Bank Financial Management

(FINS 3630)
Lecture 01
Semester 1, 2017

Chapter 1 & Chapter 7

Why are Financial Institutions Special?
 MD EMDADUL ISLAM (EMDAD)
Email: m.e.islam@unsw.edu.au
Office hours: Friday 11-12 am ( or by
appointment)
UNSW Business School, level 3, East wing, Glass
Room (371)

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 Overview

This lecture explores

why financial intermediaries are different from commercial firms.

how financial intermediaries provide a special set of service to

households and firms.

how this specialness requires a tighter regulation of financial

intermediaries compared to other firms.

And provides an overview of different types of FIs.

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 GFC and Bailouts

http://www.globalissues.org/article/768/global-financial-crisis#Thescaleofthecrisistrillionsintaxpayerbailouts

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 Bailout Programs

United States
Emergency Economic Stabilization Act and Troubled Asset
Relief Program
Big institutions bailed: Bear Stearns (sold to JP Morgan
Chase), Merrill Lynch (sold to Bank of America), Fannie
Mae and Freddie Mac, American International Group,
Washington Mutual (sold to JP Morgan Chase), Citigroup

United Kingdom
2008 United Kingdom bank rescue package
Big institutions bailed: Lloyds and Royal Bank of Scotland

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 Flow of Capitals without FIs
Households might find direct investments in corporate
securities unattractive because of :
Information/Monitoring costs,
Liquidity costs,
Price risk.

As a result
The flow of funds is likely to be low.
Little or no monitoring would occur.
Risk of investments would increase.

Without financial intermediaries:

Excess savings could only be held as cash or invested in corporate
securities.

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 Adverse selection & Moral hazard
Lack of information creates problems in the financial system on two
fronts: before the transaction is entered into and after.
Adverse selection is the problem created by asymmetric
information before the transaction occurs.
Adverse selection in financial markets occurs when the potential
borrowers who are the most likely to produce an undesirable
(adverse) outcomethe bad credit riskare the ones who most
actively seek out a loan and are thus most likely to be selected
Because adverse selection makes it more likely that loans might be
made to bad credit risks, lenders may decide not to make loans
even though there are good credit risk in the marketplace.
One solution to adverse selection is screening. This requires the
lenders to be good at collecting and analysing information.

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 Adverse selection & Moral hazard

Moral hazard is the problem created by asymmetric information after the

transaction occurs.
Moral hazard in financial markets is the risk (hazard) that the borrower
might engage in activities that are undesirable (immoral) from the lenders
point of view, because they make it less likely that the loan will be paid
back
The information problem is that the borrower knows more than the lender
about the way borrowed funds will be used and the effort that will go into
the project
Because debt contracts allow owners to keep all the profits in excess of
the loan payments, they encourage risk taking. Lenders need to find
ways to make sure borrowers dont take too much risk.
The solution is monitoring. Again, the FIs can do this more efficiently
than household savers.

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 Financial Intermediaries Specialness

FI
(Brokers)
Households Corporations

FI
Cash Equity & Debt
(Asset
Transformers)
Deposits/Insurance Cash
Policies/Units of Trusts

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 Financial Intermediaries Functions

Brokerage function
Acting as an agent for investors:
providing information and transaction services
Reduce costs through economies of scale

Asset transformation
Purchase primary securities
(By) selling financial claims (secondary securities) to households
These secondary securities are
Subject to less information asymmetry and monitoring costs
More liquid
Less risky
And thus more marketable

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 Specialness of FIs
General Areas of FI Specialness:
Information services,
Liquidity services,
Price-risk reduction services,
Transaction cost services,
Maturity intermediation services.

Institution-Specific Specialness:
Money supply transmission,
Credit allocation,
Intergenerational transfers,
Payment services,
Denomination intermediation.

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 Information Costs

PrincipalAgent problem
Agency costs: Costs relating to the risk that firm owners and
managers use savers funds in a way that is not in the best
interest of the savers.
Information and monitoring: It is costly for individual savers to
collect information and monitor the managers.

FIs act as delegated monitors by agglomerating funds of

individual households
To avoid free-rider problem: greater incentive for information
collection and monitoring activities due to higher stake.
To reduce costs of information collection and monitoring.
To develop new securities to more effectively monitor
borrowers, for example, shorter-term debt contracts

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 Liquidity and Price Risk
Lots of investments are very illiquid and involve high
price risk, for example, real estates and long-term loans

Financial intermediaries provide secondary claims to

household savers: high liquidity and low price risk, and
invest in these illiquid and risky sectors.

Advantages of FIs in managing liquidity and price risks

Diversification
Development of better risk management techniques
Superior access to market and instruments for hedging such
as loan sales market and securitization.

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 Other Special Services
Reduced Transaction Cost - Economies of scale

Maturity Intermediation - Ability to bear the risk of mismatched maturities

of assets and liabilities.

Credit Allocation (Depository FIs) - Financial intermediaries are the major

source of finance in particular sectors of an economy: residential real estate
(US and UK), farming (Australia) .

Intergenerational Wealth Transfer or Time Intermediation (life insurance,

superannuation and pension funds)

Payment Services - FIs provide efficient payment services to the society.

Denomination Intermediation - Give individuals indirect access to large

denomination markets (Money market managed funds, Debt-equity
managed funds, Unit trusts)

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 Other Special Services
The Transmission of Monetary Policy (Banks):

Financial intermediaries: most widely used medium of exchange in

the economy, such as check, transfer.
Depository institutions are the conduit through which monetary
policy actions impact the rest of the financial sector and the
economy in general.

Money supply in Australia:

M1: currency + bank current deposits by private non-bank sector
M3: currency + all bank deposits by private non-bank sector
Broad money: M3 + net borrowing of Non-bank FIs from private sector

Intermediaries liabilities play significant role in the transmission of

monetary policy.
https://en.wikipedia.org/wiki/Money_supply

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 Downside of Delegated Investment

Intermediary services are not costless.

Agency issues of FIs?

Risk management in FIs?

Monitoring FIs?

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 Depository Institutions
There are many different types of FIs, each plays one or more
functions we just discussed.
Depository institutions (DIs) are FIs that accept deposits from
individuals and institutions and make loans. They make up the
largest group of FIs by size of balance sheet.
In the U.S., these institutions include commercial banks, savings
institutions, credit unions.
In Australia, these institutions are called Authorized Depository
Institutions (ADIs), including banks, building societies, credit unions.
DIs provide important payment services to the economy.
Because the liabilities of DIs are a significant component of the money
supply that impacts the rate of inflation, DIs play a key role in the
transmission of monetary policy from the central bank to the rest of
the economy.

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 Finance Companies, Mutual Funds
Finance Companies:
raise funds by selling commercial paper (a short-term debt
instrument) and by issuing stocks and bonds.
lend these funds to consumers, who make purchase of home
appliances or automobiles and to small businesses.
Some finance companies are organized by a parent corporation to help
sell its product.
Mutual funds:
acquire funds by selling shares to many individuals and use the
proceeds to purchase diversified portfolios of stocks and bonds.
allow shareholders to pool their resources so that they can take
advantage of lower transaction costs when buying large blocks of
stocks or bonds.
In addition, mutual funds allow shareholders to hold more diversified
portfolios than they otherwise would

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 Security Firms and Investment Banks
Security firms and investment banks primarily help net suppliers of
funds transfer funds to net users of funds at a low cost and with a
maximum degree of efficiency.

Unlike other types of FIs, securities firms and investment banks do not
transform the securities issued by the net users of funds into claims
that may be more attractive to the net suppliers of funds. Rather, they
serve as brokers intermediating between fund suppliers and users

Investment banking involves the raising of debt and equity securities

for corporations or governments. This include the origination,
underwriting, and placement of securities in money and capital
markets for corporate or government issuers.

Security services involve assistance in the trading of securities in the

secondary markets (brokerage services and/or market making).

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 Specialness and Regulation
FIs receive special regulatory attention.
Reasons:
Negative externalities of FI failure: costly to households
and firms using financial services
Special services provided by FIs
Institution-specific functions such as money supply
transmission (banks), credit allocation (thrifts, farm banks),
payment services (banks, thrifts), etc.

Regulation attempts to decrease these risks.

Protect ultimate sources and users of savings
Primary role - Ensure soundness of the overall system

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 Australian Regulation System
Traditional industry-based regulation
Separate regulators for individual industry sectors banking,
insurance and security firms
It is rooted in the separation of operation for commercial banks,
insurance firms and securities firms, starting from Glass-Steagall
Act in the U.S. after the great depression in late 1920s and early
1930s, which became a common practice for most countries.

Australias current financial regulatory framework has its

origin in the late 1990s Financial System Enquiry (Wallis
Committee)
Switch from industry-based regulation to function-based
regulation
Recommending the introduction of three regulatory agencies,
each in charge of specific functional responsibilities

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Australian Regulation System (Cont.)

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 Australian Regulation System (Cont.)
Why the reform is necessary?
The trend of cross-industry operation of big financial firms (most
famous case: Citi Group) and the final repeal of Glass-Steagall Act in
the U.S. in 1999
http://www.citigroup.com/citi/about/citi_at_a_glance.html
As such, the distinction between the activities of different types of
financial institutions (for example, commercial banks versus security
firms) is becoming more and more vague.
The industry-based regulation does not fit with cross-industry
operation: overlap in regulation and grey areas.

Official regulatory framework after adopting the recommendation of

Wallis Committee
APRA (Australian Prudential Regulation Authority): Responsible for the
prudential regulation and supervision of the financial services industry
ASIC (Australian Securities and Investments Commission): Responsible for
market integrity and consumer protection across the financial system
RBA (Reserve Bank of Australia): Responsible for the development and
implementation of monetary policy and for overall financial system stability

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APRA (Australian Prudential Regulation Authority):

an integrated prudential regulator responsible for deposit

taking institutions (banks, building societies and credit
unions) as well as friendly societies, life and general
insurance and superannuation
APRA is charged with developing prudential policies that
balance financial safety and efficiency, competition,
contestability and competitive neutrality.

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ASIC (Australian Securities and Investments Commission):
administers and enforces a range of legislative provisions
relating to financial markets, financial sector intermediaries
and financial products, including investments, insurance,
superannuation and deposit taking activities (but not lending)
In addition, ASIC:
develops policy and guidance about the laws that it
administers
licenses and monitors compliance by participants in the
financial system and
provides comprehensive and accurate information on
companies and corporate activity.

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 RBA (Reserve Bank of Australia):
has responsibility for monetary policy and for overall financial
system stability.
The RBA has no obligation to protect the interests of bank
depositors or other creditors of banks rather, its task is to deal
with threats to financial stability that have the potential to spill
over to economic activity and consumer and investor
confidence.
In the event of such threats, the RBA retains its discretionary
role of lender of last resort (LOLR) for emergency liquidity
support.
The RBA, under the auspices of its Payments System Board,
also has a mandate to promote safety, competition and
efficiency in the Australian payments system, and has the
backing of strong regulatory powers.

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 Major Types of Regulation

Safety and soundness regulation

Consumer protection regulation

Investor protection regulation

Monetary policy regulation

Credit allocation regulation

Entry and chartering regulation

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 Safety and Soundness Regulation
To ensure the soundness and safety of FI and to maintain the credibility of
FI
Regulators
Australia: Australian Prudential Regulation Authority (APRA)
U.S.: the Federal Deposit Insurance Corporation (FDIC), the Federal
Reserve Board (FED), The Office of the Comptroller of the Currency
(OCC), the state regulatory agency for state-chartered banks.

First layer of protection risk reduction

Encouragement for intermediaries to diversify assets,
Disclosure of large credit exposures.
Second layer of protection minimum capital requirements
Third layer of protection:
Safety valve by central banks open market operations to provide
exchange settlement fund
Deposit insurance.
Fourth layer of protection - Monitoring and surveillance.
On-site examination and off-site supervision

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 Deposit Insurance Scheme in Australia (For your interests only, not
examinable)
The treasury department implemented a temporary deposit insurance
scheme in Oct 2008. The insurance is provided for free for the amount of
or below $1 million per customer per institution, and is provided with
charge for the amount in excess of $1 million.

Since March 31 2010, the insurance for the large deposits above $1 million
has been terminated,

Major revision in 2012

The main feature of the revised arrangements for The Financial Claims
Scheme (FCS) is the reduction in the level of the cap from $1 million to
$250 000 per person per ADI from 1 February 2012.
For detailed discussion:
http://www.rba.gov.au/publications/bulletin/2011/dec/pdf/bu-1211-5.pdf

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 Consumer and Investor Protection Regulation
Consumer protection
To ensure equal and fair access to financial services
Regulators
Australia: Australian Securities and Investments Commission
(ASIC)
U.S.: various agencies, for example, Federal Financial Institutions
Examination Council (FFIEC) for fair lending practices, which is a
federal supervisory body comprising of the members of FED, FDIC
and OCC).
Investor protection
Protections against abuses such as insider trading, lack of disclosure,
malfeasance, breach of fiduciary responsibility
Regulators
Australia: ASIC
U.S.: various agencies, for example, Securities and Exchange
Commission (SEC) for securities markets

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 Monetary Policy Regulation
Regulatory bodies: central banks, FED in the U.S. or RBA in
Australia

Central banks directly controls outside money

Bulk of money supply is inside money (deposits)

Regulators commonly impose a minimum level of cash reserves

to be held against deposits.
Cash reserves add to intermediaries net regulatory burden.
No explicit liquidity requirement in Australia, but FIs liquidity
management policy needs to be approved by APRA.

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 Credit Allocation Regulation
Supports lending to socially important sectors.

Price and Quantity restriction:

Example of asset restrictions:
Qualified thrift lender test (QTL) in the US: set minimum amount of
loans made to residential mortgages to qualify as Thrift.
65% of their assets in residential mortgage related assets
Example of interest rate restriction:
Usury laws in many US states: set maximum rates charged to
residential mortgage loans.

No such restrictions in force in Australia.

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 Entry Regulation
Regulations define scope of permitted activities under a given
charter: charter value of a firm

Increasing or decreasing entry barriers affect profitability of

existing competitors.
High direct and indirect entry costs result in larger profits for existing
companies.

Examples of entry regulation

Separation of commercial banking, investment banking and insurance:
GlassSteagall Act (U.S., 1933)
The repeal of the separation: GrammLeachBliley Act (U.S., 1999)

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 Future of Regulation
Implications of GFC: more regulations or more efficient
regulation?

Regulation overhaul in the U.S.

Dodd-Frank Bill
What is in the bill?
(http://www.wsj.com/articles/SB10001424052748703615104575328430427126018)

The major provisions

Expanded and centralized powers for Federal agencies
More restrictions and disclosures about risk taking activities by
big financial institutions (Volcker Rule)
Enhanced protection of Investors and Consumers

The economics of regulation

Every regulation is costly - net regulatory burden.
The difference between the private costs of regulations
and the private benefits for the producers of financial
services.

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 The Changing Dynamics of Specialness
Potential secular trend away from intermediation by
investing directly in primary securities.
Changed borrower preferences in terms of risk and return.
Decline in the relative costs of direct securities investment.
Growing sophistication of investors.
Falling costs of information acquisition and transaction.

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 Trends in the United States
Decline in share of depository institutions and insurance
companies
Increases in investment companies
MMMFs and Mutual funds
Give savers cheaper access to the direct securities markets
May be attributable to net regulatory burden imposed on
depository FIs
Financial Services Modernization Act
Repealed the 1933 Glass-Steagall Act
Emergence of Financial services holding companies

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 Shadow Banking system
Financial Stability Board (FSB) defines
Shadow banking as credit intermediation involving entities
and activities outside the regular banking system.

Have facilitated the change from Originate and Hold

model of commercial banking to Originate and Distribute
banking model

Shadow banking includes

Structured Investment Vehicles (SIV), Special Purpose Vehicles
(SPV), Asset Backed Commercial Paper (ABCP) conduits, Money
Market Mutual Funds ( MMMFs), Credit Hedge Funds among
others

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 The Changing Banking Environment:
A Global View

Traditional Banking
Banks as Delegated Monitors

Disintermediation
Securitization
Traditional SPV-based (special purpose vehicle)
SIV-based (special investment vehicle)
Syndication
Back to the Future
What happens when the delegated monitor delegates?
Failure to conserve the firms reputational capital

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Shadow banking in Australia

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