final report
menmen03
Lecture2-FinancialInstitutions-Jun8.pptxFinancial Institutions & Market
FIN 353 –Summer 2020
Snow Han
SFSU
Classification of Financial Markets
By nature of claim/type of securities.
Debt market; Equity market
By seasoning of claim.
Primary market; Secondary market
By organizational structure
Exchange market; Over-the-counter market
By maturity of claim.
Money market; Capital market
By immediate delivery or future delivery
Cash or spot market; Derivative market
https://www.youtube.com/watch?v=Q7FdaiPQuDg
https://www.youtube.com/watch?v=G_IK0Q1FCnk
https://www.youtube.com/watch?v=Mcc-GkjkOvE
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Why Study Financial Institutions
Indirect financing accounts for a much larger share in the U.S. financial system, which means you will have to deal with financial institutions ALL THE TIME.
Financial institutions are among the largest employers in the U.S. and often pay high salaries.
The answers are:
1. Diversify risk/Risk sharing
2. Reduce transaction costs
3. Mitigate problem of information asymmetry
1. Diversify Risk
What is risk???
Risk is uncertainty
Think about gambling
Think about stocks
Think about bonds
Do you like risk? WHY?
Interest rate
Impact of RISK
Changes in stock prices:
Affect the economy’s perception of wealth:
Influence spending decisions
Affect the market value of companies/financial institutions
Affect the IPO market and M&A market (P/E multiples)
Changes in interest rates (YTMs):
Affect the cost of borrowing (end users and intermediaries) & Affect bond/loan/mortgage prices
Influence the returns (and profit margins) to interest sensitive financial institutions (e.g., banks) and the borrowings/investments of non-financial sectors (household and companies).
Impact on the M&A market (leveraging activities)
Impact on mortgage markets (residential, commercial…etc.)
EG: GOOGLE rescind 2000 offers from contractors, CEO announce that investment activities and hiring activities will slow down.
Private debt market see default coming up.
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Diversification
Individual has limited wealth – confine you investment scale
E.g., a $5,000 investment only allows you to purchase 100 shares @ $50 / share (equity) – e.g.: APPLE- $331.5/share-BRK.B $200/share BRK.A – $300,920 – Tesla - $855/share
No diversification
What makes it worse? You have to pay the broker commission for trading
Bonds even worse—most have $1,000 as their face value (some will be $5000)
Only less than half of US household own any type of securities (stocks or bonds)
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Diversification
Diversification
Hold a portfolio – a basket full of different securities
e.g.: hedge funds, mutual funds, pension fund…etc.
Asset Transformation
Create and sell assets with preferable characteristics to investors by pulling all capital together
e.g.: Bank loans…etc.
2. Reduce Transaction Costs
Transaction costs include direct and indirect costs.
Direct Costs
Pay commission/service fee/ membership…etc.
Some are fixed cost (flat fee), some are variable costs (% costs)
Indirect Costs (legal costs, opportunity costs…etc.)
Spend time , money and energy to find you matched lenders (stocks or bonds, mortgage…etc.)
Once you find it, you have to hire lawyer to write contract…
Reduce your wealth! –Economy of Scale
Financial Institutions reduce transaction costs
Economy of Scale
The reduction of transaction cost per unit as the size (scale) of transactions increases
E.g.: mutual fund – reduce transaction costs via reducing fixed costs per unit, such as flat-fee commission
Expertise – advantages of expert management
Money managers could pick the stocks and trade for you (buy-side) – reduce your opportunity costs
*Analyst report could be sold to lots of people (sell-side)
Why when scale increases, you can reduce cost – this is true for most economy
A plant produce equipment
Usually it comes with both fixed cost, and variable cost
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3. Asymmetric Information
Asymmetric information arises when one party‘s insufficient knowledge about the other party involved in a transaction; makes it impossible to make accurate decisions when conducting the transaction
Asymmetric information can take on many forms, and is quite complicated. However, to begin to understand the implications of asymmetric information, we will focus on two specific forms:
Adverse selection
Moral hazard
3. Asymmetric Information
Adverse Selection
Happens before transaction
Potential borrowers might be the people who are most likely to produce undesirable outcomes
Lemon problem in used car market
Moral Hazard
Happens after transaction
The borrower might engage in activities that are undesirable from the lender’s perspective, and might hurt the lender’s interest
Principle-Agent problem / agency problem
Lemon Problem- adverse selection
By Nobel Prize Winner – George Akerlof
“Lemon” in the used car market
“Lemon”s in the bond and stock market
Hard to distinguish between good-quality firms vs. bad-quality firms
Investor only wish to pay the price for average-quality firms
Good quality firms will get underpaid and quit the market, while bad-quality firms get overpaid and stay in the market
Reduce the efficiency and effectiveness of financial system
How to solve adverse selection
Private collection of information and sale of information
Standard & Poor’s, Moody’s , ValueLine, Morning Star…etc. collect & sell information
Free Rider Problem
people who don’t pay for information take advantage of other people’s information
Government regulation to increase information disclosure
SEC (Security and Exchange Commission) – Auditing
Accounting Scandals – Enron 2001 – Arthur Anderson
Financial Intermediation
Expertise
E.g.: instead of buying a used car directly, you might want to go to a dealer and buy a certified used car
why more bank loans
Private BANK loans than public transaction – no free rider problem
Auditing – auditing firms certify that the firm compose their financial statements adhering to the standard accounting principles (GAAP). And make sure the firm is disclosing accurate information about sales, assets, and earnings, losses.
The big 4 – Pricewaterhouse, Earnest & Young, Deloitte, KPMG
When compare banks with other private firms that collect information, banks don’t sell their information, they use the information to initiate private loan. This means no one knows which company they are negotiating with and they are lending their money to. This can help mitigate the free-rider problem.
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Moral Hazard
Occurs when borrowers have incentives to behave differently (engage in activities that are undesirable to the lenders’ benefit) after an agreement is made between parties
After transaction occurs – misuse of the fund/money (hide information)
Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back – usually this involves risk taking e.g.: Gambling, or personal spending – agency problem
E.g.: You lend someone your money for him to start a business, but he used it for lottery instead
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Agency Theory
The analysis of how asymmetric information problems (specifically, moral hazard) affect managers’ behavior is known as agency theory.
Principal-agent problem (usu. Equity)
Stock holders – owners – principals
Managers – agents
The separation of ownership and control
Example: CEO myopia behavior
If managers have a larger share of the firms, it could help lessen agency problem
CEO could cut their R&D expenses to realize more profit for the term they work for the company,
Since usually the CEO’s bonus are directly related to the firms’ current performances, not future performances.
but it is not good for the company in the long run.
Enron – pocket their money for their own use
Also some bad mergers and acquisitions to boost the power of the CEO, but not necessarily a good thing for the company.
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How to solve agency problem?
Private Monitoring – another form of collecting information
Via shareholder monitoring (board) – expensive and time consuming
Any free rider problem?
Government regulation to increase information (same as adverse selection)
Regulations and CRIMINAL penalties for people who commit fraud or stealing profit (hard to justify)
Financial Intermediation
Venture capital – having several of their own people participate as members of the management teams (*PE)
Any free rider problem?
If you know other stock holders are monitoring the manage team, you tend to take a free ride on their monitoring activities. You could go on a vacation while have the other shareholders monitoring the management team. If you can do this, other shareholders can also do so. Eventually nobody will monitor the management team.
Venture capital. – They use the money they pooled from those venture capitalist or large investors to help entrepreneurs to start new business. In return for this, they receive the shares of the new firms (However at this time, those new shares are only available to VCs, not public available share – not an IPO) - thus no free rider problem//
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Financial Institutions
There are many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc.
Add investment banks (including broker and dealer), venture capitals
Example 2: Haidi 2010 Earthquake San Francisco Earthquake in the 1989, same scope and magnitude, but the one in Haidi cause my economic losses and more deaths
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Depository Institutions
Depository Institutions (Banks): accept deposits from individuals or institutions, and make loans.
Commercial banks
Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans
the largest financial intermediary and have the most diversified asset portfolios
Depository Institutions (cont.)
S&L , Mutual Saving Banks
Raise funds primarily by issuing savings, time, and checkable deposits which used to make residential housing mortgage
More and more similar to commercial banks
Credit Union
very small – require membership
issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company’s workers
All three are called depository institutions and they are not allowed to hold stocks , only debt instrument . And government bond.
S&L, mutual saving banks were not allowed to issue commercial loans, due to expertise, scale.
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Contractual Savings Institutions (CSIs)
All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements
Life Insurance Companies
receive funds from policy premiums, and sell annuity (annual payments upon retirement)
Liquidity is not an issue for CSIs, thus they can invest in relative illiquid securities, such as mortgages and corporate bonds
Largest CSI
Contractual Savings Institutions (Cont.)
Fire and Casualty Insurance Companies
receive funds from policy premiums,
must invest most in liquid government and corporate securities, since loss events are harder to predict
Pension and Government Retirement Funds
hosted by corporations and state and local governments
acquire funds through employee and employer payroll contributions
invest in corporate securities, and provide retirement income via annuities
Tax incentives
Pension – fixed contribution – 401(K)
,. Fixed benefit.
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Investment Intermediaries
Finance Companies
issue commercial papers /bonds to raise funds to lend to consumers to buy durable goods, and to small businesses for operations.
E.g.: Ford Motor Credit Company, Chrysler Capital
Mutual Funds
acquire funds by selling shares to individual investors
use the proceeds to purchase large, diversified portfolios of stocks and bonds, take advantage of reduced transaction costs
*money market mutual funds – checkable, and short term
Investment Banks
advise companies on securities to issue (bonds vs. stocks),
underwriting security offerings, also usually serve as brokers after the stock is listed publicly
offer M&A assistance,
act as dealers in security markets
Research department vs. trading department
Examples?
Investment Intermediaries (Cont.)
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Key Facts about Financial System
F1: Direct Finance is not the primary way of finance for businesses
(either in the US, or worldwide), Indirect Finance is, esp. BANK LOAN!
F2: Stocks are not the most important tool of direct finance, bond is
F3: When direct finance is involved, institutions play a more important role than individuals (businesses raise funds directly from lenders in financial markets)
F4: Banks are the most important resources of external funds
-But the lending role of banks is declining
F5: Only large, well established firms have easy access to securities markets for finance
F6: Collateral is an important feature of debt contracts
F7: Financial system is heavily regulated
The better known a firm is, the more information it is available to the market - analyst. Thus investors can evaluate the firms’ quality relatively easier. – less information asymmetry
You are large is to some extent evidence that you have been successful
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Other Key Facts - Collateral
Collateral is a prevalent feature of debt contracts for both households and businesses
Property promised to the lender (pledged to the lender) if the borrower default (can’t make the loan/debt payment)
Reduce lenders’ losses in the event of default
Reduce information asymmetry (both adverse selection, and moral hazard)
Debt with collateral – secured debt
Debt w/o collateral – unsecured debt -debenture
Example of secured debt vs. unsecured debt?
Corporate bonds are usually secured debt
Credit card is unsecured debt, while house mortgage/ and car loan are secured debt
The more valuable the collateral is, the less likelihood for debt holders generating large losses during the events of default.
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Net Worth
Net Worth = equity /equity capital= assets-liability
Debt holders (lenders) have prior claim than share holders.
In the cases that the firm defaults, debt holders can take title of the company’s net worth, sell it, and get compensated
The more value the net worth has, the smaller the losses the debt holders will incur at the event of default
“cushion”
Similar to collateral, net worth help lessen asymmetric information problem
Debt Indenture & Covenants
Reason why debt contracts are more prevalent than equity
Covenants are requirements put into the debt contract (Indenture) to constrain borrower’s behavior:
Covenants that discourage undesirable behavior (e.g. M&A, Dividends issuance)
Covenants that encourage desirable behavior (e.g. house mortgage) Usually for a firm, it will specify some minimum holdings of certain assets
Covenants that keep collateral value (e.g. car loan)
Covenants that provide information
Undesirable – M&A
Specify what type of investment you can use the loan to finance – only use it for certain type of equipment…etc.
For example – house mortgage with the bank. Usually the bank will require the head of the household to purchase life insurance. In case some emergency happens, loan could still be paid off.
Usually for a firm, it will specify some minimum holdings of certain assets – eg; cash
Keep collateral value – car loan – require you certain collision coverage and insurance on the car
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Economies of Scope
Lower the cost of information production for each service by applying one information resource to many different services
E.g.: make loan and underwriting bonds
The potential problem :
Conflicts of interests, when there is competition among different services
Financial intermediaries can help us collect information right? And after they collect the information, they can use it again and again.
For example, banks, when banks try to make a loan to a certain firm, it collects all sorts of information from the firm, and asses its credit risk.
After this, the bank can keep using the information to decide whether it is easy to issue bond for this company. By providing multiple services to the firms, they can establish long term relationship, reduce the cost of information production, and also realize economy of scope.
Hide information or conceal information
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The Dark Side of Financial Institutions
Conflicts of Interest
a type of moral hazard that occurs when a person or institution has multiple interests, and serving one interest is detrimental to the other
More likely to happen when a financial institution provide multiple services to a client
Three conflicts developed in financial institutions.
Share my own experience. You can teach in the summer, but then you can not travel back.
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1. Underwriting and Research in Investment Banks
Investment banks both research companies with public securities, as well as underwrite securities for companies going public.
Research is expected to be unbiased and accurate, reflecting the facts about the firm. It is used by the public to form investment decisions – (analyst report).
Underwriters will have an easier time if research is positive. if the firm’s outlook is optimistic, Underwriters can better serve the firm going public, and demand a better offer price from the market
What if the firm’s outlook is not optimistic?
Then, the investment bank acting as both a researcher and underwriter of securities for companies clearly has a conflict—serve the interest of the issuing firm or the public?
Chinese wall – between the research and underwriting/buy side department
an information barrier within an organization that was erected to prevent exchanges or communication that could lead to conflicts of interest.
between the corporate-advisory area and the brokering department in order to separate those giving corporate advice on takeovers from those advising clients about buying shares
Example: Tech Booms, Spinning
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Rating agencies assign a credit rating to a security issuance of a firm based on projected cash flow, assets pledged, etc. The rating helps investors determine the riskiness of a security, and thus the price of a security
Consultants, for a fee, help firms with variety of managerial, strategic, and operational projects, as well as design security.
An rating agency acting as both a rater and consultant for a firm clearly is not objective, especially if the consulting fees exceed the rating fees.
Example: Standard & Poor’s , and Moody’s during the housing crisis 2007-2009 – Mini case (page 158)
2. Credit Assessment and Consulting in Credit Rating Agencies
Besides this, there is also one problem with credit rating agency. The issuer of the securities will have to pay to the rating agency to have their securities rated. Investors and government are always concerned about the credit rating agency may bias its ratings upward to attract more business from the issuer.
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Auditors check the assets and books of a firm for the quality and accuracy of the information. The objective in 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.
Example: Enron Scandal (Page 157)
SOX (Sarbanes-Oxley Act)
3. Auditing and Consulting in Accounting Firms
SOX – in reaction to the Enron (2001) Scandal
Sarbanes-Oxley Act – 2002 as a reaction to Enron 2001
cover responsibilities of a public corporation’s board of directors, adds criminal penalties for certain misconduct, and required the SEC to create regulations to define how public corporations are to comply with the law.
2002 as a reaction to Enron 2001
cover responsibilities of a public corporation’s board of directors, adds criminal penalties for certain misconduct, and required the SEC to create regulations to define how public corporations are to comply with the law. – 11 titles
PCAOB –
Board member-
Independent auditing (auditor can’t provide the firm with consulting services at the same time)
Internal control
Enhanced disclosure (pro-forma)
Corporate fraud as criminal offenses
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