Financial Institutions

1. Financial Institutions Globex at Peking University

2. GDP of “domestic” economy is highlighted in green… GDP = Consumption + Gross Investment + Government Spending + (Exports – Imports) GDI = Private Consumption + Investment + Government Spending + (Net Exports) GNI = Consumption + Gross Capital Formation + Government Spending + (Net Exports)

3. Savings and investment are equal for the whole economy GDP = Consumption + Gross Investment + Government Spending + (Exports – Imports) GDP = Consumption + Gross Investment + 0 + 0 GDP = “Spend” + ”Save” + 0 + 0 • S = I for the whole economy, but not individual firms or people. • High savings economies (e.g., J & C) are high investing economies, which grows the GDP. • What is “saved” by one person is then borrowed or “invested” by another. • Financial institutions convert savings to investments.

4. In an economy, savings = investment, and financial institutions mediate savers and investors Savers Investors (borrowers; they take loans) FAMILIES FAMILIES FINANCIAL INSTITUTIONS AND CAPITAL MARKETS BUSINESSES BUSINESSES (including SOEs) OTHER ORGS OTHER ORGS (including infrastructure) • Financial Institutions & Capital Markets • pay interest to savers, so savers earn interest, e.g. 2% • charge interest to borrowers (investors), so investors pay interest on their loans, e.g., 5% • make profit on difference between interest rates, E.g., 5% - 2% = 3%

5. Financial institutions bring together savings (savers) and investment (borrowers of loans) • The following terms are used somewhat interchangeably: • Financial sector • Financial system • Financial institutions • Financial markets* • Capital markets* • *these 2 terms often refer to stocks/bonds/commodity exchanges • The financial system is important because: • The financial system in each country greatly influences that economy; also money flow is the “blood” of the economy • Financial institutions have global clients, so they connect different national economies by being the conduit for money flows • Financial sector leaders often become business & government leaders • 4) Young professionals should know how to access financial markets in order to make investments and grow their business

6. Financial institutions bring together savings (savers) and investment (borrowers) • What are financial institutions? • Financial Markets (also called Capital Markets), savers directly supply money to investors. 2 most important… • Bond market • Stock market • Financial Intermediaries, stand between savers and investors, 2 most important… • Banks • Mutual funds • Key discussion: Do our financial institutions allow money to flow to “good” investments? That is, are they making wise loans? Will borrowers use loans effectively to increase the productivity of their assets? Or will they use money inefficiently or even wastefully? If wasted, then the borrower can not repay its loan, and the saver loses her savings (or “her investment.”)

7. 1. Financial markets: savers directly supply money to borrowers • Bond market: • Large corporations and governments sell (“issue”) bonds w/ periodic interest payments and promise to repay the principal. • X buys a bond from Y, so X essentially loans money to Y. • Ys issue bonds to “raise money”; that is, bonds help Ys to “borrow” money. • Issuing bonds is called “debt financing” because Y is getting “financing” (that is, getting money, getting loans) by being in “debt” to the purchasers of their bonds.

8. 1. Financial markets: savers directly supply money to borrowers • Stock market: Stocks represent ownership in a company, and they entitle the owner of stock to a claim on the company’s profits. If a company sells 1m shares of stock, then each share is 1/1,000,000 ownership of the company. • Companies sell their stock to raise money (capital) in order to invest in, that is, try to grow, their business. • Selling stock is called “equity financing” because a company is getting financing (getting money) by giving equity (that is, ownership) to the purchasers of their stock. • Buyers of stock can later sell the stock (hopefully at higher price), but there is no guarantee that the stock price will go up. So unlike buying a bond, there’s no guarantee of pay back. • If you buy a company’s stock, then you have invested in the co., and you hope to get a positive return on your investment. You convert your savings into an investment in this co.

9. Financial institutions bring together savings (savers) and investment (borrowers) • What are financial institutions? • Financial markets, savers directly supply money to investors, • the 2 most important are… • Bond market • Stock market • Financial intermediaries, stand between savers and investors, • the 2 most important… • Banks • Mutual funds

10. 2. Financial intermediaries: stand between savers and borrowers • Banks: Unlike large corporations or governments, small businesses & individuals don’t sell bonds/stocks to raise money. Thus, they often go to a bank for a loan when they need to borrow money. Banks mediate money from savers (depositors) to borrows (people who take loans.) • Mutual Funds:A mutual fund is an institution where an individual can invest her savings (say, $10,000), and the mutual fund invests her money (in a “portfolio” of...) stocks and/or bonds. The saver then owns their $10,000 portfolio, which may go up (or down) in value. • Buying stocks in individual companies is risky because a stock’s value depends on the company’s business. Thus, savers prefer to diversify their risk by investing in a portfolio (or basket) of companies (often by placing their saving with a mutual fund) • In developed financial systems, mutual funds enable even those with small savings to put their savings in the stock & bond markets (via mutual funds)

11. We’ve looked at these four major types of financial institutions, but now let’s look at others… • What are financial institutions? • Financial markets, savers directly supply money to investors, 2 most important… • Bond market • Stock market • Financial intermediaries, stand between savers and investors, 2 most important… • Banks • Mutual funds

12. Financial institutions bring together savers and investors Savers (People & Businesses) Borrowers (Investors: People & Businesses) • Private Markets • Commercial Banks (P, $P, B) • Angel Investors ($P) • Venture Capital (e.g., Kleiner Perkins) • Private Equity (e.g., Blackstone) • Hedge Funds (e.g., Bridgewater) • Funds (various) • (Gov-Business Loans) • (Gov Grants) VC = invest in smaller companies in ~$50mm range, minority stake, co may seek funding from “friends and family” first PE = invest in larger companies, take a majority position P = People $P = Wealthy people B = Businesses

13. Financial institutions bring together savers and investors • Big Asset Managers (BAM) • Mutual Funds (e.g., Vanguard, Fidelity) • Institutional Investors (big pension funds, teachers’ retirement funds, etc.) • Large Hedge Funds • Public Markets • Exchanges: stocks, bonds, commodities (e.g., HKSE) • Issued by government & large corps (banks do due diligence, underwrite, issue, and conduct sales & trading) • Liquid and sell-able • Regulated, public disclosures required, large banks conduct “due diligence” Savers (People & Businesses) Borrowers (Investors: People & Businesses) • Private Markets • Commercial Banks (P, $P, B) • Angel Investors ($P) • Venture Capital (BAM, $P…e.g., Kleiner Perkins) • Private Equity (BAM, $P….e.g., Blackstone) • Hedge Funds ($P…e.g., Bridgewater) • Funds (various) • (Gov-Business Loans) • (Gov Grants) VC = invest in smaller companies in ~$50mm range, minority stake, co may seek funding from “friends and family” first PE = invest in larger companies, take a majority position P = People $P = Wealthy people B = Businesses

14. China’s financial institutions

15. China’s financial institutions have a few unique or less-developed characteristics • Chinese banks are mostly state-owned, dominated by Big Four. They: • ICBC, China Agricultural Bank, China Construction Bank, and Bank of China • Loan to SOEs and for infrastructure; currently (too?) many bad loans • Give few loans to individuals and smaller/medium sized private businesses • Provide low interest to savers • Financial liberalization has allowed other deposit-taking institutions including other publicly traded commercial banks, city and rural commercial banks, rural and urban cooperatives and foreign banks incorporated in China • By 2015, 2,500+ banks (~1,600 relatively small, rural credit cooperatives) • ~50% of savings in banks; due to fewer other financial options, too much savings are invested in housing, stock, and off-shore • China’s has fewer private markets, such as mutual funds, private equity, venture capital, hedge funds, etc., though these are increasing

16. Key developments in China’s banking sector

17. China’s financial institutions have a few unique or less-developed characteristics • Chinese banks dominated by Big Four. • China’s has fewer private markets though these are developing (e.g., <5% of China’s household savings are in mutual funds) • Owing to #1 and #2, “shadow banking” is prevalent, which is essentially unregulated, less regulated or informal financial organizations & transactions, e.g., • Online lending, P-to-P financing, crowd funding, etc (13th FYP somewhat strengthened regulations on these financing channels) • “Wealth management” vehicles • Off-the-books loans organized by banks (maybe between 2 companies) • Financial orgs established to connect savers-with-investors (LGFV) • Person A loans to person B (or person A loans to 50 people or businesses!)…generally, this personal lending was very helpful as China’s reformed and lacked well-developed capital markets

18. Examples of shadow/private banking options as a % of GDP • Other shadow banking sectors: • credit guarantors (who also lend) • venture capital • private equity • hedge funds • peer-to-peer lenders • rotating savings/lending clubs

19. China’s financial institutions have a few unique or less-developed characteristics • Formal “financial inclusion” has greatly expanded • A diverse range of providers, products, and policy approaches ^ financial inclusion: • reforms of rural credit cooperatives (RCCs) • policy banks • agent banking models* • fintech (“digital finance,” “Internet finance,” and “fintech” are used interchangeably) • A robust financial system: • reduces information asymmetries between lenders and borrowers • enables the safe & efficient transfer of money among individuals, firms, and government. • Consumers have high demand for new products and services, often digital • China’s rate of account ownership is similar to G-20 countries • China’s “Plan for Advancing the Development of Financial Inclusion” (2016–2020): • an ambitious agenda with emphasis on financial inclusion for micro and small enterprises (MSEs), rural residents, low-income urban groups, the poor, the disabled, and the elderly * Agent model is when, for example, small convenience stores, post offices, large retailers, or other outlets serve as third-party “agents” for more traditional financial service providers, using point-of-sale (POS) terminals or mobile devices. In most cases, personal digital devices cannot fully replace in-person interactions with financial service providers, in particular for first time consumers who must provide identification or documentation.

20. Continued: China’s financial institutions have a few unique or less-developed characteristics • China’s financial sector has been largely closed to foreign investment, though this is slowly changing • For example, new mutual fund industry reforms are opening the industry to foreign investment and ownership

21. Continued: China’s financial institutions have a few unique or less-developed characteristics • China’s public markets are dominated by SOEs and trading is limited • China controls international capital flows in/out of China • China’s exchange policy is controversial to it’s trading partners

22. #6: China’s public markets (that is, stock exchanges) are dominated by SOEs and trading is limited • Three main stock exchanges: SH, SZ, and HK. Some considerations: • Most Chinese companies listed on these exchanges are state-invested • Chinese exchanges do have “listing requirements,” e.g., report timely financial statements, audits, requirements for size, etc. • However, the rules (accounting, etc….as well as practices) for publicly listed Chinese companies are different from those in developed economies • “Insider trading” is too common and not totally dis-allowed • SH and SZ listed companies typically have: • A-shares – quoted/traded in RMB and available to mainland Chinese and only “qualified” foreign investors • B-shares – quoted/traded in US$and generally open to foreign investment • H-shares: H-shares quoted/traded in HK dollars by anyone; these are shares of mainland companies listed on HKSE

23. The growth of the bond market (on China’s stock exchanges)

24. #7: China controls/limits capital flows in and out of China; will Shanghai FTZ have increased RMB “convertibility”? • “Currency convertibility” is the ease with which a country's currency can be converted into another currency • “Full capital account convertibility” allows local currency to be exchanged for foreign currency without any restriction on the amount • Similarly, RMB “convertibility” on the “capital account” means the ability to convert RMB into foreign currency freely andat the going exchange rate. This is generally called “capital asset liberation” (CAC) • A nation’s “capital account” includes: portfolio and other investments, FDI, and changes in foreign exchange reserves • “Convertibility” is important for international trade and finance. When a currency is not convertible, it poses a risk and barrier to trade with foreigners because foreigners do not want to forever keep RMB; they want to be able to convert RMB to their home currency. That is, foreigners want to be able to convert any revenues or profits earned in China. They want to convert to their own currency and bring it home

25. #7 cont... Recall, macro-economic fundamentals Focus: structure, performance and output (GDP) of a whole economy • Primary Indicators: • GDP = the output (or “income”) of the whole economy • Inflation: Price Indices (consumer and producer) = price of a basket of goods • (Un)Employment rate • Trade Balance = exports – imports (surplus or deficit) • Balance of (Intern.) Payments (BOP) = (foreign $ in) – (domestic $ out) • = Current Acct + Capital Acct Main Levers: 1) fiscal policy & 2) monetary policy Goals: Influence interest rates and money supply in order to stabilize business cycles and affect employment and inflation…to foster the GDP

26. #7: China controls/limits capital flows in and out of China; cross borders flows still small • What are the benefits of more cross-border capital flows? • Increase efficiency of investments; that is, investments are not “stuck” in China • Prevent over investment in particular assets, due to lack of other options • Accelerate reform of financial sector(more international competition & exposure) • Make visible the cross-border flows which are currently hidden in trade and FDI accounts; visibility would give policy makers a complete picture Controls on large-scale, short-term “portfolio” flows will remain in place (don’t allow a repeat of Asia in 1997!) See chart: Relative to China’s capital markets, cross-border investment allowed is very small at ~ RMB 2t/69t

27. #7: China controls/limits capital flows in and out; the new limited cross border flows allow “qualified” foreign investors • China has been gradually relaxing regulations on foreign investment in China’s capital markets for investment, competition, integration, etc. • This also boosts demand for the RMB by global investors and promotes the RMB as an international reserve currency • 2017 focused on opening the stock and bond markets to foreign investors, mainly “institutional investors,” especially long-term investors such as pension funds (but not to individual “jump-in-jump-out” investors) • The goal of RMB convertibility is to attract foreign investors into China’s financial markets. However, with convertibility, China also has concerns about too many RMB flowing out overseas • China has taken measures to curb capital (RMB) flight, including increasing scrutiny of Chinese firms' overseas investments and Chinese people’s purchases of foreign currency

28. #8: China’s RMB exchange rate policy is controversial to its trading partners; China’s uses a “managed float” • Developed economies(with so-called free markets) prefer floating exchange rates. • The exchange rate is the “price” of a currency, e.g., RMB1 “costs” US$0.12 • With a floating exchange rate, the price of a currency fluctuates with supply and demand on the global market • ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ • Less developed economieshave used “fixed” exchange rates • They fix the price of their currency (their exchange rate) to another currency, perhaps the US$, or perhaps to a “basket” of other currencies • China’s RMB was fixed to the US$ from 19994 to ~2004 at US$1 = RMB8.28 • Now the RMB has a “managed float” against a basket of currencies, which is believed to be dominated by US$, but the make-up of the basket is confidential

29. #8: China’s RMB exchange rate policy is controversial; is the RMB still undervalued to maintain China’s exports? • RMB likely undervalued in the past, but current analysis is unclear • China maintained an undervaluation by buying US$ and selling RMB (…so the market has more supply of RMB, so therefore the price of RMB is lower.) This leads China to hold a high a level of US$ in reserves. If China decided to sell off its US$ reserves, then the value (exchange rate) of the US$ would fall, owing to a flood (over supply) of US$ on the market. This is a slight risk for the US • An undervalued RMB keeps exports inexpensive for foreign buyers • Recall example: a factory in China sells shoes for RMB100/pair. • If the exchange rate is US$1=10RMB, then the shoes coat US$10. • If the exchange rate is US$1=5RMB, then the shoes cost US$20. • So, Americans will buy more shoes made in China if the RMB has a lower exchange rate to the US$

30. #8: China’s RMB to $US From 2003-2019

31. Financial Institutions Globex at Peking University

32. Slide not used….The 2008 Financial Crisis (the “sub-prime mortgage” crisis) • What happened? Bad mortgages (low interest, little down payment, unqualified buyers, unclear/inaccurate documentation, “adjustable mortgage rates”); mortgages sold from bank to bank; mortgages “rolled up” into securities called CDOs which ultimately were not valuable because they were based on bad debt. • Results: • Banks failed: Major banks like Lehman, Merrill, Fanny Mae and Freddie Mac, Bear Stearns, AIG; 450-500 banks failed from 2008-2012 • Optional: see this short explanation on AIG and its role its role in the 2008 crisis and bailout; recall AIG provided insurance on mortgage backed securities…http://www.investopedia.com/articles/economics/09/american-investment-group-aig-bailout.asp • Individuals lost savings, homes, retirement funds • Few to no bankers penalized • Actions: • 1. The US gov “bailed out” banks with $700 billion thru TARP (reduced later to $475b.) The treasury purchased “distressed assets” (mortgage-backed securities) and essentially infused cash to banks. • 2. Dodd Frank Act of 2010 for WS reform aimed to promote financial system stability, accountability and transparency by… • Creating a number of new agencies (merging and closing others) to streamline the regulatory process and increase oversight of institutions with systemic risks • Amending the Federal Reserve Act • Creating new rules on executive compensation and corporate governance • Eliminating certain loopholes that led to the 2008 crisis • Thereby ending "too big to fail” and taxpayer bailouts and protecting consumers from abusive financial services practices

33. What is the financial sector or “Wall Street”? Essentially large banks and other financial institutions • Trends in finance in terms of sought-after jobs: • Investment banking (then and now!) • Venture capital (hot in the late 1990s tech boom, still key…) • Private equity (post 2000, after the tech bust) • Hedge funds (since ~2005, as income inequality increases and top $P ^^) • What is “investment banking”? 2 sides: • Corporate finance: investment banking (e.g., M&A, capital raising) • Capital markets: research; sales and trading