Financial Institutions Assignment #5 Outline
Financial Institutions Hubbard Chapter 12
Assignment #5 • Homework due next Monday (11/23): 1. [Type and include citation] Find an article (WSJ, FT, Economist,…) on one of these topics, and (i) summarize the issue and (ii) comment on what a good public policy changes are warranted: – Pension funds finance/regulation/reform – Current proposals w.r.t. regulation of investment banking or related institutions
2. Problems 16, 18, and 22 in Chapter 12.
Outline 1.
Why do we need financial institutions? – – – –
2.
Risk-sharing liquidity information Matching borrowers and savers
Different institutions for different problems: – – –
Securities market institutions Investment institutions Contractual savings institutions • • •
– –
3.
Property/casualty insurers Life insurers Pension funds
Depository institutions Government financial institutions
Overlap, regulation, deregulation… “reregulation”? ☺
1
Table 12.1 Financial Intermediaries in the United States*
Securities Market Institutions • Investment banks, brokers and dealers, and the exchanges themselves. • These are not intermediaries (mostly) • Functions: F ti – Matching borrowers and savers. – Risk-sharing – Mitigating Information problems – Liquidity provision
Primary markets: Investment banks • Assist companies in initial issue of securities (“primary markets”) • Underwriting: put reputation (and capital) at risk in effort to get a high price for the securities • Other services: advice and active participation in M&A…investment banks are basically extremely versatile dealmakers.
2
Secondary markets: Brokers, dealers, and exchanges • Brokers match buyers and sellers of securities in secondary markets • Dealers buy and sell securities. (Similar function to brokerage brokerage, perhaps more risk risk.)) • Exchanges provide centralized auction markets, clearing services, standardization. • Over-the-counter (OTC) markets allow some standardization, and take advantage of technology.
Investment institutions • Mutual funds: sell shares in a portfolio of financial assets (almost any kind) to – Reduce transactions costs while providing diversification – Reduce information costs – Money market mutual funds (and other “checkable” funds also provide liquidity and “asset transformation”.
• Finance companies provide loans to lower quality firms and households; usually specialize. (e.g., GMAC)
Insurance Companies • Insurance companies write contracts to protect risk of loss from particular events. • “Law of large numbers” enables insurance p to p predict loss for large g g groups. p companies • Insurance companies face problems of adverse selection and moral hazard.
3
Business practices of Insurance companies • Hazards: adverse selection and moral hazard • Strategies: – Risk-pooling Ri k li and d screening. i – Risk-based premiums – Deductibles, coinsurance, restrictive covenants, etc.
Life Insurers v. Property-Casualty Insurers • Life insurers offer various options, but mostly operate a very predictable business – Risk is mostly idiosyncratic
• Property-casualty Property casualty insurers: – Auto, home, fire, earthquake, flood, etc. – Aggregate risk may be important (e.g., 9/11, Katrina… future issues: terrorism? global warming?)
4
Pension Funds • Pension funds invest to provide for retirement benefits. • Defined contribution plans (fully funded, by definition)) • Defined benefit plans – May be fully funded or under-funded. – ERISA (1974) created PBGC to monitor and insure defined benefit funds.
Depository Institutions • All accept (checking or saving) deposits (zero maturity debt) • Commercial banks accept deposits and make loans • Savings institutions (savings and loans, mutual savings banks) accept deposits and make mortgage loans • Credit Unions (and other types of mutuals) return all profits to depositors.
5
Government Financial Institutions • Federal credit agencies make loans in the interest of public policy. – Federal government provides loans to support farmers, would-be homeowners, students, exporters etc. exporters, etc
• U.S. government also guarantees loans made by private financial institutions. – “Tenfold increase in loan guarantees in the past two decades”!?! – Can you say: “Moral hazard”? “Systemic risk”?
Financial Institutions: Blurring the Lines • Glass-Steagall Act of 1933 (and others) imposed barriers that restricted competition and scope among financial institutions. – Separated investment banks from deposit deposit-taking taking banks – Created SEC
• The Gramm-Leach-Bliley Act of 1999 removed many barriers – Led to consolidation, blurring of function of individual companies
6
Assignment #5 • Homework due next Monday (11/23): 1. [Type and include citation] Find an article (WSJ, FT, Economist,…) on one of these topics, and (i) summarize the issue and (ii) comment on what a good public policy changes are warranted: – Pension funds finance/regulation/reform – Current proposals w.r.t. regulation of investment banking or related institutions
2. Problems 16, 18, and 22 in Chapter 12.
Outline 1.
Why do we need financial institutions? – – – –
2.
Risk-sharing liquidity information Matching borrowers and savers
Different institutions for different problems: – – –
Securities market institutions Investment institutions Contractual savings institutions • • •
– –
3.
Property/casualty insurers Life insurers Pension funds
Depository institutions Government financial institutions
Overlap, regulation, deregulation… “reregulation”? ☺
1
Table 12.1 Financial Intermediaries in the United States*
Securities Market Institutions • Investment banks, brokers and dealers, and the exchanges themselves. • These are not intermediaries (mostly) • Functions: F ti – Matching borrowers and savers. – Risk-sharing – Mitigating Information problems – Liquidity provision
Primary markets: Investment banks • Assist companies in initial issue of securities (“primary markets”) • Underwriting: put reputation (and capital) at risk in effort to get a high price for the securities • Other services: advice and active participation in M&A…investment banks are basically extremely versatile dealmakers.
2
Secondary markets: Brokers, dealers, and exchanges • Brokers match buyers and sellers of securities in secondary markets • Dealers buy and sell securities. (Similar function to brokerage brokerage, perhaps more risk risk.)) • Exchanges provide centralized auction markets, clearing services, standardization. • Over-the-counter (OTC) markets allow some standardization, and take advantage of technology.
Investment institutions • Mutual funds: sell shares in a portfolio of financial assets (almost any kind) to – Reduce transactions costs while providing diversification – Reduce information costs – Money market mutual funds (and other “checkable” funds also provide liquidity and “asset transformation”.
• Finance companies provide loans to lower quality firms and households; usually specialize. (e.g., GMAC)
Insurance Companies • Insurance companies write contracts to protect risk of loss from particular events. • “Law of large numbers” enables insurance p to p predict loss for large g g groups. p companies • Insurance companies face problems of adverse selection and moral hazard.
3
Business practices of Insurance companies • Hazards: adverse selection and moral hazard • Strategies: – Risk-pooling Ri k li and d screening. i – Risk-based premiums – Deductibles, coinsurance, restrictive covenants, etc.
Life Insurers v. Property-Casualty Insurers • Life insurers offer various options, but mostly operate a very predictable business – Risk is mostly idiosyncratic
• Property-casualty Property casualty insurers: – Auto, home, fire, earthquake, flood, etc. – Aggregate risk may be important (e.g., 9/11, Katrina… future issues: terrorism? global warming?)
4
Pension Funds • Pension funds invest to provide for retirement benefits. • Defined contribution plans (fully funded, by definition)) • Defined benefit plans – May be fully funded or under-funded. – ERISA (1974) created PBGC to monitor and insure defined benefit funds.
Depository Institutions • All accept (checking or saving) deposits (zero maturity debt) • Commercial banks accept deposits and make loans • Savings institutions (savings and loans, mutual savings banks) accept deposits and make mortgage loans • Credit Unions (and other types of mutuals) return all profits to depositors.
5
Government Financial Institutions • Federal credit agencies make loans in the interest of public policy. – Federal government provides loans to support farmers, would-be homeowners, students, exporters etc. exporters, etc
• U.S. government also guarantees loans made by private financial institutions. – “Tenfold increase in loan guarantees in the past two decades”!?! – Can you say: “Moral hazard”? “Systemic risk”?
Financial Institutions: Blurring the Lines • Glass-Steagall Act of 1933 (and others) imposed barriers that restricted competition and scope among financial institutions. – Separated investment banks from deposit deposit-taking taking banks – Created SEC
• The Gramm-Leach-Bliley Act of 1999 removed many barriers – Led to consolidation, blurring of function of individual companies
6
