1. 1-0 Managing Financial Institutions: An Asset / Liability Approach; Fourth Edition Copyright © 2000 by Harcourt, Inc. All rights reserved. No part of the computer program embodied in this diskette may be reproduced or transmitted in any form or by any means, electronic or mechanical, including input into or storage in any information system, without permission in writing from the publisher. Lecture slides may be displayed and may be reproduced in print form for instructional purposes only, provided a proper copyright notice appears on the last page of each print-out. Request for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Produced in the United States of America. 0-03-022058-0

2. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-1 Chapter 1 Changing Times for Financial Institutions

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-2 Views of Financial Institutions 1930s 1970s and 1980s 1990s 21st Century

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-3 Views of Financial Institutions: Views of the 1930s Concern about the safety and soundness of financial institutions resulted in laws that limited the activities of financial institutions. Managers engaged in specific, legally permissible activities, charging prices with legally mandated maximums, and incurring legally determined costs.

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-4 Views of Financial Institutions: Views of the 1970s and 1980s Depositors withdrew their funds in search of higher returns elsewhere as interest rates rose in the 1970s. Many financial institutions could not respond because laws of the 1930s limited interest rates they could offer. Volatile interest rates created profitability problems for many financial institutions.

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-5 Technology expanded competition by facilitating the direct sale of securities by firms to investors on a global basis. Lower profits led some financial institutions to increase lending to riskier customers. Regional recessions in the late 1980s resulted in many bank failures and severe losses at U.S. savings institutions.

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-6 Views of Financial Institutions: Views of the 1990s New regulations were imposed on banks and savings institutions and deposit insurance funds were recapitalized. Mergers occurred to take advantage of new technology that allowed greater economies of scale and cross-selling opportunities.

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-7 Globalization resulted in profit opportunities from consulting, selling products to customers abroad, and international trading activities. Technology increased the use and trading of derivatives such as futures, options, and swaps.

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-8 Mergers between different types of institutions increased opportunities for synergies and noninterest revenues. Risk and culture management problems increased.

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-9 Opportunities of the 21st Century Interstate Branching New Technology Demographics Globalization

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-10 How do real physical assets differ from financial assets? Real, tangible assets are those expected to provide benefits based on their fundamental qualities. A financial asset is a contract that offers a promise of payment in the future from the party that issued the contract.

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-11 What types of assets and liabilities do financial institutions have compared to most businesses? The key difference between financial institutions and other firms is that most of the assets financial institutions hold are financial assets. Financial institutions have much higher financial leverage than nonfinancial firms. Liquidity problems result from depositors’ ability to withdraw funds at any time.

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-12 Why do nonfinancial companies have lower financial leverage than banks? Banks and savings institutions can use higher financial leverage than other firms because most of their deposits are federally insured.

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-13 What are financial institutions? Although all financial institutions hold predominantly financial assets and low percentages of fixed assets, they specialize in varying types of financial assets and services. The major types are depository, finance, contractual, investment, and securities firms.

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-14 What are depository institutions? Depository institutions are financial institutions that take deposits and make loans. They control the largest proportion of financial assets. This category includes commercial banks, savings institutions, and credit unions.

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-15 Commercial Banks Banks have been the primary source of short-term and intermediate-term loans. Competition has increased in banks’ traditional area of specialization - lending. Banks have also lost deposits. Banks package loans, provide conditional guarantees, and serve as dealers for instruments to hedge interest-rate risk.

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-16 Thrift Institutions Savings and loan associations (S&Ls) and savings banks traditionally rely on savings deposits as sources of funds. S&Ls have expanded beyond their traditional role as mortgage suppliers. Savings banks resemble S&Ls, but they have more diversified asset bases.

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-17 Credit Unions (CUs) CUs are not-for-profit organizations. CUs are subject to a common bond requirement and cannot make commercial loans. CUs have aggressively stretched common bond boundaries, becoming more like banks by offering credit cards and other investment services.

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-18 Finance Companies Finance companies specialize in loans to businesses and consumers. They acquire funds by selling commercial paper and bonds and by borrowing from commercial banks.

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-19 Why are insurance companies and pension funds called contractual savings institutions? They operate under formal agreements with policyholders or pensioners who entrust their funds to these firms.

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-20 What types of investments would you expect each to hold? Life insurers and pension funds, because they make long-term commitments, traditionally hold asset portfolios structured quite differently from those of property/liability insurers, which offer short-term policies such as automobile and home coverage.

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-21 Investment Companies Investment companies include mutual funds, money market funds, and REITs. Small savers can pool funds to invest in a variety of financial instruments. Economies of scale offer the benefits of professional management, reduced costs, and reduced risk exposure within large, diversified portfolios.

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-22 Securities Firms Securities firms assist customers with purchasing and selling stocks, bonds, and other financial assets. Investment bankers assist in the creation and issuance of new securities. Brokers assist in transfers of ownership of previously issued securities.

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-23 Brokers Full-service brokers advise clients in addition to arranging securities purchases and sales. Discount brokers execute trades but give no advice.

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-24 What is the distinction between primary and secondary securities? Primary securities are direct claims against individuals, governments, and nonfinancial firms. Secondary securities are financial liabilities of financial institutions - that is, claims against financial institutions.

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-25 Three Primary Ways Capital is Transferred Between Savers and Borrowers Direct Transfer Through an Investment Banking House Through a Financial Intermediary

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-26 Intermediation and Direct Financial Investment Direct financial investment occurs when lenders supply funds to ultimate borrowers, with the assistance of brokers or investment bankers. Indirect financial investment supplies funds to financial institutions, which issue secondary securities in return.

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-27 Intermediation occurs when institutions transform secondary securities into primary securities through direct investments. Institutions can become brokers or dealers - that is, arranging or assisting in the transfer of funds between parties without issuing financial liabilities.

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-28 Benefits of Financial Intermediation Search Costs Portfolio Selection Costs Monitoring Costs Risk Management Costs Maturity Intermediation and Liquidity

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-29 Search Costs Financial institutions provide ways to identify entities with excess funds and those needing funds. This identification by financial institutions eliminates the need for individual lenders and borrowers to find one another.

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-30 Portfolio Selection Costs Investors may wish to invest in financial assets in different dollar amounts, with different maturities, or with different risk levels from the financial liabilities borrowers wish to issue. Financial institutions issue secondary securities to lenders, and then repackage funds in forms attractive to borrowers.

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-31 Monitoring Costs Asymmetric information exists when managers have one set of information and investors have a different set of information. Managers are generally better informed about their firm’s prospects, so they generally have a better set of information.

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-32 Information asymmetry gives rise to monitoring costs - ongoing expenses incurred by investors to gather information so they can intervene if borrowers’ financial situations change. Financial institutions provide economies of scale in monitoring, thereby reducing lenders’ monitoring costs.

34. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-33 Examples of Risk Management Costs Investors can avoid the risk inherent in a single claim against a party who may fail to meet its obligations by holding shares in a mutual fund. Insurance companies can pool premiums and provide risk management services at much lower cost.

35. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-34 Banks provide letters of credit that guarantee payment by other parties, thereby facilitating trade transactions. Investment and commercial banks provide instruments that can protect businesses and other financial institutions against interest rate and foreign exchange risk.

36. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-35 Maturity Intermediation and Liquidity Banks accept small amounts from small investors as deposits and transform them into longer-term loans. Bank customers can write checks backed by the bank and do not have to carry cash. They can also use a credit card or have funds electronically wired. These services increase the economy’s liquidity.

37. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-36 Financial Institutions in the Technological Age Information has become more accessible to firms and individuals, reducing the role of financial intermediaries as monitors and information providers. Depository institutions and finance companies have been transformed into more transaction-oriented institutions.

38. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-37 Financial institutions’ role in maturity intermediation, working capital management, consulting, and PC banking has increased. Discount brokers provide low cost internet trading mechanisms. Risk from fraud, embezzlement, and technological failures has increased.

39. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-38 What does the Community Reinvestment Act require of banks? Banks are required to provide low-income financing. Regulators can reject merger and branch applications or require banks to increase low-income lending before applications will be approved.

40. Copyright © 2000 by Harcourt, Inc. All rights reserved. 1-39 What are pawn shops, and why have they grown? Pawnshops cash checks for fees and offer cash loans for collateral at rates ranging from 24 percent to 240 percent. Pawnshops cater to poor customers not served by other financial institutions. Because of the great risk of default for these transactions, charges are very high to customers with little wealth.