Chap 1, Class 1

Course

Overview

Syllabus
Organization

Introduction to Financial
What role do FIs perform
What costs do FIs reduce
How FIs are special

Institutions (FI)

Syllabus

The syllabus can be found on the course web page:

http://somfin.gmu.edu/~anderson/321
A print friendly version is available by clicking the
Print Friendly Version link at the top of the syllabus page

Time & Location: --- Here Now

Instructor:
Office:
Office Phone:
e-mail:
Office Hours:

Mike Anderson
237 Enterprise Hall
993-5816
mander19@gmu.edu
Walking/By appointment
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Prerequisites
A strong understanding of basic financial concepts
Successful completion of FNAN 301.
Students should have an operational knowledge of MS-Excel.

Required Reading
Saunders and Cornett, Financial Institutions Management: A Risk

Management Approach, 8th Edition,

Supplemental Readings
Recommended Reading on the course web page
Students are also strongly encouraged to read financial press, such as

the Wall Street Journal or Financial Times

Lecture Material
Handouts are available on the course webpage.
Handouts do not contain all the information that you will be held

responsible for on exams.

THIS IS NOT A CORRESPONDENCE COURSE AND THE
COURSE MATERIAL IS NOT DESIGNED TO EDUCATE
STUDENTS IN THIS MANNER
Students may be tested on any information made available through
course-required material - including lectures and the book
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Grading:
Category
Homework
Participation
Exams
Exam I
Exam II
Exam III

Allocation
30%
5%

15%
25%
25%

Homework:
Homework assignments must be completed individually
Grading:
Each homework problem set is scored out of a pre-designated number of points which is
listed on the cover page.
To receive full credit for a any given problem:

Answers must be correct

Answers must be handwritten in a clear and legible manner
You must show all your work (Listing inputs to your calculator does not constitute showing
your work)
Solutions must be identified by drawing a circle or box around your answer

Electronic copies of homework will receive no-credit

Homework must be submitted in class on the due date.

Weight = 30% of your final grade

Homework (continued)
Your final homework grade will be calculated as a percent of the total

points received over all homework assignments. For example, if you

received 50% of the points 1440 points available on homework your,
final homework score would be (.50)(.30) = .15
The 2 problem sets with the lowest grade (percentage score) will be
dropped
You will have two weeks from the day the homework is recorded on
blackboard to contest the grade.

Capital Adequacy Project

Will count as one homework assignments but it cannot be dropped
Graded on the basis of accuracy
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Exams:
There will be three exams 2 mid-terms and 1 final
Dates are listed on the lecture schedule available on the web page
Questions: Are the exams cumulative?
Midterms are implicitly cumulative in that the course material builds on itself
The final may be cumulative (if the performance on the first two exams is poor)
Exams
Exam I

15%

Exam II

25%

Exam III

25%

Total weight = 65%

YOU ARE REQUIRED TO TAKE ALL 3 EXAMS.

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Participation:
Your participation grade is based on daily quizzes
Quizzes are not graded you will receive full credit for attempting to

complete the exercise

Missed quizzes cannot be made up but you will be allowed to drop
your 2 lowest scores for classes that meet 2 times a week
Your lowest score for classes that meet once a week

Extra credit may be awarded to students who consistently and actively

participate in class discussion

You must attend class to be able to participate

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Extra Credit:
Extra credit can be earned for demonstrating extraordinary effort in the

course.
These points are rarely awarded.
However, if a student exerts significant effort and/or demonstrates a mastery
of material far beyond the minimum level required by the course, they may
be awarded extra credit upon calculation of the final grade.
Extraordinary effort and mastery of the material is evaluated on a case-bycase basis entirely determined at the discretion of the professor.

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 Grading

Scale:
Grade
A+
A
AB+
B
BC+
C
CD+
D
F

less than

Greater than or equal to

Reserved for exceptional performance

93%
93%
90%
90%
87%
87%
83%
83%
80%
80%
77%
77%
73%
73%
70%
70%
67%
67%
63%
63%

Percentages will be rounded to 3 decimal places prior to assigning the final letter grade

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Absences and Late Assignments

There are no excused absences
Exams:
If you are physically incapacitated or some catastrophic event prevents you from attending
one of the first two exams, I may allow you to make it up as part of your final exam. In this
case, you will be required to take both the midterm and final at the university scheduled final
exam time. Makeup exams will be granted on a case by case basis.

If you miss the final, you will receive a score of zero for that exam.
Missing two or more exams will result in a failing grade for the course
Homework/Quizzes: lost points on homework and quizzes resulting from

absences cannot be made up

Late assignments will not be accepted

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Regrading Policy
Errors: Grading errors will be corrected.
These include mechanical or mathematical errors such as an incorrect

tally of points, incorrect calculation of percentage points, etc.

Appeals: Regrade appeals are appropriate when you feel that

an answer has been graded incorrectly.
These must be submitted in writing within one week after the graded

test is returned.
The appeal must include:
A description of the question(s) that needs to be reexamined as well as an explanation
of why the original grade is incorrect.
A reference to the location, in the required course material, that supports the argument
that your answer is correct. For example, My answer to test question 5 is taken
directly from page 534 paragraph 3 of the Saunders and Cornett Text.

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Regrading Policy
Any exam submitted for regrading of a question is subject to a complete

regrade. As a result, the regraded score may increase, stay the same, or
decrease after careful consideration .
I will not consider any regrade requests after the one week deadline has
passed.

Conflicts:
The required text (Saunders and Cornett, Financial Institutions

Management: A Risk Management Approach, 8th Edition) is the main

resource for this course. Therefore, if for any reason information in other
required materials (handouts, readings ) conflicts with the information in
the text, the text will take precedence unless explicitly stated.

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Academic Conduct
Honor Code: Students are expected to follow the University Honor Code:

Student members of the George Mason University community pledge not

to cheat, plagiarize, or lie in matters related to academic work.
Lectures: Students are expected to be courteous and respectful while
attending lectures. Conduct that will not be permitted in class includes but
is not limited to:

Inappropriate outbursts
Sleeping.
Reading newspapers, magazines, or other material unrelated to the course.
Use of computers in class unless otherwise stated.
Trying to complete your homework

Email: I expect emails to be written in a professional manner. This

includes appropriate use of language and tone. In appropriate emails will

not be answered.
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Course Organization

18

web page

Getting to know Financial Institutions

Introduction
to Banking

Interest rate risk the fundamental risk

of banking
Measuring and Managing Interest Rate
Risk
Off-Balance Sheet Activity
Capital Adequacy

Measuring and
Managing
Banking Risks

Credit Risk
Liquidity Risk
Market Risk
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Introduction to Financial
Institutions

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FIs provide a conduit to channel funds from savers to

borrowers

Savers

Borrower

Savers: entities with a surplus of funds

Borrowers: entities with a deficit of funds
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This course is about:

The role that the financial institutions play in channeling

funds from savers to borrowers

How financial institutions profit from filling this role

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Why study financial institutions instead of auto manufactures

or healthcare providers?

What is special about the services they provide?

Savers

Borrower
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Why study financial institutions instead of auto manufactures

or healthcare providers?

What is special about the services they provide?

Cash

Savers
Buy Financial Assets

Debt & Equity Securities

Borrower
Buy Real Assets

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Consider a world without

Financial Institutions

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Ideal World:
Investors are perfectly informed they know everything about the company and

its actions
Information is costless
There are no market frictions liquidity, transaction costs
There would probably be no need for FIs

Do we live in an ideal world?

Investors are never perfectly informed
Information is costly
There are costs associated with investing (market frictions)

Wh
y

Without FIs: Low level of fund flows!

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Real World: In reality investors face three types of costs

when directly lending to companies
1.

Information Costs

2.

Liquidity Risk

3.

Price Risk

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Adverse Selection Prior to investing

Companies who are always in need of money are usually companies

who make poor investments and continuously lose money

Prior to purchasing a firms equity or lending to the firm, individuals
must incur costs to investigate the firms quality.
If not, they are likely to lend to the poorest (adverse) quality firms.

Moral Hazard After Investing

A company takes on excessive risk because managers (equity holders)

are compensated for good outcomes but they do not bear the full losses
for bad outcomes (agency cost!).
After a company receives a loan, managers may elect to invest in a
riskier project than what was agreed on.
Investors can try to monitor the firms actions
Monitoring is very costly
Free rider problem
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Moral Hazard

Adverse Selection

Who was facing the risk?

How were they managing it?

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How can investors reduce information risk?

Screening reduces adverse selection
Monitoring reduces moral hazard

Will individual investors screen and monitor? Not Likely!

Why Not?
There is a free rider problem

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Investment Project:
Everyone gives me $100
I am going to invest in stocks and alternative investments
Every Saturday night at 10:00 pm we will meet here and discuss the

investment allocation and portfolio performance

How many people plan to attend all the meetings?

Ideally, would you want everyone to screen and monitor?

No, it is inefficient
ideally the screening and monitoring costs will be incurred one time. If everyone
screens and monitors these costs will be incurred several times

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If FIs didnt exist there would be no secondary market for

companies debt or equity

There would be no easy way to convert securities to cash

investors would have to wait for them to mature

Investors who plan to use the money in the near future would
have to hold cash

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If investors could sell securities in a market without FIs, they

would not likely get the full value of their securities

Transaction Costs:
The price of taking out an advertisement
The price of listing on an exchange
Delivery costs

Supply and demand:

The buyer may not want to purchase the security as much as the seller

needs to sell it

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Conclusion:

Without FIs funds would flow slowly from

households to businesses because of:
Information costs
Liquidity risk
Price Risk

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Now Lets Put FIs Back

Into the Economy

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FI Functions
Broker

Savers

Borrower
Equity
& Debt

Cash
Asset
Transformer

Deposits/Insurance
Policies

Cash
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FIs act as agents for savers - Perform 2 services

1. Transaction Services
Purchase or sell securities for a commission or fee

2. Information Services
Research Securities
Provide Recommendations

How dose
this help
investors?

Reduce

costs through economies of scale (lower costs

by expanding output)

Fixed costs (exchange membership) are spread out over more

transactions
Cost per trade is lower bulk discount or standardization

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Purchase Primary Securities (stocks, bonds) from firms and

sell Secondary Securities (transformed assets) to individuals.
Secondary Assets (Transformed Assets)
1.
2.
3.

Certificates of deposit
Insurance claims
Mutual funds

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Reduces Information Costs

1.
a.
b.

Due Diligence
Delegated Monitoring

2.

Reduce Liquidity Risk

3.

Reduce Price Risk

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FIs specialize in doing due diligence Collecting

information prior to investing.

1.

Example An asset manager investigates a companies prior to investing

Does this reduce adverse selection or moral hazard?

FIs are appointed delegated monitoring watches over

the borrower, their actions and how they perform

2.

Example Bank Loan

Does this reduce adverse selection or moral hazard?

Where does the cost reduction come from?

1. Investors now share the cost of collecting information
1. Example: Bloomberg Subscription

2. Secondary securities that the bank creates, are easier to monitor

1. Example: Bank loans, are shorter term and have covenants allow for more frequent
updating of information as firms refinance their loans
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FIs specialize in engineering securities to have desirable

properties.

Increase Liquidity:
Deposit contracts can be withdrawn immediately
They pay a higher interest rate than holding cash because banks
finance these accounts using longer-term mortgages with higher
rates. Banks are better able to bear the risk of mismatching
maturities of their assets and liabilities (e.g. long maturity assets vs.
demand deposits)

Mutual funds easier to trade than a individual asset

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Through diversification:

1.

Asset diversification: FIs offer investors shares in diversified portfolios

(mutual funds). The portfolio and thus the price of its shares are less
exposed to fluctuations in the price of any individual asset.

Claim diversification: Insurance companies pool different types of risk

faced by individuals to offer claims that are contingent on certain events.

Through a decrease in transaction costs

2.

It cost less for an investor to buy shares in a mutual fund than to buy all
the assets in a portfolio.
Several individuals pay premiums but only a small subset file
claims at any given time therefore the pool of funds should be
relatively unaffected by individual claims

FIs add value by reducing

Information Risk
Liquidity Risk
Price Risk

Through their roles as:

Brokers
Asset Transformers

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Transmission of monetary policy

1.

Banks control deposits, which are a large part of the money supply.
Therefore, FI activity can affect inflation

Credit Allocation

2.

FIs are the main and sometimes only source of financing for some
sectors of the economy (residential real estate, farming)

Intergenerational wealth transfer

3.

Life insurance, trusts, pension funds allow savers to transfer

wealth across generations.

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Payment Services

4.

Without the payment services that DIs provide (ATMs, checking, wire
transfer), it would be very difficult to conduct business.

Denomination Intermediation

5.

Some assets trade in large amounts (commercial paper $250,000;

Negotiable CD $100,000). FIs give small investors access to these assets by
selling shares of a portfolio.

Maturity Intermediation

6.

FIs are in the business of collecting short term deposits and pooling them to
issue long-term loans (mortgages)
Long-term loans have higher interest rates and generate profit for the bank
FIs hold a fraction of the deposits in reserve to satisfy depositor liquidity
needs
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Safety and soundness regulation

1.

Meant to enhance FI stability include: diversification requirements, guaranty funds, monitoring and
surveillance, equity capital requirements

Monetary policy regulation

2.

Regulations meant to ensure that monetary policies can be transmitted through FIs quantitative easing
or reserve requirements

Credit allocation regulation

3.

Provide special treatment for certain sectors to ensure that financing is available (farming )

Consumer protection regulation

4.

Regulations to prevent discriminatory lending practices

Investor protection regulation

5.

Reduce moral hazard problem insider trading, lack of disclosure

Entry and charter regulation

6.
1.

Limits the entry of new FIs through charting by state or federal agencies

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FIs allow funds to easily flow from savers to borrowers

FIs reduce
Information risk
Liquidity risk
Price risk

They reduce risks through their roles as brokers and asset

transformers

FIs also provide

Payment services
Denomination Intermediation
Maturity Intermediation

Because they are special FIs are subject to special regulation

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