Finance ch.8 Financial system, intermediation, and financial institutions

The Federal Deposit Insurance Company (FDIC)

created by the Glass-Steagall Act of 1933 in response to over 9,000 bank failures during the Great Depression - the FDIC provides insurance against bank failures - all national banks and members of the Federal Reserve System are required to to purchase FDIC insurance - FDIC insures depositors for up to $250,000 if the bank fails

what are the most important financial intermediaries in the US?

depository intermediaries

diversification intermediation and default risk

diversification reduces risk to investors by reducing the firm specific risk in their investment portfolio

hedge funds usually do not actually _______

do not actually hedge

pension funds

employers and employees contribute money to pension funds that grow on a tax-free basis until the worker retires and starts to receive payments under the pension program - workers do not pay any taxes until the funds are received when they are retired

example of depository intermediaries

ex: commercial banks, savings and loans associations, savings banks, and credit unions

what kind of strategies do hedge funds use?

high-risk strategies

financial institution: mutual funds and hedge funds type of financial intermediation: ????

intermediate between investors and markets

bond funds

invest in bonds issued by the US Treasury, corporations, and other economic entities - bond funds are generally less risky than stock funds but riskier than money market funds

stock funds

invest in common stock issued by corporations

money market funds

invest in high-quality debt securities that have short maturities and relatively low amounts of risk compared to other types of mutual funds - these funds focus on short-term, highly marketable securities like US treasury bills

liquidity intermediation

savers/investor's funds are highly liquid because they can be accessed at any time, but borrowers are able to borrow money for the long-term - the financial intermediaries absorb the risk inherent in making long-term loans with highly liquid short-term funds

secondary securities

savings and checking accounts, annuities, insurance policies and pension plans, and mutual funds

property and casualty insurance

sell protection for property and health through auto, fire, health, and other types of insurance

investment companies: (primary source of funds)

sell shares and use that money to invest in other securities

long-term loans and mortgages are often financed by what?

short-term deposits and savings accounts

depository intermediaries

take your deposit and issue you a highly liquid secondary securities, like checking and savings accounts - most important financial intermediaries in the US - ex: commercial banks, savings and loans associations, savings banks, and credit unions

insurance companies

the ability to pool risk and spread the cost of insurance over as many people or entities as possible allows insurance companies to minimize the effect of losses suffered by any individual event or occurrence. - customers pay insurance companies regular premiums in exchange for the risk the insurance company is taking on

financial intermediation

the process of creating and selling low interest rate secondary securities by financial institutions and then using the proceeds to purchase higher interest rate primary securities

defined benefit plan

the sponsor of the plan agrees to pay a predetermined fixed amount of money, usually monthly, to the pensioner - under this plan, the sponsor is essentially guaranteeing the performance of the investments within the pension fund

finance companies

these companies finance loans to individuals and businesses that purchase products from a company that has a relationship with the finance company. - due to the high amount of risk of default, finance companies charge much higher interest rate than the rates on typical bank loans

how do investment banks make money?

through underwriting fees that they charge the issuers of securities

investment banks

transactional intermediaries that raise capital for corporations and governments through the public and private financial markets by linking investors to borrowers

if the hedge fund experiences a loss, the fund managers do not earn any performance fees until when? (High-water marks)

until the losses are recovered

principal: (investment banks)

when an investment bank acts as a principal, it trades securities with the firm's own account, and the investment bank directly makes or loses money depending on how the security perfroms

financial intermediary

an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers).

hedging

an investment used to reduce the risk of adverse price movements in an asset

3 services that investment banks offer to investors and issuers:

1. Advises the issuer of securities and originating financing 2. Underwriting the financing - investment banks usually form an underwriting syndicate that guarantees the price or yield on a security to the issuer 3. Distributing the securities to the ultimate investor

4 types of depository financial intermediaries:

1. Commercial banks 2. Savings and loan associates 3. Mutual savings banks 4. Credit unions

3 general categories of financial intermediaries

1. Depository intermediaries 2. Contractual intermediaries 3. Investment intermediaries

which financial institutions are the largest? and which is the smallest?

1. Insurance companies (23%) 2. Asset management (23%) 3. Foreign money center banks (23%) 7. Investment brokerage (3%)

4 functions of financial intermediaries:

1. Middlemen that transfer the assets of savers/lenders into liabilities of borrowers 2. Issue secondary securities where they turn saver/lender money into liabilities, such as savings and checking accounts 3. Create primary securities (such as mortgage loans, car loans, insurance policies) for borrowers and then sometimes sell those financial assets to other market participants in the primary market 4. Provide investment advice and portfolio management services to clients for a fee

3 types of mutual funds:

1. Money market funds 2. Bond funds 3. Stock funds

2 types of investment intermediaries:

1. Mutual funds 2. Finance companies

3 types of contractual financial intermediaries:

1. Pension funds 2. Insurance companies 3. Property and casualty insurance

commercial banks - 3 types of banking services:

1. Personal banking services - provide checking accounts, credit card financing, mortgage loans, school loans 2. Institutional banking services - when a bank lends and borrows with other financial corporations, government agencies 3. Global banking services - commercial are primary players in foreign currency transactions

example of financial intermediation

A commercial banks pays a low interest rate on funds in customer savings accounts. The bank then lends those funds at a higher rate as a mortgage to a borrower purchasing a home

investment banks: (primary source of funds)

borrow money as debt and invest in securities

buy side financial institutions

buy, hold, and trade financial products ex: mutual funds, commercial banks, insurance companies, hedge funds, money managers

how do insurance companies earn additional income?

by investing the premiums received from customers

maturity intermediation

depositors provide short-term funds, but financial institutions use those funds to make long-term loans and purchase long-term assets

deposits and borrowings make up to ___% of the balance sheet of commercial banks, which means only ___% of the balance sheet is made up of equity

deposits and borrowings - 92% equity - 8%

hedge fund managers only earn their 20% fee on profits if the fund is generating...

if the fund is generating a positive return

financial institution: commercial banks type of financial intermediation: ????

intermediate between investors and companies

what did the Financial Services Modernization Act of 1999 allow?

it allowed US financial institutions to compete on the same level with foreign banks. It eliminated most of the firewalls between banks, securities firms. and insurance companies that the Glass-Steagal Act created.

when a mutual fund increases the dollar amount of assets under management, it will increase its _______

it will increase its revenue

liquidity issues with hedge funds

large hedge funds typically move in and out of positions extremely slowly, which can often hurt their returns

hedge funds are largely ________

largely unregulated

savings and loan associates

like banks, these financial institutions take deposits and make loans; however, their focus is on home mortgage loans and personal loans instead of business loans

how do commercial banks make money?

make money by borrowing at low interest rates and lending at a higher rate

Because of the predictability of their payment streams, pension funds focus on what?

pension funds focus on long-term investment performance, and liquidity is not a major concern

the unregulated nature of hedge funds make them ideal for what?

ponzi schemes (Bernie Madoff)

investment intermediaries

pool funds from many small investors and then use those funds to purchase securities - ex: mutual funds, investment companies, finance companies - investors pay management fee in exchange for lower transaction costs and better portfolio diversification

contractual intermediaries

provide services to their clients in exchange for regular payments from their clients - ex: pension funds, life insurance companies

commercial banks: (primary source of funds)

receive money from deposits and give out loans

credit unions

similar to savings and loan associates, but all of the members have a common bond, such as membership in a particular organization, employer, occupation, etc.

these funds are historically the riskiest type of mutual funds; however, they have performed better over the long run than any other type of investment

stock funds

primary securities

stocks, bonds, loans, or mortgages

defined contribution plan

the amount of money that is invested in the plan is fixed, but the payments to the employee at retirement are determined by the fund's performance - under this plan, the sponsor does not guarantee performance of the fund or the stream of payments the worker will receive at retirement

the financial institution uses its gross spread to cover what?

the cost of operations and the cost of defaults on its primary securities

mutual savings banks

the depositors of the bank are also the owners of the bank

2-20 fee structure

the fee structure that dictates how hedge fund managers are paid 2% annual fee charged for assets under management (AUM). 20% performance fee charged on all profits generated by the fund - this fee structure is why there has been a large increase in the number of hedge funds (running one can be extremely profitable)

commercial banks

the largest and most important type of financial institution in the US

what do financial intermediaries require in return for taking on addition risk?

they require higher rates of return

agent: (investment banks)

when an investment bank acts as an agent, it is a middleman between the buyer and seller of a security

indirect finance

when funds move from investors through financial intermediaries to borrowers

direct finance

when the issuer of stocks or bonds directly receives the funds from the purchaser of the stocks or bonds

liquidity

how easily a financial asset can be converted into cash

2 types of pension plans:

1. Defined benefit plan 2. Defined contribution plan

maturity intermediation forces which buyers to pay which interest rates? why?

Requires long-term borrowers to pay higher interest rates than short-term borrowers. Because investors are risk-averse and do not like to commit funds for long periods of time without additional compensation

most mutual funds are ________ funds. a smaller percentage of mutual funds are _________ funds.

most are open-end funds smaller percent are closed-end funds

open-end funds

most mutual funds are open-end funds that are willing to sell or buy back shares at their net asset value per share at any time - this means that investors can get in and out of the mutual fund at any time

mutual funds and diversification

mutual funds are an easy way for investors to diversify their investments

finance companies usually make loans to what type of people?

people with lower credit ratings

the process of financial intermediation requires that the financial institution accepts what?

accepts many risks

hedge funds

Not open to the public. Private partnership that uses advanced investment strategies to generate high returns for wealthy investors and large institutions. - investors must commit money for a minimum of one year, and minimum investment is usually in the millions of dollars - largely unregulated

one of the largest finance companies in the US

The General Motors Acceptance Corporation (GMAC)

mutual funds

a pool of money is managed by a professional money manager

close-end funds

a smaller percent of mutual funds are close-end funds that sell a fixed number of shares and then invest the pool of money - these type of funds cannot sell additional shares once the fixed number of shares have been sold, so the size of the fund is capped

net interest margin metric (NIM)

commercial banks

sell side financial institutions

create/make markets and sell financial products ex: investment banks, commercial banks

The Glass-Steagall Act of 1933

created the FDIC and forced the separation of traditional commercial banking and investment banking - passed after the Great Depression and re-established trust and credibility on Wall Street

examples of sell side financial institutions

ex: investment banks, commercial banks

examples of buy side financial institutions

ex: mutual funds, money managers, insurance companies, hedge funds

example of contractual intermediaries

ex: pension funds, life insurance companies

intermediation and economies of scale in information costs

financial intermediaries can take advantage of economies of scale in search, information, and transaction costs

money market funds focus on...

focus on short-term, highly marketable securities like US treasury bills

absolute return strategy

generate a return for investors regardless of the return on the market - even if fund has a negative return, it is still considered to have done well if it had a better return than the market

carried interest tax issue (hedge funds)

hedge fund profits are taxed as capital gains (tax rate of 15%) which is much lower than the tax rate for normal income

insurance companies: (primary source of funds)

hold reserves from premium payments and invest in bonds