unit9.pdf

Introduction to Financial Markets Unit 9 Financial Intermediation Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 59 Bird Eye’s View The financial system is...

Introduction to Financial Markets Unit 9 Financial Intermediation Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 59 Bird Eye’s View The financial system is “the connected universe of financial instru- ments, financial institutions and financial markets operating in a given place at a given time, that is, the financial superstructure of the econ- omy.” (Goldsmith 1987, 1) Financial architecture embeds Instruments Markets Institutions Infrastructure Supervision Prof. Dr. M. De Ceuster Introduction to Financial Markets 2 / 59  Financial History Section 1 Financial History Prof. Dr. M. De Ceuster Introduction to Financial Markets 3 / 59  Financial History Money Changers Prof. Dr. M. De Ceuster Introduction to Financial Markets 4 / 59  Financial History The Oldest Bank in the World Banca Monte dei Paschi di Siena (1472)? “During the Middle Ages, the Gran Tavola (Italian for ‘Great Table’) was the largest Sienese bank; it was one of the most powerful banks in Europe from 1255 to 1298. The Gran Tavola has been called ‘the greatest bank of the thirteenth century’ as well as”one of the largest commercial and banking enterprises in Europe”. The main branches of the Gran Tavola during the mid-thirteenth century were in Pisa, Bologna, Genoa, Marseille, and Paris. (https://dbpedia.org/page/Gran_Tavola)” Prof. Dr. M. De Ceuster Introduction to Financial Markets 5 / 59  Financial History Merchant Bankers Prof. Dr. M. De Ceuster Introduction to Financial Markets 6 / 59  Financial History Amsterdam Wisselbank (1606) Prof. Dr. M. De Ceuster Introduction to Financial Markets 7 / 59  Financial History Sveriges Riksbank Prof. Dr. M. De Ceuster Introduction to Financial Markets 8 / 59  Financial History Miscellaneous Insurance contracts already existed in Babylonian times (cfr Hammurabi) Mutual funds were introduced by the Dutch in the 18th century (1774) but they only became successful 150 years later. Prof. Dr. M. De Ceuster Introduction to Financial Markets 9 / 59  Players Section 2 Players Prof. Dr. M. De Ceuster Introduction to Financial Markets 10 / 59  Players Spectrum of Business Entities Non-financial entities (providing goods and/or services) Financial enterprises Financial intermediaries Depository institutions (commercial banks, savings & loan associations, savings banks, credit unions). Non-depository institutions Insurance companies Asset management firms Pension funds Investment companies Captive finance companies (i.e. subsidiary of non-financial entity providing financial services to the group). Prof. Dr. M. De Ceuster Introduction to Financial Markets 11 / 59  Players Economic Functions Maturity/amount transformation Risk Shifting Reducing contracting and information processing costs Providing payment mechanisms Prof. Dr. M. De Ceuster Introduction to Financial Markets 12 / 59  Players Services Provided Transforming financial assets (depository institutions) Exchange financial assets on behalf of customers (brokers) Exchange financial assets for their own account (dealers) Assisting in the creation (underwriting) and the selling of financial assets (investment bankers) Providing investment advice and managing portfolios for others (Investment advisers and investment companies (mutual funds)) Prof. Dr. M. De Ceuster Introduction to Financial Markets 13 / 59  Players Business Models Spread business Depository institutions realize the interest margin. Deposits have to be transformed in loans. Life insurance companies Pension funds have to cover the cost of pension obligations at a minimum cost. They do not raise funds from the market. Fee business Investment companies Prof. Dr. M. De Ceuster Introduction to Financial Markets 14 / 59  Depository Institutions Section 3 Depository Institutions Prof. Dr. M. De Ceuster Introduction to Financial Markets 15 / 59  Depository Institutions Some Figures Financialization Prof. Dr. M. De Ceuster Introduction to Financial Markets 16 / 59  Depository Institutions The banker’s Main Asset Source The Economist 20190202 Prof. Dr. M. De Ceuster Introduction to Financial Markets 17 / 59  Depository Institutions Depository Institutions Depository institutions have a monopoly to raise funds through de- posits. Consequently, they are heavily regulated through: Licensing and supervision. Minimum requirements (on capital and liquidity). Market discipline (i.e. disclosure requirements). Depository institutions encompass: Commercial banks Thrifts Savings and loan associations Savings banks Credit unions P rof. D r. M. D e Ceuster Introduction to Financial M arkets 18 / 59  Depository Institutions Commercial Banks (or simply banks) Business model: Main liabilities: (insured and uninsured) deposits and other sources of funding. Main assets: loans and investments (in securities). Main goal: generate spread income (i.e. an interest margin). Prof. Dr. M. De Ceuster Introduction to Financial Markets 19 / 59  Depository Institutions Banks - Business Lines Individual banking or retail banking (consumer lending, residential mortgages, credit cards, investment services, private banking). Institutional banking or wholesale banking (loans to governments, non-financial corporates, other financial corporates, real estate financing, leasing activities, factoring,...). Global banking (corporate financing, capital market products, forex products,...). Prof. Dr. M. De Ceuster Introduction to Financial Markets 20 / 59  Depository Institutions Bank funding Deposits Demand deposits (checking accounts) Savings deposits Time deposits (certificates of deposit, CDs) Borrow in the interbank market (federal funds market in the US). Borrowing at the central bank’s discount window (based on eligible collateral) at the discount rate. Other nondeposit borrowing (money market, bond market). Equity Prof. Dr. M. De Ceuster Introduction to Financial Markets 21 / 59  Depository Institutions Some Figures Deposit funding Source: Liikanen Report (2012) Prof. Dr. M. De Ceuster Introduction to Financial Markets 22 / 59  Depository Institutions Some Figures LTD - ratio Source: Liikanen Report (2012) Prof. Dr. M. De Ceuster Introduction to Financial Markets 23 / 59  Depository Institutions Some Figures Absolute leverage Source: Liikanen Report (2012) Prof. Dr. M. De Ceuster Introduction to Financial Markets 24 / 59  Depository Institutions Savings Institutions under Various Names Thrifts (ie nonbank depository institutions) Historically thrifts could not accept deposits transferable by check. They could only tap the market through savings. After the creation of negotiable order of withdrawal (NOW) accounts, the differences with banks are negligible. Savings and loan associations (S&Ls) are mutually owned (the depositors are the owners) through stock ownership Savings banks Credit unions (depositors have a common bond of occupation or neighbourhood) Prof. Dr. M. De Ceuster Introduction to Financial Markets 25 / 59  Depository Institutions Cooperative Banks Are owned by the members Not necessarily profit maximizing (E.g. low cost loans to members) Wilhelm Friedrich Raiffeisen (1818-1888) Prof. Dr. M. De Ceuster Introduction to Financial Markets 26 / 59  Depository Institutions Islamic Banks When paying or receiving interest is not allowed, bankers get creative. Banks buy the property outright and rent it to the mortgage holder. They hand over the legal ownership when the contracts ends (ijara). resell the property to the customer at a fixed mark-up price and are paid in monthly installments (murabaha). Tax anomalies might rise compared to leasing (ijara) and mortgage loans (murabaha). Prof. Dr. M. De Ceuster Introduction to Financial Markets 27 / 59  Non Depository Institutions Section 4 Non Depository Institutions Prof. Dr. M. De Ceuster Introduction to Financial Markets 28 / 59  Non Depository Institutions Taxonomy Investment banking firms (see Unit 10) Insurance companies Collective investment vehicles Investment Companies Prof. Dr. M. De Ceuster Introduction to Financial Markets 29 / 59  Non Depository Institutions Insurance companies Definition Insurance companies underwrite risks by selling insurance policies in return for an insurance premium. So, they receive money now to make contingent payments later: e.g. when the insured person dies e.g. if an accident happens Prof. Dr. M. De Ceuster Introduction to Financial Markets 30 / 59  Non Depository Institutions Insurance fundamentals The income consists out of the Underwriting income which is determined by the Underwriting process i.e. process of deciding which application to accept or which ones to reject. Policy pricing i.e. how much to charge for the insurance in case of acceptance. Investment income (which is more volatile). The expenses consist out of opex & contingent payments. Prof. Dr. M. De Ceuster Introduction to Financial Markets 31 / 59  Non Depository Institutions Structure of insurance companies Home office (i.e. the manufacturer or the guarantor) is the actual insurance company. Investment company (is often structured as a separate legal entity). Distribution network: Agents who only (or mainly) sell own manufactured products, Brokers. Prof. Dr. M. De Ceuster Introduction to Financial Markets 32 / 59  Non Depository Institutions Two special insurance companies Re-insurance companies (Munich Re, Swiss Re, Hannover Re, Birkshire Hathaway, Lloyd’s, Korean Re, China Re) re-insure big risks. Monoliners guarantee the timely repayment of the bond principal and the coupons in case of default of the issuer. They only provide services to the capital market. Prof. Dr. M. De Ceuster Introduction to Financial Markets 33 / 59  Non Depository Institutions Insurance Types Life Insurance Term Insurance (pure life insurance that insures death) Cash value insurance (life insurance that builds up an investment value) Nonlife insurance Prof. Dr. M. De Ceuster Introduction to Financial Markets 34 / 59  Non Depository Institutions Insurance Types Life Insurance relates the contingent payoff to the risk of death of the insured person. Term Insurance is a pure life insurance If the insured dies while the policy is intact, the beneficiary receives the death benefit. If the insured does not die, the policy value is zero. Consequence: you cannot borrow against the TI policy Note: survivorship insurance (second to die insurance) requires two people to die before the insurance policy pays out. The premiums are of course lower. Cash value insurance (permanent life insurance) is an insurance that builds up a cash value inside the policy. Consequence: The cash can be withdrawn or borrowed against. Prof. Dr. M. De Ceuster Introduction to Financial Markets 35 / 59  Non Depository Institutions Insurance types (cont’d) Life insurers increasingly offer products which are purely investment oriented: Guaranteed investment contracts (GICs) are zero bonds issued by life insurance companies (maturity ranges from 1 to 20 years, guaranteed rate is fixed). The buyer of the GIC bears the credit risk on the insurance company. Annuities are mutual funds in an insurance wrapper. Prof. Dr. M. De Ceuster Introduction to Financial Markets 36 / 59  Non Depository Institutions Insurance types (cont’d) Policies can be written against the general account i.e. the investment portfolio of the overall company – participating policy – this portfolio determines the rating of the insurance company special accounts – no participation policy Prof. Dr. M. De Ceuster Introduction to Financial Markets 37 / 59  Non Depository Institutions Insurance types (cont’d) Nonlife insurance Health insurance (medical treatment), Property and casualty insurance (fire, flood, theft,... ), Liability insurance (litigation, third party claims), Umbrella insurance (pure liability coverage over and above standard policies), Disability insurance (inability to earn income), Long term care insurance (custodial care for people not able to care for themselves). Prof. Dr. M. De Ceuster Introduction to Financial Markets 38 / 59  Non Depository Institutions The bank insurance (bancassurance) model Strategic alliance Full integration Prof. Dr. M. De Ceuster Introduction to Financial Markets 39 / 59  Mutual Funds Section 5 Mutual Funds Prof. Dr. M. De Ceuster Introduction to Financial Markets 40 / 59  Mutual Funds Claimed Advantages Professional management Access to closed markets Time saver (no need to follow up your portfolio yourself) Tax advantage Diversification is KEY Prof. Dr. M. De Ceuster Introduction to Financial Markets 41 / 59  Mutual Funds Taxonomy Based on Management Style Actively managed funds Stock pickers based on top-down analysis quantitative analysis Higher fees Passively managed funds Index trackers Low fees Prof. Dr. M. De Ceuster Introduction to Financial Markets 42 / 59  Mutual Funds Taxonomy Retail investors - institutional investors Contractual vs statutory funds Open ended vs closed end funds Harmonized funds (European passport) vs non-harmonized funds Capitalization funds - distribution funds Monetary funds, bond funds, equity funds, balanced funds, capital guaranteed funds,... Prof. Dr. M. De Ceuster Introduction to Financial Markets 43 / 59  Mutual Funds Exchange Traded Funds Exchange traded funds (ETFs) became a popular cheap alternative for mutual funds. Prof. Dr. M. De Ceuster Introduction to Financial Markets 44 / 59  Alternative Investments Section 6 Alternative Investments Prof. Dr. M. De Ceuster Introduction to Financial Markets 45 / 59  Alternative Investments Preliminary Concept: Leverage Buy 100K of a share by using 20K of your own capital 80K of borrowed money on which an interest of 2K is charged Suppose Δ P = + 2 0 % 120 - 80 - 2 = 38. Investment yields a percentual return of 90%. Suppose Δ P = ≠2 0 % 80 - 100 - 2 = -22. Investment yields a percentual return of -110%. Prof. Dr. M. De Ceuster Introduction to Financial Markets 46 / 59  Alternative Investments Preliminary Concept: Short Selling Concept: Borrow an asset, Sell it spot, Buy it back at some future time Bearish strategy What about coupons and dividends? What about voting rights? Restrictions Prof. Dr. M. De Ceuster Introduction to Financial Markets 47 / 59  Alternative Investments Hedge Funds Actively managed funds Seek for absolute return Target High Net Worth Individuals and Institutional Investors Less regulated no limitations on the use of derivatives often short selling is being used Characterized by their investment policy Prof. Dr. M. De Ceuster Introduction to Financial Markets 48 / 59  Alternative Investments Hedge Funds & Their Strategies Equity hedge funds Equity fund that extensively uses leverage Micro-investors that focus on stocks Often they take an industry focus L/S strategy Prof. Dr. M. De Ceuster Introduction to Financial Markets 49 / 59  Alternative Investments Hedge Funds & Their Strategies Global asset managers Invest in wide universe of asset classes Often they take a country perspective Stocks Bonds Physical commodities Currencies Prof. Dr. M. De Ceuster Introduction to Financial Markets 50 / 59  Alternative Investments Hedge Funds & Their Strategies Relative value arbitrage Differences in performance of 2 securities from a homogeneous universe Examples Rating downgrades to speculative grade Many investors have to sell those assets HF buy but go short in other bonds of similar issuers Convertible bond arbitrage buy convertible sell shares if conversion seems likely Prof. Dr. M. De Ceuster Introduction to Financial Markets 51 / 59  Alternative Investments Hedge Funds & Their Strategies Event Driven Investment Takeover bids buy the victim sell the bidder Index composition changes long in new entrants short in the ‘fallen angels’ Buy distressed debt Prof. Dr. M. De Ceuster Introduction to Financial Markets 52 / 59  Alternative Investments Hedge Funds & Their Strategies Pure Short Sellers Invest in overvalued stocks Prof. Dr. M. De Ceuster Introduction to Financial Markets 53 / 59  Alternative Investments Importance 1/3 of stock market transactions have been related to HF activity 30% of the fee income of large banks is driven by HF activity BUT sometimes things go terribly wrong. E.g. Long Term Capital Management (1998) Prof. Dr. M. De Ceuster Introduction to Financial Markets 54 / 59