Chapter 1:

Financial Institutions: Businesses that provide financial services

Leverage = debt --> When a hostile takeover is done with a lot of debt, it means that the takeover occurred as a result of a company buying a controlling stake in another company

Derivatives = financial instruments whose price is derived / based on other financial instruments (eg. Arbitrage - strategy in which you buy an asset in one market and sell in another --> profit from small price
differences)

Vulture investors = identify companies which are in trouble - aim to liquidate a company for more than they pay

Insider trading = trading on the basis of insider information

Setting up a Business:

○ Legal structure of the business

○ Sole traders, Partnerships, Incorporated business
○ A corporation:
■ Stands on its own from the founder
■ Governance structure - Board of directors (represent shareholders' interest); Founder can choose the first board of directors
■ Moving from shareholder capitalism to stakeholder capitalism

Legal structure of business has implications for:

○ Risk involved
○ Tax
■ Sole traders are taxed on the team
■ Corporation - Corporation gets taxed, shareholders get taxed on dividends
○ Conflicts of interest
■ Principle Agent Problem - Different parties with different, possibly conflicting interests
○ Capital raising
■ Easier with a corporation
○ Survival of the business
■ Survival beyond the death of the owners
■ Many don't survive because of M&As

Legal Systems: Set of rules for you to operate

○ Common Law: Judges/Courts decide a precedent - sets the foundation for the future judgements
○ Civil Law System: Law is written in a book using codes - Power of interpretation is limited
○ Religion based Law: Sharia Law - Based on Quran and religious texts

Eg. US - Federal Law which applies to the whole country, State Law which applies only to that specific state

Mutual Funds - If you invest in mutual funds, you become a shareholder - Customers are the shareholders

○ Focus: Usually on Publicly Listed Corporations – Limited Liability companies, Legal entity in its own right
○ A legal structure has a range of implications:
■ Risk involved for different stakeholders
■ Tax
■ Conflict of interest
■ Possibility to raise capital
■ Survival of Business

Financial Statements

○ Financial statements are accounting reports issued periodically to present past performance and a snapshot of the firm’s assets and the financing of those assets
■ Demonstrates company’s financial health
○ Financial statements must be verified by an independent auditor who ensures that the financial statements are a true and fair representation of the company’s position
○ Big 4 Auditing Firms:
■ PwC
■ KPMG
■ EY
■ Deloitte
○ Annual report usually involves a discussion of management strategies, corporate governance and a comprehensive financial statements

○ Accounting standards = “language” of financial statements

■ IFRS (International Financial Reporting Standards)
■ US GAAP
○ Types of Financial Statements
 ■ Balance Sheet
■ AKA Statement of Financial Position
■ A = L + SE àThe two sides must balance
■ Assets – Uses of capital
■ Liabilities – Sources of Capital
■ Snapshot of what the company owns and what it owes
■ If we owe more than we own, we have negative equity à An undesirable situation
■ Book value ≠Market value hence some successful firms can borrow more than the book value of their assets
■ Income Statement (Profit and Loss Account)
■ Measure of profitability
■ Cash flow statement
■ Constructed based on Balance sheet and income statement
■ How much cash the firm has generated (income statement contains items which are not always received in cash)
■ How much cash the firm has allocated during a given time period
■ Needed to pay bills and maintain the operations (working capital)
■ Statement of Stockholders Equity

○ Shareholder’s Equity (Capital)

■ Constitutes of amount invested by shareholders and retained profit held by the firm
■ Measures the net worth of the firm

○ Market value versus Book Value

■ Book value of equity is the net worth from an accounting perspective. This may be different from the market value because the true value of an asset is subjective.
Additionally, many valuable assets (intangible assets) are not represented on the balance sheet (reputation, quality, brand image)
○ Market Capitalisation (AKA the market value of equity)
■ The market’s perception of the company
■ Market Cap = Market price x # of shares

Capital Structure

○ Funding the business

■ 2 main sources à Debt Capital (Liabilities) and Equity Capital (Shares/Stocks)

Equity: Stocks
○ Source money from the 3Fs (friends, family and fools) by issuing shares
○ Once the business establishes itself, you can raise more money from financial investors (angel investors, venture capital and private equity)
○ As it grows further, the firm can get listed on a stock exchange through an IPO and raise money from the general public
○ Stockholders are residual claimants
■ The firm pays its debt holders before it pays its equity holders
Debt: Loans, bonds, notes
■ Borrowing money from
■ Suppliers – Trade credit & payables
■ Banks – Loans
■ Finance companies – Leases
■ Investors – Bonds, notes, private placements

Stages of the life cycle and Associated Funding Patterns:

○ Stage one: Self Funding; Inside funding (Friends & Family)

○ Stage two: Information-intensive external (Banks and Financial
intermediaries)
○ Stage three: Widely known firms access investors directly (Corporate bond markets)

Important Ratios:

○ EBIT = Earnings before interest and tax

○ EBITDA
■ Earnings before interest, tax, depreciation and amortization
■ Because depreciation and amortization are non-cash expenses, EBITDA usually reflects a good estimate of the cash earnings that a firm makes
■ EBITDA = EBIT + depreciation + amortisation
○ EPS (Earnings per Share) = Net income / Outstanding Shares
 ■ Net income reported on a per-share basis
■ Diluted EPS:
■ Not just accounting for the existing shares that have been issued but also any shares that could be issued in the future
■ Eg. Promise to managers to issue shares under ESOP
■ Eg. Convertible bonds being converted to shares

Financial Systems

Derivatives:

○ Forwards – Oldest forms of derivatives

○ Futures – Oldest forms of derivatives
■ Futures are ONLY traded on Exchange – Exchange specific contracts
○ Swaps
■ Trade one type of asset for another
○ Options

Securitization = Transforming an asset into a security (traded in capital markets)

Securities are negotiable, tradable financial instruments

 ○ Service Providers;
■ Lawyers
■ Platforms to facilitate settlements
■ Auditors
● Key Building Blocks for Capital Markets:

○ Consist of: Government bonds, Corporate and FI bonds, Equity, Securitised Products
○ Regulatory frameworks
○ Regulations and standards
○ Taxation
○ Market infrastructure and technology
○ Foundations:
■ Benchmark assets
■ Supply of capital
■ Demand for capital
■ Intermediation
■ Free markets
■ Price discovery

Functions of Financial Markets

○ Channelising funds from surplus units to deficit units

○ Efficiency
○ Price determination = Valuation
○ Risk sharing
○ Liquidity
○ Financial Stability à Exist in tandem with economic and political stability
○ Information aggregation and coordination
Incentives of:
○ Investors:
■ Strong communication within the firm
■ Higher than market return
■ Strong legal and compliance teams
■ Company growth
■ Higher dividends & capital gain
■ Stronger company reputation
■ Liquidity

○ Chief financial officer / CEO

■ Seek to find largest sources of finance
■ Lowest interest rates
■ Smaller firms - Advice and knowledge
■ Higher share price --> Greater amount of finance = Maximise valuation
■ Pay less dividends & retain as much profit as possible
■ Higher profitability, lower costs
■ Better credit rating
■ Better political lobbying power to lower corporate tax rates
■ Lower risks by diversifying funding sources
Capital structure problem: Trying to find the optimal mix of financing from debt and equity

○ Regulators
■ Credibility of the economic systems
■ Steady flow of economic transaction without jeopardising credibility and transparency
■ Political incentives
■ Encourage competition and FDI
■ Promote a more open and competitive market
■ Stability of the economy
■ National security
■ Prevent fraud/scam --> Promote reputation

Classifications of Financial Markets

Primary and Secondary Markets

Primary markets involve raising money/capital for the first time
An IPO would be conducted in the primary market
Secondary markets are when securities are sold to other investors

The larger the secondary market, the more liquid the financial market - Bonds are more liquid than loans (in theory)

Debt verses Equity

Market Organization
○ Direct search: When a buyer and seller interact with each other directly without any intermediaries
○ Brokered market: When a buyer and seller meet through a broker (middle agent to connect both parties)
○ Dealer market: Makes money by buying an asset and selling at a higher price
○ Auction market: Put buyers and sellers together in an auction mechanism
● In an Auction Market, all bids and offers entered into system; price

determined at equilibrium point (Dutch auction) or highest price bid; Not determined based on supply and demand

Price determination under different methods of market organizations

○ Dealer Markets:
■ Price determined by market makers (traders/dealers) based on supply and demand
■ Their existing position (inventory of financial instruments)
■ Their view of the market
○ Broker markets: Price determined by supply/demand
○ Auction markets: All bids and offers entered into a system in which the price is determined at the equilibrium point or the highest price bid

Exchanges versus OTC

○ Exchanges are one centralized “platform” – Platform for interaction between buyers and sellers
○ Stock exchange and Derivatives exchange
○ Can be auction markets or dealer markets

○ OTCs are not localised

○ Typically dealer markets (eg. Bond market – Even though the bonds are listed on the exchange)

Key Points – Often misunderstood:

○ Trading verses Listing – Financial instruments can be listed on an exchange
■ To list a security or a financial instrument, the firm needs to meet the listing requirements and rules of that particular exchange
■ Usually involves provision of audited financial statements
■ This doesn’t necessarily mean that they trade on that exchange
■ Trading is based on supply and demand for the particular instrument
■ A stock can be listed on an exchange but very rarely traded on it if there is no or limited liquidity
■ The “Float” = How many shares are there really available to be traded
○ Some financial instruments are ONLY traded on exchanges
■ Futures are exchange specific financial instruments
○ Bonds are often listed on exchanges but are traded on OTCs
○ Forex only trades OTCs

Domestic versus International

Domestic, Euro and Foreign Markets

This concept discusses the geographic classifications of a securities issue based on certain parameters.

In order to classify, you must ask the following questions in the same order:

○ What currency is the security issued in?

○ Where is the security placed? Who are the investors?
■ Is this the same currency as the domestic country?
○ Where is the issuer?

Domestic issues: Placed with investors in the country of the currency and the issuer is also from the country of the currency

Foreign issues: Placed with investors in the country of the currency but the issuer is from a different country

Euro Issues: Placed with investors outside the country of the currency. It doesn’t matter where the issuer is from.

Domestic: Currency A, Investors A, Issuer A

Foreign: Currency A, Investors A, Issuer B
Euro: Currency A, Investors B

○ Euro in this case has no relevance to the currency Euro

● Eg 1) HK Land issues a HKD bond placed to HK Investors

Currency of issuance = HKD

Investors in HK
Issuer in HK
Hence, Domestic

● Eg 2) HK Land issues a USD denominated bond to US Investors

Currency of issuance = EUR

Investors in US
Issuer in HK
Hence, Foreign
 ● Eg 3) HK Land issued a USD Denominated bond to EU investors

Currency of issuance = USD

EU Investors
Issuer in HK
Hence, Euro

BIS Classification of Bond Markets

Bank for International Settlements - Important for international investments and capital flows
The BIS classifies security issues are classified as domestic or international - In ternational includes both foreign and euro issues

Internal vs External Classifications

Public versus Private

General public vs Private placements

Public Issues

○ Targeted at the general public (“retail” issues)

○ Subjected to heavy regulation
○ Typically underwritten by an investment bank which involves the Investment Bank buying the whole issue and distribute to the investors
○ Usually requires:
■ Disclosure (information memorandum) and due diligence (done by an investment bank) à Need to verify the information in the disclosure is complete, accurate and not
misleading
■ Rating
■ Prior approval from the regulator / queuing system
● Private Issues

○ Targeted at sophisticated investors / Qualified institutional buyers

○ Typically exempted from registration requirements
○ Lower standards of disclosure and regulation because the investors are deemed more experienced
○ Generally no need for underwriting
● Current Topics involving Market Organization

○ The advent of electronic trading (No more physical stock exchanges)

○ Demutualization and listing of exchanges
○ Mergers and Consolidation
■ M&A versus organic growth
○ Dark pools and private exchanges
■ When SEs (stock exchanges) are monopolies, they set prices which companies wouldn’t want. This causes private exchanges to appear in the market.
○ Advent of High Frequency Trading
 ■ General public is unable to follow and keep up with the technological advancements
○ Regulators push to move OTC onto Exchanges
■ If all the securities and assets are listed on one platform, there is a single point of failure. If anything goes wrong, the whole stock exchange can collapse

How to grow an SE?

○ New listing rules to make it easier --> More listing fees earned
○ Market to different companies around the world to list on their exchange
○ Change voting rights
○ HKSE product in RMB to attract Chinese buyers and sellers
○ HKSE acquired LME (London Metal Exchange)
○ HKSE is a monopoly --> They set the price

Chapter 2:
Overview of the topic:
● Concepts involved in Interest rates
● Time value of Money
● Discounted Cash flows

● Important concepts:
● Interest rates, unless specified, refer to a yearly interest rate (per annum / pa)
● Financial institutions are usually required to indicate the interest rates in the form of an annual percentage rate (APR) to enable comparisons across different borrowing
options
● The type of financial instrument we use will impact the way we calculate interest payments. The conditions need to be verified in the contract.

● Time Value of Money

○ Different debt instruments have different streams of cash payments to the holder (cash flows) with different timings
■ Need to consider whether paying $X today is more or less valuable than paying $Y in the future
■ Use Discounted Cash Flow Calculations

● Timeline

Introduction to DCF
● Based on the notion that “a dollar is worth more today than it is tomorrow” = The underlying principle of the time value of money
○ This rests on the assumption that positive interest rates exist (which in reality may not hold true – Possibility for negative interest rates)
● Present Value: The value of a cost or benefit computed in terms of cash today
● Future Value: The value of a cash flow that is moved forward in time
○ The value of an investment made today in the future
● Example

○
○ Principal = $100, APR = 6%, After 2 Years
■ FV = 100 x 1.06^2 = $112.36
■ If instead of investing the $100, I had left it in the bank, the opportunity cost is $112.36
● Compounding Frequency
○ If Annual rate 6% what is the monthly rate, if interest are computed monthly?
○ Assume is the monthly interest rate then in one year (n = 12), a deposit of $100 has a FV of 100 x (1+j)^12
○ In one year, the FV = 100 x 1.06
○ Hence, to find j, equate (1+j)^12 with 1.06

● A basis point represents 0.01% - 0.49% = 49 bp

● The greater the compounding frequency, the greater the future value
 ● Present Value for a given payment

○
● Understanding the present value is critical as it is the single most important relationship in the study of financial instruments. It forms the basis for Discounted Cash
Flow Analysis.

Comparing Revenues at Different Points in Time: Worked Example

Revenue (Present) = $2 billion - PV(1)

Revenue (1 yr later) = $1.6 billion – FV(2)
r = 8%

Converting Revenue (1 year later) to present terms,

1.6 / (1+0.8) = 1.48 billion

Cost of a delay = 2 bn – 1.48 bn = 0.52 bn

Valuing a Stream of Cash Flows

When there are interval payments, you need to use a timeline. Identify clearly the variable you are solving for

PV = 1000, Interval Payments = 1000, n = 3, I = 10, Find FV

● Calculate the future value of all deposits and Sum them

 Generalised Formula to Calculate PRESENT VALUE (NOT FUTURE value as in previous example):

Types of Financial Instruments that have a stream of cash flow payments:

Perpetuities

A perpetuity is a stream of equal cash flows that occur at regular intervals and last forever. The first cash flow arrives at the end of the first period.

Because the cash flows are all equal. This formula can only be used if r > 0

Annuities

An Annuity is a stream of N equal cash flows C paid at regular intervals after a fixed number of payments (N)

● REMEMBER the ASSUMPTIONS THAT YOU MAKE WHEN DOING CALCULATIONS

INTERNAL RATE OF RETURN

When you have to equate a given present investment cost with the future payments you will receive to calculate the interest rate (the maximum interest rate at which you can borrow the
money)

The internal rate of return is the interest rate at which the PV of the investment = cost

● Equate 4 million today and 500 000 per year for 10 years

●
● Solve for r, to get r = 4.28%
○ Represents the breakeven point at which you can borrow the 4 million
 Fixed Cash flows + Different amount on maturity date

Chapter 3:
Fundamentals of Bonds:
● A debt financial instrument with a promise to make a series of payments of specified dates. They are securities – Negotiable, tradable financial instruments
● Legal contract drawn between investors and issuers:
● Payments made by the issuer to the buyer
● Specific terms and conditions (covenants) including what happens in the event where the issuer fails to make a payment (event of default)

● The most common type of bond: Coupon bond

● Regular payments, called coupon payments, have to be made to the investor
● The interest that the issuer pays is calculated using the coupon rate
● Frequency of payments: Annual or Semi-Annual
○ Ensure to convert any values according to their frequency
● Maturity date = The date on which the principal of the bond is repaid
● Final payment comprises of: principal (face value/par value) and the final coupon payment

● Bearer Bonds: Whoever is in possession of a bond has the legal right and eligibility to claim it (Security and theft risks)

Debt Capital Markets:

Public Debt Markets (DCM): Bonds and notes

Private Debt Markets: Medium Term Notes (MTN), Private placements, Syndicated & Bilateral Loans, Project & Structured Finance, Supply chain & Trade finance

Key Formula: Bond Price

● Perpetual / Consol Bond:

● and 𝑛 =∞ and 𝑖 > 0

Zero Coupon Bonds

● Only two cash flows involved:

● The bond’s market price at the purchase date
● The bond’s face value / principal at maturity – How much you get at the end

● Yield to maturity
● The discount rate (interest rate) that allows the present value of the promised bond payments to be equal to the current market price of the bond

●
● KEY POINTS:
○ When a coupon bond is priced at its face value, the yield to maturity is equal to the coupon rate
○ The price of a bond is inversely related with the yield to maturity - The higher the YTM, the lower the price of the bond
○ The return on a bond does not necessarily equal the interest rate on that bond

Yield Curves are a graph representing the relationship between maturity and yield to maturity;
Are used to price financial instruments
Yield curves are based on the government bonds in your location

US Government Securities: Treasuries

Government securities are the reference points to price any debt instrument
Very important market because USD is the reserve currency around the world

Debt:
Interest = reference rate + risk premium
Reference rate = “Risk-free” rate
Risk premium = Cost of funding (Should compensate the investors for the risk they are taking)
AKA credit spread, margin
Risk free rate = rate of return on securities issued by the government – In theory, a government usually doesn’t default on its own currency debt (Domestic debt)

How does the bond market work?

● The Fed acts as an administrative body
● Runs through an auction mechanism (Fundamentals are different to that of an auction system for antiques, for instance)
○ Primary dealers
○ Dutch auction mechanism
● Government, through the Fed, announces an auction schedule for the auction dates of different types of securities
○ Auction date = Trade date
○ Settlement date = Value date (When the money changes hands)
● <1 maturity bills = Treasury Bills (T-bills)
● Notes: One year to 10 year maturity
● Bonds: Over 10 year maturity period
● Longest maturity (US market): 30 years – “Long bond”

● Fixed rate: interest rate is determined at the date of issue and they receive the same interest until maturity (Bond market usually follows this system)
● Floating rates: interest rate is recalculated at the beginning of each interest period according to market conditions (usually in the loan market)
● TIPS: Treasury Inflation Protected Securities
Each treasury issue stands on its own; They are not fungible – They cannot be aggregated with previous issues - Hence, the price at which they trade is different
● On the run – Securities being issued currently
● Off the run – Securities already issued

Coupon Bonds
● Pay face value at maturity
● Make regular coupon interest payments
● Return from coupon bonds = difference between the purchase price and the principal value
● Periodic coupon payments

Bond Pricing
● Relationship between bond price and interest rates is very important
○ The value of a bond is inversely related to the interest rate
● At par - YTM = Coupon rate
● At premium - YTM < Coupon rate
● At discount - YTM > Coupon rate

Short term debt instruments

 Money Market Rates

Money market instruments include: time deposits, T bills, certificates of deposits, commercial paper, Forward Rate Agreements (FRA), Bankers’ acceptances

Interest = Principal x Interest rate x (number of days / number of days in a year)

Day Count Convention

Market convention that expresses the ratio of # of days in a month to the # of days in a year

Important Dates:
● The trade date: When the deal is made
● The settlement/value date: when the money changes hands; when the transaction takes place
● The maturity date: When the money is returned

If the date of maturity lands on a day when the banks are closed (non-business day), the payment can either occur on the preceding day (preceding business day convention) or
the following day (following business day convention)

1. The date at which they realize that they have money to invest - Check whether it is a business day
2. If it is a business day, that will be the trade date. If not, the next business day will be the trade date.
3. Value date = Trade date + 2 business days
4. Maturity date = D3 + # of months
a. If maturity date is not a business day, use the modified following convention
b. If the next business day is in the next calendar month, use the preceding business day convention

Chapter 4:
Role of Financial Institutions:
Ensure the health of the overall economy; Channel funds from surplus sources of funds to deficit sources of funds
 Financial intermediaries are financial institutions that provide financial intermediation
● Financial Institutions that collect deposits: depository institutions – Because the financial regulators want to protect individuals and retail investors – they mostly save in a
bank
○ They want to ensure that people feel safe when they are depositing money

You may encounter firms that have several functions acting as a commercial bank, investment bank, mutual fund provider etc.
YOU must be able to differentiate between the entity and its functions at a financial level

2 methods of channeling funds:

● Indirect finance through Financial Intermediaries
● Direct finance through Financial markets

Financial Institutions that are NOT financial intermediaries

● Brokers
○ Act on behalf of their clients
○ Charge a commission fee for their service
○ They don’t buy and sell anything – Do NOT take position
○ Eg.
■ Real Estate brokers
■ Insurance brokers = agents to find the “right” policy for customer
■ Stock brokers = agents that execute orders on a stock exchange
● Dealers
○ Act as PRINCIPAL
○ Take position and carry inventory
○ Make money from the difference between the bid price (buy price) and the offer price (sell price)
○ Market makers are dealers who post 2-way prices and ‘make market’ = Prove liquidity
■ They will quote the price at which they are willing to buy or sell an asset
○ Eg.
■ FX dealer
■ Primary dealer in government securities – participate on behalf of the central bank
■ Security dealers in certain exchanges
● Investment Bank
● Custodian – Hold assets on behalf of the customer
○ You are the legal owner of the asset but the custodian is the person that holds the asset
○ Custodian does not take any risk, but is able to charge a significant amount for their service
● Trustees - Hold assets on behalf of the customer
○ You are the beneficial owner of the asset
○ The trustee is the legal owner

Financial Intermediation
 ● Some post offices provide banking services: because they have a lot of branches around the country = easier access for the general public
● Central bank is the bank of the commercial banks; lender of last resort

Key requirements to connect the holders of surplus funds and the holders of shortage funds:
● Risk
● Return
● Maturity

The lenders and borrowers often have different requirements in the aforementioned three areas. Hence, the need for a financial intermediary.

Function of financial intermediaries

● Engage in the process of indirect finance

● More important source of finance than the securities market
● Reduce transaction costs and asymmetric information
○ Reduce transaction costs by developing expertise and taking advantage of economies of scale
○ Provision of liquidity services
■ Checking accounts
○ Reduce their exposure to risk through risk sharing
■ Create and sell assets with lesser risk to one party in order to be able to buy assets with greater risk from another party
■ Process: Asset transformation = risky assets are turned into safer assets for investors
○ Economies of scope = multiple services to their customers

Asset transformation takes place since deposits become loans through the bank
Deposits are very liquid (a depositor can request for their money at any time)
But if the bank has already loaned it out, then they will not have sufficient liquid money

Services provided by financial intermediaries:

Maturity intermediation
You should never concentrate your risks as a bank = they need to diversify their risks by not relying on one type of asset
Need to balance the average maturity portfolio of assets and liabilities
Banks: Deposits are assets, Loans are liabilities
Maturity intermediation is the fundamental reason for the collapse of many banks

Denomination intermediation
Eg. Mutual funds
Access to a market which would usually have a large minimum investment amount

Financial intermediation and their role with the overall economy

-----------------------------------------------------------------------------------------------------------------------------------

Conflict of Interest:

● Financial intermediaries provide many services which can compete with each other.
● This would cause a conflict of interest: a situation in which one party has incentives to act in its own interest rather than the interest of the other party.
● Conflicts of interest generate incentives to generate false, misleading information – Asymmetric information

Examples of Conflict of Interest:

● Underwriting and research in investment banking

● Auditing in accounting firms
● Credit assessment

How to remedy conflicts of interest?

● Let market forces correct asymmetric information

● Regulate for transparency
● Supervisory oversight
● Separation of functions
○ Clearly separate the two parts/entities that are likely to have a conflict
○ Separate auditing and consulting functions, separate front end and back end
● Socialization of information production and provision
○ Government intervention
○ Government rating agencies

Case: Sarbanes-Oxley (SOX) Act of 2002 – Dense legislation

Cornerstone of corporate governance

This act was a response to the collapse of Enron

Collapse of Enron: One function of Arthur Anderson (a firm) was consulting how to present their financial information such that the auditing function of Arthur Anderson
would be able to audit easily – Conflict of interest

Legislation components:

● PCAOB – Supervisor of the accounting firms

● Prohibits accounting firms from simultaneously providing non-audit functions (Separation of functions)
● Board level must have an audit committee; must be independent
● Required the reporting of off-balance sheet activities
 ○ Promote transparency in a usually obscure industry
● Increased charges for white-collar crimes
● Allowed SEC additional funding

Section 404:

Companies must provide an internal control report – must document all the company’s activities.

Certified by auditors

2 executives personally sign off

They become personally liable for the company; Can be sued personally

Huge costs involved in this documentation with not much guarantee whether it will really deter such activities - Blamed for loss of competitiveness in Wall Street

Global Legal Settlement of 2002 – Investment Banking Industry

2002: Stock market crash provoked by the dot com crash

The blame went to investment banks

● $1.4 billion in fines

● Spinning was banned (Giving shares of new IPOs to their customers)
● Firms were asked to severe the link between underwriting and research activities:
○ Research was peddling the dot com bubble
● Firms must make the analyst’s recommendation public and target prices: Regulation fair disclosure
● Brokerage firms required to obtain 3rd party, independent research for their clients

Research department in investment banks are a cost center

Revenue? – How do you justify the cost of the research?

It is intended to help sell IPOs

Hence – they ask the investment banking division to write a research / analysis on which companies are good – incentive to get the company onboard with IPO –
the investment banking division receives the bonus

This practice is now banned. (They can’t allocate their research costs to the investment banking department)

Hence, this is what they do: tie up research and sales department

Asymmetric Information: Financial intermediaries are exposed to both types of asymmetric information

● Adverse selection: one party in a transaction has better information than the other party
○ Loans: banks have less information than borrowers

How to correct it?:

Independent verification with an unbiased 3rd party

● Ask for more information – due diligence
● Put some risk on the buyer as well – Have to pay premiums/interest – Pricing differentials

● Moral hazard: one party has an incentive to change behavior once an agreement is made between the two parties
○ Eg. Behave in a hazardous way (start smoking) after you have bought health insurance

How to correct?:

● Exclusion, setting certain conditions

○ Eg. Suicide in insurance companies

Current Issues in relation to conflict of interest:

● Central banks face moral hazard in SVB crisis

● Rating agencies and scrutiny towards them
● Government bailout vs bonuses
● Insider trading

Chapter 5:

What are Commercial Banks?

● Banks are financial intermediaries: They perform financial intermediation

● Collect savings from savers and the open deposit accounts
● They make loans to borrowers
● Process of asset transformation
● They aim to ensure maturity intermediation
○ Short term deposits and medium to long term loans are a bad combination
○ Banks must manage their maturity portfolio well

● Commercial banks are types of depository institutions:

● 3 main businesses and services that they can provide:

○ Retail/Consumer Banking
■ Dealing with individual investors and general public
■ Attracts the attention and scrutiny of regulators to protect the general public
■ Accept small deposits
■ Provide residential and consumer loans
■ Retail banking, consumer finance, credit cards
○ Wholesale Banking
■ Big volumes and big clients - Corporates and institutionals
■ Provide commercial and industrial loans
■ Could be funded through deposits or borrowing from the market
■ Corporate and investment bank, Trading, Treasury & Markets
○ Private banking / Asset management
■ Managing other people's money and assets
■ HNWI / Collective investments
● Not all commercial banks provide all of these services. Some provide all of these in their home country and in other countries only provide some services.

● To be successful in retail banking (many small customers and many small transactions) you need:
○ Regulation standardization
○ Automatisation
To facilitate many small transactions

● To be successful in commercial banking, you need:

○ Good security
○ High quality service - (dealing with high value customers)

Both of these have very different business models:

On one hand you have many low value transactions and on the other hand you have a few high value transaction

Forces that influence international banking:

Causes:

● New entrants
○ Eg. New payment services – E-commerce, Technology, Retailers (Walmart, Starbucks), Telephone companies (Korea, Africa)
○ More competition – From non-banking providers
● Globalization
● Technological changes
○ Difficult to continue innovating alongside cooperating with regulation
● Innovation
● Regulation / Deregulation

Broad impacts:

● Reduction in profit margins

● Increased competition

Consequences:

● Changes in the structure of banking

○ Provide other services: investment banking, consulting, risk management services, fund management services
● Disintermediation
● Ongoing product & process innovation
● Transformation of regulatory framework
 Commercial Banks:

Traditional products and services:

● Deposit accounts
● Credit services
● Payment and collection services
● Trade services
● FX services
● Credit enhancement / Payment guarantees
● Agent/Fiduciary services

New products and services:

● Investment banking services

● Consulting services
● Risk management services
● Broker/dealer services
● Insurance services
● Asset management

Roles of commercial banks:

● Making loans – Banks are lenders

● Collecting deposits
○ Acquire funds: bonds, central bank (last resort)
● Liquidity providers
○ Company that doesn’t need money now could approach a bank to establish a credit facility (if they have unstable cash flow – a credit facility allows them to put a
small amount of money each month which can be withdrawn when they need the money down the line)
● Credit enhancement – Provide guarantees
● Conduit for monetary policy
● Trustees
○ Hold assets for the customers
● Custody agents
● Payment channel

Virtual versus Conventional Banks:

Similarities: Differences:

● Regulation and capital requirements ● No physical branches allowed

● Banking products and services ● Partnership ecosystem
● Spending offers and discounts ● Lower costs
● Enhanced security
● Instant account opening, card provision
● 24/7 service
● Entirely digital consumer and user experience