HO MB1e ch11 PDF

R.
GLENN
HUBBARD ANTHONY PATRICK
O’BRIEN
Money,
Banking, and
the Financial System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall

CHAPTER 11 Investment Banks, Mutual Funds,
Hedge Funds, and the Shadow
Banking System
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
11.1 Explain how investment banks operate

11.2 Distinguish between mutual funds and hedge funds and
describe their roles in the financial system
11.3 Explain the roles that pension funds and insurance
companies play in the financial system
11.4 Explain the connection between the shadow banking system and
systemic risk

CHAPTER 11 Investment Banks, Mutual Funds,
Hedge Funds, and the Shadow
Banking System
WHEN IS A BANK NOT A BANK? WHEN IT’S A SHADOW BANK!
• During the financial crisis of 2007–2009, a variety of “nonbank” financial
institutions were acquiring funds that had previously been deposited in
banks, and they were using these funds to provide credit that banks had
previously provided. The newly developed securities they were creating
were not fully understood.
• A key issue for policymakers in dealing with the crisis was the role the
Fed should play in dealing with a financial crisis that involved many
nonbank financial firms.
• An Inside Look at Policy on page 338 discusses whether a panic in
the shadow banking system caused the financial crisis.

Key Issue and Question
Issue: During the 1990s and 2000s, the flow of funds from lenders to
borrowers outside of the banking system increased.
Question: What role did the shadow banking system play in the
financial crisis of 2007–2009?
© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 49

11.1 Learning Objective
Explain how investment banks operate.

What Is an Investment Bank?
Investment banking Financial activities that involve underwriting new security

issues and providing advice on mergers and acquisitions.
Investment bankers are involved in the following activities:

1. Providing advice on new security issues
2. Underwriting new security issues
3. Providing advice and financing for mergers and acquisitions
4. Financial engineering, including risk management
5. Research
6. Proprietary trading
Investment Banking
Providing Advice on New Security Issues
• Firms turn to investment banks for advice on how to raise funds by issuing
stock or bonds or by taking out loans.
Underwriting New Security Issues

Underwriting An activity in which an investment bank guarantees to the
issuing corporation the price of a new security and then resells the security for
a profit, or spread.
Initial public offering (IPO) The first time a firm sells stock to the public.
• An investment bank typically earns 2% to 4% of the dollar amount raised in a

secondary offering (or seasoned offering).
• In return for the spread, the investment bank takes on the risk that it cannot
profitably resell the securities being underwritten.
Investment Banking
Syndicate A group of investment banks that jointly underwrite a security issue.
• In a syndicated sale, a lead investment bank keeps part of the spread, and
the remainder is divided among the syndicate members.
• Once a firm has chosen the investment bank that will underwrite its
securities, the bank carries out a due diligence process, during which it
researches the firm’s value. The investment bank then prepares a
prospectus, which the Securities and Exchange Commission (SEC) requires
of every firm before allowing it to sell securities to the public.
• During the financial crisis of 2007–2009, investor confidence about the ability
of investment banks to gather information was shaken when investment
banks underwrote mortgage-backed securities that turned out to be very
poor investments.
Investment Banking
Providing Advice and Financing for Mergers and Acquisitions
• Investment banks are very active in mergers and acquisitions (M&A). They
advise both buyers—the “buy side mandate”—and sellers—the “sell side
mandate.”
• When advising a firm seeking to be acquired, investment banks attempt to
find an acquiring firm willing to pay significantly more than the book value of
the firm.
• Advising on M&A is particularly profitable for investment banks because the
bank does not have to invest its own capital. Its only significant costs are the
salaries of the bankers involved in the deal.
Investment Banking
Financial Engineering, Including Risk Management
• Financial engineering involves developing new financial securities or

investment strategies using sophisticated mathematical models.
• Derivative securities, used by firms to hedge, are the result of financial
engineering.
• Investment banks supply knowledge of financial markets to properly assess
the best way to raise funds by selling stocks and bonds, and construct risk
management strategies for firms in return for a fee.
• During the financial crisis, investment bank managers greatly
underestimated the risk that the prices of these derivatives might fall if
housing prices declined and people began to default on their mortgages.
Investment Banking
Research
• Investment banks assign research analysts to particular firms or industries,

to gather research notes used to advice investors on mergers and
acquisitions.
• Research analysts also advice investors to “buy,” “sell,” or “hold” particular
stocks. Overweight is a term used for a stock they recommend and
underweight for a stock they do not.
• The opinions of senior analysts at large investment banks can have a
significant impact on the market.
• They also provide useful information for the investment bank’s trading desks,
where traders buy and sell securities.
• Analysts also engage in economic research, writing reports on economic
trends and providing forecasts of macroeconomic variables.
Investment Banking
Proprietary Trading
• Beginning in the 1990s, proprietary trading, or buying and selling securities

for the bank’s own account rather than for clients, became a major part of
operations and an important source of profits for investment banks.
• Proprietary trading exposes banks to both interest-rate risk and credit risk.
During the financial crisis, it became clear that credit risk was the most
significant risk that investment banks faced. Credit risk is the risk that
borrowers might default on their loans.
• The problems investment banks faced during the financial crisis were made
worse because they had used large amounts of borrowed funds to finance
their proprietary trading. Using borrowed funds increases leverage, which
increases risk.
Investment Banking
“Repo Financing” and Rising Leverage in Investment Banking
• Among the sources of funds for investment banks are the bank’s capital—
funds from shareholders and retained profits—and short-term borrowing.
• During the 1990s and 2000s, most large investment banks converted from
partnerships to publicly traded corporations, and proprietary trading became
a more important source of profits.
• Financing investments by borrowing rather than by using capital, or equity,
increases leverage.
• As we saw in chapter 10, the ratio of a bank’s assets to its capital is its
leverage ratio. Because a bank’s return on equity (ROE) equals its return on
assets (ROA) multiplied by its leverage ratio, the higher the leverage ratio,
the greater the ROE for a given ROA. But the relationship holds whether the
ROA is positive or negative.
Investment Banking
Solved Problem 11.1
The Perils of Leverage
Suppose that an investment bank is buying $10 million in long-term mortgage-backed
securities. Consider three possible ways that the bank might finance its investment:
1. The bank finances the investment entirely out of its equity.
2. The bank finances the investment by borrowing $7.5 million and using $2.5 million of
its equity.
3. The bank finances the investment by borrowing $9.5 million and using $0.5 million of
its equity.
a. Calculate the bank’s leverage ratio for each of these three ways of financing the
investment.
b. For each of these ways of financing the investment, calculate the return on its equity
investment that the bank receives, assuming that:
i. The value of the mortgage-backed securities increases by 5% during the year
after they are purchased.
ii. The value of the mortgage-backed securities decreases by 5% during the year
after they are purchased.
Investment Banking
Solved Problem 11.1
The Perils of Leverage
Solving the Problem
Step 1 Review the chapter material.
Step 2 Step 3 Step 4

Answer question (a) by Answer the first part of Answer the second part of
calculating the leverage ratio question (b) by calculating the question (b) by calculating the
for each way of financing the bank’s return on its equity return for each of the three ways
investment. investment for each of the of financing the investment.
three ways of financing the
investment.
$10,000,000 $500,000 −$500,000

1. = 1. 1. = 5%. 1. = −5%.
$10,000,000 $10,000,000 $10,000,000
$10,000,000 $500,000 −$500,000

2. = 4. 2. = 20%. 2. = −20%.
$2,500,000 $2,500,000 $2,500,000
$10,000,000 $500,000 −$500,000

3. = 20. 3. = 100%. 3. = −100%.
$500,000 $500,000 $500,000
Investment Banking
“Repo Financing” and Rising Leverage in Investment Banking
• Federal banking regulations put limits on the size of a commercial bank’s

leverage ratio. But these regulations did not apply to investment banking.
• Investment banks increasingly relied on borrowed funds to finance their
investments and, as a group, became much more highly leveraged than
commercial banks.
• The process of reducing leverage is called deleveraging.
• Investment banks borrowed primarily by either issuing commercial paper or
by using repurchase agreements (short-term loans backed by collateral).
• If the funds raised are used to invest in mortgage-backed securities or to
make long-term loans to, for instance, commercial real estate developers,
investment banks face a maturity mismatch.
Investment Banking
Figure 11.1
Leverage in Investment Banks
Panel (a) shows that at the start of the financial crisis in 2007, large investment banks were
more highly leveraged than were large commercial banks.
Panel (b) shows that during 2008 and 2009, Goldman Sachs and Merrill Lynch reduced their
leverage ratios, or deleveraged.
Investment Banking
Making the Connection
Did Moral Hazard Derail Investment Banks?
• By the time of the financial crisis, all the large investment banks had become
publicly traded corporations.
• With corporations, there is a separation of ownership from control. The moral
hazard involved can result in a principal–agent problem, as top managers
may take actions that are not in the best interest of the shareholders.
• Underwriting complex financial securities, such as CDOs and CDS
contracts, are activities that shareholders and boards of directors do not
understand and therefore cannot effectively monitor.
• Some commentators argue, however, that since top managers also suffered
significant losses during the crisis, the moral hazard problem could not have
been so severe.
Investment Banking
The Investment Banking Industry
• The Glass-Steagall Act in 1933 separated investment banking from
commercial banking after the great stock market crash of October 1929
resulted in heavy losses from underwriting.
• Years later, economists argued that the act had protected the investment
banking industry from competition, which enabled it to earn larger profits
than the commercial banking industry.
• In 1999, the Gramm-Leach-Bliley (or Financial Services Modernization) Act
repealed the Glass-Steagall Act.
• The Gramm-Leach-Bliley Act also authorized new financial holding
companies that would allow securities and insurance firms to own
commercial banks, and allowed commercial banks to participate in
securities, insurance, and real estate activities. Large investment banks,
known as “bulge bracket” banks were separated from standalone investment
banks, and smaller, or “boutique,” banks.
Investment Banking
Where Did All the Investment Banks Go?
The effect of the financial crisis of 2007-2009 was labeled “The End of Wall
Street” because the investment banks that ran into difficulties had long been
seen as the most important financial firms in the stock and bond markets.
Investment Banking
So, You Want to Be an Investment Banker?
• Over the past 20 years, investment banking has been one of the most richly
rewarded professions in the world.
• The pay of top executives has been controversial. Some argue that not only
is their pay out of line with their economic contributions, but also that they
may have helped bring on the crisis by promoting mortgage-backed
securities.
• New college graduates are hired as analysts who spend 80 hours per week
or more researching industries, helping in the due diligence process, and
with mergers and acquisitions.
• After two to four years, the bank either promotes an analyst to the position of
associate or asks him or her to leave the firm. MBA graduates are
sometimes hired directly as associates.
Investment Banking
Distinguish between mutual funds and hedge funds and describe their roles in
the financial system.

• In addition to investment banks, investment institutions are financial firms
that raise funds to invest in loans and securities.
Investment institution A financial firm, such as a mutual fund or a hedge

fund, that raises funds to invest in loans and securities.
• The most important investment institutions are mutual funds, hedge funds,
and finance companies.
Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Mutual Funds
Mutual fund A financial intermediary that raises funds by selling shares to

individual savers and invests the funds in a portfolio of stocks, bonds,
mortgages, and money market securities.
• Mutual funds help to reduce transaction costs, provide risk-sharing benefits,

and gather information about different investments.
• The mutual fund industry in the United States dates back to 1924, with the
creation of the Massachusetts Investors Trust, State Street Investment
Corporation, and Putnam Management Company, which remain major
players today.

Types of Mutual Funds
• In closed-end mutual funds, a fixed number of nonredeemable shares is

issued, with the price of a share fluctuating with the market value of the
assets—called the net asset value, or NAV.
• In more common open-end mutual funds, investors can redeem shares after
the markets close for a price tied to the value of the assets in the fund.
• Exchange-traded funds (ETFs), like closed-end mutual funds, trade continually
throughout the day. With ETFs, market prices track the prices of the assets.
• Large institutional investors who purchase above a certain number of shares of
an ETF—called a creation unit aggregation—have the right to redeem those
shares for the assets in the fund.
• Mutual funds that do not charge a commission, or “load,” are called no-load
funds. Load funds charge buyers a commission to both buy and sell shares.
• An index fund consists of a fixed-market basket of securities, such as the
stocks in the S&P 500 stock index.
Money Market Mutual Funds
Money market mutual fund A mutual fund that invests exclusively in short-
term assets, such as Treasury bills, negotiable certificates of deposit, and
commercial paper.
• Most money market mutual funds allow savers to write checks above a
specified amount against their accounts.
• They are popular with small savers as an alternative to commercial bank
checking and savings accounts, which typically pay lower rates of interest.
• Money market mutual funds brought additional competition for commercial
banks. Rather than taking out loans from banks, firms sold commercial
paper to the funds. The interest rates the firms paid on the paper was lower
than banks charged on loans.

Hedge Funds
Hedge fund Financial firms organized as a partnership of wealthy investors that

make relatively high-risk, speculative investments.
• Hedge funds are typically organized as partnerships of 99 investors or fewer,

all of whom are either wealthy individuals or institutional investors, such as
pension funds. They are largely unregulated and free to make risky
investments.
• Modern hedge funds typically make investments that involve speculating,
rather than hedging, so their name is no longer an accurate description of
their strategies.
• Although reliable statistics on hedge funds are difficult to obtain, in 2010,
there were as many as 10,000 operating in the United States, managing
more than $1 trillion in assets.

Finance Companies
Finance company A nonbank financial intermediary that raises money through

sales of commercial paper and other securities and uses the funds to make
small loans to households and firms.
• A lower degree of regulation allows finance companies to tailor loans closer

to the needs of borrowers than do the standard loans that more regulated
institutions can provide.
• The three main types of finance companies are consumer finance, business
finance, and sales finance firms.
• Many economists believe that finance companies fill an important niche in
the financial system because they have an advantage over commercial
banks in monitoring the value of collateral, making them logical players in
lending for consumer durables, inventories, and business equipment.

Explain the roles that pension funds and insurance companies play in the
financial system

Contractual saving institution A financial intermediary such as a pension
fund or an insurance company that receives payments from individuals as a
result of a contract and uses the funds to make investments.
Contractual Savings Institutions: Pension Funds and Insurance Companies

Pension Funds
Pension fund A financial intermediary that invests contributions of workers and

firms in stocks, bonds, and mortgages to provide for pension benefit payments
during workers’ retirements.
• Representing about $10 trillion in assets in the United States in 2010, private
and state and local government pension funds are the largest institutional
participants in capital markets.
• To receive pension benefits, an employee must be vested. Vesting is the
number of years you must work in order to receive benefits after retirement.

Figure 11.2
Assets of Pension Funds, 2009
Both private and state and local pension funds concentrate their investments in stocks,
bonds, and other capital market securities.

• Employees prefer pension plans to personal savings for three reasons:
(1) pension plans can manage a portfolio more efficiently and at a lower cost;
(2) benefits such as annuities are expensive for individuals to obtain; and
(3) the tax treatment of pension funds benefits the employee.
• In a defined contribution plan, the firm invests contributions for the employees,
who own the value of the funds in the plan. Pension income during retirement
depends on the profitability of the pension plan’s investments. These are the
most common plans today.
• In a defined benefit plan, the firm promises employees a particular dollar
benefit payment, based on each employee’s earnings and years of service.
• 401(k) plans are one segment of defined contribution plans. An employee can
make tax-deductible contributions through regular payroll deductions, subject
to an annual limit, and pay no tax on accumulated earnings until retirement.
Some employers match employee contributions up to a certain amount.

Insurance Companies
Insurance company A financial intermediary that specializes in writing

contracts to protect policyholders from the risk of financial loss associated with
particular events.
• Insurers obtain funds by charging premiums to policyholders and use these

funds to make investments in stocks, bonds, mortgages, and direct loans to
firms known as private placements.
• The insurance industry has two segments:
• Life insurance companies sell policies to protect households against a
loss of earnings from the disability, retirement, or death of the insured
person.
• Property and casualty companies sell policies to protect households and
firms from the risks of illness, theft, fire, accidents, or natural disasters.

Figure 11.3
Financial Assets of U.S.
Insurance Companies
Life insurance companies
have larger asset portfolios
than do property and
casualty insurance
companies.
Property and casualty
insurance companies hold
more municipal bonds
because the interest on them
is tax exempt, while life
insurance companies hold
more corporate bonds
because they payer higher
interest rates.

Risk Pooling
• Insurance companies use the law of large numbers to make predictions.

They rely on the average occurrences of events for large numbers of people.
• By issuing a sufficient number of policies, insurance companies take
advantage of risk pooling and diversification to estimate the size of reserves
needed to pay potential claims.
• Statisticians known as actuaries compile probability tables to help predict the
risk of an event occurring in the population.

Reducing Adverse Selection through Screening and Risk-Based Premiums
• People most eager to buy insurance are those with the highest probability of
requiring an insurance payout.
• To reduce adverse selection problems, insurance company managers gather
information to screen out poor insurance risks.
• Insurance companies also reduce adverse selection by charging risk-based
premiums, which are premiums based on the probability that an individual
will file a claim.

Reducing Moral Hazard with Deductibles, Coinsurance, and
Restrictive Covenants
• Policyholders may change their behavior once they have insurance. To

reduce the likelihood that an insured event takes place, some of the
policyholder’s money is also put at risk. Insurance companies do this by
requiring a deductible.
• To further hold down costs, insurance companies may offer coinsurance as
an option in exchange for charging a lower premium.
• To cope with moral hazard, insurers also sometimes use restrictive
covenants, which limit risky activities by the insured if a subsequent claim is
to be paid.
• These tools to reduce adverse selection and moral hazard problems align
the interests of policyholders with the interests of the insurance companies.
The cost of insurance is reduced and the savings translate into lower
premiums.

Why Did the Fed Have to Bail Out Insurance Giant AIG?
• One of the most dramatic events of the financial crisis was the collapse of
American International Group (AIG), the largest insurance company in the
United States.
• It was surprising that a stable insurance company would be involved in the
crisis. AIG, however, expanded beyond the basic insurance activities.
• In 1998 AIG Financial Products, based in London, decided to begin writing
credit default swap contracts on CDOs, or insuring the value of CDOs. At
first, the CDOs included relatively high-quality corporate bonds, with only a
few mortgage-backed securities.
• But at the height of the housing boom, AIG was issuing hundreds of billions
of dollars worth of credit default swaps against CDOs consisting largely of
mortgage-backed securities.

Making the Connection (continued)
Why Did the Fed Have to Bail Out Insurance Giant AIG?
• AIG was earning $250 million annually from the premiums and,
although housing prices had begun to decline in 2006, AIG
remained optimistic.
• By September 2008, AIG had lost $25 billion on the credit default
swaps. The owners of the swaps were insisting that AIG post
collateral against the possibility of further losses. The firm did not
have sufficient assets to use as collateral and without government
assistance, it would need to declare bankruptcy.
• The U.S. Treasury and the Federal Reserve were afraid that if AIG
failed, the losses suffered by other firms would deepen the crisis,
and decided to bail out the company.

Explain the connection between the shadow banking system and
systemic risk.

Systemic Risk and the Shadow Banking System
• Financial institutions, such as investment banks, hedge funds, and money

market mutual funds are nonbank financial institutions known as the
“shadow banking system.”
• On the eve of the financial crisis, the size of the shadow banking system was
greater than the size of the commercial banking system.
• The FDIC and the SEC were created with the goal to protect depositors from
the likelihood that the failure of one bank would lead depositors to withdraw
their money from other banks, a process called contagion. Congress was
less concerned with the risk to individual depositors than with systemic risk
to the entire financial system.
Systemic risk Risk to the entire financial system rather than to individual firms
or investors.

• Deposit insurance succeeded in stabilizing the banking system, but there is
no equivalent to deposit insurance in the shadow banking system.
• In the shadow banking system, short-term loans consist of repurchase
agreements, purchases of commercial paper, and purchases of money
market mutual fund shares rather than deposits.
• With the exception of a temporary guarantee to owners of money market
mutual fund shares during the crisis, the government does not reimburse
investors who suffer losses when they make loans to shadow banks.
• During the financial crisis, the shadow banking system was subject to the
same type of systemic risk that the commercial banking system experienced
during the years before Congress established the FDIC in 1934.

Regulation and the Shadow Banking System
There have been two main rationales for exempting many nonbanks from
restrictions on the assets they can hold and the degree of leverage they can
have:
• Policymakers did not see these firms as being important to the financial
system as were commercial banks, and regulators did not believe that the
failure of these firms would damage the financial system.
• These firms deal primarily with other financial firms, institutional investors,
or wealthy private investors rather than with unsophisticated private
investors. Policymakers assumed that these investors could look after
their own interests without the need for federal regulations.

• In 1934, Congress gave the SEC broad authority to regulate the stock and
bond markets, and in 1974, it established the Commodity Futures Trading
Commission (CFTC) to regulate futures markets.
• Securities that were not traded on exchanges were not subject to regulation.
By the time of the financial crisis, trillions of dollars worth of securities were
being traded in the shadow banking system with little oversight, and subject
to significant counterparty risk.
• When derivatives are traded on exchanges, the exchange serves as the
counterparty, which reduces the default risk to buyers and sellers.
• In 2010, Congress enacted regulatory changes that would push more trading
in derivatives onto exchanges.

The Fragility of the Shadow Banking System
We can summarize the vulnerability of the shadow banking system as follows:

• Many firms in the shadow banking system were borrowing short term and
lending long term.
• These firms were also more vulnerable to incurring substantial losses and
possible failure. The investors in investment banks and hedge funds had no
federal insurance against loss of principal, increasing the probability of a run.
Being largely unregulated, shadow banks could invest in more risky assets
and become more highly leveraged than commercial banks.
• Finally, during the 2000s when housing prices began to decline, many
shadow banking firms suffered heavy losses and some were forced into
bankruptcy. Given the increased importance of these firms in the financial
system, the result was the worst financial crisis since the Great Depression.

Answering the Key Question
At the beginning of this chapter, we asked the question:
“What role did the shadow banking system play in the financial crisis of 2007–
2009?”
Although we will discuss the financial crisis of 2007–2009 more completely in
the next chapter, this chapter has provided some insight into the role of the
shadow banking system.
Many shadow banks, particularly investment banks and hedge funds, were
overly reliant on financing long-term investments with short-term borrowing,
were highly leveraged, and held securities that would lose value if housing
prices fell. When housing prices did fall, these firms suffered heavy losses,
and some were forced into bankruptcy. Given the importance of shadow
banking to the financial system, the result was a financial crisis.

AN INSIDE LOOK AT POLICY
Did a Shadow Bank Panic Cause the Financial Crisis of 2007–2009?

WASHINGTON POST, Explaining FinReg: Shadow Bank Runs, or the Problem Behind the Problem
Key Points in the Article
• Yale University economist Gary Gorton argues that a bank run in the shadow
banking system caused the financial crisis that began in 2007, which was
triggered by rising delinquencies and foreclosures in the subprime mortgage
market.
• Without deposit insurance, depositors demanded collateral, which took the
form of highly rated mortgage-backed securities.
• When the subprime mortgage crisis began, no one knew which banks were
most at risk, and investors lost confidence in all institutions in the shadow
banking market.
• The shadow banking system was subject to great disruption from new
information—something that commercial banks avoid with deposit insurance.

AN INSIDE LOOK AT POLICY
The table below shows the widespread decline from 2007 to 2008 in the
issuance of securitized and corporate debt.

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HUBBARD ANTHONY PATRICK

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

11.1 Explain how investment banks operate

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

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Investment banking Financial activities that involve underwriting new security

Investment bankers are involved in the following activities:

Underwriting New Security Issues

• An investment bank typically earns 2% to 4% of the dollar amount raised in a

• Financial engineering involves developing new financial securities or

• Investment banks assign research analysts to particular firms or industries,

• Beginning in the 1990s, proprietary trading, or buying and selling securities

Step 2 Step 3 Step 4

$10,000,000 $500,000 −$500,000

$10,000,000 $500,000 −$500,000

$10,000,000 $500,000 −$500,000

• Federal banking regulations put limits on the size of a commercial bank’s

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 22 of 49

Investment institution A financial firm, such as a mutual fund or a hedge

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Mutual fund A financial intermediary that raises funds by selling shares to

• Mutual funds help to reduce transaction costs, provide risk-sharing benefits,

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

• In closed-end mutual funds, a fixed number of nonredeemable shares is

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Hedge fund Financial firms organized as a partnership of wealthy investors that

• Hedge funds are typically organized as partnerships of 99 investors or fewer,

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Finance company A nonbank financial intermediary that raises money through

• A lower degree of regulation allows finance companies to tailor loans closer

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 29 of 49

Contractual Savings Institutions: Pension Funds and Insurance Companies

Pension fund A financial intermediary that invests contributions of workers and

Contractual Savings Institutions: Pension Funds and Insurance Companies

Contractual Savings Institutions: Pension Funds and Insurance Companies

Contractual Savings Institutions: Pension Funds and Insurance Companies

Insurance company A financial intermediary that specializes in writing

• Insurers obtain funds by charging premiums to policyholders and use these

Contractual Savings Institutions: Pension Funds and Insurance Companies

Contractual Savings Institutions: Pension Funds and Insurance Companies

• Insurance companies use the law of large numbers to make predictions.

Contractual Savings Institutions: Pension Funds and Insurance Companies

Contractual Savings Institutions: Pension Funds and Insurance Companies

• Policyholders may change their behavior once they have insurance. To

Contractual Savings Institutions: Pension Funds and Insurance Companies

Contractual Savings Institutions: Pension Funds and Insurance Companies

Contractual Savings Institutions: Pension Funds and Insurance Companies

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 41 of 49

• Financial institutions, such as investment banks, hedge funds, and money

Systemic Risk and the Shadow Banking System

Systemic Risk and the Shadow Banking System

Systemic Risk and the Shadow Banking System

Systemic Risk and the Shadow Banking System

We can summarize the vulnerability of the shadow banking system as follows:

Systemic Risk and the Shadow Banking System

Systemic Risk and the Shadow Banking System

Did a Shadow Bank Panic Cause the Financial Crisis of 2007–2009?

Key Points in the Article

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