FINANCIAL MARKETS AND INSTITUTIONS

1999

THE MERGER OF CITIGROUP AND TRAVELERS INS. GROUP IN 1998

• PRIOR TO THE ACT COMMERCIAL BANKS CAN ENGAGE IN ONLY LIMITED ACTIVITIES
• -NO SECURITIES AND INSURANCE COVERAGE

BANKS LIMIT THE BUSINESS THEY DO

• NON BANK INSTITUTIONS CONVERT TO BANK HOLDING COMPANIES
• -I.E. GOLDMAN SACHS AND MORGAN STANLEY

• TRANSACTION DEPOSITS
• -DEMAND DEPOSIT ACCOUNT (CHECKING)
• -(TRADITIONALLY NO INTEREST)

• NEGOTIABLE ORDER OF WITHDRAWAL (NOW) ACCOUNT (1981)
• -WITH INTERESTS BUT REQUIRES A LARGER MINIMUM BALANCE

BONDS ISSUED BY BANKS

• BANK CAPITAL
• -PRIMARY CAPITAL
• -(TIER I) COMMON AND PREFERRED STOCKS, RETAINED EARNINGS

• SECONDARY CAPITAL (TIER II)
• -SUBORDINATED NOTES AND BONDS

CERTAIN CAPITAL REQUIREMENTS IN ORDER TO ABSORB LOSSES

IN THE PAST BANK CAPITAL WAS A PERCENTAGE OF TOTAL ASSETS

SINCE 1992 BANK CAPITAL WAS A PERCENTAGE OF RISK WEIGHTED ASSETS

A PERCENTAGE OF TOTAL ASSETS

PERCENTAGE OF RISK WEIGHTED ACTIVITIES (LOOK AT SLIDE 16 ON CH.17)

WORKING CAPITAL LOANS(CURRENT ASSETS-CURRENT LIABILITIES=WORKING CAPITAL)

TERM LOANS- USED TO PURCHASE FIXED ASSETS, AND THEY HAVE PROTECTIVE COVENANTS

INFORMAL LINE OF CREDIT(SUSCEPTIBLE TO HAVING CREDIT LINE CUT)

REVOLVING CREDIT LOAN- WHETHER YOU BORROW OR NOT, YOU WILL BE CHARGED, (MUCH MORE SAFER) REVOLVING WOULD BE BEST SUITED FOR EMERGENCIES BECAUSE THEY ARE LIQUID.

• PRIMARILY DEBT SECURITIES
• -TREASURY SECURITIES
• -AGENCY SECURITIES
• -CORPORATE AND MUNICIPAL SECURITIES (INVESTMENT GRADE ONLY)
• -MORTGAGE BACKED SECURITIES.

• ACTIVITIES THAT DO NOT AFFECT THE BALANCE SHEET RIGHT AWAY, BUT LIKELY IN THE FUTURE.
• -THEY CREATE CONTINGENT OBLIGATIONS
• -THESE ACTIVITIES NEED TO BE DISCLOSED NOWADAYS.

• OBLIGATION OF A BANK TO PROVIDE A SPECIFIED LOAN AMOUNT TO A PARTICULAR BUSINESS UPON REQUEST.
• -NOTE ISSUANCE (NIF) FOR COMMERCIAL PAPERS

BACKS A CUSTOMERS OBLIGATION TO A THIRD PARTY

BANKS EARN FEE INCOME

• Agreement between a customer and a bank to
• exchange one currency for another on a particular future date at a specified
• exchange rate

• Allows customers to hedge their
• exchange-rate risk

The bank can also serve as an intermediary

• Two parties agree to periodically exchange interest payments on a
• specified notional amount of principal (Fixed rate for floating rate and the reverse)

• The bank can serve as an intermediary or a guarantor for a fee, or the
• counterparty in a swap contract

• Privately negotiated contracts that protect buyers against the risk of
• default on debt securities
• -(Sellers receive periodical fees income, but they will have to cover the losses on the debt
• securities for the buyers in cases of default –E.g., AIG)

IN OTHER WORDS, WHEN YOU BUY SOMETHING THAT IS RISKY, BUY INSURANCE TO PROTECT YOURSELF.

• Federal-
• National bank
• –Chartered by the Comptroller of the Currency
• –Members of the Federal Reserve System

• State
• State bank
• -Chartered by state agencies
• –May be members of the Federal Reserve System

• BANK HOLDING COMPANY (BHC)
• -MOST BANKS ARE OWNED BY BHC'S
• -BHC'S HAVE MORE POTENTIAL FOR PRODUCT DIVERSIFICATION THAN
• INDEPENDENTLY OWNED BANKS

• USED TO BE $100,000 PER DEPOSITOR
• CURRENTLY UP TO $250,000 PER DEPOSITOR THROUGH DECEMBER 31, 2013

• Banks are not allowed to use borrowed or deposited funds to purchase
• common stocks

Banks can invest only in investment-grade bonds

• Prevent any firm that accepts deposits from underwriting stocks and
• bonds of corporations

• Separated banking and securities activities
• –To prevent potential conflicts of interest

Essentially repealed the Glass-Steagall Act

• Easier for commercial banks to engage in securities and insurance
• activities
• –Increase the degree to which banks can
• offer securities services
• –Allow securities firms and insurance
• companies to acquire banks

• Risk-based capital requirements are higher for banks that conduct more
• off-balance sheet activities

• SARBANES OXLEY ACT OF 2002
• Make corporate managers, board members, and auditors of public firms
• more accountable for the accuracy of the financial statement that their
• respective firms provided.

TO ABSORB POTENTIAL OPERATING LOSSES

TO BOOST ROE

THE CAMELS SYSTEM.

• Capital adequacy
• -Regulators determine the capital ratio (capital divided by assets) of
• a bank

Asset quality

• The FDIC evaluates the quality of a bank’s assets, including its loans and
• securities

Capacity Capital

Collateral Character

Condition

Management

• The FDIC specifically rates the bank’s management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment
• -Also assesses the bank’s internal control systems

Earnings

• A commonly used profitability ratio to
• evaluate banks is return on assets (ROA), defined as earnings after taxes
• divided by assets
• -Earnings can also be compared to industry earnings

Liquidity

• Regulators prefer that banks do not consistently rely on outside
• sources of funds such as the discount window

Sensitivity

• The degree to which a bank might be exposed to adverse financial market conditions
• -Much emphasis on a bank’s sensitivity to interest rate movements

• Goal: Maximize shareholder wealth
• -Managerial decisions may conflict with this goal

• -Agency problems
• –The problem that an agent may not behave in the best interests of a principal

• Agency costs
• –The costs associated with the existence, prevention, and correction of agency problems

The profitability a bank is highly influenced by interest rate changes

Net interest margin

(Interest revenues – interest expenses)/Assets

REMEMBER NET INTEREST MARGIN IS A PROFITABILITY MEASURE, SO YOU WANT IT TO BE HIGHER!!!! THE HIGHER THE BETTER!!!!!

RATE SENSITIVE ASSETS-RATE SENSITIVE LIABILITIES

• RATE SENSITIVE DEFINITION- The applicable interest rate is adjusted frequently (as the market
• interest rate changes)

IMPLICATION- NEGATIVE FOR MOST BANKS REMEMBER BANKS LIKE LOW INTEREST RATES..... SO WHEN I RATE GOES DOWN, ASSETS GET PAID BUT THEY WILL EVENTUALLY LOWER AND DEPOSITS WILL LOWER. THIS IS A BENEFIT.

• Duration
• -A measure of how sensitive the value of assets (or liabilities) is to interest rate changes
• -A higher duration means a higher sensitivity

IMPLICATION- FOR MOST BANKS THIS NUMBER IS POSITIVE.

Analysis of how a bank’s performance is affected by interest rate changes

• IMPLICATION- USUALLY NEGATIVE
• REMEMBER, IF I RATE IS HIGH, THEN BANK STOCKS GO DOWN HIGH INTERESTS RATES HURTS BANKS

BANKS USUALLY HAVE

• NEGATIVE GAP
• POSITIVE DURATION GAP
• NEGATIVE B2 IN THE REGRESSION ANALYSIS

RISING INTERESTS RATES HURT BANK PERFORMANCE

MATURITY MATCHING-(ASSET SIDE AND LIABILITY SIDE MOVE IN SAME DIRECTION)

USING FLOATING RATE LOANS(BANKS LIKE TO USE THIS WHEN THEY EXPECT INTEREST RATES TO INCREASE)

• USING INTEREST RATE FUTURES(BOTH FUTURES AND SWAPS ALLOW YOU TO LOCK IN 1 RATE)
• USING INTEREST RATE SWAPS

USING INTEREST RATE CAPS( IF YOU HAVE A LOAN, YOU CAN SET UP A CAP TO HOW HIGH THE INTEREST RATE CAN BE)

The risk that a debtor may not be able to repay the credit

NO!!!!!! BANKS NEED TO KNOW THE LEVEL AT WHICH THEY CAN BEAR RISK

TAKE A RISK TO THE AMOUNT YOU CAN TOLERATE

A BANK CANNOT SIMULTAANEOUSLY MAXIMIZE RETURN AND MINIMIZE CREDIT RISK

THE BANK ATTEMPTS TO EARN A REASONABLE RETURN AND MAINTAIN CREDIT RISK AT A TOLERABLE LEVEL.(DEPENDS ON INDIVIDUAL BANKS SITUATION)

• The risk that the value of securities may change due to changes in
• financial market conditions
• -As banks pursue new services related to the trading/holding of securities, their exposure to market risk increases

THE VALUE AT RISK APPROACH-(VaR)- THE MAXIMUM POSSIBLE LOSS GIVEN A PROBABILITY OR SCENARIO

REMEMBER!!!! A BANKS MARKET RISK ALSO DEPENDS ON ITS INTEREST RATE RISK EXPOSURE. MOST BANKS ASSESS IONTEREST RATE RISK OVER A RELATIVELY LONG TIME, BUT MARKET RISK ON A SHORTER TERM HORIZON

THE EXTENT TO WHICH LIABILITIES ARE USED TO FINANCE ASSETS

HIGHER

-MAJORITY OF BANK ASSETS GENERATE PREDICTABLE CASH FLOWS

• -BANKS MUST MEET THEIR MINIMUM CAPITAL REQUIREMENTS
• -THE REQUIREMENT FOR A BANK DEPENDS ON ITS RISK

IT REDUCES THEIR PROFITABILITY

ROE=ROA * EQUITY MULTIPLIER

• EQUITY MULTIPLIER= ASSETS/EQUITY
• ROA= NET INCOME/ASSETS

• BETTER ABILITY TO ABSORB LOSSES
• LOWER RETURN FOR SHAREHOLDERS

• ABSOLUTELY INCREASE CAPITAL:
• KEEP RETAINED EARNINGS
• ISSUE NEW STOCKS

• RELATIVELY:
• SELL LOANS
• REDUCE ANY OTHER RISKY ACTIVITIES

Depository institutions specializing in mortgage lending

• -Savings bank
• –Insured by Bank Insurance Fund (BIF)

• -Savings and loan associations (S&Ls)
• –Insured by Savings Association Insurance Fund (SAIF)

–BIF and SAIF are both administrated by FDIC

S&Ls are the most common

SIs are usually small in terms of their assets

• Savings banks are concentrated in
• northeastern U.S.

S&Ls are spread across the country

SIs are either stock owned or mutual

Most are stock owned

• CASH
• MORTGAGES
• -PRIMARY USE
• MORTGAGE BACKED SECURITIES

• OTHER SECURITIES
• TREASURY SECURITIES
• CORPORATE BONDS

• Liquidity risk
• Relatively high

• Credit risk
• Relatively low

• Interest rate risk
• Relatively high

• Nonprofit,
• mutual organizations owned by depositors (members) with common bonds
• Same university, community, church, ...

Deposits are called shares, and the interest paid is called dividends

CU income is not taxed

Either federally or state chartered

CUs are not taxed

Affiliation-supported facilities

Employees may lack incentives

Limited size and diversification

Unable to get funds by issuing stocks

• If CUs need funds temporarily, they can borrow from other credit unions or from the
• Central Liquidity Facility (CLF)

CLF acts as a lender for CUs much like the Fed’s discount window for banks

• CLF is part of a larger system called the Corporate Credit Union Network
• -Credit union for credit unions

NCUA (NATIONAL CREDIT UNION ASSOCIATION)

CAPITAL RATION OF 8% OF RISK WEIGHTED ASSETS

• Deposits are insured by the National Credit Union Share Insurance Fund
• (NCUSIF, since 1970)
• ADMINISTERED BY NCUA

• 90 percent of CUs are insured by NCUSIF (all Federal CU are insured)
• Used to be up to $100,000 per depositor
• Currently up to $250,000 per depositor through December 31, 2013

• Localized depositors
• -Can have unanticipated surges of withdrawals

Relatively high

• Concentrate on personal loans to members, Many of whom may be employed by same
• employer

Relatively high

• More insulated from interest rate risk than banks
• -Assets (consumer loans) maturities are typically short term, matching the short-term liabilities
• -The spread between interest revenues and interest expenses has been relatively stable

Relatively low

• Shared facility (shared branching) by participating CUs (since 1992)
• -Allow members to make deposits and withdrawals as if it were their own credit union branch

• As of April 2010
• -Most CUs participate
• -4034 service center locations

THEY PROVIDE SHORT AND INTERMEDIATE TERM CREDIT TO CONSUMERS AND SMALL BUSINESSES.

• –Provide financing for customers of retail
• stores or wholesalers

Provide direct loans to individuals

–Offer loans to small businesses

Wholly owned subsidiary with the primary purpose to finance sales of the parent company’s products and services

Provide financing to distributors/consumers of the parent company’s products

Purchase receivables of the parent company

Corporations can separate manufacturing and retailing from financing

Easier and less expensive to analyze each segment of the parent firm

• Captive establishes credit rating separate from the parent firm
• –Can get funding on its own

No reserve requirement

No restrictions on how to obtain funds

Competitive advantage in retail sales

• A short-term money market source but finance companies can roll over
• their issues to create a permanent source of funds (INTEREST RATE RISK)

• Secured commercial paper allows smaller and medium-sized finance
• companies access to the market

USUALLY DONE BY A COSIGNER OR BY REAL PROPERTY, NO DONT CO SIGN.

FINANCIAL INSTITUTIONS

THE TIME BETWEEN CASH DISBURSEMENT AND CASH COLLECTION. OFTEN BACKED BY ACCOUNTS OR INVENTORY.

LOANS TI FINANCE THE CASH CYCLE OF COMPANIES

• Finance companies do not hold assets that can be easily sold
• -May securitize loans

• Balance sheet structure does not call for much liquidity because of
• little deposit outflow

Relatively low

Maturities of assets and liabilities typically do not differ much

• Assets are typically not as sensitive as liabilities to interest rates
• -Can use adjustable rates and shorter maturities on their loans

Relatively low

The major risk faced by finance companies

Loan delinquency rates are typically higher than those of other lending institutions

High-risk, high-return nature of loans makes performance sensitive to prevailing economic conditions

Relatively high

• Automotive loans
• Banking (Ally Bank)
• Investing
• Insurance
• Mortgages

• FOUNDED IN 1998
• BOUGHT BY EBAY IN 2002

• MAJOR SERVICES:
• ONLINE PAYMENT
• BUYER CREDIT/BILL ME LATER(DONE BY FINANCE COMPANIES)
• MONEY MARKET FUND
• DEBIT CARDS

A pool of investments managed by professional managers

• Benefits
• -Administration and record keeping
• -Diversification and divisibility
• -Professional management
• -Reduced transaction costs

-Very popular since 90s

Not listed

Transactions with the fund

• Number of shares outstanding changes when
• new shares are sold or old shares are redeemed

Listed on exchanges

Transactions with other investors

Fixed number of shares outstanding

The value (not necessarily price) of each share in a fund

MARKET VALUE OF ASSETS-LIABILITIES/NUMBER OF SHARES OUTSTANDING



For open-end funds, NAV is the price that investors will buy (sell) shares from(to) the fund

For closed-end funds, share prices are frequently lower than their NAVs The mysterious “closed-end fund discount”

IN ORDER TO BUY, PAY ME FIRST

FRONT END = BUY

BACK END = SELL

(BOTH ARE ONE TIME CHARGES)

ANNUAL 12B-1 CHARGE

Capital appreciation (aggressive growth)-HIGH RISK

• Growth
• Growth and income (BOTH OF THESE ARE SAFE)

Specialty- BASED ON INDUSTRY

INDEX- DJIA, S&P ETC.

INTERNATIONAL AND GLOBAL

• MULTIFUND (FUNDS ON FUNDS) AVOID!!!!!
• WHY IS THIS BAD? OVERPAYMENT

Invest in stocks, bonds, and money market securities

• The actual composition of a fund is adjusted over time to reflect the
• portfolio manager’s expectation on the market situation

Track indexes, Listed on exchanges, Becomes very popular in recent years, Have the characteristics of both open-end funds and closed-end funds

• Similar to indexed mutual funds
• Share price reflects changes in an index
• Pay dividends earned in additional shares
• Low management fees

• Similar to closed-end funds
• Listed with continuous price during the trading hours
• Transaction costs (broker fees) MARKET ORDER

Have tax advantages over indexed mutual funds, Unlike closed-end funds, share prices of ETFs do not deviate from their net asset value too much

• A closed-end fund that invests in real estate or mortgages
• Equity REIT
• -Invest in properties
• -Can be used to hedge against inflation

• Mortgage REIT
• -Invest in mortgages and construction loans
• (AVOID WHEN INFLATION IS HIGH!!!!)

• An investment company that offers a fixed (unmanaged) portfolio of securities as
• redeemable "units" to investors for a specific period of time
• -Assembled by a sponsor, e.g., a bank.
• -Sold through brokers to investors

• Pool of money from wealthy individuals and institutional investors invested in young, growing, and typically privately-held firms
• -Usually in the form of limited partnership
• -Exits through IPOs or sales of the firms
• -High risk and high return

• Pool of money from wealthy individuals and institutional investors aiming at acquiring majority stakes in businesses
• -Usually in the form of limited partnership
• -Profit from improved business performance

• Unregulated, not allowed to advertise
• -Target wealthy individuals and institutions
• Usually in the form of limited partnership
• High risk and high return
• -Use strategies to magnify returns on investment

• Investment strategies
• -Along with equity investments
• -Long/short derivative securities
• -Sell stocks short
• -Use borrowed funds

• Researchers have found that, on average, mutual funds did not outperform the market
• -Raise questions on the ability of fund managers
• -Mutual funds may still fit investors’ needs by providing diversification and other services

• Goldman Sachs, Morgan Stanley
• -They are now bank holding companies
• -Some well-known ones including Bear Stearns, Lehman Brothers, and Merrill Lynch, were either bankrupted or acquired

Functions of IBFs

• Originating
• Registration statement
• Prospectus
• Underwriting
• Distribution
• Advising

A GROUP OF UNDERWRITERS

UNDERWRITER BEARS RISK

ISSUER BEARS RISK

TRUE

TRUE

• WHY?
• EASIER TO DISTRIBUTE
• LESS PRICE UNCERTAINTY

• An issuer can also choose to place its bonds by itself
• -Usually smaller issues targeting a few institutional investors
• –Insurance companies, commercial banks, etc.
• -Flexible (negotiable) terms on the issues
• -To avoid the underwriting fees

• The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition
• -The assets of the company being acquired are usually used as collateral for the loans, in addition to the assets of the acquiring company

Activities of purchasing undervalued assets and reselling them at higher prices

• -Asset stripping
• –A firm is acquired and then its individual divisions are sold off by the arbitrager

A merger usually involves two firms of similar sizes, resulting in a new larger firm

An acquisition usually has one large acquiring firm and one small target firm. After the acquisition only the large acquiring firm is left

• Uncertainty in asset prices
• Sources of financing
• Transaction costs

• Traditional
• Executes transactions and provides information and advice
• -E.g., Merrill Lynch of Bank of America
• HIGHER TRANSACTIONS COSTS THAN DISCOUNT BROKER!

• Executes transactions only
• Compete in price (broker commission)
• Becomes more popular

FINRA (FINANCIAL INDUSTRY REGULATORY AUTHORITY)

• Provides insurance on cash and securities deposited at brokerage firms
• -$500,000 total, including $100,000 against cash
• -SEC-registered brokers are insured

• MARKET RISK BASED ON MARKET CONDITIONS
• INTEREST RATE RISK BASED ON INTEREST RATE CHANGES
• CREDIT RISK BASED ON CUSTOMER CREDIT
• EXCHANGE RATE RISK- THIS BECOMES MORE IMPORTANT AS COMPANIES MOVE TOWARDS GLOBALIZATION.

THE PROBLEM THAT AN AGENT MAY NOT BEHAVE IN THE BEST INTERESTS OF A PRINCIPAL.

THE COSTS ASSOCIATED WITH THE ESISTENCE, PREVENTION, AND CORRECTION OF AGENCY PROBLEMS