients. Other firms have introduced
asset management accounts enabling brokers to attract additional funds from
their clients. They in addition provide investment advice and counsel,
regular statements of account, easy access to cash through check-writing
privileges in corporation with participating banks, and the ability to borrow
against securities holdings. Any funds deposited by an investor earn market
rates while under the securities firm’s management.
Regulating Securities Firms
The industry for securities is regulated and the involvement and issuing and
trading securities is closely monitored. Fees and commissions are
determined using guidelines. Customers such as the institutional investors
have the ability to negotiate their fees and therefore reduce their transactions
costs on large volumes of trades. Individual investors on the other hand,
whose average trades are much smaller, face higher transactions costs.
Discount brokers offer limited investment advice and services, and charge
lower fees than firms offering a full line of services. Discount firms which
provide an alternative for small investors willing to manage their own
accounts to minimize transactions costs have increased in number.
Diversification has been embraced by many brokers. Because brokers
anticipated declining revenues from traditional services, they began
experimenting with other opportunities to replace or even enhance profits.
Asset management accounts, merchant banking endeavors, and mutual fund
endeavors are some of the efforts brokers undertake to diversify.
Firms have to seek approval before undertaking new issues. Increased
competition is viewed as reducing profits and driving out smaller regional
investment banks out of business, causing the industry to consolidate and
become dominated by a few large firms. Critics also feared that investors
70
would lack access to sufficient current information under the advance
registration procedures.

Insider Trading
Attempts by brokers and investment banks to profit from inside information
have been illegal for many years, having been scrutinized by the market.
Although regulations are in place prohibiting insider trading, tracking a firm
that is a takeover target or on which there is unusual trading volume,
prevention of illegal insider trading profits lies largely with the securities
industry itself. A special focus of concern is maintaining the so-called
Chinese Wall, an imaginary barrier between the investment banking arm of a
securities firm and its brokerage and trading arm. Theoretically, the firm
may not profit on trades for its own inventory using information obtained
through investment bankers’ contracts with clients.

Emerging Issues
As investment banks have increased their merchant banking activities, some
clients have questioned whether investment banks are becoming more
concerned with their own investments than with their traditional functions of
advising clients and arranging financing for others. Since depository
institutions are prohibited from underwriting bonds and stock, disgruntled
clients of investment bankers have few alternatives. The compatibility of
merchant banking and investment banking is an issue that should be
critically analyzed by regulators.

Data for Securities Firms

Fee and interest income are both important to the securities industry just the
same way it is for other financial institutions. The firms exposure to interest
rate and market risk is indicated by the importance of trading and
underwriting as sources of income. The sensitivity of operations to economic
conditions is revealed by differences in the relative importance of income
categories from year to year.
Interest expense incurred on borrowings to purchase securities inventories, is
a major expense category and profitability is greatly affected by changes in
interest rates. Because interest costs are determined by the financial markets
and not by an individual firm, management of personnel expenses is
extremely important.

Managing Assets and Liabilities of Securities Firms

Diversification to protect income: Securities firms have diversified not only
to respond to competition, but also to protect against swings in commission
income resulting from changes in market conditions. Diversification is
prominently discussed in the annual reports of many leading securities firms.
Use of Risk Management Tools: Securities firms are not only developing
hedging techniques for their clients, they are themselves relying on
sophisticated hedging strategies to manage interest rate risk.
72