FMI Chapter 2: Financial Institutions in The Financial System PDF

Chapter 2 Financial Institutions  2 Outline Facts About Financial Structure Role of Financial Institutions Depository Financial Institutions (Banks) Banking and the Management of Financial Institutions Banking Industry: Structure a...

Chapter 2 Financial Institutions  2 Outline Facts About Financial Structure Role of Financial Institutions Depository Financial Institutions (Banks) Banking and the Management of Financial Institutions Banking Industry: Structure and Competition Non-Depository (Non-Bank) Financial Institutions Investment Companies (Mutual Funds) Investment Companies, Brokerage Firms and Dealers Insurance Companies Pension Funds  3 2.1. Facts of Financial Structure Facts About Financial Structure Throughout the World  4 Cont‘d I. Stocks are not the most important source of finance for businesses. II. Issuing marketable securities is not the primary funding source for businesses. III. Indirect finance (financial intermediation) is far more important than direct finance. IV. Banks are the most important source of external finance. V. The financial sector is among the most heavily regulated. VI. Only large, well established firms have to securities access markets. VII. Collateral is a prevalent feature of debt contracts. VIII. Debt contracts are typically extremely complicated legal documents with restrictive covenants. Services of Financial Institutions Transforming Financial Assets Exchanging Financial Assets on Behalf of Customers Exchanging Financial Assets for Own Account Assisting in the Creation of Financial Assets Providing Investment Advice Managing Portfolios Role of Financial Institutions  Transfer of funds from savers to investors  Providing Maturity Intermediation  Reducing Risk Through Diversification  Reducing Costs of Contracting and Information Processing  Providing a Payments Mechanism  Reducing asymmetric information  5 Role of Financial Institutions Reducing Transaction Costs Transactions costs influence financial structure For example, an individual with limited income may fail to diversify his/her portfolio. Transactions costs can hinder the flow of funds to people with productive investment opportunities Financial intermediaries make profits by reducing transactions costs 1. Take advantage of economies of scale (example: mutual funds) 2. Develop expertise to lower transactions costs Also provides investors with liquidity  6 Cont‘d Reducing Asymmetric Information Asymmetric information occurs when one party to a transaction has more information than the other. We focus on two specific forms: Adverse selection Moral hazard The analysis of how asymmetric information problems affect behavior is known as agency theory.  7 Cont‘d Adverse Selection Occurs when one party in a transaction has better information than the other party Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected Moral Hazard Occurs when one party has an incentive to behave differently once an agreement is made between parties After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back.  15 Cont‘d  25 2.3. Depository Financial Institutions (Banks) Depository institutions are financial intermediaries that accept deposits from individuals and institutions and make loans. These institutions include commercial banks and the so- called thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions. Commercial Banks raise funds primarily by issuing checkable deposits (deposits on which checks can be written), savings deposits (deposits that are payable on demand but do not allow their owner to write checks), and time deposits (deposits with fixed terms to maturity).  26 Cont’d They then use these funds to make commercial, consumer, and mortgage loans and to buy government bonds and treasury bills. Savings and Loan Associations (S&Ls) and Mutual Savings Banks: These depository institutions obtain funds primarily through savings deposits (often called shares) and time and checkable deposits. In the past, these institutions were constrained in their activities and mostly made mortgage loans for residential housing. Over time, these restrictions have been loosened so that the distinction between these depository institutions and commercial banks has blurred. These intermediaries have become more alike and are now more competitive with each other.  27 Cont’d Credit Unions/Cooperatives: These financial institutions are typically very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans.  28 2.4. Banking and the Management of Financial Institutions Banks play an important role in channeling funds to finance productive investment opportunities. They provide loans to businesses, finance college educations, and allow us to purchase homes with mortgages. In the commercial banking setting, it is important to look loans, balance sheet management, and income determinants to understand how banking is conducted to earn the highest profits possible.  29 The Bank Balance Sheet The Balance Sheet is a list of a bank‘s assets and liabilities Total assets = total liabilities + capital A bank‘s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers  30 The Bank Balance Sheet – US Example  31 Basics of Banking Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan. Banks tend to ―borrow short and lend long(in terms of maturity). T-account Analysis: Deposit of $100 cash into First National Bank  32 Cont’d Deposit of $100 check (written on an account at another bank, say, the Second National Bank) The First National Bank deposits the check in its account at the Fed/NBE, and the Fed collects the funds from the Second National Bank. Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount.  33 Cont’d Deposit of $100 cash into First National Bank assuming Required Reserve ratio of 10%. $10 the deposit must remain in reserves to meet federal of regulations (10% reserve req.). Now, the bank is free to work with the $90 in its transformation asset function. In this case, the bank loans the $90 to its customers.  34 Cont’d Loaning out excess reserves  35 General Principles of Bank Management Now let‘s look at how a bank manages its assets and liabilities. The bank has four primary concerns: 1. Liquidity management 2. Asset management 3. Liability management 4. Managing capital adequacy  36 Liquidity management Let us see how a typical bank, the First National Bank, can deal with deposit outflows that occur when its depositors withdraw cash from checking or savings accounts or write checks that are deposited in other banks. In the example that follows, we assume that the bank has ample excess reserves and that all deposits have the same required reserve ratio of 10% (the bank is required to keep 10% of its time and checkable deposits as reserves).  37 Cont’d The first T–Account shows the First National Bank‘s initial balance sheet. The bank‘s required reserves are 10% of $100 million, or $10 million. Given that it holds $20 million of reserves, the First National Bank has excess reserves of $10 million. When a deposit outflow of $10 million occurs, the bank‘s balance sheet is shown in the bottom T–Account.  38 Liquidity management  39 Cont’d The situation is quite different when a bank holds insufficient excess reserves. Let‘s assume that instead of initially holding $10 million in excess reserves, the First National Bank makes additional loans of $10 million, so that it holds no excess reserves.  40 Cont’d  41 Cont’d After $10 million has been withdrawn from deposits and hence reserves, the bank has a problem: It has a reserve requirement of 10% of $90 million, or $9 million, but it has no reserves! To eliminate this shortfall, the bank has four basic options. One is to acquire reserves to meet a deposit outflow by borrowing them from other banks in the federal funds market or by borrowing from corporations. The cost of this activity is the interest rate on these borrowings, such as the federal funds rate. A second alternative is for the bank to sell some of its securities to help cover the deposit outflow. The bank incurs some brokerage and other transaction costs when it sells these securities.  42 Cont’d  43 Cont’d A third way that the bank can meet a deposit outflow is to acquire reserves by borrowing from the Fed. In our example, the First National Bank could leave its security and loan holdings the same and borrow $9 million in discount loans from the Fed. The cost associated with discount loans is the interest rate that must be paid to the Fed (called the discount rate). Finally, a bank can acquire the $9 million of reserves to meet the deposit outflow by reducing its loans by this amount and depositing the $9 million it then receives with the Fed, thereby increasing its reserves by $9 million.  44 Cont’d  45 Asset Management Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. I. Get borrowers with low default risk, paying high interest rates II. Buy securities with high return, low risk III. Diversify IV. Manage liquidity  46 Liability Management Liability Management: managing the source of funds, from deposits, to CDs (Certificates of deposit), to other debt - overnight loan markets. I. No longer primarily depend on checkable deposits II. When see loan opportunities, borrow or issue CDs to acquire funds This new flexibility in liability management meant that banks could take a different approach to bank management. The greater emphasis on liability management explains some of the important changes over the past three decades in the composition of banks‘ balance sheets.  47 Capital Adequacy Management Banks have to make decisions about the amount of capital they need to hold for the following main reasons. 1. Bank capital is a cushion that prevents bank failure. For example, consider these two banks:  48 Cont’d What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Let‘s assume both banks lose $5 million from bad loans. Impact of $5 million loan loss  49 Cont’d Conclusion: A bank maintains reserves to lessen the chance that it will become insolvent: it does not have sufficient assets to pay off all holders of its liabilities. When a bank becomes insolvent, government regulators close the bank, its assets are sold off, and its managers are fired. So, why don‘t banks want to hold a lot of capital? Answer next slide.  50 Cont’d 2. Higher is bank capital, lower is return on equity Capital , EM , ROE   51 Cont’d 3. Trade-off between safety and returns to equity holders: Benefits the owners of a bank by making their investment safe Costly to owners of a bank because the higher the bank capital, the lower the return on equity Choice depends on the state of the economy and levels of confidence  52 Cont’d 4. Banks also hold capital to meet capital requirements. The Basel Committee on Banking Supervision sets minimum capital requirements - the ratio of bank capital to risk weighted assets.  53 Strategies for Managing Capital: As the manager of the First National Bank, you have to make decisions about the appropriate amount of bank capital to hold in your bank. To raise its capital, a bank can issue more equities, reduce dividends to shareholders, or reduce the bank‘s assets by making fewer loans. To reduce its capital, a bank can sell or retire stock (repurchased out of the company's retained earnings), increase dividends to reduce retained earnings, increase asset growth via debt (like CDs). Our discussion of the strategies for managing bank capital leads to the following conclusion: A shortfall of bank capital is likely to lead a bank to reduce its assets and therefore is likely to cause a contraction in lending.  54 How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis Shortfalls of bank capital led to slower credit growth: Huge losses for banks from their holdings of securities backed by residential mortgages. Losses reduced bank capital Banks could not raise much capital on a weak economy and had to tighten their lending standards and reduce lending.  55 Off-Balance-Sheet Activities Although asset and liability management has traditionally been the major concern of banks, in the more competitive environment of recent years banks have been aggressively seeking out profits engaging by in off- balance-sheet activities. Off-balance-sheet activities involve trading instruments and generating income from fees and loan financial sales, activities that affect bank profits but do not appear on bank balance sheets.  56 Cont’d Loan sales (secondary loan participation) Involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan from the bank‘s balance sheet. Banks earn profits by selling loans for an amount slightly greater than the amount of the original loan. Generation of fee income, Examples: Making foreign exchange trades on a customer‘s behalf, Servicing a mortgage-backed security by collecting interest and principal payments and then paying them out, Guaranteeing debt securities such as banker‘s acceptances (by which the bank promises to make interest and principal payments if the party issuing the security cannot), and providing backup lines of credit.  57 Cont’d Other lines of credit for which banks get fees include standby letters of credit to back up issues of commercial paper and other securities and credit linesunder writing Euronotes, which are medium-term Eurobonds. Creating SIVs (structured investment vehicles), which can potentially expose banks to risk, as it happened in the global financial crisis. Off-balance-sheet activities involving guarantees of securities and backup credit lines increase the risk a bank faces. Even though a guaranteed security does not appear on a bank balance sheet, it still exposes the bank to default risk: If the issuer of the security defaults, the bank is left holding the bag and must pay off the security‘s owner.  58 Cont’d Trading activities and risk management techniques: Banks‘ attempts to manage interest-rate risk have led them to trading in financial futures, options for debt instruments, and interest-rate swaps. Banks engaged in international banking also conduct transactions in the foreign exchange market. Although bank trading in these markets is often directed toward reducing risk or facilitating other bank business, banks may also try to outguess the markets and engage in speculation. Trading activities, although often highly profitable, are dangerous because they make it easy for financial institutions and their employees to make huge bets quickly. Principal-agent problem arises  59 Cont’d Given the ability to place large bets, a trader (the agent), whether she trades in bond markets, in foreign exchange markets, or in financial derivatives, has an incentive to take on excessive risks: If her trading strategy leads to large profits, she is likely to receive a high salary and bonuses, but if she takes large losses, the financial institution (the principal) will have to cover them. Internal controls to reduce the principal-agent problem: Complete separation of the people in charge of trading activities from those in charge of the bookkeeping for trades. Managers must set limits on the total amount of traders‘ transactions and on the institution‘s risk exposure. Managers must also scrutinize risk assessment procedures using the latest computer technology. One such method involves the value-at-risk approach. In this approach, the institution develops a statistical model with which it can calculate the maximum loss that its portfolio is likely to sustain over a given time interval, dubbed the value at risk, or VAR.  60 Measuring Bank Performance Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts: Operating Income Operating Expenses Net Operating Income Note how this is different from, say, a manufacturing firm‘s income statement.  61 Measuring Bank Performance - Banks’ Income Statement  62 Cont’d  63 Cont’d  64 Cont’d  66 Financial Innovation Innovation is result of search for profits. A change in the financial environment will stimulate a search for new products and ideas that are likely to increase the bottom line. There are generally three types of we can changes examine: 1. Response to Changes in Demand Conditions 2. Response to Changes in Supply Conditions 3. Avoidance of Existing Regulation  79 2.6. Non-Depository (Non-Bank) Financial Institutions Non-depository institutions serve as the intermediary between the savers and the borrowers, but they do not accept deposits. Such institutions perform their activities of lending to the public either by way of selling securities or through the insurance policies. Non-depository institutions include investment companies, insurance companies, brokerage firms, and pension funds.  80 A. Investment Companies (Mutual Fund) i. Introduction Investment companies are financial intermediaries that sell shares to the public and invest the proceeds in a diversified portfolio of securities. Each share sold represents a proportional interest in the portfolio of securities managed by the investment company on behalf of its shareholders. The type of securities purchased depends on the company's investment objective..  81 Cont’d When investors decide to invest in a particular asset class, such as equities, there are two ways they can do it: direct investment or indirect investment. Direct investment is when an individual personally buys shares in a company, such as buying shares in Apple, the technology giant. Indirect investment is when an individual buys a stake in an investment fund, such as a mutual fund that invests in the shares of a range of different types of companies, perhaps including Apple. Achieving an adequate spread of investments through holding direct investments can require a significant amount of money and, as a result, many investors find indirect investment very attractive.  82 Cont’d There a range of funds available that pool the resources is of a large number of investors to provide access to a range of investments. These pooled funds are known as collective investment schemes (CISs), funds, or collective investment vehicles. The term ‗collective investment scheme‘ is an internationally recognized one, but investment funds are also very well-known by other names, such as mutual funds, unit trusts or open-ended investment companies (OEICs). Investment funds may structure as open-ended funds and closed-ended funds.  83 Cont’d An open-ended fund is one that can create new shares in response to investor demand or cancel them when sold so that their capital can expand or contract – an example is a mutual fund. A closed-ended fund, by contrast, has a fixed capital base so if an investor wants to buy shares they will do so on the stock exchange and buy them from another investor who wants to sell. They have a fixed capital base as is seen with US closed-ended funds. Funds may be established in one country and then marketed internationally.  85 ii. The Benefits of Collective Investment Investment funds pool the resources of a large number of investors, with the aim of pursuing a common investment objective. This pooling of funds brings a number of benefits, including: Economies of scale - commission as a proportion of the fund is very small. Diversification - risk is lessened when the investor holds a diversified portfolio of investments (in many different sectors). Access to professional investment management – however, entry fees, exit charges and annual management fees applies, these are needed to cover the fund managers‘ salaries, technology, research, their dealing, settlement and risk management systems, and to provide a profit. Access to geographical markets, asset classes or investment strategies which might otherwise be inaccessible to the individual investor In some cases, the benefit of regulatory oversight In some cases, tax deferral. Bank Risk: Where It Comes from and What to Do about It The bank’s goal is to make a profit in each of its lines of business. They want to pay less for the deposits they receive than for the loans they make and the securities they buy. In the process of doing this, the bank is exposed to a host of risks: Liquidity risk, Credit risk, Interest-rate risk, and Trading risk. 12-90  Liquidity Risk Liquidity risk is the risk of a sudden demand for liquid funds. Banks face liquidity risk on both sides of their balance sheets. Deposit withdrawal is a liability-side risk. Things like lines of credit are an asset-side risk. Even if a bank has a positive net worth, illiquidity can still drive it out of business. 12-91  Liquidity Risk In the past, the common way to manage liquidity risk was to hold excess reserves. This is a passive way to manage liquidity risk. Holding excess reserves is expensive, because it means forgoing higher rates of interest than can be earned with loans or securities. There are two other ways to manage liquidity risk. The bank can adjust its assets or its liabilities. 12-92  Liquidity Risk On the asset side a bank has several options. 1. The easiest option is to sell a portion of its securities portfolio. Most are U.S. treasuries and can be sold quickly at relatively low cost. Banks that are particularly concerned about liquidity risk can structure their securities holdings to facilitate such sales. 12-93  Liquidity Risk 2. A second possibility is for the bank to sell some of its loans to another banks. Banks generally make sure that a portion of the loans they hold are marketable for this purpose. 3. Another way is to refuse to renew a customer loan that has come due. However this is bad for business. The bank can lose a good customer. Reducing assets lowers profitability. 12-94  Liquidity Risk Bankers prefer to use liability management to address liquidity risk. 1. Banks can borrow to meet any shortfall either from the Fed or from another bank. 2. The bank can attract additional deposits. This is where large certificates of deposits are valuable: They allow banks to manage their liquidity risk without changing the asset side of their balance sheet. 12-95  Liquidity Risk In the financial crisis of 2007-2009, banks could neither sell their illiquid assets nor obtain funding at a reasonable cost to hold those assets. When the interbank lending market dried up, many banks faced a threat to their survival. 12-96  Credit Risk The risk that a bank’s loans will not be repaid is called credit risk. To manage credit risk, banks use a variety of tools. 1. Diversification is where banks make a variety of different loans to spread the risk. 2. Credit risk analysis is where the bank examines the borrower’s credit history to determine the appropriate interest rate to change. 12-97  Credit Risk Diversification can be difficult for banks, especially if they focus on a certain type of lending. If a bank lends in only one geographic area or one industry, it is exposed to economic downturns that are local or industry-specific. It is important that banks find a way to hedge these risks. 12-98  Credit Risk Credit risk analysis produces information that is very similar to the bond rating systems in Chapter 7. Banks do this for small firms wishing to borrow, and credit rating agencies perform the service for individual borrowers. The result is an assessment of the likelihood that a particular borrower will default. In the financial crisis of 2007-2009, banks underestimated the risks associated with mortgage and other household credit. 12-99  A bank’s capital is its net worth - a cushion against many risks, including market risk. Market risk is the decline in the market value of assets. The larger a bank’s capital cushion, the less likely it will be made insolvent by an adverse surprise. In the financial crisis of 2007-2009, banks were too leveraged - they had too many assets for each unit of capital. 12-100  Mark-to-market accounting rules require banks to adjust the recorded value of the assets on their balance sheets when the market value changes. When the price falls, the value is “written down” and writedowns reduce a bank’s capital. Banks don’t like to hold a large capital cushion because capital is costly. The more leverage the greater the possible reward for each unit of capital and the greater the risk. 12-101  Interest-Rate Risk A bank’s liabilities tend to be short-term, while assets tend to be long term. The mismatch between the two sides of the balance sheet create interest-rate risk. When interest rates rise, banks face the risk that the value of their assets will fall more than the value of their liabilities, reducing the bank’s capital. Rising interest rates reduce revenues relative to expenses, directly lowering a bank’s profits. 12-102  Interest-Rate Risk The term interest-rate sensitive means that a change in interest rates will change the revenue produced by an asset. For a bank to make a profit, the interest rate on its liabilities must be lower than the interest rate on its assets. The difference in the two rates is the bank’s net interest margin. When a bank’s liabilities are more interest-rate sensitive than its assets, an increase in interest rates will cut into the bank’s profits. 12-103  Interest-Rate Risk The first step in managing interest-rate risk is to determine how sensitive the bank’s balance sheet is to a change in interest rates. Managers must compute an estimate of the change in the bank’s profit for each one- percentage-point change in the interest rate. This procedure is called gap analysis. This can be refined to take account of differences in the maturity of assets and liabilities, but it gets complicated. 12-104  Interest-Rate Risk Bank managers can use a number of tools to manage interest-rate risk. 1. They can match the interest-rate sensitivity of assets with that of liabilities. Although this decreases interest-rate risk, it increases credit risk. 2. Alternatives include the use of derivatives, specifically interest-rate swaps. 12-105  Trading Risk Today banks hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank’s capital. Risk that the instrument may go down in value rather than up is called trading risk, or market risk. Traders normally share in the profits from good investments, but the bank pays for the losses. This creates moral hazard - traders take more risk than the banks would like. 12-106  Trading Risk The solution to the moral hazard problem is to compute the risk the traders generate. Use standard deviation and value at risk. The bank’s risk manager limits the amount of risk any individual trader is allowed to assume and monitors closely. The higher the inherent risk in the bank’s portfolio, the more capital the bank will need to hold. 12-107  Traders are gambling with someone else’s money, sharing the gains but no the losses from their risk taking. Traders are prone to taking too much risk, and in the cases here, hiding their losses when trades turn sour. The moral hazard presents a challenge to bank owners, who must try to rein in traders’ tendencies. Odds are that someone who is making large profits on some days will register big losses on other days. 12-108  Other Risks Foreign exchange risk comes from holding assets denominated in one currency and liabilities denominated in another. Banks manage this in two ways: They work to attract deposits that are denominated in the same currency as their loans, matching assets to liabilities. They use foreign exchange futures and swaps to hedge the risk. 12-109  Other Risks Sovereign risk arises from the fact that some foreign borrowers may not repay their loans because their government prohibits them from doing so. If a foreign country is experiencing a financial crisis, the government may decide to restrict dollar- denominated payments. Banks have three options: Diversification, Refuse loans to certain countries, or Use derivatives to hedge the risk. 12-110  Other Risks Operational risk is when computer systems fail or buildings burn down. This was an issue for some banks when the World Trade Center was destroyed. The banks must make sure their computer systems and buildings are sufficiently robust to withstand potential disasters. This means anticipating what might happen and testing to ensure a system’s readiness. 12-111 Summary of Sources and Management of Bank Risk 12-112 Nondepository Financial Institutions Chapter 2  79 Non-Depository (Non- Bank) Financial Institutions Non-depository institutions serve as the intermediary between the savers and the borrowers, but they do not accept deposits. Such institutions perform their activities of lending to the public either by way of selling securities or through the insurance policies. Non-depository institutions include investment companies, insurance companies, brokerage firms, and pension funds.  Life Insurance Companies One of the oldest type of intermediary. Invest funds obtained through the sale of policies. Primary investments: Long term taxable, not highly marketable securities: corporate bonds and commercial mortgages. Insure against dying too soon and living too long.  Life Insurance Companies Regulation of life insurance companies includes: Sales practices Premium rates Allowable investments  Types of Life Insurance Policies Whole Life Insurance Constant premium that is paid through entire life of policy Build up cash reserves or savings which can be withdrawn as borrowing or outright by canceling the policy Savings component pays a money market rate of interest that changes with market conditions  Types of Life Insurance Policies Term Life Insurance Pure insurance with no cash reserve or savings element Premiums are relatively low at first but increase with the age of the insured individual Universal {variable) Life Variation on whole life policy "Unbundle" the term insurance and tax-deferred savings component Owner can elect how to allocate the savings component among a menu of investment options, thereby potentially earning above money market rates  Life Insurance Companies Based on actuarial tables, life insurance companies have ability to predict cash flow Typically insurance companies use excess funds to buy long-term corporate bonds and commercial mortgages Higher yields Unlikely of having to sell prior to maturity However, lately they have branched out into riskier ventures such as common stock and real estate  Life Insurance Basics Public makes payments in exchange for protection Companies lend out the funds collected. Companies use the interest and dividend income received to pay benefits to policyholders Insurance companies have a reasonably predictable stream of payments to policy holders distributed over time.  Dealing with Asymmetric­ Information Problems in Insurance Limiting adverse selection Restricting the availability and quantity of. insurance. Limiting moral hazard in insurance Deductible: A fixed amount of an insured loss that a policyholder must pay before the insurer is obliged to make payments. Coinsurance: A policy feature that requires a policyholder to pay a fixed percentage of a loss above a deductible.  Property and Casualty Insurance Companies Insure against casualties such as automobile accidents, fire, theft, personal negligence, malpractice, etc. Losses can be unexpected and highly variable. Invest in bonds and short-term securities.  80 Investment Companies Investment companies are financial intermediaries that sell shares to the public and invest the proceeds in a diversified portfolio of securities. Each share sold represents a proportional interest in the portfolio of securities managed by the investment company on behalf of its shareholders. The type of securities purchased depends on the company's investment objective..  81 Cont’d When investors decide to invest in a particular asset class, such as equities, there are two ways they can do it: direct investment or indirect investment. Direct investment is when an individual personally buys shares in a company, such as buying shares in Apple, the technology giant. Indirect investment is when an individual buys a stake in an investment fund, such as a mutual fund that invests in the shares of a range of different types of companies, perhaps including Apple. Achieving an adequate spread of investments through holding direct investments can require a significant amount of money and, as a result, many investors find indirect investment very attractive.  Mutual Funds There are three types of investment companies: open-ended funds, close-ended funds and unit- trusts. A mutual fund (open-ended funds)pools the funds of many people and managers invest the money in a diversified portfolio of securities to achieve some stated objective  Open-end Mutual Fund Sell redeemable shares in the fund to the general public Shares represent a proportionate ownership in a portfolio held by the fund Shareholder can go directly to fund and buy additional shares or redeem shares at their net asset value (NAV)  Open-End Mutual Funds Net Asset Value (NAV) Fund calculates the total market value of its portfolio and divides this figure by the number of outstanding shares. Redeem outstanding shares or issue new ones at the NAV. Number of shares is not fixed but increases as more money is invested. Commonly known as Mutual Funds.  Closed-End Investment Company Issues a fixed number of shares. Invests the proceeds in a portfolio of assets. Shares are transferable. Price of the share is determined by supply and demand.  Mutual Funds Mutual funds are regulated by the Securities and Exchange Commission (SEC) Primary objective of regulation is the enforcement of reporting and disclosure requirements to protect the investor Many investors are attracted to families of mutual funds Number of mutual funds operated under one management umbrella Investors can easily transfer money among funds within the family  Net Asset Value Example A fund has 10 million shares and is worth $100 million. NAV = $10.00 You can buy fractional shares.  Unit-Trusts  A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. Unit trusts typically invest in bonds.  They differ in several ways from both mutual funds and closed-end funds that specialize in bonds. First, there is no active trading of the bonds in the portfolio of the unit trust. Once the unit trust is assembled by the sponsor (usually a brokerage firm or bond underwriter) and turned over to a trustee, the trustee holds all the bonds until they are redeemed by the issuer. Typically, the only time the trustee can sell an issue in the portfolio is if there is a dramatic decline in the issuer’s credit quality. As a result, the cost of operating the trust will be considerably less than costs incurred by either a mutual fund or a closed-end fund  Unit-Trusts Second, unit trusts have a fixed termination date, while mutual funds and closed-end funds do not. Third, unlike the mutual fund and closed-end fund investor, the unit trust investor knows that the portfolio consists of a specific portfolio of bonds and has no concern that the trustee will alter the portfolio.  The Benefits of Collective 85 Investment Investment funds pool the resources of a large number of investors, with the aim of pursuing a common investment objective. This pooling of funds brings a number of benefits, including: Economies of scale - commission as a proportion of the fund is very small. Diversification - risk is lessened when the investor holds a diversified portfolio of investments (in many different sectors). Access to professional investment management – however, entry fees, exit charges and annual management fees applies, these are needed to cover the fund managers‘ salaries, technology, research, their dealing, settlement and risk management systems, and to provide a profit. Access to geographical markets, asset classes or investment strategies which might otherwise be inaccessible to the individual investor In some cases, the benefit of regulatory oversight In some cases, tax deferral.  Finance Companies Consumer Finance Companies Make consumer loans Specialty Finance Companies-specialize in credit card financing Commercial finance Companies Make commercial loans usually on a secured (collateralized) basis Loans not as risky as consumer loans Since lending is short-term, these companies borrow substantial amounts in commercial paper market  Finance Companies Historically finance companies have played an important role in financing growing undercapitalized companies Commercial finance companies originated the concept of leveraged buyout (LBOs) which relies heavily on debt to pay for acquisition of a company  Securities Brokers and Dealers These financial institutions play a crucial role in the distribution and trading of huge amounts of securities  Brokers and Dealers Involved in the secondary market, trading ''used'' or already outstanding securities Brokers match buyers and sellers and earn a commission1 Dealers commit their own capital in the buying and selling of securities and hope to make profit on the transaction  Brokers and Dealers Many of the nationwide stock exchange firms act as investment bankers, dealers, and brokers A number of large stock exchange firms have branched out to provide new types of financial services previously out of their operating charter Commercial banks, investment banks, and broker dealers have now combined under single holding company umbrellas  Investment Banks Sell and distribute new stocks and bonds directly from issuing corporations to original purchasers investment banks are ranked by the volume of securities they underwrite Underwriting is typically conducted through a syndicate which includes many investment banks and brokerage fi rms Investment banks derive a substantial amount of income from offering advice to fi rms involved in mergers and acquisitions What price one firm should pay for another How the transaction should be structured Provide strategic advice in hostile takeovers-when one firm seeks to acquire another against the other's wishes  Venture Capital Funds, Mezzanine Debt Funds, and Hedge Funds Venture capital funds, mezzanine debt funds, and hedge funds are usually not available to public investors and not registered with SEC Funding comes from wealthy individuals or other financial institutions, possibly sponsored by brokerage firms and banks Both venture capital funds and mezzanine debt funds provide an important source of funding to small and midsize companies Financing by both venture and mezzanine funds is non-traded and held until maturity  Venture Capital Funds Invest funds in start-up companies Traditional bank financing for these firms in the early stage of growth would be very limited The Venture Capital Fund receives a substantial equity stake in the firm Although many start-up companies will fail, significant profit on those that are successful Receives profits when it takes the successful company public in an initial public offering  Mezzanine Debt Funds Provide.debt funds to small and midsize companies Issue convertible debt and subordinated debt Sometimes simply invest in a combination of high-yielding debt and equity issued by the same company Used to provide long-term funds, sometimes part of a management-buyout financing package  Hedge Funds Hedge funds: Limited partnerships that, like mutual funds, manage portfolios of assets on behalf of savers, but with very limited governmental oversight as compared with mutual funds.  Pension Funds Program established by an employer to provide retirement benefits to employees.  Defined Benefit Plan Retirement benefits are defined by the plan Employer contributions are adjusted to meet the benefits and insure the plan is fully funded-enough funds to meet future obligations Vesting Retirement benefits remain with the employee if they leave the firm and is based on length of employment  Defined Contribution Plan Contributions are defined by the plan Contribution may be made by employees or employers or a combination of the two Employee contributions are tax deferred-taxes payable when funds are withdrawn Benefits depend on the performance of the assets in the plan Avoids the problems of vesting and funding Individual employee has the ability to choose the assets in which to invest  Pension Funds Defined contribution plans are the type favored by most employers, although some employers offer both plans In addition to employer-sponsored plans, some individuals are given tax incentives to set up their own pension plans  Pension Fund Basics Tax-exempt institutions set up to provide participants with retirement income that will supplement other sources of income. The number of people likely to retire each year is quite predictable.  Banks Versus Nondepository Institutions Many nondepository institutions offer services that compete directly with banks Traditionally many of the different markets were segmented, however, today they often compete for the same business