Part 1 midterm October Financial Intermediation. Summary of all the slides with some difficult English words translated in Dutch. All the slides are relevant for the Midterm.
FI: An entity that acts as the middlemen between two parties in a financial transaction
Equity and debt
Households = net savers Corporations = net borrowers
Cash
Without FI’s: low level of funds flows because of:
1. Information cost: collecting information on corporations is too costly for households.
2. Less liquidity: investing directly in corporations dries up liquidity among households.
3. Substantial price risk: risk of loss when selling equity and debt of corporation.
With FI’s:
Functions of FI’s
1. Brokerage function (bemiddelingsfunctie)
- Provides information and transaction services.
- Reduces costs through economies of scale (schaalvoordelen)
- Encourage higher rate of savings.
2. Asset transformer
- Purchase primary securities (effecten) by selling financial claims to households.
- Secondary securities often more marketable (verhandelbaar).
- Value added: transformation of financial risk.
How do FI resolve financial markets’ shortcomings?
- Reducing cost of information
, - Providing liquid assets
- Lowering price risk
Cost reduction
Cost of information
- Investors exposed to agency costs (bemiddelingskosten)
FI as a delegated monitor
- Informational advantage
- High incentives
- Economies of scale
FI as an information producer
- New secondary securities for more effective monitoring.
- Shorter term debt contracts easier to monitor than bonds.
- FI reduce information asymmetry between borrowers and lenders.
Specialness of FI’s
Liquidity and price risk
- Demand deposits and other claims are more liquid
Immediate withdrawal and loans with short notice
- Secondary claims issued by FI’s have lower price risk
Fixed principal value and guaranteed interest rate
- More attractive to small investors
How can FI’s offer high liquidity and low price risk if they invest in illiquid and risky assets of
corporations? → FI’s can diversity away some but not all of the portfolio risks.
Specialness and regulation (regelgeving)
Potential problems → what happens if FI’s take excessive risk and fail?
- Loss of households’ savings
- Disruption in capital provision for businesses (verstoring kapitaal voorziening)
- Household’s exposure to drops in income and other disasters.
→ example: global finance crisis 07-08 → regulating FI’s
One solution to the excessive risk taking behaviours of FI’s:
! Basel III: late 2009 in response to crisis.
- International banking supervision (bankentoezicht)
- Capital requirements, stress testing, liquidity risk
Cost of regulation (regulatory tax)
- Private costs for the individual FI’s (lower profit)
- Regulations stay forever, we add one layer on the previous layers (laag
toevoegen)
- Aim: social benefits provided by FI’s exceed their social costs (voordelen zijn
hoger dan de kosten)
Safety and Soundness (veiligheid en degelijkheid)
- Protecting depositors and borrowers against the risk of FI failure
, - Maintain the credibility of FI in their eyes (no bank run during crisis)
1. Encouraging diversification: no more than 15% of the bank equity to single borrower
2. Minimum capital requirements: loans, debt, equity etc.
- Minimum level of equity that the FI owners need to contribute to the funding of
its operations
- Minimum ratio of capital (equity) to assets
- Banks and insurance companies
- Lower risk of insolvency, why? Losses are borne first by equity holders, and only
after equity is wiped out, by liability holders.
Examples capital requirements:
- EU & NL: minimum 8%, Capital Purchase Program in TARP, Stress test
- Also liquidity coverage ratio: ratio of highly liquid assets to total assets, stress test
3. Guaranty funds
- Protecting FI claim holders
- Deposit Insurance Fund (DIF): insuring the deposits of individuals, funded by
insurance payments of banks:
-Raised from 100k to 250k during the crisis
-EU & NL: 100.000 per person per bank
- Securities Investors Protection Corporation (SIPC): for customers of securities
(brokerage) firms. (beursvennootschappen)
- State guaranty funds for claim holders in life and property-casualty insurance
industries (levens- en schadeverzekeringen)
4. Monitoring and surveillance (toezicht en bewaking)
- On-site an off-site
- National Bank Surveillance System (NBSS)
-Collecting and analysing bank data
-Early warning system by comparing with peers
- Global financial crisis lead to a significant increase in monitoring ‘Too-Big-To-Fail’
financial services firms
-Dodd-Frank reform
Credit allocation regulation (krediet toewijzing)
- Supports FI’s lending (kredietverlening) to socially important sectors such as
housing and farming
- Subsidizing certain sectors
-Requirements for minimum amounts of assets
-Maximum interest rates of fees
- Savings institutions: minimum 65% of assets in residential mortgage
(woninghypotheek) related assets
Monetary policy regulation (monetair beleid)
- Facilitates (vereenvoudigt) transmission (overdracht) of monetary policy from the
central bank to the rest of the economy
- Reserve requirements: the amount of cash to be held against deposits
Low: expansionary monetary policy (geldhoeveelheid vergroten beleid)
, High: contractionary monetary policy (geldhoeveelheid verkleinen beleid
- Often higher than necessary
Consumer protection regulation
- Prevents discrimination in lending and ensures the need of communities are met
by banks and mortgage lenders
- Community Reinvestment Act (CRA)
- Home Mortgage Disclosure Act (HMDA)
Investor Protection regulation
- Protects investors (beleggers) who use investment banks directly or indirectly
through mutual or pension funds
- Protections against abuses (misbruik) such as insider trading (handel met
voorkennis), lack of disclosure (gebrek aan openbaring), breach (schending) of
fiduciary responsibilities.
Example: an investment bank is creating a derivative based on subprime mortgage-backed
securities in early 2007.
- Long investor: the mortgage market will continue to do well
- Short investor: it will do poorly
What is the bank’s fiduciary duty? → a legal obligation of one party to act in the best
interest of another. The obligated party is typically a fiduciary, that is someone entrusted
(toevertrouwd) with the care of money or property.
Entry regulation
- Level of entry obstruction affects profitability and value of firms already
competing in the industry.
- High cost of entry: direct (required equity) and indirect (restricting individuals
who can establish (oprichten) FIs)
- Regulations define (bepalen) scope of permitted activities.
Incentives vs regulation
Regulation: restrict the choices (regelgeving: beperkt de keuzes)
- Dis-incentivizing effect (ontmoedigend effect)
- No structural reform
- Timid approach (timide aanpak): no banning of assets, many exemptions and
loopholes.
- Not empowering consumers (consumenten niet in staat stellen) → FinTech
Incentives (aansporing, prikkels): make the desired outcome the most profitable
- Tie (koppel) the losses of customers to the losses of decision makers.
- Publicly traded (beursgenoteerde) financial services companies vs. partnership.
- Double layer liability in the 18th century.
, - Executive pay and top-level compensation
Trends and cycles of financial intermediaries
Changing dynamics
Decline in share of depository institutions (bewaarinstellingen) and insurance companies.
- Increases in investment companies with cheaper access (toegang) to the direct
securities market.
Business loans have declined in importance (zakelijke leningen minder belangrijk)
- Commercial paper market
Offsetting (compenseren) increase in securities and mortgages
- Securitization of mortgage loans
- CDO’s and CLO’s
The rise (opkomst) of disintermediation through FinTech
C&I loans are Commercial and
Industrial loans.
Commercial paper: short-term debt
issued (uitgegeven) by a corporation
for financing of accounts payable and
inventories and meeting short-term
liabilities.
Trends in the United States
- Savers preference for quasi-direct investments
- Financial Services Modernisation Act (1999)
o Financial services holding companies
- Shift (verschuiving) from ‘originate and hold’ to ‘originate and distribute’
o Affects incentives to monitor and control risk
o Shifts risk off the balance sheet to the financial system
o Degraded (slechte) quality and increased risk
Modernization Act (FSMA)
- 1999 in the US, after 70 years of separation between financial institutions with
different services.
- No barrier between commercial banking, insurance and investment banking
- Financial services holding companies
- Contributed (bijgedragen) to the crisis 07-08. → time to reverse? (tijd om om te
keren?)
Examples:
- ABN AMRO, ING Group.
- Goldman Sachs, Morgan Stanley, GMAC: non-depository institutions, but
converted to bank holding companies. Why? (bankholding = onderneming die
zeggenschap heft over een of meer banken, maar zich niet perse bezighoudt met
bankieren)
, o Stability from retail deposits
o Regulatory exemptions (vrijstellingen van regelgeving) and ‘too-big-to-fail’
benefits
Are banks still special?
Con: dilutes (verdunnen) the
monitoring incentives of banks.
Pro: More liquid assets, risk-sharing
Has secondary loan market reduced
the traditional bank specialness?
- Yes, because it decreases
the monitoring incentives
of banks due to risk
sharing → Regulation
- No, because it benefits the equity holders or the borrowers by alleviating
financial constraints (verlichten financiële beperkingen) and reducing cost of
capital.
It has altered (veranderen/wijzigen) the key features of bank specialness:
- Information production and monitoring at loan origination
- Creation of an active secondary market for bank loans while continuing their
lending.
Types of FIs
1. Depository institutions
2. Non-depository institutions
Depository institutions
- Lending funded through deposits
- Commercial banks: consumer, commercial and real estate(onroerend goed) loans
- Savings banks: concentrated on residential mortgages (woninghypotheken)
- Credit unions: non-profit, organized and owned by depositors
Non-depository institutions
Finance companies: lending funded through short and long term debt
Securities firms and investment banks: brokers
Insurance companies: protecting from adverse events funded by premiums
Mutual funds and hedge funds: pool financial resources and invest in diversified portfolios of
assets.
Private equity firms: pool financial resources and invest in diversified portfolios of private
equity (equity of private companies)
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