1. Meeting 2

2. What are FI?  Non depository a financial institution that funds their investment activities from the sale of securities or insurance  Depository a financial institution that accepts deposits and channels the money into lending activities

3. What are the benefit of FI for economy?  Fulfill Economic Goals  Economic Growth  Price Stable  Full Employment  Reduce Cost of Monitoring  High Liquidity  Reduce Price Risk  Reduced Transaction Costs  Provide Maturity Intermediation or Asset transformation  As Transmission of Monetary Policy  Major Source of Finance (Credit Allocation)  Provide Payment Mechanism

4. Without FI Function HouseHold Corporation Equity and debt claim Cash World Without FI

5. With FI Function

6. FI Function

7. Denomination Divisibility – pool savings of many small SSUs into large investments. Currency Transformation – buy and sell financial claims denominated in various currencies. Maturity Flexibility – Offer different ranges of maturities to both DSUs and SSUs. Credit Risk Diversification – Assume credit risks of DSUs; spread risk over many different types of DSUs. Liquidity – Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.

8.  The Functions of Intermediation: Financial intermediation can improve economic efficiency in at least five ways, by:  1) facilitating transactions  2) facilitating portfolio creation  3) easing household liquidity constraints  4) spreading risks over time; and  5) reducing the problem of asymmetric information.  Brokerage: Brokerage is acting as an agent to bring buyers and sellers together in order to complete financial transactions.  Externalities: Spillover effects, negative or positive, generated by the actions of financial institutions in particular, and the financial system in general, are called externalities.

9. Types of Financial Institution  Deposit-type or “Depository” Institutions  Contractual Savings Institutions  Investment Funds  “Other” Institutions

10. Deposit type institutions  called depository institutions,  accept and manage deposits and make loans.  two types : chartered banks and near banks.  Chartered banks = large and federally regulated  Near banks = regulated by a combination of federal and provincial regulations. Consist of: 1) trust companies; 2) mortgage loan companies; and 3) credit unions (caisses populaires in Quebec).

11. Contractual Savings Intitutions  For example : Insurance companies provide their clients with protection against a variety of risks, while pension funds manage pension funds or pension plans such as registered retirement savings plans (RRSPs), registered pension plans (RPPs), and public pension plans.

12. Investment Fund  Known as mutual funds, pool funds for investment in a wide range of activities and instruments.  Consumer and business financial intermediaries (i.e., sales, finance, and consumer loan companies) and investment dealers are also included in this category.

13. Copyright© 2006 John Wiley & Sons, Inc. 13 Depository Institutions take deposits and make loans. Commercial Banks  Thrift Institutions  Savings & Loan Associations  Savings Banks  Credit Unions

14. Regulation about FI  1. Safety and soundness regulation  2. Monetary policy regulation  3. Credit allocation regulation  4. Consumer protection regulation  5. Investor protection regulation  6. Entry regulation

15. Copyright© 2006 John Wiley & Sons, Inc. 15 Commercial Banks  Largest single class of financial institution  Issue wide variety of deposit products - checking, savings, time deposits  Carry widely diversified portfolios of loans, leases, government securities  May offer trust or underwriting services

16. Copyright© 2006 John Wiley & Sons, Inc. 16 Thrift Institutions  Closely resemble commercial banks  Focus more on real estate loans, savings deposits, and time deposits

17. Copyright© 2006 John Wiley & Sons, Inc. 17 Credit Unions: Unique Characteristics  Mutual ownership -“owned” by depositors or “members”  “Common bond” - members must share some meaningful common association  Not-for-profit and tax - exempt  Restricted mostly to small consumer loans

18. Copyright© 2006 John Wiley & Sons, Inc. 18 Contractual Institutions bring long-term savers and borrowers together.  Life Insurance Companies  Casualty Insurance Companies  Pension Funds

19. Copyright© 2006 John Wiley & Sons, Inc. 19 Life Insurance Companies insure against lost income at death.  Policyholders pay premiums, which are pooled and invested in stocks, bonds, and mortgages  Investment earnings cover the costs and reward the risks of the insurance company  Investments are liquidated to pay benefits.

20. Copyright© 2006 John Wiley & Sons, Inc. 20 Casualty Insurance Companies cover property against loss or damage.  Sources and uses of funds resemble those of life insurers, but  Casualty claims are not as predictable as death claims; so  More assets are in short-term, easily marketable investments

21. Copyright© 2006 John Wiley & Sons, Inc. 21 Pension Funds help workers plan for retirement.  Workers and/or employers make contributions, which are pooled and invested in stocks, bonds, and mortgages  Net of administrative costs, investment earnings are reinvested and compounded  Retirement benefits replace paychecks (at least partly)

22. Copyright© 2006 John Wiley & Sons, Inc. 22 Investment Funds help small investors share the benefits of large investments.  Mutual Funds provide intermediated access to various capital markets  shareholders’ money is pooled and invested in stocks, bonds, or other securities according to some objective  Money Market Mutual Funds (“MMMFs”) are uninsured substitutes for deposit accounts  MMMFs buy money market instruments wholesale, pay investors interest, and allow  limited check-writing

23. Copyright© 2006 John Wiley & Sons, Inc. 23 “Other” Financial Institutions  Finance Companies— Make loans but do not take deposits; raise loanable funds in commercial paper market and from shareholders  Federal Agencies— Issue “agency securities” backed by government and lend at sub-market rates for favored social purposes

24. Copyright© 2006 John Wiley & Sons, Inc. 24

25. Copyright© 2006 John Wiley & Sons, Inc. 25 Financial Markets are classified in several ways.  Primary and Secondary  Organized and Over-the-Counter  Spot and Futures  Options  Foreign Exchange  International and Domestic  Money and Capital

26. Copyright© 2006 John Wiley & Sons, Inc. 26 Primary and Secondary Markets  Primary markets are where financial claims are “born”: DSUs receive funds, claims are first issued  Secondary markets are where financial claims “live”—are resold and repriced  Claims become more liquid because SSUs  can set their own holding periods  Trading sets prices and yields of widely held securities

27. Copyright© 2006 John Wiley & Sons, Inc. 27 Organized and Over-the- Counter Markets  Organized Exchanges: physical, relatively exclusive.  Physical trading floor and facilities available to members of exchange, for securities listed on exchange.  New York Stock Exchange  Chicago Board of Trade (futures) OTC Markets: virtual, relatively inclusive.  Decentralized network available to any licensed dealer willing to buy access and obey rules, for wide range of securities.  The NASDAQ is a famous OTC market.

28. Copyright© 2006 John Wiley & Sons, Inc. 28 Spot and Futures Markets  Spot Markets: immediate payment for immediate delivery  Futures or Forward Markets: immediate payment for promise of future delivery “Futures” contracts: standardized as to amounts, forms, and dates; trade on organized exchanges “Forward” contracts: individualized between parties with particular needs

29. Copyright© 2006 John Wiley & Sons, Inc. 29 Option Markets  Rights in underlying securities or commodities— writer grants owner some exclusive right for some certain time  Main types of options: Puts (options to sell) Calls (options to buy)  Options on listed securities and widely held commodities trade actively on organized exchanges

30. Copyright© 2006 John Wiley & Sons, Inc. 30 Foreign Exchange Markets  Any currency is convertible to any other at some exchange rate  “Forex” involves spot, future, forward, and option markets

31. Copyright© 2006 John Wiley & Sons, Inc. 31 International and Domestic Markets  Help participants diversify both sources and uses of funds  Examples of major international markets: Eurodollars—US dollars deposited outside U.S. Eurobonds—bonds issued outside US but denominated in $US

32. Copyright© 2006 John Wiley & Sons, Inc. 32 Money and Capital Markets  Money markets: wholesale markets for short- term debt instruments resembling money itself  Capital markets: where “capital goods” are permanently financed through long-term financial instruments (“Capital goods”—real assets held long-term to produce wealth—land, buildings, equipment, etc.)

33. Copyright© 2006 John Wiley & Sons, Inc. 33 Money Markets  Help participants adjust liquidity—  DSUs borrow short-term to fund current operations  SSUs lend short-term to avoid holding idle cash  Common characteristics of money market instruments—  Short maturities (usually 90 days or less)  High liquidity (active secondary markets)  Low risk (and consequently low yield)  Dealer/OTC more than organized exchange

34. Copyright© 2006 John Wiley & Sons, Inc. 34 Examples of Major Money Market Instruments  Treasury Bills  Negotiable Certificates of Deposit  Commercial Paper  Federal Funds (“Fed Funds”)

35. Copyright© 2006 John Wiley & Sons, Inc. 35 Capital Markets  Help participants build wealth DSUs seek long-term financing for capital projects SSUs seek highest possible return for given risk  Differences from money markets— Long maturities (5 to 30 years) Less liquidity (secondary markets active but more volatile) Higher risk in most cases (with higher potential yield) Traded “wholesale” and “retail” on organized exchanges and in OTC markets

36. Copyright© 2006 John Wiley & Sons, Inc. 36 Examples of Major Capital Market Instruments  Common stock  Corporate bonds  Municipal bonds  Mortgages

37. Copyright© 2006 John Wiley & Sons, Inc. 37

38. Copyright© 2006 John Wiley & Sons, Inc. 38 Efficiency in financial markets  Allocational Efficiency: highest/best use of funds  DSUs try to fund projects with best cost/benefit ratios  SSUs try to invest for best possible return for given maturity and risk  Informational Efficiency: prices reflect relevant information  Informationally efficient markets reprice quickly on new information;  informationally inefficient markets offer opportunities to buy “underpriced” assets or sell “overpriced” assets  Operational Efficiency: transactions costs minimized

39. Copyright© 2006 John Wiley & Sons, Inc. 39 Risks of Financial Institutions  Credit or default risk: risk that a DSU may not pay as agreed  Interest rate risk: fluctuations in a security's price or reinvestment income caused by changes in market interest rates  Liquidity risk: risk that a financial institution may be unable to disburse required cash outflows, even if essentially profitable

40. Copyright© 2006 John Wiley & Sons, Inc. 40 Risks of Financial Institutions, cont.  Foreign exchange risk: effect of exchange rate fluctuations on profit of financial institution  Political risk: risk of government or regulatory action harmful to interests of financial institution.

41. Things to do>>>  Make a group report about Basel (Bank for International Settlement) and its relation with Risk Management in Bank  Times New Roman, 12, 1.5 space, not more than 5 pages.

42. CHAPTER 1 Why Are Financial Institutions Special? Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

43. 1-43 Why Are Financial Intermediaries Special?  Objectives:  Explain the special role of FIs in the financial system and the functions they provide  Explain why the various FIs receive special regulatory attention  Discuss what makes some FIs more special than others  Explain the crisis in financial markets

44. 1-44 Without FIs Corporations (net borrowers) Households (net savers) Cash Equity & Debt

45. 1-45 FIs’ Specialness  Without FIs: Low level of fund flows.  Information costs  Economies of scale reduce costs for FIs to screen and monitor borrowers  Less liquidity  Substantial price risk

46. 1-46 With FIs Cash HouseholdsCorporations Equity & Debt FI (Brokers) FI (Asset Transformers) Deposits/Insurance Policies Cash

47. 1-47 Functions of FIs  Brokerage function  Acting as an agent for investors:  e.g. Merrill Lynch, Bank of America  Reduce costs through economies of scale  Encourages higher rate of savings  Asset transformer:  Purchase primary securities by selling financial claims to households  These secondary securities often more marketable  Transformation of financial risk

48. 1-48 Role of FIs in Cost Reduction  Information costs:  Investors exposed to Agency Costs  Role of FI as Delegated Monitor  FI likely to have informational advantage  Economies of scale in obtaining information.  FI as an information producer  Shorter term debt contracts easier to monitor than bonds  Greater monitoring power and control  Acting as delegated monitor, FIs reduce information asymmetry between borrowers and lenders

49. 1-49 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 in diversifying risks

50. 1-50 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

51. 1-51 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.

52. 1-52 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

53. 1-53 Regulation  Safety and soundness regulation:  Regulations to increase diversification  No more than 10 percent of equity to single borrower  Minimum capital requirements  TARP and Capital Purchase Program

54. 1-54 Regulation  Guaranty funds:  Deposit insurance fund (DIF):  Securities Investors Protection Fund (SIPC)  Monitoring and surveillance:  FDIC monitors and regulates DIF participants  Increased regulatory scrutiny following crises  Regulation is not costless  Net regulatory burden

55. 1-55 Web Resources  For information on regulation of DIs and investment firms visit: FDIC www.fdic.govwww.fdic.gov SIPC www.sipc.orgwww.sipc.org Federal Reserve www.federalreserve.govwww.federalreserve.gov Appendix 1B of text www.mhhe.com/saunders7e www.mhhe.com/saunders7e

56. 1-56 Regulation  Monetary policy regulation  Federal Reserve directly controls outside money  Bulk of money supply is inside money (deposits)  Reserve requirements facilitate transmission of monetary policy

57. 1-57 Regulation  Credit allocation regulation  Supports socially important sectors such as housing and farming  Requirements for minimum amounts of assets in a particular sector or maximum interest rates or fees  Qualified Thrift Lender Test (QTL)  65 percent of assets in residential mortgages  Usury laws and Regulation Q (abolished)

58. 1-58 Regulation  Consumer protection regulation  Community Reinvestment Act (CRA)  Home Mortgage Disclosure Act (HMDA)  Effect on net regulatory burden  FFIEC processed info on as many as 17 million mortgage transactions in 2009  Analysts questioning the net benefit

59. 1-59 Consumer Protection Regulation  Potential extensions of regulations  CRA to other FIs such as insurance companies in light of consolidation and trend toward universal banking  New additions:  Consumer Financial Protection Agency (2009)  Credit card reform bill effective 2010

60. 1-60 Regulation  Investor protection regulation  Protections against abuses such as insider trading, lack of disclosure, malfeasance, breach of fiduciary responsibility  Key legislation  Securities Acts of 1933, 1934  Investment Company Act of 1940

61. 1-61 Regulation  Entry regulation  Level of entry impediments affects profitability and value of charter.  Regulations define scope of permitted activities  Financial Services Modernization Act of 1999  Affects charter value and size of net regulatory burden

62. 1-62 Web Resources  For more information on regulation of depository institutions visit: FFIEC www.ffiec.govwww.ffiec.gov Federal Reserve www.federalreserve.govwww.federalreserve.gov FDIC www.fdic.govwww.fdic.gov OCC www.occ.treas.govwww.occ.treas.gov

63. 1-63 Changing Dynamics of Specialness  Trends in the United States  Decline in share of depository institutions and insurance companies  Increases in investment companies  May be attributable to net regulatory burden imposed on depository FIs  Financial Services Modernization Act  Financial services holding companies

64. 1-64 Risk and the Financial Crisis  Reactions to FSM Act and other factors:  Shift from “originate and hold” to “originate and distribute”  Affects incentives to monitor and control risk.  Shift to off balance sheet risks  Degraded quality and increased risk  Housing market bubble  Encouraged subprime market and more exotic mortgages

65. 1-65 Global Trends  US FIs facing increased competition from foreign FIs  Only 2 of the top ten banks are US banks  Foreign bank assets in the US typically more than 10 percent  As high as 21.9 percent

66. 1-66 Largest Banks

67. 1-67 Financial Crisis  DJIA fell 53.8 percent in less than 1 ½ years as if mid-March 2009  Record home foreclosures  1 in 45 in default in late 2008  Goldman Sachs and Morgan Stanley  Only survivors of the major firms

68. 1-68 Financial Crisis  AIG bailout  Citigroup needed government support  Chrysler and GM declared bankruptcy in 2009  Unemployment in excess of 10 percent

69. 1-69 Beginning of the Collapse  Home prices plummeted in 2006-07  Mortgage delinquencies rose  Forelosure filings increased 93 percent from July 2006 to July 2007  Securitized mortgages led to large financial losses  Subprime mortgages  Countrywide Financial bailed out and eventually taken over by Bank of America

70. 1-70 Significant failures and events  Bear Stearns funds filed for bankruptcy  Acquired by J.P. Morgan Chase  Fed moved beyond lending only to Depository Institutions  Government seizure of Fannie Mae and Freddie Mac  Lehman Brothers failure  Crisis spread worldwide

71. 1-71 Rescue Plan  Federal Reserve and other central banks infused $180 billion  $700 billion Troubled Asset Relief Program (TARP)  Still struggling in 2009  $827 billion stimulus program  American Recovery and Reinvestment Act of 2009

72. 1-72 Pertinent Websites The Banker Federal Reserve FDIC FFIEC Investment Co. Institute OCC SEC SIPC Wall Street Journal www.thebanker.com www.federalreserve.gov www.fdic.gov www.ffiec.gov www.ici.com www.occ.treas.gov www.sec.gov www.sipc.org www.wsj.com