CHAPTER 2: FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS

2.3 FINANCIAL INSTITUTIONS

 DIRECT FUND TRANSFERS- common among individuals, small businesses, less developed
financial markets and institutions
 FINANCIAL INTERMEDIARY/FINANCIAL SERVICES- large businesses in developed economies
 Set of highly efficient financial intermediaries
 Specific original roles and restrictive regulation against diversification  removal of
regulation against diversification
 Institutional identity is still there but the differences between institutions is now unclear
(performing different financial services).

DIFFERENT TYPES OF FINANCIAL INSTITUTIONS

1. INVESTMENT BANKS
- Help corporations to design attractive securities
- Buy securities from corporation
- Resell to savers
- UNDERWRITERS- guarantees the raise of needed capital

2. COMMERCIAL BANKS
- Traditional department stores of finance- savers and borrowers
- Checking accounts and loans
- Part of financial services corporations

3. FINANCIAL SERVICES CORPORATIONS

- Large conglomerates- combination of many different financial institutions
- Started in one area but diversified

4. CREDIT UNIONS
- Cooperative associations- common bond
- Loans to fellow employees- automobile, home and home improvements
- Cheapest source of funds to individual borrowers

5. PENSION FUNDS
- Retirement plans- fund by corporations or government agencies  workers
- Trust department of commercial banks or life insurance companies – administrator
- Funds are invested to bonds, stocks, mortgages and real estate
CHAPTER 2: FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS

6. LIFE INSURANCE COMPANIES

- Annual premiums  stocks, bonds, real estate and mortgages
- Payments to beneficiaries of insured parties
- Variety of tax-deferred savings plans

7. MUTUAL FUNDS
- Accept money from savers  buy stocks, long-term bonds or short-term debt instruments
by businesses or government
- Pooling funds to reduce risk by diversification
- Economies of scale- security analysis, portfolio management, trading securities
- Different funds- meet objectives of different types of savers
- BOND FUNDS- safety
- STOCK FUNDS- willing to accept significant risks – higher returns
- Some are used as INTEREST-BEARING CHECKING ACCOUNTS (MONEY MARKET FUNDS)

- Retirement funds then are defined benefit plans

- Retirement funds are now defined contribution plan.
- VALUE LINE INVESTMENT SURVEY and MORNINGSTAR MUTUAL FUNDS- publications found
in libraries and Internet
 Information on objectives and past performances of funds

8. EXCHANGE-TRADED FUNDS (ETFs)

- Operated by mutual fund companies
- Buy portfolio of stocks then sell it to the public (PUBLIC MARKET)

9. HEDGE FUNDS
- MUTUAL FUNDS- regulated by SEC; small investors
- Hedge funds- unregulated; institutions and individuals with high net worth
- Trying to hedge risks
- Portfolio is hedged against overall movements in interest rates but better performance if
smaller spread
- LONG-TERM CAPITAL MANAGEMENT- Hedge Funds- high profile hedge fund (managers-
well-respected practitioners and experts in investment theory)
 Incorrect assumptions and bankrupt

- More popularity for hedge funds  lower the minimum investment requirement  small
investors  need for more regulation

10. PRIVATE EQUITY COMPANIES

CHAPTER 2: FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS

- Buying and managing the entire firms

- Most money for acquisitions are borrowed.

- All financial institutions except hedge funds and private equity companies  regulated 
safety of institutions and protect investors
- Regulation:
 Prohibited nationwide branch banking
 Restrictions on types of assets to purchase
 Interest rate ceiling
 Limitations on types of services
- Impede the free flow of capital and hurt the efficiency of capital markets  1980s-1990s –
deregulation of financial markets

- Excessive deregulation and insufficient supervision  FINANCIAL CRISIS

- DODD FRANK ACT- new agency for consumer protection
 Increase transparency of derivative transactions
 Force financial institutions- limit excessive risk-taking and hold more capital

APPENDIX:

SECURITIZATION HAS DRAMATICALLY TRANSFORMED THE BANKING INDUSTRY

- Then, simpler commercial banking – receives deposits and make loans

 Limited funding- cap on the number of loans
 Most loans- individuals and businesses in local market
 Lower ability to spread the risk

- Financial engineers- idea of SECURITIZATION OF LOANS

 AGENT (INVESTMENT BANK) will build an ENTITY
 ENTITY will buy loans from different banks
 ENTITY will issue SECURITIES backed by loan payments
- Began in 1970s- Government-backed entities bought pools of home mortgages and issued
securities backed by cash flows from diversified portfolio of mortgages
- INNOVATION
 No longer to hold loans  converted to cash to redeploy capital to make other loans
 Investors- invest in diversified portfolio of home mortgages
 Traded in open market- easy trading

- COLLATERALIZED DEBT OBLIGATIONS (CDOs)- issuance of different classes of securities

backed by portfolio of loans.
CHAPTER 2: FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS

- TRANCHES OF CDOs
 CLASS A BONDS- first claim, least risky, rated AAA
 CLASS B BONDS- high rating
 CLASS C BONDS- highest risk but sold at a lowest price
1. Excellent performance of underlying mortgages  highest returns
2. Poor performance  suffer the most
- Backed by pools of higher risk subprime mortgages  financial crisis
- HOUSING BOOM
 Financial institutions and mortgage brokers- new mortgages
 Investment bankers- create new CDOs
 Securities  sold to commercial and investment banks – hedge funds, mutual funds and
pension funds
- Mistaken belief that housing prices will never fall – viewed as solid investments + false
rating

- Collapse of housing market  declining value of securities  destroying the balance sheets
of financial institutions
- Hard to value- backed by large, diverse pool of mortgages
- Tried to sell securities and further depressed or decreased the prices

- Crisis  Reformation of securitization business and criticism against rating agencies for
misleading ratings
- GARY GORTON- revive the securitization to revive the economy