Principles Of Banking & Finance Chapter 2 : Financial Systems Economic function: Channeling funds from units who have saved surplus funds to units who have a shortage of funds. Lenders-Savers : Units who have saved can lend funds. Borrower-Spenders : Units with a shortage of funds must borrow funds to finance their spending. Channelling of funds are important because, – Lender-savers have excess of available funds but do not frequently have profitable investment opportunities, while borrower-spenders have investment opportunities but lack of funds. Borrower-spenders may want to invest in excess of their current income or to adjust the composition of their wealth. Direct Finance : Borrower-Spenders borrow funds directly from lenders in the financial markets by selling them securities. Indirect Finance : A financial intermediary helps to transfer funds from one to another. (Most Important) Monetary function: Enables savers/spenders to separate the act of sale from the act of purchase and enables them to overcome the main problem of barter. (“The Double Coincidence of Wants”)
Structure Financial Markets: – Markets in which funds are moved from Lenders-Savers to Borrower-Spenders. – Where securities are being traded. – Have direct effect on personal wealth and behaviours of businesses and consumers. – Contribute to increase the production and efficiency in the economy. Securities: – Financial claims on issuer’s future income or assets. – Represents financial assets (buyer) and financial liabilities (seller). – Governments and corporations raise funds to finance their activities by issuing debt and equity instruments. Bonds: Securities that promise to make periodic payments of a sum of money for a specified period of time. – Shares: Securities that represent ownership in the issuing firm. Financial Intermediaries: – Economic agents who specialize in the activities of buying and selling financial contracts and securities. – Financial Securities: Easily marketable and sold. – Financial Contracts: Not easily marketable and sold. Financial Institution: – Banks are the largest financial institution in the economy. Accepts deposits and makes loans. – Borrows deposits from people who have saved and in turn make loans to others. – Mutual funds, pension funds, insurance companies and investment banks have been growing at the expense of banks. Taxonomy of Financial Intermediaries USA: Depository Institutions – Intermediaries with a significant proportion of their funds derived from customer deposits. 1. Commercial Banks – Accepts deposits (liabilities) to make loans (assets) and to buy government securities. – Deposits: Checkable, Savings and Time deposits Loans: Consumer, Commercial and Mortgages – Largest group of financial intermediaries in USA. – Industry has experienced a consolidation as a result of mergers and acquisitions. 2. Savings & Loan Associations – In the past, S&L and thrift institutions form the 2nd largest group of financial intermediaries, concentrating mostly on residential mortgages. – Acquiring funds primarily through savings deposits. 1950 & 1960 – Grew much rapidly than Commercial Banks. 1979 & 1982 – Change in monetary policy causes a dramatic surge in interest rates. S&L had negative interest spreads in funding the fixed-rate long-term residential mortgages. – Had to pay more competitive interest rates on savings deposits as FED limited the interest rates payable on deposits by S&Ls. (Regulation Q)
Early 1980s – Congress passed acts allowing S&Ls to expand their deposit-taking (Offer checking a/c) and asset-investment powers (Make consumer & commercial loans) to overcome effects of rising rates and disintermediation Safer and more diversified institutions are formed, but for a small significant group of S&Ls it created an opportunity to take more risk to improve profitability. Mid 1980s – Texas real estate and land prices crash, determined the default of many borrowers with mortgage loans issued by S&Ls, thus many S&Ls failed at end of 1980s. 1989 – New legislation, FIRREA is adopted. (Financial Institutions Reform, Recovery & Enforcement Act) 3. Credit Unions – Non-profit institutions mutually organised and owned by depositors. Satisfy the depository and lending needs of their members belonging to a particular group. – Deposits used to provide loans to other members and earnings from these loans are used to pay higher rates to member depositor. – Most numerous among depositary institutions (8535 in 2006 according to Credit Union National Association) Contractual Savings Institutions – Acquire funds at periodic intervals on a contractual basis. – Liquidity of assets is less important as they can predict with reasonable accuracy the future payments due to their customers. Invest their funds in long-term securities. (Corporate Bonds, Stocks and Mortgages) 1. Insurance Companies – Protect individuals and firms (aka. policy holders) from adverse events. – Receive premiums from policy holders and promise a compensation if particular events occur. – Invest premiums in bonds, mortgages and stocks. – Life insurance protects the policy holder in the event of death, illness or retirement. – Property and causality insurance provides protection against personal injury liabilities. Hold more liquid assets due to higher probability of loss of funds in case of major disasters. At present, traditional life insurance no longer primary business, with the emphasis shifted to underwriting annuities. – Annuities: Contracts that accumulate funds & pay out fixed/variable income streams to contract holders/beneficiaries. 2. Pension Funds – Public and Private pension funds – Provides retirement income in the form of annuities to employees covered by a pension plan. – Receive contributions from employers or employees and invest amounts in corporate bonds and stocks. – US promoting the establishment of pension funds, further developments in terms of numbers and options. In some countries, pensions are important (US & UK) while not in others (France, Germany & Italy), due to different relevance of prose pension schemes. Investment Intermediaries Comprises of mutual funds, finance companies, investment banks and securities firms. 1. Mutual Funds – Pool resources from individuals and companies and invest these resources in diversified portfolios of bonds, stocks and money market instruments. – 2nd most important financial intermediary in the USA in terms of asset size.
Advantages: – Provides opportunities to small investors to invest in financial securities and diversify risks. – Take advantage of lower transaction costs when they buy larger block of financial securities. Open-ended funds : Allows shareholders to sell outstanding shares and investors to buy new shares at any time. Long-term funds comprises of.. Bond Funds : Funds containing fixed-income debt securities. Equity Funds : Funds containing stock securities. Hybrid Funds : Funds containing both debt and stock securities.
Short Term funds : Represented by money market mutual funds, containing various mixes of money market securities and partially allow shareholders to write cheques against the value of their holdings. 2. Finance Companies – Makes loans to individuals and corporations by providing consumer lending, business lending and mortgage financing. – Do not accept deposits (unlike Commercial Banks). – Raise funds by selling commercial papers (a short-term debt instrument) and issuing stocks and bonds. – Often loans to customers perceived as too risky by commercial banks.
Sales finance institution : Make loans to customers of a particular retailer or manufacturer. Personal credit institution : Make loans to consumers perceived as too risky by commercial banks. Business credit institution : Provide financing to companies through equipment leasing and factoring. 3. Investment Banks: – Assist corporations or governments in the issue of new debt or equity securities. – Includes the origination, underwriting and placement of securities in primary financial markets. – Underwriting: IB purchases entire issue of securities at predetermined price and esells in the market – Includes corporate finance activities. (Advising on Mergers & Acquisitions) – Earn income from fees of a fixed percentage of the deal being worked. 4. Securities Firms: – Assist in the trading of existing securities in the secondary markets. – Brokers : Agents of investors who match buyers with sellers of securities. (Earn commission for their services) – Dealers : Agents who link buyers and sellers by buying and selling securities. (Earn money through the bid-ask spread ) Bid-ask spread = Best ask (Lowest immediate price charged) – Best Bid (Highest Immediate price received for a unit of stock) Main service offered by brokers is securities orders, which are trade instructions. Market Orders: – Instructions to trade at the best price currently available in the market. – Traders pay the bid-ask spread (w/ price uncertainty). Limit Orders: – Instructions to trade at the best price available, but only if no worst than the limit price (w/ execution uncertainty) Standing limit orders are trading options that offer liquidity Both investment banks and securities firms includes several types of firms : – National full-line firms acting both as broker-dealers and underwriters (Merrill Lynch, Morgan Stanley) – National full-line firms that specialize more in corporate finance and highly active in trading securities. (Goldman Sachs) – Specialized investment banks subsidiaries of commercial banks (JP Morgan Chase ) – Specialized discount brokers-stockbrokers that conduct trading activities for customers without offering any investment advice. Charles Schwab) – Specialized electronic trading securities firms enabling trades on a computer via the Internet. – Regional securities firms specializing in the service of customers of a particular geographical region. Retail & Wholesale Banks (Distinction of FIs by function) Retail Banks: Provides intermediation and payment services to individuals and small businesses dealing with a large number of small value transactions. Wholesale Banks: Consists mainly of investment banks, deals with a smaller number of larger value transactions.
Financial Intermediaries Around The World UK – Banking system comprises commercial banks, investment banks and building societies, providing wide range of services to individuals and corporations (life insurance to underwriting). – Investment banks involved in the traditional investment banking activities like in the USA. – Deregulation has allowed building societies to expand their activities, from providing mortgages to traditional banking. – Among contractual savings institutions, pension funds and insurance companies constitute a large proportion of household assets. Insurance services are provided by bank subsidiaries as well as insurance companies, unlike banking, insurance industry is not dominated. Japan – Comprises shareholder-owned banks. Ordinary Banks : Counterpart of commercial banks in other countries, providing mainly short-term loans to individuals and corporations. Trust Banks : Provides long-term loans to corporations in addition to a range of services which includes ordinary banking, asset management and investment advisory. Long-term Credit Banks: Provides long and medium-term loans to large corporations by using the funds raised from medium and short-term bonds. Comprises cooperative banks (credit unions and credit associations), providing banking services to small corporations and owned by their members. – Among contractual savings institutions, life insurance companies are significantly more important than other countries, providing traditional life insurance products, making long-term loans to corporations, and manage corporate pension funds. – Pension funds significant important than France and Germany but less than in USA and UK. France – Commercial banks are the most important industry in the banking system, mutual and cooperative banks as significant.
Credit Mutuel : Provides loans to individuals with modest income Credit Cooperative : Provides loans to members while receiving deposits from everybody. Credit Agricole Mutuel : Provides loans to farmers. Credit Populaire : Provides loans to trade sector and medium-sized industries. – Savings banks can make loans only to non-industrial or non-commercial entities or individuals, more unique is to offer accounts whose interest is tax free up to a given amount. – Among contractual savings institutions, mostly are insurance companies, insurance services can also be provided by commercial banks. Pension funds are rare. Germany – Universal banks provide full range of products and services : deposits, loans, life insurance, underwriting, investments in equity securities etc. – Majority of the banking system are not profit-maximising entities. – Savings banks are non-profit maximizing entities, but operated in the public interest. – Cooperative banks are mutual organizations owned by the depositors. – Insurance holds a large proportion of assets, insurance services can be provided by universal banks. – Pension funds very few.
Financial Instruments (Securities) 1. Debt Instruments – Instruments that promise the payment of given sums to the investors. Zero Coupon Bonds: Instruments that promise to pay the bondholder the principal sum at the end of the instrument’s life. (aka. Discount Bonds – sold at a discount) Coupon Bonds : Contractual agreements by the borrowers to make coupon or interest payments until the maturity date w/ face value. Perpetual Bonds : Never mature & pays coupons of a specified amount forever. (aka.
Consols) Floating-rate Bonds : Coupon rates that vary over bond’s lifetime, w/ premium set over some market Interest rate (eg. T-Bill) & reset on a pre-specified basis. Index-linked Bonds :Coupons & principal grow in line w/ inflation ( real-risk free but indexation not perfect) Callable Bonds : Can be repaid before maturity; Payment restricted to a specified date (European) or allowed at any time prior to maturity (American) Putable bonds : Redemption date under the control of the holder (Opp. o Callable Bonds) Convertible Bonds : Can be converted into shares in the firm’s equity (allows for capital gains) Foreign Bonds : Issued by foreign borrower in domestic currency denomination Eurobonds : Denominated in foreign currency and sold domestically. Foreign & Euro Bonds pay out Annual coupon payments.. 2. Equity Instruments – Do not have maturity date. – Riskier than debt instruments as – Firms not contractually obliged to make periodic payments to equity holders. – Firms must pay all debt holders before they make any payment to equity holders, thus making them residual claimants. Equity claims confer ownership rights to equity holders. – Equity holders can benefit from any increase in the income or asset value of the company – Investors can obtain high capital gains when stock price increases – Equity holders have the right to vote for directors or on certain issues. 3. Bonds, Notes & Bills Bonds : – Debt owed by issuer to the investors, claims that normally pay periodic interest until the maturity date and pay back the par value to the investor at the maturity date. – Coupon payments based on fixed interest rate. Original maturity of ten to twenty years. – Free of default risk. Notes : – Original maturity of one to ten years. – Free of default risk. Bills : – Money market securities with original maturity of less than one year. – Do not pay any interest, but issued at a discount from their par value and repaid at the par value at the maturity date. Municipal Bonds : – Debt instruments issued to finance public interest projects. – Not default free and not easily marketable. – Pay lower interest rates than bond as interest payments are exempt for taxation.
Corporate Bonds : – Issued by large corporations when they need long-term financing. – Make interest payments twice a year. – High interest rates as degree of risk higher than government and municipal bonds. Maturities: <1year = Short-term (aka. Money Market Securities) 1-10yrs = Intermediate-term >10yrs = Long-term 4. Common & Preferred Stocks Common Stocks : – Represent ownership interests in the firm. – Stockholders receive dividends when distributed. – Take capital gains/losses when stock price increase/decreases. Have the right to vote. Preferred Stocks : – Equity claims with limited ownership rights. – Distribute fixed constant dividend. – Price of stocks is relatively stable as dividend is a constant amount. – No voting rights. – Preferred stockholders have residual claim on assets. Structure of Financial Markets Nature of Financial Securities Traded Primary Market : – Financial market in which new issues of financial securities are sold to initial buyers. – Facilitate new financing to corporations. Price of securities’ issues partly determined by similar ones traded in secondary market. Secondary Market : – Financial Market in which securities that have been previously issued can be resold. – Most trading takes place here. – Makes securities more liquid and thus, more desirable to investors and easier for the firm to sell in the primary market. – Sets the price for similar securities traded on the primary market – Can be organized as exchanges or over-the-counter (OTC) markets.
Forms Of Organisation. Exchanges : – Buyers and sellers meet in one central location to conduct trades through their brokers. OTC : – Dealers at different locations have an inventory of securities, ready to buy and sell them to anyone willing to accept the price. – Competitive due to technological links among dealers about prices. Maturity Of Financial Instruments Money Markets : – Financial markets where only short-term debt instruments are traded. – Mainly wholesale markets where firms and financial institutions manage their short- term liquidity needs.
Capital Markets : – Markets in which long-term securities are traded, includes equity instruments, government and corporate bonds. – Securities are often held by financial intermediaries such as mutual funds, pension funds and insurance companies. How Trade Intermediation Occurs Quote-driven dealer markets: – Dealer/Market-maker on one side of every trade. – Hold an inventory of the security, quote prices and provide liquidity – Profit from the bid-ask spread & speculating
Order-driven markets: – Buyers & Sellers trade directly w/o intermediation (Most are auction markets) – Trading Rules: Buyers seek lowest price & Sellers seek highest price Brokered Markets: – Brokers perform active search role to match buyers & sellers (Find liquidity) – Hold no inventory as they do not participate in the trade themselves – Most important types are for large blocks of stocks & bonds. Hybrid Markets: – Quote & Order driven (eg.
NYSE) – Specialist assigned to single stock Secondary Markets Around The World UK : – London Stock Exchange (LSE) enables domestic and overseas companies to raise equity capital. – August 2007, LSE merged with Borsa Italiana: Leading the European equities business – Frequently traded stocks (Constituents of the FTSE 100): Primary trading is the electronic, order- driven system called SETS (Stock Exchange Electronic Trading Services) – Thinly traded stocks traded on quote-driven, competing dealer market called SEAQ (Stock Exchange Automated Quotations) LSE is a Hybrid Market: SETS as primary trading venue for FTSE 100 stocks, but Quote-driven dealers still exist in providing liquidity to FTSE 100 Stocks. – In 2004, total capitalisation of domestic listed companies on LSE was much lower than NYSE. – Foreign companies constitute a high proportion of listed companies in UK. – Bond markets important in the UK. Eurobond for has replaced domestic bond market trading of bonds denominated in a currency other than the country in which they are sold. Eurobond accounts for the trading of most (up to 80%) of the new issues of international bonds. Japan : – 8 stock exchanges, Tokyo Stock Exchange the most important. – An OTC market becoming more important in recent years. – Debt markets well developed. Europe : – Euronext is formed on 22nd September 2000 when exchanges of Amsterdam, Brussels and Paris merged. – Expanded at the beginning of 2002 with the acquisition of LIFFE (London Financial Futures and Options Exchange) and merger with the Portuguese exchange BVLP (Bolsa de Valores d de Lisboa Porto). Today, Euronext is Europe’s leading cross-border exchange, integrating trading and clearing operations on regulated and non-regulated markets. – Formed in response to the globalization of capital markets and to create a pan-European exchange offering its participants increased liquidity and lower transaction costs. – In April 2007 NYSE Euronext was established, operating the world’s largest and most liquid exchange group, offering the most diverse array of financial products and services
Germany : – Deutsche Borse is composed of 7 regional exchanges, with Frankfurt being the most important. – Markets have been traditionally underdeveloped compared to other countries. – Bond markets more important than the stock markets. – Most of the debt traded is issued by the government and banks. – In December 2004, Deutsche Borse made a cash offer for the acquisition of all LSE’s shares.