Appunti di Economics of Financial Intermediation II, Appunti di Economia degli Intermediari Finanziari

Scarica Appunti di Economics of Financial Intermediation II e più Appunti in PDF di Economia degli Intermediari Finanziari solo su Docsity! Economics of Financial Intermediation II Banking and the management of financial institutions The bank balance sheet The Balance Sheet is a list of a bank’s assets and liabilities Total assets = total liabilities + capital A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets). Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers. Balance Sheet: Liabilities Checkable deposits Bank accounts that allow the owner (depositor) of the account to write checks to third parties. - Non-interest earning checking accounts - Interest earning checking accounts - Some money-market deposits accounts Checkable deposits accounts are payable on demand; that is, if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately. A checkable deposit is an asset for the depositor because it is part of his or her wealth. Because the depositor can withdraw funds and the bank is obligated to pay, checkable deposits are a liability for the bank. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest to have access to a liquid asset that can be used to make purchases. The bank’s costs of maintaining checkable deposits include interest payments and the costs incurred in servicing these accounts (processing, preparing, and sending out monthly statements). Nontransaction Deposits Nontransaction deposits are the primary source of bank funds. Owners cannot write checks on nontransaction deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposits. There are two basic types of nontransaction deposits: savings accounts and time deposits (also called certificates of deposit, or CDs). In savings account funds can be added or withdrawn at any time. Time deposits have a fixed maturity length, ranging from several months to over five years, and assess substantial penalties for early withdrawal (the forfeiture of several months’ interest). - Small-denomination time deposits (deposits of less than $100,000) are less liquid, earn higher interest rates, and are a more costly source of funds for the banks. Large- denominations time deposits are available in denominations of $100,000 or more and are typically bought by corporations or other banks. - Large-denomination CDs are negotiable; like bonds, they can be resold in a secondary market before they mature. For this reason, negotiable CDs are held by corporations, money market mutual funds, and other financial institutions as alternative assets to Treasury bills and other short-term bonds Checkable deposits + Nontransaction deposits account for the majority of bank borrowings in commercial banks. Depositors are households and nonfinancial firms. Borrowings Banks also obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations. Borrowings from the Fed are called discount loans. Banks also borrow reserves overnight in the federal (fed) funds market from other U.S. banks and financial institutions. Banks borrow funds overnight to have enough deposits at The Financial Institutions Industry the Federal Reserve to meet the amount required by the Fed. Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks). Borrowings have become a more important source of bank funds over time and they are more volatile than deposits. Balance sheet: Equity The bank’s net worth, which equals the difference between total assets and liabilities. A bank’s capital is raised by selling new equity (stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which could force the bank into insolvency (having liabilities in excess of assets, meaning that the bank can be forced into liquidation). Balance sheet: Assets Reserves All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves are these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Although reserves earn a low interest rate, banks hold them for two reasons. First, some reserves, called required reserves, are held because of reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction must be kept as reserves. This fraction is called the required reserve ratio. Banks hold additional reserves, called excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account. Cash Items in Process of Collection Suppose that a check written on an account at another bank is deposited in your bank and the funds for this check have not yet been received (collected) from the other bank. The check is classified as a cash item in process of collection, and it is an asset for your bank. Banks do not hold a lot of capital to prevent insolvency because the higher is bank capital, the lower is return on equity (ROE). An Example: deposit outflow of €10 million, the bank has 10% reserve requirement and no excess reserves; the bank has a shortfall (not enough reserves). How can the bank recover the €9 million? Borrow from banks, sell securities, borrow from the central bank and reduce its loan portfolio. Bank runs Deposit withdrawals can be very dangerous for banks. In the extreme scenario, they can lead to a bank run. Bank runs occur when depositors withdraw their deposits en masse fearing that the bank may become insolvent in the near future. Self-fulfilling prophecy in case the bank is not in deep financial trouble. Many examples in the 1930s (a more recent example was the Northern Rock in 2007). Measures of bank profitability: - Return on Assets (ROA): Net Profit (after taxes)/Total assets Indicates how efficiently a bank is being run because it indicates how much profit is generated on average by each dollar of assets - Return of Equity (ROE): Net Profit (after taxes)/Equity Capital Indicates how much the bank is earning from its equity - Equity multiplier (EM): Total assets/Equity Capital the amount of assets per dollar of equity capita ROE = ROA x EM The lower the bank capital, the higher the return for the owners of the bank, while as capital increases, EM falls and ROE falls. Banks also hold capital because they are required to do so by regulatory authorities. What should a bank manager do if she feels the bank is holding too much capital? - Buy back some of the bank’s stock - Increase dividends to reduce retained earnings - Increase asset growth via extra debt Reversing these strategies will help a manager if she feels the bank is holding too little capital - Issue stock - Decrease dividends to increase retained earnings - Slow asset growth (retire debt) Bank’s Income Statement Operating Income Operating Income comes from a bank’s ongoing operations - The largest component are the interests on loans - Net interest = Interests on loans and other assets - Interest expenses on debt - The Net interest fluctuates with the level of interest rates - Very high in the 1980s, very low nowadays - Noninterest income is mostly generated by fees and commissions Operating Costs/Expenses The expenses incurred in conducting the bank’s ongoing operations - Interest expenses on debt are directly subtracted from interests on loans to derive Net interest - Biggest component of noninterest expenses are salaries, rent, purchases of equipment, etc. - Operating Income - Operating Costs/Expenses gives the Operating profit (loss) - Net provisions for loan losses are provisions made to face likely losses on the loan portfolio. - Provisions for loan losses typically peak during an economic recession. - Operating profit (loss) – Net provisions for loan losses = Net operating income (loss) Net income is computed by subtracting other residual and extraordinary items as well as taxes. Measures of Bank Performance Although net income gives us an idea of how well a bank is doing, it suffers from one major drawback: It does not adjust for the bank’s size, thus making it hard to compare how well one bank is doing relative to another. Another commonly watched measure of bank performance is called the net interest margin (NIM), the difference between interest income and interest expenses as a percentage of total assets. NIM reflects the quality of asset-liability management. Banks are facing several challenges in terms of profitability: - low interest rate levels have narrowed the net interest margin. - prolonged economic recessions have increased the provisions for loan losses - competition from other banks and non-banks has decreased fees and commissions Bank Management in Covid times - Liquidity Banks are very liquid. Following the onset of the pandemic, central banks have implemented expansionary monetary policy measures. The interbank market has remained liquid. Deposits have increased. - Loan portfolio Banks have expanded their lending under Government-guaranteed programs and reduced, on average, other forms of lending, especially to risky borrowers. - Net interest income Interest on bank loans on average have decreased, as Government-guaranteed loans are offered at very low rates (sufficient to cover loan management expenses). Interest on deposits remain low but floored in most cases at zero (except for borrowings from central bank). - Net operating income Personnel and administrative costs are likely to decrease because of the Covid-19 measures (home working, etc.). However, net write downs for loan losses are likely to increase for most banks in view of future defaults on the loan portfolio once Governmental aid measures come to an end. - Capital If the loan loss provisions are adequate, we do not expect large variations in capitalization ratios. Most banks in the Eurozone complied with the recommendation not to distribute dividends, hence the retained earnings increased in 2020 and part of 2021. However, dividend distribution and share buybacks have actively resumed in 2021 Risk Management in banks Interest rate risk banks perform asset transformation by transforming short-term deposits into long-term ones. The maturity characteristics of deposits and loans are different; maturity mismatch exposes banks to interest rate risk. Maturity matching helps mitigate rate risk. Interest rate risk: - refinancing risk - reinvestment risk Refinancing risk effect of an interest rate increase when the maturity of the assets exceeds the maturity of the liabilities. Consider the case of a bank that issues $100 mln CDs with 1 year maturity to finance $100mln loans with 2 year maturity. The cost of funds is 9% in year 1 and the interest return on the loans is 10% per year. - Profit for first year = (10%-9%)x100mln = $1mln GDS and TDS The ability to maintain mortgage payments is usually measured by GDS and TDS GDS refers to the gross debt service ratio: - equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income - acceptable threshold generally set around max. 25% to 30% TDS refers to the total debt service ratio - equal to the total accommodation expenses plus all other debt service payments divided by gross income - acceptable threshold generally set around max. 35% to 40% A mortgage loan applicant has the following data: GDS Ratio= (Annual mortgage payments + Property taxes) / Annual gross income = [($3,500 ×12) + $4,500] / $175,000 = 26.57% => Pass TDS Ratio = Annual total debt payments / Annual gross income = [($3,500 ×12) + $4,500 + $950 + $29,000] / $175,000 = 43.69% => Fail Credit scores Loan officers may use more sophisticated credit scores than GDS and TDS to decide whether to approve or not a consumer loan application. Other variables may affect the applicant’s willingness to make timely payments: - Marital status & age - Payment history - Previous relations with the bank & credit history - Job stability - Residence and stability of residence - Number of credit cards All this information can be combined with GDS and TDS to determine a score. Based on the score the loan officer accepts or denies the application. In some countries, consumers are entitled to know their credit score for free, if they were denied a loan or credit card because of their credit score. In any case, U.S. residents are entitled a free copy of their annual credit report. Collateral Collateral plays a crucial role in mortgages (and some other consumer loans). Perfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan. This includes: - Confirming the legal description of the property - Confirming that there are no other claims against the property - Confirming that no property taxes are unpaid - Verifying that the purchase price is in line with the market value Small and medium enterprises business lending High margins, small loan sizes Commercial & industrial loans can be for as short as a few weeks to as long as 5/10 years or more: - Short-term loans are used to finance working capital needs - Long-term loans are used to finance fixed asset purchases Credit requests are presented formally to a credit approval officer and/or committee. Loans to small firms or individual entrepreneurs are normally backed up by the personal assets of the owner. Loans to medium firms are more focused on the business itself rather than the owner. The bank performs: - Cash flow analyses, which provide information regarding an applicant’s expected cash receipts and disbursements - Classic financial ratios analyses: Liquidity ratios, Asset management ratios, Debt and solvency ratios, Profitability ratios - Additional information collected on management and specific conditions (geographic, sector, etc.) that may affect the ability to meet the loan obligations Large enterprises business lending Lending fees and spreads are smaller relative to small and mid-size corporate loans, but the transactions are often large enough to make them worthwhile. Banks’ relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role. Large corporations often use: - loan commitments (line of credit) - bank guarantees to the company for the participation to tenders or the supply of goods and services - term loans Loan officers often rely on rating agencies and market analysts to aid in their credit analysis. The information available on the market for large enterprises is often sufficient to allow a good estimate of the probability of default for such firms. Asymmetric information issues are much less significant than for small and medium sized enterprises Credit registry Credit registry (or register) is a database typically managed by the central bank (national central bank, in case of the Eurosystem) that collects information on all debt granted to a household or a firm by the banking or financial system. It collects all debt positions. It’s extremely helpful for banks to judge the borrowers’ overall debt position and decide whether to grant a loan or not 2. Monitoring: involves requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact. Financial institutions write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense. Long-term customer relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness. Other tools to mitigate credit risk 3. Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan (also called credit line) 4. Credit Rationing: (1) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or (2) lenders will only finance part of a project, requiring that the remaining part comes from equity financing 5. Diversification of Loan Portfolio by: (1) size of lender; (2) sector of business activity; (3) geographical area – this reduces the potential default correlation in the loan portfolio, i.e. the tendency of defaults to cluster. 6. Use of Credit Derivatives Example: Bank A extended a term loan to company Alpha for 1,000,000 Eur and would like to reduce its credit risk exposure to the company. Insurance company Safe trades Credit Default Swaps having company Alpha as a reference entity. Bank A can buy credit protection against the risk of default of company Alpha by entering a CDS contract as a protection buyer. Pros: Flexible and the borrower is not informed. Cons: Limited to large borrowers for which CDS are available Climate risk exposes banks to potential losses Risk measurement and management Banks are required to set aside capital to face their risks As a result, banks involve in: - Risk measurement, aimed at measuring their exposure to the individual sources of risk - Risk management, aimed at mitigating their risk exposure Interest rate risk measurement - Income Gap Analysis - Duration Gap Analysis One simple and quick approach to measuring the sensitivity of bank income to changes in interest rates is gap analysis (also called income gap analysis), in which the amount of rate- sensitive liabilities is subtracted from the amount of ratesensitive assets. Income Gap Analysis Measures the sensitivity of a bank’s current year net income to changes in interest rates • Requires determining which assets and liabilities will have their interest rate change as market interest rates change. The first step in assessing interest-rate risk is for the bank manager to decide which assets and liabilities are rate-sensitive, that is, which have interest rates that will be reset (repriced) within the year. Rate sensitive assets - assets with maturity less than one year - variable-rate mortgages - short-term commercial loans - portion of fixed-rate mortgages (say 20%) - short-term CDs - federal funds - short-term borrowings - portion of checkable deposits (10%) - portion of savings (20%) Rate sensitive liabilities - money market deposits - variable-rate CDs This calculation, GAP, can be written as GAP = RSA - RSL where RSA = rate-sensitive assets; RSL = rate-sensitive liabilities. The Income Gap Analysis suffers from three major weaknesses: 1. Market value effects - A change in interest rates affects the immediate interest received or paid on assets and liabilities, but also the present value of the cash flows on assets and liabilities. - The income gap analysis only investigates the first effect and ignores the second - Partial and short-term measure of the overall interest rate risk exposure 2. Different maturity buckets If RSL > RSA, i ↑ results in: NIM ↓, Income ↓ GAP = RSA − RSL = $32.0m −$49.5m = −$17.5m ∆Income = GAP x ∆i = − $17.5m x 5% = −$0.9m - The income gap analysis ignores the maturity distribution of assets and liabilities that are not classified as rate-sensitive. - A possible solution: Maturity bucket approach that measures the gap for several maturity subintervals 3. Runoffs and prepayments - Virtually all assets and liabilities pay some interest and/or principal back in any given year (even rate insensitive assets or liabilities). - Banks normally estimate a percentage of mortgages that can be repaid or fixed term deposits that will be withdrawn. - The actual percentages may be significantly different Maturity Bucket approach Determining Rate Sensitive Items between 1 and 2 years Rate-Sensitive Assets = $5m + $ 10m + 20%  $10m RSA = $17m Rate-Sensitive Liabs. = $5m + $5m + 10%  $15m + 20%  $15m RSL = $14.5m GAP = 17-14.5 = $2.5 mln - Rate-sensitive assets and liabilities are the ones that reprice between 1 and 2 years. - The bank manager also expects 20% of fixed-rate mortgages to be repaid between 1 and 2 years and 10% of checkable deposits + 20% of savings deposits to be rate sensitive over this period Interest rate risk management Both income gap analysis and duration gap analysis indicate that First National Bank will suffer from a rise in interest rates. What can banks do? 1. Eliminate the income gap by: - Increasing the amount of rate-sensitive assets to $49.5m, or - Reducing the amount of rate-sensitive liabilities to $32m Either way, a change in interest rates would have no impact on next year’s net interest income. 2. Immunize the market value of the net worth by adjusting assets and liabilities so that the duration gap is zero If assets are easier to adjust than liabilities, the bank manager can fix 𝐷𝑈𝑅𝑎 so that 𝐷𝑈𝑅𝑔𝑎𝑝 is set to zero: 𝐷𝑈𝑅𝑎 = 𝐿 /𝐴 × 𝐷𝑈𝑅𝑙 = 95 / 100 × 1.03 = 0.98 The average duration of assets should be reduced to 0.98 years Conversely, if liabilities are easier to adjust than assets, the bank manager can fix 𝐷𝑈𝑅𝑙, so that 𝐷𝑈𝑅𝑔𝑎𝑝 is set to zero: 𝐷𝑈𝑅𝑙 = 𝐴 / 𝐿 × 𝐷𝑈𝑅𝑎 = 100 / 95 × 2.70 = 2.84 The average duration of liabilities should be increased to 2.84 years. Observations - Immunization techniques may be difficult to implement in practice and costly to do in the short run. - The maturity (and duration) of assets and liabilities often depends upon the bank’s particular field of expertise - An easier alternative to hedge against interest rate risk is to use financial derivatives: Interest rate forward contracts, Interest rate futures, Interest rate swaps, Interest rate options. Interest rate risk management using forwards An example of hedging using an interest rate forward contract: - First National Bank owns $5 million of T-bonds that mature in 2037. Because these are long-term bonds, FNB is exposed to interest-rate risk. - First National Bank agrees to deliver $5 million in face value of 6% Treasury bonds maturing in 2037. - Rock Solid Insurance Company agrees to pay $5 million for the bonds. - FNB and Rock Solid agree to complete the transaction one year from today at the FNB headquarters in town. - FNB is hedging by reducing price risk from increases in interest rates in one year Interest rate risk management using futures If a futures contract on the 6% T-bond with expiry 2037 is traded in the futures market, FNB can short futures instead of entering a forward contract with Rock Solid Insurance. Example: The 6% T-bond with expiry 2037 is one of the deliverable bonds under the 1-year T-bond futures contract that trades on the CBOT. The value of one futures contract is $100,000. FNB can go short $5,000,000/$100,000 = 50 futures contracts - In case of a perfect hedge, the payoffs from forward and futures contracts are equivalent. - In case interest rates increase: loss on the underlying T-bond position; gain on the forward/futures position. - Gains and losses offset each other and the position is immunized from interest rate risk. - A perfect hedge is hard to achieve using futures contracts. Interest rate risk management using IRS An example of hedging using an interest rate swap. - FNB has more rate-sensitive liabilities than rate-sensitive assets, which is typical of commercial banks that tend to borrow short-term and lend long-term. - Most assets are fixed rate, while most liabilities are floating rate or repricing shortly • This exposes FNB to losses if interest rates rise. - To mitigate this risk, FNB may wish to “convert” part of its fixed rate assets into rate- sensitive assets. - This can be done with an interest rate swap Example - Notional principal of $1 million. - Term of 10 years. - FNB swaps 6% payment for Libor from Friendly Finance Company. - By doing this, $1m have been converted from fixed-rate assets to floating rate assets IRS are: - Very flexible - Available over long horizons - Usually liquid, but the market can freeze in a financial crisis - Subject to counterparty risk Banking regulation The financial system is one of the most heavily regulated industries in our economy. The main target of regulation have been commercial banks, given their key role in the allocation of financial resources in the economy. Main types of regulation: 1. Deposit insurance schemes 2. Restrictions on activities and asset holdings 3. Capital requirements Deposit insurance schemes The inability of depositors to assess the quality of a bank’s assets can lead to panic (bank runs). Deposit insurance was introduced in 1933 in the U.S. to protect depositors and is provided by the FDIC (Federal Deposit Insurance Corporation) • Current level of individual standard insurance: $250,000. Deposit insurance schemes proved to be very effective to avoid bank runs. In the EU, deposit guarantee schemes insure depositors up to EUR 100,000. Deposit insurance schemes reduce bank runs but don’t prevent financial crises; as a matter of fact, deposit insurance creates moral hazard incentives for banks to take on greater risk. Restrictions on activities and asset holdings Because banks are most prone to panics, they are subjected to strict regulations to restrict their holding of risky assets such as common stocks. Bank regulations also promote diversification, which reduces risk by limiting the dollar amount of loans in particular categories or to individual borrowers. The most famous restriction on bank activities was the Glass-Steagall Act. The Glass-Steagall Act was passed by the U.S. Congress as part of the Banking Act of 1933. It prohibited commercial banks from participating in the investment banking business and vice versa. The linkages between banking and investing activities were believed to have caused - Advanced Measurement Approach (AMA), which requires sophisticated simulations of operational events and potential losses Pillars II and III Supervisory Review changes: - Similar amount of supervision in different countries - Local regulators can adjust parameters to suit local conditions - Importance of early intervention stressed Market Discipline – Banks will be required to disclose: - Scope and application of Basel framework - Nature of capital held - Regulatory capital requirements - Nature of institution’s risk exposures Basel III In response to the 2007-09 crisis, approved in 2010, ongoing implementation. Capital Definition and Requirements Three types: - Common equity Tier 1 - Additional Tier 1 (contingent convertible bonds) - Tier 2 (some subordinated bonds) Definitions of types of capital tightened and limits are set for each capital class • Risk weights less dependent on credit ratings • Extra capital buffers have been introduced to encourage banks to set aside capital and retain earnings in good times to face losses in bad times (most of these measures are discretional) and reduce procyclicality. Basel III has also introduced restrictions on leverage ratio - Ratio of Tier 1 capital to total exposure (on-balance and off-balance, not risk weighted) must be greater than 3% Capital for counterparty risk arising from over-the-counter transactions (to be added to market risk calculation). - Liquidity coverage ratio: designed to make sure that the bank can survive a 30- day period of acute stress. - Net stable funding ratio: A longer term measure designed to ensure that stability of funding sources is consistent with the long-term nature of the assets that have to be funded. Stress tests The main concern after 2007-09 financial crisis is that banks have sufficient capital to account for their risks and continue operations throughout times of economic and financial stress. Stress tests have been introduced in many countries to assess the resilience of banks to a common set of adverse economic developments in order to “identify potential risks, inform supervisory decisions and increase market discipline”. Too big to fail A financial institution is classified as “too big to fail” if it would pose a serious risk to the economy if it were to collapse. The formal name of too big to fail is Systemically Important Financial Institutions (SIFIs). These institutions are subject to dedicated rules and supervision: - Higher capital requirements - Periodic stress tests - Strict oversight by the regulator (Fed, ECB) It is unclear if these measures are sufficient or if they should be forced to split into smaller institutions. Ongoing challenges for financial institutions From bail-out to bail-in (living wills): - Bail-out when governments rescue financial institutions (typically with taxpayers’ money) - Bail-in when creditors and depositors pay to rescue financial institutions (debt is cancelled) Corporate culture: - Short-termism - Male dominated (the «Lehman sisters» theory) Green banking Investment banking and shadow banking Investment banks perform a variety of crucial functions in financial market, in particular - Underwriting Stocks and Bonds - Equity Sales - Mergers and Acquisitions Investment banks were essentially created in the U.S. by the passage of the Glass- Steagall Act. Prior to this, investment banking activities were part of large commercial banks. Underwriting stocks and bonds The investment banker purchases the offering (stocks or bonds) from the company and then resells the offering in the market The services provided during this process include: 1. Giving advice: - Explaining current market conditions to help determine which type of security (equity, debt, etc.) to offer. - Assisting in determining when to issue, how many, at what price (more important with IPOs than SEOs) 2. Filing documents - Registration is required for issues greater than $1.5 million and with a maturity greater than 270 days - A portion of the registration statement known as the prospectus is made available to the public - Debt issues require several additional steps, including acquiring a credit rating, hire a bond counsel, etc. - For equity issues, the investment banker may also arrange for the securities to appear on one of the exchanges 3. Underwriting - Firm commitment: the investment bank purchases the entire offering at a fixed price and then resells the offering to the market; an underwriter may form an underwriting syndicate to share the underwriting risk - Best effort: an alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its “best effort” to sell the entire issue - Private Placement: the entire issue is sold to a small, selected group of investors. This is rarely done with equity issues Equity sales Equity Sales: when a firm sells an entire division (or maybe the entire company), enlisting the aid of an investment banker The investment bank assists in: - determining the value of the division or firm and finding potential buyers - developing confidential financial statements for the division for prospective buyer (confidential memorandum) - negotiating the terms of the sale on behalf of the seller and helping reach a definitive agreement Mergers and acquisitions - Investment bankers may assist both acquiring firms and potential targets (although not both in the same deal because of conflict of interests) - The deal may be a hostile takeover, where the target does not wish to be acquired - The success of credit cards led to the development of debit cards for direct access to checkable funds. Electronic banking: - Automated Banking Machines combine ATMs, the internet, and telephone technology to provide a “complete” service. - Virtual banks now exist where access is only possible via the internet Electronic payments: - The development of computer systems and the internet has made electronic payments of bills a cost-effective method over paper checks or money. - The U.S. is still far behind some European countries in the use of this technology. - The U.S. writes close to 10 billion checks. In Europe, however, two-thirds of transactions are electronic (in Scandinavian countries, nearly 100%). - Electronic money, or stored cash, only exists in electronic form. It is accessed via a stored-value card or a smart card Residual concerns: - Equipment to accept e-money not available in all locations - Security and privacy concerns from customers Insurance companies and pension funds Insurance companies assume the risk of their clients in return for a fee, called the insurance premium. Most people purchase insurance because they are risk-averse, i.e., they would rather pay a certainty equivalent (the premium) than accept a gamble. If insurance did not exist, everyone would have to set aside reserves to face adverse events and, ultimately, those reserves may be inadequate. Fundamentals of insurance Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to: 1. There must be a relationship between the insured (the party covered by the insurance) and the beneficiary (the party who receives the payment if the event occurs). Further, the beneficiary must be someone who would suffer if it weren’t for the insurance. 2. The insured must provide full and accurate information to the insurance company. 3. The insured is not to profit as a result of insurance coverage. 4. If a third party compensates the insured/beneficiary for the loss, the insurance company’s obligation is reduced by the amount of the compensation. 5. The insurance company must have a large number of insured so that the risk can be spread out among many different policies. 6. The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. 7. The insurance company must be able to estimate the probability of the loss occurring (this may prove difficult for insurance on some rare catastrophic events). Adverse selection in insurance Asymmetric information plays a large role in the design of insurance products. The presence of adverse selection and moral hazard impacts the industry, but is fairly well understood by the insurance companies. The adverse selection problem raises the issue of which policies an insurance company should accept: - Those most likely to suffer a loss are most likely to apply for insurance. - In the extreme, insurance companies should turn down anyone who applies for an insurance policy. However, insurance companies have found reasonable solutions to deal with this problem. An example from health insurance: - Health insurance policies require a physical exam. - Preexisting conditions may be excluded from the policy. Moral hazard insurance Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy. Insurance companies use deductibles to help control this problem Deductible: The amount of any loss that must be paid by the insured before the insurance company pays anything Types of insurance Insurance is classified according to which type of undesirable event is covered: - Life Insurance - Health Insurance - Property and Casualty Insurance Life insurance Life insurance is a contract between an insurer and an insured in which the insurer guarantees payment of a death benefit to named beneficiaries when the insured dies. Some life insurance policies instead provide insurance against the risk of living too long and running out of retirement assets. Life insurance policies come in many forms. Some of the typical policies include: 1. Term Life: the insured is covered only while the policy is in effect, usually 10– 20 years (if the insured dies afterwards, no payment is made and all premia paid are “lost”). Low premium. 2. Whole Life: similar to term life, but it allows the insured to borrow against the policies cash value. When the term of policy expires, the insured can get the cash value of the policy. Cash value is the difference between the premium and the cost of insurance and it accumulates over time in a cash value account. Whole life has higher premium than term insurance. 3. Universal Life: permanent life insurance which includes both a term life portion and a savings portion (which accumulates at a higher rate than whole life). 4. Annuities: the insured makes a fixed payment or a series of payments prior to the onset of the annuity. The annuity then pays a benefit to the insured until death. It is used to cover retirement years, not death. Health insurance Health insurance policies are vulnerable to the adverse selection problem - those with health problems are more likely to seek coverage • Individual policies must be priced assuming adverse selection. Hence the premium is typically very high. Most health insurance is offered through group policies where the company pays all or part of the employee’s policy premium. In some countries (e.g., U.S.), public healthcare access is limited and health insurance is essential (and often paid by employers). In Europe, public healthcare is the norm, and private insurance is less common. Property and casualty insurance Earliest form of insurance (it dates back to the Middle Ages). Property Insurance protects businesses and owners from the risks associated with ownership. Property insurance provides protection against most risks to property, such as fire, theft and some types of damage. Two types of property insurance: - Named-peril policies insure against losses only from perils specifically named in the policy (typically theft, fire, explosion). - Open-peril policies insure against any losses except from perils specifically named in the policy (typically earthquakes, war, terrorism, etc.) Also - Casualty Insurance (also known as liability insurance) protects against losses that occur as a result of the insured’s interactions with others or their property. - «Liability insurance» as it covers the losses that the insured party would be responsible for if found legally liable. - Car insurance and worker’s compensation insurance are classic examples of casualty insurance. Car insurance: The insured can cause an accident and the insurance company will cover the damage caused to third parties. - Worker’s compensation insurance covers injuries to employees on the job. Insurance liabilities - Pension protection act of 2006 further strengthened pension funding rules to ensure greater transparency and a stronger system. Regulation in the EU: - Different member states have different rules. - Homogeneous reporting requirements to increase transparency The mutual funds industry Mutual funds pool the resources of many small investors by selling them shares and using the proceeds to buy securities. Suppose you wanted to start savings for retirement, but you can only afford to invest $100 / month. How do you develop a diversified portfolio? Mutual funds are one potential answer. The growth of mutual funds The first mutual fund similar to the funds of today (i.e., new shares were issued when new money was invested) was introduced in Boston in 1824. The stock market crash of 1929 set the mutual fund industry back as small investors avoided stocks and distrusted mutual funds. The Investment Company Act of 1940 reinvigorated the industry by requiring better disclosure of fees and investment policies. Mutual funds now play an important investment role in many countries. Benefits of mutual funds There are five principal benefits of mutual funds: 1. Liquidity intermediation: investors can quickly convert investments into cash. 2. Denomination intermediation: investors can participate in equity and debt offerings that, individually, require more capital than they possess. 3. Diversification: investors immediately realize the benefits of diversification even for small investments. 4. Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the individual investor. 5. Managerial expertise: many investors prefer to rely on professional money managers to select their investments (although we saw that they do not outperform the market!). Mutual fund structure Investment companies usually offer a number of different types of mutual funds. Investors can often move investments among these funds without penalty. Mutual funds are structured as closed-end funds or open-end funds. - Closed-End Fund: a fixed number of nonredeemable shares are sold through an initial offering and are then traded in the OTC market. Price for the shares is determined by supply and demand forces. The fund cannot grow and investors cannot make withdrawals (the only way to exit is to sell the shares on the OTC market). - Open-End Fund: investors may buy or redeem shares at any point, the number of shares outstanding is continuously adjusted. The price is determined by the net asset value (NAV) of the fund. Very liquid investment (investors can withdraw at any time). The fund can grow over time. Most funds are open-end. Calculating the net asset value (NAV) Definition: Total value of the mutual fund’s stocks, bonds, cash, and other assets minus any liabilities such as accrued fees, divided by the number of shares outstanding. Classes of investment 1. Stock (equity) funds 2. Bond funds 3. Hybrid funds 4. Money market funds 5. Index funds 1. Stock funds Other than investing in common equity, the stated objective of any particular fund can vary dramatically. - Capital Appreciation Funds seek rapid increase in share price, not being concerned about dividends. - Total Return Funds seek a balance of current income (i.e., dividends) and capital appreciation. - World Equity Funds invest primarily in foreign firms. - Other types invest specifically in value firms, growth firms, a particular industry, etc. to appeal to different types of investors. 2. Bond funds Investment grade funds invest in high-quality, low-risk securities. High yield funds invest in high-risk securities in search for a higher return. Government bond funds invest in government bonds, as well as state and local government bonds (in the U.S.). In general bond funds are less attractive to investors than equity funds: - Lower risk in the bond market - Less expertise required to invest in bonds 3. Hybrid funds The combine stocks and bonds into a single fund and account for about 5% of all mutual fund accounts Money Market Mutual Funds - Open-end funds that invest only in money market securities - Offer check-writing privileges Although money market mutual funds offer higher returns than bank deposits, the funds are not covered by deposit insurance. Net assets have grown dramatically over the years 4. Index funds A special class of mutual funds that does not fit into any of the categories discussed so far. The fund contains the stocks of the index it’s mimicking. - For example, an S&P 500 index fund would contain the 500 stocks in the S&P500 They offer benefits of traditional mutual funds without the fees of the professional money manager. They have been gradually replaced by ETFs in many investors’ portfolios. ETFs are more liquid (directly traded on the exchange) and cheaper (lower fees). Fee structure of mutual funds Originally, mutual fund shares were sold by brokers who demanded a fee for their service – a load. The fee could be charged upfront or when funds were taken out. - Load funds charge an upfront fee for buying the shares (Class A shares) - Deferred load funds charge a fee when the shares are redeemed (Class B shares) If the particular fund charges no front or back-end fees, it is referred to as class C shares or no-load fund. Most funds now are no-load funds and can be purchased directly by investors, without the intermediation of a broker. Other fees charges by mutual funds include (but are not limited to!): - Redemption fee: another name for a back-end load. Typically used to discourage early withdrawal and encourage long-term investments. - Exchange fee: A fee (usually low) for transferring money between funds in the same family. - Account maintenance fee: A fee charged if the account balance is too low. In general, fees have shrunk over the years due to increased competition but remain quite high. Full disclosure of fees is mandatory Regulation of mutual funds