Accounting Fundamentals for Financial Institutions Midterm
Asset and Liability Management
Fin6102
Ferriter – Spring 2018
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Why Study Financial Markets and Institutions?
Markets and institutions are primary channels to allocate capital in our society
Proper capital allocation leads to growth in:
Societal wealth
Income
Economic opportunity
In this first part of class we will examine:
the structure of domestic and international markets
the flow of funds through domestic and international markets
an overview of the strategies used to manage risks faced by investors and savers
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Primary versus Secondary Markets
Primary markets
markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds)
Secondary markets
markets where existing financial instruments are traded among investors (e.g., exchange traded: NYSE and over-the-counter: NASDAQ)
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You might also wish to mention electronic communication networks or ECNs. ECNs allow direct electronic trading among buyers and sellers without a third party. Two former ECNs, BATS (formed in 2005) and DirectEdge (formed in 1998), merged in fall 2013, and applied to become an exchange. The combined entity makes them the number two stock market ahead of NASDAQ and behind NYSE. Together the two have about 270 employees. The NYSE and NASDAQ have far more! Sign of the times.
BATS Global Markets is a stock exchange based in Lenexa, Kansas, a suburb of Kansas City. BATS was founded in June 2005 as an Electronic Communication Network (ECN) and its name stands for Better Alternative Trading System.[2] (Trades stocks on BZX and options on BYX exchange.) (source BATS website)
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Primary versus Secondary Markets
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Without FIs
Ch 1-5
Corporations
(net borrowers)
Households
(net savers)
Cash
Equity and debt claims
©McGraw-Hill Education.
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FIs’ Specialness
Without FIs: Low level of funds flow between households and corporations.
Monitoring costs
Economies of scale reduce costs for FIs to screen and monitor borrowers
Liquidity costs
Substantial price risk
Ch 1-6
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Functions of FIs
Brokerage function
Acting as an agent for savers:
e.g. Bank of America Merrill Lynch
Reduce transaction and information costs
Encourages higher rate of savings
Asset-transformation
Issue more attractive financial claims to household savers
Finance the purchase of primary securities by selling financial claims to household investors and others
Ch 1-7
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With FIs
Ch 1-8
Cash
Households
Corporations
Equity and debt
FI
(brokers)
FI
(asset transformers)
Deposits and insurance policies
Cash
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Role of FIs in Cost Reduction
Information costs:
Investors exposed to Agency Costs
Role of FI as Delegated Monitor
FI likely to have greater incentive to monitor
Economies of scale in obtaining information
FI as an information producer
New secondary securities may enable FIs to monitor more effectively (e.g., bank loans)
Short-term contracts allow more control and monitoring power for FIs
Reduction of information asymmetry
Ch 1-9
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Specialness of FIs
Liquidity and Price Risk
Secondary claims issued by FIs have less price risk
Demand deposits and other claims are more liquid
More attractive to small investors
FIs have advantage over households in diversifying risks due to size
Ch 1-10
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The S&L debacle of 1980s was linked to inadequate diversification of S&Ls, especially in the oil based economies of the Southwest.
Other Special Services
Reduced transactions costs
Maturity intermediation
Transmission of monetary policy
Credit allocation (areas of special need such as home mortgages)
Intergenerational transfers or time intermediation
Payment services (FedWire and CHIPS)
Denomination intermediation
Ch 1-11
©McGraw-Hill Education.
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Agriculture, small businesses, and home ownership in particular, have received special treatment in terms of loan subsidies and guarantees and other liquidity improving activities.
One of the key impediments to allowing non-FIs to act as banks, has been the fear of allowing non-FIs to gain access to the payment system. The arguments remain compelling even though some non-FIs have made inroads into the traditional business lines of banks in particular. Protection of the payment system is paramount, in terms of the role of FI regulators.
Specialness and Regulation
FIs receive special regulatory attention
Reasons:
Negative externalities of FI failure
Special services provided by FIs
Institution-specific functions such as money supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks, thrifts), etc.
Ch 1-12
©McGraw-Hill Education.
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Primary versus Secondary Markets
How were primary markets affected by the financial crisis?
Do secondary markets add value to society or are they simply a legalized form of gambling?
How does the existence of secondary markets affect primary markets?
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Primary market issuance declined sharply during the crisis although with low interest rates bond issuance boomed after market uncertainty declined in 2010. Stock issuance remained weaker longer, recovering in 2012 and 2013.
Secondary markets add liquidity for risky investments and encourage investment in primary markets. Secondary markets also aid in price discovery, providing up to date signals of the ongoing value of firms. These signals also provide benchmarks for corporate performance. It is not true that secondary markets are simply a legalized form of gambling.
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Money versus Capital Markets
Money markets
markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills)
little or no risk of capital loss, but low return
Capital markets
markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year
substantial risk of capital loss, but higher promised return
Figure 1.3
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Foreign Exchange (FX) Markets
FX markets
trading one currency for another (e.g., dollar for yen)
Spot FX
the immediate exchange of currencies at current exchange rates
Forward FX
the exchange of currencies in the future on a specific date and at a pre-specified exchange rate
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Spot FX: Note that ‘immediate’ usually means delivery within one or two business days.
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Derivative Security Markets
Derivative security
a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity,
generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future,
the main purpose of the derivatives markets is to transfer risk between market participants.
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Derivative Security Markets
Selected examples of derivative securities
Exchange listed derivatives
Many options, futures contracts
Over the counter derivatives
Forward contracts
Forward rate agreements
Swaps
Securitized loans
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Exchange listed are more regulated, more transparent, and generally involve no default risk for the counterparty.
OTC derivatives are nonstandard, largely unregulated and may involve substantial counterparty credit risk.
Forward rate agreements are prearranged loan contracts with the loan terms set now, drawdowns in the future.
Regulation of FIs
Important features of regulatory policy:
Protect ultimate sources and users of savings
Including prevention of unfair practices such as redlining and other discriminatory actions
Primary role:
Ensure soundness of the overall system
Ch 1-18
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Safety and Soundness Regulation
Protect against the risk of FI failure:
Diversification of assets
No more than 5 percent of equity to single borrower
Minimum capital requirements
TARP and Capital Purchase Program
Guaranty funds:
Deposit Insurance Fund (DIF):
Securities Investors Protection Corporation (SIPC)
Ch 1-19
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Safety and Soundness Regulation Continued
Monitoring and surveillance:
Involves on-site examinations and review of accounting statements
FDIC monitors and regulates DIF participants
Increased regulatory scrutiny following crises
Regulation is not costless
Net regulatory burden
Ch 1-20
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Derivatives and the Crisis
Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s.
Growing importance of ‘shadow banking system’
Mortgage derivatives spread the risk of mortgages to a broader base of investors.
Change in banking from ‘originate and hold’ loans to ‘originate and sell’ loans.
Decline in underwriting standards on loans
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(Optional slide: Hide if you do not wish to cover this topic)
This helped fuel a ‘credit boom’ that led to unsustainable increases in home prices. The shadow banking system refers to non-bank FIs who indirectly provide financing for loans buy originating loans or more likely by purchasing securities backed by loans. Shadow banking allows more rapid growth in credit by increasing the supply of funds available.
When home prices began falling in late 2006, more institutions were affected.
Resulted in a change in culture at some banks as well from a lending culture to a trading culture that was less risk averse.
The instructor may wish to ask students whether it makes sense to blame the instrument or the users. Warren Buffett has called derivatives, ‘weapons of mass destruction.’ However, used properly they allow market participants to transfer risk to other parties that they themselves do not wish to bear, and allow others lower cost methods to gain exposure to markets. It does seem reasonable to require greater transparency in OTC derivatives to ensure that players can cover the promises they make. Derivatives that involve payments of principal, such as credit default swaps, should be required to be traded on an exchange so that there are guarantees of performance and reasonable limits to speculation.
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Derivatives and the Crisis
Subprime mortgage losses were large, reaching over $700 billion.
The “Great Recession” was the worst since the “Great Depression” of the 1930s.
Trillions $ global wealth lost, peak to trough stock prices fell over 50% in the U.S.
Lingering high unemployment and below trend growth in the U.S.
Sovereign debt levels in developed economies reached post-war all-time highs
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(Optional slide: Hide if you do not wish to cover this topic)
Led to overall large declines in home prices nationwide. Houses are illiquid assets and falling home values are a drag on economic growth. Millions of homeowners are ‘underwater,’ owing more on their homes than their current market value.
Much of the wealth loss may be temporary over the long term, but growth declined at a rapid rate during the crisis. As of 2014 only now beginnin to see a return to more normal growth rates of the U.S. economy.
The instructor may wish to ask students whether it makes sense to blame the instrument or the users. Warren Buffett has called derivatives, ‘weapons of mass destruction.’ However, used properly they allow market participants to transfer risk to other parties that they themselves do not wish to bear, and allow others lower cost methods to gain exposure to markets. It does seem reasonable to require greater transparency in OTC derivatives to ensure that players can cover the promises they make. Derivatives that involve payments of principal, such as credit default swaps, should be required to be traded on an exchange so that there are guarantees of performance and reasonable limits to speculation.
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Financial Institutions (FIs)
Financial Institutions
institutions through which suppliers channel money to users of funds
Financial Institutions are distinguished by:
whether they accept insured deposits
depository versus non-depository financial institutions
whether they receive contractual payments from customers
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Institutions that accept insured deposits must be regulated by the government to offset the government’s liability. Insured deposits are a low cost source of financing, but the regulatory burden increases these institution’s costs significantly.
FIs that receive contractual payments, such as life insurers, pension funds and property and casualty insurers have steady premium income to invest. This allows them to take on more risk in their investment portfolio.
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Depository versus Non-Depository FIs
Depository institutions:
commercial banks, savings associations, savings banks, credit unions
Non-depository institutions
Contractual:
insurance companies, pension funds,
Non-contractual:
securities firms and investment banks, mutual funds.
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Note: savings associations, savings banks and credit unions are often called ‘thrifts.’
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Regulation of Financial Institutions
Dodd-Frank Bill
Promote robust supervision of FIs
Financial Service Oversight Council to identify and limit systemic risk,
Broader authority for Federal Reserve (Fed) to oversee non-bank FIs,
Higher equity capital requirements,
Registration of hedge funds and private equity funds.
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Regulation of Financial Institutions
Dodd-Frank Bill
Comprehensive supervision of financial markets
New regulations for securitization and over the counter derivatives
Additional oversight by Fed of payment systems
Establishes a new Consumer Financial Protection Agency
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Regulation of Financial Institutions
Dodd-Frank Bill
New methods to resolve non-bank financial crises
More oversight of Fed bailout decisions
Increase international capital standards and increased oversight of international operations of FIs.
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Although a very small component of the personal lending market, person to person lending (P2P) is now growing rapidly as the regulatory burden of the Dodd-Frank bill has added significantly to the cost of banking. P2P lenders, such as Prosperity, are privately funded and are largely unregulated so they can often offer lower loan rates. This is an unintended effect of the law.
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Risks Faced by Financial Institutions
Credit
Foreign exchange
Country or sovereign
Interest rate
Market
Off-balance-sheet
Liquidity
Technology
Operational
Insolvency
Volcker Rule: Insured institutions may not engage in proprietary trading
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The Volcker Rule has not yet been fully implemented as of June 2014 and an extension has been granted for CLOs (collateralized loan obligations).
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Globalization of Financial Markets and Institutions
The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before,
Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access to foreign markets,
International mutual funds allow diversified foreign investment with low transactions costs,
Global capital flows are larger than ever.
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