FIN 3080 Exam 2

what are money market mutual funds? in what assets do these funds typically invest? what factors caused the strong growth in this type of fund over various periods from 1992 to 2009?

4. Money market mutual funds provide an alternative investment opportunity to interest bearing deposits at commercial banks, which may explain the increase in MMMFs in the 1980s and early 2000s when the spread earned on MMMFs investments relative to deposits was mostly positive. Figure 17-2 illustrates the net cash flows invested in taxable money market mutual funds and the interest rate spread between MMMFs and the average rate on MMDAs. Both investments are relatively safe and earn short-term returns. The major difference between the two is that interest-bearing deposits (below $250,000) are fully insured by the FDIC but, because of bank regulatory costs (such as reserve requirements, capital adequacy requirements, and deposit insurance premiums), generally offer lower returns than noninsured MMMFs. Thus, the net gain in switching to MMMFs is a higher return in exchange for the loss of FDIC deposit insurance coverage. Many investors appeared willing to give up FDIC insurance coverage to obtain additional returns in the late 1980s and late 1990s through 2001. Further, during the bull market run in the 1990s investors moved out of money market funds and into equity funds to get the benefits of these high returns. While the 2008-2009 financial crisis and the collapse in stock and other security prices produced a sharp drop in mutual fund activity, MMMFs saw smaller drops as investors moved out of long-term, equity funds and into the safer MMMFs. As the economy recovered after 2009, so did assets invested in mutual funds. However, despite growing stock market values, investors had not completely switched back to long-term mutual funds from MMMFs.

what is meant by the term depository institution? how does a depository institution differ from an industrial corporation?

A depository institution is a financial intermediary that obtains a significant proportion of its funds from customer deposits. Industrial corporations tend to obtain a greater proportion of their funds from stockholders, bondholders, and other types of creditors.

what is the difference between a load fund and a no-load fund? is the argument that load funds are more closely manage and therefore have higher returns supported by the evidence presented in the table?

A load fund charges an up-front fee that often is called a sales charge and is used as a commission payment for sales representatives. These fees can be as high as 5.75 percent. A no-load fund does not charge a sales fee, although a small annual fee can be charged to cover certain administrative expenses. This small fee, which is called a 12b-1 fee, usually ranges between 0.25 and 0.75 percent of assets. Load funds have adjusted returns that are decreased after the fee is removed. In each case the relative performance ranking of the fund decreases after the load is subtracted. The argument in favor of load funds is that they provide the investor with more personal attention and advice on fund selection than no-load funds. However, the cost of increased personal attention may not be worthwhile. High fees do not guarantee good performance. For example, Table 17-6 lists initial fees for the largest U.S. stock funds in 2016. Notice that only American Funds assesses a load fee on mutual fund share purchases. After adjusting for this fee, the 12-month returns on the 7 American Funds mutual funds fall from 10.95 percent to 4.62 percent to 8.39 percent to 0.67 percent.

contrast the activities of securities firms with other FIs

A major similarity between securities firms and all other types of FIs is a high degree of financial leverage. They all solicit funds that are used to finance an asset portfolio consisting of financial securities. The difference is that securities firms' liabilities tend to be extremely short term (see the balance sheet in Table 16-7). Unlike other types of FIs, securities firms and investment banks do not transform the securities issued by the net users of funds into claims that may be "more" attractive to the net suppliers of funds (e.g., banks and their creation of bank deposits). Rather, they serve as brokers intermediating between fund suppliers and users.

what is a mutual fund? in what sense is it a financial institution?

A mutual fund represents a pool of financial resources obtained from individuals and invested in the money and capital markets. It represents another way for those with extra funds to channel those funds to those in need of extra funds.

what are the principal liabilities for commercial banks? what does this liability structure tell us about the maturity of the liabilities of banks? what types of risks does this liability structure entail for commercial banks?

According to Table 11-1, the principal sources were deposits, borrowings, and other liabilities. Of these, deposits comprised 76.1% of total assets. Of the total stock of deposits, transaction accounts represented 15.5 percent of total deposits (and 11.8 percent of total assets), or $1,797.2 billion. Transaction accounts are checkable deposits that are either demand deposits or NOW accounts (negotiable order of withdrawal accounts). Since their introduction in 1980, NOW accounts have dominated the transaction accounts of banks. Nevertheless, since limitations are imposed on the ability of corporations to hold such accounts, demand deposits are still held. NOW accounts may only be held by individuals, sole proprietorships, nonprofit organizations, governmental units, and pension funds. Historically, demand deposits were prohibited from paying interest. Thus, businesses could not earn interest on their bank demand deposits. However, as of July 2011, the federal prohibition against the payment of interest on demand deposits, including business checking accounts, was repealed. The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100,000. Important components of bank retail savings accounts are small nontransaction accounts, which include passbook savings accounts and retail time deposits. Small nontransaction accounts compose 76.7 percent of total deposits (and 58.4 percent of total assets). However, this disguises an important trend in the supply of these deposits to banks. Specifically, the amount held of retail savings and time deposits has been falling in recent years, largely as a result of competition from money market mutual funds. These funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds while requiring relatively small-denomination investments. The third major segment of deposit funds is large time deposits ($100,000 or more); these deposits amounted to $895.0 billion, or approximately 7.7 percent of total deposits (and 5.9 percent of total assets) in 2016. These are primarily negotiable certificates of deposit (deposit claims with promised interest rates and fixed maturities of at least 14 days) that can be resold to outside investors in an organized secondary market. As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity. Nondeposit liabilities comprise borrowings and other liabilities that total 12.6 percent of total assets, or $1,914.3 billion. These categories include a broad array of instruments, such as purchases of federal funds (bank reserves) on the interbank market and repurchase agreements (temporary swaps of securities for federal funds) at the short end of the maturity spectrum, to the issuance of notes and bonds at the longer end. Overall, the liability structure of banks' balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are key exposure concerns for bank managers.

what is the adverse selection problem? how does adverse selection affect the profitable management of an insurance company?

Adverse selection is the problem that customers who apply for insurance policies are more likely to be those most in need of insurance (i.e., someone with chronic health problems is more likely to purchase a life insurance policy than someone in perfect health). Thus, in calculating the probability of having to pay out on an insurance contract and, in turn, determining the insurance premium to charge, insurance companies' use of health (and other) statistics representing the overall population may not be appropriate (since the insurance company's pool of customers is likely to be more prone to health problems than the overall population). Insurance companies deal with the adverse selection problem by establishing different pools of the population based on health and related characteristics (such as income). By altering the pool used to determine the probability of losses to a particular customer's health characteristics, the insurance company can more accurately determine the probability of having to pay out on a policy and can adjust the insurance premium accordingly.

how does the regulation of insurance companies compare with that of depository institutions

An important piece of legislation affecting the regulation of life insurance companies is the McCarran-Ferguson Act of 1945, which confirms the primacy of state over federal regulation of insurance companies. Thus, unlike the depository institutions, which can be chartered at either the federal or state levels, a life insurer is chartered entirely at the state level. In addition to chartering, state insurance commissions supervise and examine insurance companies using a coordinated examination system developed by the National Association of Insurance Commissioners (NAIC). Regulations cover areas such as insurance premiums, insurer licensing, sales practices, commission charges, and the types of assets in which insurers may invest. In 2009, the U.S. Congress considered establishing an optional federal insurance charter. Support for such a charter increased following the failure of the existing state-by-state regulatory system to act in preventing the problems at insurance giant AIG from becoming a systemic risk to the national economy. Those in favor of an optional federal insurance charter noted that under the current state by state system, insurers face obstacles such as inconsistent regulations, barriers to innovation, conflicting agent licensing, and education requirements. The Wall Street Reform and Consumer Protection Act of 2010 established the Federal Insurance Office (FIO), an entity that reports to Congress and the President on the insurance industry. While the industry continues to be regulated by the states, the FIO has the authority to monitor the insurance industry, identify regulatory gaps or systemic risk, deal with international insurance matters and monitor the extent to which underserved communities have access to affordable insurance products. The Wall Street Reform and Consumer Protection Act also called for the establishment of the Financial Stability Oversight Council (FSOC), which is charged with designating any financial institution (including insurance companies) that presents a systemic risk to the economy and subjecting them to greater regulation. Also the result of the Wall Street Reform and Consumer Protection Act, the Federal Reserve has become a major supervisor of insurance firms. The Fed extended much of its authority over the insurance industry through the designation of three of the largest insurers (American International Group, Prudential Financial, and MetLife) as "systemically important financial institutions." However, with the closure of the Office of Thrift Supervision in 2011, the Fed also supervises 14 insurance companies that own savings institutions. In total, the Fed supervises about one-third of U.S. insurance industry assets. This increased oversight by the Fed has incited concern among insurance companies and state regulators that the Fed will enact onerous capital rules and supervise insurance firms like banks. Promoting the concerns are cases like that of MetLife that failed the Fed's "stress tests" in 2012 despite the firm's protests the Fed misunderstood its business model. In 2015, MetLife sued the U.S. to overturn its designation as a non-bank systemically important financial institution. The insurer argued that its failure would not pose a risk to the financial system. MetLife further argued that, because it is harder for a customer to pull money from an insurance contract than it is for a depositor to withdraw money from a bank deposit account during a crisis, the insurance industry is safer than banking. Not counting on the courts to agree, in 2016 MetLife announced that it would divest a large piece of its life insurance unit: a unit that had been the core of the company's business for decades. However, shortly after this, a federal judge ruled that MetLife did not deserve to be labeled too big to fail and as such was allowed to shed its designation as a systemically important financial institution and the increased regulatory oversight that went along with that designation.

what is meant by an off-balance-sheet activity? what are some of the forces responsible for them?

An off-balance-sheet activity is a transaction, contract, or commitment that a bank enters into but is not directly accounted for on the bank's balance sheet. An item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement. They are often reported in the notes to the financial statement or on a separate schedule. Examples of these are letters of credit, lines of credit, options, forwards, and swaps. Their increase has been a result of increased competition from other financial institutions as well as other risk management and regulatory incentives to move these activities off the balance sheet.

explain how annuities represent the reverse of life insurance activities

Annuities represent the reverse of life insurance principles. While life insurance involves different contractual methods to build up a fund and the eventual payout of a lump sum to the beneficiary, annuities involve different methods of liquidating a fund over a long period of time, such as paying out a fund's proceeds to the beneficiary. The contract may be initiated by investing a lump sum or by making periodic payments before the annuity payments begin.

what are the different firms in the securities industry and how do they differ from each other

Firms in the industry can be divided along a number of dimensions. The largest firms, the so-called national full-line firms, service both retail customers (especially in acting as broker-dealers, thus assisting in the trading of existing securities) and corporate customers (such as underwriting, thus assisting in the issue of new securities). With the changes in the past few years, national full-line firms now fall into three subgroups. First are the commercial bank holding companies that are the largest of the full service investment banks. They have extensive domestic and international operations and offer advice, underwriting, brokerage, trading, and asset management services. The largest of these firms include Bank of America (through their acquisition of Merrill Lynch), Morgan Stanley, and J.P. Morgan Chase (through its many acquisitions, including that of Bear Stearns, for $236 million in 2008). Second are the national full-line firms that specialize more in corporate business with customers and are highly active in trading securities. Examples are Goldman Sachs and Salomon Brothers/Smith Barney, the investment banking arm of Citigroup (created from the merger of Travelers and Citicorp in 1998). Third are the large investment banks. These firms maintain more limited branch networks concentrated in major cities operating with predominantly institutional client bases. These firms include Lazard Ltd. and Greenhill & Co. The rest of the industry is comprised of firms that perform a mix of primary and secondary market services for a particular segment of the financial markets: 1. Regional securities firms that are often subdivided into large, medium, and small categories and concentrate on servicing customers in a particular region, e.g., New York or California (such as Raymond James Financial). 2. Specialized discount brokers that effect trades for customers on- or offline without offering investment advice or tips (such as Charles Schwab). 3. Specialized electronic trading securities firms (such as E*trade) that provide a platform for customers to trade without the use of a broker. Rather, trades are enacted on a computer via the Internet. 4. Venture capital firms that pool money from individual investors and other FIs (e.g., hedge funds, pension funds, and insurance companies) to fund relatively small and new businesses (e.g., in biotechnology). 5. Other firms in this industry include research boutiques, floor specialists, companies with large clearing operations, and other firms that do not fit into one of the preceding categories. This would include firms such as Knight Capital Group (a leading firm in off-exchange trading of U.S. equities) and floor specialist Hilliard Lyons.

what types of fees do hedge funds charge?

Hedge fund managers generally charge two type of fees: management fees and performance fees. As with mutual funds, the management fee is computed as a percentage of the total assets under management and typically run between 1.5 to 2.0 percent. Performance fees are unique to hedge funds. Performance fees give the fund manager a share of any positive returns on a hedge fund. The average performance fee on hedge funds is approximately 20 percent but varies widely. For example, Steven Cohen's SAC Capital Partners charges a performance fee of 50 percent. Performance fees are paid to the hedge fund manager before returns are paid to the funds investors. Hedge funds often specify a "hurdle" rate, which is a minimum annualized performance benchmark that must be realized before a performance fee can be assessed. Further, a "high water mark" is usually used for hedge funds in which the manager does not receive a performance fee unless the value of the fund exceeds the highest net asset value it has previously achieved. High water marks are used to link the fund manager's incentives more closely to those of the fund investors and to reduce the manager's incentive to increase the risk of trades.

what is a hedge fund and how is it different from a mutual fund?

Hedge funds are investment pools that invest funds for (wealthy) individuals and other investors (e.g., commercial banks). They are similar to mutual funds in that they are pooled investment vehicles that accept investors' money and generally invest it on a collective basis. Hedge funds, however, are not subject to the numerous regulations that apply to mutual funds for the protection of individuals, such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in the pricing of funds shares, disclosure regulations, and regulations limiting the use of leverage. Further, hedge funds do not have to disclose their activities to third parties. Thus, they offer a high degree of privacy for their investors. Until 2010, hedge funds were not required to register with the SEC. Thus, they were subject to virtually no regulatory oversight (e.g., by the SEC under the Securities Act and Investment Advisers Act) and generally took significant risk. Even after 2010, hedge funds offered in the United States avoid regulations by limiting the asset size of the fund. Historically, hedge funds avoided regulations by limiting the number of investors to less than 100 individuals (below that required for SEC registration), who must be deemed "accredited investors." To be accredited, an investor must have a net worth of over $1 million or have an annual income of at least $200,000 ($300,000 if married). Institutional investors can be qualified as accredited investors if total assets exceed $5 million. These stiff financial requirements allowed hedge funds to avoid regulation under the theory that individuals with such wealth should be able to evaluate the risk and return on their investments. According to the SEC, these types of investors should be expected to make more informed decisions and take on higher levels of risk. Because hedge funds have been exempt from many of the rules and regulations governing mutual funds, they can use aggressive strategies that are unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading. Further, since hedge funds that do not exceed $100 million in assets under management do not register with the SEC, their actual data cannot be independently tracked. Therefore, much hedge fund data are self-reported. It is estimated that in 2016 there were over 10,000 hedge funds in the world, with managed assets estimated at $2.98 trillion.

how do life insurance companies earn profits

Insurance companies earn profits by taking in more premium income than they pay out in policy payments. Firms can increase their spread between premium income and policy payouts in two ways. The first way is to decrease future required payouts for any given level of premium payments. This can be accomplished by reducing the risk of the insured pool (provided the policyholders do not demand premium rebates that fully reflect lower expected future payouts). The second way is to increase the profitability of interest income on net policy reserves. Since insurance liabilities typically are long term, the insurance company has long periods of time to invest premium payments in interest earning asset portfolios. The higher is the yield on the insurance company's investments, the greater is the difference between the premium income stream and the policy payouts (except in the case of variable life insurance) and the greater is the insurance company's profitability.

what benefits do mutual funds have for individual investors?

Investing in mutual funds allows an investor to achieve a greater level of diversification than could likely be achieved by investing in individual stock on one's own account. A single share of a mutual fund could represent ownership in over a thousand different companies. Whereas the investment in the mutual fund might cost one hundred dollars, buying over a thousand individual shares of stock could cost over one hundred thousand dollars. Further, since mutual funds can buy and sell securities in large blocks, its trading cost are much lower than those of the individual investor buying a few shares at a time

explain the difference between the investing and investment banking activities performed by securities firms and investment banks

Investing involves managing pools of assets such as closed‑ and open‑end mutual funds (in competition with commercial banks, life insurance companies, and pension funds). Securities firms can manage such funds either as agents for other investors or as principals for themselves and their stockholders. The objective in funds management is to choose asset allocations to beat some return‑risk performance benchmark. Investment banking refers to activities related to underwriting and distributing new issues of debt and equity securities. New issues can be either first‑time issues of companies' debt or equity securities or the new (or seasoned) issues of firms whose debt or equity is already trading.

why do commercial banks hold investment securities?

Investment securities consist of items such as interest-bearing deposits purchased from other FIs, federal funds sold to other banks, repurchase agreements, U.S. Treasury and agency securities, municipal securities issued by states and political subdivisions, mortgage-backed securities, and other debt and equity securities. Investment securities generate interest income for the bank and are also used for trading and liquidity management purposes. Many investment securities held by banks are highly liquid, have low default risk, and can usually be traded in secondary markets.

how can life insurance and annuity products be used to create a steady stream of cash disbursements and payments to avoid either the payment or receipt of a single lump sum cash amount?

Life insurance and annuity products can be used to create a steady stream of cash disbursements and payments to avoid paying or receiving a single-lump sum cash amount. That is, a life insurance policy (whole life or universal life) requires regular premium payments that entitle the beneficiary to the receipt of a single lump sum payment. Upon receipt of such a lump sum, a single annuity could be obtained, which would generate regular cash payments until the value of the insurance policy is depleted.

contrast the balance sheets of depository institutions with those of life insurance firms

Life insurance companies have long-term liabilities because of the life insurance products that they sell. As a result, the asset side of the balance sheet predominantly includes long-term government and corporate bonds, corporate equities, and a declining amount of mortgage products. The asset side of a depository institution's balance sheet is comprised primarily of short- and medium-term loans to corporations and individuals and some liquid investment securities (e.g., Treasury securities).

what are long-term mutual funds? in what assets do these funds usually invest? what factors caused the strong growth in this type of fund during the 1990s and the decline in growth in the early and late 2000s?

Long‑term mutual funds primarily invest in assets that have maturities of more than one year. Long-term funds comprise equity funds (composed of common and preferred stock securities), bond funds (composed of fixed-income securities with a maturity of over one year), and hybrid funds (composed of both stock and bond securities). Some money market assets are included for liquidity purposes. Short-term funds comprise taxable money market mutual funds (MMMFs) and tax-exempt money market mutual funds (containing various mixes of those money market securities with an original maturity of less than one year). Long-term equity funds typically are well diversified, and the risk is more systematic or market based. Bond funds have extensive interest rate risk because of their long-term, fixed-rate nature. Sector, or industry-specific, funds have systematic (market) and unsystematic risk, regardless of whether they are equity or bond funds. The principal type of risk for short-term funds is interest rate risk, because of the predominance of fixed-income securities. Because of the shortness of maturity of the assets, which often is less than 60 days, this risk is mitigated to a large extent. Short-term funds generally have virtually no liquidity or default risk because of the types of assets held. The growth in long term funds in the 1990s and early 2000s reflected the dramatic increase in equity returns, as well as the reduction in transaction costs, and the recognition of diversification benefits achievable through mutual funds. The 2008-2009 financial crisis and the collapse in stock and other security prices produced a sharp drop in long-term mutual fund activity. At the end of 2008, total assets fell to $5,435.3 billion. Investor demand for certain types of mutual funds plummeted, driven in large part by deteriorating financial market conditions. Stock market funds suffered substantial outflows, while inflow to U.S. government money market funds reached record highs. As the economy recovered starting in 2009, so did assets invested in mutual funds, growing to $7,873.0 billion by the end of 2011. By 2016, total assets in long-term funds were $13,208.8 billion, far surpassing pre-crisis levels.

what is a money center bank and a regional bank?

Money center banks operate in the global banking market. They are active in international lending and lending to multinational corporations and usually have operations abroad. Moreover, they access international money markets for funds to finance their global asset portfolios. Therefore, money center banks perform intermediation services on a global scale. Regional banks tend to concentrate more on domestic business than do money center banks. They are often market makers for smaller commercial banks in their regions (correspondent banks), providing them with intermediation and information services. They also service the large domestic corporations operating in their region. Size alone, however, does not distinguish money center banks from regional banks. Money center banks tend to be located in the major cities and are also net borrowers of funds in the interbank market. Thus, even though Bank of America is large and located in Los Angeles, it is not classified as a money center because its extensive retail outlet makes it a net supplier of funds in the interbank market. Small commercial banks tend to focus more on local customers. They offer highly personalized service to smaller corporate and individual clients. They rely on regionals and money center banks to obtain more sophisticated money management and information services on behalf of their customers.

how is the net asset value (NAV) of a mutual fund determined? what is meant by the term marked-to-market daily?

Net asset value (NAV) is the average market value of the mutual fund. The total market value of the fund is determined by summing the total value of each asset in the fund. The value of each asset can be found by multiplying the number of shares of the asset by the corresponding price of the asset. Dividing this total fund value by the number of shares in the mutual fund will give the NAV for the fund. The NAV is calculated at the end of each daily trading session, and thus reflects any adjustments in value cased by (a) changes in value of the underlying assets, (b) dividend distributions of the companies held, or (c) changes in ownership of the fund. This process of daily recalculation of the NAV is called marking‑to‑market.

what is a 12b-1 fee? suppose that you have a choice between two mutual funds, one a load fund with no annual 12b-1 fee and the other a no-load fund with a maximum 12b-1 fee. how would the length of your expected holding period influence your choice between these two funds?

No-load funds generally require a small percentage (or fee) of investable funds to meet fund level marketing and distribution costs. Such annual fees are known as 12b-1 fees after the SEC rule covering such charges. The SEC does not limit the size of 12b-1 fees that funds may charge. However, under Financial Industry Regulatory Authority (FINRA) rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund's average net assets per year. FINRA imposes an annual cap of 0.25 percent on shareholder service fees. Because these fees, charged to cover fund operating expenses, are paid out of the fund's assets, investors indirectly bear these expenses. Because the sales load is a one-time charge, it must be converted to an annualized payment incurred by the shareholder over the life of his or her investment. With this conversion, the total shareholder cost of investing in a fund is the sum of the annualized sales load plus any annual fees. Generally, the longer your holding period, the more you would prefer the load fund since a longer holding period would allow you to spread the cost of the load across more years. Eventually, the annualized cost of the load would be less than the annual 12b-1 fee.

what are the economic reasons for the existence of mutual funds?

One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors. By pooling investments from a large number of small investors, portfolio managers are able to hold well-diversified stocks. In addition, they also can obtain cheaper transactions costs and engage in information, research, and monitoring activities at lower costs. Many small investors are able to gain benefits of the money and capital markets by using mutual funds. Once an account is opened in a fund, a small amount of money can be invested on a periodic basis. In many cases, the amount of the investment would be insufficient for direct access to the money and capital markets. On the other hand, corporations are more likely to be able to diversify by holding a large bundle of individual securities and assets, and money and capital markets are easily accessible by direct investment. Further, an argument can be made that the goal of corporations should be to maximize shareholder wealth, not to be diversified.

How does the liability maturity structure of a bank's balance sheet compare with the maturity structure of the asset portfolio? what risks are created or intensified by these differences?

Overall, the liability structure of banks' balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are key exposure concerns for bank managers.

how is the combined ratio defined? what does it measure?

The combined ratio is equal to the loss ratio plus the expense ratio. It is a measure of the overall underwriting profitability of a line, which includes the loss, loss adjustment expenses, and expense ratios. Technically, the combined ratio is equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written. The combined ratio after dividends adds dividends paid to policyholders as a portion of premiums earned to the combined ratio. If the combined ratio is less than 100 percent, premiums alone are sufficient to cover both losses and expenses related to the line. As seen in Table 15-6, this was the case from 2013-2016. The combined ratio before dividends was 95.7, 96.5, 97.6, and 99.5, respectively, over this period.

what are the similarities and differences among the four basic lines of life insurance products

The four basic lines of life insurance products are: (1) ordinary life, (2) group life, (3) credit life, and (4) other activities. Ordinary life is sold on an individual basis and represents the largest segment (77.8% in 2015) of the life insurance market. The insurance policy can be structured as pure life insurance (term life) or may contain a savings component (whole life or universal life). Group policies (21.6%) are similar to ordinary life insurance policies except that they cover a large number of insured persons under a single policy, providing cost economies in evaluating, screening, selling, and servicing the policies. Credit life (<1%) typically is term life sold in conjunction with some debt contract. Their cost per unit of coverage is usually much higher than other methods of covering these liabilities in the event of unexpected death. Thus, they are a rarely used type of life insurance. Other major activities of life insurance companies are the sale of annuities, private pension plans, and accident and health insurance.

what are the key activity areas for securities firms? how does each activity area assist in the generation of profits and what are the major risks for each area?

The key activity areas of security firms are: a) Investment Banking: Investment banks specialize in underwriting and distributing new issues of debt and equity securities. New issues can be placed either privately or publicly and can represent either a first issued (IPO) or a secondary issue. Secondary issues of seasoned firms typically will generate lower fees than an IPO. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the firm acts as the agent and receives a fee based on the success of the offering. The firm serves as a principal by actually takes ownership of the securities in a firm commitment underwriting. Thus, the risk of loss is higher. Finally, the firm may perform similar functions in the government markets and the asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue. b) Venture Capital: A difficulty for new and small firms in obtaining debt financing from commercial banks is that CBs are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm's other owners. c) Market Making: Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. In this capacity, the firms are providing agency transactions for a fee. Security firms also take inventory positions in assets in an effort to profit on the price movements of the securities. These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets. d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, and program trading. Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market. Pure arbitrage involves the purchase and simultaneous sale of an asset in different markets because of different prices in the two markets. Risk arbitrage involves establishing positions prior to some anticipated information release or event. Program trading involves positioning with the aid of computers and futures contracts to benefit from small market movements. In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment banks. e) Investing: Securities firms act as agents for individuals with funds to invest by establishing and managing mutual funds and by managing pension funds. The securities firms generate fees that affect directly the revenue stream of the companies. f) Cash Management: Cash management accounts are checking accounts that earn interest and may be covered by FDIC insurance. The accounts have been beneficial in providing full-service financial products to customers, especially at the retail level. g) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions. For example, they assist in finding merger partners, underwrite any new securities to be issued by the merged firms, assess the value of target firms, recommend terms of the merger agreement, and even assist target firms in preventing a merger (for example, writing restrictive provisions into a potential target firm's securities contracts). h) Other Service Functions: Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis.

who are the major regulators of commercial banks? which banks does each agency regulate?

The key commercial bank regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve System (FRS), and state bank regulators. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks. In so doing, it levies insurance premiums on banks, manages the deposit insurance fund (which is generated from those premiums and their reinvestment), and conducts bank examinations. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision itself is technically made by the bank's chartering or licensing agency. Because of problems in the thrift industry and the insolvency of the savings association insurance fund (FSLIC) in 1989, the FDIC now manages the insurance fund for both commercial banks and savings associations; the fund is called the Depositors Insurance Fund or DIF. The Office of the Comptroller of the Currency (OCC) is the oldest U.S. bank regulatory agency. Its primary function is to charter so‑called national banks as well as to close them. In addition, the OCC examines national banks and has the power to approve or disapprove their merger applications. Instead of seeking a national charter, however, banks can seek to be chartered by 1 of 50 individual state bank regulatory agencies. Historically, state chartered banks have been subject to fewer regulations and restrictions on their activities than national banks. This lack of regulatory oversight was a major reason many banks chose not to be nationally chartered. Many more recent regulations (such as the Depository Institutions Deregulation and Monetary Control Act of 1980) attempted to level the restrictions imposed on federal and state chartered banks. Not all discrepancies, however, were changed and state chartered banks are still generally less heavily regulated than nationally chartered banks. In addition to being concerned with the conduct of monetary policy, the Federal Reserve, as this country's central bank, also has regulatory power over some banks and, where relevant, their holding company parents. Since 1980, all banks have had to meet the same noninterest‑bearing reserve requirements whether they are members of the FRS or not. The primary advantage of FRS membership is direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves. Finally, many banks are often owned and controlled by parent holding companies—for example, Citigroup is the parent holding company of Citibank (a national bank). Because the holding company's management can influence decisions taken by a bank subsidiary and thus influence its risk exposure, the FRS regulates and examines bank holding companies as well as the banks themselves. State-chartered commercial banks are regulated by state agencies. State authorities perform similar functions as the OCC performs for national banks.

what has been the recent trend in the number of commercial banks in the US? what factors account for this trend?

The number of commercial banks has declined from 14,483 in 1984 to 5,289 in 2016. Consolidations in the form of mergers and acquisitions and departures due to bank failures explain the decline. Many of the acquired banks were banks that had failed or were failing.

what are the main advantages of being a member of the Federal Reserve System?

The primary advantages of FRS membership are direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves.

what is venture capital

Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm's other owners. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm's managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be fully informed about the firm's operations, any problems, and whether the joint goals of all of the firm's owners are being met.

which of the insurance lines listed below will be charged a higher premium by insurance companies and why? a) low-severity, high-frequency lines versus high-severity, low-frequency lines b) long-tail versus short-tail lines

a. In general, loss rates are more predictable on low severity, high-frequency lines than on high-severity, low-frequency lines. For example, losses in fire, auto, and homeowners peril lines tend to be expected to occur with high frequency and to be independently distributed across any pool of insured customers. Thus, only a limited number of customers are affected by any single event. Furthermore, the dollar loss of each event in the insured pool tends to be relatively small. Applying the law of large numbers, the expected loss potential of such lines—the frequency of loss times the extent of the damage (severity of loss)—may be estimable within quite small probability bounds. Other lines, such as earthquake, hurricane, and financial guarantee insurance, tend to insure very low-probability (frequency) events. Here, many policyholders in the insured pool are affected by any single event (i.e., their risks are correlated) and the severity of the loss could be potentially enormous. This means that estimating expected loss rates (frequency times severity) is extremely difficult in these coverage areas. As a result, premiums for high-severity low-frequency lines will be charged higher premiums than low-severity high-frequency lines.

in what ways are securities firms and investment banks financial intermediaries?

as with all intermediaries, these firms bring together those who may need extra money with those who wish to invest their money. This may take the form of an investment banker underwriting an IPO for a growing company or a brokerage firm finding a good investment for a client.

what are the major sources of funds for commercial banks in the US? what are the major uses of funds for commercial banks in the US?

major sources are reported on liability side: deposits, borrowed funds, equity; major uses are reported on asset side: loans, securities, cash

what are the differences between community banks, regional banks, and money center banks?

Small or community banks —with less than $1 billion in asset size—tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans and accessing the local deposit base. Clearly, this group of banks is decreasing both in number and importance. In 2016, 88.1 percent of the banks in the United States were classified as community banks. However, these banks held only 7.1 percent of the assets of the banking industry. The relative asset share of the largest banks (over $1 billion in size), on the other hand, increased from 63.4 percent in 1984 to 92.9 percent in 2016. The largest 10 U.S. banks as of 2016 are listed in Table 11-3. The ranking is by size of assets devoted to banking services. The table also lists the assets at the holding company level. Many of these large depository institutions (e.g., J. P. Morgan Chase and Bank of America) operate in other financial service areas (e.g., investment banking and security brokerage) as well. Thus, assets held at the holding company level can be much larger than those devoted to banking services only. Notice that several of these large depository institutions manage assets of over $1 trillion. The majority of banks in the two largest size classes are often either regional or superregional banks. Regional or superregional banks range in size from several billion dollars to several hundred billion dollars in assets. The banks normally are headquartered in larger regional cities and often have offices and branches in locations throughout large portions of the United States. They engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industrial lending (C&I loans), both regionally and nationally. Although these banks provide lending products to large corporate customers, many of the regional banks have developed sophisticated electronic and branching services to consumer and residential customers. Regional and superregional banks utilize retail deposit bases for funding, but also develop relationships with large corporate customers and international money centers. These banks have access to the markets for purchased funds, such as the interbank or federal funds market, to finance their lending and investment activities. Some of the very biggest banks are often classified as being money center banks. U.S.-based money center banks include: Bank of New York Mellon, Deutsche Bank (through its U.S. acquisition of Bankers Trust), Citigroup, J. P. Morgan Chase, and HSBC North America (formerly Republic NY Corporation). It is important to note that asset or lending size does not necessarily make a bank a money center bank. For example, Bank of America Corporation, with $2,189.8 billion in assets in 2016, is not a money center bank, but HSBC North America (with only $295.5 billion in assets) is a money center bank. Classification as a money center bank is based in part on location of the bank and in part on the bank's heavy reliance on nondeposit or borrowed sources of funds. Specifically, a money center bank is a bank located in a major financial center (e.g., New York) that heavily relies on both national and international money markets for its source of funds. In fact, because of its extensive retail branch network, Bank of America tends to be a net supplier of funds on the interbank market (federal funds market). By contrast, money center banks have fewer retail branches and rely heavily on wholesale and borrowed funds as sources of funds. Money center banks are also major participants in foreign currency markets and are therefore subject to foreign exchange risk

what are three sources of underwriting risk in the P&C industry?

. The three sources of underwriting risk in the PC industry are: (a) unexpected increases in loss rates, (b) unexpected increases in expenses, and/or (c) unexpected decreases in investment yields or returns. Loss risk is influenced by whether the product lines are property or liability (with the latter being less predictable), whether they are low-severity, high- frequency lines or high-severity, low-frequency lines (with the latter being more difficult to estimate), and whether they are long-tail or short-tail lines (with the former being more difficult to estimate). Loss rates are also affected by product inflation and social inflation. Unexpected increases in expenses are a result of increases in commission costs to brokers, general expenses, taxes and other expenses related to acquisitions. Finally, investment yields depend on the stock and bond markets as well as on the asset allocations of the portfolios.

what are the major functions performed by the FDIC?

Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of member banks. In so doing, it levies insurance premiums on member banks, manages the deposit insurance fund, and conducts bank examinations. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision itself is technically made by the bank chartering or licensing agency such as the OCC. Because of the problems in the thrift industry and the insolvency of the savings institutions' fund (the FSLIC) in 1989, the FDIC now manages both the commercial bank insurance fund and the S&L insurance fund. The Deposit Insurance fund is called DIF.