CHAPTER 12

FINANCIAL INSTITUTIONS AND INTERMEDIARIES: AN OVERVIEW

INTRODUCTION

What is a Financial Institution?

A financial institution is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange.

Financial institutions encompass a broad range of business operations within the financial
services sector including, banks, trust companies, insurance companies, brokerage firms and
investment dealers. Virtually everyone living in a developed and developing economy has on
ongoing or at least periodic need from the services of financial institutions.

Financial institutions can operate at several scales from local community credit unions to
international investment banks.

The financial system matches savers and borrowers through two channels:
(1) financial markets, and
(2) banks and other financial intermediaries

These two channels are distinguished by how funds flow from savers, or lenders, to borrowers
and by the financial institutions involved. Funds flow from lenders to borrowers directly through
financial markets such as the New York Stock Exchange and Philippine Stock Exchange or
indirectly through financial intermediaries, such as banks.

FINANCIAL INTERMEDIARIES

A financial intermediary is a financial firm, such as a bank, that borrows funds from savers and
lends them to borrowers.
Basic Structure of Financial Institutions / Intermediaries

A. Depository Institutions
1. Commercial Banks / Universal Banks
2. Savings And Loans Associations
3. Mutual Savings Bank
4. Credit Union

B. Contractual Savings Institutions

1. Insurance companies
2. Pension funds

C. Investment Intermediaries
1. Investment Banks
2. Mutual Funds
3. Hedge Funds
4. Finance Companies
5. 'Money Market Mutual Funds

Depository Institutions

Commercial banks are the most important intermediaries. Commercial banks play a key role in
the financial system by taking in deposits from households and firms and investing most of
those deposits, either by making loans to households and firms or by buying securities, such as
government bonds, or securitized loans.

Many firms rely on bank loans to meet their short-term needs for credit, such as funds to pay for
inventories (which are goods firms have produced or purchased but not yet sold) or to meet
their payrolls. Many firms rely on bank loans to bridge the gap between the time they must pay
for inventories meet their payrolls and when they receive revenues from the sales of goods and
services. Some firms also rely on bank loans to meet their long-term credit needs, such as
funds they require to physically expand the firm.

Universal bank. Also referred to as a full-service financial institution, a universal bank provides
a large array of service highs including those of commercial banks and investment banks.
The types of services offered include:

 Deposit accounts such as checking and savings

 Loans and credit
 Asset and wealth management
 Buying and selling securities
 Financial and investment advice Insurance products

Examples of universal banks are:

 Deutsche Bank, ING Bank, UBS, Credit Service, HSBC, Banks of America, JP Morgan
Chase, Wells Fargo, BPI; BDO

Savings and Loans Associations, Mutual Savings Bank, Credit Unions are the other depository
institutions and are introduced in Chapter 6.

These financial intermediaries are legally different from banks, although these "nonbanks"
operate in a very similar way by taking in deposits and making loans.

Contractual Savings Institutions

These are financial intermediaries that receive payments from individual as a result of a contract
and uses the funds to make investments.

Insurance Companies. Insurance companies specialize in writing contracts to protect their

policyholders from the risk of financial losses associated with particular events, such as
automobile accidents or fires. Insurance companies collect premiums from policyholders, which
the companies then invest then obtain the funds necessary to pay claims to policyholders and to
cover their other costs. So, for instance, when you buy an automobile insurance policy. the
insurance company may lend the premiums you pay to a hotel chain that needs funds to
expand.

The insurance industry has two segments:

a) Life insurance companies sell policies to protect households against a loss of earnings
from the disability; retirement or death of the insurance person. Examples and Insular
Life Corporation and Philam life Insurance Corporation.
b) Property and casualty companies sell policies to protect household and firms from the
risks of illness, theft, fire, accidents and natural disasters. Examples are Standard
Insurance Company and Malayan Insurance Corporation.
Pension Funds. Pension fund is a financial intermediary that invests contributions of workers
and firms in stocks, bonds, and mortgages to provide pension benefit payments during workers'
retirements.

For many people, saving for retirement is the most important form of saving. People can
accumulate retirement savings in two ways: through pension funds sponsored by employers or
through personal savings accounts. Most notable examples of pension funds are Social Security
System (SSS) for employees of private companies and Government Service Insurance System
(GSIS) for government employees. Pension funds invest contributions from workers and firms in
stocks, bonds, and mortgages to earn the money necessary to pay pension benefit payments
during worker's retirements. The SSS and government pension funds are important source of
demand for financial securities.

Types of Pension Funds Plans

The two basic types of pension plans are:

a) Defined contribution plan b) Defined benefit plant

Defined Contribution Plan has the following features:

a. Employer places contributions from employer into investments such as mutual funds,
chosen by the employees. Employees own the value of the funds in the plan. They also
bear the risk of poor investment returns.
b. If the employee's investments are profitable, employer's income during retirement will be
high. On the other hand, if the employee investment are not profitable, employee's
income retirement will be low.
c. Most private employers "Defined Contribution Plans" in the United States are 401 (k)
plans. Some employers match employee's contribution up to a certain amount. Many
401(k) participants invest through mutual funds, which enable them to hold a large
collection of assets at a modest cost.

Defined Benefit Plan

a. An employer promises employees a particular peso benefit payment, based on each
employee's earnings and years of service. The benefit payments may or may not be
indexed to increase with inflation.
b. If the funds in the pension plan exceed the amount promised, the excess remains with
the employer managing the fund.
c. If the funds in the pension plan are insufficient to pay the promised benefit, the plan is
underfunded and the employer is liable for the different.
Investment Intermediaries. Investment intermediaries are financial firms that raise funds to
invest in loans. and securities. The most important investment intermediaries are investment
banks, mutual funds, hedge funds finance companies and money market mutual fund. Mutual
funds and hedge funds, in particular, have come to play an increasingly important role the
financial system.

Investment Banks. Investment banks, such as Goldman, Sachs and Morgan Stanley, Merrill
Lynch differ from commercial banks in that they do not take in deposits and until very recently
rarely lent directly to households. (In late 2016, Goldman Sachs began engaging in fintech
online lending, offering loans of to $30,000 to households with high credit card balances but
good credit histories.) Instead, they concentrate on providing advice to firms issuing stocks and
bonds or considering mergers with other firms. They also engage in underwriting, in which they
guarantee a price. stocks or bonds and then make a profit by selling the stocks or bonds at a a
firm issuing higher price. In the late 1990s, investment banks increased their importance as
financial intermediaries by becoming heavily involved in e securitization of loans, particularly
mortgage loans. Investment banks also began engage in propriety trading, which involves
earning profits by buying and selling securities.

Mutual Funds. These financial intermediaries allow savers to purchase shares in portfolio of
financial assets, including stocks, bonds, mortgages, and money market securities. Mutual
funds offer savers the advantage of reducing transactions costs. Rather than buy many stocks,
bonds, or other financial assets individually each with its own transactions cost- a saver can buy
a proportional share of these assets by buying into the fund with one purchase. Mutual funds
provide risk-sharing benefits by offering a diversified portfolio of assets and liquidity benefits
because savers can easily sell the shares. Moreover, the company managing the fund - for
example, BPI Mutual Funds, specializes in gathering information about different investments.

Types of mutual funds

1. Closed-end mutual funds

This mutual fund issues a fixed number of nonredeemable shares, which investors may
then ride in over-the counter markets just as stocks are traded. The price of a share
fluctuates with the market value of the assets - often called the net asset value (NAV) in
the fund.

2. Open-end mutual fund

This mutual fund issues share that investor can redeem each day after the markets
close for a price tied to the NAV.
Many mutual funds are called no-load funds because they do not charge buyers a commission,
or "load." Mutual fund companies earn income on no-load funds by charging a management fee
- typically about 0.5% of the value of the fund's assets for running the fund. The alternative,
called load funds, charge buyers a commission to both buy and sell shares.

Some funds hold a wide range of stocks or bonds, others specialize in securities issued by a
particular industry or sector, and still others invest as an index fund in a fixed market basket of
securities, such as the stocks in the S&P 500 index. Mutual fund companies also offer funds
that specialize in the stocks and bonds of foreign firms, and these provide a convenient way for
small investors to participate in foreign financial markets.

Hedge Funds. Hedge funds are financial firms organized as a partnership of wealthy investors
that make relatively high risk, speculative investments, Hedge funds are similar to mutual funds
in that they accept money from investors and use the funds to buy a portfolio of assets.
However, a hedge fund typically has no more than 99 investors, all of whom are wealthy
individuals or institutions such as pension funds. Hedge funds usually make riskier investments
than do mutual funds, and they charge investors much higher fees.

Hedge funds frequently short securities whose prices they think may decline, meaning that they
buy the securities from a dealer and sell them in the market, planning to bring them back after
their prices decline.

Short-selling can cause security prices to fall by increasing the volume of securities being sold.

Investments in hedge funds are typically illiquid with investors often not allow to withdraw their
funds for one or three years. And even then, investors are typically given only a narrow window
of time within which they can redeem their investment.

Despite these criticisms, many economists believe that hedge funds play an important role in
the financial system because hedge funds are able to mobilize large amount of money and
leverage the money when buying securities. Hence, they are able to force price changes that
can correct market inefficiencies.

Finance Companies. Finance companies are intermediaries that raise funds through sales of
commercial paper and other nonbank financial securities and use the funds to make small loans
to households and firms. Finance companies raise funds by selling commercial paper (a short-
term debt investment) and by issuing stocks and bonds. They lend these funds to consumers,
who make purchases of such items as cars, furniture and home improvements, and to small
business. Some finance companies are organized by a parent corporation to help sell its
product.
The three main types of finance companies are
a) Consumer finance companies
b) Business finance companies
c) Sales finance companies

Consumer finance companies

These companies make loans to enable consumers to buy cars, furniture and appliances; to
finance home improvement and to refinance household debts.

Examples are Toyota Finance Company makes loans to consumers who purchase Toyota
automobiles and Megaworld Finance Company who extends loans to purchases of Megaworld
Condominium units.

Business finance companies

These companies are engaged in factoring that is, purchasing at a discount the accounts
receivable of small business firms. Some business finance companies purchase expensive
equipment, such as airplanes or construction equipment and then leave the equipment to firms
over a fixed length of time.

Sales finance companies

These companies are affiliated with department stores and companies that manufacture and
sell high-priced goods.

Large department stores issue credit cards that consumers can use to finance purchases at
those stores. Example is SM Department store has established tie-ups with Banco de Oro
(BDO) - Credit Card Company. This convenient access to credit is part of the stores marketing.

Money Market Mutual Funds. These are relatively new financial institutions that have the
attributes of a mutual fund but also function to some extent as a depositing institution because
they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that
are then used to buy money market instruments that are both safe and very liquid. The interest
on these assets is then paid out to the shareholders. These money market mutual funds invest
exclusively in short-term assets, such as treasury bills, negotiable certificates of deposit and
commercial paper.

PRIMARY ASSETS AND PRIMARY LIABILITIES OF FINANCIAL INTERMEDIARIES

The previous section discusses how financial intermediaries play an important role in the
economy. Now we look at the principal financial intermediaries and how they perform the
intermediation function. They fall into three categories: depository institutions (banks),
contractual savings institutions, and investment intermediaries. Figure 11-2 provides a guide to
the discussion of the financial intermediaries that fit into these three categories by describing
their primary liabilities (sources of funds) and assets (uses of funds).
 CHAPTER 13
BASICS OF COMMERCIAL BANKING

INTRODUCTION

Commercial banking is a business. Banks fill a market need by providing a service, and they
earn a profit by charging customers for that service. The key commercial banking activities are
taking in deposits from savers and making loans to households and firms. To earn a profit, a
bank needs to pay less for the funds it receives from depositors than it earns on the loans it
makes. We begin our discussion of the business of banking by looking at a bank's sources of
funds -primarily deposits -and uses of funds - primarily loans.

THE BANK BALANCE SHEET

A bank's sources and uses of funds are summarized on its balance sheet, which is a statement
that lists an individual's or a firm's assets and liabilities to indicate the individual's or firm's
financial position on a particular day. An asset is something of value that an individual or firm
owns. A liability is something that an individual or a firm owes, particularly a financial claim on
an individual pr a firm. Bank capital also called shareholders' equity is the difference between
the value of the bank's assets and the value of its liabilities. (Figure 13.1 presents the Balance
Sheet of an existing bank in the Philippines.

BANK ASSETS

Banks acquire bank assets with the funds they receive from depositors, the funds they borrow,
the funds they acquire from their shareholders purchasing the bank's new stock issues, and the
profits they retain from their operations. A bank manager builds a portfolio of assets that reflect
both the demand for loans by the bank's customers and the bank's need to balance returns
against risk, liquidity, and information costs. The following are the most important bank assets.

Reserves and Other Cash Assets

The most liquid asset that banks hold is reserves, which consist of vault cash-cash on hand and
in the bank (including in ATMs) or in deposits at other banks- and deposits banks have with the
Central Bank (Bangko Sentral ng Pilipinas). As authorized by Congress, the BSP mandates that
banks hold a percentage of their demand deposits and NOW accounts (but not Money Market
Deposit Accounts (MMDAs)) as required reserves. Reserves that bank hold over and above
those that are required are called excess reserves.

Securities

Marketable securities are liquid assets that banks trade in financial markets. Banks are allowed
to hold securities issued by the government, Treasury and other government agencies,
corporate bonds that received investment-grade rating when they were first issued, and some
limited amounts of municipal bonds, which are bonds issued by state and local governments.
Because of their liquidity, bank holding of Government Treasury securities are sometimes are
sometimes called secondary reserves. Commercial banks cannot invest checkable deposits in
corporate bonds (although they may purchase them using other funds) or common stock in
nonfinancial corporations.

Loans Receivable

By far largest category of bank assets is loans. Loans are illiquid relative to marketable
securities and entail greater default risk and higher information costs. As a result, the interest
rates banks receive on loans are higher than those they receive on marketable securities.
1. Loans to businesses called commercial and industrial, or C&I, loans
2. Consumer loans, made to households primarily to buy automobiles, furniture and other
goods
3. Real estate loans, which include mortgage loans and any other loans backed with real
estate as collateral. Mortgage loans made to purchase homes are called residential
mortgages, while mortgages made to purchase stores, offices, factories, and other
commercial buildings, are called commercial mortgages.

Other Assets

Other assets include banks' physical assets, such as computer equipment and buildings. This
category also includes collateral received from borrowers who have defaulted on loans.
BANK LIABILITIES

The most important bank liabilities are the funds a bank acquires from savers. The bank uses
the funds to make investments, for instance, by buying bonds, or to make loans to households
and firms. Bank deposits offer households and firms certain advantages over other ways in
which they might hold their futonds. For example, compared with holding cash, deposits offer
greater safety against theft and may also pay interest. Compared with financial assets such as
Treasury bills, deposits are more liquid. Deposits against which checks can be written offer a
convenient way to make payments. Banks offer a variety of deposit accounts because savers
have different needs. We next review the main types of deposit accounts.

Demand or Current Account Deposits

Bank offer savers demand or current account deposits, which are accounts against
which depositors can write checks. Current account deposits come in different varieties,
which are determined partly by banking regulations and partly by the desire of bank
managers to tailor the checking accounts they offer to meet the needs of households
and firms. Demand deposits and NOW (negotiable order of withdrawal) accounts are the
most important categories of checkable deposits. Demand deposits are current account
deposits on which banks do not pay interest. NOW accounts are checking accounts that
pay interest. Businesses often hold substantial balances in demand deposits because
demand deposits represent a liquid asset than can be accessed with very low
transactions costs.

Nondemand Deposits
Savers use only some of their deposits for day-to-day transaction. Banks offer
nondemand deposits for savers who are willing to sacrifice immediate access to their
funds in exchange for higher interest payments. The most important types of
nontransaction deposits are saving accounts, money market deposit accounts (MMDAs),
and time deposits, or certificates of deposit (CDs).

Borrowings
Banks often have more opportunities to make loans than they can finance with finds they
attract from depositors. To take advantage of these opportunities, banks raise funds by
borrowing. A hank can earn a profit from this borrowing if the interest rate it pays to
borrow funds is low than the interest it earns by lending the finds to households and
firms, Borrowings include short-term loans in the SP finds marker, loans from often just a
bank's foreign branches or other subsidiaries or affiliates, repurchase agreements, and
discount loans from the 1SP. The federal Funds market is the market in which banks
make short-term loans overnight to other banks. Although the name indicates that
government money is involved, in fact, the loans in the federal funds market involve the
bank's own funds.
 Bank Capital
Bank capital, also called shareholders' equity, or bank net worth, is the difference
between the value of a bank's assets and the value of its liabilities.

BASIC OPERATIONS OF A COMMERCIAL BANK

Banks make profits through the process of asset transformation: They borrow short (accept
deposits) and lend long (make loans). When a bank takes in additional deposits, it gains an
equal amount of reserves; when it pays out deposits, it loses an equal amount of reserves.

Although more liquid assets tend to earn lower returns, banks still desire to hold them.
Specifically, banks hold excess and secondary reserves because they provide insurance
against the costs of a deposit outflow. Banks manage their assets to maximize profits by
seeking the highest returns possible on loans and securities while at the same time trying to
lower risk and making adequate provisions for liquidity. Although liability management was once
a staid affair, large (money center) banks now actively seek out sources of funds by issuing
liabilities such as negotiable CDs or by actively borrowing from other banks and corporations.

In this section, we look at how banks earn a profit by matching savers and borrowers. When a
depositor puts money in a checking account and the bank uses the money to finance a loan, the
bank has transformed a financial asset (a deposit) for a saver into a liability (a loan) for a
borrower. Like other businesses, a bank takes inputs, adds value to them, and delivers outputs.

To analyze further the basics of bank operations, we will work with an accounting tool known as
a T-account, which shows changes in balance sheet items that result from particular
transaction.

To take a simple example, suppose you use P100 in cash to open a checking account at
Philippine Commercial Bank (PCB). As a result, PCB acquires P1,000 in vault cash, which it
lists as an asset and, according to banking regulations, counts as part of its reserves. Because
you can go to a PCB branch or an ATM at any time and withdraw your deposit, Philippine
Commercial Bank (PCB) lists your P100 as a liability in the form of current account (CA)
deposits. We can use. a T-account to illustrate the changes in PCB's balance sheet that result:
MANAGEMENT OF BANK ASSETS

To maximize its profits, a bank must simultaneously seek the highest returns possible on loans
and securities, reduce risk and make adequate provisions for liquidity by holding liquid assets.

Although more liquid assets tend to earn lower returns, banks still desire to hold them.
Specifically, banks hold excess and secondary reserves because they provide insurance
against the costs of a deposit outflow.

Banks try to accomplish these objectives by using the following strategy:

1. Banks try to find borrower who will pay high interest rates and will most likely settle their
loans on time. By adopting consecutive loan policies, banks avoid high default rate but
may miss out on attractive lending opportunities that earn high interest rates.
2. Banks try to purchase securities with high returns and low risk. By diversifying and
purchasing many different types of assets (short-term and long-term, treasury bills)
banks can lower risk associated with investments.
3. Banks manage the liquidity of the assets so that its reserve requirements can be met
without incurring huge costs. This implies that liquid securities must be held even if they
earn a somewhat lower return than other assets. The bank must balance its desire for
liquidity against the increased earnings that can be obtained from less liquid assets such
as loans.

MANAGEMENT OF BANK LIABILITIES

Before the 1960s, bank liability management involved

a) heavy dependence on demand deposits as sources of bank funds, and b) non-reliance
on overnight loans and borrowing from other banks to meet their reserve needs In the
60s - large banks key financial centers such as New York, Chicago and San Francisco in
the United States, began to explore ways in which the liabilities on their balance sheets
could provide them with reserves and liquidity. Overnight loans market such as the
federal funds market in the United States expanded and new financial instruments
enables to banks to acquire funds quickly.

Banks no longer depended on demand deposits as the primary source of bank funds.
Instead, they aggressively set target goals for their asset growth and tried to acquire
funds (by issuing liabilities) as they were needed.
 Hence, negotiable CDs and bank borrowings greatly increased in importance as a
source of bank funds in recent years. Demand deposits have decreased in importance
as source of funds.

MANAGEMENT OF BANK CAPITAL

Banks manage the amount of capital they hold to prevent bank failure and to meet bank capital
requirements set by the regulatory authorities.

However, they do not want to hold too much capital because by so doing, they will lower the
returns to equity holders.

In determining the amount of bank capital, managers must decide how much of the increased
safety that covers with higher capital (the benefit) they are willing to trade off against the lower
return on equity that comes with higher capital (the cost).

Because of the high costs of holding capital to satisfy the requirement by regulatory authorities,
bank managers often want to hold less capital than is required.

BANK CAPITAL AND BANK PROFIT

As with any other business, a bank's profit is the difference between its revenue and its costs. A
bank's revenue is earned primarily from interest on its securities and loans and from fees it
charges for credit and debit cards, servicing deposit accounts, providing financial advice and
wealth management services, originating and collecting payments on securitized loans, and
carrying out foreign exchange transactions. A bank's costs are the interest it pays to its
depositors, the interest it pays on loan or other debt, and its costs of providing its services. A
bank's net interest margin is the difference between the interest it receives on its securities and
loans and the interest it pays on deposits and debt, divided by the total value of its earning
assets.

If we subtract the bank's cost of providing its services from the fees it receives, divide the result
by the bank's total assets, and then add the bank's net interest margin, we have an expression
for the bank's total profit earned per peso of assets, which is called its return on assets (ROA).
ROA is usually measured in terms of after-tax profit, or the profit that remains after the bank has
paid its taxes:
A bank's shareholders own the bank's capital, which represents the value of their investment -
or- equity in the firm. Naturally, shareholders are more interested in the profit the bank's
managers are able to earn on the shareholders' investment than in the return on the bank's total
assets. So, shareholders often judge bank managers not on the basis of ROA but on the basis
of return on equity (ROE). which is after-tax profit per peso of equity, or bank capital:

The ratio of assets to capital is one measure of bank leverage, the inverse of which (the ratio of
capital to assets) is called a bank's leverage ratio. Leverage is a measure of how much debt an
investor assumes in making an investment. The ratio of assets to capital is a measure of bank
leverage because banks take on debt by, for instance, accepting deposits to gain the funds to
accumulate assets.

Moral hazard can contribute to high bank leverage in two ways. First, bank managers are
typically compensated at least partly on the basis of their ability to provide shareholders with a
high ROE. As we have seen, riskier investments normally have higher expected returns. So to
increase ROE, bank managers may make riskier investments. Depositors with accounts below
the deposit insurance limit do not suffer losses if their bank fails as a result of the bank's
managers having taken on excessive risk. So, bank managers do not have to fear that
becoming more highly leveraged will cause many depositors to withdraw their funds.

To deal with the risk of banks becoming too highly leveraged, government regulations called
capital requirements have placed limits on the value of the assets commercial banks can
acquire relative to their capital. Expanded capital requirements, domestically and globally, were
an important regulatory response by governments to a financial crisis.

MANAGING BANK RISK

In addition to risks that banks may face from inadequate capital relative to their assets, banks
face several other types of risk. In this section, we examine how banks deal with the following
three types of risks: liquidity risk, credit risk, and interest-rate risk.

Managing Liquidity Risk

Liquidity risk is the possibility that a bank may not be able to meet its cash needs by selling
assets or raising funds at a reasonable cost. For example, large deposit withdrawals might force
as bank to sell relatively illiquid securities and possibly suffer losses on the sales. The challenge
to banks in managing liquidity risk to reduce their exposure to risk without sacrificing too much
profitability. For example, a bank can minimize liquidity risk by holding fewer loans and
securities and more reserves. Such as strategy reduces the bank's profitability, however,
because the bank earns no interest on vault cash and only a low interest rate on its reserve
deposits with the Fed. So, although the low interest rate environment during the years
following the financial crisis caused many banks to hold large amounts of excess reserves,
more typically banks reduce liquidity risk through strategies of asset management and liquidity
management.

Managing Credit Risk

Credit risk is the risk that borrowers might default on their loans. One source of credit risk is
asymmetric information, which often results in the problems of adverse selection and moral
hazard. Because borrowers know more about their financial health and their rule plans for using
borrowed money than do banks, banks may find themselves inadvertently lending to poor credit
risks or to borrowers who intend to use borrowed funds for something other than their intended
purpose. We next briefly consider the different methods banks can use to manage credit risk.

a. Diversification Investors-whether individuals or financial firms can reduce their

exposure to risk by diversifying their holdings. If banks lend too much to one borrower, to
borrower in one region, or to borrowers in one region, or to borrowers in one industry,
they are exposed to greater risks from those loans. For example, a bank that had
granted most of its loans to oil exploration and drilling firms in Texas would have likely
suffered serious losses on those loans following the decline in oil prices that began in
June 2014 and lasted through January 2016. By diversifying across borrowers, regions,
and industries, banks can reduce their credit risk.

b. Credit-Risk Analysis In performing credit-risk analysis, bank loan officers screen loan
applicants to eliminate potentially bad risks and to obtain a pool of credit worthy
borrowers. Individual borrowers usually must give loan officers information about their
employment, income, and net worth. Business borrowers supply information about their
current and projected profits and net worth. Business borrowers supply information
about their current and projected profits and net worth. Banks often use credit-scoring
systems to predict statistically whether a borrower is likely to default. For example,
people who change jobs.

Reducing Interest-Rate Risk

Bank managers can use a variety of strategies to reduce their exposure to interest-rate risk.
Banks with negative gaps can make more adjustable rate or floating-rate loans. That way, if
market interest rates rise and banks must pay higher interest rates on deposits, they will also
receive higher interest rates on their loans. Unfortunately for banks, many loan customers are
reluctant to take out adjustable-rate loans because while the loans reduce the interest-rate risk
banks face, they increase the interest-rate risk borrowers face.

Banks can also use interest-rate swaps in which they agree to exchange, or swap, the
payments from a fixed-rate loan for the payments on an adjustable-rate loan owned by a
corporation or another financial firm. Swaps allow banks to satisfy the demands of their loan
customers for fixed-rate loans while still reducing exposure to interest-rate risk. Banks can also
use futures contracts and options contracts to help hedge interest-rate risk
 CHAPTER 14
EXPANDING THE BOUNDARIES OF BANKING

INTRODUCTION

The activities of banks have changed dramatically during the past five decades Between 1960
and 2018, banks
1) increased the amount of funds they raise from time deposits and negotiable certificate of
deposits;
2) increased their borrowings from repurchase agreements;
3) reduced their reliance on commercial and industrial loans and on consumer loans;
4) increased their reliance on real estate loans; and 5) expanded into nontraditional lending
activities and into activities where their revenue is generated from fees rather than from
interest.

Off-Balance-Sheet Activities
Banks have increasingly turned to generating fee income from off-balance-sheet activities.
Traditional banking activity, such as taking in deposits and making loans, affects a bank's
balance sheet because deposits appear on the balance sheet as liabilities, and loans appear as
assets. Off-balance-sheet activities do not affect the bank's balance sheet because they do not
increase either the bank's assets or its liabilities. For instance, when a bank buys and sells
foreign exchange for customers, the bank charges the customers a fee for the service, but the
foreign exchange does not appear on the bank's balance sheet. Banks also charge fees for
private banking services to high-income households.

1. Loan commitments. A bank earns a fee for a loan commitment. In a loan commitment,
a bank agrees to provide a borrower with a stated amount of funds during a specified
period of time. The fee is usually split into two positions:
a) upfront fee when the commitment is written and
b) non-usage fee on the unused portion of the loan.

Interest is charged for loans are actually made. It is usually marked up over a
benchmark lending rate.
2. Standby letters of credit. With a standby letter of credit, the bank commits to lend
funds to the borrower - the seller of the commercial paper-to pay off its maturing
commercial paper.

This is also availed of in connection with importation of goods by the businessmen.

3. Loan sales. A loan sale is a financial contract in which a bank agrees to sell the
expected future returns from an underlying bank loan to a third party. Loan sales, also
called secondary loan participations involve sale of loan contract without recourse, which
means that the bank does not provide any guarantee on the value of the loan sold and
no insurance.

With securitization, instead of the bank holding the loans in their own portfolio, it
converts bundles of loans into securities that are sold directly to investors through
financial markets.

Large banks sell loans primarily to domestic and foreign banks and to other financial
institutions.

4. Trading activities. Banks earns fees from trading in the multibillion dollar markets for
futures, options, and interest-rate swaps. Bank trading in these markets is primarily
related to hedging the banks' own loan and securities portfolios or to hedging services
provided for bank customers.

As the beginning of financial crisis of 2007-2009, most people were unfamiliar with such
terms are mortgage-backed securities (MBSs), collateralized obligation (CDOs), and
credit default swaps (CDDs).

During the financial crisis, these terms became familiar as economists, policymakers,
and the general public came to realize that commercial banks no longer played the
dominant role in routing funds from savers to borrowers. Instead, a variety of "nonbank"
financial institutions including investment banks, mutual funds and hedge funds were
acquiring funds that had previously been deposited in banks.

They were then using these funds to provide credit that banks had previously provided.
These nonbanks were using newly developed financial securities that even long-time
veterans of banking did not fully understand.

These nonbank financial institutions have been labeled the "Shadow Banking” system
because while they match savers and borrowers, they do so outside the commercial
banking system.

In this chapter, we describe the different types of firms that make up the shadow banking
system.
INVESTMENT BANKS
Investment banks offer distinct financial services, dealing with larger and more complicated
financial deals than retail banks.

The smooth functioning of securities markets, in which bonds, stocks, and derivatives are
traded, involves several financial institutions including investment banks, securities brokers and
dealers and venture capital firms.

Investment banks assist in the initial sale of securities in the primary market, securities brokers
and dealers assist in the trading of securities in the secondary markets. Finally venture capital
firms provide funds to companies not yet ready to sell securities to the public.

Role of Investment Banks

Investment banks work with large companies, other financial institutions such as investment
houses, insurance companies, pension funds, hedge funds, governments, and individuals who
are very wealthy and have private funds to invest.

Investment banks have two distinct roles. The first is corporate advising. meaning that they help
companies take part in mergers and acquisitions, create financial products to sell, and bring
new companies to market. The second is the brokerage division where trading and market-
making- in which the investment bank provides mediation between those who want to buy
shares and those who want to sell-take place. The two supposed to be separate and distinct, so
within an investment bank there is a so-called "wall" between these divisions to prevent conflict
of interest.

An investment bank is a financial intermediary that performs various services, including complex
financial transactions as raising capital for corporations, governments or other entities,
underwriting, securities, facilitating mergers and other corporate reorganizations.

Investment banks employ professional investment bankers who help corporations, governments
and other groups plan and manage large projects saving their client time and money by
identifying risks associated with project before the client moves forward.

Typical divisions within investment banks include

1. Industry coverage groups
 2. Financial products groups

Industry coverage groups are established to have separate groups within the bank each having
expertise in specific industries or market sections such as technology or health care. They
develop client relationships with companies within various industries to bring financing, equity
issue or merger and acquisition business to the bank.
Financial products groups provide investment banking financial products such as IPOs, M&As,
Corporation restructuring and various types of financing. There may be separate product groups
that specialize in asset financing, leasing, leveraged financing and public financing.

Types of Firms Engaged in Investment Banking

The classification of investment banks is primarily based on "size" which may refer to the size of
the banks in terms of the number of offices or employees or to the average size of M & A deals
handled by the bank.
a. Bulge Bracket Banks
b. Middle-Market Banks
c. Boutique Banks

Discussion

a. Bulge Bracket Banks

The bulge bracket banks are the major, international investment banking firms with
easily recognizable names such as Goldman Sacks, Deutsche Bank, Credit Suisse
Group AG, Morgan Stanley and Bank of America.

The bulge bracket banks are the largest in terms of number of offices and employees
and also in terms of handling the largest deals and the largest corporate clients.

Each of the bulge bracket banks operates internationally and has the largest global as
well as domestic presence. They provide their clients with the full range of investment
banking services including

1. Trading, all types of financing, asset management services

2. Equity research and issuance
3. M&A services
Most bulge bracket banks also have commercial and retail banking divisions and generate
additional revenue by cross-selling financial products.

One notable shift in that happened after the financial crisis in the investment banking market
place is the number of Fortune 500 and high net-worth clients that opted to retain the services of
elite boutique investment banking firms over the bulge bracket firms.

b. Middle-Market Banks
Middle-market investment banks occupy the middle position between smaller regional
investment banking firms and massive bulge bracket investment bank.

They provide the same full range of investment banking services as bulge bracket banks
such as
a) Equity and debt capital market services
b) Financing and asset management services
c) M&A and restructuring deals

Deals could range from about $50 Million to $500 Million or more.

Expanding the Boundaries of Banking

c. Boutique banks are further divided into:

1) Regional Boutique Banks
2) Elite boutique Banks

Regional boutique banks are the smallest of the investment banks, both in terms of
firm size and typical deal size. They commonly serve smaller firms and organization
but may have as clients’ major corporations headquartered in their areas. They
generally handle smaller M&A deals, in the range of $50 to $100 million or less.

Elite boutique banks. There are often like regional boutique in that they usually do
not provide a complete range of investment banking services and may limit their
operations to handling M&A related issues. They are more likely to offer restructuring
and asset management services. Most elite boutique banks begin as regional
boutiques and then gradually work up to elite status through handling successions of
larger and larger deals for more prestigious clients.

The other nonbank financial institutions (e.g., Mutual Funds, Hedge Funds and
Finance Companies) that make up the shadow-banking system are discussed in
Chapter 12.
AREAS OF BUSINESS

While the brokerage and corporate advising divisions of an investment bank are theoretically
distinct, there is inevitably overlap between the two areas of, for example, market-making and
underwriting new share issue, or mergers and acquisitions advising and research.

A. Brokerage
1. Proprietary trading. Investment banks have their own funds, and they can both
invest and trade their own money, subject to certain conditions.
2. Acting as a broker. Banks can match investors who want to buy shares with
companies wanting to sell them, in order to create a market for those shares (known
as market-making).
3. Research. Analysts look at economic and market trends, make buy or sell
recommendations, issue research notes, and provide advice on investment to high
net-worth and corporate clients.

B. Corporate advising
1. Bringing companies to market. Investment banks can raise funds for new issues,
underwriting Initial Public Offerings (IPOs) in exchange for a cut of the funds they
raised.
2. Bringing companies together. Banks facilitate mergers and acquisitions (M&A) by
advising on the value of companies, the best way to protected, and how to raise
capital.
3. Structuring products. Clients who want to sell a financial product to the public may
bring in an investment bank to design it and target the retail or commercial banking
market.

HOW INVESTMENT BANKS MAKE OR LOSE MONEY

Making money
Banks receive fees in return for providing advice, underwriting services, loans and guarantees,
brokerage services, and research and analysis.

They also receive dividends from investments they hold, interest from loans, and charge a
margin on financial transactions they facilitate.

Losing money
The advising division may end up holding unwanted shares if the take-up of an IPO is lower
than expected. The trading division of a bank may make the wrong decisions and end up losing
the bank money.

In a year of little corporate activity, banks may have to rely on trading profits to bolster their
returns. Banks may create financial products which they fail to sell on to other investors, leaving
them holding loss-making securities or loans.