Financial Markets

and Institutions

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 Chapter 7

Nonbank Operations
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 Reading

 Chapter 21,22,23,24,25, Financial Markets and Institutions;

Jeff Madura; South-Western Cengage Learning (2015).

 Chapter 20,21,22, Financial Markets and Institutions; Federic

S. Mishkin, Stanley G. Eakins; Pearson (2012).

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 Content
 Finance Companies
 Insurance Companies
 Pension Funds
 Mutual Funds
 Other Nonbank Operations

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 Introduction
- A part of financial intermediary institutions
-
Raise capital by issuing financial tools
-
Invest in financial tools
- Not commercial banks
- Include:
-
Contractual Saving Institutions
-
Investment Intermediaries

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Types of financial intermediaries

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 7.1. Insurance Companies
7.1.1. Background
-Insurance companies were created to provide insurance and retirement
funding for individuals, firms, and government agencies.
-Insurance companies provides various forms of insurance and investment

services to individuals and charge a fee (premium) for this financial service
under specified conditions based on a contract.
-An individual’s decision to purchase insurance may be influenced by the

likelihood of the conditions that would result in receiving an insurance

payment.
-Insurance companies employ underwriters to calculate the risk of specific

insurance policies.
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 7.1. Insurance Companies
1. Background
-Determinants of insurance premiums:
-
The probability of the condition under which the company will
have to provide a payment to the insured and the potential size
of payment
-
Degree of competition within the industry for the specific type
of insurance offered.
-
The present value of the expected payment
-
Contain a markup to cover overhead expenses and to provide a
profit beyond expenses.
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 7.1. Insurance Companies
1. Background
-Determinants of insurance premiums:
-
Dilemma when setting insurance premiums:
-
Rely on statistics about the general population
- Adverse selection problem means that people who have insurance are
more likely to suffer losses (and therefore to file claims) than people
who do not have insurance.
- Moral hazard problem which means that some people take more
risks
once they are insured.
- Need rely on the probability of a loss incurred by the people who obtain
insurance instead.
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 7.1. Insurance Companies
1. Background
-Investments by insurance companies:
-
Investthe insurance premiums and fees receives from
other services until the funds are needed to pay
insurance claims.
-
The performance of insurance companies is partially dependent
on the return on the invested funds
-
Investment decisions balance the goals of return, liquidity and
risk
-
They want to generate a high rate of return while maintaining
- risk atneed
They a tolerable level.sufficient liquidity
to maintain 10
 7.1. Insurance Companies
7.1.2. Life insurance operations
-A dominant force in the insurance industry
-Compensate the beneficiary of a policy upon the policyholder’s
death
-Charge policyholders a premium that should reflect the probability
of making a payment to the beneficiary as well as the size and timing
of the payment
-Commonly offer employees of a corporation a group life policy that
become quite popular and has generated a large volumn of business
in recent years.
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 7.1. Insurance Companies
2. Life insurance operations
Sources of funds:
-
- Obtain much from premiums, about 31% of total income
- The most impotant source of fund is the provision of annuity plans
- The third largest source is investment income
- Capital: built by retaining earning and issuing new stock. They use capital
as a means of financing investment in fixed assets
Insurance companies maintain an adequate capital level not only to cushion
potential losses, but also to reassure their customers

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 7.1. Insurance Companies
2. Life insurance operations
Uses of funds
-
- Government securities: insurance companies invest in U.S. Treasury
securities, state and local goverment bonds, and foreign bonds.
- Corporate securities: corporate bonds are the most popular asset of life
insurance companies. They usually hode a mix of medium- and long-term
bonds for cah management and liquidity needs. In addition, insurance
companies invest in package of corporate bonds, called collateralized loan
obligations (CLOs).
- Mortgages: life insurance companies hold all types of mortgage, including
one to four family, multifamily, commercial, and farm related. These
mortgages are typically originated by another financial institution and the
solde to insurance companies in the secondary market
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 7.1. Insurance Companies
2. Life insurance operations
Uses of funds
-
- Real estate: insurance companies sometime purchases real estate and lease
it for commercial purposes.
- Policy loans: life insurance companies lend a small protion of their funds to
whole life policyholders (called policy loans).

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Exhibit 7.1 How Insurance Companies Finance
Economic Growth

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 7.1. Insurance Companies
3. Other types of insurance operations
-Property and casualty insurance
- Protects against fire, theft, liability, and other events that result in economic
and noneconomic damage
- Property insurance: buildings, automobiles, othe assets.
- Casualty insurance: potential liabilites for harm to others (products failure
of accidents)
- Premium reflects the probability of a payout to the insured and the
potential
magnitude of the payout
- PC and life insurance have very different characteristics

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 7.1. Insurance Companies
3. Other types of insurance operations
Health care insurance
-
- Various types, including coverage for hospital stays, visit the phisicians,
and surgical procedures.
Business insurance:
-
- Protect business from many types of risk
- Some forms overlap with property and casualty insurance
- Liability insurance can protect a business against potential
liability of
claims by its employees

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 7.1. Insurance Companies
3. Other types of insurance operations
Bond insurance
-
- Protect investors that purchase bonds when bond issuers default on
their bonds
- The insurance on bonds is only as good as the insurance company’s ability
to cover claims
- During the credit crisis 2008, many insured bonds might suffer major losses

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 7.1. Insurance Companies
7.1.3. Other types of insurance operations
Mortgage insurance:
-

- Protects the lender that provide mortgage in the event

homeowners cannot cover their payments and default onthat
loans their
- mortgages
Mortgage lenders commonly require to obtain
homeowners mortgage
insurance
- Periodic insurance premiums

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 7.2. Pension Funds
• Provide a savings plan for employees that can be used
for retirement.
• Receive premiums from the employer and/or employee
• Bemajor investors in stocks, bonds, and various types of
loan packages such as mortgage-backed securities

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 7.2. Pension Funds
• Public pension funds:
• Can be state, local or federal,
• Many public pension plans are funded on a pay-as-you-go basis. Thus,
existing employee and employer contributions are essentially supporting
previous employee
• Private pension plans:
• Are created by private agencies, including industrial, labor, service,
nonprofit, charitable, and educational organizations.
- Defined-benefit plans: constributions are dictated by the benefits that will
eventually be provided
- Defined-contribution plans: provide benefits that are determined by the
accumulated contributions and the fund’s investment performance.
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Exhibit 7.2 How Pension Funds Finance Economic
Growth

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 7.3. Finance Companies
7.3.1. Types of finance companies
-Finance companies specilize on providing short- and

intermediate-term credit consumers and small

to businesses.
-Types of finance companies:
-
Consumer finance companies
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Business finance companies
-
Captive finance subsidiaries

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 7.3. Finance Companies
1. Types of finance companies
- Consumer finance companies provide financing for customers
of retail stores or whole salers. Many of them also provide
presonal loans and mortgage loans
- Business finance companies offer loans to small businesses.
They also provide financing in the form of credit cards.
- Captive finance subsidiary (CFS) is a wholly owned
subsidiary whose primary purpose is to finance sales of the
parent company’s products and services, provide wholesale
financing to distributiors of the parent’s company products, and
purchase receivables of the parent’s company.
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 7.3. Finance Companies
7.3.2. Sources and uses of funds
Sources of funds:
- Loans from banks: finance companies commonly borrow from commercial banks
and
can consistently renew the loans over time.
-Commercial paper (CP): financial companies are available only for short-term

financing, and can roll over their issues. The best-known ones can issues CP through
direct placement, others use dealers.
-Deposits: some states allow finance companies obtain funds by offering customer

deposits under some conditions although it has not been a major sourse of funds.
-Bonds: finance companies in need of long-term funds can issue bonds. Decision of

issuing bonds depend on the company’s balance sheet structure and its expectations
about future interest rates.
-stock
Capital: finance companies can build their capital base by retaining earnings25or
 7.3. Finance Companies
7.2.2. Sources and uses of funds
Uses of funds
-Consumer loans: Finance companies extend consumer loans in the form of
personal loans. They normally offer automobile loan, home improvement, mobile
homes, and others.
-Business loans and leasing: In addition to consumer loans, finance
companies
also provide business (commercial) loans.
-Real estate loans: finance companies offer real estate loans in the form of

mortgages on commercial real estate and second mortgages on residential real

estate.

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Exhibit 7.3. How Finance Companies Finance
Economic Growth

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 7.4. Mutual Funds
7.4.1. Background on mutual funds
-A mutual fund (MF) is an investment company that sell shares and uses proceeds
to manage a portfolio of securities.
-MFs pool investments by individual investors and use the funds to accommodate

financing needs of governments and corporations in the primary markets. They also
frequently invest in securities in the secondary market.
-MFs provide an impotant service for corporation, governments who need funds

and individual investors who wish to invest funds.

-MFs hire portfolio managers to invest in a portfolio of securities that satisfies the

desires of investors.
-Due to thier diversification, management expertise, and liquidity, MFs have grown

at a rapid pace.
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Exhibit 7.4 How Mutual Funds Finance Economic
Growth

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 7.4. Mutual Funds
2. Types of funds
Based on the liquidity of shares
-
- Open-end funds:
-
Open to investment from investors at any time. Investors can
purchase shares directly from and sell (redeem) their shares back to the
open-end fund at any time. Thus, the number of shares is always changing.
- There are many different categories of open-end mutual funds,
allowing
investors to invest in a fund that fits their particular investment objective.
- Closed-end funds:
- Do not redeem the shares they sell

- The market price can deviate from the aggregate value of the underlying

stocks
the number
- The numberofofshares originally
outstanding shares usually remains constant and is equal30
 7.4. Mutual Funds
2. Types of funds
Based on mutual fund categories:
-
- Stock mutual fund
- Bond mutual fund
- Money market mutual funds
- Exchange-traded funds (ETFs)
- (Venture capital funds; Private equity funds; Vulture funds; Hedge funds;
Real estate investment trusts)

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 7.5. Other nonbank operations
1. Thrift/Saving Operations
1. Background on thrift operations
-Include saving banks and savings and loan associations (S&Ls). The
two types of thrifts now have very similar sources and uses of funds.
-Ownership of savings institutions (SIs):
- SIs are classified as either stock owned or mutual (owned by depositors)
- Stock-owned institutions are more susceptible to unfriendly takeovers
- When a mutual SI is involved in an acquisition, it first converts to a
stock- onwed SI.
- Some SIs have beed acquired by commercial banks that wanted to
diversify
their operations
- the total
While assets of SIsamong
consolidation in aggregate
SIs hashave
resulted in a smaller number of 32
increased
institutions,
 7.5. Other nonbank operations
1. Thrift/Saving Operations
2. Sources and Uses of Funds
Sources of funds:
-
- Deposits: SIs obtain most of their funds from a variety of savings and time
deposits, including passbook savings, retail certificates of deposits (CDs)
and money market deposit accounts (MMDAs)
- Borrowed funds:
-
Borrow from other depository institutions that have excess funds in
the frderal fund market
-
Borrow through a repurchase agreement (repo)
-
Borrow at the Federal Reserse
- Capital (net worth) of an SI is primarily composed of retained earnings
funds obtained from issuing
and 33
stock
 7.5. Other nonbank operations
1. Thrift/Saving Operations
2. Sources and Uses of Funds
Uses of funds
-
- Cash: To satisfy reserve requirements and accommodate withdrawal
requests.
- Mortgages: are the primary asset of SIs, typically have long-term maturities
and can usually be prepaid by borrowers. They can be sold in secondary
market, although their market value changes in response to interest rate
movement (interest rate risk and credit risk).
- Mortgage-back securities: the return on these securities is highly
influenced by the default rate on the underlying mortgages.

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 7.5. Other nonbank operations
1. Thrift/Saving Operations
2. Sources and Uses of Funds
Uses of funds:
-
- Other securities: all SIs invest in secutiries such as Treasury bonds and
corporate bonds with high liquidity
- Consumer and commercial loans: SIs provides corporate and consumer
loans with maturity typically from 1 to 4 years. It results in reducing their
exposure to interest rate risk but increasing some noninterest costs
- Other uses of funds: providing temporary financing to other institutions
through the use of repurchase agreements, and lending funds on a
short- term basis through the federal funds market

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Exhibit 7.5 How Savings Institutions Finance Economic
Growth

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 7.5. Other nonbank operations
1. Thrift/Saving Operations
5. Credit Unions (CUs):
-CUs are nonprofit organizations composed of members with a
common bond, such as an affliation with a particular labor union,
church, university, or residential area.
-Ownership of CUs:
- Technically owned by the depositors. The depositors are called shares, and
interest paid on the deposits is called a dividend that is not taxed.
- CUs can be federally or state chattered.
- Most CUs are very small.
- Their objective is to safety those members. They act as intermediaries by
repacking deposits from member savers and providing them as loans
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member
to borrowers.
 7.5. Other nonbank operations
1. Thrift/Saving Operations
5. Credit Unions (CUs):
Advantages and disadvantages
-
- CUs are nonprofit so they are not taxed
- Employees may not have incentive to manage efficiently.
- Many CUs are unable to diversify geographically
- CUs increasingly have been merging

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 7.5. Other nonbank operations
1. Thrift/Saving Operations
5. Credit Unions (CUs)
CUs sources of funds:
-
- CUs obtain most of their funds from share deposit by
members
- CUs also offer checkable accounts called share drafts
- CUs can borrow from other CUs or from CLF
CUs uses of funds
-
- CUs use the majority of their funds for loas to members
- CUs purchase government and agency securities

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 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Facilitating new stock offerings
-
- Origination: when a corporation dicides to publicly issue stock, it may
contact security firms to determine the appropriate amount and price of
stock to issue.
- Underwriting: the original securities firm may form an underwriting
syndicate by asking other securities firms to underwrite a portion of the
stock. When securities firms facilitate IPOs, they attempt to price the stock
high enough to satisfy both the issuing firms and the institutional investors.
- Distribution: once all agreements between the issuing firm, the originating
securities firms, and other participating securities firms are compakete and
the registration is approved by the SEC, the stock may be 40
 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Facilitating new stock offerings
-
- Advising: the securities firm act as an adviser throughout the origination
stage. Even after the stock is issued, the securities firm may continue to
provide advice on the timing, amount, the terms of future financing.
- Private placement of shares: securities firms are also hired to facilitate
private placements of stock. With a private placement (or direct placement),
an entire stock offering may be placed with a small set of institutional
investors and not offered to the general public

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 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Facilitating new bond offerings
-
- Origination
- Underwriting
- Distribution
- Advising
- Private placement of bonds

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 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Facilitating leveraged buyouts:
-
- Assess the market value of the firm (or division) of concern so that
the
acquirer does not pay more than the target firm’s value.
- Arrange financing
- Help the acquirer purchase any common stock of the target
that is outstanding.
- May be retained in an advisory capacity.

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 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Facilitating arbitrage
-
- Arbitrage activity in the security industry involves purchasing undervalued
shares and reselling them at a higher price.
- The securities firms work closely with arbitrage firms by searching
for undervalued firms and reasing funds for arbitrage firms.
- It is sometime difficult to distinguish between arbitrage and LBO
- Some attempts at arbitrage fail because the target firm successfully defends
against a takeover.

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 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Facilitating corporate restructuring
-
- Advising on corporate restructuring: Assessing how corporation
restructuring could change the valuation of a business, i.e. Combininn or
seperating 2 business, or spining off a unit by creating new shares
representing the unit and distributing them to existing shareholders
- Financing merges and acquisitions: securities firm s can raise large amounts
of funds in the capital markets to meet the outside financing requirement of
merges and acquistions.

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 7.5. Other nonbank operations
2. Securities Operations
1. Services provided by Securities operations
Providing brokerage services
-
- Securities firms commonly serve as brokers by executing buy or sell
orders desired by their customers
- By service they provide, they can classified into full-service
brokerage
firms and discount brokerage firms
- Brokerage firms have reduce placing order costs by implementing
online order systems.
Investing their own funds:
-
- Securities companies commonly use some of their funds to invest in a
various typesofofsecurities
wide range derivatives.
including stocks, bonds, mortgage-backed 46