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Chapter 3

Chapter 3. Financial Intermediaries. Deficit Sectors. Financial Intermediaries. $. Surplus Sectors. Claims. $. $. Claims. Claims. Advantages of Financial Intermediaries. Pooling of small savings. Diversification of risks.

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Chapter 3

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  1. Chapter 3 Financial Intermediaries

  2. Deficit Sectors Financial Intermediaries $ Surplus Sectors Claims $ $ Claims Claims

  3. Advantages of Financial Intermediaries • Pooling of small savings. • Diversification of risks. • Economies of scale in monitoring information and evaluating risks. • Lower transactions costs. • Special reasons. • The above are not mutually exclusive.

  4. Primary Market vs. Secondary Market • The primary market for securities involves the initial sale. • The secondary market for securities involves the resale.

  5. Investment Banking • Investment banking is the marketing of securities when they are initially sold. • Some securities are sold to private buyers. Others are sold to the public. The exact difference is a technical legal issue. • Public offerings must be registered with the Securities and Exchange Commission (SEC).

  6. Public Offerings • Investment banking firms sell public offerings. They are essentially marketers of securities and charge a fee for their services. This is often called an underwriting fee. • Syndicates of investment banks are often involved in public offerings. This spreads the resale risk.

  7. Types of Public Offerings • Firm Commitments. The investment banker purchases the security issue outright and bears the resale risk. • Best Efforts. The investment bankers sell whatever they’re able. • Fees for firm commitments are much higher. Most bond issues are sold by firm commitment.

  8. Shelf Registration. • Some securities are sold by shelf registration. This is essentially a pre- registration of a security issue. Anytime during the next two years the securities can be brought to market very rapidly. • Rule 144A. • They do not have to be registered with the SEC and can be resold to other qualified financial institutions.

  9. Secondary Market • Many securities are traded on organized exchanges such as the New York Stock Exchange or NASDAQ. • Most bonds are traded over-the-counter (OTC). The OTC market is a network of dealers located throughout the country. • Some securities are traded over anonymous electronic trading systems.

  10. Security Dealers • Dealers are marketmakers for securities. They maintain an inventory and buy and sell from that inventory. A dealer offers to buy at the bid price and offers to sell at the asked price. • The size of the bid-asked spread depends upon two major factors. Volume of trading. Inherent price risk.

  11. Security Brokers • Brokers are agents who carry out transactions for buyers or sellers. Brokers charge commissions for their services. • There are different types of brokers. • Full-service brokers provided execution and advice and charge the highest fees. • Discount brokers provided execution only.

  12. Mutual Funds • Mutual funds represent a pooling of funds by many investors. • Open-end vs. closed-end funds. • Net Asset Value (NAV) = liquidating value. • For closed end funds, typically Price < NAV.

  13. Advantages of Mutual Funds • Information Economies. • Diversification. • Lower transactions costs.

  14. Mutual Fund Costs Sales Fees Front End Load Rear End Load 12b-1 Fees (Annual)

  15. Mutual Fund Costs Expense ratio includes: Management fee. Administrative fee. Other fees. Additional Costs: Brokerage commissions.

  16. Insurance Companies • Life insurance. • Casualty insurance. • Insurance companies are large investors in fixed income securities. • Adverse selection. • Moral hazard. Coinsurance.

  17. Pension Funds • Defined benefit plans. Dollars paid out usually set by some formula, e.g., Pension = (# Years)(Average) (X%). Pension Benefit Guarantee Corporation. Employer bears the reinvestment risk. • Defined contribution plans. Dollars paid in are specified. Dollars paid out depend upon returns. Employee bears the reinvestment risk.

  18. Pension Funds Cash Flows Horizon Date 0 1 2 Time $ In C C $ Out Reinvestment

  19. Pension Benefit Guaranty Corporation • Insures pensions of private defined benefit plans. • Does not ensure government defined benefit plans. • Collects premiums from covered plans. • Underfunded. • Limited benefits.

  20. Commercial Banks and Thrifts • Heavily regulated. Safety. Widespread effects. Competition. • Regulatory agencies. The Federal Reserve. The FDIC. The comptroller of the currency. State banking authorities. • Charters. Branches. Insurance. Capital. Failure.

  21. Important Regulations • Glass Steagall Act – separated commercial banking from investment banking, dealers, brokers, mutual funds, insurance. • Restrictions lifted beginning in 1980s and repealed in 1999.

  22. Important Regulations • RESTRICTIONS ON BRANCHING • Banks used to be restricted to operating in one state. • Within states, there were three types of branching rules: one office, limited branching, unrestricted branching.

  23. Bank Economies of Scale Cost per Dollar of Assets High Cost   LowCost SmallBank LargeBank Size

  24. Federal Deposit Insurance Corporation • FDIC has the power to close failing banks. • FDIC insurance covers depositors up to $250,000 for any shortfalls.

  25. Bank Balance Sheet

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