Chapter 9
Banking and Mutual Fund Industries
Department of Economics and Finance
City University of Hong Kong
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 1 / 52
Course Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 2 / 52
Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 3 / 52
Ten Largest Banks in the World, 2024
Rank Bank, Country Assets (US billions) % Change in Assets
tna
1 Industrial & Commercial Bank of China 6,329 +10.58%
2 Agricultural Bank of China 5,646 +15.17%
3 China Construction Bank Corporation 5,427 +8.54%
4 Bank of China 4,592 +9.99%
5 JPMorgan Chase & Co 3,875 +5.72%
6 JPMorgan Chase Bank, N.A. 3,395 +6.03%
7 Bank of America Corporation 3,180 +4.22%
8 HSBC Holdings 3,039 +3.03%
9 BNP Paribas 2,866 +0.75%
10 Mitsubishi UFJ Financial Group 2,668 -8.53%
Key Observations
Chinese banks continue to dominate top positions
All top 4 spots held by Chinese banks
Most banks showing positive growth in assets
Two U.S. banking groups in top 7
Source: LexisNexis Risk Solutions Bankers Almanac (October 2024)
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Historical Development: US vs HK Banking Systems
United States Hong Kong
Started 1782 (Bank of North Started 1845 (Oriental Bank)
America) Centralized system
Decentralized system Single main regulator
Multiple regulators HKMA
Federal Reserve About 160 licensed banks
FDIC
OCC Three-tier system
State regulators 3 层
Around 6,000 banks
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 5 / 52
Key Di↵erences in Banking Structure
United States
Unit banking history (one bank, one office)
Interstate banking restrictions (until 1994)
Focus on domestic retail banking
Strong community banking presence
Hong Kong diflercnt ?
International financial center
Three-tier licensing system:
Licensed Banks
Restricted License Banks
Deposit-Taking Companies
Strong foreign bank presence
Gateway to mainland China
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 6 / 52
Regulatory Philosophy Comparison
US Approach HK Approach
Multiple overlapping regulators Single integrated regulator
Emphasis on competition Emphasis on stability
Strict separation of banking and More flexible business model
commerce Focus on international standards
Focus on consumer protection
Key Observation
Di↵erent historical paths led to distinct systems:
US: Competitive, fragmented market
碎⽚
HK: Concentrated, internationally oriented market
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 7 / 52
Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 8 / 52
Bank Consolidation Trends
Key Statistics Drivers
Number of banks declined dramatically Regulatory changes
since mid-1980s Technology
Consolidated from over 14,000 to Economies of scale
around 6,000 banks
Market competition
Top 10 banks hold over 50% of total
banking assets
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 9 / 52
Ten Largest U.S. Banks, 2022
Rank Bank Holding Company Assets (billions) Share of U.S. Bank Assets (%)
1 JPMorgan Chase 3,380 14.8
2 Bank of America 2,440 10.6
3 Citigroup 1,720 7.5
Igegap
4 Wells Fargo 1,713 7.5
5 U.S. Bank 582 2.6
6 PNC Bank 534 2.3
7 Truist Bank 532 2.3
8 Goldman Sachs 502 2.2
9 TD Bank 405 1.8
10 Capital One 388 1.7
Total 12,196 53.3
Source: http://www.federalreserve.gov/Releases/Lbr/current/default.htm
Key Observations
Top 4 banks control 40.4% of U.S. bank assets
Clear tier structure: Big 4, Regional banks, Others
Significant concentration: over 53% of assets in top 10
Large gap between 4th and 5th ranked banks
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Number of Insured Commercial Banks in the United States
Source: https://www5.fdic.gov/hsob/HSOBRpt.asp
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Nationwide Banking Development
Evolution of Interstate Banking
Riegle-Neal Act of 1994 跨 洲1 银 ⾏
Allowed full interstate branching
Eliminated geographical restrictions
Impact:
Creation of super-regional banks
Emergence of large, complex banking organizations (LCBOs)
Enhanced competition across state lines
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National Banking Development
Advantages Disadvantages
Community banks will survive Fear of decline in:
despite changes (information, Small banks
service, market focus etc.) Small business lending
Increase in competition and Rush to consolidation may
efficiency increase risk taking
Increased diversification of
bank loan portfolios
Key Implications
prote.it
Balance between consolidation and preservation of community
banking
Trade-o↵ between efficiency gains and potential risks
Important role of diversification in stability
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Separation of Banking Services
Historical Context Current Structure
Glass-Steagall Act (1933) m
Mixed model:
Separated commercial and Universal banking permitted
investment banking State regulation remains
Limited bank activities SEC oversees securities
Gramm-Leach-Bliley Act (1999) Fed supervises holding
废 除 Glass-Steagall
Repealed companies
Allowed financial
supermarkets
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International Comparison: Separation of Banking Services
Universal Banking Countries Asian Models
Germany Hong Kong
Universal banking model Three-tier banking system
Banks can engage in Permitted to:
commercial/investment Full/Wholesale/Limited Scope
banking/insurance Mainland China
UK (Post-1986)
取消 Separate licenses required
”Big Bang” deregulation State-owned banks dominate
Securities underwriting commercial banking
permitted but through legally Gradual opening to universal
separate subsidiaries banking
Key Trends
Global trend toward universal banking
Varying degrees of regulatory separation
Balance between efficiency and risk control
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 15 / 52
Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 16 / 52
Financial Innovation - Driving Forces
Response to Changes in Demand Conditions
Risk management needs
Interest rate volatility
Exchange rate fluctuations
More well-developed financial instruments
Response to Changes in Supply Conditions
Technological advancement
Information processing
Telecommunications
Competition among institutions
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Financial Innovation - Regulatory and Digital Evolution
Avoidance of Existing Regulation
Tax regulations
Capital requirements
Portfolio restrictions
Separation of financial institutions
Example: E-Banking Revolution
Online banking services
Electronic trading
Internet-based financial services
Mobile payments and digital wallets
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Shadow Banking - Definition and Overview
Definition
Credit intermediation involving entities and activities outside regular
banking system
Performs bank-like functions without:
X Explicit public sector credit guarantees
Access to central bank funding
Key Functions Similar to Traditional Banking
Credit intermediation 涉及正规银⾏体系之外的实体和活动的信⽤中介
执⾏类似银⾏的功能，但没有：
Maturity transformation 明确的公共部⻔信贷担
Liquidity transformation 保获得央⾏资⾦的渠道
主要功能与传统银⾏类似
信⽤中介
期限转换
流动性转换
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Shadow Banking - Key Components
Main Entities
Finance companies
Money market mutual funds
Investment banks
Hedge funds
Special purpose vehicles (SPVs)
Key Activities
Securitization
Asset-backed securities (ABS)
Mortgage-backed securities (MBS)
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Shadow Banking - A Simple Example
Traditional Banking
1 Depositors put money in bank
2 Bank makes loans to borrowers
3 Bank holds loans on balance sheet
4 Bank is supervised and regulated
5 Deposits insured by government
Shadow Banking 不 正規
1 MMF receives funds from investors
2 Finance company makes loans to borrowers
3 Finance company sells loans to SPV
4 SPV issues commercial paper
5 MMF buys commercial paper
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Securitization Process - The Heart of Shadow Banking
Definition
Transformation of illiquid assets into marketable capital market
instruments
Multiple institutions involved in asset transformation
Mortgage Securitization Example
1 Loan Origination: Mortgage broker arranges residential mortgage
2 Servicing: Loan servicer funds and manages mortgage
3 Bundling: Bundler:
Purchases mortgages
Collects monthly payments
”Passes through” to third parties
4 Distribution: Investment bank:
Divides portfolio into standardized amounts
Sells to investors
Key Concept
”Originate-to-distribute” business model
Sequence: Loan origination Servicing Bundling Distribution
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Shadow Banking - Key Di↵erences
Traditional vs. Shadow Banking
Traditional: One entity (bank) performs all functions
Shadow: Multiple entities involved
Money Market Fund (MMF)
Finance company
Special Purpose Vehicle (SPV)
No deposit insurance in shadow banking
Less regulation and supervision
More complex interconnections
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Shadow Banking - Vulnerabilities
Risk of Runs
Similar to traditional bank runs
But no safety net
No access to central bank lending
No government deposit insurance
Chain Reaction
Problems in one entity a↵ect others
Multiple steps in intermediation chain
放 of shocks
Amplification
⼤
Systemic risk concerns
Key factor that led to the global financial crisis from 2007 to 2009.
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 24 / 52
Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 25 / 52
The Basic Idea of Mutual Fund Industry
Investment Challenge:
How to invest 100/month for retirement?
How to achieve diversification with limited funds?
Basic Definition:
Mutual funds pool resources from many small investors
Sell shares to investors
Use proceeds to buy diversified securities
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Mutual Fund Industry: Key Statistics
Current Market Significance
57% of retirement assets held by mutual funds
28% of U.S. stock market owned through mutual funds
44% of U.S. households participate
Assets over 14 trillion
Growth rate: approximately 17% annually (past 25 years)
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Historical Development
Key Milestones
1 1824: First modern mutual fund (Boston)
2 1929: Stock market crash impact
Reduced investor confidence
Created distrust in mutual funds
3 1940: Investment Company Act
Improved industry regulation
Enhanced fee disclosure
Renewed investor confidence
4 1980-2013: Dramatic growth
From 5.7% to 75% household participation
5.3 trillion in retirement market
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Five Principal Benefits of Mutual Funds (1/2)
1 Liquidity Intermediation
Quick conversion to cash
Easy entry and exit
2 Denomination Intermediation
Access to larger investments
Participation in diverse markets
3 Diversification
Immediate portfolio diversification
Even with small investments
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Five Principal Benefits of Mutual Funds (2/2)
4 Cost Advantages
Lower transaction fees
Economies of scale
Better negotiating power
5 Managerial Expertise
Professional money management
Investment research and analysis
Portfolio monitoring
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Industry Growth Trends
Key Growth Indicators
Assets: 47B (1970) 13T Growth Drivers
(2012) Retirement planning
Funds: 361 (1970) 7,596 Financial education
(2012) Product innovation
Accounts: 10.7M (1970) Regulatory improvements
264M (2012)
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 31 / 52
Total Industry Net Assets and Number of Mutual Funds
Source: Investment Company Institute, 2016 Investment Company Fact Book
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Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 33 / 52
Mutual Fund Structure: Basic Types
Closed-End Funds
Fixed number of shares Open-End Funds
Initially o↵ered, then traded Flexible number of shares
OTC
Continuous buying/redemption
Price determined by market
Price based on NAV
supply/demand
Direct transactions with fund
No redemption from fund
company
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Net Asset Value (NAV)
Definition:
Total Assets - Liabilities
NAV =
Number of Shares Outstanding
Example Calculation:
Assets:
Stocks: 20,000,000
Bonds: 10,000,000
Cash: 500,000
Liabilities: 300,000
Shares Outstanding: 10 million
NAV = 30,200,000 10,000,000 = 3.02
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Organizational Structure
Key Players and Relationships
1 Shareholders
Fund owners/investors
Voting rights
2 Board of Directors
Oversees fund activities
Hires service providers
Protects shareholder interests
3 Service Providers
Investment advisor
Administrator
Underwriter
Transfer agent
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Investment Objective Classes: Overview
Distribution of Fund Types
Stock (Equity) Funds: 51%
Bond Funds: 22%
Money Market Funds: 18%
Hybrid Funds: 9%
Key Consideration: Each type serves di↵erent investment goals and risk
tolerances
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Stock (Equity) Funds
Major Categories
Capital Appreciation Funds
Focus: Share price growth
Lower dividend priority
Total Return Funds
Balance of growth and income
Moderate risk approach
World Equity Funds
International exposure
Geographic diversification
Specialized Funds
Sector-specific
Style-specific (Value/Growth)
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Bond and Hybrid Funds
Bond Funds
Hybrid Funds
Strategic Income Funds
Balanced funds
Government Bond Funds
Combine stocks and bonds into
Corporate Bond Funds
a single fund
World Bond Funds
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Money Market and Index Funds
Money Market Funds Index Funds
Short-term securities Passive management
High liquidity Mirror specific index
Normally Open-end funds Lower fees
Not federally insured Tax efficient
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Fee Structure: Share Classes
Class A Shares (Front-Load)
Upfront sales charge
Lower annual expenses
Class B Shares (Back-Load)
Deferred sales charge
Higher annual expenses
Class C Shares (Level-Load)
No front/back load
Higher ongoing expenses
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Additional Fund Fees
Contingent Deferred Sales Charge
Incur when investors sell Class-B fund shares within a specified period
after the initial purchase date.
May disappear entirely
Exchange Fees
For switching between funds
Account Maintenance Fees
For small accounts
12b-1 Fees
Marketing and distribution
Ongoing sales commissions
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Outline
1 Historical Development
2 Banking Structure and Evolution
3 Financial Innovation and Shadow Banking
4 Overview of Mutual Funds
5 Mutual Fund Structure and Operations
6 Mutual Fund Industry Issues
EF Dept. (City University of Hong Kong) CB3044 Introduction to Financial Markets 43 / 52
Regulatory Framework: Key Laws
Four Primary Laws Governing Mutual Funds
1 Securities Act of 1933
Registration requirements
Disclosure standards
2 Securities Exchange Act of 1934
Trading regulations
Anti-fraud provisions
3 Investment Company Act of 1940
Registration requirements
Operating standards
4 Investment Advisers Act of 1940
Fund advisor regulation
Fiduciary responsibilities
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Independent Director Requirements
2001 SEC Rules
Independent directors must be majority of board
Independent directors select/nominate other independent directors
Legal counsel must be independent
Significance
Only U.S. companies required by law to have independent directors
Ensures oversight independence
Protects shareholder interests
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Hedge Funds: Key Characteristics
A special type of mutual fund, but di↵erent from Traditional
Mutual Funds as follows:
Structure
Operations
High minimum investment
Highly leveraged
( 1M+)
Limited regulation
Long-term commitment required
Complex strategies
High fees (1% + 20% of profits)
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LTCM Case Study
Long Term Capital Management
Background
Founded by John Meriwether
Nobel laureates on board
30%+ initial returns
Crisis
80B in equity positions
1T in derivatives
Required federal intervention
Legacy
Systemic risk awareness
Regulatory reforms
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Hedge Fund Regulation
2006 SEC Regulations
Mandatory registration of advisors
Increased oversight
Response to:
Fraud concerns
”Retailization” trend
Systemic risk
Recent Examples
Amaranth Advisors ( 6B loss)
Other significant failures
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Industry Abuses
Investor confidence is critical for the mutual fund industry.
Asymmetric Information problem: the Principal-agent problem again.
Major Types of Misconduct:
Late Trading Market Timing
Trading after 4:00 PM Time zone arbitrage
Using same-day NAV NAV exploitation
Illegal under SEC rules Not explicitly illegal
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Major Cases and Settlements
Significant Legal Actions
Alliance Capital
250M in fines/restitution
Market timing charges
Bank of America/Canary Capital
375M fines/restitution
160M fee reduction
Janus
225M total settlement
Fee reduction + restitution
Putnam Investments
100M settlement
Fifth-largest fund family
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SEC Findings and Government Response
SEC Survey Results
25% allowed illegal late trades
50% permitted market timing
30% shared sensitive information
Regulatory Response
Increased independent directors
Stricter 4:00 valuation rule
Enhanced redemption fees
Greater transparency requirements
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Chapter Summary
Banking Industry Mutual Fund Industry
Structure Growth
Consolidation trend Pooling investors’ funds
Nationwide banking together
Evolution Providing many benefits in
investing
From Separation of banking
service toward Universal Structure
banking model Open vs. closed-end funds
Innovation Multiple fund types
Shadow banking growth Challenges
Securitization importance Late trading/market timing
and problem Regulatory compliance
Common Themes
Both face increasing regulation and Technology-driven innovation
Principal-agent and information asymmetry issues
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