EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 1: Introduction; What do banks do?

2. Why take this module? • Compulsory for Financial Economics degree courses • Careers: banking, business • Further study in financial economics • Reading the FT • Understanding the financial crisis of 2007-09

3. Why are financial markets important? • For individuals • Savers, borrowers • For companies • SMEs, corporations • Role in the wider economy • Finance is an input into every sector • Finance and macroeconomics • Recessions linked to financial crises typically experience slow recoveries – as now…

4. Aims of this module • Provide building blocks for understanding the financial system • what are bonds, equities, options, swaps, repos, etc.? • how are they traded? • Cast light on financial crises, especially 2007-09 • what happened? • why did it all go so wrong? • how can we prevent it from happening again? • Economics curriculum debate • Institute for New Economic Thinking (INET)

5. Module organisation • Lectures • Spring term: Tues 11am-1pm, LTB2 (weeks 16-25) • Summer term: Thurs 1-3pm, LTB8 (week 30 only: 24 April) • Classes • Spring term: weeks 18-25 (i.e. start w/c Mon 27 January) • Summer term: week 31 only (i.e. Mon 28 April – Fri 2 May) • 4 groups • CLAa01: Mondays 11-12, 3.108 (with GTA) • CLAa02: Fridays 11-12, 3.108 (with GTA) • CLAa03: Fridays 11-12, 5A.303 (with me) • CLAa04: Tuesdays 10-11, 3.108 (with GTA) • GTA: Daniel Gonzalez Olivares (dgonza…)

6. Assessment • Term paper, submission date: 12 noon, Friday 2nd May • Summer exam: 2 hours; answer any 2 questions from 5; questions largely essay-based • The aggregate module mark is the larger of: 50% coursework mark + 50% final examination mark or 100% final examination mark

7. Books • Textbooks: • Glen Arnold, Modern Financial Markets and Institutions, Pearson Education, 2012 • Marc Levinson, Guide to Financial Markets, 5th edition, The Economist, 2010 • Further reading: • Alan S. Blinder, Andrew W. Lo and Robert M. Solow, Rethinking the Financial Crisis, Russell Sage Foundation Publications, 2012 • Many recent articles • Good reads: • Alan S. Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead, Penguin, 2013 • Gary B. Gorton, Misunderstanding Financial Crises: Why We Don't See Them Coming, Oxford University Press, 2012

8. Useful websites • Newspapers/news websites: • Financial Times, The Economist, Reuters • Central banks and regulators: • Bank of England – http://www.bankofengland.co.uk • Financial Conduct Authority – http://www.fca.org.uk/ • European Central Bank – http://www.ecb.europa.eu • US Federal Reserve – http://www.federalreserve.gov/ • Bank for International Settlements – http://www.bis.org/ • Industry associations: • British Bankers’ Association – http://www.bba.org.uk/ • American Bankers’ Association – http://www.aba.com

9. DO FOR SUCCESS • Attend lectures • Take notes • Ask questions • Review lecture presentations • Do the readings • Attend classes • Do problem sets before class and review answers • Take part in class discussions • You need be confident to write detailed short essays • Do the term paper (insurance policy) • REVISE

10. Overview of module • What do banks do? • Financial intermediation, bank runs & bank regulation • Money markets • Bond markets • Securitisation; credit rating • Equity (stock) markets • Derivatives I: futures and options • Derivatives II: credit derivatives • Financial regulation after the crisis • Opportunity to present (optional): • 5-10 minute presentation on a paper of your choice

11. WHAT DO BANKS DO? • As an introduction, the rest of this lecture describes the main activities undertaken by banks • It distinguishes between retail and investment banking • Identifies the three core functions of a retail bank • Describes the range of activities undertaken by investment banks • Briefly defines what is meant by the “shadow banking system”

12. LEARNING OUTCOMES At the end of this topic the student should understand: • Types of banking • Retail, corporate, commercial, investment, universal • Core elements of banking • Deposit taking, lending, payments • Lending • Types of loans made by banks • Factors that bankers consider when granting loans • Range of services offered by banks • E.g. cash management, insurance, stock broking, providing guarantees, help with overseas trade • Wide variety of activities undertaken by investment banks

13. WHAT IS BANKING? • Retail banking: three core functions • Taking in deposits • Making loans • Providing a payments mechanism (money transmission) • Customers • Households • Small & medium sized firms (SMEs) • Corporate banking • Additional services used by large firms, e.g. cash management, overseas trade, foreign exchange risk management • Investment banking • Financial services, e.g. advice; share & bond issuance; IPOs; M&A • Market activities, e.g. trading bonds, shares & derivatives; brokerage; market making; asset management

14. Exhibit 2.1 An overview of the different aspects of banking

15. Exhibit 2.1 An overview of the different aspects of banking (cont.)

16. CORE BANKING • Money deposited (or lent to the bank via the issue of a financial market security) • Classified as liabilities • Current account / cheque (check) account / sight account • Time or savings deposit accounts Table 2.1 The typical liabilities of banks – a rough breakdown

17. Lending • Techniques to screen and monitor borrowers to reduce risk • Diversify across a range of borrowers • Bank’s assets • Loansto individuals and corporations typically account for 50%–70% of a commercial bank’s assets • 10%–35% might be lent out to other banks and institutions in the financial markets on a short-term basis (inter-bank lending) • Some (usually <20%) is likely to be invested in long-term investments, e.g. government bonds, company preference shares • 1%-10% may be in the form of buildings, equipment, software or other assets such as gold • Liquid reserves (<1%): cash holdings, use to meet unexpected outflows

18. Household lending • Consumer loans (personal loans) • Unsecured • Up to £25,000 if not secured by collateral • Usually repayable within five years • Interest rate is usually fixed at a constant percentage of the outstanding amount throughout the period • Secured • Loans secured on property: may be seized if borrower fails to pay • Repaid over 20–25 years • Carry a lower rate of interest • Banks also lend via credit cards

19. Lending to businesses • Banks make it attractive for companies to borrow • Administrative and legal costs are low • Speed • Flexibility • Availability to small firms. • Arrangement fee • Interest rate may be either fixed or floating (variable) • Linked to bank base rate or LIBOR (London Inter-Bank Offered Rate) • Premium to base rate, e.g. 1 per cent (100 basis points, bps)

20. Lending by financial institutions Exhibit 2.3 Lending by financial institutions (mostly banks) in selected European countries to businesses and to households – amounts outstanding 2010 (household lending is further broken down to consumer credit and house mortgages) (€ billion). Source: European Central Bank

21. Overdraft • An arrangement to take more money out of a bank account than it contains • For a few months or a year • Interest is charged on the excess drawings • Advantages • Flexibility • Cheapness (relative) • Drawback • Bank has the right to withdraw the facility at short notice

22. Term loans • A business loan with a maturity of more than one year and a specified schedule of principal and interest payments • May or may not be secured with collateral • Not repayable at the demand of the bank at short notice • Bank can be flexible with regard to the conditions • Payment schedules • Grace period or repayment holiday, e.g. pay interest only in first 3 years • ‘Balloon’ payment structure: payments are end-weighted • ‘Bullet’ repayment: all capital and interest paid at end • Self-amortising term loans: pay off some of principal each year • Mortgage-style repayment schedule: constant monthly payment • Instalment arrangement: funds are advanced in stages • E.g. as collateralised asset is being built

23. Examples of loan repayments Exhibit 2.4 Simple examples of loan repayment arrangements

24. Security for banks on business lending • Asymmetric information • One party in the negotiation is ignorant of, or cannot observe, some of the information which is essential to the contracting and decision-making process • What can the bank do? • Assess borrower’s competence and honesty • Evaluate the proposed project • Why the funds are needed • Detailed cash forecasts covering the period of the loan • Relationship vs. transactional banking • Long-term relationship: regular information flows, lower monitoring costs • Transactional banking: borrower shops around for services

25. Collateral • Assets which may be seized if the borrower fails to repay as promised (default) • A means of recovering part or all of the bank’s investment • May include stocks (inventories) of unsold goods, debtors, equipment, land, buildings and marketable investments such as shares • Fixed-charge collateral • Lender may seize the specific asset used to back the loan • Floating charge • Right to seize assets ‘floats’ over general assets of the firm • On liquidation, proceeds from selling assets go first to secured loan holders, including floating-charge • Seniority of debt

26. Loan covenants • Restrictions on what the firm’s managers may do until debt is fully repaid, e.g.: • Limits on further debt issuance • Especially senior (higher ranking) debt • Dividend level • Prevents excessive withdrawal of shareholder funds • Limits on the disposal of assets • Retention of e.g. property and land • Financial ratios • Interest cover: ratio of annual profit to annual interest charge • Working capital ratio; debt to net assets ratio • If breached, bank has right to terminate lending

27. Other security measures • Guarantees from third parties • E.g. parent company • Personal guarantees by company directors • Also demonstrates own commitment to the project • Creditworthiness • Knowledge of character and talents of borrower • Credit ratings agencies • The amount that the borrower is prepared to put into the project or activity, relative to that asked from the bank

28. Payment mechanisms • Cash dispensing: retail branches, ATMs • Cheque (check) • Paper, now declining in popularity • Giro • Instruction to bank to pay e.g. electricity bill • Standing orders and direct debits • SO: fixed amount on fixed date • DD: payee may vary amount and date of payment (e.g. variable electricity bill) • Plastic cards • Debit cards • Credit cards • Store cards • Telephone banking (incl. mobiles in LDCs); Internet banking

29. Clearing systems • A system for transferring the money from one bank account to another, e.g. at another bank • Clearing banks • Usually large banks with extensive retail operations (branches) • Smaller banks make an arrangement with a clearing bank • UK Payments Council overseas various payment services • Cheque and Credit Clearing Company (CCCL): cheque clearing • BACS Ltd (Bankers’ Automated Clearing Services): clears electronic payment for e.g. DD, SO, salaries • CHAPS (Clearing House Automated Payment System): same day electronic transfers • SWIFT: international electronic payment system • EU: TARGET2 for cross-border transfers within the EU • USA: CHIPS and Fedwire are electronic systems for high-value payments

30. CORPORATE BANKING • Uncommitted facility • Bank is not obliged to provide funds • Facility can be cancelled and so the borrower may have to repay at short notice • Overdraft: e.g. 6-month arrangement, which may be renewed (rolled over or revolved) but this is not guaranteed • Uncommitted line of credit: alternative to an overdraft • Borrower may request up to a maximum amount, for a short period (e.g. 1 or 6 months) • Bank is not committed: must use ‘best efforts’ to provide funds • Interest rate: a number of basis points over (say) 1-month LIBOR • Banker’s acceptance • Document states bank will pay fixed sum of money on a future date; this may be sold to an investor for a (discounted) price to raise funds prior to that date

31. Committed facilities • Lender enters into an obligation to provide funds upon request by the borrower • Provided agreed conditions and covenants in the loan agreement are met • Borrower pays a commitment fee on undrawn portion • E.g. a term loan • Revolving credit (revolving credit facility, RCF) • Allows the borrower to both draw down the loan in tranches and to reborrow sums repaid within the term of the facility so long as the committed total limit is not breached • One and five years • Usually unsecured lending • Payments based only on the amount they’ve actually used or withdrawn, plus interest • Front-end or facility fees are paid for setting it up • Commitment feesare paid on undrawn amount

32. Project finance • Company provides equity capital for a separate legal entity (‘special purpose vehicle’, SPV) • Formed to build and operate a project, e.g. oil pipeline • Project must be identifiable and separable from rest of co.’s activities • Project finance • Bank loans or bond issues direct to the separate entity • Returns are tied to the cash flows of the particular project rather than secured against the parent firm’s assets • Recourse finance: lenders have recourse to parent company if insufficient cash flows • Features • Complexity: high transaction and legal costs • Transfers risk, but greater risk for lenders: higher interest rates • Off-balance-sheet financing: debt not recorded in parent co.’s balance sheet

33. Other corporate banking activities • Cash management • Manage large daily flows of cash; earn interest; accessibility • Guarantees • Guarantee a transaction by a third party, e.g. importer’s payment for goods supplied • Overseas trade • Letter of credit: bank is obliged to pay exporter for shipped goods • Forfaiting: bank supplies cash to exporter in return for right to claim payments for goods shipped to an importer • Risk management • Foreign exchange: mitigate risk from exchange rate movements • Interest risk management • Usually involve derivatives

34. Other commercial banking services • Stockbroking • Buying and selling of shares and bonds by individuals • Asset management • Banks establish mutual funds, unit trusts or investment trusts • Gives investors access to diversified portfolios • Custody and safety deposits • Safekeeping of certificates of ownership (shares, bonds) • May also assist with administration e.g. of income & tax • Insurance and pensions • E.g. life insurance offered alongside mortgages; pension savings • Foreign exchange: currency exchange and travellers cheques • Asset-based lending: e.g. car leases, hire purchase

35. INVESTMENT BANKING • Separation of commercial banks and investment banks (‘utility’ and ‘casino’ banking) • US: Glass-Steagall Act 1933, repealed 1999 • UK: Report of the Independent Commission on Banking 2011 (‘Vickers report’) recommended ‘ring-fencing’ of retail banking from wholesale and investment banking • Investment banking under Glass-Steagall • Not allowed to take deposits • Activities: issuance of securities, underwriting, securities dealing • Commercial banking under Glass-Steagall • Allowed to take deposits and make loans • Restrictions on activities: no underwriting or trading of securities

36. Raising finance • Advise and assist corporate clients and governments on alternative ways of raising finance • Underwrite new security issues • Guarantee to buy any not purchased by investors • ‘Primary’ market issuance of shares and bonds • Share issuance • Initial public offerings (IPOs): issue shares on stock market for the first time • Seasoned equity offerings (SEOs): follow-on share offerings • Bonds • Longer term: bond issuance • Shorter term: commercial paper and medium-term notes

37. M&A; corporate restructuring • Mergers & acquisitions • Advice on takeover regulation and tactics • Financing for deals • For pure advice, fees for smaller company deals are around 3–4% of total sale value; for larger deals (billions) around 0.125–0.5% • Corporate restructuring • Divestiture: selling off a subsidiary • Balance sheet restructuring: writing down debt, debt-equity swaps • Valuations for acquisitions • Strategic review: possible sale of company • Long term relationships with clients

38. Other activities • Risk management • Manage company’s exposure to changes in interest rates, exchange rates, commodity prices • Investment of temporary cash surpluses • Syndicated loans • Investment bank arranges deal and may also take part as a lender • Privatisation • Selling off state-owned assets, e.g. Royal Mail (October 2013) • Public-private partnerships (PPPs): contract with private firm to build and operate e.g. a school, hospital, prison • Selling shares in state-owned (rescued) banks: Lloyds, RBS

39. Market activities • Investment banks are also active in secondary market trading • Broker • Buy / sell financial instruments in the market on behalf of clients • Earn commissions • Market maker • Market makers (dealers) in a quote-driven system • Quote ‘buy’ and ‘sell’ prices for the same security • Small bid-offer spread between the two prices gives a return to the bank • Proprietary trading (‘prop trading’) • Bank takes positions in securities, using its own money, to make a profit for itself

40. Areas of market activity • Fixed income, currencies and commodities trading (FICC) • Fixed income: interest-rate securities e.g. corporate bonds, sovereign (government) bonds • Equities • Shares and equity-linked securities, e.g. futures in shares or market indices, equity options, warrants, preference shares • Derivatives • Create (originate) new derivatives, market them to clients • Assist firms in hedging, e.g. price of aviation fuel for an airline • Securitisation: re-bundling of debt e.g. house mortgages • Originate (sell) 1000 mortgages • Create a special purpose vehicle (SPV) with rights to the mortgage interest payments • SPV issues bonds to other investors, paying interest on these bonds from the mortgage payments

41. Other market activities • Asset management • Manage assets of pension funds, charities, companies • Manage collective investment vehicles: unit trusts, investment trusts, OEICs • Investment research and advice • Analysts examine data on quoted companies • Make recommendations on their shares, bonds & other securities • Wealth management and private banking • Banking services and financial advice to high-net-worth individuals (>$1m in investable funds) • Brokerage for hedge funds • Private equity (venture capital) investment • Finance for new, growing companies not (yet) publicly quoted

42. SHADOW BANKING SYSTEM • Ben Bernanke (US Federal Reserve Chairman) defines ‘shadow banking’ as: • A diverse set of institutions and markets that, collectively, carry out traditional banking functions • But do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions • Examples include • Securitisation vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies. (Ben Bernanke, Some Reflections on the Crisis and the Policy Response, 2012) • Played an important role in the financial crisis of 2007-09