Financial Intermediation Summary.pages
! !
Financial Intermediation and Debt Markets!
! Summary Semester 1 2014 Part 1: Notes
2
Topic 1: Roles and Operations of Banks
2
Topic 2: Bank Financial Statements
10
Topic 3: Banking Risks
13
Topic 4: Interest Rates and Interest Rate Risk Management
19
Topic 5: Market Risk
29
Topic 6: Lending Policies & Credit Risk
36
Topic 7: Liquidity Risk
49
Topic 8: Regulation and Bank Runs
56
Topic 9: Securitisation
65
Part 2: Formula Sheet
77
FINM3006
"1
Part 1: Notes
Topic 1: Roles and Operations of Banks
!
Specialness: Areas of Financial Intermediaries’ Provision of Service! Information Costs
- Aggregation of funds in an FI provides incentive to collect information about customers! - Relatively large size of the FI allows the collection of information be accomplished at a lower average cost (economies of scale) than for individuals
Liquidity & Price Risk
- FI’s provide financial claims to household savers with superior liqduity attributes and lower price risk
Transaction Cost Services
- Similar to economies of scale in information production costs!
Maturity Intermediation
- FI's can better bear the risk of mismatching the maturities of their assets and liabilities
Transmission of Monetary Supply
- Depository insitutations are the conduit through which monetary policy actions by the country’s central bank impact the rest of the financial system and the economy
Credit Allocation
- FIs are the major source of financing for particular sectors of the economy!
- FI size can result in economics of scale in transaction costs
- E.g. Farming, small business, residential real estate Intergenerational Wealth Transfers
- FI’s (Insurance companies and pension funds) provide savers with the ability to transfer wealth from one generation to the next
Payment Services
- Efficiency with which depository institutions provide payment services such as check clearing directly benefits the economy
Denomination Intermediation
- FI’s (mutual funds) allow small investors to overcome constraints to buying assets imposed by large minimum denomination size
! Without FI’s:! - Flow of Funds is likely to be low!
- Information costs high for households! - Less liquidity and substantial price risk, even if a market exists the depth may not be sufficient - absence of market makers! - The problem of funding new investment (ideas)!
FINM3006
"2
- Costly state verification: debt general optimal for outside claims owing to recourse and seniority of claim! - Inalienability of human capital: lender cannot extract maximum (optimal) effort without
!
giving up something !
- A Saver with excess cash confronts problems! - Lenders assess risk of default through information asymmetries, moral hazard and
!
agency costs!
- Excess savings could only be held as cash or invested in corporate securities! - Little or no monitoring would occur! - Risk of investments would increases! - As riskiness of investment increases, so does the need for regulation!
!
With FIs:!
Two Major Functions:!
!
Brokerage Function:
Intermediation Function (AssetTransformation/Liquidity Creation)
- Pull demands and transaction on wholesale market
- Purchase primary securities by selling financial claims to households
- Acting as an agent for investors
- These secondataries secutires are often more marketing
- Reduces costs through economies of scale
- Transformation of financial Risk
- Encourages higher rate of savings
*More detail below!
!
FINM3006
"3
Financial Intermediaries are better able to resolve the costs facing an individual making a direct investment!
!
Roles of FI’s in Cost Reduction and Other Special Services:! Agglomeration of funds resolves the following problems: ! - Greater incentive for information collection and monitoring activities (free-rider problem and delegated monitor)!
!
- Development of new secondary securities to more effectively monitor!
Reduce Information Costs:! - Economies of Scale! - Investors exposed to Agency Costs:! - Role of FI as delegated monitor! - Short Term debt contracts easier to monitor than bonds! - FI likely to have informational advantage over households!
!
- FI’s reduce information asymmetry between borrowers and lenders!
Reduced Transaction Costs! - Economies of Scale of transaction costs: purchase of assets in bulk, lower buy-sell
!
spreads!
Maturity Intermediation:! - Ability to bear the risk of mismatched assets and liabilities! - Maturity intermediation function!
!
Transmission of Monetary Policy! - Financial intermediaries: most widely used medium of exchange in the economy! - Money Supply in Australia. The liabilities and assets of intermediaries’ play significant role
!
in the transmission of monetary policy!
Credit Allocation:! - Financial intermediaries are the major source of finance in certain sectors of an economy!
!
Denomination Intermediation:! - Money market managed funds! - Debt-equity managed funds! FINM3006
"4
- Unit trusts! - Give individuals indirect access to large denomination markets (Allows investment in new
!
areas)!
Regulation: ! Important Features of Regulatory Policy:! - Protect ultimate sources and users of savings! - Financial services is the most regulated industry worldwide! - Including prevention of unfair practices such as ‘redlining’ and other discriminatory actions! - Primary Role: Ensure soundness of the system as a whole! - Regulation is not costless: Net regulatory burden!
!
Six Categories of Regulation based on Intended Social Welfare Benefits:! 1. Safety and soundness regulation: diversification, credit exposures, capital adequacy! 2. Monetary policy regulation: Cash reserves, liquidity! 3. Credit Allocation Regulation: Lend to socially important sectors! 4. Consumers protection regulation: Product disclosure and codes of conducts (New Gov Department “Consumer Financial Protection Agency”! 5. Investor Protection Regulation: Insider trading, product disclosure, fiduciary duties (Asic, Corporations Law)! 6. Entry and Chartering Regulation: Protection of Industry, prudential control. For example, if your government allows banks to monopolise; high economics profit, therefore
!
chartering is high. !
Failures in the financial system are driven by the fact that the failure of a single banking institution will weaken other banking institutions which they were involved! Banks have common exposures and trade with each other!
! !
FINM3006
"5
Australian Banking Industry vs. US Banking Industry!
Banking Composition
Australia
US
“Four Pillars” full services retail and commercial lending!
Three major types of DI’s: Commercial Banks, savings institutions and Credit Unions
! Relatively Concentrated Participants
Banks, credit unions, building societies (ADI’s)!
8000 Commercial Banks ! Many national, and state-based
Non-deposit taking financial companies Competition
Dominant market share across most consumer finance lines!
Perfectly competitive market with some national lenders dominating market Share
However, increasing competition from foreign, regional and non-bank lenders Sustainability
Stream One: Empower consumers to get a better deal (Increase Competition)!
GFC Reform: Different pages
Stream Two: Support smaller lenders to compete with big banks! Stream Three: Secure the long-term safety and sustainability of our financial system Reform
Ban on mortgage-exit fees Paperwork reform!
1863: National Bank Act! 1913: Federal Reserve Act!
e-Conveyancing! Financial Claims Scheme: Covered up
1927: McFadden Act!
to $1m, reduced to $250K!
1930: Hawley-Smoot Tariff Act!
Covered bonds (Packaged cash flows from banks home loans without moving them off the balance sheet, Aimed at giving small banks access to wholesale
1932: Reconstruction Finance Corporation Act (President Hoover attempt to stimulate the economy, reduced competition which ultimately backfired) !
market GFC Reform Regulation Frameworks
APRA: Australian Prudential Regulation Authority !
FDIC: Federal Deposit Insurance Corporation!
ASIC Australian Securities and Investments Commission!
OCC: Office of the Comptroller of the Currency!
RBA: Reserve Bank of Australia
FRS: Federal Reserve System
! ! ! FINM3006
"6
Australian Regulatory Authorities!
!
APRA
ASIC
RBA
Oversees
Banks, credit unions, building socs, general insurance, super, etc.
Australian companies, financial markets, financial services organisations and professionals who deal and advise in investments, superannuation, insurance, deposit taking and credit.
Acts as Central Bank
Respsonsibilities
Development of prudential policies that balance: financial safety, competition, contestability, competitive neutrality
Market integrity and consumer protection Enforces Corporations Law
Development and implementation of monetary policy and overall financial system stability Lender of last resort function
Mission
Aprroach is: Forwardlooking, risk based, consultative, Consistent, international best practice
Sets standards for financial market behaviour with aim to protect investor and consumer confidence
Monetary policy to achieve low and stable inflation over the medium term
! Question: Is there any relationship between credit ratings and assets? ! In theory, yes as banks increase in asset numbers, they SHOULD become safer. However, in practice we see banks of different size and composition across different credit ratings. ! There is one theory that as banks increase the total value of assets, as does the riskiness of the bank and their investments. Such riskiness could indeed lower overall credit rating!
!
Question: What does a low number of significant players in the Banking market (Like the big Four) mean for deposit and mortgage competition?! Increases competition.! Impact on sustainability: Last few slides of this lecture!
!
Question: What is the primary distinction between a credit union and a bank?! -Credit unions operate predominantly in the ‘retail’ sector and business driven by deposit taking, consumer credit and housing loan finance!
!
Mutual ADI’s and Banks: Differences! - Ownership structure! - Not for profit! - Product suite! FINM3006
"7
- Banks have more varied assets and liabilities (type and duration)! - Differences in operating characteristics and profitability across businesses !
!
Question: What impact occurs between competition and sustainability?! - More competition reduces profits and price; therefore decreases banks charter value! - Reduction in value forces banks to take on riskier investments, increasing volatility !
!
Financial Claims Scheme: ! Guarantee on deposits up to $1m, reduced to $250K *Look at liquidity risk! - Deposit portability will eat into profits and increase overall riskiness of banks!
!
USA Regulatory Agencies FDIC
OCC
FRS
Oversees
Banks, credit unions, building socs, general insurance, super, etc.
Charters National Banks, sub-agency of the US Treasury
Acts as cetranl bank
Respsonsibilities
Preventing contagious runs Can shutdown banks or ask or panics, insures deposits to for restructuring $250K, Levies insurance premiums, manages deposit insurance fund, carries out bank examination
Monetary policy, lender of last resort function Examines and has regulatory power over some banks and bank holding companiest
Mission
Attempts to pay back creditors
National Banks are automatically members of the FRS
Examines national banks and has the power of approval over bank mergers
! Global Financial Crisis! Three Main Causes:! !
- Poor risk perceptions (low credit spreads)!
!
- Low short and long interest rates (easy leverage and high house prices and
corporate acquisitions)! !
- Lack of appropriate regulation!
The Volcker Rule: Proposed addition to the Dodd-Frank Wall Street Reform and Consumer Protection Act The proposal specifically prohibits a bank or institution that owns a bank from engaging in proprietary trading that is not at the behest of its clients, and from owning or investing in a hedge fund or private equity fund, and also limits the liabilities that the largest banks can hold.!
FINM3006
"8
Financial Intermediation and Debt Markets!
! Summary Semester 1 2014 Part 1: Notes
2
Topic 1: Roles and Operations of Banks
2
Topic 2: Bank Financial Statements
10
Topic 3: Banking Risks
13
Topic 4: Interest Rates and Interest Rate Risk Management
19
Topic 5: Market Risk
29
Topic 6: Lending Policies & Credit Risk
36
Topic 7: Liquidity Risk
49
Topic 8: Regulation and Bank Runs
56
Topic 9: Securitisation
65
Part 2: Formula Sheet
77
FINM3006
"1
Part 1: Notes
Topic 1: Roles and Operations of Banks
!
Specialness: Areas of Financial Intermediaries’ Provision of Service! Information Costs
- Aggregation of funds in an FI provides incentive to collect information about customers! - Relatively large size of the FI allows the collection of information be accomplished at a lower average cost (economies of scale) than for individuals
Liquidity & Price Risk
- FI’s provide financial claims to household savers with superior liqduity attributes and lower price risk
Transaction Cost Services
- Similar to economies of scale in information production costs!
Maturity Intermediation
- FI's can better bear the risk of mismatching the maturities of their assets and liabilities
Transmission of Monetary Supply
- Depository insitutations are the conduit through which monetary policy actions by the country’s central bank impact the rest of the financial system and the economy
Credit Allocation
- FIs are the major source of financing for particular sectors of the economy!
- FI size can result in economics of scale in transaction costs
- E.g. Farming, small business, residential real estate Intergenerational Wealth Transfers
- FI’s (Insurance companies and pension funds) provide savers with the ability to transfer wealth from one generation to the next
Payment Services
- Efficiency with which depository institutions provide payment services such as check clearing directly benefits the economy
Denomination Intermediation
- FI’s (mutual funds) allow small investors to overcome constraints to buying assets imposed by large minimum denomination size
! Without FI’s:! - Flow of Funds is likely to be low!
- Information costs high for households! - Less liquidity and substantial price risk, even if a market exists the depth may not be sufficient - absence of market makers! - The problem of funding new investment (ideas)!
FINM3006
"2
- Costly state verification: debt general optimal for outside claims owing to recourse and seniority of claim! - Inalienability of human capital: lender cannot extract maximum (optimal) effort without
!
giving up something !
- A Saver with excess cash confronts problems! - Lenders assess risk of default through information asymmetries, moral hazard and
!
agency costs!
- Excess savings could only be held as cash or invested in corporate securities! - Little or no monitoring would occur! - Risk of investments would increases! - As riskiness of investment increases, so does the need for regulation!
!
With FIs:!
Two Major Functions:!
!
Brokerage Function:
Intermediation Function (AssetTransformation/Liquidity Creation)
- Pull demands and transaction on wholesale market
- Purchase primary securities by selling financial claims to households
- Acting as an agent for investors
- These secondataries secutires are often more marketing
- Reduces costs through economies of scale
- Transformation of financial Risk
- Encourages higher rate of savings
*More detail below!
!
FINM3006
"3
Financial Intermediaries are better able to resolve the costs facing an individual making a direct investment!
!
Roles of FI’s in Cost Reduction and Other Special Services:! Agglomeration of funds resolves the following problems: ! - Greater incentive for information collection and monitoring activities (free-rider problem and delegated monitor)!
!
- Development of new secondary securities to more effectively monitor!
Reduce Information Costs:! - Economies of Scale! - Investors exposed to Agency Costs:! - Role of FI as delegated monitor! - Short Term debt contracts easier to monitor than bonds! - FI likely to have informational advantage over households!
!
- FI’s reduce information asymmetry between borrowers and lenders!
Reduced Transaction Costs! - Economies of Scale of transaction costs: purchase of assets in bulk, lower buy-sell
!
spreads!
Maturity Intermediation:! - Ability to bear the risk of mismatched assets and liabilities! - Maturity intermediation function!
!
Transmission of Monetary Policy! - Financial intermediaries: most widely used medium of exchange in the economy! - Money Supply in Australia. The liabilities and assets of intermediaries’ play significant role
!
in the transmission of monetary policy!
Credit Allocation:! - Financial intermediaries are the major source of finance in certain sectors of an economy!
!
Denomination Intermediation:! - Money market managed funds! - Debt-equity managed funds! FINM3006
"4
- Unit trusts! - Give individuals indirect access to large denomination markets (Allows investment in new
!
areas)!
Regulation: ! Important Features of Regulatory Policy:! - Protect ultimate sources and users of savings! - Financial services is the most regulated industry worldwide! - Including prevention of unfair practices such as ‘redlining’ and other discriminatory actions! - Primary Role: Ensure soundness of the system as a whole! - Regulation is not costless: Net regulatory burden!
!
Six Categories of Regulation based on Intended Social Welfare Benefits:! 1. Safety and soundness regulation: diversification, credit exposures, capital adequacy! 2. Monetary policy regulation: Cash reserves, liquidity! 3. Credit Allocation Regulation: Lend to socially important sectors! 4. Consumers protection regulation: Product disclosure and codes of conducts (New Gov Department “Consumer Financial Protection Agency”! 5. Investor Protection Regulation: Insider trading, product disclosure, fiduciary duties (Asic, Corporations Law)! 6. Entry and Chartering Regulation: Protection of Industry, prudential control. For example, if your government allows banks to monopolise; high economics profit, therefore
!
chartering is high. !
Failures in the financial system are driven by the fact that the failure of a single banking institution will weaken other banking institutions which they were involved! Banks have common exposures and trade with each other!
! !
FINM3006
"5
Australian Banking Industry vs. US Banking Industry!
Banking Composition
Australia
US
“Four Pillars” full services retail and commercial lending!
Three major types of DI’s: Commercial Banks, savings institutions and Credit Unions
! Relatively Concentrated Participants
Banks, credit unions, building societies (ADI’s)!
8000 Commercial Banks ! Many national, and state-based
Non-deposit taking financial companies Competition
Dominant market share across most consumer finance lines!
Perfectly competitive market with some national lenders dominating market Share
However, increasing competition from foreign, regional and non-bank lenders Sustainability
Stream One: Empower consumers to get a better deal (Increase Competition)!
GFC Reform: Different pages
Stream Two: Support smaller lenders to compete with big banks! Stream Three: Secure the long-term safety and sustainability of our financial system Reform
Ban on mortgage-exit fees Paperwork reform!
1863: National Bank Act! 1913: Federal Reserve Act!
e-Conveyancing! Financial Claims Scheme: Covered up
1927: McFadden Act!
to $1m, reduced to $250K!
1930: Hawley-Smoot Tariff Act!
Covered bonds (Packaged cash flows from banks home loans without moving them off the balance sheet, Aimed at giving small banks access to wholesale
1932: Reconstruction Finance Corporation Act (President Hoover attempt to stimulate the economy, reduced competition which ultimately backfired) !
market GFC Reform Regulation Frameworks
APRA: Australian Prudential Regulation Authority !
FDIC: Federal Deposit Insurance Corporation!
ASIC Australian Securities and Investments Commission!
OCC: Office of the Comptroller of the Currency!
RBA: Reserve Bank of Australia
FRS: Federal Reserve System
! ! ! FINM3006
"6
Australian Regulatory Authorities!
!
APRA
ASIC
RBA
Oversees
Banks, credit unions, building socs, general insurance, super, etc.
Australian companies, financial markets, financial services organisations and professionals who deal and advise in investments, superannuation, insurance, deposit taking and credit.
Acts as Central Bank
Respsonsibilities
Development of prudential policies that balance: financial safety, competition, contestability, competitive neutrality
Market integrity and consumer protection Enforces Corporations Law
Development and implementation of monetary policy and overall financial system stability Lender of last resort function
Mission
Aprroach is: Forwardlooking, risk based, consultative, Consistent, international best practice
Sets standards for financial market behaviour with aim to protect investor and consumer confidence
Monetary policy to achieve low and stable inflation over the medium term
! Question: Is there any relationship between credit ratings and assets? ! In theory, yes as banks increase in asset numbers, they SHOULD become safer. However, in practice we see banks of different size and composition across different credit ratings. ! There is one theory that as banks increase the total value of assets, as does the riskiness of the bank and their investments. Such riskiness could indeed lower overall credit rating!
!
Question: What does a low number of significant players in the Banking market (Like the big Four) mean for deposit and mortgage competition?! Increases competition.! Impact on sustainability: Last few slides of this lecture!
!
Question: What is the primary distinction between a credit union and a bank?! -Credit unions operate predominantly in the ‘retail’ sector and business driven by deposit taking, consumer credit and housing loan finance!
!
Mutual ADI’s and Banks: Differences! - Ownership structure! - Not for profit! - Product suite! FINM3006
"7
- Banks have more varied assets and liabilities (type and duration)! - Differences in operating characteristics and profitability across businesses !
!
Question: What impact occurs between competition and sustainability?! - More competition reduces profits and price; therefore decreases banks charter value! - Reduction in value forces banks to take on riskier investments, increasing volatility !
!
Financial Claims Scheme: ! Guarantee on deposits up to $1m, reduced to $250K *Look at liquidity risk! - Deposit portability will eat into profits and increase overall riskiness of banks!
!
USA Regulatory Agencies FDIC
OCC
FRS
Oversees
Banks, credit unions, building socs, general insurance, super, etc.
Charters National Banks, sub-agency of the US Treasury
Acts as cetranl bank
Respsonsibilities
Preventing contagious runs Can shutdown banks or ask or panics, insures deposits to for restructuring $250K, Levies insurance premiums, manages deposit insurance fund, carries out bank examination
Monetary policy, lender of last resort function Examines and has regulatory power over some banks and bank holding companiest
Mission
Attempts to pay back creditors
National Banks are automatically members of the FRS
Examines national banks and has the power of approval over bank mergers
! Global Financial Crisis! Three Main Causes:! !
- Poor risk perceptions (low credit spreads)!
!
- Low short and long interest rates (easy leverage and high house prices and
corporate acquisitions)! !
- Lack of appropriate regulation!
The Volcker Rule: Proposed addition to the Dodd-Frank Wall Street Reform and Consumer Protection Act The proposal specifically prohibits a bank or institution that owns a bank from engaging in proprietary trading that is not at the behest of its clients, and from owning or investing in a hedge fund or private equity fund, and also limits the liabilities that the largest banks can hold.!
FINM3006
"8
