FNAN 320: Exam 3 - Chapter PowerPoints

Annuities

- An annuity is a financial instrument in which a person (the "annuitant") makes a payment in exchange for the promise of a series of future payments. - There are fixed-period and lifetime annuities. - And there are deferred versus immediate annuities. - Finally, insurance companies offer fixed versus variable annuities

Lending by the Federal Reserve to Commercial Banks in 1914-1940

- As banks became illiquid in the early 1930s, lending declined - the existence of a lender of last resort is no guarantee it will be used

The future of banks

- In November of 1999, the Gramm-Leach-Bliley Financial Services Modernization Act went into effect - financial holding companies are a limited form of universal banks - in the U.S., the different financial activities must be undertaken in separate subsidiaries and financial holding companies are still prohibited from making equity investments in nonfinancial companies - thanks to recent technological advances, almost every service traditionally provided by financial intermediaries can now be produced independently, without the help of a large organization - as we survey the financial industry, we see the two trends running in opposite directions

Reforming LIBOR

- LIBOR rates are not based on actual transactions as are rates of U.S. treasury bills, but on a daily morning survey of a panel of London Banks - the global dependence on LIBOR as a measure based on good-faith reporting, created incentives for British Bankers Association (BBA) panel banks to manipulate it - In 2012, the UK and US governments revealed the manipulation of LIBOR and announced record fines for two panel banks for multiyear manipulations of LIBOR - Eliminating LIBOR would lead to financial chaise and replacing it would create extensive legal headaches - Officials have suggested changing the method for computing LIBOR and switching from the average of survey responses to the median response

Should the lender of last resort also supervise?

- The crisis exposed faults in every system and strengthened the case for making the central bank the leading financial supervisor. - Multiple regulators complicated the U.S. response. - The United Kingdom's streamlined system facilitated rapid analysis and response, but had problems as their central bank is not the financial supervisor. 1. The lack of immediate, direct access to supervisory information also was a handicap for the European Central Bank (ECB). 2. During the crisis, the ECB acted early to flood the euro-area system with liquidity

Nondepository Institutions

- There are five major categories of nondepository institutions - nondepository institutions alao include an assortment of alternative intermediaries

At their founding, the financial GSEs has similar financial character:

- They issued short term bonds and used the proceeds to provide loans or guarantees of one form or another - because of their implicit relationship to the government, they paid less than private borrowers for their liabilities and passed on some of these benefits in the form of subsidized mortgages and loans

Still riding the GSE train

- U.S. governments role in mortgage finance has become so large that a rapid exit is not an option - In September 2008, amidst the financial crisis, investors shunned the debt of Fannie Mae and Freddie Mac so the U.S. Treasury put these GSEs into federal conservatorship - GSEs assets exceed their equity by more than 40 times - GSEs are profitable again, reducing the pressure on Congress to act on reforms -Many people benefit from the system, but the rate of U.S. ownership has been dropping

The unique role of banks and shadow banks

- as they key providers of liquidity, banks ensure a sufficient supply of the means of payment for the economy to operate smoothly and efficiently - we all rely heavily on these intermediaries for access to the payments system - if they were to disappear, we would no loner be able to transfer funds - other financial institutions do not have these essential day-to-day functions of facilitating payments - because of their role in liquidity provision, banks and shadow banks are prone to runs - they hold illiquid assets to back their liquid liabilities - a bank promise of full and constant value to depositors is based on assets of uncertain value - banks and shadow banks are linked to one another both on their balance sheets and in their customers minds - if a bank begins to fail, it will default on its loan payments to other banks and thereby transmit its financial distress to them - MMMFs hold large volumes of commercial paper, most of which was issued by banks - and (shadow) banks are the key repo lenders to securities brokers and hedge funds - banks and shadow bank are so interdependent they are capable of initiating contagion throughout the financial system - the ramifications of a financial crisis outside the system of banks and shadow banks may be more limited, but they are still damaging - as a result, the government also protects individuals who do business with finance companies, pension funds, and insurance companies

Deregulation provided benefits for the economy

- banks became more profitable - operation costs and loan losses fell - interest rates paid to depositors rose - interest rates charged to borrowers fell

The sources and consequences of runs, panics and crises

- banks fragility arises from the fact that they provide liquidity to depositors 1. they allow depositors to withdraw their balances - if a bank cannot meet this promise of withdrawal on demand because of insufficient liquid assets, it will fail - banks also promise to satisfy depositors withdrawal requests on a first-come, first-served basis - reports that a bank has become insolvent can spread fear that it will run out of cash and close its doors - mindful of the first-come, first-served policy, people rush to the bank to et their money first - such a bank run can cause a bank to fail - no bank is immune to the loss of depositor's confidence just because it is profitable and sound - the largest savings banks in the U.S., Washington mutual, failed in September 2008 - withdrawals from Wachovia Bank, at the time the fourth largest U.S. commercial bank, led to its emergency sale - quiet, invisible runs on shadow banks were even more dramatic - in march 2008, repo lenders and other creditors stopped lending to Bear Sterns, the fifth largest U.S. investment bank - the run halted only when the federal reserve bank of new york stepped in and JPMorgan Chase acquired Bear Sterns

Property and casualty insurance

- car insurance is an example of this - it is a combination of; 1. property insurance on the car itself 2. casualty insurance on the driver, who is protected against liability for harm or injury to other people or their property - holders of property and casualty insurance pay premiums in exchange for protection during the term of the policy

The government safety net

- government officials employ a combination of strategies to protect investors and ensure stability of the financial system - they operate as the lender of last resort - they provide deposit insurance - the safety net causes bank managers to take on too much risk

Regulation and supervision of the financial system

- government officials employ three strategies to ensure that the risk created by the safety net are contained - the goal of government regulation is not to remove all the risk that investors face - financial intermediaries facilitate the transfer and allocation of risk, improving economic efficiency - tightening regulations on banks might push risk taking outside the view of the authorities - banks are regulated and supervised by a combination of the U.S. Treasury, the federal reserve, the FDIC and state banking authorities - the overlapping nature of this regulatory structure means the more than one agency works to safeguard the soundness of each bank - a bank can effectively choose its regulators by choosing whether to be a state or national bank and whether or not to be belong to the federal reserve system - in 2010, the Dodd-Franck Act closed OTC and merged it with the SEC and fulfilling report requirements

Hedge funds

- hedge funds are strictly for millionaires - hedge funds come in two basic sizes: 1. maximum of 99 investors, each with at least $1 million in net worth 2. Maximum of 499 investors, each with at least $5 million in net worth - hedge funds are run by a general partner, or manager, who is in charge of day-to-day decisions - managers are required to keep a large portion of their own money in the fund to solve the problem of moral hazard - hedge funds are not low risk enterprises - because they are set up as private partnerships, they are not constrained in their investment strategies - hedge funds managers typically strive to create returns that roughly equal those of the stock market - while individual hedge funds are very risky, a portfolio that invests in a large number of these funds can expect returns equal to the stock market average with less risk

Defined-benefit pension systems

- if a company goes bankrupt, the pension benefit guaranty corporation (PBGC) will take over the fund's liabilities - increases the incentive for a firm's managers to engage in risky behavior - regulators monitor pension funds regularly

The government as lender of last resort

- in 1873 Walter Bagehot suggested the need for a lender of last resort to make sure solvent institutions can meet their depositors withdrawal demands - significantly reduces, but does not eliminate, contagion - while the Fed had the capacity to operate as the lender of last resort in the 190s, banks did not take advantage of the opportunity - the mere existence of a lender of last resort will not keep the financial system from collapsing - Another flaw in the system is that those who approve the loans must be able to distinguish an illiquid from an insolvent institution 1. During a crisis, computing the market value of a bank's assets is almost impossible - a bank will go to the central bank only after exhausting all other options 1. this need to seek a loan from the government raises the question of its solvency 2. officials are likely to be generous in their evaluation - knowing that the government will be there, also gives bank managers that incentive to take on too much risk 1. the central bank's difficulty in distinguishing a bank's insolvency from its illiquidity creates a moral hazard for bank managers - it is important for a lender of last resort to operate in a manner that minimizes the tendency for bankers to take too much risk - in the crisis of 2007-2009, we learned that the U.S. lender of last resort mechanism has not kept pace with the evolution of the financial system 1. Some intermediaries facing sudden flight were shadow banks, which do not normally have access to Fed loans - by using its emergency lending authority, the Fed was able to lend to such nonbank intermediaries to stem the crisis - during the crisis, the Fed utilized this emergency authority repeatedly when it needed to lend to securities brokers, MMMFs insurers, other nonbank intermediaries and even to nonfinancial firms - Because of this the Fed developed a number of new policy tools to deliver liquidity when and where it was needed

Why you are obliged to buy health insurance

- in 2015 the U.S. supreme court upheld the affordable care act - adverse selection problem for health insurance programs - can be addressed in one of two ways 1. allow price discrimination 2. make insurance mandatory - adverse selection was managed in the U.S. prior to the mainly through participation in group insurance offered through an employer - 18% of the population was uninsured and persons with "preexisting conditions" could not obtain new coverage - advances in DNA testing is adding to the adverse selection problem

Time consistency

- in good times governments and central banks say they will not bail out financial intermediaries - they intermediaries know that in a time of crisis, policymakers will have incentive to bail them out - promises in the good times lack creditability - there is no costless way to overcome the problem of time consistency

Problems created by the government safety net

- in protecting depositors, the government creates moral hazard - comparing bank balance sheets before and after the implementation of deposit insurance: 1. in the 1920s , banks ratio of assets to capital was about 4 to 1 2. today it is about 9 to 1 - most economic historians believe government insurance led to this rise in risk - government officials are worried about the largest institutions because they can pose a threat to the entire financial system if they fail - some intermediaries are treated as too big to fail or too interconnected to fail - in most cases, the deposit insurer quickly finds a buyer for a failed bank or the government may act as the lender of last resort - following the Lehman failure, governments in Europe and the U.S. guaranteed all of the liabilities of their largest banks - during the crisis, governments also recapitalized some intermediaries to prevent a run by their creditors 1. the government gave them public money in return for partial ownership rights - the FDIC shut down 297 banks in 2009 and 2012 - whenever the government provides a safety net without charging an appropriate fee in advance of the protection, they create an incentive for financial institutions to take risks that can threaten the system as a whole - however, in the midst of a crisis, they must balance the often-conflicting goals of crisis management and crisis prevention - in the aftermath of the crisis, limited the unintended consequences of the government safety net is the lending problem facing regulators 1. some argue that too big to fail institutions are just too big and need to be broken up 2. this does not eliminate the ban incentives from deposit insurance and government guarantees to smaller institutions - the conflict between crisis prevention and crisis mitigation exemplifies the problem of time consistency

How much life insurance do you need?

- life insurance is to support people who need it if something happens to you - people with young children need it the most - the best approach is to buy term life insurance - you should consider a term policy worth six to eight times your annual income

The Role of insurance companies

- like life insurers, property and casualty insurers pool risks to generate predictable payouts - they reduce risk by spreading it across many policies - although there is no way to know exactly which policies will require payment, the insurance company can accurately estimate the percentage of policyholders who will file claims - adverse selection and moral hazard create significant problems in the insurance market - insurance companies work hard to reduce both adverse selection and moral hazard - insurance companies might also require deductibles or they may require coinsurance

Bank runs, bank panics and financial crises

- losses on Lehman Brothers debt compelled a money-market mutual fund (MMMF) to "break the buck" to lower its value below $1 - investors in other funds rushed to withdraw their shares at the promised $1 per share - the resulting runs undermined a key components of the U.S. intermediation mechanism

Lender of last resort

- make loans to prevent the failure of solvent banks - provide liquidity in sufficient quantity to prevent or end a financial panic

The day the bank of new york borrowed $23 billion

- on November 20th, 2985, there was a software error at Bank of New York - they made payments without receiving funds - it was committed to paying out $23 billion that it did not have, at least until it could correct the computer error - the Fed, as lender of last resort, stepped in and made a collateralized loan of $23 billion - this prevented a computer problem from becoming a full-blown financial crisis

Types of insurances

- on the balance sheets of insurance companies, these promises to policyholders show up as liabilities - on the asset side, insurance companies hold a combination of stocks and bonds - property and casualty companies profit from the fees they charge for administering the policies they write - because assets as essentially reserves against sudden claims, they have to be liquid - life insurance companies hold assets of longer maturity than property and casualty insurers

Number of ways banks can operate in foreign countries, depend on these legal environment requirements

- open a foreign branch that offers the same services as those in the home country - banks can create an international banking facility (IBF), which allows it to accept deposits from and make loans to foreigners outside the country - the bank can create a subsidiary called an Edge Act corporation, which is established specifically to engage in international banking transactions

Public pensions and the social security system

- pay-as-you-go: transfers tax revenue to current retirees - excess revenue is spent by the treasury - trust fund is in U.S. treasury securities which would have to be repaid with future tax revenue - problems: 1. population is aging so ratio of workers to retirees is falling 2. People are living longer so they receive more in benefits

London Interbank Offered Rate (LIBOR)

- serves as the global benchmark for interest-rate derivates, making is the leading global interest-rate indictor - this is the standard against which many private loan rates are measured - the gap between the LIBOR and expected Fed policy interest rate provides a key measure of the intensity and persistence of the liquidity crisis - it was revealed in 2012 that the LIBOR had been widely manipulated by global banks 1. this has raised doubts about using it as a benchmark 2. Led to government intervention to reform the way LIBOR is determined

Reinsurance and "cat bonds"

- some risks are too big for insurance companies - reinsurance companies insure insurance companies against really big risks - catastrophic bonds allow investors to share some of this risk

Profitability - charter banks depend on this

- state banks have more operational flexibility, which means a better chance of making a profit - if the comptroller of the currency won't let a bank do something, they can always just change their charter

Government-sponsored enterprises

- the U.S. government is directly involved in the financial intermediation system - the risk-taking of government-related intermediaries contributed importantly to the financial crisis of 2007-2009 - a hybrid corporate form know as a government-sponsored enterprise (GSE) is chartered by the government as a corporation with public purpose - the privatized depression-era federal national mortgage association (fannie mae) and a similarly government chartered competing entity, the federal home loan mortgage corporation (freddie mac) are examples - while the debt issued by Fannie and Freddie was not guaranteed by the government, market participants generally assumed that it would be in a crisis - in 1968, Congress also established the government national mortgage corporation (Ginnie Mae) as a GSE that is wholly owned by the federal government - the U.S. government explicitly guarantees Ginnie Mae debt - congress also chartered the student loan marketing association (Sallie Mae) as a GSE, but by 2004 had terminated the charter, making Sallie Maw a wholly private-sector firm

The securities investor protection corporation

- the securities investor protection corporation, SIPC, insures investors from fraud - if a brokerage firm fails and you don't receive the securities you purchased, you are insured - SPIC insurance replaces missing securities or cash that were supposed to be there - up to $500,000 - the SIPC does not insure you against making poor investments

The globalization of Banking

- there are a number of ways banks can operate in foreign countries, depending on factors such as the legal environment - alternatively, a bank holding company can purchase a controlling interest in a foreign bank

Competition and Consolidation

- there are roughly 5400 commercial banks in the U.S. today, and that number has been shrinking - the number of banks with branches has changed significantly as well 1. for many years, most U.S. banks were unit banks, or banks without branches 2. three-quarters of today's banks not only have branches, they have many of them - the primary reason for this structure is the McFadden Act of 1927 - the result was a fragmented banking system nearly devoid of large institutions - we ended up with a network of small, geographically dispersed banks that faced little competition - the opposite of what the act wanted - in many states, more efficient and modern banks were legally precluded from opening branches to compete with local banks - some banks reacted to branching restrictions by creating bank holding companies - in 1956, Congress passed the Bank Holding Company Act - Technology has eroded the value of the local banking monopoly 1. in the 1970s and 1980s, states responded by loosening their branching restrictions - in 1994, Congress passed the Riegel-Neal Interstate Banking and Branching Efficiency Act - deregulation provided benefits for the economy - the financial crisis of 2007-2009 has focused attention on the costs of deregulation 1. do the benefits of deregulation outweigh the risks?

Bank holding Companies

- these are corporations that own a group of other firms - can be thought of as a parent firm for a group of subsidiaries - initially these were created as a way to provide nonbank financial services in more than one state

Too big to fail or too interconnected to fail

- they are too big or too complex to shut down or sell in an orderly fashion without painful spillovers - regulators call such an institution too big to resolve and the Dodd-Frank law gave special legal definition to such a firm: systemically important financial institutions (SIFI)

In terms of the financial system as a whole, insurance companies specialize in three of the five functions performed by intermediaries

- they pool small premiums and make large investment with them - they diversify risks across a large population - they screen and monitor policyholders to mitigate the problem of asymmetric information

Making finance safe

- to absorb large unforeseen losses, banks need to finance themselves with equity not just debt - large capital buffers are the principal mechanism to limit systemic risk and are the most effect response to the too-big-to-fail problem - risk taking being shifted from banks to shadow banks which could offset the gain in safety - ratchet up bank equity capital requirements until the tradeoff between banking efficiency and financial safety shift in favor of the later

A short history on U.S. banking

- to start a bank, one needs permission in the form of a bank charter - until 1863, 1. all ban charters were issued by stat banking authorities 2. there was no national currency so banks issued banknotes - these banknotes did not hold value from one place to another and banks regularly failed - during the civil war, congress passed the national banking act of 1863 - state banks devised another way to make money demand deposits - this is how we got the dual-banking system we have today - about 3/4 quarters have a state charter and the rest of federal charter - which carter a bank chooses depends on its profitability - the great depression lead to the glass steagall act of 1933 - the law separated commercial bans from investment banks 1. separating these two types of banks limited financial institutions from taking advantage of economies of scale and scope that might exist - this changed in 1999 with the Gramm-Leach-Bliley Financial Services Modernization Act which repealed the Glass-Steagall Act - the financial crisis of 2007-2009 lead to the largest reform since the Great Depression, the Dodd-Frank Wall street reform and consumer protection act and 2010.

Sources and Consequences of runs, panics and cirses

- what matters during a bank run is not whether a bank is solvent, but whether it is liquid - solvency means that the value of the bank's assets exceeds the value of its liabilities 1. it has positive net worth - Liquidity means that the bank has sufficient reserves and immediately marketable assets to meet depositors demand for withdrawals - the primary concern is that a single bank's failure might cause a small-scale bank run that could turn into a system-wide bank panic - this phenomenon of spreading panic on the part of depositors in banks is called contagion - this was powerful at the peak of the 2007-2009 financial crisis - information asymmetries are the reason that a run on a single bank can turn into a bank panic - depositors are in the same position as uninformed buyers in the used car market - cannot tell the difference between a good bank and a bad bank - anything that affects borrowers ability to make their loan payments or drives down the market value of securities has the potential to imperil the bank's finances - downturns in the business cycle put pressure on banks, increasing the risk of panics - financial disruptions can also occur whenever borrowers net worth falls, like during deflation

Regulators of Depository Institutions

1. Commercial banks - regulators: 1. federal deposit insurance corporation 2. office of the comptroller of the currency 3. federal reserve system 4. state authorities 2. Savings banks/saving loans - regulators: 1. office of the comptroller of the currency 2. federal deposit insurance corporation 3. state authorities 3. Credit Unions - regulators: 1. national credit union administration 2. state authorities

Most finance companies specialize in one of three loan types:

1. Consumer loans 2. Business Loans 3. Sales loans - some also provide commercial and home mortgages

There are two basic pension fund types:

1. Defined-benefit (DB) pension plans 2. Defined-contribution (DC) pension plans

Two types of insurance

1. Life insurance 2. Property and casualty insurance

Consequences of regulatory competition

1. Regulators force each other to innovate, improving the quality of the regulations they write 2. It allows bank managers to shop for the most lenient regulator - the one whose rules and enforcement are the least stringent

Owners and managers of these financial firms cite three reasons to create them:

1. Their range of activities, if properly managed, permits them to be well diversified 2. These firms are large enough to take advantage of economies of scale 3. These companies hope to benefit from economies of scope

There are three reasons for the government to get involved in the financial system:

1. To protect investors 2. to protect bank customers from monopolistic exploration 3. to safeguard the stability of the financial system

Examples of how to get rid of adverse selection and moral hazard

1. a person wanting life insurance needs a physical exam 2. people who want auto insurance must provide their driving records 3. policies also include restrictive covenants that require the insured to engage or not to engage in certain activities

Primary services of brokerage firms are:

1. accounting - to keep track of customers investment balances 2. custody services - to make sure valuable records such as stock certificates are safe 3. access to secondary markets - in which customers can buy and sell financial instruments

Give major categories of nondepository institutions

1. insurance companies 2. pension funds 3. securities firms, including brokers, mutual-fund companies, and investment banks 4. finance companies 5. government-sponsored enterprises

Regulatory requirements designed to minimize the cost of failures to the public:

1. new banks must obtain a charter 2. once open, regulations: - restricts competition - specifies what assets the bank can and cannot hold - requires the bank to hold a minimum level of capital - makes public information about the banks balance sheet

The national banking act of 1863

1. state banks were not eliminated, but did impose a 10% tax on their bank notes 2. The act created a system of federally chartered banks, or national banks 3. National banks could issue banknotes tax-free

To obtain insurance, a ship's owner would:

1. write the details of the proposed voyage 2. add the amount he was willing to pay for the service 3. circulate the paper among the patrons at Lloyd's coffeehouse 4. Interested individuals would decide how much to risk and sign their names - the underwriters

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Aims to prevent financial crises and government bailouts and intermediaries, partly through government oversight of systemically important financial institutions - requires closer government oversight over key establishments called systemically important financial institutions (SIFS) regardless of their legal form - sharply alters the authorities of the government agencies that govern the financial system - it also forbids depositories from proprietary trading

Bank Holding Company Act of 1956

Allowed bank holding companies to provide various nonbank financial services

Dual banking system

Banks can choose whether to get their charters from the Comptroller of the Currency at the U.S Treasury or from state officials.

Government Deposit Insurance

Congress response to the Fed's inability to stem the bank panics of the 1930s was to create nationwide deposit insurance

The glass-steagall act of 1933

Established federal deposit insurance and prohibited commercial banks from engaging in the insurance and securities businesses - created the federal deposit insurance corporation (FDIC) - severely limited the activities of commercial banks - provided insurance to individuals depositors, so they would not lose their savings in the event that a bank failed - restricted bank assets t certain approved forms for debt

Insurance companies

Modern forms of insurance can be traced back to around 1400, when wool merchants insured their overland shipments from London to Italy for 12 to 15 percent of their value - the first insurance codes were developed in Florence in 1523, specifying the standard provisions for a general insurance policy 1. They also stipulated procedures for handling fraudulent claims in an attempt to reduce the moral hazard problem - 1688, Lloyd's of London was established and began to insure ships on trade routes:

Gramm-Leach- Bliley Act of 1999

Repealed by Glass-Steagall Act's prohibition of mergers between commercial banks and insurance companies or securities firms - this effectively repealed the Glass-Steagall Act of 1933 - it allowed a commercial bank, investment bank, and insurance company to merge and form a financial holding company - to serve all their customers financial needs, bank holding companies are converting to financial holding companies

Riegel-Neal Interstate Banking and Branching Efficiency Act of 1994

Repealed the McFadden Act's prohibition of interstate branching - this legislation reversed restrictions from the McFadden Act - Since 1977, banks have been able to acquire an unlimited number of branches nationwide - the number of commercial banks has fallen by about one-half - the number of savings institutions has fallen even more

The combustible mix of liquidity risk and information symmetries means that the financial system in inherently unstable

a financial institution can create and destroy the value of its assets in a short period of time - a single firm's failure can bring down the entire system

Adverse selection

a person with terminal cancer has an incentive to buy life insurance for the largest amount possible

Eurodollars

are dollar-denominated deposits in foreign banks - originally the euromarket was a response to restrictions on the movement of international capital that were instituted with the Bretton Woods system of exchange rate management 1. to ensure the pound would retain its value, the British government imposed restrictions on the ability of British banks to finance international transactions 2. In an attempt to evade these restrictions, London banks began to offer dollar deposits and dollar denominated loans to foreigners - the eurodollar market in London is one of the biggest and most important financial markets in the world - the interest rate at which banks lend each other eurodollars is called the London Interbank Offered Rate (LIBOR)

Investment banks

are the conduits through which firms raise funds in the capital market - through their underwriting services, these investment banks issue new stocks and a variety of other debt instruments - the underwriter guarantees the price of a new issue and then sells it to investors at a higher price - this is a practice called placing the issue - the underwriter profits from the difference between the price guaranteed to the firm that issues the security and the price at which the bond or stock is sold to investors - since the price at which the investment bank sells the bonds or stocks in financial markets can turn out to be lower than the price guaranteed by the issuing company, there is some risk to underwriting - for large issues, investors will band together and spread the risk among themselves rather than one taking the risk alone - also provide advice to firms that want to merge with or acquire other firms - investment bankers do the research to identify potential margers and acquisitions and estimate the value of the new, combined company - in facilitating these combinations, investment banks perform a service to the economy - mergers and acquisitions help to ensure that the people who manage firms do the best job possible

Unit banks

banks without branches

Business finance

companies provide loans to businesses - also provide both inventory loans and accounts receivable loans

Sales finance

companies specialize in larger loans for major purchases, such as automobiles

Government regulation

established a set of specific rules for intermediaries to follow

Consumer finance

firms provide small installment loans to individual consumers

Deposit insurance

guaranteeing that depositors receive the full value of their accounts if the institution fails

The Federal deposit insurance corporation (FDIC)

guarantees that a depositor will receive the full account balance up to some maximum amount even if a bank fails - bank failures, in effect, become the problem of the insurer; bank customers need not worry - when a bank fails, the FDIC resolves the insolvency either by closing the institution or finding a buyer - closing the bank is called payoff method - the second approach, and more commonly applied is called the purchase and assumption method - because the U.S. treasury backs the FDIC, it can withstand virtually any crisis that does not undermine the nations sovereign credit standing - deposit insurance clearly helped to prevent runs on commercial banks - however, it did not prevent the crisis of 2007-2009 and the runs associated with it. 1. deposit insurance only covers depository institutions - however, as the system developed, shadow banks gained importance 1. they too face the risk of runs by their short-term creditors 2. these nonbanks lack the benefits of deposit insurance

Cat bonds

if there is no catastrophe, they pay a high return - if a specific event (described in the bond) occurs, they pay nothing

Whole life insurance

is a combination of term life insurance and a savings accounts - the policyholder pays a fixed premium over his/her lifetime in return for a fixed benefit wen the policyholder dies - tends to be an expensive way to save so its use a savings vehicle has declined

U.S. Banking system

is composed of a large number of very small banks and a small number of very large ones

Too-big-to fail policy

is ripe from reform - normally, the fear of withdraw of large depositors from a bank or MMF restrains them from taking too much risk - but the too-big-to-fail policy renders to deposit insurance ceiling meaningless - compounds the problems or moral hazard

life insurance

it comes in two basic forms: 1. Term life insurance 2. While life insurance

Lender of last resort

making loans to banks that face sudden deposits outflows

The government is obligated to protect small investors

many are unable to judge the soundness of their financial institution - competition is supposed to discipline all the institutions in the industry, but only the force of law can ensure a bank's integrity

The growing tendency for small firms to merge into large ones reduced competition

monopolies are inefficient, so they government intervenes to prevent the firms in an industry from becoming too large - in the financial system, that means making sure even large banks face competition

Government examination

of an institution's books by specialists provides detailed information on the firm's operation

Mutual-funds

offer liquidity services as well - the primary function of mutual funds, is to pool the small savings of individuals in diversified portfolios that are composed of a wide variety of financial instruments

Pension Funds

offers people the ability to make premium payments today in exchange for promised payments under certain future circumstances - provides a way to make sure that a worker saves and has sufficient resources in old age - they help savers to diversify their risk - by pooling the savings of many small investors, pension funds spread the risk - people can use a variety of methods to save for retirement, including employer sponsored plans and individual savings plans - many employer-sponsored plans require a person work for a certain number of years before qualifying for benefits, a process called vesting - the balance sheets of pension funds look like those of life insurance companies - both hold long-term assets like corporate bonds and stocks - the only difference is that life insurance companies hold only half the equities that pension funds do - the U.S. government provides insurance for private defined-benefit pension systems

The McFadden Act of 1927

out lawed interstate branching and required national banks to abide by the laws of the states in which they operated - This legislation required that nationally chartered banks meet the branching restrictions of the states in which they were located - Some states have laws forbidding branch banking, resulting in a large number of small banks - there was fear that large banks would drive small banks out of business, reducing the quality in smaller communities

Defined-benefit plans

participants receive a life-time retirement income based on the number of years they worked at the company and their final salary

Brokers

provide loans to customers who wish to purchase stock on margin - they provide liquidity, both by offering check writing privileges with their investment accounts and by allowing investors to sell assets quickly

Term life insurance

provides a payment to the policy holder's beneficiaries in the event of the insured's death at any time during the policy's term - generally renewable every year as long as the policyholder is less than 65 years old

Government supervision

provides general oversight of financial institutions

Finance companies

raise funds directly in the financial markets by issuing commercial paper and securities and then use them to make loans to individuals and corporations - they are concerned largely with reducing the transactions and information costs that are associated with intermediated finance - because of their narrow focus, finance companies are particularly good at: 1. screening potential borrowers creditworthiness 2. monitoring their performance during the term of the loan 3. seizing collateral in the event of a default

Regulator Shopping

results in ineffective oversight from the financial crisis of 2007-2009 highlighted in these cases - AIG was supervised by the U.S. Office of Thrift Supervision (OTS) that also had supervised failed savings banks like countrywide, IndyMac and Washington Mutual - they has less expensive than other supervisors with the insurance business, especially the complexity of AIG

Purchase-and-assumption method

the FDIC finds a firm willing to take over the failed bank - depositors prefer this method - the transaction is typically seamless - no depositors suffer a loss

Payoff method

the FDIC pays off all the bank's depositors, then sells all the bank's assets

Universal banks

these are firms that engage in nonfinancial as well as financial activities

Defined-contribution plans

these are replacing defined benefit plans - sometimes referred to as "401(k)" after their IRS code - the employer takes no responsibility for the size of the employee's retirement income

Deductibles

these require the insured to pay the initial cost of repairing accidental damage, up to some maximum amount

Coinsurance

this is where the insurance company shoulders a percentage of the claim, usually 80 to 90 percent and the insured assumes the rest

underwriters

underwriting implied unlimited liability

Are your deposit insured?

what does "each depositor insured to $250,000 really mean? 1. Deposit insurance covers individuals, not accounts 2. If you have more than one account at the same bank, all in your name, they will be insured together up to the insurance limit 3. If you have accounts at more than one bank, they will be insured separately, up to the insurance limit at each bank 4. The rules for government deposit insurance can change

Moral hazard

without fire insurance, people would have more fire extinguishers in their houses