Chapter One

Overview of the Financial System

Asamnew T

Department of Accounting and Finance,

Addis Ababa University
 Chapter Objectives
 Understanding the role of financial system in the
economy
 Understanding financial assets: its characteristics
and roles
 Understanding what a financial market is, its
classifications, its actors
 Understanding function of financial intermediaries:
 Lending and borrowing in the financial system
Financial System
 What is a financial system?
 An economic arrangement wherein financial
institutions facilitate the transfer of funds and assets
between borrowers, lenders, and investors.
 Financial System
 The financial system has six parts, each of which plays a
fundamental role in our economy.
 Those parts are:
 money,
 financial instruments,
 financial markets,
 financial institutions,
 government regulatory agencies, and
 central banks.
 Financial System…
 We use money to pay for our purchases and to store our
wealth.
 We use financial instruments, to transfer resources from
savers to investors and to transfer risk to those who are
best equipped to bear it.
 Stocks, mortgages, and insurance policies are examples of financial
instruments.
 financial markets allows us to buy and sell financial
instruments quickly and cheaply
 Financial System…
 Financial institutions provide a myriad of services, including
access to the financial markets and collection of information
about prospective borrowers to ensure they are
creditworthy.
 Government regulatory agencies are responsible for making
sure that the elements of the financial system—including
its instruments, markets, and institutions—operate in a safe
and reliable manner.
 central banks monitor and stabilize the economy.
 National bank of Ethiopia is our central bank
 Core Functions OF A Financial
System
1. The investment chain
2. Risk Management
3. Payment systems
4. Providing information
 1. The investment chain
 Through the investment chain, savers and
borrowers are brought together.
 Savers provide financing to businesses,
 and businesses that wish to grow offer opportunities
for savers to take part in the growth and resulting
potential returns.
 The efficiency of this chain is critical to allocating
what would otherwise be uninvested capital to
businesses
………….that can use it to grow their enterprises
 1. The investment chain…..
 Pooling resources and subdividing shares
 Financial systems enable multiple investors to
contribute to projects that no one of them alone
could afford.
 Transferring resources across time and space.
 Firms in one industry, or in one location, may seek to
invest surplus funds in other industries or at other
locations.
 2. Managing Risk
 Financial systems provide ways for investors to
exchange, and thereby to control, risks.
 For example,
 insurance enables the pooling of risks,
 hedging enables the transfer of risk to speculators,
 diversification exploits low correlations that may exist
among risky projects
 3. Payment systems
 Financial systems provide mechanisms that
facilitate exchanges of goods and services, as well
as assets,
 followed by settlement, transferring ownership in
return for the agreed remuneration.
 It is an essential requirement for commercial
activities to take place and for participation in
international trade and investment.
 4. Providing information
 One of the most prominent friction in the financial market
is asymmetric information
 Financial markets, institutions and intermediaries produce
useful information of potential borrowers to investors.
 Financial systems enable price discovery
– that is, for those who wish to trade to observe the prices (rates of
exchange) at which agreements can be made.
– other information, for example about expectations of future
asset price volatility, can be inferred from market prices.
 Financial Assets
 An asset, broadly speaking, is any possession that has value
in an exchange.
 Assets can be classified as tangible or intangible.
 A tangible asset is one whose value depends on particular physical
properties—examples are buildings, land, or machinery.
 Intangible assets, by contrast, represent legal claims to some
future benefit.
 Their value bears no relation to the form, physical or otherwise, in which
these claims are recorded.
 Financial assets are intangible assets.
 For financial assets, the typical benefit or value is a claim to future cash.
 Real Assets Vs Financial Assets
Real Assets:
- are assets used in the process of production in the
economy, i.e., items such as factories, machinery,
patents, human capital, knowledge .

Financial assets:
- are claims to the output of the production process. In other

words, they are legal contract representing the right to receive

future financial benefits
equity bondunder a stated set of conditions.depos
(corporate/ E.g. wit bank
shares, s
mutual fund shares, government),
insurance policies, and it h s,
derivative instruments
 Financial Assets…
 The claim that the holder of a financial asset has may be
either a fixed dollar amount or a varying, or residual,
amount.
 In the former case, the financial asset is referred to as a debt
instrument.
 An equity instrument (also called a residual claim) obligates the
issuer of the financial asset to pay the holder an amount based on
earnings, if any, after holders of debt instruments have been paid.
 Some securities fall into both categories….Preferred stock
 Both debt and preferred stock that pay fixed dollar amounts are
called fixed-income instruments.
 The Price of a Financial Asset and
Risk
 A basic economic principle is that the price of any financial
asset is equal to the present value of its expected cash flow,
even if the cash flow is not known with certainty.
 By cash flow, we mean the stream of cash payments over time.
 Financial Assets versus Tangible
Assets
 Both are expected to generate future cash flow for their
owner
 Financial assets and tangible assets are linked.
 Ownership of tangible assets is financed by the issuance of some type
of financial asset—either debt instruments or equity instruments
 Ultimately, the cash flow for a financial asset is generated by some
tangible asset.
 PROPERTIES OF FINANCIAL ASSETS
 Moneyness
 Divisibility and Denomination
 reversibility,
 cash flow,
 term to maturity,
 convertibility,
 currency,
 liquidity,
 return predictability, and
 complexity
Financial Systems - Approaches
◼ Faced with end users desire (lend or borrow), there are
three approaches:
◼ First, they may decide to deal directly with one another.

◼ Second, they may decide to deal via markets

◼ Third, they may decide to deal via intermediaries.

L B

Markets

Intermediarie
s
 Financial Markets
 In a market economy, the allocation of economic resources
is driven by the outcome of many private decisions
 Prices are signals that direct economic resources to their best use
 Financial Markets…
 Two types of markets in an economy:
1. The market for products (manufactured goods
and services)
2. The market for factors of production( labor and
capital)
 Our focus is one part of the factor market, the
market for financial assets……financial market
 Financial Markets….

 A financial market is a market where financial assets are

exchanged (i.e.» traded).
 Financial markets are markets in which funds are
transferred from people and firms who have an excess of
available funds to people and firms who have a need of
funds.
Financial Markets…
 Financial markets, such as bond and stock
markets, are crucial in an economy.
 These markets channel funds from savers to
investors, thereby promoting economic
efficiency.
 Well functioning financial markets, such as the
bond market, stock market, and foreign exchange
market, are key factors in producing high
economic growth.
 Financial Markets…
 Debt markets, or bond markets, allow governments,
corporations, and individuals to borrow to finance activities.
 In this market, borrowers issue a security, called a bond,
that promises the timely payment of interest and principal
over some specific time horizon.
 The interest rate is the cost of borrowing.
 There are many different types of market interest rates,
including mortgage rates, car loan rates, credit card rates,
etc.
 Financial Markets…
 The stock market is the market where common stock (or
just stock), representing ownership in a company, are traded.
 Companies initially sell stock (in the primary market) to
raise money. But after that, the stock is traded among
investors (secondary market).
 The foreign exchange market is where international
currencies trade and exchange rates are set.
 Foreign exchange (FX) markets are the largest of all
financial markets, with average daily turnover in excess of
US$5 trillion.
 Financial Markets…
 Exercise: Of all the active markets, the stock
market receives the most attention from the
media. Why?
Functions
◼ of Financial Market
Financial markets provid the followin three major
economic functions:e g
❑ Price discovery
❑ Liquidity
❑ Reduced transaction costs
◼
Price discovery:
◼ Since the interactions of buyers and sellers in a Financial market
determine the price of the traded asset, they determine the required
return that participants in a financial market demand in order to buy
a financial instrument.
Functions of Financial Market
Functions of Financial Market
 Functions of Financial Market
Reduced Transaction Costs:
◼ This is performed when Financial Market participants
are charged and /or bear the costs of trading a financial
instruments.
Functions of Financial Market
Functions of Financial Market
 Classification of Financial Markets
 There are many ways to classify financial markets.

 Financial Intermediaries
 Instead of savers lending/investing directly with borrowers,
a financial intermediary (such as a bank) plays as the
middleman:
 The intermediary obtains funds from savers
 The intermediary then makes loans/investments with borrowers
 This process, called financial intermediation, is actually the
primary means of moving funds from lenders to borrowers.
 More important source of finance than securities markets
(such as stocks).
 Financial Intermediaries…
 Financial intermediary needed because of transactions costs,
risk sharing, and asymmetric information
1. Transactions Costs
 Financial intermediaries make profits by reducing transactions costs.
 Reduce transactions costs by developing expertise and taking
advantage of economies of scale.
Financial Intermediaries…
2. Risk Sharing
 Financial Intermediaries low transaction costs allow them to
reduce the exposure of investors to risk, through a process
known as risk sharing.
 Financial Intermediaries create and sell assets with lesser risk
to one party in order to buy assets with greater risk from
another party.
 This process is referred to as asset transformation, because in a sense
risky assets are turned into safer assets for investors.
 Financial Intermediaries…
 Financial intermediaries also help by providing the means
for individuals and businesses to diversify their asset
holdings.
 Low transaction costs allow them to buy a range of assets,
pool them, and then sell rights to the diversified pool to
individuals.
 Financial Intermediaries…
3. Asymmetric Information
 Another reason Financial intermediaries exist is to reduce the impact
of asymmetric information.
 One party lacks crucial information about another party, impacting
decision-making.
 We usually discuss this problem along two fronts: adverse selection
and moral hazard.
 Financial Intermediaries…
 Adverse Selection
 Before transaction occurs
 Potential borrowers most likely to produce adverse outcome are
ones most likely to seek a loan
 Similar problems occur with insurance where unhealthy people
want their known medical problems covered
Financial Intermediaries…
 Moral Hazard
 After transaction occurs
 Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won’t pay loan
back
 Again, with insurance, people may engage in risky activities
only after being insured
 Another view is a conflict of interest
Financial Intermediaries…
 Financial intermediaries reduce adverse selection and
moral hazard problems, enabling them to make profits.
 Because of their expertise in screening and monitoring,
they minimize their losses, earning a higher return on
lending and paying higher yields to savers.
 41

Types of Financial Intermediaries

 Chapter 2
Financial Institutions
 2

Outline

• Facts About Financial Structure

• Role of Financial Institutions
• Depository Financial Institutions (Banks)
• Banking and the Management of Financial Institutions
• Banking Industry: Structure and Competition
• Non-Depository (Non-Bank) Financial Institutions
• Investment Companies (Mutual Funds)
• Investment Companies, Brokerage Firms and Dealers
• Insurance Companies
• Pension Funds
 3

2.1. Facts of Financial Structure

• Facts About Financial Structure Throughout the World

 4

Cont‘
d
I. Stocksare not the most important source offinance for
businesses.
II. Issuing marketable securities is not the primary funding source for
businesses.
III. Indirect finance (financial intermediation) is far more important
than direct finance.
IV. Banks are the most important source of external finance.
V. The financial sector is among the most heavily regulated.
VI. Only large, well established firms have access tosecurities
markets.
VII. Collateral is a prevalent feature of debt contracts.
VIII. Debt contracts are typically extremely complicated legal
documents with restrictive covenants.
Services of Financial Institutions

• Transforming Financial Assets

• Exchanging Financial Assets on Behalf of Customers
• Exchanging Financial Assets for Own Account
• Assisting in the Creation of Financial Assets
• Providing Investment Advice
• Managing Portfolios
Role of Financial Institutions

 Transfer of funds from savers to investors

 Providing Maturity Intermediation
 Reducing Risk Through Diversification
 Reducing Costs of Contracting and Information
Processing
 Providing a Payments Mechanism
 Reducing asymmetric information
 5

Role of Financial Institutions

Reducing Transaction Costs

• Transactions costs influence financial structure
• For example, an individual with limited income may fail to diversify his/
her portfolio.
• Transactions costs can hinder the flow of funds to people
with productive investment opportunities
• Financial intermediaries makeprofits by reducing
transactions costs
1. Take advantage ofeconomies (example: mutual ofscale
funds)
2. Develop expertise to lower transactions costs
• Also provides investors with liquidity
 6

Cont‘
d
Reducing Asymmetric Information
• Asymmetric information occurs when one party to a
transaction has more information than the other. We focus
on two specific forms:
• Adverse selection
• Moral hazard
• The analysis of how asymmetric information problems
affect behavior is known as agency theory.
 7

Cont‘
d
Adverse Selection
• Occurs when one party in a transaction has better information
than the other party
• Before transaction occurs
• Potential borrowers most likely toproduceadverse outcome
are ones most likely to seek loan and be selected
Moral Hazard
• Occurs when one party has an incentive to behave differently
once an agreement is made between parties
• After transaction occurs
• Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won't pay
loan back.
 8

How Adverse Selection Influences Financial Structure

Lemons Problem in Securities Markets

• If we can't distinguish between good and bad securities,
willing pay only average of good and bad securities‘ value.
• Result: Good securities undervalued and firms won't issue
them; bad securities overvalued so too many issued.
 9

Tools to Help Solve Adverse Selection (Lemons) Problems

• Private Production and Sale of Information

• One way to get this material to saver-lenders is to have private
companies collect and produce information that distinguishes good
from bad firms and then sell it.
• Free-rider problem interferes with this solution
• Government Regulation to Increase Information
• For example, annual audits of public corporations
• Financial Intermediation
• Used car dealers analogy for lemons problem - Used-car dealers
produce information in the market by becoming experts in determining
whether a car is a peach or a lemon. Once they know that a car is good,
they can sell it with some form of a guarantee.
• A financial intermediary, such as a bank, becomes an expert in
producing information about firms, so that it can sort out good credit
risks from bad ones. (Fact 3).
 10

Cont‘
d
• Collateral and Net Worth
• If a borrower defaults on a loan, the lender can sell the collateral
and use the proceeds to make up for the losses on the loan.
• Net worth (also called equity capital), the difference between a
firm‘s assets (what it owns or is owed) and its liabilities (what it owes)
, can perform a similar role to collateral.
 1
1

Moral Hazard in Equity and Debt Contracts

Moral Hazard in Equity Contracts: the Principal-Agent Problem

• The separation of ownership and control involves moral
hazard, in that the managers in control (the agents) may act in
their own interest rather than in the interest of the
stockholder- owners (the principals) because the managers
have less incentive to maximize profits than the stockholder-
owners do.
Tools to Help Solve the Principal-Agent Problem
• Production of Information
• Engage in a particular type of information production, the monitoring
of the firm‘s activities: auditing the firm frequently and checking on
what the management is doing.
• Monitoring process can be expensive in terms of time and money, as
reflected in the name economists give it, costly state verification.
• The free-rider problem decreases monitoring
 12

Cont‘
d
• Government Regulation to Increase Information
• Laws to force firms to adhere to standard accounting principles that
make profit verification easier. They also pass laws to impose stiff
criminal penalties on people who commit the fraud of hiding and
stealing profits.
• Fraudulent managers have the incentive to make it very hard for
government agencies to find or prove fraud.
• Financial Intermediation (e.g., venture capital)
• Venture capital firms pool the resources of their partners and use the
funds to help budding entrepreneurs start new businesses. In
exchange for the use of the venture capital, the firm receives an equity
share in the new business. Another reason why indirect finance is so
important (Fact 3).
• Debt Contracts
• The borrower pay the lender fixed dollar amounts at periodic intervals
– the lender doesn‘t care If the managers are hiding profits.
• Explains Fact # 1 Why debt is used more than equity
 13

Cont‘
d
How Moral Hazard Influences Financial Structure in Debt Markets
• Even with the advantages just described, debt is still
subject to moral hazard.
• In fact, debt may create an incentive to take on very risky
projects.
• Most debt contracts require the borrower to pay a fixed
amount (interest) and keep any cash flow above this
amount.
• For example, what if a firm owes $100 in interest, but only
has $90? It is essentially bankrupt. The firm ―has nothing
to lose by looking for ―risky projects to raise the needed
cash.
 14

Cont‘
d
Tools to Help Solve Moral Hazard in Debt Contracts
• Net Worth and Collateral
• When borrowers have more at stake because their net worth is high or
the collateral they have pledged to the lender is valuable, the risk of
moral hazard will be greatly reduced.
• Monitoring and Enforcement of Restrictive Covenants
• Restrictive covenants are directed at reducing moral hazard either by
ruling out undesirable behavior or by encouraging desirable behavior.
• Financial Intermediation
• Borrowers may be clever enough to find loopholes in restrictive
covenants that make them ineffective.
• Banks and other intermediaries have special advantages in monitoring
 15

Cont‘
d
 16

Moral Hazard - Conflicts of Interest

• Conflicts of interest are a type of moral hazard that occurs

when a person or institution has multiple interests, and
serving one interest is detrimental to the other.
• Three classic conflicts developed in financial institutions.
• Looking at these closely offers insight in avoiding these
conflicts in the future.
 17

Conflicts of Interest - Underwriting and Research in Investment

Banking

• Investment banks may both research companies with

public securities, as well as underwrite securities for
companies for sale to the public.
• Research is expected to be unbiased and accurate,
reflecting the facts about the firm. It is used by the public
to form investment choices.
• Underwriters will have an easier time if research is
positive. Underwriters can better serve the firm going
public if the firm‘s outlook is optimistic.
 18

Cont‘
d
• An investment bank acting as both a researcher and
underwriter securities for companies clearly has a
of the interest of the issuing firm or the
conflict—serv
e public?the tech boom, research reports were clearly
• During
distorted to please issuers. Firms with no hope of ever
earning a profit received favorable research.
• This also lead to spinning, where underpriced equity was
allocated to executives who would promise future
business to the investment bank.
 19

Conflicts of Interest - Auditing and Consulting in Accounting

Firms

• Auditors check the assets and books of a firm for the

quality and accuracy of the information. The objective is an
unbiased opinion of the firm‘s financial health.
• Consultants, for a fee, help firms with variety of
managerial, strategic, and operational projects.
• An auditor acting as both an auditor and consultant for a
firm clearly is not objective, especially if the consulting
fees exceed the auditing fees.
 20

Conflicts of Interest - Credit Assessment and Consulting in Rating

Agencies

• Rating agencies assign a credit rating to a security

issuance of a firm based on projected cash flow, assets
pledged, etc. The rating helps determine the riskiness of a
security.
• Consultants, for a fee, help firms with variety of
managerial, strategic, and operational projects.
• An rating agency acting as both an rater and consultant
for a firm clearly is not objective, especially if the
consulting fees exceed the rating fees.
 21

Cont‘
d
• Rating agencies, such as Moody‘s and Standard and
Poor, were caught in this game during the housing
bubble.
• Firms asked the rater to help structure debt offering to
attain the highest rating possible. When the debt
subsequently defaulted, it was difficult for the agency to
justify the original high rating.
• Perhaps it was just error. But few believe that—most see
the rating agencies as being blinded by high consulting
fees.
 22

Remedies – US context

• Sarbanes-Oxley Act of 2002

• Established an oversight board to supervise accounting firms
• Increased the SEC‘s budget for supervisory activities
• Limited consulting relationships between auditors and firms
• Enhanced criminal charges for obstruction
• Improved the quality of the financial statements and board
 23

Cont‘
d
• Global Legal Settlement of 2002
• Required investment banks to sever links between research and
underwriting
• Spinning is explicitly banned
• Added additional requirements toensure independence and
objectivity of research reports
 24

Cont‘
d
• Will these work?
• There is much criticism over the cost involved with these
separations. In other words, financial institutions can no longer take
advantage of the economies of scope gained from relationships.
• Some have argued that Sarbanes-Oxley has negatively impacted the
value of U.S. Capital Markets.
 25

2.3. Depository Financial Institutions (Banks)

• Depository institutions are financial intermediaries that

accept deposits from individuals and institutions and
make loans.
• These institutions include commercial banks and the so-
called thrift institutions (thrifts): savings and loan
associations, mutual savings banks, and credit unions.
• Commercial Banks raise funds primarily by issuing
checkable deposits (deposits on which checks can be
written), savings deposits (deposits that are payable on
demand but do not allow their owner to write checks), and
time deposits (deposits with fixed terms to maturity).
 26

Cont’d

• They then use these funds to make commercial, consumer, and

mortgage loans and to buy government bonds and treasury bills.
• Savings and Loan Associations (S&Ls) and Mutual Savings Banks:
These depository institutions obtain funds primarily through
savings deposits (often called shares) and time and checkable
deposits.
• In the past, these institutions were constrained in their activities
and mostly made mortgage loans for residential housing.
• Over time, these restrictions have been loosened so that the
distinction between these depository institutions and
commercial banks has blurred.
• These intermediaries have become more alike and are now more
competitive with each other.
 27

Cont’d

• Credit Unions/Cooperatives: These financial institutions

are typically very small cooperative lending institutions
organized around a particular group: union members,
employees of a particular firm, and so forth.
• They acquire funds from deposits called shares and
primarily make consumer loans.
 28

2.4. Banking and the Management of Financial Institutions

• Banks play an important role in channeling funds to

finance productive investment opportunities.
• They provide loans to businesses, finance college
educations, and allow us to purchase homes with
mortgages.
• In the commercial banking setting, it is important to look
loans, balance sheet management, and income
determinants to understand how banking is conducted to
earn the highest profits possible.
 29

The Bank Balance

Sheet
• TheBalance Sheet is a list of a bank‘s assets and
liabilities
• Total assets = total liabilities + capital
• A bank‘s balance sheet lists sources of bank funds
(liabilities) and uses to which they are put (assets)
• Banks invest these liabilities (sources) into assets (uses)
in order to create value for their capital providers
 30

The Bank Balance Sheet – US Example

 31

Basics of
Banking
• Asset transformation is, for example, when a bank takes
your savings deposits and uses the funds to make, say, a
mortgage loan. Banks tend to ―borrow short and lend
long(in terms of maturity).

• T-account Analysis:
• Deposit of $100 cash into First National Bank
 32

Cont’d

• Deposit of $100 check (written on an account at another bank, say, the

Second National Bank)

• The First National Bank deposits the check in its account at the Fed/
NBE, and the Fed collects the funds from the Second National Bank.

• Conclusion: When bank receives deposits,reserves by equal

amount; when bank loses deposits, reserves by equal amount.
 33

Cont’d

• Deposit of $100 cash into First National Bank

assuming Required Reserve ratio of 10%.

• $10 of the deposit must remain in reserves tomeet federal

regulations (10% reserve req.).
• Now, the bank is free towork withthe $90 in its asset
transformation function. In this case, the bank loans the $90 to its
customers.
 34

Cont’d

• Loaning out excess reserves

 35

General Principles of Bank Management

• Now let‘s look at how a bank manages its assets and

liabilities.
• The bank has four primary concerns:
1. Liquidity management
2. Asset management
3. Liability management
4. Managing capital adequacy
 36

Liquidity management

• Let us see how a typical bank, the First National Bank, can
deal with deposit outflows that occur when its
depositors withdraw cash from checking or savings
accounts or write checks that are deposited in other
banks.
• In the example that follows, we assume that the bank has
ample excess reserves and that all deposits have the
same required reserve ratio of 10% (the bank is required to
keep 10% of its time and checkable deposits as
reserves).
 37

Cont’d

• The first T–Account shows the First National Bank‘s initial

balance sheet.
• The bank‘s required reserves are 10% of $100 million, or
$10 million.
• Given that it holds$20million of reserves, the First
National Bank has excess reserves of $10 million.
• When a deposit outflow of $10 million occurs, the bank‘s
balance sheet is shown in the bottom T–Account.
 38

Liquidity management
 39

Cont’d

• The situation is quite different when a bank holds

insufficient excess reserves.
• Let‘s assume that instead of initially holding $10 million in
excess reserves, the First National Bank makes additional
loans of $10 million, so that it holds no excess reserves.
 40

Cont’d
 41

Cont’d

• After $10 million has been withdrawn from deposits and hence
reserves, the bank has a problem: It has a reserve requirement
of 10% of $90 million, or $9 million, but it has no reserves!
• To eliminate this shortfall, the bank has four basic options.
• One is to acquire reserves to meet a deposit outflow by
borrowing them from other banks in the federal funds market
or by borrowing from corporations.
• The cost of this activity is the interest rate on these borrowings,
such as the federal funds rate.
• A second alternative is for the bank to sell some of its
securities
to help cover the deposit outflow.
• The bank incurs some brokerage and other transaction costs
when it sells these securities.
 42

Cont’d
 43

Cont’d

• A third way that the bank can meet a deposit outflow is to

acquire reserves by borrowing from the Fed.
• In our example, the First National Bank could leave its
security and loan holdings the same and borrow $9 million
in discount loans from the Fed.
• The cost associated with discount loans is the interest rate
that must be paid to the Fed (called the discount rate).
• Finally, a bank can acquire the $9 million of reserves to
meet the deposit outflow by reducing its loans by this
amount and depositing the $9 million it then receives with
the Fed, thereby increasing its reserves by $9 million.
 44

Cont’d
 45

Asset Management

• AssetManagement: the attempt to earn the highest

possible return on assets while minimizing the risk.
I. Get borrowers with low default risk, paying high interest
rates
II. Buy securities with high return, low risk
III. Diversify
IV. Manage liquidity
 46

Liability Management

• Liability Management: managing the source of funds, from

deposits, to CDs (Certificates of deposit), to other debt -
overnight loan markets.
I. No longer primarily depend on checkable deposits
II. When see loan opportunities, borrow or issue CDs to
acquire funds
• This new flexibility in liability management meant that
banks could take a different approach to bank
management.
• The greater emphasis on liability management explains
some of the important changes over the past three
decades in the composition of banks‘ balance sheets.
 47

Capital Adequacy Management

• Banks have to makedecisionsabout the amount of

capital they need to hold for the following main reasons.
1. Bank capital is a cushion that prevents bank failure. For
example, consider these two banks:
 48

Cont’d

• What happens if these banks make loans or invest in securities (say,

subprime mortgage loans, for example) that end up losing money?
• Let‘s assume both banks lose $5 million from bad loans.
• Impact of $5 million loan loss
 49

Cont’d

• Conclusion: A bank maintains reserves to lessen the

chance that it will become insolvent: it does not have
sufficient assets to pay off all holders of its liabilities.
• When a bank becomes insolvent, government regulators
close the bank, its assets are sold off, and its managers are
fired.
• So, why don‘t banks want to hold a lot of capital? Answer
next slide.
 50

Cont’d

2. Higher is bank capital, lower is return on equity

• Capital , EM , ROE
 51

Cont’d

3. Trade-off between safety and returns to equity holders:

• Benefits the owners of a bank by making their investment
safe
• Costly to owners of a bank because the higher the bank
capital, the lower the return on equity
• Choice depends on the state of the economy and levels of
confidence
 52

Cont’d

4. Banks also hold capital to meet capital requirements.

• The Basel Committee on Banking Supervision sets
minimum capital requirements - the ratio of bank capital
to risk weighted assets.
 53

Strategies for Managing Capital:

• As the manager of the First National Bank, you have to

make decisions about the appropriate amount of bank
capital to hold in your bank.
• To raise its capital, a bank can issue more equities, reduce
dividends to shareholders, or reduce the bank‘s assets by making
fewer loans.
• To reduce its capital, a bank can sell or retire stock (repurchased out
of the company's retained earnings), increase dividends to
reduce retained earnings, increase asset growth via debt (like
CDs).
• Our discussion of the strategies for managing bank capital
leads to the following conclusion:
• A shortfall of bank capital is likely to lead a bank to reduce its assets
and therefore is likely to cause a contraction in lending.
 54

Howa Capital Crunch Caused a Credit Crunch Duringthe Global

Financial Crisis

• Shortfalls of bank capital led to slower credit growth:

• Huge losses for banks from their holdings of securities backed by
residential mortgages.
• Losses reduced bank capital
• Banks could not raise much capital on a weak economy and
had to tighten their lending standards and reduce
lending.
 55

Off-Balance-Sheet Activities

• Although asset and liability management has traditionally

been the major concern of banks, in the more competitive
environment of recent years banks have been
aggressively seeking profits by engagin inoff-
balance-sheetout activities. g
• Off-balance-sheet activities involve trading financial
instruments and generating income from fees and loan
sales, activities that affect bank profits but do not appear
on bank balance sheets.
 56

Cont’d

• Loan sales (secondary loan participation)

• Involves a contract that sells all or part of the cash stream from a specific
loan and thereby removes the loan from the bank‘s balance sheet.
• Banks earn profits by selling loans for an amount slightly greater than the
amount of the original loan.
• Generation of fee income, Examples:
• Making foreign exchange trades on a customer‘s behalf,
• Servicing a mortgage-backed security by collecting interest and principal
payments and then paying them out,
• Guaranteeing debt securities such as banker‘s acceptances (by which the
bank promises to make interest and principal payments if the party issuing
the security cannot), and providing backup lines of credit.
 57

Cont’d

• Other lines of credit for which banks get fees include standby letters of
credit to back up issues of commercial paper and other securities and credit
linesunder writing Euronotes, which are medium-term Eurobonds.
• Creating SIVs (structured investment vehicles), which can potentially
expose banks to risk, as it happened in the global financial crisis.
• Off-balance-sheet activities involving guarantees of securities and backup
credit lines increase the risk a bank faces. Even though a guaranteed security
does not appear on a bank balance sheet, it still exposes the bank to default
risk: If the issuer of the security defaults, the bank is left holding the bag and
must pay off the security‘s owner.
 58

Cont’d

• Trading activities and risk management techniques:

• Banks‘ attempts to manage interest-rate risk have led them to
trading in financial futures, options for debt instruments, and
interest-rate swaps.
• Banks engaged in international banking also conduct transactions in
the foreign exchange market.
• Although bank trading in these markets is often directed toward
reducing risk or facilitating other bank business, banks may also try
to outguess the markets and engage in speculation.
• Trading activities, although often highly profitable, are dangerous
because they make it easy for financial institutions and their
employees to make huge bets quickly.
• Principal-agent problem arises
 59

Cont’d

• Given the ability to place large bets, a trader (the agent), whether she
trades in bond markets, in foreign exchange markets, or in financial
derivatives, has an incentive to take on excessive risks: If her trading
strategy leads to large profits, she is likely to receive a high salary and
bonuses, but if she takes large losses, the financial institution (the
principal) will have to cover them.
• Internal controls to reduce the principal-agent problem:
• Complete separation of the people in charge of trading activities from
those in charge of the bookkeeping for trades.
• Managers must set limits on the total amount of traders‘ transactions
and on the institution‘s risk exposure.
• Managers must also scrutinize risk assessment procedures using the
latest computer technology.
• One such method involves the value-at-risk approach.
• In this approach, the institution develops a statistical model with which
it can calculate the maximum loss that its portfolio is likely to sustain
over a given time interval, dubbed the value at risk, or VAR.
 60

Measuring Bank Performance

• Much like any business, measuring bank performance

requires a look at the income statement. For banks, this is
separated into three parts:
• Operating Income
• Operating Expenses
• Net Operating Income
• Note how this is different from, say, a manufacturing firm‘s
income statement.
 61

Measuring Bank Performance - Banks’ Income Statement

 62

Cont’d
 63

Cont’d
 64

Cont’d
 65

2.5. Banking Industry: Structure and Competition

• In recent years the traditional banking business of making

loans that are funded by deposits has been in decline.
• Some of this business has been replaced by the shadow
banking system, in which bank lending has been replaced
by lending via the securities market.
 66

Financial Innovation

• Innovation is result of search for profits.

• A change in the financial environment will stimulate a
search for new products and ideas that are likely to
increase the bottom line.
• There are generally three types of changes we can
examine:
1. Response to Changes in Demand Conditions
2. Response to Changes in Supply Conditions
3. Avoidance of Existing Regulation
 67

1. Response to Changes in Demand Conditions

• Major change is huge increase in interest-rate risk starting

in 1960s (in the case of US).
• Adjustable-Rate Mortgages are an example of the reply to
interest-rate volatility.
• Banks also started using derivates to hedge risk, and
intermediaries (like the CBOT) started developing
extensive interest rate products.
 68

2. Response to Changes in Supply Conditions

• Major change is improvement in information technology

have
• Lowered the cost of processing financial transactions, making it
profitable for financial institutions to create new financial products
and services.
• Made it easier for investors to acquire information, thereby making
it easier for firms to issue securities.
 69

Financial Innovation: Bank Credit and Debit

Cards
• Many store credit cards existed long before WWII.
• Improved technology in the late 1960s reduced
transaction costs making nationwide credit card programs
profitable.
• The success of credit cards led to the development of debit
cards for direct access to checkable funds.
 70

Financial Innovation: Electronic Banking

• Automatic Teller Machines (ATMs) were the first

innovation on this front.
• Today, over 250,000 ATMs service the U.S. alone.

• Automated Banking Machines combine ATMs, the

internet, and telephone technology to provide “complete”
service.
• Virtual banks now exist where access is only possible via
the internet.
 71

E-Finance: Wi ll “Clicks” dominate “Bricks” in Banking?

• Will virtual banks on the internet become the primary

form for bank business, eliminating the need for physical
bank branches? Here’s some evidence:
─ Internet-only banks have experienced low revenue growth
─ Depositors appear reluctant to “trust” the security of their funds in
I-banks
─ I-bank customers seem concerned that their transactions are truly
secure and private
─ Empirical evidence shows that long-term savings products are
purchased more often face-to-face
─ Technology glitches are still present
 72

Financial Innovation: Electronic Payments

• The development of computer systems and the internet

has made electronic payments of bills a cost-effective
method over paper checks or money.
• The U.S. is still far behind some European countries in the
use of this technology.
 73

Financial Innovation: E-
Money
• Electronic money, or stored cash, only exists in electronic
form. It is accessed via a stored-value card or a smart card.
• E-cash refers to an account on the internet used to make
purchases.
 74

Financial Innovation: Junk

Bonds
• Prior to 1980, debt was never issued that had a junk
rating. The only junk debt was bonds that had fallen in
credit rating.
• Michael Milken of Drexel assisted firms in
Burnham issuing original-issue junk andalmost single-
debt,
handedly created the market.
 75

Financial Innovation: Commercial Paper

Market
• Commercial paper refers to unsecured debt issued
by corporations with a short original maturity.
• The development of money market mutual funds assisted
in the growth in this area.
 76

Financial Innovation: Securitization

• Securitization refers to the transformation of illiquid

assets into marketable capital market instruments.
• Today, almost any type of private debt can be securitized.
This includes home mortgages, credit card debt, student
loans, car loans, etc.
 77

3. Avoidance of Existing Regulations

• Two sets of regulations have seriously restricted the

ability of banks to make profits:
• Reserve requirements that force banks to keep a certain fraction
of their deposits as reserves (vault cash and deposits in the
Federal Reserve System) and
• Restrictions on the interest rates that can be paid on deposits.
• These regulations have been major forces behind financial
innovation.
 78

Cont’d

• The desire to avoid restrictions on interest payments and the

tax effect of reserve requirements led to two important
financial innovations.
• Money Market Mutual Funds (MMMFs): allow investors similar
access to their funds as a bank savings accounts, but offered
higher rates, especially in the late 1970s.
• Currently, MMMFs have assets around $2.6 trillion. In an odd
irony, risks taken by MMMFs almost brought down the industry
in 2008.
• Sweep Accounts: Funds are ―swept‖ out of checking accounts
nightly and invested at overnight rates. Since they are no
longer checkable deposits, reserve requirement taxes are
avoided.
• A sweep account combines two or more accounts at a bank or a
financial institution, moving funds between them in a predetermined
manner.
 79

2.6. Non-Depository (Non-Bank) Financial Institutions

• Non-depository institutions serve as the intermediary

between the savers and the borrowers, but they do not
accept deposits.
• Such institutions perform their activities of lending to the
public either by way of selling securities or through the
insurance policies.
• Non-depository institutions include investment companies,
insurance companies, brokerage firms, and pension
funds.
 80

A. Investment Companies (Mutual Fund)

i. Introduction
• Investment companies are financial intermediaries that sell
shares to the public and invest the proceeds in a diversified
portfolio of securities.
• Each share sold represents a proportional interest in the portfolio
of securities managed by the investment company on behalf
of its shareholders.
• The type of securities purchased depends on the company's
investment objective.

.
 81

Cont’d

• When investors decide to invest in a particular asset

class, such as equities, there are two ways they can do it:
direct investment or indirect investment.
• Direct investment is when an individual personally buys shares in a
company, such as buying shares in Apple, the technology giant.
• Indirect investment is when an individual buys a stake in an investment
fund, such as a mutual fund that invests in the shares of a range of different
types of companies, perhaps including Apple.
• Achieving an adequate spread of investments through
holding direct investments can require a significant
amount of money and, as a result, many investors find
indirect investment very attractive.
 82

Cont’d

• There is a range of funds available that pool the

resources of a large number of investors to provide
access to a range of investments.
• These pooled funds are known as collective investment
schemes (CISs), funds, or collective investment vehicles.
The term ‗collective investment scheme‘ is an
internationally recognized one, but investment funds are
also very well-known by other names, such as mutual
funds, unit trusts or open-ended investment companies
(OEICs).
• Investment funds may structure as open-ended funds and
closed-ended funds.
 83

Cont’d

• An open-ended fund is one that can create new shares in

response to investor demand or cancel them when sold so
that their capital can expand or contract – an example is a
mutual fund.
• A closed-ended fund, by contrast, has a fixed capital base
so if an investor wants to buy shares they will do so on the
stock exchange and buy them from another investor who
wants to sell. They have a fixed capital base as is seen with
US closed-ended funds.
• Funds may be established in one country and then
marketed internationally.
 84

Cont’d

• Funds that are established in Europe andmarketed

internationally are often labeled as undertakings for
collective investment in transferable securities (UCITS)
funds, meaning that they comply with the rules of the EU
UCITS directive.
• The UCITS branding is seen as a measure of quality that
makes them acceptable for sale in many countries in the
Middle East and Asia, but many African regulators only
allow funds which they have registered as meeting
domestic regulations to be marketed to their citizens.
• International fund management houses include
BlackRock, Fidelity and J.P. Morgan.
 85

ii. The Benefits of Collective Investment

• Investment funds pool the resources of a large number of

investors, with the aim of pursuing a common investment
objective.
• This pooling of funds brings a number of benefits, including:
• Economies of scale - commission as a proportion of the fund is very
small.
• Diversification - risk is lessened when the investor holds a diversified
portfolio of investments (in many different sectors).
• Access to professional investment management – however, entry fees,
exit charges and annual management fees applies, these are needed to
cover the fund managers‘ salaries, technology, research, their
dealing, settlement and risk management systems, and to provide a
profit.
• Access to geographical markets, asset classes or investment
strategies which might otherwise be inaccessible to the individual
investor
• In some cases, the benefit of regulatory oversight
• In some cases, tax deferral.
Bank Risk: Where It Comes from
and What to Do about It
• The bank’s goal is to make a profit in each
of its lines of business.
• They want to pay less for the deposits they
receive than for the loans they make and the
securities they buy.
• In the process of doing this, the bank is
exposed to a host of risks:
• Liquidity risk,
• Credit risk,
• Interest-rate risk, and
• Trading risk.

12-90
 Liquidity Risk
• Liquidity risk is the risk of a sudden
demand for liquid funds.
• Banks face liquidity risk on both sides of
their balance sheets.
• Deposit withdrawal is a liability-side risk.
• Things like lines of credit are an asset-side risk.
• Even if a bank has a positive net worth,
illiquidity can still drive it out of business.

12-91
 Liquidity Risk
• In the past, the common way to manage
liquidity risk was to hold excess reserves.
• This is a passive way to manage liquidity risk.
• Holding excess reserves is expensive, because it
means forgoing higher rates of interest than
can be earned with loans or securities.
• There are two other ways to manage
liquidity risk.
• The bank can adjust its assets or its liabilities.

12-92
 Liquidity Risk
On the asset side a bank has several options.
1. The easiest option is to sell a portion of its
securities portfolio.
• Most are U.S. treasuries and can be sold
quickly at relatively low cost.
• Banks that are particularly concerned about
liquidity risk can structure their securities
holdings to facilitate such sales.

12-93
 Liquidity Risk
2. A second possibility is for the bank to sell
some of its loans to another banks.
• Banks generally make sure that a portion of
the loans they hold are marketable for this
purpose.
3. Another way is to refuse to renew a
customer loan that has come due.
• However this is bad for business.
• The bank can lose a good customer.
• Reducing assets lowers profitability.

12-94
 Liquidity Risk
Bankers prefer to use liability management
to address liquidity risk.
1. Banks can borrow to meet any shortfall
either from the Fed or from another bank.
2. The bank can attract additional deposits.
• This is where large certificates of deposits are
valuable:
• They allow banks to manage their liquidity
risk without changing the asset side of
their balance sheet.

12-95
 Liquidity Risk
• In the financial crisis of 2007-2009, banks
could neither sell their illiquid assets nor
obtain funding at a reasonable cost to hold
those assets.
• When the interbank lending market dried
up, many banks faced a threat to their
survival.

12-96
 Credit Risk
• The risk that a bank’s loans will not be
repaid is called credit risk.
• To manage credit risk, banks use a variety
of tools.
1. Diversification is where banks make a
variety of different loans to spread the
risk.
2. Credit risk analysis is where the bank
examines the borrower’s credit history to
determine the appropriate interest rate
to change.
12-97
 Credit Risk
• Diversification can be difficult for banks,
especially if they focus on a certain type of
lending.
• If a bank lends in only one geographic area or
one industry, it is exposed to economic
downturns that are local or industry-specific.
• It is important that banks find a way to hedge
these risks.

12-98
 Credit Risk
• Credit risk analysis produces information
that is very similar to the bond rating
systems in Chapter 7.
• Banks do this for small firms wishing to borrow,
and credit rating agencies perform the service
for individual borrowers.
• The result is an assessment of the likelihood
that a particular borrower will default.
• In the financial crisis of 2007-2009, banks
underestimated the risks associated with
mortgage and other household credit.

12-99
• A bank’s capital is its net worth - a cushion
against many risks, including market risk.
• Market risk is the decline in the market value of
assets.
• The larger a bank’s capital cushion, the less
likely it will be made insolvent by an
adverse surprise.
• In the financial crisis of 2007-2009, banks
were too leveraged - they had too many
assets for each unit of capital.

12-100
• Mark-to-market accounting rules require
banks to adjust the recorded value of the
assets on their balance sheets when the
market value changes.
• When the price falls, the value is “written down”
and writedowns reduce a bank’s capital.
• Banks don’t like to hold a large capital
cushion because capital is costly.
• The more leverage the greater the possible
reward for each unit of capital and the
greater the risk.
12-101
 Interest-Rate Risk
• A bank’s liabilities tend to be short-term,
while assets tend to be long term.
• The mismatch between the two sides of the
balance sheet create interest-rate risk.
• When interest rates rise, banks face the
risk that the value of their assets will fall
more than the value of their liabilities,
reducing the bank’s capital.
• Rising interest rates reduce revenues relative
to expenses, directly lowering a bank’s profits.

12-102
 Interest-Rate Risk
• The term interest-rate sensitive means
that a change in interest rates will change
the revenue produced by an asset.
• For a bank to make a profit, the interest
rate on its liabilities must be lower than
the interest rate on its assets.
• The difference in the two rates is the bank’s net
interest margin.
• When a bank’s liabilities are more interest-
rate sensitive than its assets, an increase in
interest rates will cut into the bank’s
profits.
12-103
 Interest-Rate Risk
• The first step in managing interest-rate
risk is to determine how sensitive the
bank’s balance sheet is to a change in
interest rates.
• Managers must compute an estimate of
the change in the bank’s profit for each
one-percentage-point change in the
interest rate.
• This procedure is called gap analysis.
• This can be refined to take account of
differences in the maturity of assets and
liabilities, but it gets complicated. 12-104
 Interest-Rate Risk
• Bank managers can use a number of tools
to manage interest-rate risk.
1. They can match the interest-rate
sensitivity of assets with that of liabilities.
• Although this decreases interest-rate risk, it
increases credit risk.
2. Alternatives include the use of
derivatives, specifically interest-rate
swaps.

12-105
 Trading Risk
• Today banks hire traders to actively buy
and sell securities, loans, and derivatives
using a portion of the bank’s capital.
• Risk that the instrument may go down in
value rather than up is called trading risk,
or market risk.
• Traders normally share in the profits from
good investments, but the bank pays for
the losses.
• This creates moral hazard - traders take more
risk than the banks would like.
12-106
 Trading Risk
• The solution to the moral hazard problem
is to compute the risk the traders generate.
• Use standard deviation and value at risk.
• The bank’s risk manager limits the amount
of risk any individual trader is allowed to
assume and monitors closely.
• The higher the inherent risk in the bank’s
portfolio, the more capital the bank will
need to hold.

12-107
• Traders are gambling with someone else’s money,
sharing the gains but no the losses from their risk
taking.
• Traders are prone to taking too much risk, and in
the cases here, hiding their losses when trades
turn sour.
• The moral hazard presents a challenge to bank
owners, who must try to rein in traders’ tendencies.
• Odds are that someone who is making large
profits on some days will register big losses on
other days.

12-108
 Other Risks
• Foreign exchange risk comes from holding
assets denominated in one currency and
liabilities denominated in another.
• Banks manage this in two ways:
• They work to attract deposits that are
denominated in the same currency as their
loans, matching assets to liabilities.
• They use foreign exchange futures and swaps
to hedge the risk.

12-109
 Other Risks
• Sovereign risk arises from the fact that
some foreign borrowers may not repay
their loans because their government
prohibits them from doing so.
• If a foreign country is experiencing a financial
crisis, the government may decide to restrict
dollar-denominated payments.
• Banks have three options:
• Diversification,
• Refuse loans to certain countries, or
• Use derivatives to hedge the risk.

12-110
 Other Risks
• Operational risk is when computer systems
fail or buildings burn down.
• This was an issue for some banks when the
World Trade Center was destroyed.
• The banks must make sure their computer
systems and buildings are sufficiently
robust to withstand potential disasters.
• This means anticipating what might happen
and testing to ensure a system’s readiness.

12-111
Summary of Sources and
Management of Bank Risk

12-112
 Nondepository
Financial Institutions

Chapter 2
 79

Non-Depository (Non-Bank)
Financial Institutions
• Non-depository institutions serve as the intermediary
between the savers and the borrowers, but they do not
accept deposits.
• Such institutions perform their activities of lending to the
public either by way of selling securities or through the
insurance policies.
• Non-depository institutions include investment companies,
insurance companies, brokerage firms, and pension
funds.
 Life Insurance Companies
■ One of the oldest type of intermediary.
■ Invest funds obtained through the sale of policies.
■ Primary investments: Long term taxable, not highly
marketable securities: corporate bonds and
commercial mortgages.
■ Insure against dying too soon and living too long.
 Life Insurance Companies
■ Regulation of life insurance companies
includes:
■ Sales practices
■ Premium rates

■ Allowable investments
Types of Life Insurance Policies
■ Whole Life Insurance
■ Constant premium that is paid through
entire life of policy
■ Build up cash reserves or savings which can
be withdrawn as borrowing or outright by
canceling the policy
■ Savings component pays a money market
rate of interest that changes with market
conditions
Types of Life Insurance Policies
■ Term Life Insurance
■ Pure insurance with no cash reserve or savings element
■ Premiums are relatively low at first but increase with the age of
the insured individual
■ Universal {variable) Life
■ Variation on whole life policy
■ "Unbundle" the term insurance and tax-deferred savings
component
■ Owner can elect how to allocate the savings component among a
menu of investment options, thereby potentially earning above
money market rates
 Life Insurance Companies
■ Based on actuarial tables, life insurance
companies have ability to predict cash flow
■ Typically insurance companies use excess
funds to buy long-term corporate bonds and
commercial mortgages
■ Higher yields
■ Unlikely of having to sell prior to maturity
■ However, lately they have branched out into
riskier ventures such as common stock and
real estate
 Life Insurance Basics
■ Public makes payments in exchange for
protection
■ Companies lend out the funds collected.

■ Companies use the interest and

dividend income received to pay
benefits to policyholders
■ Insurance companies have a reasonably
predictable stream of payments to
policy holders distributed over time.
 Dealing with Asymmetric
Information Problems in Insurance
■Limiting adverse selection
■ Restricting the availability and quantity of
.
insurance.
■Limiting moral hazard in insurance
■ Deductible: A fixed amount of an insured loss that
a policyholder must pay before the insurer is
obliged to make payments.
■ Coinsurance: A policy feature that requires a
policyholder to pay a fixed percentage of a loss
above a deductible.
 Property and Casualty Insurance
Companies

■ Insure against casualties such as

automobile accidents, fire, theft,
personal negligence, malpractice, etc.
■ Losses can be unexpected and highly
variable.
■ Invest in bonds and short-term securities.
 80

Investment Companies
• Investment companies are financial intermediaries that sell
shares to the public and invest the proceeds in a diversified
portfolio of securities.
• Each share sold represents a proportional interest in the portfolio
of securities managed by the investment company on behalf
of its shareholders.
• The type of securities purchased depends on the company's
investment objective.

.
 81

Cont’d
• When investors decide to invest in a particular
asset class, such as equities, there are two ways they
can do it: direct investment or indirect investment.
• Direct investment is when an individual personally buys shares in a company,
such as buying shares in Apple, the technology giant.
• Indirect investment is when an individual buys a stake in an investment fund, such
as a mutual fund that invests in the shares of a range of different types of
companies, perhaps including Apple.
• Achieving an adequate spread of investments
through holding direct investments can require a
significant amount of money and, as a result, many
investors find indirect investment very attractive.
 Mutual Funds

■ There are three types of investment companies:

open-ended funds, close-ended funds and unit-trusts.
■ A mutual fund (open-ended funds)pools the funds of
many people and managers invest the money in a
diversified portfolio of securities to achieve some
stated objective
 Open-end Mutual Fund
■ Sell redeemable shares in the fund to the general
public
■ Shares represent a proportionate ownership in a
portfolio held by the fund
■ Shareholder can go directly to fund and buy
additional shares or redeem shares at their net asset
value (NAV)
 Open-End Mutual
Funds
■ Net Asset Value (NAV)
■ Fund calculates the total market value of
its portfolio and divides this figure by the
number of outstanding shares.
■ Redeem outstanding shares or issue new
ones at the NAV.
■ Number of shares is not fixed but
increases as more money is invested.
■ Commonly known as Mutual Funds.
 Closed-End Investment
Company
■ Issues a fixed number of shares.
■ Invests the proceeds in a portfolio
of assets.
■ Shares are transferable.

■ Price of the share is determined by

supply and demand.
 Mutual Funds
■ Mutual funds are regulated by the Securities
and Exchange Commission (SEC)
■ Primary objective of regulation is the
enforcement of reporting and disclosure
requirements to protect the investor
■ Many investors are attracted to families of
mutual funds
■ Number of mutual funds operated under one
management umbrella
■ Investors can easily transfer money among funds
within the family
 Net Asset Value Example
■A fund has 10 million shares and is
worth $100 million.
■ NAV = $10.00
■ You can buy fractional shares.
 Unit-Trusts
 A unit trust is similar to a closed-end fund in that the number of unit
certificates is fixed. Unit trusts typically invest in bonds.
 They differ in several ways from both mutual funds and closed-end
funds that specialize in bonds.
• First, there is no active trading of the bonds in the portfolio of the unit
trust.
• Once the unit trust is assembled by the sponsor (usually a brokerage
firm or bond underwriter) and turned over to a trustee, the trustee
holds all the bonds until they are redeemed by the issuer.
• Typically, the only time the trustee can sell an issue in the portfolio is if
there is a dramatic decline in the issuer’s credit quality.
• As a result, the cost of operating the trust will be considerably less than
costs incurred by either a mutual fund or a closed-end fund
 Unit-Trusts
• Second, unit trusts have a fixed termination date,
while mutual funds and closed-end funds do not.
• Third, unlike the mutual fund and closed-end fund
investor, the unit trust investor knows that the
portfolio consists of a specific portfolio of bonds
and has no concern that the trustee will alter the
portfolio.
 The Benefits of Collective
85

Investment
• Investment funds pool the resources of a large number of
investors, with the aim of pursuing a common investment
objective.
• This pooling of funds brings a number of benefits, including:
• Economies of scale - commission as a proportion of the fund is very small.
• Diversification - risk is lessened when the investor holds a diversified
portfolio of investments (in many different sectors).
• Access to professional investment management – however, entry fees, exit
charges and annual management fees applies, these are needed to cover
the fund managers‘ salaries, technology, research, their dealing,
settlement and risk management systems, and to provide a profit.
• Access to geographical markets, asset classes or investment strategies
which might otherwise be inaccessible to the individual investor
• In some cases, the benefit of regulatory oversight
• In some cases, tax deferral.
 Finance Companies
■ Consumer Finance Companies
■ Make consumer loans
■ Specialty Finance Companies-specialize in credit
card financing
■ Commercial finance Companies
■ Make commercial loans usually on a secured
(collateralized) basis
■ Loans not as risky as consumer loans

■ Since lending is short-term, these companies

borrow substantial amounts in commercial
paper market
 Finance Companies
■ Historically finance companies have played an
important role in financing growing
undercapitalized companies
■ Commercial finance companies originated the
concept of leveraged buyout (LBOs) which
relies heavily on debt to pay for acquisition of
a company
 Securities Brokers and
Dealers
■ These financial institutions play a crucial role
in the distribution and trading of huge
amounts of securities
 Brokers and Dealers
■ Involved in the secondary market, trading
''used'' or already outstanding securities
■ Brokers match buyers and sellers and earn
a commission1
■ Dealers commit their own capital in the
buying and selling of securities and hope
to make profit on the transaction
 Brokers and Dealers
■ Many of the nationwide stock exchange firms act
as investment bankers, dealers, and brokers
■ A number of large stock exchange firms have
branched out to provide new types of financial
services previously out of their operating
charter
■ Commercial banks, investment banks, and
broker dealers have now combined under single
holding company umbrellas
 Investment Banks
■ Sell and distribute new stocks and bonds directly from issuing
corporations to original purchasers
■ investment banks are ranked by the volume of securities they
underwrite
■ Underwriting is typically conducted through a syndicate
• which includes many investment banks and brokerage firms
■ Investment banks derive a substantial amount of income from offering
advice to firms involved in mergers and acquisitions
■ What price one firm should pay for another
■ How the transaction should be structured
■ Provide strategic advice in hostile takeovers-when one firm seeks to
acquire another against the other's wishes
 Venture Capital Funds, Mezzanine
Debt Funds, and Hedge Funds

■ Venture capital funds, mezzanine debt funds,

and hedge funds are usually not available to
public investors and not registered with SEC
■ Funding comes from wealthy individuals or
other financial institutions, possibly sponsored
by brokerage firms and banks
■ Both venture capital funds and mezzanine debt
funds provide an important source of funding to
small and midsize companies
■ Financing by both venture and mezzanine funds
is non-traded and held until maturity
 Venture Capital Funds
■ Invest funds in start-up companies
■ Traditional bank financing for these firms in the
early stage of growth would be very limited
■ The Venture Capital Fund receives a substantial
equity stake in the firm
■ Although many start-up companies will fail,
significant profit on those that are successful
■ Receives profits when it takes the successful
company public in an initial public offering
(IPO).
 Mezzanine Debt
Funds
■ Provide .debt funds to small and midsize
companies
■ Issue convertible debt and subordinated
debt
■ Sometimes simply invest in a combination of
high-yielding debt and equity issued by the
same company
■ Used to provide long-term funds, sometimes
part of a management-buyout financing
package
Hedge Funds
■ Hedge funds:
■ Limited partnerships that, like mutualfunds,
manage portfolios of assets on behalf of
savers, but with very limited governmental
oversight as compared with mutual funds.
 Pension Funds
■ Program established by an employer to
provide retirement benefits to employees.
 Defined Benefit Plan
■ Retirement benefits are defined by the plan
■ Employer contributions are adjusted to meet the
benefits and insure the plan is fully funded-enough
funds to meet future obligations
■ Vesting
■ Retirement benefits remain with the employee if they leave the
firm and is based on length of employment
 Defined Contribution Plan
■ Contributions are defined by the plan
■ Contribution may be made by employees or employers
or a combination of the two
■ Employee contributions are tax deferred-taxes payable
when funds are withdrawn
■ Benefits depend on the performance of the assets in
the plan
■ Avoids the problems of vesting and funding
■ Individual employee has the ability to choose the
assets in which to invest
 Pension
Funds
■ Defined contribution plans are the type favored
by most employers, although some employers
offer both plans
■ In addition to employer-sponsored plans,
some individuals are given tax incentives to set
up their own pension plans
 Pension Fund Basics
■ Tax-exempt institutions set up to
provide participants with retirement
income that will supplement other
sources of income.
■ The number of people likely to retire
each year is quite predictable.
 Banks Versus Nondepository
Institutions
■ Many nondepository institutions offer services
that compete directly with banks
■ Traditionally many of the different markets
were segmented, however, today they often
compete for the same business