Depository & Non Depository

FINANCIAL INTERMEDIARY
 DEPOSIT TAKING AND NON DEPOSIT
TAKING INTERMEDIARIES
• A bank can accept deposits. Such deposits of the
customers can be withdrawn by cheque or
otherwise (withdrawal slip, letter and voucher) on
demand, or repayable on maturity to the
customers.
• The bank lends or invests the funds collected from
its customers,.
• Acceptance of deposits and lending the same are
thus core functions of a bank. The above process is
known as intermediation.
 INTERMEDIATION
• The principle of intermediation is closely related
to the core banking functions, taking of deposit
and extending of credit.
• Banks are ‘financial intermediaries’ because they
invest or lend the funds of depositors who
themselves are unable to lend their funds to
others due to risk and other factors involved in
direct lending.
 INTERMEDIATION….Cont’d
Banks assume the credit and other risks involved
in direct lending to those who need funds
(borrowers) because of their expertise and
administrative abilities to manage such risks.
Thus banks mediate between the depositors
(savers of money) and borrowers (users of
money) and earn interest spread as a reward for
risk taking and also for meeting administrative
expenses and making provision for some portions
of loans that turn bad or difficult to recover
(termed as ‘non-performing assets’ or NPAs).
 DISINTERMEDIATION
• The term ‘disintermediation’ means the reversal of
the intermediation process involved in banking. An
investment by a person in certain stocks of a
company is a direct exposure or risk taking by the
investor in the particular company.
• In this example of dis-intermediation, the investor
may or may not get back the capital invested in
the company when he wants, as he has assumed
the risk involved in direct investment.
DIAGRAM ON INTERMEDIATION
THE COMMON CHARACTERISTICS OF
ALL FINANCIAL INTERMEDIARIES
First, they take money from those who seek to save,
whether it be in exchange for a deposit account bearing
interest or in exchange for a paper financial claim.
Secondly, they lend the money provided by those
savers to borrowers, who may issue a paper asset in
return.
Thirdly, in exchange for such lending they acquire a
portfolio of paper assets (claims on borrowers) which
will pay an income to the intermediary and which it
may ‘manage’ by buying and selling the assets on
financial markets in order to yield further profits for
itself.
Financial Intermediary
 Advantages of Financial Intermediaries
 Financial consultancy,
 Pooling of small savings. offered to the investors
 Diversification of risks. and capital users;
 Economies of scale in  The possibility of better
monitoring information gathering and valuing the
and evaluating risks. existing information on
 Lower transactions costs. the market;
 Additional facilities
offered to the users and
capital owners, a part of
these being taken over by
intermediation institutions.
 The disadvantages of financial
intermediation
−big transaction costs, due to collection of taxes, fees
and commissions;
−the loss of direct contact with the international
financial market, therefore some investors aren’t
sensitive anymore to the markets’ signs;
−the existence of a routine in the relationship with
the financial intermediary, many markets being led
according to the solutions offered over the time by
important intermediary firms.
 Function of Financial
Intermediaries (FIs)

• Financial Intermediaries
1. Engage in process of indirect finance
2. More important source of finance than
securities markets
3. Needed because of transactions costs and
asymmetric information
 Function of Financial Intermediaries

• Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing
expertise and taking advantage of economies of
scale
 Function of Financial Intermediaries
• A financial intermediary’s low transaction costs mean that
it can provide its customers with liquidity services,
services that make it easier for customers to conduct
transactions

1. Banks provide depositors with checking accounts that enable

them to pay their bills easily

2. Depositors can earn interest on checking and savings accounts

and yet still convert them into goods and services whenever
necessary.
 Function of Financial Intermediaries
• Another benefit made possible by the FI’s low transaction
costs is that they can help reduce the exposure of investors
to risk, through a process known as risk sharing
– FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another party

– This process is referred to as asset transformation, because in a

sense risky assets are turned into safer assets for investors
 Asymmetric Information:
Adverse Selection and Moral Hazard
• Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to seek
loan and be selected
 Asymmetric Information:
Adverse Selection and Moral Hazard
• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage
in undesirable (immoral) activities making it
more likely that won't pay loan back
 Asymmetric Information:
Adverse Selection and Moral Hazard

• Financial intermediaries reduce adverse

selection and moral hazard problems,
enabling them to make profits.
 Why have financial intermediaries grown so
rapidly?
Financial intermediaries satisfy portfolio preferences of lenders and
borrowers: For the lenders, they diversify the portfolio, particularly, the
credit/ default risk. For the borrowers, they offer a much wider choice of
(tailor-made) credit than the ultimate lender would have been able to
provide. They get more choice in maturity, size of loan, interest rates.
2. Cost advantages: There is cost involved in a borrower locating a
lender, in the lender getting information on the borrower. FIs specialize in
these tasks.
3. Risk reduction: Particularly for the lender (diversification acts as a
hedge).
 Why have financial intermediaries grown so rapidly?

4. Liquidity intermediation: The lenders are able to withdraw

their funds when required, at a small cost.

5. Government regulation: These include: Banking Act, capital

adequacy requirements, reserve requirements, regulations regarding
investment, auditing and examinations, lender of last resort privilege.
These enhance the image of FIs in the eyes of the lenders.

Further, there has been a more rapid expansion of unregulated FIs

compared with regulated FIs. These (unregulated) FIs compensate
the depositors for the higher risk with higher rates of return.
 Two theories of financial intermediation:
Old theory:
This holds that the services offered by financial
intermediaries are primarily the transformation of assets.
New theory:
i) It isolates three types of financial intermediaries:
broker, mutual fund and deposit-taking intermediary.
ii) Financial intermediaries actively manage their
portfolios through the application of resources to reduce
costs.
iii) Financial intermediaries play a more important role
in developing economies than in developed ones.
THE ROLE OF FINANCIAL INTERMEDIARIES
 Brokerage

A broker is an intermediary who brings together lenders and

borrowers who have complementary needs and does this by assessing

and evaluating information. The lender may have neither the time

nor the ability to undertake search activities in order to assess

whether a potential borrower is trustworthy. Household avoids such

information gathering, monitoring and evaluation costs,

 Maturity Transformation
Intermediaries hold liabilities (e.g. deposits)
that have a shorter term to maturity than their
assets (e.g. loans), i.e. they borrow short and
lend long. E.g., a building society will typically
hold around 70% of its liabilities in the form of
deposits repayable ‘on demand’, i.e. which can
be withdrawn at any time without penalty. In
contrast, around 75% of its assets are
repayable only after five years or more.
maturity transformation function in part
because of the ‘law of large numbers’,.
 Risk Transformation
This involves the financial intermediaries in shifting
the burden of risk from the lender to themselves.
Their ability to do so depends largely on economies
of scale in risk management. The large amounts of
deposits (liabilities) the financial intermediaries
collect allow them to diversify their assets across a
wide variety of types and sectors. ‘Pooling’ risk and
reward in this way means that no individual is
exposed to a situation in which the default of one or
more borrowers is likely to have a significant effect.
 Collection and parcelling
Financial intermediaries also transform the nature of
their assets through the collection of a large number
of small amounts of funds from depositors and their
parcelling into larger amounts required by
borrowers. Often the financial intermediaries have
relied on obtaining many small deposits from
conveniently located branches of their operations.
This process is known as ‘size intermediation’ and
benefits borrowers because they obtain one large
loan from one source, thus reducing transaction
costs. Of course this loan is an asset to the financial
intermediary and a liability to the borrower.
Financial Intermediaries
Chief sources and uses of funds by important
intermediaries:

Intermediaries sources of funds uses of funds

1. commercial banks deposits loans, govt. bonds,
mortgages etc.
2. savings and loan assoc. deposits mortgages
3. credit unions deposits mortgages
4. pension funds contributions stocks and bonds
5. mutual funds shares stocks and bonds
6. money market funds shares short term assets
 Types of Financial Intermediaries
• Depository Institutions (Banks)
– Commercial banks, Savings & Loan Associations (S&Ls), Mutual
Savings Banks in US
– Three-tier system of deposit-taking institutions, namely,
licensed banks, restricted licence banks,
deposit-taking companies in Hong Kong (collectively known as
AI: Authorized Institutions)
• Contractual Savings Institutions
– Life insurance companies
– Fire & casualty insurance companies
– Pension funds, government retirement funds
(e.g. Mandatory Provident Fund Scheme in Hong Kong)
 Types of Financial Intermediaries
• Investment Intermediaries
– Finance companies
– Mutual funds
– Money market mutual funds
Depository Institutions (Banks)
 Commercial Banks
– Raise funds primarily by issuing checkable, savings, and time
deposits which are used to make commercial, consumer and
mortgage loans
– Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset portfolios
 Commercial Banks
• Most prominent financial institution
• Range in size from huge (BankAmerica) to small (local banks)
• Major sources of funds
– used to be demand deposits of public
– now rely more on “other liabilities”
– also accept savings and time deposits
• Uses of funds
– short-term government securities
– long-term business loans
– home mortgages
 NATIONAL SAVINGS
 Savings Institutions exist in the Country to complement the commercial banks and finance companies as the
major deposit taking institutions. The main savings institutions are the National Savings and Credit Bank and
cooperative Societies.
 These Savings institutions promote savings among middle and lower income groups in the rural areas that
are not adequately served by the Commercial Banks and finance Companies.

 The national Saving Banks’s principal activity is to carry out the functions of a national savings bank, namely
to accept deposits and to provide retail loans to small borrowers. The government guarantees all deposits.
Funds raised through the premiums saving certificates are unique to this bank. Attractive prizes for lucky
draw winners and payment of dividends contributed to the growth of these deposits.

 Other deposit products are savings deposits, fixed deposits and Giro deposits and save-as-you-earn deposits.
The Giro savings scheme is attractive due to its features, which enable depositors to remit funds and make
payments while earning an interest. Lending is channeled to housing, credit cards, hire-purchase and
corporate loan.
Contractual Savings
Institutions(CSIs)

2-34
• All CSIs acquire funds from clients at periodic intervals on a
contractual basis and have fairly predictable future payout
requirements.
– Life Insurance Companies receive funds from policy premiums,
can invest in less liquid corporate securities and mortgages,
since actual benefit pay outs are close to those predicted by
actuarial analysis
– Fire and Casualty Insurance Companies receive funds from policy
premiums, must invest most in liquid government and corporate
securities, since loss events are harder to predict
 Insurance Companies
• Life insurance.
• Casualty insurance.
• Insurance companies are large investors in
fixed income securities.
• Adverse selection.
• Moral hazard. Coinsurance.
 Life Insurance Companies
• Insure against death
• Receive funds in form of premiums
• Use of funds is based on mortality statistics—
predict when funds will be needed
• Invest in long-term securities—high yield
– Long-term corporate bonds
– Long-term commercial mortgages
 Pension Funds

• Defined benefit plans. Dollars paid out

usually set by some formula, e.g., Pension = (#
Years)(Average) (X%). Pension Benefit
Guarantee Corporation. Employer bears the
reinvestment risk.
• Defined contribution plans. Dollars paid in are
specified. Dollars paid out depend upon
returns. Employee bears the reinvestment
risk.
 Pension Funds Cash Flows

Horizon
0 1 2 Date

Time
$ In C C $ Out

Reinvestment
Pension Benefit Guaranty Corporation
• Insures pensions of private defined benefit
plans.
• Does not ensure government defined benefit
plans.
• Collects premiums from covered plans.
• Underfunded.
• Limited benefits.
 Pension and Retirement Funds
• Concerned with long run
• Receive funds from working individuals
building “nest-egg”
• Accurate prediction of future use of
funds
• Invest mainly in long-term corporate
bonds and high-grade stock
 Contractual Savings
Institutions (CSIs)
• All CSIs acquire funds from clients at periodic intervals on a
contractual basis and have fairly predictable future payout
requirements.
– Pension and Government Retirement Funds hosted by
corporations and state and local governments acquire funds
through employee and employer payroll contributions, invest in
corporate securities, and provide retirement income via annuities
Investment Financial Intermediary
 Finance Companies
• sell commercial paper (a short-term debt instrument)

and issue bonds and stocks to raise funds to lend to

consumers to buy durable goods, and to small

businesses for operations

 FINANCE HOUSES
• Investment intermediaries provide a mechanism through which small savers pool

funds to purchase a variety of financial assets rather than just one or two. An

example of how pooling works can be seen by considering a mutual fund

company, which is one type of investment intermediary.

• A finance Company is another type of investment intermediary. Finance

Companies make loans to individuals and businesses, as do banks, but instead of

holding deposits, as banks do, finance companies borrow the money they lend.

They borrow from individuals by selling them bonds and commercial paper.

Commercial paper is a short-term promissory note that a certain amount of

money plus interest will be paid back on demand.

 Investment Banking
• Investment banking is the marketing of
securities when they are initially sold.
• Some securities are sold to private buyers.
Others are sold to the public. The exact
difference is a technical legal issue.
• Public offerings must be registered with the
Securities and Exchange Commission (SEC).
 Public Offerings
• Investment banking firms sell public offerings.
They are essentially marketers of securities
and charge a fee for their services. This is
often called an underwriting fee.
• Syndicates of investment banks are often
involved in public offerings. This spreads the
resale risk.
 Types of Public Offerings
• Firm Commitments. The investment banker
purchases the security issue outright and
bears the resale risk.
• Best Efforts. The investment bankers sell
whatever they’re able.
• Fees for firm commitments are much higher.
Most bond issues are sold by firm
commitment.
• Shelf Registration.
– Some securities are sold by shelf registration.
This is essentially a pre- registration of a
security issue. Anytime during the next two
years the securities can be brought to market
very rapidly.
• Rule 144A.
– They do not have to be registered with the
SEC and can be resold to other qualified
financial institutions.
Underwriter
Spread
4%

3%

2%

.75%
Bond
AAA AA A BBB BB B Rating
Securities Firms and Investment Banks
(IBs)
•• Investment
Investmentbanks
banks(IBs)
(IBs)help
helpcorporations
corporationsand
andgovernments
governments
raise
raisecapital
capitalthrough
throughdebt
debtand
andequity
equitysecurity
securityissues
issuesin
inthe
the
primary
primarymarket
market
–– underwriting
underwritingisisassisting
assistingin
inthe
theissue
issueof
ofnew
newsecurities
securities
–– IBs
IBsalso
alsoadvise
adviseon
onmergers
mergersandandacquisitions
acquisitions(M&As)
(M&As)andandcorporate
corporate
restructuring
restructuring
•• Securities
Securitiesfirms
firmsassist
assistin
inthe
thetrading
tradingof
ofsecurities
securitiesin
in
secondary
secondarymarkets
markets
–– broker-dealers
broker-dealersassist
assistin
inthe
thetrading
tradingof
ofexisting
existingsecurities
securities
 Securities Firms and
Investment Banks (IBs)
•• The
Thesize
sizeof
ofthe
theindustry
industryisisusually
usuallymeasured
measuredbybythe
theequity
equity
capital
capitalof
offirms
firmsrather
ratherthan
thantotal
totalasset
assetsize
size
–– the
thelargest
largestfirm
firminin1987
1987had
had$3.2
$3.2billion
billioninintotal
totalcapital
capital
–– the
thelargest
largestfirm
firminin2007
2007had
had$114.2
$114.2billion
billioninintotal
totalcapital
capital
•• The
Thenumber
numberof offirms
firmsininthe
theindustry
industryusually
usuallyfollows
followsthe
the
overall
overallcondition
conditionofofthe
theeconomy
economy
–– 5,248
5,248firms
firmsinin1980
1980
–– 9,515
9,515firms
firmsinin1987
1987
–– 5,808
5,808firms
firmsinin2007
2007
•• As
Aswith
withcommercial
commercialbanks,
banks,consolidation
consolidationhas
hasoccurred
occurred
through
throughmergers
mergersand
andacquisitions
acquisitions

McGraw-Hill/Irwin 16-52
 Securities Firms and
Investment Banks (IBs)
•• The
Thelargest
largestfirms
firmsininthe
theindustry
industryare
arediversified
diversified
financial
financialservice
servicefirms
firmsor
ornational
nationalfull-service
full-serviceIBs
IBs
–– service
serviceboth
bothretail
retailand
andwholesale
wholesalecustomers
customersby
byacting
acting
as
asbroker-dealers
broker-dealers
–– service
servicecorporate
corporatecustomers
customersby
byunderwriting
underwritingsecurity
security
issues
issues
•• The
Thesecond
secondlargest
largestgroup
groupof offirms
firmsare
arefull-service
full-service
firms
firmsthat
thatspecialize
specializein
incorporate
corporatefinance
financeoror
primary
primarymarket
marketactivity
activity(i.e.,
(i.e.,focus
focusless
lesson
on
secondary
secondarymarket
marketactivities)
activities)

McGraw-Hill/Irwin 16-53
 Securities Firms and
Investment Banks (IBs)
•• AAthird
thirdgroup
groupof offirms
firmsincludes
includesthe
therest
restof
ofthe
the
industry
industryand
andisisfurther
furtherdivided
dividedinto
intofive
fivesubgroups
subgroups
–– IB
IBsubsidiaries
subsidiariesof
ofcommercial
commercialbanks
banks(i.e.,
(i.e.,Section
Section20
20
subsidiaries)
subsidiaries)
–– discount
discountbrokers
brokers
–– regional
regionalsecurities
securitiesfirms
firms
–– specialized
specializedelectronic
electronictrading
tradingfirms
firms
–– venture
venturecapital
capitalfirms
firms

McGraw-Hill/Irwin 16-54
 Securities Firms and
Investment Banks (IBs)
•• Investment
Investmentbanking
banking
–– first
firsttime
timedebt
debtand
andequity
equityissues
issuesoccur
occurthrough
throughinitial
initial
public
publicofferings
offerings(IPOs)
(IPOs)
–– new
newissues
issuesfrom
fromaafirmfirmwhose
whosedebtdebtor orequity
equityisisalready
already
traded
tradedare arecalled
calledseasoned
seasonedequityequityofferings
offerings(SEOs)
(SEOs)
–– aaprivate
privateplacement
placementisisaasecurities
securitiesissue
issuethat
thatisisplaced
placed
with
withoneoneororaafew
fewlarge
largeinstitutional
institutionalinvestors
investors
–– public
publicofferings
offeringsare
areoffered
offeredto tothe
thepublic
publicat atlarge
large
–– IBs
IBsact
actonly
onlyas
asan
anagent
agentin inbest
bestefforts
effortsunderwriting
underwriting
–– IBs
IBsact
actasasprincipals
principalsin infirm
firmcommitments
commitments

McGraw-Hill/Irwin 16-55
 Securities Firms and
Investment Banks (IBs)
•• Market
Marketmaking
makinginvolves
involvesthe
thecreation
creationof
of
secondary
secondarymarkets
marketsfor
foran
anissue
issueof
ofsecurities
securities
–– agency
agencytransactions
transactionsare
aretwo-way
two-waytransactions
transactionson
on
behalf
behalfofofcustomers
customers
–– with
withprincipal
principaltransactions
transactionsmarket
marketmakers
makersseek
seekto
to
profit
profitfor
fortheir
theirown
ownaccounts
accounts
•• Trading
Tradinginvolves
involvestaking
takingan
anactive
activenet
netposition
positionin
in
an
anasset
asset
–– position
positiontrading
tradinginvolves
involvesrelatively
relativelylong-term
long-termpositions
positions
in
inassets
assets

McGraw-Hill/Irwin 16-56
 Securities Firms and
Investment Banks (IBs)
–– pure
purearbitrage
arbitrageinvolves
involvesattempts
attemptsto toprofit
profitfrom
fromprice
price
discrepancies
discrepancies
–– risk
riskarbitrage
arbitrageinvolves
involvesattempts
attemptsto toprofit
profitby
by
forecasting
forecastinginformation
informationreleases
releases
–– program
programtrading
tradingisisthe
thesimultaneous
simultaneousbuying
buyingandand
selling
sellingof
ofat
atleast
least15
15different
differentstocks
stocksvalued
valuedat at$1
$1
million
millionor
ormore
more
–– stock
stockbrokerage
brokerageinvolves
involvestrading
tradingononbehalf
behalfofof
customers
customers
–– electronic
electronicbrokerage
brokerageoffers
offerscustomers
customersdirect
directaccess,
access,
via
viathe
theinternet,
internet,totothe
thetrading
tradingfloor
floor

McGraw-Hill/Irwin 16-57
 Securities Firms and
Investment Banks (IBs)
•• Investing
Investinginvolves
involvesmanaging
managingpools
poolsof
ofassets
assetssuch
such
as
asclosed-
closed-and
andopen-end
open-endmutual
mutualfunds
funds
–– as
asagents
agents
–– as
asprincipals
principals
•• Cash
Cashmanagement
managementinvolves
involvesdeposit-like
deposit-likeaccounts
accounts
such
suchas
asmoney
moneymarket
marketmutual
mutualfunds
funds(MMMFs)
(MMMFs)
that
thatoffer
offercheck
checkwriting
writingprivileges
privileges
•• Merger
Mergerand
andacquisition
acquisition(M&A)
(M&A)assistance
assistance

McGraw-Hill/Irwin 16-58
 Securities Firms and
Investment Banks (IBs)
•• Venture
Venturecapital
capital(VC)
(VC)isisaaprofessionally
professionallymanaged
managed
pool
poolofofmoney
moneyused
usedto tofinance
financenew
new(i.e.,
(i.e.,start-up)
start-up)
and
andoften
oftenhigh-risk
high-riskfirms
firms
–– VC
VCusually
usuallypurchases
purchasesananequity
equitystake
stakeininthe
thestart-up
start-up
–– usually
usuallybecome
becomeactive
activein
inmanagement
managementof ofthe
thestart-up
start-up
–– institutional
institutionalventure
venturecapital
capitalfirms
firmsfind
findand
andfund
fundthe
the
most
mostpromising
promisingnew
newfirms
firms
•• venture
venturecapital
capitallimited
limitedpartnerships
partnerships
•• financial
financialventure
venturecapital
capitalfirms
firms
•• corporate
corporateventure
venturecapital
capitalfirms
firms

McGraw-Hill/Irwin 16-59
 Securities Firms and
Investment Banks (IBs)
•• Industry
Industrytrends
trendsdepend
dependheavily
heavilyon
onthe
thestate
stateof
of
the
thestock
stockmarket
market
–– commission
commissionincome
incomedeclined
declinedmarkedly
markedlyafter
afterthe
the1987
1987
stock
stockmarket
marketcrash
crashandandthe
the2001-2
2001-2stock
stockmarket
market
decline
decline
–– improvements
improvementsin inthe
theU.S.
U.S.economy
economyininthe
themid-2000s
mid-2000s
led
ledtotoincreases
increasesin incommission
commissionincome
income
–– income
incomefellfellwith
withthethestock
stockmarket
marketin
in2006-8
2006-8because
becauseofof
rising
risingoil
oilprices
pricesand
andthe
thesubprime
subprimemortgage
mortgagecollapse
collapse
 Balance Sheets of Securities Firms
and Investment Banks (IBs) (2007)
•• Long
Longpositions
positionsininsecurities
securitiesand
andcommodities
commodities
represent
represent24.1%
24.1%of ofassets
assets
•• Securities
Securitiespurchased
purchasedunder
underagreement
agreementto toresell
resell
represent
represent21.6%
21.6%of oftotal
totalassets
assets
•• Securities
Securitiessold
soldunder
underagreement
agreementto torepurchase
repurchase
represent
represent41.5%
41.5%of oftotal
totalliabilities
liabilitiesand
andequity
equity
•• Equity
Equitycapital
capitalamounted
amountedto to3.0%
3.0%of oftotal
total
liabilities
liabilitiesand
andequity
equity
–– compares
comparestoto10.1%
10.1%for
forcommercial
commercialbanks
banks
–– SEC
SECrequires
requiresminimum
minimumnetnetworth
worthto
toassets
assetsof
of2%
2%

McGraw-Hill/Irwin 16-61
 Regulation of Securities Firms
and Investment Banks (IBs)
•• The
TheSecurities
Securitiesand
andExchange
ExchangeCommission
Commission(SEC)
(SEC)isis
the
theprimary
primaryregulator
regulatorofofthe
thesecurities
securitiesindustry
industry
•• The
TheNational
NationalSecurities
SecuritiesMarkets
MarketsImprovement
Improvement
Act
Act(NSMIA)
(NSMIA)ofof1996
1996reaffirmed
reaffirmedfederal
federal(over
(over
state)
state)authority
authority
–– even
evenso,
so,state
stateattorneys
attorneysgeneral
generalintervene
intervenethrough
through
securities-related
securities-relatedinvestigations
investigationsthat
thathave
haveled
ledto
tomany
many
highly
highlypublicized
publicizedcriminal
criminalcases
cases

McGraw-Hill/Irwin 16-62
 Regulation of Securities Firms
and Investment Banks (IBs)

•• The
The Sarbanes-Oxley
Sarbanes-Oxley Act
Act (SOX)
(SOX) of
of 2002
2002
–– created
createdan
anindependent
independentauditing
auditingoversight
oversight
board
boardunder
underthe
theSEC
SEC
–– increased
increasedpenalties
penaltiesfor
forcorporate
corporatewrongdoers
wrongdoers
–– forced
forcedfaster
fasterand
andmore
moreextensive
extensivefinancial
financial
disclosure
disclosure
–– created
createdavenues
avenuesof ofrecourse
recoursefor
foraggrieved
aggrieved
shareholders
shareholders

McGraw-Hill/Irwin 16-63
 Regulation of Securities Firms
and Investment Banks (IBs)

•• The
The SEC
SEC sets
sets rules
rules governing
governing underwriting
underwriting
and
and trading
trading activity
activity
–– SEC
SECRule
Rule144A
144Adefines
definesboundaries
boundariesbetween
between
public
publicofferings
offeringsand
andprivate
privateplacements
placements
–– SEC
SECRule
Rule415
415allows
allowsshelf
shelfregistration
registration
•• allows
allowsfirms
firmsthat
thatplan
planto
tooffer
offermultiple
multipleissues
issuesofof
stock
stockover
overaatwo-year
two-yearperiod
periodtotosubmit
submitone
one
registration
registrationstatement
statementsummarizing
summarizingthethefirm’s
firm’s
financing
financingplans
plansfor
forthe
theperiod
period

McGraw-Hill/Irwin 16-64
 Regulation of Securities Firms
and Investment Banks (IBs)
•• Two
Twoself-regulatory
self-regulatoryorganizations
organizationsoversee
overseethe
the
day-to-day
day-to-dayregulation
regulationof
oftrading
tradingpractices
practices
–– the
theNew
NewYork
YorkStock
StockExchange
Exchange(NYSE)
(NYSE)
–– the
theNational
NationalAssociation
Associationof
ofSecurities
SecuritiesDealers
Dealers(NASD)
(NASD)
•• The
TheU.S.A.
U.S.A.Patriot
PatriotAct
Actbecame
becameeffective
effectivein
in2003
2003
–– firms
firmsmust
mustverify
verifyidentities
identitiesof
ofcustomers
customers
–– firms
firmsmust
mustmaintain
maintainrecords
recordsofofidentities
identitiesof
ofcustomers
customers
–– firms
firmsmust
mustverify
verifycustomers
customersarearenot
noton
onsuspected
suspected
terrorist
terroristlists
lists

McGraw-Hill/Irwin 16-65
 Regulation of Securities Firms
and Investment Banks (IBs)

•• Industry
Industry isis protected
protected by
by the
the Securities
Securities
Investor
Investor Protection
Protection Corporation
Corporation (SIPC)
(SIPC)
–– protects
protectsinvestors
investorsagainst
againstlosses
lossesof
ofup
upto
to
$500,000
$500,000due
dueto
tosecurities
securitiesfirm
firmfailures
failures(but
(but
not
notagainst
againstpoor
poorinvestment
investmentdecisions)
decisions)
–– created
createdfollowing
followingpassage
passageof ofthe
theSecurities
Securities
Investor
InvestorProtection
ProtectionAct
Actin
in1970
1970

McGraw-Hill/Irwin 16-66
 Global Issues

•• Securities
Securities firms
firms and
and investment
investment banks
banks are
are
by
by far
far the
the most
most global
global of
of any
any group
group of
of
financial
financial institutions
institutions
•• U.S.
U.S. firms
firms are
are increasingly
increasingly looking
looking to
to
expand
expand their
their business
business abroad—particularly
abroad—particularly
into
into China
China an an India
India

McGraw-Hill/Irwin 16-67
Investment Banking Services
 Investment banking firms (IBFs) assist in raising capital
for corporations and state and municipal governments
 IBF’s serve both financing entities and investors:
 Serve as an intermediary buying securities (promise to pay)
from issuing companies and selling them (securities) to
investors
 Generate fees for services rather than interest income
 Sell investing services to institutional and other investors
 Advise companies on mergers and acquisitions
 Value companies for sale or purchase
 In recent years, loaned funds for mergers and acquisitions
Investment Banking Services

Origination Distribution
Investment
Banking
Services
Underwriting Advising
How IBFs Facilitate New Stock
Issues
 Origination
 Company wishes to issue additional stock or issue
stock for the first time contacts IBF
 Getsadvice on the amount to issue
 Helps determine stock price for first-time issues

 IBF assists with SEC filings

 Registration statement
 Prospectus—summary of registration statement given to

prospective investors
How IBFs Facilitate New Stock
Issues
 Underwriting stock
 Issuer and investment bank negotiate the underwriting
spread
 The difference between the net price given the company
and the selling price to investors
 Incentive to under-price IPO’s
 The lead investment bank usually forms an
underwriting syndicate
 Other IBFs underwrite a part of the security offering
 Helps spread the underwriting risk among IBFs
How IBFs Facilitate New Stock
Issues
 Distribution of stock
 Full underwriting vs. best efforts
 IBFs in the syndicate have retail brokerage
operations
 Other IBF added as part of selling group
 Corporation incurs flotation costs
 Underwriting spread
 Direct issuance costs—accounting, legal fees, etc.
How IBFs Facilitate New Stock
Issues
 Advising
 The IBF acts as an advisor throughout the process
 Corporations do not have the in-house expertise
 Includes advice on:
 Timing
 Amount
 Terms
 Type of financing
How IBFs Facilitate New Bond
Issues
 Origination
 IBF may suggest a maximum amount of bonds that
should be issued based on firm characteristics
 Decisions on coupon rate, maturity
 Benchmark with market prices of bonds of similar risk
 Credit rating
 Bond issuers must register with the SEC
 Registration Statement
 Prospectus
How IBFs Facilitate New Bond
Issues
 Underwriting bonds
 Public utilities often use competitive bids to
select an IBF, versus…..
 Corporations typically select an IBF based on
reputation and prior working experience
 The underwriting spread on bonds is lower than
that for stocks
 Can place large blocks with institutional investors
 Less market risk
How IBFs Facilitate New Bond
Issues
 Distribution of bonds
 Prospectus
 Advertisements to public
 Flotation costs are typically in the range of 0.5
percent to 3 percent of face value
How IBFs Facilitate New Bond
Issues
 Private placement of bonds
 Avoids underwriting and SEC registration expenses
 Potential purchaser may buy the entire issue
 Insurance companies
 mutual funds
 commercial banks
 pension funds
 Demand may not be as strong, so price may be less,
resulting in a higher cost for issuing firm
 Investment banks may be involved to provide advice
and find potential purchasers
How IBFs Facilitate Leveraged
Buyouts
 IBFs facilitate LBOs in three ways:
 They assess the market value of the LBO firm
 They arrange financing
 Purchase outstanding stock held by public
 Often invest in the deal themselves
 Provide advice
How IBFs Facilitate Arbitrage
 Arbitrage = purchasing of undervalued shares
and reselling the shares at a higher price
 IBFs work with arbitrage firms to search for
undervalued firms
 Asset stripping
 A firm is acquired, and then its individual divisions
are sold off
 Sum of the parts is greater than the whole
 Kohlberg, Kravis, and Roberts
How IBFs Facilitate Arbitrage
 IBFs generate fee income from advising
arbitrage firms as well as a commission on the
bonds issued to support arbitrage activity
 IBFs also provide bridge loans
 When fund raising is not expected to be complete
when the acquisition is initiated
 IBFs provide advice on takeover defense
maneuvers
How IBFs Facilitate Arbitrage
 History of arbitrage activity
 Greenmail is when a target company buys back stock
from arbitrage firm at a premium over market price
 Arbitrage activity has been criticized
 Resultsin excessive financial leverage and risk for
corporations
 Restructuring sometimes results in layoffs

 Arbitrage helps remove managerial inefficiencies

 Target shareholders can benefit from higher share
prices
Brokerage Services
 Full-service versus discount brokerage
services
 Full-service firms provide investment advice as
well as executing transactions
 Discount brokerage firms only execute security
transactions upon request
 Online brokerage firms
Allocation of Revenue Sources
 Importance of brokerage commissions has
declined in recent years
 Largest source of revenue has been trading and
investment profits
 Underwriting and margin interest also make
up a significant portion of revenue
 Revenue from fees earned on advising and
executing acquisitions has increased over time
Regulation of Securities Firms
 Regulated by the National Association of
Securities Dealers (NASD) and securities
exchanges
 The SEC regulates the issuance of securities and
specifies disclosure rules for issuers
 Also regulates exchanges and brokerage firms
 SEC establishes general guidelines, while the
NASD provides day-to-day self-regulatory duties
Regulation of Securities Firms
 The Federal Reserve determines the credit limits
(margin requirements) on securities purchased
 The Securities Investor Protection Corporation
(SIPC) offers insurance on brokerage accounts
 Insured up to $500,000
 Brokers pay premiums to SIPC to maintain the fund
 Boosts investor confidence, increasing economic
efficiency
Regulation of Securities Firms
 Financial Services Modernization Act of 1999
 Permitted banking, securities activities, and
insurance to be offered by a single firm
 Varied financial services organized as subsidiaries
under special holding company
 Financial holding companies regulated by the
Federal Reserve
Risks of Securities Firms

Market Risk Interest Rate

Risk

Credit Risk Exchange Rate

Risk
Risks of Securities Firms
 Market risk
 Securities firms’ activities are linked to stock
market conditions
 When stock prices are rising:
 Greater volume of stock offerings
 Increased secondary market transactions

 More mutual fund activity

 Securities firms take equity positions which are

bolstered when prices rise

Risks of Securities Firms
 Interest rate risk
 Performance of securities firms can be sensitive to
interest rate movements because:
 Market values of bonds held as investments increase as interest
rates fall
 Lower rates can encourage investors to withdraw money from

banks and invest in stocks

 Exchange rate risk
 Operations in foreign countries
 Investments in securities denominated in foreign
currency
Valuation of Securities Firms
 Value of a securities firm depends on its
expected cash flows and required rate of return

V = f [E(CF),
+ k]
Where:
V = Change in value of the securities firm
E(CF) = Change in expected cash flows
k = Change in required rate or return
Valuation of Securities Firms
 Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB)
+ ? +
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions
MANAB = The ability of the security firm’s management
Valuation of Securities Firms
 Investors required rate of return
k = f(Rf , RP)
+ +

Where:

Rf = Risk free interest rate

RP = Risk premium
Interaction With Other Financial
Institutions
 Offer investment advice and execute security
transactions for financial institutions that maintain
security portfolios
 Compete against financial institutions that have
brokerage subsidiaries
 Glass-Steagall Act of 1933 separated the functions
of commercial banks and investment banking firms
 Financial Services Modernization Act of 1999
 Effectively repealed Glass-Steagall
 Commercial banks, securities firms, and insurance
companies will increasingly offer similar services
Globalization of Securities Firms
 Securities firms have increased their presence
in foreign countries
 Merrill Lynch has more than 500 offices spread
across the world
 Allows them to place securities in various markets for
corporations or governments
 International M&A

 Ability to handle transactions with foreign securities

Globalization of Securities Firms
 Growth in international securities transactions
 Created more business for large securities firms
 International stock offerings
 Increased liquidity for issuing firm, avoiding downward

price pressure
 Growth in Latin America
 Increased business due to NAFTA
 Growth in Japan
 Some barriers to foreign securities firms still exist
 Mutual Funds
• Mutual Funds acquire funds by selling shares
to individual investors (many of whose shares
are held in retirement accounts) and use the
proceeds to purchase large, diversified
portfolios of stocks and bonds

2-96
 Investment Intermediaries
• Money Market Mutual Funds acquire funds by selling
checkable deposit-like shares to individual investors
and use the proceeds to purchase highly liquid and
safe short-term money market instruments
 Mutual Funds
• Stock or bond market related institutions
• Pool funds from many people
• Invest in wide variety of securities—
minimize risk
 Money Market Mutual Funds
• Individuals purchase shares in the fund
• Fund invests in highly liquid short-term money
market instruments
– Large-size negotiable CD’s
– Treasury bills
– High-grade commercial paper
 Mutual Funds
• Mutual funds represent a pooling of funds by
many investors.
• Open-end vs. closed-end funds.
• Net Asset Value (NAV) = liquidating value.
• For closed end funds, typically Price < NAV.
 Advantages of Mutual Funds
• Information Economies.
• Diversification.
• Lower transactions costs.
 Mutual
Sales Fees Fund Costs
Front End Load
Rear End Load
12b-1 Fees (Annual)
ExpenseMutual Fund
ratio includes: Costs
Management fee.
Administrative fee.
Other fees.

Additional Costs:
Brokerage commissions.
 Savings and Loan Associations (S&L’s)
• Traditionally acquired funds through savings deposits
• Used funds to make home mortgage loans
• Now perform same functions as commercial banks
– issue checking accounts
– make consumer and business loans
 Regulation Reason: Ensure Soundness
of Financial Intermediaries
• Because providers of funds to financial intermediaries may
not be able to assess
whether the institutions holding their funds are sound or
not, if they have doubts about the overall health of
financial intermediaries, they may want to pull their funds
out of both sound and unsound institutions, with the
possible outcome of a financial panic that produces large
losses for the public and causes serious damage to the
economy.
 Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)
• To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
– Restrictions on Entry
– Disclosure
– Restrictions on Assets and Activities
– Deposit Insurance
– Limits on Competition
– Restrictions on Interest Rates
 Regulation of Financial Markets
• Three Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial Intermediaries
3. Improve Monetary Control
 FIN 444
Financial Institutions in Hong Kong

Week 1 Introduction:
Financial System and Financial Intermediation

Mishkin (2006): Chapter 2

Overview of the Financial System

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rights reserved.
 Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are claims
on the borrower’s future income or assets

2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets

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Function of Financial Markets

Figure 2.1 Flow of Funds Through the Financial System

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rights reserved.
 Classifications of Financial Markets

1. Debt Markets
– Short-Term (maturity < 1 year) Money Market
– Long-Term (maturity > 1 year) Capital Market

2. Equity Markets
– Common Stock

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 Characteristics of Debt Markets Instruments

• Debt instruments
– Buyers of debt instruments are suppliers (of capital) to the
firm, not owners of the firm
– Debt instruments have a finite life or maturity date
– Advantage is that the debt instrument is a contractual
promise to pay with legal rights to enforce repayment
– Disadvantage is that return/profit is fixed or limited

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rights reserved.
 Characteristics of Equity Markets Instruments

• Equity instruments (common stock is most

prevalent equity instrument)
– Buyers of common stock are owners of the firm
– Common stock has no finite life or maturity date
– Advantage of common stock is potential high income
since return is not fixed or limited
– Disadvantage is that debt payments must be made
before equity payments can be made

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rights reserved.
 Classifications of Financial Markets

1. Primary Market
– New security issues sold to initial buyers

2. Secondary Market
– Securities previously issued are bought
and sold

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rights reserved.
 Classifications of Financial Markets
3. Exchanges
– Trades conducted in central locations
(e.g., New York Stock Exchange,
The Stock Exchange of Hong Kong)

4. Over-the-Counter Markets
– Dealers at different locations buy and sell
(e.g., The U.S. government bond market and Nasdaq OTC
stock exchange in US; Notes issued by Hong Kong
Mortgage Corporation in Hong Kong)

NYSE home page

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http://www.nyse.com
rights reserved.
 Function of Financial
Intermediaries (FIs)
• Financial Intermediaries
1. Engage in process of indirect finance
2. More important source of finance than
securities markets
3. Needed because of transactions costs and
asymmetric information

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 Function of Financial Intermediaries

• Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing
expertise and taking advantage of economies of
scale

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rights reserved.
 Function of Financial Intermediaries

• A financial intermediary’s low transaction costs

mean that it can provide its customers with
liquidity services, services that make it easier for
customers to conduct transactions
1. Banks provide depositors with checking accounts that
enable them to pay their bills easily
2. Depositors can earn interest on checking and savings
accounts and yet still convert them into goods and
services whenever necessary

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rights reserved.
 Function of Financial Intermediaries

• Another benefit made possible by the FI’s low

transaction costs is that they can help reduce the
exposure of investors to risk, through a process
known as risk sharing
– FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another
party
– This process is referred to as asset transformation,
because in a sense risky assets are turned into safer assets
for investors

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 Asymmetric Information:
Adverse Selection and Moral Hazard
• Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to seek
loan and be selected

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 Asymmetric Information:
Adverse Selection and Moral Hazard
• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage
in undesirable (immoral) activities making it
more likely that won't pay loan back

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rights reserved.
 Asymmetric Information:
Adverse Selection and Moral Hazard
• Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits.

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rights reserved.
Financial Intermediaries

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rights reserved.
 Types of Financial Intermediaries
• Depository Institutions (Banks)
– Commercial banks, Savings & Loan Associations (S&Ls), Mutual
Savings Banks in US
– Three-tier system of deposit-taking institutions, namely,
licensed banks, restricted licence banks,
deposit-taking companies in Hong Kong (collectively known as
AI: Authorized Institutions)
• Contractual Savings Institutions
– Life insurance companies
– Fire & casualty insurance companies
– Pension funds, government retirement funds
(e.g. Mandatory Provident Fund Scheme in Hong Kong)

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 Types of Financial Intermediaries
• Investment Intermediaries
– Finance companies
– Mutual funds
– Money market mutual funds

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 Depository Institutions (Banks)
• Commercial banks
– Raise funds primarily by issuing checkable, savings, and
time deposits which are used to make commercial,
consumer and mortgage loans
– Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset portfolios

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rights reserved.
 Contractual Savings
Institutions (CSIs)
• All CSIs acquire funds from clients at periodic
intervals on a contractual basis and have fairly
predictable future payout requirements.
– Life Insurance Companies receive funds from policy
premiums, can invest in less liquid corporate securities and
mortgages,
since actual benefit pay outs are close to those predicted
by actuarial analysis
– Fire and Casualty Insurance Companies receive funds
from policy premiums, must invest most in liquid
government and corporate securities, since loss events are
harder to predict

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rights reserved.
 Contractual Savings
Institutions (CSIs)
• All CSIs acquire funds from clients at periodic
intervals on a contractual basis and have fairly
predictable future payout requirements.
– Pension and Government Retirement Funds hosted by
corporations and state and local governments acquire
funds through employee and employer payroll
contributions, invest in corporate securities, and provide
retirement income via annuities

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rights reserved.
 Investment Intermediaries
• Finance Companies sell commercial paper (a short-
term debt instrument) and issue bonds and stocks to
raise funds to lend to consumers to buy durable
goods, and to small businesses for operations
• Mutual Funds acquire funds by selling shares to
individual investors (many of whose shares are held
in retirement accounts) and use the proceeds to
purchase large, diversified portfolios of stocks and
bonds

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rights reserved.
 Investment Intermediaries
• Money Market Mutual Funds acquire funds by
selling checkable deposit-like shares to individual
investors and use the proceeds to purchase highly
liquid and safe short-term money market instruments

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rights reserved.
 Regulation of Financial Markets
• Three Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial
Intermediaries
3. Improve Monetary Control

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rights reserved.
 Regulation Reason:
Increase Investor Information
• Asymmetric information in financial markets means that
investors may be subject to adverse selection and moral
hazard problems that may hinder the efficient operation of
financial markets and may also keep investors away from
financial markets
• The Securities and Exchange Commission (SEC) (SEC in US;
Securities and Futures Commission, SFC in Hong Kong)
requires corporations issuing securities to disclose certain
information about their sales, assets, and earnings to the
public and restricts trading by the largest stockholders (known
as insiders) in the corporation

2-132
 Regulation Reason:
Increase Investor Information
• Such government regulation can reduce adverse selection and
moral hazard problems in financial markets and increase their
efficiency by increasing the amount of information available
to investors

2-133
Regulation Reason: Ensure Soundness
of Financial Intermediaries
• Because providers of funds to financial
intermediaries may not be able to assess
whether the institutions holding their funds are
sound or not, if they have doubts about the overall
health of financial intermediaries, they may want to
pull their funds out of both sound and unsound
institutions, with the possible outcome of a financial
panic that produces large losses for the public and
causes serious damage to the economy

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rights reserved.
Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)
• To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
– Restrictions on Entry
– Disclosure
– Restrictions on Assets and Activities
– Deposit Insurance
– Limits on Competition
– Restrictions on Interest Rates

2-135
 Regulation: Deposit Insurance
• The government can insure people providing funds to
a financial intermediary from any financial loss if the
financial intermediary should fail
• The Federal Deposit Insurance Corporation (FDIC in
US; Deposit Protection Scheme, DPS managed by The
Hong Kong Deposit Protection Board), insures each
depositor at a commercial bank or mutual savings
bank up to a loss of $100,000 per account
(HK$100,000 per depositor per bank in Hong Kong)

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rights reserved.