Chapter 1

________ _______ are one type of structure through which _________ flow.

Financial markets funds

Money markets

markets that trade debt securities with maturities of one year or less (CDs, U.S. Treasury bills) -little or no risk of capital loss, usually low return and low transaction costs

Secondary markets

markets where existing financial instruments are traded among investors (NYSE, NASDAQ)

Regulators attempt to _________ social welfare while __________ the burden imposed by regulation.

maximize, minimizing

'shadow banking system'

non-bank FIs who inderectly provide financing for loans by originating loans or more likely by purchasing securities backed by loans -shadow banking allows more rapid growth in credit by increasing the supply of funds available

Over the derivatives (OTC derivatives)

-Forward contracts, Forward rate agreements, Swaps, Securitized loans -OTC derivatives are nonstandard, largely unregulated and may involve substantial counterparty credit risk.

Two dimensions of financial markets

-Primary versus secondary markets -Money versus capital markets

Trends in the U.S. Bank holding companies (BHC)

-Reduction in number and increase in size of fin. institutions -created to enable banks to grow by acquisition and raise capital more easily -regulated by the Fed. Reserve (Bank Holding Company Act of 1956) -most U.S. banks are owned by BHC's

1999 Financial Services Modernization Act (Gramm-Leach-Bliley Act)

-Removed remaining restrictions of the Glass-Steagall Act of 1933 -Commercial banking and investment banking could be performed in the same FI -FI could declare themselves to be a Financial Holding Company (FHC) and conduct commercial banking, investment banking, insurance and other financial activvities within the same institution -"too big to fail"

1933 Banking Act (Glass-Steagall Act)

-commercial and investment banking separated -established Federal Deposit Insurance Corporation (FDIC) -prohibited banks from paying interest on demand deposits

Trends in U.S. Mortgage derivatives

-helped fuel 'credit' boom that led to unsustainable increases in home prices -spread the risk of mortgages to a broader base of investors so when home prices fell in 2006 more institutions were affected

Trends in U.S. Mortgage derivatives Change in banking from 'originate and hold' loans to 'originate and sell' loans >>> (2)

-increases liquidity, reduces credit and interest rate risk -decline in underwriting standards on loans

Exchange listed derivatives

-many options, future contracts -Exchange listed are more regulated, more transparent, and generally involve no default risk for the counterparty.

Globalization of Fin. Markets & Instit.

-pool of savings from foreign investors increasing & investors look to diversify globally -info on foreign markets & investments becoming accessible and deregulation across globe allowing greater access to foreign markets -int. mutual funds allow diversified foreign investment w/ low transactions costs -global capital flows are larger than ever

finance companies

FIs that make loans to both individuals and businesses. -do not accept deposits but rely on short and long term debt funding

FIs Benefit to Overall Econ (4)

1) Conduit through which Fed. Reserve conducts monetary policy 2) Efficient credit allocation 3) intergenerational wealth transfers 4) payment services

Dodd-Frank Bill (2010 Wall Street Reform and Consumer Protection Act) (5+)

1) Promote robust supervision of FIs - Fin Service Oversight Council to identify and limit systemic risk -Broader authority for Fed to oversee non-bank FIs -higher equity capital reqs -Registration of hedge funds & private equity funds 2) Comprehensive supervision of fin markets -new regulations for securitization and over the counter derivatives -additional oversight by Fed of payment syst's 3) Establishes new Consumer Fin. Protection Agency 4) New methods to resolve non-bank financial crises -more oversight of Fed bailout decisions 5) Increase international capital standards and increased oversight of international operations of FIs

FIs Benefits to Suppliers of Funds (5) Slide 29

1) Reduce monitory costs, act as delegated monitors 2)Act as asset transformers to ^ liquidity & v price risk -convert ower risk, high liquid liabilities to high risk, less liquid assets (diversification) 3) Reduce transaction costs 4) Provide maturity intermediation 5) Provide denomination intermediation

Proper capital allocation leads to growth in: (3)

1) Societal wealth 2) Income 3) Economic opportunity

Risks faced by FIs:

1) credit 2) foreign exchange 3) country or sovereign 4) interest rate 5) market 6) Volcker Rule 7) Off-balance-sheet 8) Liquidity 9) Technology (hacking, failure) 10) Operational 11) Insolvency

pension funds

FIs that offer savings plans through which fund participants accumulate savings during their work years before withdrawing them during their retirement years-funds originally invested and accumulated in pensions are tax exempt

investment funds

FIs that pool financial resources of individuals and companies and invest them in diversified portfolios of assets

Non-depository institutions

Contractual -insurance companies, pension funds Non-contractual -securities firms and investment banks, mutual funds

securities firms and investment banks

FIs that help firms issue securities and engage in related activities such as securities brokerage and securities trading

Volcker Rule

Insured institutions may not engage in proprietary trading -Can't invest own capital in risky investment

How were primary markets affected by the financial crisis?

Primary market issuance declined sharply during the crisis although with low interest rates bond issuance boomed after market uncertainty declined in 2010. Stock issuance remained weaker longer, recovering in 2012 and 2013.

Enterprise risk management

Recognizes the importance of managing the combined impact of the full spectrum of risks as an interrelated risk portfollio -popularity rose as a result of failure of adv. risk measurement & management syst to detect exposures that led to fin. crisis -stresses importance of building a strong risk culture

Do secondary markets add value to society or are they simply a legalized form of gambling? How does the existence of secondary markets affect primary markets?

Secondary markets add liquidity for risky investments and encourage investment in primary markets. Secondary markets also aid in price discovery, providing up to date signals of the ongoing value of firms. These signals also provide benchmarks for corporate performance. It is not true that secondary markets are simply a legalized form of gambling.

The Securities Exchange Act of 1934

Securities and Exchange Commission (SEC) is the main regulator of securities markets

Primary VS Secondary Markets

Slide 6

Derivative security

a financial security whose payoff is linked to/derived from another security or commodity

depository institutions (4)

commercial banks, savings associations, savings banks, credit unions

Thrifts

depository institutions in the form of savings associations, savings banks and credit unions. similar services to commercial banks but loans tend to be concentrated in one segment

Commercial banks

depository institutions whose major assets are loans and whose major liabilities are deposits. -their loans are broader in range -liabilities include more non-deposit sources of funds than others

Regulations impose a burden on FIs; before the financial crisis, U.S. regulatory changes were _________ in _______.

deregulatory, nature

insurance companies

financial institutions that protect individuals and corporations from adverse events

The Securities Act of 1933

full and fair disclosure and securities registration

Financial Institutions

institutions through which suppliers channel money to users of funds

Mortgage Derivatives

investment securities developed by financial industry to provide different risk and interest-rate profiles from pools of mortgages

denomination intermediation

lump smaller sums into larger loans

FIs are heavily regulated to protect society at large from _______ _______.

market failures

Primary markets

markets in which corporations and governments raise capital by issuing new securities (e.g. stocks and bonds)

Capital markets

markets that trade debt (bonds) and equity (stock) instruments with matruties of more than one year -substantial risk of capital loss, but higher promised return

Forward rate agreements

prearranged loan contracts with the loan terms set now, drawdowns in the future.

Insolvency risk

risk that an FI may not have enough capital to offset a sudden decline in the value of its assets -loss of asset value is charged to Equity. When Equity < 0, bank is insolvent

A derivative security is generally an agreement to exchange a?

standard quantity of assets at a set price on a specific date in the future.

Liquidity risk

that a sudden surge in liability withdrawals may require an FI to liquidate assets quickly at "fire sale" prices

Forward FX

the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

Spot FX

the immediate exchange of currencies at current exchange rates

FX markets

trading one currency for another

The main purpose of the derivatives markets is to?

transfer risk between market participants

delegated monitors

underwrites(accesses) risk, who money is given to, monitors loans and seizes assets when necc.

Financial Institutions are distinguished by:

whether they accept insured deposits -depository versus non-depository financial institutions whether they receive contractual payments from customers

asset transoformer

you deposit short term assets, converted to long term -rely on having a min. amt of money liquid -avoid run on bank