Financial Management II Research Paper

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Course Learning Outcomes for Unit II Upon completion of this unit, students should be able to:

1. Explain foundational finance theories. 1.1 Explore the financial aspects of a chosen company. 1.2 Discuss the structure of a company’s capital in relation to its banking relationships.

2. Analyze a financial forecast using relevant data.

2.1 Examine how the banking structure of a company affects current and past investments.

Course/Unit Learning Outcomes

Learning Activity

1.1

Unit Lesson Chapter 3 Chapter 4 Unit II Scholarly Activity

1.2 Unit Lesson Chapter 3 Unit II Scholarly Activity

2.1 Unit Lesson Chapter 3 Unit II Scholarly Activity

Required Unit Resources Chapter 3: Banks and Other Financial Institutions Chapter 4: Federal Reserve System Unit Lesson In Unit II, we will focus on the banking environment and Federal Reserve System as well as the overall money supply. Each of us is affected in some way by the policies implemented by the Federal Reserve. This unit lesson looks at how the money supply is impacted by the Federal Reserve and its ability to regulate the markets as well as the structure of various banking institutions.

UNIT II STUDY GUIDE The Banks and the Federal Reserve

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The Federal Reserve

There are several government agencies that regulate our nation’s financial activities. The Federal Reserve System (also known as “the Fed”), the country’s central bank, plays a major role in our economy. Founded by Congress in 1913, the Fed works to provide the country with a more stable financial and monetary system. While the Fed is involved in many areas, it is focused mainly on maintaining an adequate money supply. It realizes this by influencing interest rates, borrowing, and the buying and selling of government securities. The Fed tries to make adequate funds available for consumer spending and business expansion while keeping interest rates and consumer prices in check. While the Fed does play a major role in managing the money supply, it also oversees other financial institutions. In other words, it makes sure that banks

comply with federal laws so consumers are treated fairly and consistently. Most importantly, the Fed insures the money that individuals deposit into financial institutions, so they can recover any losses if the bank fails and/or closes. By backing the banks and other institutions, the Fed enables consumers to trust the places in which they deposit and invest their money. Without such support, the economy would be unstable and there would be an ever-growing fear within our own economy.

Banks and Other Financial Institutions In the United States and other developed countries, a set of efficient financial intermediaries has advanced. Their original roles were generally specific, and regulation prevented them from diversifying. However, in recent years, regulations against diversification have been largely removed; today, the differences between institutions have been blurred. In general, the banking system has five major functions:

• accepting deposits, • granting loans, • issuing checkable deposit accounts, • clearing checks, and • creating deposit money (Akrani, 2011).

Still, there remains a degree of institutional identity. Therefore, it is useful to understand the major categories of financial institutions. Let’s examine the different categories of financial institutions in more detail. Investment Banks When we consider the variety of financial institutions, we must look at how they compare in terms of purpose. The investment banks, for instance, tend to help companies get funding they need. What do these financial institutions really do? They help corporations design attractive securities, then they buy the securities and sell them to other entities. Investment banks are also called underwriters because they guarantee that a company will have the money needed for a project or investment. The recent credit crisis has had a dramatic effect on the investment banking industry. For instance, Lehman Brothers eventually went bankrupt, and Merrill Lynch was forced to sell out to Bank of America (BoA). The two remaining major investment banks received Federal Reserve approval to become commercial bank holding companies. These banks are typically part of financial services corporations.

The Federal Reserve building in Washington, D.C. (Cupertino10, 2013)

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Commercial Banks Commercial banks include those such as BoA, Citibank, and JPMorgan Chase. These are traditional retailers of finance because they have many different types of savers and borrowers that they service. These banks have typically been the main organizations through which individuals have checking accounts. In addition, the Federal Reserve uses these banks to change the money supply. However, presently, there are other institutions that serve these purposes as well. These financial service corporations are usually big conglomerations that are the combination of many different financial institutions. Most financial services corporations started in one area but now have diversified to cover most of the financial spectrum. For instance, Citigroup owns Citibank, an investment bank, a securities brokerage organization, insurance companies, and leasing companies. Other Types of Banks What about some of the other types of institutions? Credit unions are one example; these institutions have members who share a common bond such as working in the same company or being in the same industry. The savings of the credit union members is used to make loans to other members for things like purchasing automobiles or homes. Many times, credit unions are the cheapest way for borrowers to receive these funds. Pension funds get contributions from employees, and the employer invests these contributions in different areas (usually bonds, stocks, or real estate). The proceeds of these accounts go into a retirement fund for the employee (Melicher & Norton, 2020). Life insurance companies are another institution. These companies use customers’ annual premiums and invest them in stocks, bonds, real estate, and other investments. They then pay the insured parties’ beneficiaries. Recently, these companies have started to offer tax-deferred savings plans as a benefit to their customers. Another type of financial market includes mutual funds, which is when money from savers is taken and used to buy stocks, bonds, or short-term debt instruments from businesses or government agencies. Mutual funds reduce risk through diversification because they pool funds (Melicher & Norton, 2020). A new and exciting type of institution is ETFs (exchange traded funds); these are much like regular mutual funds and are many times managed by mutual fund companies. ETFs buy a portfolio of particular types of stocks, for instance, the S&P 500 or media companies, and then sell shares. ETF shares are usually traded in public markets, so investors can buy shares in ETFs that have stocks in a particular market that is of interest to them.

There are many benefits to mutual funds. (Vaeenma, n.d.)

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What about hedge funds? These are similar to mutual funds because they take money from clients and use the funding. There are several important differences, though. One is that hedge funds are pretty much unregulated, which is different than mutual funds, which are regulated by the Securities and Exchange Commission (SEC). This regulatory difference is because mutual funds deal with small investors while hedge funds usually have large minimum investments, many times well over a million dollars. Institutions and individuals with high net worth are the target market of hedge funds.

Further, hedge funds got their name because they were general used for people who were trying to “hedge” risk. For instance, a hedge fund manager who believes that interest rate differentials between corporate and Treasury bonds are too large might simultaneously buy a portfolio of corporate bonds and sell a portfolio of Treasury bonds. In this case, the portfolio would be “hedge” against overall movements in interest rates, but it would perform especially well if the spread between these securities became smaller. Keep in mind that some hedge funds are much riskier than average stocks or mutual funds. For instance, in 1998, Long-Term Capital Management (LTCM), a high-profile hedge fund, made incorrect assumptions and spiraled out of control (Yang, 2014). LTCM had many billions of dollars under management, and it owed large

amounts of money to a number of banks. To avert a worldwide crisis, the Federal Reserve orchestrated a buyout of the firm with a group of upstate banks. Finally, private equity companies are entities that are similar to hedge funds, but they buy and manage entire firms instead of buying some stocks of a firm. Most of the money used to buy the largest companies is loaned out. While private equity activity slowed around the financial crisis, over the past decade, a number of prestigious companies have been acquired by private equity firms. In 2013, two major deals were announced; Berkshire Hathaway partnered with the private equity firm 3G Capital to purchase the Heinz Company, and, around the same time, Dell Computer announced plans to go private with the assistance of the private equity firm, Silver Lake Partners (Goldman, 2013). Some criticized these deals for not offering enough payment to the existing shareholders, and there was a possibility that another private equity firm or outside investor will make a competing offer (Edwards, 1999). Most financial institutions (except for hedge funds and private equity companies) are regulated to protect the investors and also ensure the safety of the institutions. Some examples of those regulations include:

• an exclusion on nationwide branch banking, • limitations on the types of assets the institutions could purchase, • upper limits on the interest rates they could pay, and • restrictions on the types of services they could provide.

These regulations tended to hinder the free flow of capital and, consequently, hurt the efficiency of the capital markets. Distinguishing this fact, policy makers took several steps during the 1980s and 1990s to deregulate financial services companies. Many believed that excessive deregulation and inadequate supervision of the financial sector was partially responsible for the major financial crisis of 2008. With those concerns in mind, Congress passed the Dodd- Frank Act in 2010. The legislation’s main goals were to create a new agency for consumer protection, work to increase the transparency of certain transactions, and force financial institutions to take steps to limit excessive risk-taking and to hold more capital (Maxfield, 2017).

Hedge funds are another way to invest, but they can carry more risk than other investments. (8vfand, n.d.)

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Conclusion In summary, the financial institutions all play a role in how or financial markets perform. With so many options available to investors and consumers, the financial markets will continue to excel and expand in terms of value and sheer volume. Diversification is key during such times of expansive growth and success. As technology starts to play a bigger role in the way we invest, we will start to see more of its influence. Electronic communications networks (ECNs) use technology to bring buyers and sellers together. In fact, the sudden interest in ECNs accelerated the move toward 24-hour trading. U.S. investors who wanted to trade after the U.S. markets closed could utilize an ECN, thereby bypassing the NYSE and NASDAQ. Such changes within the industry illustrate the growing importance of global trading. Is it possible that floor traders and other physical exchanges may be a thing of the past? Only time can tell.

References Akrani, G. (2011, April 20). Functions of banks – Important banking functions and services. Kalyan City Life.

http://kalyan-city.blogspot.com/2011/04/functions-of-banks-important-banking.html Cupertino10. (2013). ID 32019219 [Photograph]. Dreamstime. https://www.dreamstime.com/royalty-free-

stock-images-federal-reserve-building-washington-dc-image32019219 Edwards, F. R. (1999). Hedge funds and the collapse of long-term capital management. The Journal of

Economic Perspectives, 13(2), 189–210. 8vfand. (n.d.). ID 92954489 [Image]. Dreamstime. https://www.dreamstime.com/stock-photo-hedge-funds-

shown-businessman-concept-image92954489 Goldman, D. (2013, February 5). Dell plans to take company private. CNN.

https://money.cnn.com/2013/02/05/technology/enterprise/dell-lbo/index.html Maxfield, J. (2017, February 3). The Dodd-Frank Act explained. The Motley Fool.

https://www.fool.com/investing/2017/02/03/the-dodd-frank-act-explained.aspx Melicher, R. W., & Norton, E. A. (2020). Introduction to finance: Markets, investments, and financial

management (17th ed.). Wiley. https://bookshelf.vitalsource.com/#/books/9781119560579 Vaeenma. (n.d.). ID 130566544 [Image]. Dreamstime. https://www.dreamstime.com/why-mutual-fund-

image130566544 Yang, S. (2014, July 10). The epic story of how a 'genius' hedge fund almost caused a global financial

meltdown. Business Insider. https://www.businessinsider.com/the-fall-of-long-term-capital- management-2014-7

Suggested Unit Resources The following chapter from your textbook is not necessary to complete the unit, but it does offer great information about how policy affects the money supply. Chapter 5: Policy Makers and the Money Supply

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In order to access the following resource, click the link below. If you are interested in learning more about the Federal Reserve, the video below is a great resource. It explores the fundamentals of this institution. Cinelan (Producer). (2014). We the economy: Fed head—What is the Federal Reserve? [Video]. Films on

Demand. https://libraryresources.columbiasouthern.edu/login?auth=CAS&url=http://fod.infobase.com/PortalPla ylists.aspx?wID=273866&xtid=60803

The transcript for this video can be found by clicking on “Transcript” in the gray bar to the right of the video in the Films on Demand database. Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. How well do you know the unit material? Take the Unit II Knowledge Check Quiz to find out! (PDF of Unit II Knowledge Check Quiz)