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MSc in Finance 2017-18

Banking and Financial Institutions


Laszlo Haas
LECTURE 1
INTRODUCTION TO
FINANCIAL INTERMEDIATION

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Syllabus

1. Introduction to financial markets and institutions

2. Issues in bank management

3. Central banking and bank regulation

4. Pension funds, insurance companies and investment funds

5. The Global Financial Crisis

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Recommended reading

There is no required textbook for the course

Main recommended text


• Mishkin and Eakins, 2015, Financial Markets and Institutions, 8th
ed., Pearson

Other recommended texts


• Casu, Girardone and Molyneux, 2015, Introduction to Banking,
2nd ed., Pearson
• Simpson, 2014, Financial Markets, Banking, and Monetary Policy,
Wiley

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Grading and assessment

The assessment for the course has three components

• exam (40%)
– one-hour, short multiple choice or open-ended questions
– to be held in class on November 18, 2017

• group presentation (40%)


– group presentation on banks
– to be held in class on December 10, 2017

• class participation and problem solving (20%)

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This lecture

1. Introduction to financial markets and institutions


1.1 Financial markets
1.2 Financial intermediaries
1.3 Financial regulation
1.4 Shadow banking and fintech disruption

2. Issues in bank management

3. Central banking and bank regulation

4. Pension funds and insurance companies

5. Investment funds

6. The Global Financial Crisis


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1. Financial markets and institutions

Financial markets and institutions are critical for the economy


• they allow flow of funds from investors to borrowers
• they perform the asset pricing function

A. Direct finance: financial markets


• borrowers raise funds directly from investors
• by selling securities representing claims on future income/assets

B. Indirect finance: financial intermediaries


• borrowers raise funds from investors via financial intermediaries

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1. Financial markets and institutions

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Source: Mishkin Eakins 2015
1. Financial markets and institutions

Source: Mishkin Eakins 2015


Reading: 160101 KPMG - The rise of non bank credit: evolution or revolution
Grant Thornton - Capital for commerce, non-bank lending 2014
8 Casu et al. – Comparative banking markets 2006
1.1 Financial markets – classification

Financial markets are markets used to raise financing


1. Money markets – short-term financing (<1 year)
2. Capital markets – longer-term financing
• Debt markets
– medium (1-10 years) or long-term (>10 years)
• Equity markets
– pay dividends, in theory forever
– represents an ownership claim in the firm

Other markets typically included in financial markets


3. Derivatives markets
4. Foreign exchange markets
5.
9 Commodity markets
1.1 Financial markets – classification

Financial markets can be classified further into


1. Primary markets
• new security issues sold to initial buyers
• typically involves investment bank that underwrites the offering
2. Secondary markets
• secondary trading of securities already issued
• trading may be
– at an organized exchange (e.g. NYSE Euronext)
– over-the-counter (OTC) where dealers at different locations
• involves both brokers and dealers
– brokers fill customer orders
– dealers are counterparties in the actual transaction
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1.1 Financial markets – classification

Financial markets have been on a trend of internationalization


• International bond market
– foreign bonds – issued outside borrower’s home country
– Eurobonds – “offshore” bonds issued in a currency outside
that currency’s home market
• Eurocurrency market
– foreign currency deposited outside of its home country
– Eurodollars are USD deposited outside the US
• World equity markets
– foreign IPOs in London, New York and Hong Kong
– depositary receipts (ADR, GDR) to get around listing problems
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1.1 Financial markets – classification

Local v Eurobond markets


Government Corporate, financial Corporate, non-financial
Onshore Offshore Onshore Offshore Onshore Offshore
US 12,551 12 10,381 5,395 3,245 1,960
Japan 12,967 3 1,236 366 936 48
France 1,800 65 1,290 1,583 294 449
Germany 1,813 313 447 2,345 388 127
UK 1,433 128 293 2,658 20 316
Italy 2,012 246 744 1,005 359 97
China 1,478 8 1,127 107 628 17
Spain 691 184 757 1,630 24 23
Netherlands 412 33 477 1,313 114 96
Canada 1,063 124 274 395 171 180
Australia 383 13 586 562 43 38
Brazil 847 52 511 122 10 35
Korea 487 7 237 110 399 47
12 Source: Bank for International Settlements
1.1 Financial markets – investment banks

Investment banks perform a variety of functions in financial markets


• underwriting
– including equities, bonds, syndicated loans
• dealmaking
– including in mergers and acquisitions, sales, spin-offs etc
• ancillary services
– sales and trading, including stocks, derivatives, fixed income,
currencies, commodities
– market making i.e. facilitating trading by holding securities in
inventory and quoting bid and ask prices
– securities research, often with buy or sell recommendations
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1.1 Financial markets – investment banks

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Source: http://markets.ft.com/investmentBanking/tablesAndTrends.asp
A. Underwriting

Investment bank sells and markets the security offering


• advice
─ what type of security to issue, when, how many, at what price
• filing documents
─ prepare prospectus, register with market regulator
─ arrange exchange listing (typically for equities)
─ acquire a credit rating, hire a bond counsel, etc
• selling the offering
– firm commitment: buys entire offering at a predetermined price
and then resells in the market (bought deal)
– best efforts: make full-fledged attempt but does not take
responsibility for unsold inventory (e.g. high-risk securities)
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– private placement: sale to a small, select group of investors
A. Underwriting

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Source: Mishkin Eakins 2015
B. Dealmaking

Mergers and acquisitions


• buy-side (buyer) or sell-side (target/seller)
• help in all areas including
– finding counterparty, tender
– valuation
– deal specifics
– financing
– due diligence
– legal issues

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B. Dealmaking

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Source: http://markets.ft.com/investmentBanking/tablesAndTrends.asp
1.1 Financial markets – brokers and dealers

Securities brokers e.g. Scottrade, Charles Schwab, Fidelity


• brokerage services: intermediary to buy or sell a security
– market order: buy or sell at current price
– limit order: most you will pay (buy), least you will accept (sell)
– short sales
• other services
– financial consulting
– insuring client’s operations
– margin credit for purchasing equity with borrowed funds
– others driven by demand (e.g. ML cash management account)
Securities dealers e.g. BAML, Barclays, Citi, Morgan Stanley
• sell to end users, hedge their risk through interdealer market
• market making: holding inventory, quoting bid and ask prices
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1.2 Financial intermediaries

Financial intermediaries (FI) are “middleman” institutions that


allocate funds from investors to borrowers indirectly
• obtain funds from investors
• makes loans/investments with borrower-spenders

The relative importance of FIs v financial markets varies by country


• Anglo-American financial systems more market-oriented
• Continental European and other systems more bank-oriented

FIs are needed due to


A. transactions costs
B. risk sharing
C. asymmetric information
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A. Transaction costs

Financial intermediaries reduce transaction costs of fund allocation


• they develop expertise and economies of scale
• they provide customers with
– liquidity services: bank deposits are liquid assets that earn
interest but can be converted into good and services anytime
– diversification services: FIs buy a range of assets, pool them,
and sell rights to the diversified pool

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B. Risk sharing

Financial intermediaries act as a systemic “risk buffer” by allowing


investors to limit their risk exposure

• asset transformation
– create and sell assets with lesser risk to investors
– buy assets with greater risk from borrowers

• risks that FIs accept include


– maturity risk (take short-term deposits, give long-term loans)
– credit risk
– currency risk
– liquidity risk
– macroeconomic risk
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C. Asymmetric information

A key impediment to fund allocation is asymmetric information


• before transaction: adverse selection (lemons) problem
– if investor cannot distinguish good and bad borrowers, she
only pays an average of good and bad values
• good securities undervalued so won’t be issued
• bad securities overvalued so too many issued
• after transaction: moral hazard
– borrower has an incentive to pursue private interests, including
if it harms its outside investors
– agency theory analyzes how moral hazard affects borrower
and investor behavior

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C. Asymmetric information

FIs have a cost advantage in producing information and monitoring


contracts over atomistic investors that invest directly
• cost reduced by expertise and economies of scale and scope
• banks especially important when weak disclosure, investor rights
– Anglo-American market-oriented systems: strong disclosure
and investor rights allow investors to “cut out” the middleman
– bank-oriented systems elsewhere: weaker disclosure and
investor rights deter investors from investing directly

Reading: Douglas - Financial intermediation and delegated monitoring REF 1984


Bhattacharya and Thakor - Contemporary banking theory JFI 1993

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1.2 Financial intermediaries

Type of intermediary Sources of funds Uses of funds $bn


Depository institutions
Commercial banks Deposits Business and consumer 11,343
loans, mortgages, bonds
Savings and loan associations, Deposits Mortgages 918
mutual savings banks
Credit unions Deposits Consumer loans 905
Contractual savings institutions
Life insurance companies Premiums Corporate bonds, mortgages 5,999
Non-life insurance companies Premiums Treasuries, muni bonds, 1,443
corporate bonds and stocks
Pension funds, government Employer/employee Corporate bonds and stocks 9,631
retirement funds contributions
Investment intermediaries
Finance companies Commercial paper, Consumer and business 1,533
stocks, bonds loans
Mutual funds Stocks Stocks, bonds 9,284
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Money market mutual funds Stocks Money market instruments 2,650
1.2 Financial intermediaries – classification

Depository institutions accept deposits and make loans

• Commercial banks – most important FIs with diversified portfolios


– funds primarily from savings and time deposits
– make commercial, consumer and mortgage loans

• Savings & loan associations (S&L), mutual savings banks (MSB),


credit unions (CU)
– funds primarily from savings and time deposits
– make mortgage and consumer loans, but commercial loans
becoming more prevalent
– MSBs, CUs issue deposits as shares and owned by their
depositors, with CUs belonging to a particular group e.g. a
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company’s workers
1.2 Financial intermediaries – classification

Contractual savings institutions (CSI) get funds on a contractual


basis and have fairly predictable future payout requirements
• Life insurance companies
– funds from policy premiums
– invest in less liquid corporate securities and mortgages, since
benefit payouts are predicted quite well by actuarial analysis
• Non-life insurance companies (fire and casualty)
– funds from policy premiums
– invest in liquid government and corporate securities, since loss
events are harder to predict
• Pension and government retirement funds
– funds from employee and employer payroll contributions
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– invest in corporate securities
1.2 Financial intermediaries – classification

Investment intermediaries

• Finance companies
– funds from commercial paper (short-term debt), bonds, stocks
– make consumer loans for durable goods, small business loans
• Mutual funds
– funds from selling shares to individual investors (often held in
retirement accounts)
– invest in large, diversified portfolios of financial securities
• Money market mutual funds
– funds from checkable deposit-like shares to individual investors
– invest in liquid and safe short-term money market instruments
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1.3 Financial regulation

Financial regulation aims to maintain integrity of the financial system


• subject participants to requirements, restrictions and guidelines
• handled by government or non-government organizations
• affects the very structure of financial markets and intermediaries
• objectives include
– market confidence
– financial stability
– consumer protection
– reduction of financial crime

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1.3 Financial regulation

1. Financial market regulation


• Securities and Exchange Commission (SEC)
• objective: to ensure information is available to investors
– asymmetric information subjects investors to
adverse selection and moral hazard problems
– hinders markets, can keep investors away altogether
• two main types of regulation
A. Information disclosure
• publicly traded securities must be registered upfront
• market participants must disclose information about
financial position and performance
B. Insider trading
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• to prevent expropriation of outside investors
1.3 Financial regulation

2. Regulation of financial intermediaries


• objectives
– to ensure intermediaries are in sound financial position
– banks further regulated to implement monetary policy

• five main types of regulation


A. Entry requirements
B. Restrictions on assets and activities
C. Financial reporting and disclosure
D. Corporate governance
E. Deposit insurance
other regulation may include restrictions on credit rating,
31 competition, interest rates on deposits
1.3 Financial regulation

A. Entry requirements
• must hold government license
• granted only with strong credentials and large initial funds

B. Restrictions on assets and activities


• bank reserve and capital adequacy requirements
– reserve: % of deposits in vault cash + funds held with FED
– capital adequacy: % of assets as capital
• on certain activities and affiliations
– e.g. separation of commercial banking v investment banking
by Glass-Steagall Act 1933, repealed 1999

Reading: 151015 NYT - What is Glass-Steagall


32 160201 MB - Glass-Steagall revisited
160829 AB - Real reasons to bring back Glass-Steagall
1.3 Financial regulation

C. Financial reporting and disclosure


• intermediaries must make certain information public
• bookkeeping must follow certain strict principles
• books are subject to periodic supervisory inspection

D. Corporate governance
• requirements on corporate form and location
– e.g. banks must be incorporated in local jurisdiction
• requirements on organizational structure
– must have certain offices and officers
– officers may need to be approved persons
• constitution or articles of association that is approved, or
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contains or does not contain particular clauses
1.3 Financial regulation

E. Deposit insurance
• depositors insured for loss if intermediary fails
• Federal Deposit Insurance Corporation (FDIC) insures deposits
of up $250k at a commercial bank or mutual savings bank
• National Credit Union Share Insurance Fund (NCUSIF)

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1.3 Financial regulation – U.S.

Regulatory agency Subject Nature


Securities and Exchange Organized exchanges Disclosure, insider trading
Commission (SEC) and financial markets
Federal Reserve System All depository Capital and reserve requirements,
institutions examine members' books
Office of the Comptroller Federally chartered Charter, examine books,
of the Currency depository institutions restrict assets
National Credit Union Federally chartered Charter, examine books
Administration (NCUA) credit unions restrict assets
State banking and State-chartered Charter, examine books
insurance commissions depository institutions restrict assets, restrict branching
Federal Deposit Insurance Depository institutions Insure, examine books
Corporation (FDIC) ex. credit unions restrict assets
Commodities Futures Futures market Trading procedures
Trading
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Commission (CFTC) exchanges
1.3 Financial regulation – Europe

European System of Financial Supervision (ESFS)

European Supervisory Authorities (ESA, microprudential)


European Banking Authority (EBA) London
European Securities and Markets Authority (ESMA) Paris
European Insurance and Occupational Pensions Authority (EIOPA) Frankfurt

European Systemic Risk Board (ESRB, macroprudential)


European Central Bank (ECB) Frankfurt
European Commission (EC) Brussels
National central banks and supervisory authorities

Reading: ECB - Report on financial structures 2015


36 https://en.wikipedia.org/wiki/List_of_financial_regulatory_authorities_by_country
1.4 Shadow banking and fintech disruption

Financial intermediation fast changing due to rapid growth of


market-based financing and rise of shadow banks
• perform maturity/credit/liquidity transformation without central
bank regulation or public sector credit guarantees
• shadow banks include
– finance companies
– asset-backed commercial paper (ABCP) conduits
– structured investment vehicles (SIVs)
– credit hedge funds
– money market mutual funds
– securities lenders
– limited-purpose finance companies (LPFCs)
– government-sponsored enterprises (GSEs)
37 Reading: 160816 BFT - What is shadow banking
FRBNY - Shadow banking 2010
1.4 Shadow banking and fintech disruption

Fintech startups also put financial intermediaries under pressure


• established financial services firms invest heavily in technology
– customers want real-time, mobile, consumer-friendly services
– to attract customers, cut costs and increase profits

• but, fintech startups are disrupting the incumbent system


– free of legacy technology systems and regulation, creating
consumer-friendly products more efficiently
– capitalizing on incumbents’ slowness, low digital awareness
and other weaknesses, high transaction costs, market gaps
Reading: 160101 CFED - Shifting ground - the changing landscape in financial markets and technology
160801 AB - Robo revolution - banks coopting roboadviser solution
Capgemini - World Retail Banking Report 2016
Citi - Digital disruption, banking tipping point 2016
38 McKinsey - Cutting through the fintech noise 2016
McKinsey - Fight for the customer, banking review 2015
1.4 Shadow banking and fintech disruption

Investment in private fintech startups is growing exponentially

• Citi 2016: investment from $1.8bn in 2010 to $19bn in 2015


– 73% in personal/SME finance, a profit center in global banking
– focus on lending, payments, savings and insurance
Savings/ Capital
Payments Lending Insurance Total
Investment markets
Personal/SME 26 10 47 0 10 92
Corporate 3 0 4
IB/Markets 4 4
Total 29 10 47 5 10 100

• McKinsey 2015: by 2025 fintech will threaten


– 10-40% of retail banking revenues
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– 20-40% of retail banking profits
Fintech in Hungary

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Source: FintechGroup, http://fintechzone.hu/magyar-fintech-showcase-75