ECONOMICS OF FINANCIAL INTERMEDIATION, Appunti di Economia degli Intermediari Finanziari

Scarica ECONOMICS OF FINANCIAL INTERMEDIATION e più Appunti in PDF di Economia degli Intermediari Finanziari solo su Docsity! FUNCTION OF FINANCIAL MARKETS Financial markets help transfer funds from people or businesses without investment opportunities (lenders- savers) to those who have them and need money (borrowers-spenders). Funds go from people with surplus of money to those in need. Business firms and governments are usually net borrowers. Households are usually net lenders. SEGMENTS OF FINANCIAL MERKETS 1. Direct finance → borrowers borrow directly from lenders by selling financial instruments which are claims on the borrower’s future income or assets (bonds and stocks) 2. Indirect finance → borrowers borrow indirectly from lenders via financial intermediaries. The latter stays between borrowers and lenders to make profits. ALLOCATION OF RESOURCES Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. If someone saves a sum of money, but there are no financial markets, they won’t earn any return on it. However, if someone else could use that money to increase their own productivity, they would be willing to pay some interest for the use of the funds. For the allocation of resources to be efficient, capital should flow to companies with best future prospects (best investment opportunities). An inefficient allocation would lead to the bankruptcy of those companies whose future prospects are not so bright. However, there are other cases in which an inefficient allocation of resources can be observed - overvaluation / undervaluation of individual assets → in the first case, the number of sellers is higher than the number of buyers. When this happens, stock prices are bound to decrease. In the second case, sellers are less than buyers. Hence, stock prices will increase. - generalized overvaluation → stock prices are generally too high than their intrinsic value, which creates a financial bubble. When the market realizes that such thing is happening, prices will readjust causing a financial clash. CONSUMPTION TIMING Financial markets allow consumers to time their purchases better, improving their well-being. In the absence of financial markets, the part of the salary that is not used is saved and used after the retirement. However, such sum is lower than the salary and hence will last less. Thanks to financial markets, households can use financial assets to store wealth and transfer consumption from high-earning periods of life to low-earning ones (retirement, poor health, …). They can help optimize consumption. DIRECT FINANCE – FINANCIAL MARKETS DEBT MARKETS In debt markets governments and corporations issue bonds. Bonds are securities that offer interest (and in some cases the gradual repayment of the principal) over time until a specified date – maturity – when a final payment is done. Bonds represent an obligation to repay interests and principal. When someone buys a bond, they become creditors. The interest rate represents the cost of borrowing. EQUITY MARKETS In equity markets corporations issue equities such as common stocks to raise capital. Equities often pay dividends, have no maturity date, and represent an ownership claim in the firm. However, if ownership is diluted, to have voting rights people must own a certain number of shares in the same company. As the company increases profits, the share value grows, and people can sell their shares at a higher price. In the Euro area and other countries, companies borrow from banks and increase their capital thanks to their shareholders. It has been observed that companies that go public on stock markets grow better. Both in the debt and in the equity markets we can distinguish between - primary market → new securities are first issued and placed in this market to be sold to initial buyers (i.e., IPOs – initial public offering). The company hires an investment bank. The latter will start a roadshow asking potential investors at what prices the IPO would be successful. The bank will then sell the company’s securities at such price. In this market, corporations acquire new funds (debt or capital). - secondary market → securities that have been previously issued are here bought and sold by investors. Examples are the NYSE and the Euronext. Both brokers and dealers are involved. The former execute orders on behalf of their clients; the latter buy and sell securities on their own account. The corporations that had issued the securities acquire no funds. The secondary market provides liquidity, making it easy to buy and sell the securities of the company, and determines the price of the securities being placed in the primary market. DERIVATIVES MARKET Derivatives are securities whose value derives from an underlying asset (equity, interest rates, foreign exchange rates, commodities, …). The payoffs depend on the value of such assets. Derivatives are widely used by financial and non-financial companies to hedge risks, and by speculators to make profits. If they are used mainly for speculative reasons rather than hedging, they become dangerous and toxic. Therefore, they are heavily regulated. The main classes of derivatives are forward/futures contracts, swaps, options, credit derivatives. STRUCTURE OF FINANCIAL MARKETS Markets can be further classified as 1. REGULATED EXCHANGES → they were established in central locations. They are extremely transparent, since all prices are known at every time. Stocks, futures, options, and commodities are traded. In these markets liquidity is very high. 2. OVER-THE-COUNTER MARKETS → they are markets of dealers. They are established in different locations and have a portfolio of certain securities they are ready to buy and sell. Prices are dealer-based, and therefore these markets are less transparent. Liquidity is low. Government bonds, corporate bonds, swaps, and foreign exchange are traded. In Italy, the government bonds market is so liquid that it is part of a regulated exchange. This is because there is always high demand for these assets. According to the maturity of the securities 1. MONEY MARKET → market for short-term (< 1 year) securities 2. CAPITAL MARKET → market for long-term (> 1 year) securities and equities (no maturity) INTERNATIONALIZARION OF FINANCIAL MARKETS Borrowers usually issue securities, denominated in their own currency, in their home country → they trade in the domestic market. However, there are some bonds sold in a foreign country and denominated in that country’s currency. Foreign bonds are subject to the regulation of the country in which they are issued. Yankee bonds are bonds issued by Italian companies in the US in USD. Reverse Yankee bonds are issued by US companies in the Eurozone in euros. If shares are liquid enough, they can also be traded on international markets. of each cash flow. The present value analysis enables us to find the value of future streams of cash flows and compare different debt instruments to find the one that offers the highest yield. PV APPLICATIONS INVOLVING A SINGLE CASH FLOW 1. Simple loan → a party (e.g., bank) lends an amount – loan principle – to the borrower. At the maturity date, the borrower will repay the loan principle AND the interest accrued on the loan (computed at the simple interest rate agreed with the lender). Remember that all interest rates are expressed on an annualized basis. A simple loan of $100 for one year with 10% simple interest rate will grant the lender $𝟏𝟎𝟎 ∙ (𝟏 + 𝟎. 𝟏) = $𝟏𝟏𝟎 at the end of the year. If the bank extends the loan for one more year, the lender will get $𝟏𝟏𝟎 ∙ (𝟏 + 𝟎. 𝟏) = $𝟏𝟎𝟎 ∙ (𝟏 + 𝟎. 𝟏) ∙ (𝟏 + 𝟎. 𝟏) = $𝟏𝟐𝟏 or equivalently $𝟏𝟎𝟎 ∙ (𝟏 + 𝟎. 𝟏)𝟐 = $𝟏𝟐𝟏 at the end of the 2nd year. If the bank renews the loan for n years at the interest rate i, the $100 would turn into $𝟏𝟎𝟎 ∙ (𝟏 + 𝒊)𝒏 Computing the present value of these future cashflows we get $𝟏𝟏𝟎 (𝟏+𝟎.𝟏) = $𝟏𝟎𝟎 and $𝟏𝟐𝟏 (𝟏+𝟎.𝟏)𝟐 = $𝟏𝟎𝟎 When we talk about simple capitalization, we mean that interests are not calculated on interests, but only one the principle. This is what happens with one-year loans. Interests generate interests in loans with maturity higher that one year. The PV analysis enables us to compute the yield to maturity. It is the interest rate that equates the PV of future cash flows from a debt instrument with its value today. This allows to compare investments with different cash flows and timing. The YTM in our example is 𝟏𝟎𝟎 = 𝟏𝟏𝟎 ∙ 𝟏 (𝟏+𝒊)𝟏 → 𝒊 = 𝟏𝟎%. In this case, the YTM coincides with the simple interest rate. 2. Zero-coupon (or discount) bond → it is a short-maturity bond (typically <1 year) that pays the face value of the bond at expiry and no coupon in between. Investors buy these bonds at their market price, which is less than the face value. The difference is the interest earned on the investment. In Italy, these bonds are called BOT; in the USA, they are TB (treasury bills). Consider a one-year T-bill with face value (CF) of $1000 and current purchase price (today’s value = PV) of $900. To calculate the YTM 𝑷𝑽 = 𝑪𝑭 ∙ 𝟏 (𝟏 + 𝒊)𝟏 → 𝟗𝟎𝟎 = 𝟏𝟎𝟎𝟎 ∙ 𝟏 (𝟏 + 𝒊)𝟏 → 𝒊 = 𝟏𝟏. 𝟏% PV APPLICATIONS INVOLVING MULTIPLE CASH FLOWS 1. Fixed-payment loans → they repay the loan principal and interest in several payments with fixed periodicity (monthly, quarterly, …). All payments are equal over the loan term. This technique takes the name of amortization. Classic examples are installments loans, such as auto loans and home mortgages. Consider a loan of $1000 (principal) that grants yearly payments of $85.81 for the next 25 years. To compute the YTM 𝟏𝟎𝟎𝟎 = 𝟖𝟓. 𝟖𝟏 (𝟏 + 𝒊)𝟏 + 𝟖𝟓. 𝟖𝟏 (𝟏 + 𝒊)𝟐 + 𝟖𝟓. 𝟖𝟏 (𝟏 + 𝒊)𝟑 + ⋯ + 𝟖𝟓. 𝟖𝟏 (𝟏 + 𝒊)𝟐𝟓 → 𝒊 = 𝟕% 2. Coupon bonds → they pay a fixed interest payment (coupon rate x CF of the bond) at a specified frequency (semi-annual, quarterly, …) until maturity. At expiry, the face (or par) value of the bond is repaid, together with the last coupon payment. Consider a bond with CF of $1000, coupon rate of 10%, annual coupon frequency, 8-year maturity, and price of $889.20. To compute the YTM 𝟖𝟖𝟗. 𝟐𝟎 = 𝟏𝟎𝟎 (𝟏 + 𝒊)𝟏 + 𝟏𝟎𝟎 (𝟏 + 𝒊)𝟐 + 𝟏𝟎𝟎 (𝟏 + 𝒊)𝟑 + ⋯ + (𝟏𝟎𝟎𝟎 + 𝟏𝟎𝟎) (𝟏 + 𝒊)𝟖 → 𝒊 = 𝟏𝟐. 𝟐𝟓% The coupon rate is equal to the YTM if and only if the bond trades at par (price = CF). Price and YTM are negatively related. As i ↑, cash flows ↓. Therefore, the present value ↓. PERPETUITIES They are perpetual bonds with no maturity that make a fixed coupon payment forever. Since they do not expire, they don’t have a face value. Their price equals the coupon payment divided by the YTM. 𝑃 = 𝐶 𝑖 A perpetuity with price of $2000 that pays a coupon of $100 annually forever has a YTM 𝟐𝟎𝟎𝟎 = 𝟏𝟎𝟎 𝒊 → 𝒊 = 𝟓% The YTM of a perpetuity is computed as 𝑖 = 𝐶 𝑃 . This formula gives a good approximation for the YTM on coupon bonds with a term to maturity of 20 years or more. This approximation is called current yield. NEGATIVE INTEREST RATES When interest rates are negative, one may expect the demand to collapse, bond prices to fall, and an increase in interest rate as to attract investors. Cash may seem more attractive. However, since most government bonds are held by banks or other financial intermediaries, holding cash would be highly costly for them. Hence, government bonds with negative interest rates are still more attractive than cash (if rates don’t become too negative). Indeed, banks may use such bonds as collaterals when borrowing from each other. REAL AND NOMINAL INTEREST RATES The real interest rate is adjusted for expected changes in the price level 𝑖𝑟 = 𝑖 − π𝑒. It reflects true cost of borrowing more accurately. When the real interest rate is low, there are greater incentives to borrow and less to lend. This interest rate is usually referred to as the ex ante real interest rate, since it is adjusted for the expected level of inflation. After the fact, the ex post real interest rate can be calculated, since it is based on the observed level of inflation. Inflation-linked bonds (or inflation-indexed bonds) can help protect investors from inflation. Both the CF and the coupons are indexed to a defined price index, usually the Consumer Price Index or the Retail Price Index. Investors obtain the (ex post) interest rate at the time of the purchase. These bonds are usually issued by Governments. INTEREST RATES AND RETURNS The concept of rate of return on an investment is different from the YTM. The rate of return measures how well people do on their investments over a certain holding period. This period varies according to the investment horizon of each investor. The rate of return on a bond sold before its maturity can be calculated as 𝑹 = 𝑪 + 𝑷𝒕+𝟏 − 𝑷𝒕 𝑷𝒕 → 𝑹 = 𝑪 𝑷𝒕 + 𝑷𝒕+𝟏 − 𝑷𝒕 𝑷𝒕 Return = Current Yield + Capital Gain Yield The YTM is guaranteed if and only if bonds are held until maturity. For bonds with maturity longer than the holding period, as rates increase, price falls, leading to capital loss. That is because the new bonds issued grant a higher YTM at the same price, so people would prefer to buy those. The longer the maturity, the greater the price and return changes associated with the interest rate change. This means that prices and returns are more volatile. This is due to the higher interest-rate risk of long- term bonds. Interest-rate risk (or price risk) is the risk associated with the changes in i when the maturity is longer than the holding period. The price at which investors will sell their bonds before they expire is equal to the PV of the future cash flows missing. Consider a coupon bond with a CF of $1000, an initial interest rate of 10% equal to its coupon rate. If interest rates rise to 20% - 2-year maturity bond sold after one year → 𝑷 = 𝟏𝟎𝟎𝟎+𝟏𝟎𝟎 (𝟏+𝟎.𝟐)𝟏 = 𝟗𝟏𝟕 - 5-year maturity bond sold after one year → 𝑷 = 𝟏𝟎𝟎 (𝟏+𝟎.𝟐)𝟏 + 𝟏𝟎𝟎 (𝟏+𝟎.𝟐)𝟐 + 𝟏𝟎𝟎 (𝟏+𝟎.𝟐)𝟑 + 𝟏𝟎𝟎𝟎+𝟏𝟎𝟎 (𝟏+𝟎.𝟐)𝟒 = 𝟕𝟒𝟏 We talk about reinvestment risk when investors hold a series of short bonds over a long holding period. They buy short-term bonds and reinvest what they gained at expiry. The interest rate at which the reinvestment occurs is uncertain. If i ↑, the investors will gain; if i ↓, they will lose. DURATION Formally, duration is a weighted average of the maturities of the future cash payments of the bonds. Intuitively, duration is the time it takes a bondholder to ger their initial investment back. It is shorter than the maturity (except for zero-coupon bonds) because of the coupon payments, which could be reinvested. Let’s say that someone buys a bond with 10-year maturity, 5% coupon rate, $100 CF at the price of $98. They will get their $98 back in less than 10 years. A formula linking duration to the approximate change in bond price following a change in i is %𝜟𝑷 ≈ −𝑫𝑼𝑹 × 𝜟𝒊 (𝟏 + 𝒊) where the i at the denominator is the initial interest rate. The greater the duration of a security, the greater the percentage change in the market value of such security for a given change in interest rate. The greater the duration, the greater its interest-rate risk. All else equal - when the maturity of a bond lengthens, the duration rises as well - when interest rates rise, the duration of a coupon bond falls. The higher the coupon rate on the bond, the shorter the duration of the bond. Finally, duration is additive, which means that the duration of a portfolio is the weighted average of the duration of the individual securities, with the weights equaling the proportion of the portfolio invested in each security. THE TERM STRUCTURE OF INTEREST RATES Even in the common market, there are different term structures and interest rates. For bonds with short maturity, interest rates are low, and until some time ago they stared at negative values. The actual yield curve is not so smooth; it is derived, hence more jagged. For short maturity bonds, the rates are set by central banks. For longer maturity bonds, interest rates are determined by the market. DETERMINANTS OF ASSET DEMAND Assets are pieces of property that are stores of value. If such value is financial, they are financial assets. When deciding whether to buy and hold an asset or which asset to buy, individuals must consider - their wealth, defined as the total resources they own, including all assets. An increase in wealth would raise the quantity demanded of an asset - the expected return on the asset. Individuals will choose the one with the higher expected return. An increase in such return will lead to an increase in the quantity demanded of the asset YIELD CURVE The yield curve is the time structure of interest rates. It is normally upward sloping, but it can take different shapes. A risky situation presents whenever there is an inverted yield curve. A hump-shaped curve is something we can observe today in the US. It is not inverted. It starts low and then goes up and down. Three theories can explain the yield curve. 1. EXPECTATION THEORY → first to be introduced. It worked for a while, until it started to observe hump-shaped curves which were not predicted. It is based on the key assumption that bonds of different maturities are perfect substitutes (investors are indifferent between holding one or the other). This implies that expected returns on bonds of different maturities are equal. Ex. an investor has a 2-year horizon. They can choose between 2 investment strategies i. buying a 1-year bond at $1, and when it matures, they will buy another 1-year bond with the return of the first bond ii. buying a 2-year bond at $1 and hold it. For these to be perfect substitutes, returns must be equal → (1 + 𝑖𝑡) × (1 + 𝑖𝑡+1 𝑒 ) = (1 + 𝑖2𝑡)2 If the investor chooses the second option, they don’t face any uncertainty about expected interest rates. In general, for n periods 𝑖𝑛𝑡 = 𝑖𝑡 + 𝑖𝑡+1 𝑒 + 𝑖𝑡+2 𝑒 + ⋯ + 𝑖𝑡+(𝑛−1) 𝑒 𝑛 This states that the interest rate on a long-term bond equals the average of short rates expected to occur over the life of the long-term bond. This explains why the yield curve has different slopes. a. When short rates are expected to rise in future, average of future short rates is above today’s short rate → yield curve is upward sloping. b. When short rates are expected to not change in future, average of future short rates is the same as today’s → yield curve is flat. c. When short rates are expected to fall, average of future short rates is below today’s → yield curve downward sloping. This theory doesn’t explain the intermediate changes in yield curves. 2. MARKET SEGMENTATION THEORY → introduced when the expectation theory hit a bump. It assumes that bonds of different maturities are not substitutes at all. This implies that markets are completely segmented, and each maturity has a market of its own. Interest rates at each maturity are determined separately by the demand and supply of bonds in that maturity segment. However, maturities are correlated. Hence, this theory can explain some weird shapes, but it unrealistic to assume that bond market investors will only focus on one maturity each. 3. LIQUIDITY PREMIUM THEORY → it merges the previous theories. It modifies the pure expectation theory with features of the market segmentation theory. It assumes that bonds of different maturities are substitutes, but not perfect. Investors prefer liquidity. Hence, they must be paid a positive liquidity premium lnt to hold bonds with maturities loner that their investment horizon. The liquidity premium is typically positive, but not always. 𝑖𝑛𝑡 = 𝑖𝑡 + 𝑖𝑡+1 𝑒 + 𝑖𝑡+2 𝑒 + ⋯ + 𝑖𝑡+(𝑛−1) 𝑒 𝑛 + 𝑙𝑛𝑡 This theory is consistent with the inverted and humped yield curve. Even if the expectation of the future interest rate would give a flat yield curve (expectation theory), investors would still prefer the short-term bonds over the long-term ones. Hence, they would be asking for a higher yield for higher maturities. An inverted yield curve often predicts a recession, since investors consider short term bonds riskier than long term ones. Interest rates will be set high by the CB in case of inflation, and it will be harder for the economy to recover. CENTRAL BANKS AND THE CONDUCT OF MONETARY POLICY In 1668, the Sveriges Riksbank was established. Its main functioning was lending money to the government of Sweden. As global trade increased, during the 17th century the level of international payments raised. This brought up the need to create more central banks throughout Europe to secure these payments and increase the efficiency of international trade. The founding of the Bank of England in 1694 marks the de facto origin of central banks. The Federal Reserve Bank (FED) was established in 1913- to avoid the risk of power concentration, it was designed to distribute the power over 12 regional Federal Reserve banks and remain privately owned by its member banks. Most established market economies established their central banks after WW2. Their structure became very similar to those of central banks in Europe. Over the last two centuries, central banks decreased the lending to governments and moved towards the safeguard of monetary stability, regulating the national currency, and acting as lenders of last resort to banks suffering from liquidity and/or credit crises. THE EUROPEAN CENTRAL BANK The ECB came into existence on June 1, 1998, to handle the transitional issues of the nations that became part of the Eurozone. The Eurosystem comprises the ECB and the National Central Banks of the EU MSs that have adopted the euro. NCBs control their own banking systems, while the ECB alone conducts the monetary policy of the Eurozone. The ECB is an independent entity, mostly owned by the NCBs of the MSs (≈ 5% of its equity is owned by EU countries that have not adopted the euro). The Governing Council is the main decision-making body of the ECB. It is responsible for conducting the monetary policy in the euro area. The primary objective is maintaining price stability. At the beginning of each month, the Council decides on the monthly monetary policy decisions in accordance with the economic and monetary developments in the Eurozone. The Council is chaired by the ECB president and consists of the president, the vice-president, 4 members of the Executive Board, and the governors of the 19 NCBs of the Eurozone. TASKS OF THE ECB 1. MONETARY POLICY TO MAINTAIN PRICE STABILITY → the ECB aims at keeping inflation low and stable. The desirable level of inflation is around 2%. Until 2021, the ECB wanted to maintain rates below the target. Lower inflation was perceived as better than high inflation (π < 2% better than π > 2%). Since July 2021, a new strategy adopts a “symmetric 2% inflation target over the medium term”. Deviations from the 2% target from above and below are equally bad (π = 3% is equally bad as π = 1%). 2. FINANCIAL STABILITY and MACROPRUDENTIAL POLICY → the ECB monitors developments in the financial sectors of the euro area and the EU to identify any vulnerabilities and check the resilience of the financial system. 3. PROMOTION OF PAYMENT AND SECURITIES SETTLEMENT FACILITIES → the ECB must ensure that payments work smoothly. If this wasn’t the case, people wouldn’t be incentivized to execute transactions. 4. Supervision of NCBs in the provision of cash → euros are materially printed by NCB. However, it’s the ECB that decides in what amounts they can do so. 5. Management of foreign reserves and own funds to conduct foreign exchange operations (when needed). 6. ECB statistics to provide the data necessary to undertake the tasks of the European System of Central Banks. All these additional tasks are carried out by different competent authorities. Since there is no fiscal union (no common taxation) between EU countries, the fiscal system is country- based. Along the different rescue plans adopted, this system has proved to be catastrophic during sovereign and financial crisis. The Single Supervisory Mechanism, established in 2014, gave the ECB the additional task of SUPERVIZING BANKS in the EU (Eurozone and SSM members). Larger banks, the so-called significant banks, are directly supervised by the ECB. Smaller banks are supervised indirectly by the ECB through the direct supervision of national supervising authorities. By doing so, supervision across banks in the EU is consistent and harmonized. THE FED – FEDERAL RESERVE BANK The Federal Reserve System is one of the largest and most influential central banks in the world. It is an independent body privately owned by its member banks. While the ECB is entirely independent, the Fed is subject to oversight from the Congress, which periodically reviews its activities. The Fed supervises and regulates all the nation’s financial institutions and simultaneously serves as their banker. TASKS OF THE FED 1. MONETARY POLICY → the Fed has a dual mandate of long-term price stability and macroeconomic stability. It aims at achieving these goals by creating jobs – employment maximization comes first. 2. FINANCIAL STABILITY 3. SUPERVIZING and REGULATING FINANCIAL institutions and activities 4. Promotion of payment and securities settlement facilities 5. Promoting consumer protection and community development → these are not goals for the ECB. 6. Production of data and statistics. MONETARY POLICY TRANSMISSION MECHANISM The primary objective of the monetary policy conducted by central banks is to maintain price stability, often along with macro stability towards growth and employment. The monetary policy transmission mechanism is the process through which monetary policy decisions affect the economy in general and the price level. As the official interest rates change, the banking sectors either tightens or loosens financial conditions in the economy. Borrowing money becomes either cheaper or more expensive, so people will be respectively more incentivized or more reluctant to borrow. If the process runs b. The mezzanine tranche is responsible for losses between 5% and 20%. They are not very risky, and they normally enjoy an investment-grade rating. c. The senior tranche is the safest one and enjoys a very high rating – AA or AAA. It is responsible for losses over 20%. In a normal structure, it shouldn’t be affected. During the financial crisis, defaults affected all tranches, bringing significant losses especially to banks, insurance companies, and other investment companies that had senior tranches in their portfolios. 3. Covered bond purchase programme – CBPP → the Eurosystem conducts net purchases of covered bonds. They are bonds issued by banks and backed by a pool of loans. However, unlike the pool of underlying assets of ABS, the loans remain on the bank’s balance sheet as a guarantee for covered bondholders. Classic underlying loans are public sector or mortgage loans. Covered bonds are widespread in Europe. 4. Corporate sector purchase programme – CSPP → the Eurosystem conducts net purchases of corporate (non-banks) bonds to inject liquidity directly into the corporate sector, without the intermediation of the banking sector. This should strengthen the monetary policy transmission channel. 5. Pandemic emergency purchase programme – PEPP → discontinued in December 2021. All asset purchase programmes are carried out by NCBs. The eligibility criteria of the assets that can be purchased are clearly specified by the ECB. - TRANSMISSION PROTECTION INSTRUMENT – TPI → the ECB buys (government or public sector) bonds issued in countries that could be momentarily in trouble but whose finance is still stable. The Eurosystem provides credit only against adequate collateral. Typically, collateral refers to marketable financial securities (i.e., bonds) or other types of assets (non-marketable assets or cash). The term eligible asset is used for assets that are accepted as collateral by the Eurosystem. These assets are of good credit quality. A haircut is applied to collateral. It varies according to the riskiness of the collateral. The haircut is subtracted from the value of the collateral. A tighter monetary policy implies a higher haircut. EMERGENCY LIQUIDITY ASSISTANCE The monetary policy measures outlined before do not reflect the lender of last resort function of the ECB. The emergency liquidity assistance (ELA) allows euro area credit institutions to receive CB credit. It provides CB money to solvent financial institutions that are facing temporary liquidity problems. ELA is arranged by NCBs. However, ELA is very expensive and banks resorting to it develop a bad reputation. Being a lender of last resort can help rescue banks with temporary problems, otherwise solvent, and can also help avoid bank panics. However, there is a certain level of moral hazard. Indeed, banks and other financial institutions may take on more risks knowing the CB will come to the rescue. MONETARY POLICY AT THE FEDERAL RESERVE Monetary policy instruments of Fed and ECB are very similar. 1. Depository institutions must keep minimum reserves at the Fed. 2. The official target interest rate is the Federal funds rate. It is the rate at which depository institutions lend reserve balances to each other overnight to meet their reserve requirements. These loans are not collateralized. The Fed is not an active actor; it only sets the range within which the Federal funds rate should be (now it is 3.00-3.25%). The effective rate may be different. 3. Through open market operations, the Fed buys and sells securities in the open market to adjust the supply of reserve balances and align the effective Fed funds rate to the target. 4. The Fed also injects liquidity via discount loans. a. Primary credit → healthy banks borrow as they wish from the primary credit facility or standing lending facility. b. Secondary credit → given to troubled banks experiencing liquidity problems (as lender of last resort). c. Seasonal credit → designed for small, regional banks that have seasonal patterns of deposits. Similarly to the ECB, the Fed adopted a range of new tools to respond to the financial crisis and provide the financial system with the necessary liquidity. - Term auction facility → extends loans of fixed amounts to banks at interest rates determined by competitive auctions. - New lending programs → included landing to non-banks, and lending to promote the purchase of asset-backed securities and commercial paper. CENTRAL BANK BALANCE SHEETS As a result of quantitative easing, CB assets have exploded after the financial crisis. The pool of assets has become larger, riskier, and more illiquid at times. All of this has led to an excess liquidity in the economy, excessive (indirect) financing of the increased budget deficits, and moral hazard. Central banks have played an essential role in reverting the tightening in financial conditions caused by the financial crisis and the pandemic. TACKLING CLIMATE CHANGE (per conoscenza personale) Central banks have been recently called to contribute fighting against climate change. Climate risk has two components. - Physical risk → losses arising from natural events (e.g., floods, fires, windstorms, etc.) – location. - Transition risk → losses arising from transitioning to a carbon-neutral economy (e.g., carbon tax, technological changes, new regulation, reputational losses, etc.) – sector of activity. Network for Greening the Financial System (NGFS) was launched in 2017 by a group of central banks and supervisors to “define and promote best practices to be implemented… to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments”. In July 2021 the ECB has officially presented an action plan to incorporate climate change in its monetary policy strategy. The Fed has created two new committees to assess the impact of climate risk on the banking system and financial stability. However, climate change will not affect its monetary policy decisions. MONEY MARKETS AND INTERBANK LENDING Money is not actually traded in money markets. The securities traded are short term with high liquidity. They are quite close to being money. These securities - are usually sold in large denominations (1,000,000 USD or more) → they are mainly for institutional investors - have low default risk - mature in one year or less from their issue date, although most mature in less than 120 days - are highly liquid. The banking system should handle the needs for short-term securities. They benefit from information advantage. However, they are heavily regulated and have reserve requirements, which create additional expenses for banks. This creates a distinct cost advantage for money markets over banks. Regulations on the level of interests that banks could offer to depositors in the US led to a significant growth in money markets, especially in the ‘70s and ‘80s. When interest rates rose, depositors moved their money from banks to money markets. Investors in money markets need a place for warehousing surplus funds for short periods of time. Borrowers look for low-cost sources of temporary funds. Firms and governments use these markets because the timing of their cash inflows and outflows are not well synchronized. Money markets provide a way to solve these cash-timing problems. MONEY MARKETS INSTRUMENTS - SHORT-TERM GOVERNMENT BONDS → these bonds have maturities up to 12 months. In Italy they are called Buoni ordinari del Tesoro (BOT) and they typically expire in 3, 6, or 12 months. In the US they are called Treasury bills (T-bills) and have maturities from 1 month to 1 year. These bonds are zero-coupon bonds. The investor pays a price lower than the face value and the government pays the face (par) value at expiry. The difference between the par value and the price paid is the interest earned on the bond. Government bonds are placed through auctions, which are often reserved to authorized dealers (large banks). The calendar of the auctions is available on the website of the Treasury. Italian auctions are competitive on yield. Interested dealers place their offers (up to 5) in terms of quantity and yield requested. The Treasury sets a minimum and a maximum yield and assigns the issue starting from the lowest yield until the entire sum has been allocated. The accepted offers are satisfied at the quantity and yield requested. The Treasury computes the weighted average of the yields corresponding to the offers accepted. The result is the yield of the Treasury bill. The successful dealers place the treasury bills to investors at a price in line with the average yield. Ex. the Italian government wants to allocate €4,000,000 and is willing to accept bids with a yield between 0.86% and 0.90%. Bank A wants €1,000,000 at 0.9%, bank B 1,000,000 at 0.88%, bank C €1,000,000 at 0.87%, and bank D €2,000,000 at 0.86%. Banks B, C, and D will receive the quantities asked at the yields requested. Bank A won’t receive anything. The weighted average is 0.88 × 1 4 + 0.87 × 1 4 + 0.86 × 1 2 = 0.86 The weighted average price of the issue is 𝑃 = 100 (1+𝑤.𝑎.𝑦.) 𝑎𝑐𝑡 360 Investors who want to buy from the successful dealers will pay a price slightly above P (because of fees). - CERTIFICATES OF DEPOSIT – CDs → they are time deposits with a bank. They pay interests and principal at maturity but cannot be withdrawn before expiry, which is between 1 and 6 months. 1. Non- negotiable CDs are sold for small denominations, which makes them affordable to retail investors. Since they cannot be traded, they are insured by CBs. 2. Negotiable CDs are addressed to companies, since they are sold for large denominations (>100,000 USD or EUR). They are not insured and can be bought and sold to other companies in a secondary market until maturity. - COMMERCIAL PAPER → unsecured short-term debt instruments issued by top credit quality companies. They are issued to finance accounts payable and inventories and to meet short- term liabilities. Their maturity is shorter than 1 year (<270 days in the US to avoid registration requirements). Commercial paper is usually issued at a discount from the face value and for large denominations (>100,000 USD or EUR). Commercial paper is bought by other companies, financial institutions, wealthy individuals, and money market funds (through which retail investors can buy it). It is usually traded on secondary markets is Europe, placed to investors, and held to maturity in the US. Using commercial paper is cheaper than asking banks for loans. Indeed, the rate of return on commercial paper is lower than the prime rate (lowest interest rate that US banks grant to high quality companies). - FOREIGN CURRENCY DEPOSITS → foreign currency deposited in banks outside of home countries. The most popular are Eurodollars – US dollars deposited outside the US. As such, they are not subject to US banking regulations. These deposits are typically offered by large, - other financial intermediaries – insurance companies, pension funds, mutual funds, hedge funds - retail investors (mostly for government bonds) GOVERNMENT BONDS Government bonds with medium and long-term maturity are typically referred to as treasury notes (between 1 and 10 years) and treasury bonds (between 10 and 30 years). They have different maturities to satisfy governments’ future financial plans and needs. Italian bonds are - CTZ – Certificati del Tesoro Zero Coupon → zero-coupon bonds with maturity of 2 years. Like BOTs, but with longer maturity - BTP – Buoni Poliennali del Tesoro → fixed semi-annual coupon, maturities from 3 to 50 years - CCT – Certificati del Credito del Tesoro → floating semi-annual coupon (indexed at 6-month BOT yield), maturity of 7 years - CCTEu – Certificati del Credito del Tesoro indicizzati all’Euribor → floating semi-annual coupon (indexed at 6-month Euribor + spread), 7-year maturity Inflation-linked bonds protect investors against inflation. They are - BTP€i – BTP indicizzati all’inflazione europea → face value and coupons are adjusted for inflation based on Eurostat index. They protect against inflation in the Eurozone. 5 to 30 years maturities. - BTPItalia → face value and coupons are adjusted for inflation based on Istat index. Protects against inflation in Italy. Maturities from 4 to 8 years. Medium and long-term government bonds are mostly placed through auctions (with some exceptions like BTPItalia). Occasionally, special issues (e.g., BTPItalia) or issues addressed to foreign investors can be placed directly to investors without auctions. This happens because they are either ad-hoc, or difficult to place as usual (through auctions). Italian medium/long-term government bond auctions are marginal price auctions. Interested dealers place their offer (up to 5) in terms of quantity and price that they are willing to pay. The amount placed is determined excluding bonds made at prices not suitable with respect to market conditions. The lowest price among those bid by awarded dealers is the auction (marginal) price. This price is applied to all successful dealers. Government bonds are then placed by the successful dealers to investors at a price in line with the marginal one. The Treasury uses the lowest price instead of the highest to attract investors in future auctions. Ex. the Treasury wants to allocate 4000 bonds and is willing to accept bids with a price between $97.5 and $98.3. Dealer A wants 1000 bonds at $97.5, dealer B 1000 at $98, dealer C 2000 at $98.2, dealer D 2000 at $98.3. Dealers A, B, and C will receive the quantities asked at the price of $97.5. After issuance, government bonds can be traded on the secondary market. This market is highly liquid. It is organized 1. over-the-counter (OTC) by specialized market makers 2. as a segment of the regulated exchange. CORPORATE BONDS Corporate bonds are issued by companies (financial and nonfinancial firms) to meet financing needs. These bonds are coupon-bearing. They can be issued 1. privately → bonds are sold to institutional investors, who will typically hold them to maturity. These bonds provide very low liquidity 2. publicly → by issuing to the public, the company becomes a regulated entity asked to comply with different requirements. Indeed, bonds issue is subject to formal registration and registered bonds must be sponsored by underwriters before being placed to investors. This process is quite expensive. Investment banks help companies and facilitate this process. These bonds can be traded on the secondary market. They provide higher liquidity than bonds placed privately, but much lower than government bonds. The secondary market of corporate bonds is mostly OTC, with a few bonds traded on regulated exchanges. BOND INDENTURE The terms of the bond are specified in the bond indenture – contract between the issuer and the bondholder. The terms of the bond indenture must be 1. face or par value of the bond → principal repaid at maturity 2. coupon rate → it determines the interest payment (= coupon rate x face value) 3. coupon frequency → when interest payments are due (usually semiannually) 4. maturity date → usually 5-7 years for nonfinancial firms, wider range of expiries for financial firms 5. any additional feature (guarantees, callability, convertibility, …) Corporate bonds often come with a series of additional features. - COLLABILITY → callable (or redeemable) bonds can be repurchased by the issuing firm before the maturity date. However, they must wait for the period of call protection to be over. Option will be exercised if interest rates on the market have fallen significantly compared to when the bond was issued. Indeed, this would increase the future value and the price of the bond above the call price. Issuers would repurchase the bond at par and issue b0nds at a lower yield. To compensate the cost, bondholders will demand a higher coupon, all else equal. - FLOATING-RATE → floating-rate bonds have an adjustable coupon rate linked to a reference rate (Libor + spread, Euribor + spread, …). - PUTTABILITY → puttable bonds give the holder the right to demand early repayment of the face value of the bond. Option will be exercised if interest rates on the market have increased significantly compared to when the bond was issued. Indeed, the future value of the bond falls because of the presence of other bonds offering higher coupon rates. Investors would use the proceeds to buy a similar bond offering a higher yield. It can normally be exercised only upon the occurrence of specified events/conditions or at certain dates. A variation is the extendable bond, where the holder has the right to extend the bond’s life (when coupon rate exceeds current rates). - CONVERTIBILITY → convertible bonds can be exchanged for shares of the firm’s common stock. The conversion can take place only at certain times during the bond’s life and is normally at the discretion of the bondholder. The conversion rate is pre-specified in the bond indenture. Bondholders benefit from price appreciation of the company’s stock. Bondholders like a conversion feature, so the price of these bonds will be higher. Contingent convertible (CoCos) bonds are automatically converted into equity if a pre-specified trigger event occurs. They are used by banks (subject to minimal capital requirements). When capital falls below a threshold, CoCos are automatically converted into capital. - COVENANTS → managers are more interested in protecting stockholders than in protecting bondholders and might not use the funds provided by the bonds as the bondholders might prefer. Since bondholders cannot look to managers for protection when the firm gets into trouble, they must impose rules and restrictions on managers designed to protect their interests. These agreements are called covenants. 1. Negative covenants forbid the issuer from taking certain actions (dividend limits, issuance of new debt, …). They are usually linked to threshold values of financial ratios i. max debt-to-equity ratio ii. min interest coverage ratio iii. min level of earnings iv. … The interest rate is lower the more restrictions are placed on management through these covenants because the bonds will be considered safer by investors. 2. Positive covenants force the issuer to undertake actions (insurance, auditing of financial statements, …). A covenant violation puts the company in technical default. Indeed, covenants usually include a cross-default clause. This means that if one debt class defaults, all classes default. The bonds protected by the violated covenant are not the only ones to which the technical default applies. Bondholders are represented and coordinated by a bondholders committee inside the company. If a company is in financial distress, the company may need to renegotiate the debt. This will call for coordination to prevent bankruptcy. For most decisions (except convertibility), bondholders act as one. SENIORITY Corporate bonds are usually distinguished by the type of collateral that secures them and by the order in which they are paid off if the firm defaults. 1. SECURED bonds are collateralized by underlying assets that the bondholders can seize in case of default of the issuer. They are mortgage bonds and equipment trust certificates in nonfinancial firms, and covered bonds in banks. They are paid first (around 75% of their investment). 2. SENIOR UNSECURED bonds (debentures) are backed only by the general creditworthiness of the issuer. They are paid (around 40% of their investments) after secured bondholders have been paid. Hence, they will have higher interest rates. In event of default, bondholders must go to court to seize assets. 3. SUBORDINATED – JUNIOR debentures have lower priority claim and are paid (around 15/20% of their investment) only after non subordinated bondholders have been paid. CREDIT RATINGS Credit risk is the risk that issuers will fail to repay their debt (principal and/or interests). Default for companies encompasses several events: 1. liquidation → the company will close 2. in-court restructuring → the company goes on bankruptcy, stays on it for some time, and then comes out 3. missed interest payments after a grace period has expired. For sovereign, default encompasses: 1. out-of-court restructuring 2. missed interest payments. Credit risk can be assessed thanks to credit history. At origination, credit ratings were unsolicited and paid by investors through the sale of rating publications. However, this system was exposed to moral hazard, since also investors who didn’t pay for the rating could have access to it. Now, most ratings are issuer-paid. The issuer applies for a rating to the credit agency and submits all the required information. The lead analyst in charge collects the information, processes it and makes a rating recommendation to the rating committee. The latter assigns the rating, which is then communicated to the issuer and publicly to investors. Obtaining a rating is expensive, since the required information are a lot, and they must be continuously provided. Issuers pay an initial fee for the first rating and other maintenance fees. Moreover, this process is exposed to conflict of interest. Since the agency is paid directly by the company, it may feel some undue pressure to give a nice rating. To determine the final credit rating of companies, the agency runs - financial risk analysis on financial ratios - business risk analysis by comparing the companies to their peers 1. in the same market and sector 2. on competitiveness 3. and management skills, strategies, and corporate governance - position limits → while hedgers can hold as many futures as they will, speculators may hold up to a maximum number of contracts. Ex. In March 2020 I take a long position in 10 contracts (contract unit 1,000 barrels) for September 2020 delivery at a future price of $33.03 per barrel. I commit to take delivery of 10,000 barrels of oil and pay $33.03 × 10,000 = $330,300 in 6 months. Hedgers use forward and futures contracts to lock in a price at which to buy or sell an asset in the future. - Long hedge → long position to lock in a purchase price - Short hedge → short position to lock in a sale price The futures (and forwards) price for a given contract changes continuously over time but will always converge to the spot price at delivery. If this was not the case, there would be an arbitrage opportunity on the market (free lunch). Suppose that at delivery the futures price 𝐹𝑇 is above the spot price 𝑆𝑇. One could sell a future contract for 𝐹𝑇, buy the asset spot for 𝑆𝑇, and make delivery. They would realize an immediate profit of 𝐹𝑇 − 𝑆𝑇. This profit is not risky (no uncertainty linked to the prices). No-arbitrage arguments require 𝐹𝑇 = 𝑆𝑇. The price of future contracts is lower than the spot price in t = 0 because of the dividends that the share pays during the life of the contract (profits that the buyer loses). Most futures contracts do not lead to delivery and are closed before the delivery period by entering an opposite trade. Speculators bet on a change in the price of the underlying asset between now and the delivery date. Suppose I bet on an increase in crude oil prices between March and September. If the oil price increases before September, I do not need to wait until the expiry of the contract to realize the profit. I can close out my position any time prior to the delivery period by entering an opposite (short) position in 10 contracts for September delivery. The total gain (or loss) comes from the change in futures price between March and the date when the position is closed. Delivery is typically too inconvenient and expensive even for hedgers. Hence, they also close their positions before delivery. Ex. It’s now September 2020. The price of crude oil has increase from $33.03 to $35. To close the contract entered in March, I enter a short position with the same counterparty for the same number of barrels but at the new future price, which is equal to the spot price. The two contracts will cancel each other out, and the counterparty will cash out, giving me $35 − $33.03 = $1.97 per barrel. I will buy the oil at $35, but thanks to the $1.97 gained from the futures contract, it would be like I bought the oil for $33.03. MARGIN ACCOUNTS FOR FUTURES CONTRACTS If futures prices move in the direction opposite than the one expected, speculators incur in a loss (not offset by the profits on the underlying asset, like hedgers). To ensure that futures investors honor their obligations, exchanges impose a margin system. When opening a futures position (both long and short), the investor must deposit an initial margin into a margin account. At the end of each trading day, the margin account is adjusted to reflect the gains or losses arising from changes in the futures price. If the balance of the margin account falls below the maintenance margin, the investor receives a margin call and must deposit additional funds. If the balance increases above the initial margin level, the investor can withdraw the surplus. DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS 1. Futures contracts are settled daily through margins, while forward contracts are settled at delivery. 2. Fu contracts are guaranteed by the exchange, while for contracts are subject to counterparty risk. 3. The details of fu contracts are specified by the exchange, while for contracts are ad-hoc. 4. Fu contracts can only be closed by entering an opposite position in the same contract, while for contracts can be closed upon agreements with the original counterparty. However, most for contracts lead to a delivery in practice. 5. Typical assets traded under for contracts are foreign currencies, while typical assets traded under fu contracts are commodities, stock indexes, foreign currencies, and interest rates. STOCK INDEX FUTURES Futures contracts on stock indices are very popular. Stock indexes are not physical. They are financial instruments that replicate an underlying portfolio. Indexes cannot be bought directly. Hence, they are settled in cash. The size of one futures contract is given in index points (monetary multiple (multiplier) of the index). Ex. One stock index futures contract on the S&P 500 is equal to $250 times the index; one contract on the FTSE 100 is £10 times the index; one contract on the FTSE MIB is €5 times the index; … Stock index futures are used for - Speculation → as an alternative to ETFs (exchange-traded funds) or funds. Ex. cherry picking. - Arbitrage → to ripe profits from discrepancies between the price of the index and the price of the underlying stock portfolio - Hedging → to hedge an exposure to the underlying stock portfolio. Typically, mutual funds own diversified portfolios of shares. A decrease in stock prices would generate losses. To protect themselves, funds can enter a short position future. Ex. Consider an investor who took a long position in five S&P 500 futures contracts with December expiry in March 2021. The 9-month futures price of the S&P 500 in March 2021 was 2,080. The futures (= spot) price of the S&P 500 in December was 2,250. The investor receives (2,250 – 2,080) x $250 x 5 = $212,500. BASIS RISK Since futures are standardized with respect to what can be bought and for what maturity, hedging using futures contracts is hardly perfect. The hedger is exposed to basis risk. Discrepancies between the hedging needs and the future contracts available entail that 1. the asset underlying the futures contract may not be the same as the one the hedger needs to hedge – cross-hedging. If this is the case, the hedger must compare the past time series of prices of the asset they need with the future time series of prices of the assets available. The hedger will then compute the correlation factor and will choose the contract whose price is most highly correlated with the asset price. 2. the hedging horizon may not coincide with any of the available futures expiries (for example the hedger wants to hedge a position between March and August, but futures contracts are only available for March, June, September, December expiries). The hedger will choose a delivery month as close as possible, but later than the expiration of the hedge. Opening another hedge is too risky. It’s safer to enter a contract and close it before expiry. 3. The hedger may not be certain of the exact hedging horizon. Unless the mutual fund manager tries to hedge a portfolio that almost perfectly mirrors the underlying index, the fund is exposed to basis risk. Forward contracts are ad-hoc, so they may be free from the first two problems and perfect hedging is achievable. THE DERIVATIVES MARKET – SWAP CONTRACTS INTEREST RATE SWAPS A swap is an agreement between two parties to exchange cash flows at specified future times according to certain specified rules. The most common type of swap is the plain vanilla interest rate swap (IRS). One party agrees to 1. pay interest cash flows computed at a predetermined fixed rate on a notional principal for a predetermined number of years, and 2. receive interest cash flows computed at a floating rate on the same notional principal for the same period. The other party will do the opposite. The fixed interest rate is called swap rate, while the floating interest rate is a standard reference rate (e.g., Libor, now SOFR, or Euribor). Interest rate swaps are over-the-counter derivatives. Banks are the main swap dealers and trade IRS for themselves as well as for their customers. They are exposed to interest rate risk, as most of their assets and liabilities are interest-rate sensitive. Ideally, banks should “match” the interest rate risk exposure of their assets and liabilities. To do so, they should both lend and borrow at fixed (or floating) interest rates. This is impossible to achieve in practice. When they feel they are overexposed to one of the two interest rates, they can use IRS to hedge against interest rate risk. The IRS contract specifies - the swap (fixed) rate - the reference (floating) rate - the notional used to compute the interest cash flows. However, it is never exchanged in plain vanilla IRS - the periodicity of interest payments (quarterly, semi-annual or annual) - the maturity of the IRS (typically between 1 and 30 years) - the day count conversion used to compute the interest cash flows. Ex. in March 2022, Credit Suisse agrees to receive 6-month LIBOR from Goldman Sachs and pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million. Suppose that Goldman Sachs borrows mostly at a fixed (average) rate of 5.2% and then swaps fixed for floating with Credit Suisse. The net effect is borrowing at Libor + 0.2%. Suppose that Credit Suisse borrows mostly at a floating (average) rate of Libor + 0.1% and then swaps fixed for floating with Goldman Sachs. The net effect is borrowing at a fixed rate of 5.1%. FORWARD RATE AGREEMENTS – FRA A forward rate agreement is an over-the-counter contract between two counterparties to exchange a fixed interest payment for a floating interest payment on a single future date. Most contracts are indexed at Libor (now SOFR or other replacement rates) or Euribor. The notional is never exchanged and it is only used to compute the interest payments. An IRS is essentially a series of FRAs. Every interest payment under the IRS is an FRA. CURRENCY SWAPS A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. They can be of different types (fixed to fixed, fixed to floating, floating to floating). Unlike in an IRS, the notional is often (but not always) exchanged both at inception and at maturity. The exchange rate at which the two notionals are exchanged at inception is typically the spot exchange rate between the two currencies. Currency swaps are used by large multinational banks and companies (MNC) to hedge against both exchange rate and interest rate risks. Suppose a U.S. MNC wants to finance a €40 million expansion of a German subsidiary. The current spot exchange rate is S0($/€) = $1.30/€. So, the equivalent dollar amount is $52million (€40m × $1.30/€). The project has an economic life of 5 years. Options available to the company are - borrowing USD and convert to Euro → exposes the company to exchange rate risk seek loans and be selected. A classic example of adverse selection is the lemon’s problem in the secondhand car markets. If we distinguish between “good” and “bad” (lemons) used cars, buyers are willing to pay only an average of good and bad car values. This would make good car sellers exit the market as prices are perceived as too low, and only lemon cars would be sold. However, buyers know that all of this is likely to happen, so they directly exit the market. Therefore, the used car market will function inefficiently. Car dealers can help by providing information and reassurance that what people are buying are not lemons. The lemon’s problem can be applied to securities (bond and stock) markets. If investors cannot distinguish between good and bad securities, they will be willing to pay only an average of good and bad securities’ value. Therefore, good securities will be undervalued, and firms will not issue them, while bad securities will be overvalued and there would be too many issued. Investors don’t want to buy bad securities, so they will exit the market, which will stop functioning efficiently. To solve adverse selection, we can resort to i. private production and sale of information → this is the job of credit rating agencies. However, they are hindered by free-riders. Only few investors pay for information, but their actions can be observed by anyone, including those who didn’t pay. Free-riding could freeze the market ii. government regulation to increase information → an example are independent audits of public corporations. However, companies still know more and have an incentive to make themselves look good. Hence, government regulation doesn’t always work iii. financial intermediaries → analogy to the solution to the lemon’s problem by used car dealers. Financial intermediaries avoid free-rider problems by making private loans that cannot be traded and observed by other investors. This is more beneficial for small and medium firms, since large ones are more likely to use direct instead of indirect financing, given that they can produce and disseminate information. Financial intermediation is more beneficial in less developed markets where information may be more difficult to acquire. Syndicated loans are huge loans made by a syndicate of banks. Risk is shared between these banks. Because of their huge size, all the details of these loans are made public iv. collateral and net worth → collateral are assets promised to the lender if the borrower defaults. It facilitates lending. However, collateral can quickly lose value. Net worth = net assets – net liabilities. Companies with higher net worth (or equity capital) find it easier to borrow. However, companies that need to borrow are those that find it difficult to raise capital (riskier to begin with). b. Moral hazard → one party has an incentive to behave differently once an agreement is made between parties. Moral hazard arises after transactions occur. The hazard that a borrower has incentives to engage in undesirable (immoral and excessively risky) activities makes it more likely that they won’t pay the loan back. In single-entrepreneurs firms, ownership and management coincide. Moral hazard arises from the separation of ownership by shareholders from the control by managers and is particularly severe in equity contracts (principle-agency problem). Managers and officers may drift away from the principals’ interest and the obligations taken on through the contract, acting in own interests. That’s because they have more information about their activities that shareholders do. Debt contracts are less prone to moral hazard issues, as they require fixed periodic payments. Nevertheless, debt is not fully free from moral hazard. Indeed, it may create an incentive to take on very risky projects. Most debt contracts require borrowers to pay a fixed amount (interest) and keep any cash flow above this amount. On one hand, every time interest payments are due, bondholders/banks perform a check to see if companies are undertaking risky transaction. On the other hand, if a firm that owes $100 in interest only has $90, it is essentially bankrupt. The firm has nothing to lose by looking for “risky” projects to raise the needed cash. Moral hazard can be solved thanks to i. collateral → borrowers have “skin in the game” or valuable collateral to lose, which reduces the incentive to take excessive risk. Hence, the debt contract becomes incentive compatible – incentives of borrowers are aligned with those of the lender ii. monitoring and enforcement of restrictive covenants → debt contracts are packed with covenants of different types, which aim at a. discouraging undesirable behavior of undertaking risky investment projects b. encouraging desirable behavior → minimum liquidity requirements, max leverage ratios, … c. keeping collateral valuable (e.g., through insurance) d. providing information iii. financial intermediaries → they have special advantages in monitoring and a closer relation with the borrower. They try to detect early stages of default/distress. For instance, a bank can closely monitor the use of a revolving credit line. CONFLICTS OF INTEREST Financial intermediaries play a crucial role in mitigating asymmetric information issues. However, they are prone to conflicts of interest. These are a type of moral hazard that occurs when an institution has multiple interests and serving one interest is detrimental to the other. This happens because financial intermediaries provide multiple services to their customers. Classic conflicts developed in financial institutions are 1. underwriting and research in investment banking → investment banks may both research companies with public securities, as well as underwrite securities for companies for sale to the public. These financial services are combined because of information synergies. Research is expected to be unbiased and accurate, reflecting the facts about the firm, since it is used by the public to form investment choices. Underwriters will have an easier time if research is positive. They can better serve firms going public if their outlook is optimistic. Hence, the research department may favor the placement of certain securities 2. auditing and consulting in accounting firms → auditors check the assets and books of a firm for the quality and accuracy of information. The objective is an unbiased opinion on the firm’s financial health. Consultants, for a fee, help firms with variety of managerial, strategic, and operational projects. An auditor acting as both an auditor and consultant for the same firm is not objective, especially if the consulting fees exceed the auditing fees. Auditors may hope that, by giving good audits, they would attract new customers for its consulting services. Audits can also provide favorable audit to solicit or retain audit business 3. credit assessment provided by credit rating agencies → rating agencies assign a credit rating to a security issuance of a firm based on projected cash flow, assets pledged, … The rating helps determine the riskiness of a security. However, since most ratings are paid by the debt issuers, rating agencies may feel an undue pressure to give favorable ratings. Remedies to these conflicts of interest are regulations. - Sarbanes-Oxley Act, 2002 → it limited consulting relationships between auditors and firms and improved the quality of the financial statements - Global Legal Settlement, 2002 → it required investment banks to cut links between research and underwriting and added additional requirements to ensure independence and objectivity of research reports - Dodd Frank Act, 2010 (for rating agencies) → it introduced stricter rules and supervision of credit rating agencies and increased the legal liability of rating agencies for the ratings provided. SECOND MIDTERM BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS The balance sheet is a list of a bank’s assets and liabilities. Tot assets = tot liabilities + capital (equity) A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets). Banks invest these liabilities into assets to create value for their capital providers. Capital comes from debt holders, while liabilities come from deposit holders. (CHIEDI) LIABILITIES – DEPOSITS Most big banks issue bonds (debt securities) to get funding. Other liabilities may comprehend liabilities towards employees. In the US there is a distinction between 1. checkable deposits (standard bank accounts in the EU) → they allow the owner to withdraw (write checks to third parties) without notice at any time (payable on demand). They can be non-interest earning, interest earning, or some money-market deposit accounts. They are safe and liquid but offer low interest (for depositors). Checkable deposits are very costly for the bank because it must keep an amount of liquidity adequate to satisfy depositors needs. These deposits are slightly more volatile 2. non-transaction deposits (≈ saving/time deposits in other countries) → the depositor commits to keep the money deposited for a certain period. If they withdraw earlier, they will face penalties. Different banks can offer different conditions. Non-transaction deposits offer higher interest rates in exchange (higher cost of funding for banks) for not being able to dispose of the money as depositors will. They are cheaper to manage and are a more stable source of funding. Checkable and non-transaction deposits account for most bank borrowings in commercial banks. Main depositors are households and nonfinancial firms. LIABILITIES – BORROWINGS Borrowings provide funds from - discount loans/advances with the central bank - fed funds / other interbank loans with other banks → they greatly depend on market conditions - interbank offshore deposits with other banks → international deposits like Eurodollars - repurchase agreements - commercial paper and notes/ bonds Notes and bonds are medium to long term borrowings, while all the other are short term. While depositors are fairly loyal, so deposits are quite stable, borrowings are more volatile (except for notes and bonds, due to their longer maturities). Nevertheless, their importance has grown over time. Non-commercial banks rely more on other borrowings than deposits. Large banking groups perform more activities than traditional (commercial) banks. If the bank faces a deposit outflow of $10 million, the bank still has reserves of $10 million, of which $9 mln are required reserves and $1 mln is in excess. The bank won’t face any liquidity issue or change in other parts of its balance sheet. Suppose instead that the bank has not kept any excess reserves. A deposit outflow of $10 million will leave the bank in a shortfall. It won’t have enough required reserves. To recover the $9 million, the bank can 1. borrow from other banks 2. sell securities, which are considered the liquidity buffer of banks 3. borrow from the central bank 4. reduce its loan portfolio – call back loans The 3rd and 4th options are equally unlikely. Banks borrow from CB as lenders of last resort only if they are forced to, since it would give them a bad reputation. Moreover, banks try to keep their loan portfolios as stable as possible, since borrowers may lose faith in them and stop asking for loans. The examples made are quite unlikely. Indeed, losses of 10% of deposits is a huge loss that will put the bank into a liquidity crisis. This won’t happen in normal market conditions. BANK RUNS Deposit withdrawals can be very dangerous for banks and lead to a bank run in extreme scenarios. If a sufficiently large number of depositors becomes worried that the bank may become insolvent soon, they will withdraw their deposits en masse. The first that get to the bank may be able to get all their money back. Those who come late could only get part, if not nothing, of their deposits. This becomes a self-fulfilling prophecy in case the bank is not in deep financial trouble. Northern Rock was a mortgage banks based in the UK that approached the Bank of England for a rescue package. The news rapidly spread, and depositors run to get their money out. Under standard market conditions, if only one bank faces a deposit outflow, while the interbank market continues to work normally, there shouldn’t be any problem. Problems arise when the interbank market stops functioning and faces liquidity shortages. Deposit insurance mechanisms could prevent bank runs. ASSET MANAGEMENT The main objective of asset management is earning the highest possible return on assets while minimizing the risk, and still making adequate provisions for liquidity. To do so, banks could follow four different strategies, although not all are necessarily feasible in theory. 1. Get borrowers with low default risk who pay high interest rates. However, who is willing to pay higher interest rates is at high risk of default. 2. Buy securities with high return and low risk – senior tranches of ABS before the financial crisis. This strategy is not particularly easy to adopt. 3. Diversification. If one section is badly hit, the other sectors would still perform well. Geographical diversification is constrained by the nature/type of bank. Small local banks are the less diversified. Therefore, if the crisis first hits their (geographical) area of interest, they are in trouble. Banks can diversify a. portfolios of securities by issuer and geographically b. loan portfolios by sector of activity and geographically. This strategy may create a vicious circle between bonds held and the government that issued them. Most banks tend to hold bonds issued by the domestic government. Until the financial crisis (when bailout was possible), governments were ready to bail out at the condition that banks would hold their bonds. After the crisis, governments noticed that a lot of taxpayers’ money was being used to bail out banks, so they started demanding that banks were bailed in by their creditors. 4. Manage liquidity to ensure reserves are met without bearing large costs. LIABILITY MANAGEMENT Liability management is the active management of the funding sources – deposits, CDs, and other debt. It is relatively new – 1960-70s. Prior to that, almost all funding came from deposits. Since they are difficult to control and obtain, banks no longer primarily depend on deposits. This ensures extra flexibility and allows banks to take advantage of lending opportunities by resorting to other funding sources – borrowing from other banks, issuing of CDs or notes. Banks manage both sides of the balance sheet together, whereas it was most separate in the past. They liability side was taken as given and only the asset side was actively managed. Most banks now manage both sides via the ALM (asset and liability management) committee. CAPITAL ADEQUACY MANAGEMENT Capital adequacy management manages the amount of capital banks need to hold to 1. prevent bank failure – insolvency 2. guarantee a good return on equity for investors 3. satisfy minimum capital requirements imposed by regulators. The first two points are common to non-financial firms. The third point is specific for banks. The business generates losses, which will be absorbed by the capital. If both banks lose $5 million from bad loans, HCB will still have $5 million in capital, while LCB will become insolvent – negative equity. Capital = shareholders equity + net profit/loss Banks don’t hold a lot of capital because the higher it is, the lower is the return on equity for shareholders. Therefore, banks should keep capital as low as possible. - Return on assets – ROA = net profit / total assets - Equity multiplier – EM = 1 / capital ratio = total assets / equity capital - Return on equity – ROE = net profit / equity capital = ROA x EM As capital increases, EM and therefore ROE fall. If capital is too much, the bank is wasting resources. If a bank manager feels the bank is holding too much capital, they should 1. buy back some of the bank’s stock 2. increase dividends to reduce retained earnings 3. increase asset growth via extra debt – new loans. On the other hand, if the bank is keeping too little capital, the manager should 1. issue stock 2. decrease dividends to increase retained earnings. Banks are very reluctant to do so. They stop paying dividends only when regulators impose them to 3. slow asset growth by retiring debt – call back loans. The slowdown in growth of credit triggered a crunch in 2007. The housing boom and bust led to large bank losses, also on SIVs, which had to be recognized on the balance sheet. These losses reduced capital. Banks were forced to either raise new capital or reduce lending. They did not touch their bonds portfolios because they were their only source of liquidity. They also didn’t issue shares because market conditions were not ideal – no one was willing to buy and stock market prices were plummeting. Indeed, too many shares would entail lower prices and too little profit for investors. It’s much easier to raise debt/capital when banks are in good financial conditions. MEASURING BANK PERFORMANCE To measure the performance of banks, we should look at the income statement. - OPERATING INCOME → it comes from a bank’s ongoing operations – main business activities. The largest components are 1. net interests = interests banks receive on loans and other assets – interests banks pay on funding sources. Interests on the funding side don’t change as fast as interests on loans. Net interests were very high in the 1980s, Nowadays, they are low, but on the rise thanks to the increase in interest rates. 2. net fees and commissions generated by providing any service. They are a backup when net interests decrease. second year is uncertain. If at the end of the first year interest rates on loans decrease to 8% the bank will incur a loss in the second year (8% - 9%) x 100mln = - $1 mln. Maturity matching helps mitigate interest rate risk. However, it is difficult to achieve as it is in contrast with the nature of asset transformers of financial institutions. CREDIT RISK The business of financial institutions is making loans. Credit risk is the risk that borrowers won’t repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal. Loan losses are charged off against the equity capital. - Securities are mostly safe since this portfolio is mainly made of government bonds (with some exceptions like Greece). However, other bonds are exposed to this risk since their issuer could default. - Interbank loans are also quite safe since banks are unlikely to default. - Loans are the most subject to credit risk. Credit risk is the largest source of risk for banks. It is particularly severe in times of recession, while it becomes milder in times of expansion. LIQUIDITY RISK Banks are exposed to liquidity risk as depositors can demand immediate cash for the financial claims they hold with the bank. However, for banks it is unprofitable to hold large cash reserves to face potential liquidity problems. In normal conditions, these problems could be faced with - cash reserves - sale of government bonds in the securities portfolio - additional borrowing. However, the bulk of assets are loans, so this could be difficult. Liquidity risk arises when cash reserves and securities are not enough to cover large deposit withdrawals. In a liquidity crisis (e.g., bank runs), banks can be forced to - liquidate assets at fire-sale prices - borrow from the central bank. MARKET RISK Market risk is the risk of incurring unexpected losses in the trading book due to changes in market prices. The trading book includes financial assets and liabilities frequently traded on organized markets with the purpose of generating profit (bonds, equities, FX contracts, derivatives). Its value is assessed twice a day to verify how much the bank would lose if market values changed. Changing asset conditions translate into a change in the market prices of the assets and liabilities in the trading book. Assets and liabilities held for long-term investments, funding, or hedging purposes are recorded at book (face) value. Those held in the trading book are recorded at fair (market) value. Example – The bank buys bonds A and B at 100, both with face value of $1,000,000. Bond A goes in the securities portfolio and bond B in the trading portfolio. In one year, the market price of bond A is 102.5 and that of bond B is 103. The former is recorded in the securities portfolio at 1,000,000, while the latter is goes in the trading portfolio at 1,030,000. FOREIGN EXCHANGE RISK Foreign exchange risk is the risk that exchange rate changes can adversely affect the value of a bank’s assets and liabilities denominated in foreign currency. This risk is more prominent for large international banks that lend to foreign borrowers and borrow funds in different currencies. Unless borrowing and lending are matched, the bank is exposed to FX risk. This risk can be hedged with currency swaps and derivatives. OPERATIONAL RISK Operational risk is the risk of losses resulting from inadequate or failed internal processes, people, and systems, or from external events. The definition includes 1. people risk → losses arising from employees’ misconduct (e.g., unauthorized trading) 2. technology and processing risks (e.g., IT disruptions, cyber-attacks). Nowadays, these are the main components 3. legal risks → losses arising from legal fines imposed on the bank (e.g., the Libor scandal). Banks are fined quite often by regulators and consumers 4. regulatory risks → losses arising from new potential regulation. The adoption of a regulation must be highly profitable. If this is not the case, there is no exposure to regulatory risk. Some risks may have a very small probability of happening, but if they happen, they will have a huge impact. Risks with small probabilities and impacts are not taken into much consideration. CLIMATE RISK Climate risk has two components 1. physical risk → losses arising from natural events (floods, fires, windstorms, …) – location plays a role 2. transition risk → losses arising from transitioning to a carbon-neutral economy (carbon tax, technological changes, new regulation, reputational losses, …) – sector of activity plays a role Banks are quite green themselves. What may expose them to climate risk and potential losses is from whom they finance – climate risk comes from their loan portfolio. Regulators are debating whether to incentivize or punish banks and companies to reach their goal. RISK MEASUREMENT AND MANAGEMENT Banks are required to set aside capital to face their risks. Therefore, they are involved in - risk measurement aimed at measuring the bank’s exposure to each source of risk – it will produce a numerical estimate of risk exposure. Non-financial firms must file a report once a year (twice in some instances). Banks must file reports quarterly and must be very detailed about the risks to which they are exposed. - risk management aimed at mitigating the bank’s risk exposure. INTEREST RATE RISK MEASUREMENT The income gap analysis measures the sensibility of a bank’s current year net income to changes in interest rates. It requires to determine which assets and liabilities will have their interest rate change as market interest rates change – which assets and liabilities are interest rate sensitive. The focus is 1 year, but it can be moved. In our example, rate-sensitive assets are - those with maturity less than 1 year = $5m - variable-rate mortgages = $10m - short-term commercial loans = $15m - portion (≈ 20%) of fixed-rate mortgages = $2m → banks know that a fraction of mortgages will be paid earlier than expected – prepaid mortgages. RSA = $32m Rate-sensitive liabilities are - money market deposits = $5m - variable-rate and short-term CDs = $25m - Fed funds = $5m - short-term borrowings = $10m - portion (≈ 10%) of checkable deposits = $1.5m → deposits tend to be very stable. However, banks know that a portion of them will be withdrawn - portion (≈ 20%) of savings = $3 RSL = $49.5m If i ↑ by 5 percentage points (say from 5% to 10%) - the asset income increases by 5% x $32m = $1.6m - the liability cost increases by 5% x $49.5m = $2.5m - the total income changes by $1.6 – $2.5 = - $0.9m If RSL > RSA (because liabilities reprice earlier), an increase in i results in a decrease in NIM (net interest margin) and income. GAP = RSA – RSL = $32m – $49.5m = - $17.5m Δ income = GAP x Δi = - $17.5m x 5% = - $0.9m The interest rate gap analysis is essentially a short-term focus on interest-rate risk exposure. It 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. Hence, it is a partial and short-term measure of the overall interest rate risk exposure. 2. Different maturity buckets → the income gap analysis ignores the maturity distribution of assets and liabilities that are not classified as rate-sensitive. A possible solution would be a maturity bucket approach that measures the gap for several maturity subintervals. Since it is supplementary to the income gap analysis, we only consider assets and liabilities that reprice. For instance, in our previous example we could consider i. those assets and liabilities that reprice between 1 and 2 years ii. 20% of fixed-rate mortgages that are expected to be repaid between 1 and 2 years iii. 10% of checkable deposits iv. 20% of savings deposits Example 2 – FNB has more RSL than RSA, 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. On a notional of $1 million, FNB swaps 6% payment for Libor from Friendly Finance Company (term of 10 years). Thus, $1m have been converted from fixed-rate assets to floating rate assets. IRS are very flexible, available over long horizons, usually liquid. However, they are exposed to counterparty risk and the market may freeze in a financial crisis. CREDIT RISK MEASURES AND MANAGEMENT Credit risk is the risk that the borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal; for firms, default may also include debt renegotiations (e.g., a company is a temporary liquidity problem, but it will have the money the following month, so it will ask to postpone the debt). Banks accept the credit risk of loans in return for an interest that covers the cost of funding, the potential losses arising from lending, and a profit margin. Nevertheless, banks must be careful not to impose a too high interest rate that could squeeze the borrower into default. The main elements of credit risk are 1. PROBABILITY OF DEFAULT OF THE BORROWER → probability that the borrower will default on the loan before the loan is entirely repaid. Banks must provide only a target interval within which this probability must fall. To estimate it, the bank can rely on a. credit scores for mortgages and consumer loans. These loans are continuously monitored, and scores may be changed. b. accounting ratios and past relationship for small and medium firms. Indeed, SMes are private, so they are not obliged to make public their financial statements. Banks must come up with their internal rating and put them together in something like cumulative default tables. c. accounting ratios, past relationship, market measures, credit ratings for large firms. Credit agencies track how many and what companies, having a certain rating, default over the years. Then, they can compute the empirical frequency of default for each credit rating and publish them in cumulative default tables. Since these tables have been computed over so many years, it is plausible that they are good predictions of the future. Stage 1 loans are performing. Stage 2 loans are experiencing some problems that however could be fixed. Stage 3 loans will cause losses. 2. EXPOSURE AT DEFAULT → It reflects how much the bank is exposed to losses if the borrower defaults – amount outstanding in case of default. It is usually the face value of the loans plus all unpaid interests. Example – Bank A extended a loan to company B with face value of 100€ with residual time to maturity of one year, that pays an annual interest of 3€. The EAD is equal to 103€. In case of a credit line, the EAD is equal to the maximum amount the borrower can withdraw. Indeed, banks know that, in case of distress, the borrower will withdraw the maximum possible. Banks attach many covenants to credit lines. If they sense that the borrower is in trouble, they can unilaterally decide to lower the maximum amount withdrawable. Example – Bank A extended a revolving credit line of $1,000 to company B. The amount drawn so far is $300. The EAD is equal to $1,000. 3. LOSS GIVEN DEFAULT → amount that an investor loses in case of default of the issuer. It is computed as 𝐿𝐺𝐷 = 𝐸𝐴𝐷 − 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑣𝑎𝑙𝑢𝑒 or, alternatively, 𝐿𝐺𝐷 = 𝐸𝐴𝐷(1 − 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑟𝑎𝑡𝑒). Example – Bank A gives a mortgage to a household of 100,000€. Upon default of the borrower, the bank sells the house and recovers 25,000€ → recovery rate = 25%. Banks must compute both the expected LGD and the actual LGD. Collateral pays a crucial role in determining the recovery rate of bank loans. During the financial crisis, as houses’ price/value dropped, banks’ collateral deteriorated. During the covid-19 pandemic, banks didn’t have to worry because the recovery value of the guaranteed loans was granted by the government. The concepts of adverse selection and moral hazard provide the framework to understand the principles financial managers must follow to reduce or eliminate the asymmetric information problem. Screening can be used to mitigate adverse selection. Banks collect reliable information about potential borrowers to estimate their probability of default. Screening has led some institutions to specialize in certain regions or industries, gaining expertise in evaluating firms or individuals. While specialization is perfect for screening, it is not desirable for the diversification of the loan portfolio. Indeed, some unpredictable external shocks may cause troubles to those banks that are specialized in that sector. Business loans should be diversified by industry (further divided according to how polluting they are) and geographically. CREDIT SCORES IN CONSUMER LOANS Once screening is done, banks come up with credit scores for mortgages and other consumer loans. These loan applications are among the most standard of all credit applications. The decision to approve or disapprove them depends on their credit rating, which should reflect - the applicant’s ability and willingness to make timely interest and principal payments - the value of the borrower’s collateral. The ability to maintain mortgage payments is usually measured by - GDS – gross debt service ratio → it is equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, … / property and all expenses related to it) divided by gross income. An acceptable threshold is generally set around maximum 25-30% - TDS – total debt service ratio → it is equal to the total accommodation expenses plus all other debt service payments divided by gross income. An acceptable threshold is generally set around maximum 35-40%. 𝐺𝐷𝑆 𝑟𝑎𝑡𝑖𝑜 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑚𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑡𝑎𝑥𝑒𝑠 𝑎𝑛𝑛𝑢𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑖𝑛𝑐𝑜𝑚𝑒 = (3500 × 12) + 4500 175000 = 26.57% 𝑇𝐷𝑆 𝑟𝑎𝑡𝑖𝑜 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑎𝑛𝑛𝑢𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑖𝑛𝑐𝑜𝑚𝑒 = (3500 × 12) + 4500 + 950 + 29000 175000 = 43.69% Both GDS and TDS want to estimate the income coverage of potential borrowers. 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 that may affect the applicant’s willingness to make timely payments are - marital status and age - payment history - previous relations with the bank and 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 this score, the loan officer accepts or denies the application. Nowadays, the screening on mortgages is almost automatic. Requests are processed by a softer and then double-checked by a manager. Indeed, finance researchers have introduced a softer to reduce/eliminate discrimination. However, there still are some instances of discrimination, even with AI programs. In some countries, consumers that were denied a loan or credit card because of their credit score are entitled to know it for free (U.S., following the Wall Street Reform bill of 2010). In any case, U.S. residents are entitled a free copy of their annual credit report (basis for computing the credit score). COLLATERAL Perfecting collateral is the process of ensuring that the 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 → banks will force borrowers to pay taxes because, if they become owners if the property, they don’t want to pay those unpaid taxes - verifying that the purchase price is in line with the market value. If the value of collateral deteriorates, in some instances banks can ask for additional collateral. SMALL AND MEDIUM ENTERPRISES BUSINESS LENDING Commercial and 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, while 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. Banks perform on these companies both cash flow analyses, which provide information regarding an applicant’s expected cash receipts and disbursements, and classic financial ratios analyses - liquidity ratios - asset management ratios - debt and solvency ratios - profitability ratios - interest coverage ratios → they reflect whether the company has enough income to pay interest on the loans. This ratio is only calculated for SMes. Additional information collected on management and specific conditions (geographic, sector, …) may also affect the ability to meet the loan obligations. Banks don’t have an absolute policy on which applications to accept. In favorable market conditions, they may be willing to extend credit also to riskier firms. In hard times, their risk tolerance may decrease, and they could decide to stop lending to risky companies. LARGE ENTERPRISES BUSINESS LENDING Lending fees and spread are smaller relative to small and mid-size corporate loans. Nevertheless, 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 companies that participate in public tenders or supply goods and services. Indeed, these companies must be backed by bank guarantees - term loans. at the first sign of trouble. Between 1934 and 1981, fewer than 15 banks each year have failed in the US. Up to the ‘60s, only six countries had deposit insurance. By the 1990s, the number topped 70. This is because during these decades the riskiness of banks increased as they leveraged their balance sheets. EU deposit guarantee schemes have been harmonized since 2014. Prior to that they were heterogeneous across MS. Nowadays, they insure depositors up to €100,000. Even if bank runs have been reduced, deposit insurance schemes did not prevent financial crises. Indeed, they create moral hazard incentives for banks to take on greater risk. - RESTRICTIONS ON ACTIVITIES AND ASSET HOLDINGS The most famous restriction on bank activities was the Glass-Steagall Act. It was passed by the US Congress as part of the Banking Act of 1933. It introduces a clear separation between commercial and insurance banks. The former store deposits and give loans, while the latter help companies place securities. The linkages between banking and insurance activities were believed to have caused the 1929 market crash and the ensuing depression. Indeed, conflicts of interest arose when banks invested in risky securities with their account-holders’ money. Indeed, up to 1933 it was very common for banks to help their customers place bonds and stocks using their depositors, and to persuade clients to make investments that served the bank’s interests but went against the individual’s interest. The Glass-Steagall Act drew a distinct line between the banking industry and the investment industry, forbidding a financial institution to be both a bank and a brokerage. The Glass-Steagall Act was largely repealed in 1999 by the Graham-Leach-Bliley Act (GLBA), allowing commercial banks to engage in investment banking and some securities trading. The only part that survived limits the type of assets banks may hold (for instance, banks may not hold common equity). The Glass-Steagall Act was never reintroduced. A strict distinction between commercial and investment banking like the one regulated in the Glass-Steagall Act was never formally introduced in Europe. Nevertheless, they should be kept distinct (e.g., Chinese walls in banking) and conflicts of interests between different areas should be explicitly addressed. CAPITAL REQUIREMENTS The focus of regulation is currently on strengthening bank capital. Three Basel agreements set minimum capital requirements that banks must meet. Before 1988, capitalization requirements and their enforcement were heterogeneous across countries. Banks were regulated using balance sheet measures like the ratio of capital to assets. This caused bank leverage to increase in the 1980s as they started looking for new sources of income – off-balance sheet derivatives trading. Moreover, the link between capitalization and the risk banks were taking on was not considered. Therefore, a Basel Committee on Bank Supervision was set up. 1. 1988 BASEL AGREEMENT It was designed to address uniquely credit risk. It consisted of three main steps. a. The asset-to-capital ratio must be <20. Assets include both on-balance sheet (securities and loan portfolios) and off-balance sheet (derivatives, letters of credit, and guarantees) items. The latter are direct credit substitutes that materialize in loans whenever the bank must step in. b. Cooke ratio → capital must be at least 8% of the risk-weighted amount of total assets. Indeed, a risk weight is applied to each on-balance sheet asset according to its risk (0% to cash and government bonds; 20% to claims on the OECD banks; 50% to residential mortgages; 100% to corporate loans, bonds, …). For each off-balance sheet item, we first calculate a credit equivalent amount and then apply a risk weight. The risk weighted amount (RWA) consists of i. sum of risk weight times asset amount for on-balance sheet items ii. sum of risk weight times credit equivalent amount for off-balance sheet items. Example – Both bank A and bank B have a risk-weighted amount of total assets of 0% × 100 + 20% × 200 + 50% × 1000 + 100% × 1500 = 2040 Therefore, they have the same capital requirements (even though they are not equally risky). c. Two types of capital. i. Tier 1 capital → it is what we would call common equity. It is the top quality (call) capital. It also comprises non-cumulative perpetual preferred shares. They do not give voting rights but pay an extra dividend in exchange. Holders of these shares can require the payment of dividends if the firm makes profits. At least 50% of capital must be Tier 1. ii. Tier 2 capital → cumulative preferred stock, certain types of 99-year debentures (senior unsecured bonds that are quasi-perpetual), subordinated debt with an original life of more than 5 years. Junior debt (bonds) is considered as quasi- capital. Tier 2 capital has been introduced because, being undercapitalized, banks needed new additional sources of capital to be recognized. 1996 AMENDMENT The amendment to the 1988 Basel Agreement was implemented in 1998. The position of banks in derivatives greatly increased during the ‘90s and many of them faced losses in their trading portfolios. This amendment required banks to measure and hold capital for market risk for all instruments in the trading book, including those off-balance sheet (in addition to the 1988 BIS Accord on credit risk capital). The capital requirement was proportional to the 99% 10-day VaR computed on the trading book. This amendment was enriched by Basel 2.5 in 2011. Before the financial crisis, there weren’t enough charges for credit derivatives. Indeed, since calculations were computed looking at periods of normal market conditions, black swans couldn’t be considered. Basel 2.5 included - a stressed VaR for market risk, calculated over a one-year period of stressed market conditions - extra capital charges for credit derivatives. BASEL II It was implemented in 2007 to address - regulatory arbitrage practices arising from Basel 1988 → even if it was recognized that not all assets are equally risky, there was no distinction according to the riskiness of corporations. Loopholes in regulations were used to make a profit. In our example, bank A took on more risk, while keeping capital charges equal to those of bank B. - excessive bank leverage - lack of homogeneous transparency on banks’ activities → each CB could decide the level of regulation to impose on its national banks and how strictly to monitor them. Basel II is based on three pillars. 1. New minimum capital requirements for credit and operational risk. Risk weights could be based on either external credit ratings (standardized approach) or a bank’s own internal credit rating (IRB approach). Basel two provides both the table of risk weights to be used under the standardized approach and the formula for computing the internal rating. This formula translates PD (probability of default), LGD (loss given default), EAD (exposure at default), and M (effective maturity) into a risk weight. The standardized approach has been criticized because it relies too much on external ratings. The second, even if it would provide a better assessment of credit risk, is costly and mostly used by large banks. 2. More thorough and uniform supervisory discipline → Pillar II. 3. Market discipline – better disclosure → Pillar III. Basel II also recognized credit risk mitigants. They include - collateral - guarantees - netting - use of credit derivatives. Their benefits increase as banks move from the standardized to the IRB approach. In Basel II, there is a capital charge also for operational risk. It can be calculated according to three alternatives - basic indicator → 15% of annual gross income is set aside. This % is quite high - standardized → different % for each business line, which are then aggregated. It is less expensive than the first alternative - advanced measurement approach (AMA) → it requires sophisticated simulations of operational events and potential losses. Only large, sophisticated banks can bear the costs. Pillar II introduced some supervisory review changes. - Similar amount of supervision in different countries. - Local regulators can adjust parameters to suit local conditions. - Stress on the importance of early intervention. Pillar III regarded market discipline. Banks must disclose - what is the scope (for what it is needed) of the Basel framework and how it will be applied → how is the risk exposure mitigated - nature of capital held - regulatory capital requirements for each risk that asks for capital charges - the nature of their risk exposure. This pillar fostered the explosion of bank financial statements. BASEL III Basel III was approved in 2010 in response to the 2007-09 crisis and is still being implemented. It identifies three capital classes - common equity Tier 1 - additional Tier 1 – contingent CoCo (contingent convertible) bonds - Tier 2 – subordinated bonds Capital definitions are tightened, and limits are set for each class. Banks are encouraged to be less dependent on external credit ratings and come up with their own ones. Also, 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 and reduce procyclicality. However, most of these measures are discretionary and are not being enforced. Basel III also introduced - capital to cover counterparty risk. Indeed, during the financial crisis, many losses came from over-the-counter transactions - restrictions on leverage ratio → ratio of Tier 1 capital to total exposure (on- and off-balance, not risk weighted) must be greater than 3% - liquidity coverage ratio designed to make sure that the bank can survive a 30-day period of acute stress (liquidity dry out) - net stable funding ratio → longer term measure designed to ensure that stability of funding sources is consistent with the long-term nature of the assets that must be funded. money is borrowed on behalf and in the name of the target company, increasing its debt and risk. When bonds are used, they will be rated sub-investment grade. When loans are taken, they are considered risky, and the assets of the company being acquired are placed as collateral. It’s the target that will have to pay back the loans and bonds. Typical targets are mature companies that generate strong operating cash flows that can cover the interest payments on the large debt. Leverage (debt to equity ratio) in financing LBOs is intense, typically 90%-10%. LBOs were very popular in the 1980s and were mostly hostile takeovers. Several companies targeted by LBOs went bankrupt due to the excessive leverage. After the financial crisis, the LBOs market froze, but it started to work again during the Covid-19 pandemic. There is mixed evidence on the overall value creation from LBOs and private equity in general. In Scandinavian countries, PEFs are very active in sectors such as healthcare and education. However, these sectors are so crucial to social welfare that it has been argued that they should be kept in other hands rather than PEFs. VENTURE CAPITAL FIRMS VCFs provide funds for start-up companies that have significant long-term growth potential. They are often very engaged with the management of the companies they finance and provide expertise. Indeed, founders could be extremely good in what they have developed, but they could know very little to nothing about how to manage a firm. VCFs are mostly limited partnerships whose sources of capital are wealthy investors, investment banks, pension funds, and corporations. Investors must be willing to wait years before withdrawing money. Examples of venture-backed firms include Apple, Cisco Systems, Starbucks, Tesla, … Start-up companies have too much asymmetric information. They have no history, their business plans are very poor/short, and they cannot provide any collateral. Moreover, managers of start-ups may have objectives that differ significantly from profit maximization. That’s why banks are not willing to lend them money. Venture capitalists can reduce this information problem in several ways - long-term motivation - sitting on the board of directors - disbursing funds in stages as the start-up reaches required results - investing in several firms, diversifying some risk. VCFs are usually clustered in different geographic areas. In the US, they are mostly concentrated in the Silicon Valley. However, this is gradually changing and VCFs are getting more dispersed. The steps of a venture capital deal are 1. fundraising → the venture firm solicits commitments from potential investors 2. investment phase i. seed investing → capital required to start the business ii. early-stage investing → given as the first goals are reached iii. later-stage investing iv. VCFs get equity shares in the company 3. exit usually consists in an IPO. The start-up firm is publicly traded, VC investors sell their shares to equity investors and obtain their profit. If the start-up is not good enough for an IPO, it can be merged or acquired by a bigger firm. FINANCIAL INNOVATION In recent years, the traditional banking business of making loans that are funded by deposits has been in decline. Some of this has been replaced by the shadow banking system, in which bank lending is done via the securities market. The term shadow bank was coined by economist Paul McCulley in 2007. Shadow banks perform activities like commercial banks. They raise (mostly borrow) short-term funds in the money markets and use them to buy assets with longer-term maturities. However, they are not subject to traditional bank/financial regulation. This entails that they can perform both borrowing and lending activities only up to a certain amount. To scale up, fintech companies must either be filed as normal banks, becoming neo-banks, or be incorporated by a bank. Regulators are slow. They realize that something is wrong only when bad things happen. Some sectors of the market stay long in the shadow before regulators intervene. Until shadow banks are regulated, they have no safety nets. They cannot borrow from the central bank in case of emergency and their depositors’ funds are not covered by insurance. Examples of shadow banks include - money market mutual funds → they acquire funds by selling deposit-like shares to individual investors and use the proceeds to purchase short-term money market instruments. They have become popular because, when interest rates were low, they allowed people to invest in instruments that offered higher interest rates. However, as the market exploded, investors got scared and pulled their money out. MMMFs offer very safe, liquid investments. Therefore, some argue that they do not need to be regulated. On the other hand, some people argue that, since they are so prominent, their crash would cause distress in the whole market, and that this is enough to call for regulation - finance companies → they sell commercial paper and issue bonds/stocks to raise funds to lend to consumers and small businesses - entities linked to the securitization process, like a. asset-backed commercial paper conduits → they are legally independent entities that buy the underlying portfolio from banks and perform the securitization. They do so only if they are sure that all tranches will be bought or if they are willing to keep the residual risk. b. structured investment vehicles (SIVs) or special purpose vehicles (SPVs) c. government-sponsored enterprises like Freddie Mac and Fannie Mae. The securitization process Through securitization, financial intermediaries can transfer credit risk (originated from loans, bonds, mortgages) away from their balance sheet, reduce capital requirements in the case of banks (which are proportional to credit risk), and generate liquidity from otherwise illiquid assets through the sale to the SPV and the final investors of the tranches. These tranches can also be bought by other commercial banks that have few to no non-performing loans and are willing to slightly increase their credit risk exposure. Mortgages, homogeneous loans (student loans), and non-performing loans are still securitized. Some banks, like Illimity in Italy, are specialized in risky assets. Financial innovation can be beneficial to customers in terms of - higher yields than the ones offered by traditional banking products - lower fees / transaction costs. It is crucial to be sure not to be undertaking too much risk. Financial innovation can be spurred by - changes in demand conditions from customers - changes in supply conditions 1. Bank credit and debit cards. Many store credit cards existed long before WWII. As technology improved in the late 1960s, transaction costs decreased, and nationwide credit card programs became profitable. The success of credit cards led to the development of debit cards for direct access to checkable funds. 2. Electronic banking → Automated Banking Machines ATMs, internet and telephone technology provide a complete service. Virtual banks now exist where access is only possible via the internet. 3. Electronic payments → the development of computer systems and the internet have made electronic payments of bills a cost-effective method over paper checks or money. The US is still far behind some European countries in the use of this technology. Indeed, the US writes close to 10 billion checks, while in Europe 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 – CBDC. Nevertheless, equipment to accept e-money is not available in all locations. Moreover, customers have concerns about security and privacy. - avoidance of regulation → it may be profitable to offer products that banks are not allowed to because of regulations. INSURANCE COMPANIES AND PENSION FUNDS Insurance companies assume the risk of their clients in return for a fee – insurance premium. Some insurances are compulsory (car insurance), while others are not. Most people purchase insurance because they are risk-averse. This means that they would rather pay a certain equivalent than accept a gamble. If insurance didn’t exist, everyone would have to set aside reserves to face adverse events. Ultimately, these reserves may be inadequate. Although there are many types of insurance and insurance companies, there are 7 basic principles all insurance companies are subject to. 1. There must be a relationship between the insured, who is the party covered by the insurance, and the beneficiary, who is the party that receives the payment if a specified event occurs. The beneficiary must also be someone who would suffer if there was no insurance. 2. The insured must provide full and accurate information about their condition (e.g., preexisting medical conditions, risk exposure, …) to the insurance company. 3. The insured is not to profit because of insurance coverage. Insurance only covers losses. 4. Linked to point 3, if a third party compensates the insured/beneficiary, the insurance company’s obligation is reduced by the amount of the compensation. The company will only have to pay the difference between the value of the loss and the compensation provided by the third party. 5. The insurance company must have many insured so that the risk can be spread out among many different policies. The company collects the premia and uses them to cover losses. 6. The loss must be quantifiable. Insurance contracts cannot be bought if the loss is hypothetical. For instance, 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 in some rare, catastrophic events, precisely because of their rare occurrence. The last two points are of great importance. ASYMMETRIC INFORMATION IN INSURANCE Asymmetric information impacts the industry but is well understood by insurance companies. - Adverse selection raises the issue of which policies an insurance company should accept, as those most prone to suffer losses are precisely those more likely to apply for insurance. In the extreme, insurance companies should turn down anyone who applies for an insurance policy. However, they would thus run out of business. Therefore, they have found reasonable solutions to deal with this problem. For instance, health insurance, which is the branch most exposed to losses 1. requires a physical exam 2. may exclude some preexisting conditions. There is no adverse selection for car insurance since it is compulsory. What may change is the size of the premium. - Moral hazard occurs when the insured fails to take proper precautions to avoid losses or takes on more risk since losses are covered by the insurance policy. The insured must prove they took all the precautions needed to avoid losses (e.g., locking all doors or activating the alarm in case of theft insurance). Insurance companies use deductibles to help control moral b. Overfunded → funds exceed the expected payout. c. Underfunded → funds are not expected to meet the required benefit payouts. - Defined-contribution pension plans → a set amount is invested for retirement, but the benefit payout is uncertain. It will depend on the earnings of the fund. Thus, the burden is shifted on the employee. In any case, they will receive at least a minimum amount – floor. - Public pension plans are set up by government bodies for the public (e.g., social security). - Private pension plans are set up by employers, groups, or individuals. These plans have become increasingly popular given the skepticism concerning the viability of public pension plans. The reliance on public or private pension plans depends on the country. SOCIAL SECURITY PENSION PLANS Social security pension plans are traditionally based on a pay as you go system, where current funding is used (partially) to pay current benefits – workers today pay benefits to retirees. This system is exposed to uncertainty, since the projected number of workers is falling, while that of retirees is increasing, which will cause problems in years to come if not corrected. The sustainability of the social security system is hard to measure. Many factors are hard to predict, such as birth rates and the rate of immigration. Although it may not fail, it is wise for workers to plan other sources for their retirement cash flows. REGULATION OF PENSION PLANS Private pension plans are regulated to avoid underfunding and failing pension plans that leave employees without pension payments. - In the US, all pension plans must follow several standards, like disclosure, guidelines for funding, … After the Enron scandal, a government agency has been introduced to insure pension benefits up to a limit. Moreover, a Pension protection act has strengthened pension funding rules to ensure greater transparency and a stronger system. - In the EU, regulation is state-specific. Each MS can implement different rules. However, in all states, pension plans must comply with homogeneous reporting requirements to increase transparency. CLIMATE CHANGE AND THE INSURANCE INDUSTRY Insurance companies have become increasingly aware of the losses they can incur due to climate change and have indicated it as one of their main challenges for the future. Pulling out would be unfair and would lead to reputational damages. Governments have already stepped in in past cases imposing insurance companies to keep renovating insurance policies against climate change-linked events. THE MUTUAL FUND INDUSTRY Mutual funds pool the resources of many small investors by selling them shares and using the proceeds to buy securities. Mutual funds can help investors develop a diversified portfolio. The first mutual fund like the funds of today (they issue new shares when new money is 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 Act of 1940 reinvigorated the industry by requiring better disclosure of fees and investment policies. MF now play an important investment role in many countries. VEDI GRAFICI LECTURE 20 THE BENEFIT OF MUTUAL FUNDS There are five principal benefits of mutual funds. 1. Liquidity intermediation → investors can get their liquidity back in a very short time and at a very low cost. 2. Denomination (= amount/size of investment) intermediation → investors can participate in equity and debt markets in proportions that they wouldn’t be able to afford otherwise. Without MF, to have access to a well-diversified portfolio, investors would have to buy each security individually, which would require more capital than they possess. 3. Diversification → small investors can have access to assets they would not be able to invest in otherwise. MF allow to reach a great level of diversification, even for small investments. 4. Cost advantages → MF can negotiate and thus reduce transaction costs. Investors can buy the shares of MF that replicate the assets they would like to invest in. 5. Managerial expertise → if someone wants to invest in the stock market, but they know nothing about it, they may prefer to invest in MF, since they are essentially delegating the decision to experts. However, some MF managers want to undergo active investment (investing in a specific security). There is no evidence that active investment (where managers decide on what to invest) can outperform passive investment (the market). MUTUAL FUNDS’ STRUCTURE Investment companies usually offer several different types of mutual funds. Investors can often move investments among these funds without penalty. - Closed-end funds are funded by a fixed number of nonredeemable shares. Investors buying these shares cannot sell them back to the fund to get liquidity, but they must sell them in the OTC market. Thus, the size of the fund cannot grow, and the price of the shares is only determined by supply and demand forces. Closed-end funds are less common and diffused. - Open-end funds can grow over time. The number of shares in these funds increases as investments come in and decreases as money is taken out. Open-end funds are very liquid, as people can buy and redeem shares at any point. The price of the fund is determined by the net asset value. Investors that want to sell will do it at NAV. 𝑁𝐴𝑉 = 𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑀𝐹 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑎𝑛𝑦 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑔 = 𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑢𝑛𝑑′𝑠 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 (GRAFICO A TORTA slide 13) In the US, most MF shares are held by households rather than institutional investors. This is quite recent. CLASSES OF INVESTMENT 1. STOCK FUNDS The main distinction is between capital appreciation funds (growth funds), which are primarily invested in assets that managers think will grant a very significant growth in stock price, and total return funds, which are more heavily shifted towards shares that grant a more stable and large return (shares of value companies). There are other funds that invest in foreign companies (world equity funds) or that invest specifically in value firms, growth firms, a particular industry, and others to appeal to different types of investors. 2. BONDS FUNDS There are three main categories. i. Investment grade funds, which invest in high-quality, low-risk securities. ii. High yield funds, which invest in high-risk securities in search for a higher return. iii. Government bond funds, which invest in government bonds, as well as state and local government bonds (in the US). They are less popular than equity funds, as bonds are perceived as less risky, and it is easier to understand how they work. Therefore, investors feel more confident in directly investing in bonds. 3. HYBRID FUNDS They invest in both stocks and bonds. They are not particularly popular among investors, but they have funds that, especially in volatile times, offer a nice hedging strategy. Indeed, the stock and the bond market perform in the opposite way at the same time. This means that when the stock market is not performing well, the bond market is, and vice versa. Managers on hybrid funds will shift the proportion invested in each market based on how they are performing. 4. MONEY MARKET MUTUAL FUNDS They are open-end funds that invest in money market securities. Investors place here their liquidity buffers for emergencies. Putting these buffers in a bank would give no profit, so they would be better off putting them in a MMMF. Nevertheless, bank deposits are covered by insurance, while MMMF are not. 5. INDEX FUNDS The principle is the same as for ETFs. Both attempt at tracking the performance of an underlying index to ensure diversification. The shares that perform well will balance those that are underperforming. Buying a share of these index funds is like buying a portion of the index. Once the composition of an index is reviewed, also all the funds based on that index are reviewed. There is no action thinking involved. It is a form of passive investment that therefore does not require professional money managers. ETFs (exchange-traded funds) are essentially index funds that are traded in stock exchanges. They are typically more liquid and cheaper (less fees). There are more funds, like those that invest in commodities. Others provide more sustainable sources of investment. All those mentioned above can also be replicated regarding more sustainable investments. FEE STRUCTURE OF MUTUAL FUNDS Mutual funds are quite expensive. The fees attached to them can greatly vary according to the jurisdiction. Given that the fees can be very high, investors are interested in the net profit (fees subtracted). Funds can charge - load fees to be paid upfront for buying the shares - back-end or redemption fees → to be paid when shares are redeemed. They can charge both, only one, or neither. Those that do not charge these fees are referred to as no-load funds. Most funds in the US are now no-load and can be purchased directly by investors without the intermediation of a broker. In Europe, load fees are still relatively popular. Other fees charges include - exchange fees when the investor wants to transfer their investment/money between funds in the same family. The first transfer is usually free - ongoing fees, charged for managing the fund. They are higher for those funds that require a lot of work – active funds. - performance fees are not charged for passive funds where there is no extra performance involved. If managers achieve an extra performance compared to a benchmark, they can charge this fee, which is proportional to the extra performance. However, if the asset manager underperforms the benchmark, investors won’t receive any compensation. All fees must be disclosed. They have decreased in time due to higher competition. Nevertheless, there are still countries in which fees are quite high. In Italy, they are extremely high. REGULATION OF MUTUAL FUNDS