FINS3630 Lecture 1.pdf

Lecture 1: An Overview of Financial Institutions

Dr Lixiong Guo Semester 2, 2015

Topics for Today  The goals of the financial system and the importance of a well-

functioning financial system.  Why financial institutions develop and how they help to achieve the goals of the financial system.  FIs function as asset transformers – What make asset transformation possible. – Information problems in investing and why FIs provide an efficient solution.

 FIs function as brokers.  An overview of different types of FIs.  Regulation of FIs.

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An Overview of the Financial System  The financial system has five parts, each of which plays a

fundamental role in our economy. – Money: Medium of exchange, unit of account, store of value. – Financial instruments: legal contracts used to transfer resources and risks between suppliers of funds and users of funds. – Financial markets: places to buy and sell financial instruments. – Financial institutions: institutions that provide a myriad of services that facilitate the flow of funds from savers to investors.

– Central bank: monitor and stabilize the economy.

 The financial system plays two important roles: – The first is to channel savings to investments. – The second is to allow economic agents to share risks.

– The two are often closely related.

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An Overview of the Financial System  Why is the channelling of savings to investments so important to 

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the economy? The answer is that it produces an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy. Suppose you have saved $1,000 this year and you do not have any investment opportunities yourself. If there is no financial markets, you will just hold on to the $1,000 and earn no interest. However, Carl the carpenter can use your $1,000 to purchase a new tool that will shorten the time it takes him to build a house, thereby earning an extra $200 per year. If there is a financial market, you can lend him the $1,000 at a fee of $100 per year, both of you would be better off. You would earn $100 on your $1,000 and Carl would earn $100 more income per year.

Funds Flow Through the Financial System Direct Finance Primary Securities Funds

Financial Markets

Borrowers-Spenders (Mostly Firms and Governments)

Lender-Savers (Primarily households)

Funds Secondary Securities

Financial Institutions Indirect Finance

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Primary Securities Funds

Funds Primary Securities

Direct Finance  In direct finance, corporations borrow funds directly from

households in financial markets by selling them securities, which are claims on the corporation’s future income or assets. – We call these securities the primary securities.

 A balance sheet view of direct finance Corporations

Households

 Household savers face several costs and risk when they invest

directly in corporations. – Information and monitoring costs: • High cost of information collection before the transaction. • High cost of monitoring after the transaction. 6

Direct Finance (cont.) – Liquidity cost: • The relative long-term nature of corporate equity and debt, and the lack of liquid secondary markets in which households can sell these securities, creates a disincentive for household investors to directly invest in corporations.

– Price risk: • Even if financial markets exist to provide liquidity services, household investors face the risk that the sale price of the direct claim will be lower than the purchase price of that claim. This is another disincentive for household to invest directly in corporations because household savers are usually more concerned with preserving the value of their saving than earning high returns. • Given the usually small size of household investments, they do not have the scale to diversify the price risk.

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Direct Finance – Transaction costs: • Household investors often face prohibitively high transaction costs when investing directly in corporations because of the usually small size of their investments. • In our previous example of the carpenter, suppose you need to pay a lawyer $500 to write up the loan contract to protect yourself. When you figure in this transaction costs for making the loan, you realize that you cannot earn enough from the deal and will regrettably tell Carl to look somewhere else.

 As a result, in a world with only direct finance, many households

may prefer either not to save or to save in the form of cash.

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Indirect Finance  However, the economy has developed an alternative way to

channel household savings to investments – indirect finance.  In indirect finance, financial institutions (FIs) stand between the lender and the borrower, borrowing from the lender and then providing the funds to the borrower.  By pooling savings from a large number of individual households, the FI can take advantage of economy of scale to significantly reduce the information and monitoring costs and transaction costs. – For example, suppose it costs $100 to buy a broker’s report. For a small investor with a $10,000 investment, this cost may seem to be inordinately high. The average cost is $1 per $100 investment. However, for an FI with $10 million investments, the average cost is only 0.1 cents per $100 investment.

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Indirect Finance (cont.) − In our previous example of the carpenter, instead of a loan contract

costing $500, an FI can hire a topflight lawyer for $5,000 to draw up a loan contract that can be used for 2,000 loans at a cost of $2.5 per loan. At a cost of $2.5 per loan, it now becomes profitable for the FI to lend Carl the $1,000.

 How does the FIs solve the problems of liquidity costs and price

risk?  The securities the FI buys are the primary securities issued by corporations but the securities the FI issues to household lenders are what we call the secondary securities.  Although the secondary securities are backed by the primary securities the FI holds, they are claims on the FI’s future income and assets not that of the corporations that have issued the primary securities.  The secondary securities are designed to appeal to households. For example, they are highly liquid and have very low price risk. 10

Indirect Finance (cont.) −

e.g. Bank deposits are almost risk free and can have very short maturities.

 The process looks as if the FIs have transformed primary

securities, which are not attractive to an average household saver, into secondary securities, which are very attractive.  This role of the FI is called asset transformation and the FI playing this role is also called an asset transformer.  A balance sheet view of indirect finance Corporations

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Households

FI

Assets

Liabilities

Assets

Liabilities

Assets

Real Assets

Primary securities

Primary securities

Secondary securities

Secondary securities

Liabilities

Risk Transformation  The real puzzle is how FIs can offer highly liquid and low price

risk contracts to savers on the liability side of their balance sheet while investing in relatively illiquid and higher price risk securities issued by corporations on the asset side. – There are two transformations here: risk and liquidity.

 The answer for risk transformation lies in the ability of the FIs to

diversify away some but not all of their portfolio risk. – Due to their small size, many household savers are constrained to holding relatively undiversified portfolios and thus are unable to achieve the same diversification effect as the FIs.

 Instead, the FIs can invest in many different firms at the same

time. As long as the returns on different investments are no perfectly positively correlated, FIs can diversify away significant amount of firm-specific risk.  This allows the FI to predict more accurately its expected return on its asset portfolio. 12

A Review of Statistics  Suppose there are two assets, A and B. The variances of the

returns be 𝜎𝐴 2 and 𝜎𝐵 2 , respectively, and the correlation between the two returns be 𝜌𝐴𝐵 . The proportion of the portfolio value invested in A and B are 𝑦𝐴 and 𝑦𝐵 . Then the variance of the portfolio return is 𝜎𝑝 2 = 𝑦𝐴 2 𝜎𝐴 2 + 2𝑦𝐴 𝑦𝐵 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 + 𝑦𝐵 2 𝜎𝐵 2

 If 𝜌𝐴𝐵 =1, then 𝜎𝑝 = 𝑦𝐴 𝜎𝐴 + 𝑦𝐵 𝜎𝐵  If 𝜌𝐴𝐵 =0, then 𝜎𝑝 2 = 𝑦𝐴 2 𝜎𝐴 2 + 𝑦𝐵 2 𝜎𝐵 2  If 𝜌𝐴𝐵 =−1, then 𝜎𝑝 = 𝑦𝐴 𝜎𝐴 − 𝑦𝐵 𝜎𝐵 . If we choose the portfolio weight

to be

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𝑦𝐴 𝑦𝐵

=

𝜎𝐵 , 𝜎𝐴

then 𝜎𝑝 = 0.

Diversification  Suppose we have N assets available, the variance of the i-th

asset is 𝜎𝑖 2 , all returns are uncorrelated with each other. The 1 proportion of the portfolio value invested in i-th asset is . Then 𝑁 the variance of the portfolio return is 𝑁

𝜎𝑝 2 = 𝑖=1

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1 𝑁

2

𝜎𝑖 2

Define the maximum of 𝜎𝑖 2 is 𝜎𝑚𝑎𝑥 2 , then 𝑁

𝜎𝑝 2 ≤ 𝑖=1

1 𝑁

2

𝜎𝑚𝑎𝑥 2

𝜎𝑚𝑎𝑥 2 = 𝑁

 As N increases, 𝜎𝑝 2 diminishes, and, in the limit, as N goes to

infinity, 𝜎𝑝 2 goes to zero.

 Thus, if we have sufficiently many assets with uncorrelated

returns, we can drive portfolio risk as low as we wish and make returns as predictable as desired. 14

Liquidity Transformation  Liquidity transformation exposes modern banks to a potential

catastrophe – insolvency of the bank.  Let’s look at the following balance sheet of a bank Assets

Liabilities

Reserves $100,000

Demand Deposits $1,000,000

Loans

$900,000

 The liabilities of $1 million exceed the bank’s ability to satisfy

them in the unlikely event that all depositors should seek to withdraw simultaneously. This potential failure is because loans are illiquid.  Suppose all $1 million deposits come from one depositor and the probability that the deposit will be withdrawn after one period is 𝑝 = 0.1. Is it prudent to keep $100,000 reserve?

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Liquidity Transformation  What about having 1,000 depositors of $1,000 each, assuming

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the probability of withdraw of each depositor is still 0.1 and the depositors are independent? What about having 1 million depositors with $1 deposit each? As the number of depositors increases, assuming independence, the withdrawal of 10% becomes more predictable; in the limit, a 10% cash holding will “almost certainly” satisfy deposit withdrawals. Hence, the answer for liquidity transformation lies in the ability of the FIs to diversify the source of their funds. By diversifying its source of funds, the FI can predict more accurately its expected daily withdrawals and set aside cash to meet these withdrawals without liquidating its entire long-term investments at loss.

Information Problems in Investing  An important economic function of the FIs is to solve the problem

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of asymmetric information, that is the issuers of financial instruments know much more about their business prospects and their willingness to work than potential lenders or investors. Lack of information creates problems in the financial system on two fronts: before the transaction is entered into and after. Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risk—are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make loans even though there are good credit risk in the marketplace.

Adverse Selection  Suppose there are two firms in the economy, one has a safe 

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project and the other has a risky project. If you lend $1,000 to the safe firm, the project generates a sure profit of $1050 for the firm and the firm is willing to give it all to you as loan repayment. If you lend $1,000 to the risky firm, the project will generate a profit of either $10,000 or $0 for the firm with equal probabilities. Suppose you only want to lend to the safe firm but cannot tell the difference. If you charge an interest rate of 5% or lower, both firms are willing to borrow. This rate is too low for you because you might pick the risky firm. If you charge an interest rate above 5%, the safe firm will not borrow, so it will withdraw from the market, leaving only the risky firm, which you don’t want to lend to.

Adverse Selection  As a result, if you do not have the information to distinguish the

two firms, you may decide not to make a loan to any firm.  However, if you know which firm is safe and which is risky, you would not have the problem and the safe firm will be funded.  One solution to adverse selection is screening. This requires the lenders to be good at collecting and analysing information.  FIs have a distinct advantage over individual households in this aspect because: – They have developed expertise in information collection and screening. – They can take advantage of economy of scale to significantly lower the average cost of information collection.

 The financial markets have also developed other solutions to

adverse selection, for example, the use of collaterals. If a loan is insured in some way, then the borrower isn’t a bad credit risk. 19

Moral Hazard  Moral hazard is the problem created by asymmetric information 

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after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back. The information problem is that the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into the project. Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking. Lenders need to find ways to make sure borrowers don’t take too much risk. The solution is monitoring. Again, the FIs can do this more efficiently than household savers.

FIs Function As Brokers  Besides asset transformation, FIs also assist with direct finance

as brokers.  The FIs are involved as agents not principals and are usually compensated with a fee for performing the services.  The FIs mainly provide information and transaction services.  The FIs can perform these services more efficiently than individuals can because of economy of scale.

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Depository Institutions  There are many different types of FIs, each plays one or more

functions we just discussed.  Depository institutions (DIs) are FIs that accept deposits from individuals and institutions and make loans. They make up the largest group of FIs by size of balance sheet. – In the U.S., these institutions include commercial banks, savings institutions, credit unions. – In Australia, these institutions are called authorized depository institutions (ADIs), including banks, building societies, credit unions. – DIs provide important payment services to the economy. – Because the liabilities of DIs are a significant component of the money supply that impacts the rate of inflation, DIs play a key role in the transmission of monetary policy from the central bank to the rest of the economy. 22

Finance Companies, Mutual Funds  Finance Companies: finance companies raise funds by selling

commercial paper (a short-term debt instrument) and by issuing stocks and bonds. They lend these funds to consumers, who make purchase of home appliances or automobiles and to small businesses. Some finance companies are organized by a parent corporation to help sell its product.  Mutual funds: they acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. In addition, mutual funds allow shareholders to hold ore diversified portfolios than they otherwise would.

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Insurance Companies  Life insurance companies insure people against financial hazards

following a death and sell annuities. They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages. They also purchase stocks, but are restricted in the amount that they can hold.  Property-causality insurance companies insure their policy holders against loss from theft, fire, and accidents. They are very much like life insurance companies, receiving funds through premiums fro their policies, but they have a greater possibility of loss of funds if major disasters occur. For this reasons, they use their funds to buy more liquid assets than life insurance companies do.

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Security Firms and Investment Banks  Security firms and investment banks primarily help net suppliers

of funds transfer funds to net users of funds at a low cost and with a maximum degree of efficiency.  Unlike other types of FIs, securities firms and investment banks do not transform the securities issued by the net users of funds into claims that may be more attractive to the net suppliers of funds. Rather, they serve as brokers intermediating between fund suppliers and users.  Investment banking involves the raising of debt and equity securities for corporations or governments. This include the origination, underwriting, and placement of securities in money and capital markets for corporate or government issuers.  Security services involve assistance in the trading of securities in the secondary markets (brokerage services and/or market making). 25

Security Firms and Investment Banks  The main difference between brokers is whether they offer advice

or not, they are either – Full-service brokers: Offering advice on buying and selling securities, make recommendations, provide research and compile tailored investment plans. – Non-advisory brokers: Offering no recommendations or advice regarding the appropriateness of your decision

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Regulations of FIs  FIs are special because the services they provide are crucial to

the economy. Failure to provide these services or a breakdown in their efficient provision can be costly to both the ultimate sources and users of the savings.  The negative externalities when something goes wrong in the financial sector make a case for regulation. – Negative externality: Actions by an economic agent imposing costs on other economic agents.

 Safety and soundness regulations – Diversification requirement, Capital adequacy requirement  Investor protection regulations – Disclosure, Insider trading

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Financial Regulatory Framework in Australia

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Financial Regulators in Australia

 APRA = Australian Prudential Regulation Authority. – Responsible for the prudential regulation and supervision of the finance services industry.  ASIC = Australia Securities and Investments Commission – Responsible for market integrity and consumer protection across the financial systems. – Set standards for financial market behavior with aim to protect investor and consumer confidence. – Administers the Corporate Law to promote honesty and fairness in companies and markets.

 RBA = Reserve Bank of Australia – Responsible for the development and implementation of monetary policy and for overall financial stability.

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