Financial Instruments, Financial Mar

and Financial Institutions

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 Introduction
• The international financial
system exists to facilitate the
design, sale, and exchange of a
broad set of contracts with a very
specific set of characteristics.
• We obtain financial resources
through this system:
• Directly from markets, and
• Indirectly through institutions.
Introduction
• Indirect Finance: An institution stands
between lender and borrower.
• We get a loan from a bank or finance company
to buy a car.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 • Direct Finance: Borrowers sell
securities directly to lenders in the
financial markets.
• Direct finance provides financing for
governments and corporations.
• Asset: Something of value that you
own.
• Liability: Something you owe.
Figure 01.1: Funds Flowing
through the
Financial System

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 Introduction
• Financial development is linked
to economic growth.
• The role of the financial system is
to facilitate production,
employment, and consumption.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 • Resources are funneled through
the system so resources flow to
their most efficient uses.
Introduction
We will survey the financial system
in three steps:
1. Financial instruments or
securities
• Stocks, bonds, loans and insurance.
• What is their role in our economy?
2. Financial Markets
• New York Stock Exchange, Nasdaq.
• Where investors trade financial
instruments.
3. Financial institutions
• What they are and what they do.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 Financial Instruments
Financial Instruments: The written
legal obligation of one party to
transfer something of value,
usually money, to another party at
some future date, under certain
conditions.
• The enforceability of the obligation is
important.
• Financial instruments obligate one
party (person, company, or
government) to transfer something to
another party.
• Financial instruments specify payment
will be made at some future date.
• Financial instruments specify certain
conditions under which a payment
will be made.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 Uses of Financial
Instruments
• Three functions:
• Financial instruments act as a means of payment
(like money).
• Employees take stock options as payment for
working.
• Financial instruments act as stores of value (like
money).
• Financial instruments generate increases in wealth
that are larger than from holding money.
• Financial instruments can be used to transfer
purchasing power into the future.
• Financial instruments allow for the transfer of risk
(unlike money).
• Futures and insurance contracts allows one person
to transfer risk to another.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -

 • The use of borrowing to finance part of an
investment is called leverage.
• Leverage played a key role in the financial crisis of
2007-2009.
• How did this happen?
• The more leverage, the greater the risk that an
adverse surprise will lead to bankruptcy.
• The more highly leveraged, the less net worth.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -8

 • How did this happen?
• Some important financial institutions,
during the crisis, were leveraged at more
than 30 times their net worth.
• When losses are experienced, firms try to
deleverage to raise net worth.
• When too many institutions deleverage, prices fall,
losses increase, net worth falls more.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -9

 • This is called the “paradox of leverage”.
• The “paradox of leverage” reinforces the
destabilizing liquidity spiral from.
• Both spirals feed the cycle of falling prices
and widespread deleveraging that was the
hallmark of the financial crisis of 2007-
2009.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -10

 Characteristics of Financial
Instruments
• These contracts are very complex.
• This complexity is costly, and people do not
want to bear these costs.
• Standardization of financial instruments
overcomes potential costs of complexity.
• Most mortgages feature a standard application with
standardized terms.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -11

 Characteristics of Financial
Instruments
• Financial instruments also communicate
information, summarizing certain details
about the issuer.
• Continuous monitoring of an issuer is costly and
difficult.
• Mechanisms exist to reduce the cost of
monitoring the behavior of counterparties.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -12

 Characteristics of Financial
• A counterparty is the person or institution on the
other side of the contract.

Instruments
• The solution to high cost of obtaining
information is to standardize both the
instrument and the information about the
issuer.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -13

 Characteristics of Financial
• Financial instruments are designed to handle
the problem of asymmetric information.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -14

 Underlying Versus Derivative
Instruments
• Two fundamental classes of financial
instruments.
• Underlying instruments are used by
savers/lenders to transfer resources directly to
investors/borrowers.
• This improves the efficient allocation of
resources.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -15

 • Examples: stocks and bonds.
Underlying Versus Derivative
Instruments
• Derivative instruments are those where their
value and payoffs are “derived” from the
behavior of the underlying instruments.
• Examples are futures and options.
• The primary use is to shift risk among investors.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -16

 A Primer for Valuing
Financial
Instruments
Four fundamental characteristics influence the value of a
financial instrument:
1. Size of the payment: • Larger
payment - more valuable.
2. Timing of payment: • Payment is
sooner - more valuable.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -17

 3. Likelihood payment is made: •
More likely to be made - more valuable.
4. Conditions under with payment is
made:
• Made when we need them - more valuable.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -18

 A Primer for Valuing
Financial
Instruments
We organize financial instruments by how they
are used:
• Primarily used as stores of value
1. Bank loans
• Borrower obtains resources from a lender to be
repaid in the future.
2. Bonds

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -19

 A Primer for Valuing
Financial
• A form of a loan issued by a corporation or
government.
• Can be bought and sold in financial markets.

Instruments
3. Home mortgages
• Home buyers usually need to borrow using
the home as collateral for the loan.
• A specific asset the borrower pledges to protect the
lender’s interests.
4. Stocks

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -20

 A Primer for Valuing
Financial
• The holder owns a small piece of the firm and
entitled to part of its profits.
• Firms sell stocks to raise money.
• Primarily used as a stores of wealth.

Instruments
5. Asset-backed securities
• Shares in the returns or payments arising from
specific assets, such as home mortgages and
student loans.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -21

 A Primer for Valuing
Financial
• Mortgage backed securities bundle a large
number of mortgages together into a pool in
which shares are sold.
• Securities backed by sub-prime mortgages played an
important role in the financial crisis of 2007-2009.

Instruments
Primarily used to Transfer Risk
1. Insurance contracts.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -22

 A Primer for Valuing
Financial
• Primary purpose is to assure that payments
will be made under particular, and often rare,
circumstances.
2. Futures contracts.
• An agreement between two parties to
exchange a fixed quantity of a commodity or
an asset at a fixed price on a set future date.
• A price is always specified.
• This is a type of derivative instrument.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -23

 A Primer for Valuing
Financial
Instruments
3. Options
• Derivative instruments whose prices are based on
the value of an underlying asset.
• Give the holder the right, not obligation, to buy or
sell a fixed quantity of the asset at a pre-
determined price on either a specific date or at any
time during a specified period.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -24

 A Primer for Valuing
Financial
• These offer an opportunity to store value
and trade risk in almost any way one would
like.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -25

 • The biggest risk we all face is becoming
disabled and losing our earning capacity.
• Insuring against this should be one of our highest
priorities.
• More likely than our house burning down.
• It is important to assess to make sure you
have enough insurance.
• One risk better transferred to someone else.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -26

 Financial Markets
• Financial markets are places where financial
instruments are bought and sold. • These
markets are the economy’s central nervous
system.
• These markets enable both firms and
individuals to find financing for their activities.
• These markets promote economic efficiency:
• They ensure resources are available to those who put
them to their best use.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -27

 • They keep transactions costs low.
The Role of Financial
Markets
1. Liquidity:
• Ensure owners can buy and sell financial
instruments cheaply.
• Keeps transactions costs low.
2. Information:

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -28

 • Pool and communication information about issuers
of financial instruments.
3. Risk sharing:
• Provide individuals a place to buy and sell risk.

The Structure of Financial

Markets
1. Distinguish between markets where new
financial instruments are sold and where they

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -29

 are resold or traded: primary or secondary
markets.
2. Categorize by the way they trade: centralized
exchange or not.
3. Group based on the type of instrument they
trade: as a store of value or to transfer risk.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -30

 Primary versus Secondary
Markets
• A primary market is one in which a
borrower obtains funds from a lender by
selling newly issued securities.
• Occurs out of the public views.
• An investment bank determines the price, purchases
the securities, and resells to clients.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -31

 • This is called underwriting and is usually very
profitable.

Primary versus Secondary

Markets
• Secondary financial markets are those where
people can buy and sell existing securities.
• Buying a share of IBM stock is not purchased from
the company, but from another investor in a
secondary market.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -32

 • These are the prices we hear about in the news.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -33

 Centralized Exchanges, OTC’s,
and
ECN’s
• Centralized exchanges - buyers and sellers
meet in a central, physical location.
• Over-the-counter markets (OTS’s)
decentralized markets where dealers stand
ready to buy and sell securities electronically.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -34

 Centralized Exchanges, OTC’s,
and
• Electronic communication networks (ECN’s)
electronic system bringing buyers and sellers
together without the use of a broker or dealer.
ECN’s
• History

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -35

 Centralized Exchanges, OTC’s,
and
• The New York Stock Exchange (NYSE) is a
place with an address where trading takes place
in person on the floor of the exchange.
• A firm purchases a license issued by the
Exchange.
• Others were acquired by specialists who oversaw
the trading.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -36

 Centralized Exchanges, OTC’s,
and
ECN’s
• History
• In the past, the only alternative was an OTC
market.
• Networks of physically dispersed dealers, who buy
and sell electronically.
• The largest is the Nasdaq.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -37

 Centralized Exchanges, OTC’s,
and
• In 2005, the NYSE merged with Archipelago (now
NYSE Arca), and Nasdaq merged with Instinet.

ECN’s
• History
• Market continues to globalize.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -38

 Centralized Exchanges, OTC’s,
and
• In 2007, the NYSE merged with Paris-based
Euronext becoming the first international
operator of major exchanges.
• Nasdaq attempted to acquire the London Stock
Exchange but dropped its bid in 2007 right
before the financial crisis.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -39

 • Trading is what makes financial markets
work.
• Placing an order in a stock market has the
following characteristics:
• The stock you wish to trade.
• Whether you wish to buy or sell.
• The size of the order - number of shares.
• The price you would like to trade.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -40

 • You can place a market order.
• Your order is executed at the most favorable price
currently available.
• Values speed over price.
• You can place a limit order:
• Places a maximum on the price to buy or a minimum
price to sell.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -41

 • Executing a trade requires someone on the
other side.
• Broker
• Direct access to electronic trading network through an
ECN like Acra or Instinet.
• Customer orders interact automatically without an
intermediary.
• Liquidity is provided by customers.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -42

 • For a well known stock, the NYSE is another
place from which to order.
• Liquidity is supplemented by designated market
makers (DMMs).
• The person on the floor charged with making a
market.
• To make the market work, they often buy and sell on
their own account.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -43

 Debt and Equity versus
Derivative Markets
• Used to distinguish between markets
where debt and equity are traded and those
where derivative instruments are traded.
• Equity markets are the markets for stocks.
• Derivative markets are the markets where
investors trade instruments like futures and
options.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -44

 Debt and Equity versus
Derivative Markets
• In debt and equity markets, actual claims are
bought and sold for immediate cash payments.
• In derivative markets, investors make
agreements that are settled later.
• Debt instruments categorized by the loan’s
maturity
• Repaid in less than a year - traded in money markets.
• Maturity of more than a year - traded in bond markets.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -45

 • This article highlights large swings in financial
markets during the financial crisis from
20072009.
• Before the crisis, professional investors made
their own institutions and the overall financial
system vulnerable by taking on too much risk.
• When the crisis hit, they faced a shortfall of
liquidity.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -46

 • Liquidity swings caused many financial
markets to plunge and rebound together.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -47

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -48
 Characteristics of a Well-Run
Financial Market
• Essential characteristics of a well-run
financial market:
• Must be designed to keep transaction costs low.
• Information the market pools and communicates must
be accurate and widely available.
• Borrowers promises to pay lenders much be credible.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -49

 Characteristics of a Well-Run
Financial Market
• Because of these criteria, the governments
are an essential part of financial markets as
they enforce the rules of the game.
• Countries with better investor protections have
bigger and deeper financial markets.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -50

 • Liquid, interbank loans are the marginal
source of funds for many banks, with their
cost guiding other lending rates.
• The financial crisis of 2007-2009 strained
interbank lending.
• Anxious banks preferred to hold their liquid assets
in case their own needs arose.
• They also were concerned about the safety of their
trading partners.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -51

 • The rising cost and reduced availability of
interbank loans created a vicious circle of:
• increased caution,
• greater demand for liquid assets, • reduced
willingness to lend, and • higher loan rates.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -52

 Financial Institutions
• Firms that provide access to the financial markets, both

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -53

 • to savers who wish to purchase financial instruments directly and
• to borrowers who want to issue them.
• Also known as financial intermediaries.
• Examples: banks, insurance companies, securities firms, and
pension funds.
• Healthy financial institutions open the flow of
resources, increasing the system’s efficiency.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -54

 The Role of Financial
Institutions
• To reduce transaction costs by specializing in
the issuance of standardized securities.
• To reduce the information costs of screening
and monitoring borrowers.
• They curb asymmetries, helping resources flow to most
productive uses.
• To give savers ready access to their funds.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -55

 • Financial intermediation and leverage in the US
have shifted away from traditional banks and
toward other financial institutions less subject
to government regulations.
• Brokerages, insurers, hedge funds, etc.
• These have become known as shadow banks.
• Provide services that compete with banks but do not
accept deposits.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -56

 • Take on more risk than traditional banks and are less
transparent.

• The rise of highly leveraged shadow banks,

combined with government relaxation of rules
for traditional banks, permitted a rise of
leverage in the financial system as a whole.
• This made the financial system more vulnerable to
shocks.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -57

 • Rapid growth in some financial instruments
made it easier to conceal leverage and
risktaking.

• The financial crisis transformed shadow

banking.
• The largest US brokerages failed, merged, or converted
themselves into traditional banks to gain access to
funding.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -58

 • The crisis has encouraged the government to
scrutinize any financial institution that could,
by risk taking, pose a threat to the financial
system.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -59

 The Structure of the Financial
Industry
• We can divide intermediaries into two
broad categories:
• Depository institutions,
• Take deposits and make loans • What most people
think of as banks
• Non-depository institutions.
• Include insurance companies, securities firms,
mutual fund companies, etc.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -60

 The Structure of the Financial
Industry
1. Depository institutions take deposits and
make loans.
2. Insurance companies accept premiums,
which they invest, in return for promising
compensation to policy holders under certain
events.
3. Pension funds invest individual and company
contributions in stocks, bonds, and real estate

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -61

 The Structure of the Financial
in order to provide payments to retired
workers.
Industry
4. Securities firms include brokers, investment
banks, underwriters, and mutual fund
companies.
• Brokers and investment banks issue stocks and
bonds to corporate customers, trade them, and
advise customers.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -62

 The Structure of the Financial
• Mutual-fund companies pool the resources of
individuals and companies and invest them in
portfolios.
• Hedge funds do the same for small groups of
wealthy investors.

Industry
5. Finance companies raise funds directly in the
financial markets in order to make loans to
individuals and firms.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -63

 The Structure of the Financial
• Finance companies tend to specialize in
particular types of loans, such as mortgage,
automobile, or business equipment.
Industry
6. Government-sponsored enterprises are
federal credit agencies that provide loans
directly for farmers and home mortgagors.
• Guarantee programs that insure loans made by
private lenders.
• Provides retirement income and medical care
through Social Security and Medicare.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -64

 Figure 01.2: Flow of Funds
through Financial
Institutions

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -65

 Insurance Companies

1
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -66
 Objectives
• What is the nature of the business of
insurance companies
• How do insurance companies generate
income
• What is the difference between a stock and a
mutual company
Objectives

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -67

 • Types of life policies and property and
casualty policies
• Insurance industry regulation
• Impact of the Financial Modernization Act
of 1999
• Structure of insurance companies
• Insurance company investment strategies
Overview of Insurance
Companies
• Insurance companies are risk bearers

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -68

 • They accept risk in return for premiums

• Acceptance of risk is the underwriting

process
Overview of Insurance
Companies
• Sources of Income
– Premiums
• Profit if premiums exceed underwriting loss plus
expenses

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -69

 • Loss if underwriting loss plus expenses exceed
premiums
– Investment income
• Premiums earn investment income
Overview of Insurance
Companies (continued)
• Major Forms of Insurance Companies
– Stock insurance company
• Owned by independent shareholders and publicly
traded

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -70

 – Mutual insurance company
• Policyholders are owners
Types of Insurance
• Life Insurance
• Health Insurance
• Property and Casualty Insurance
• Liability Insurance
• Disability Insurance
Types of Insurance
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -71
 • Long-term Care Insurance
• Structured Settlements
• Investment-Oriented Products
• Annuity
Insurance Companies vs.
Types of Products
• Multiline Insurance
• Life and Health Insurance Company
(L&H)
– Specializes in life and health insurance

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -72

 • Property and Casualty Insurance
Company (P&C)
– Specializes in property and casualty
insurance
Insurance Companies vs.
Types of Products
• Monoline Insurance Companies
• Specialize in financial guarantees for
– Asset-backed securities
Fundamental of the
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -73
 Insurance Industry
• Premiums, as income, are invested for future
returns
• The timing of payouts for claims is uncertain
• Payouts may be massive depending on the
disaster
• Requires prudent portfolio management
Regulation of Insurance
Companies

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -74

 • Insurance companies are regulated by the
Government
• States craft laws and regulations based on
models developed by the IC (Insurance
Commissioners)
Regulation of Insurance
Companies (continued)
• Insurance companies may also be rated by
rating agencies
– Moody’s, S&P, Best, Fitch, etc.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -75

 • The Government impose statutory surplus or
reserve rules
– Important as it becomes the ultimate
immediate amount available to pay claims
Deregulation of the
Insurance industry
• Gramm-Leach-Bliley Act (GLB) 1999
– Removed anti-affiliation restrictions
• Commercial banks
• Investment banks

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -76

 • Insurance companies
• The GLB accelerated and facilitated
affiliations between these institutions
Structure of Insurance
Companies
• Insurance company organization
– Home office (designs and guarantees the
product)
– Investment company (invests premiums)
– Marketing (distribution component)

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -77

 Structure of Insurance
Companies
• Bankassurance
– More recently the investment and
distribution functions are being performed by
independent firms and banks
• Reinsurance
– The spreading of risk among other insurance
companies for a portion of the
premiums

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -78

 Types of Life Insurance
• Term
– Fixed rate/fixed number of years/declining
coverage
• Permanent Life or Cash Value
– Cash value (inside buildup)
increases/favorable tax treatment
Types of Life Insurance
• Guaranteed cash value life

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -79

 – Participating
• Dividend paid based on investment returns and
realized actuarial experience
– Nonparticipating
• Dividend and cash values are guaranteed
Types of Life Insurance
• Variable Life
– Cash value/death benefit dependent on
owner directed asset allocation
• Universal Life

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -80

 – Flexible premium separates term from cash
value elements
Types of Life Insurance
• Variable Universal Life
– Combines features of Variable Life and
Universal Life
• Survivorship (Second to Die)
– Death benefit is not paid until the second of
both insured dies
Taxation of Life Insurance
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -81
 • Cash value or inside buildup in a whole life
policy is not taxed
• Beneficiary of the death benefit is not
subject to income tax
• Death benefit may or may not be subject to
estate tax depending on beneficiary structure
General Account and
Separate Account Products
• General Account Products

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -82

 – Insurance companies must support the
guaranteed performance from the
investment portfolio of the overall company
• Whole life
• Universal life
• Fixed annuities
General Account and
Separate Account Products
• Separate Account Products
– Insurance products that receive no guarantee
from the general account
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -83
 • Participating policies
– Provides guarantee of minimum dividend,
but dividend may increase if investment
portfolio performs well
Insurance Company
Investment Strategies
• Investment portfolios should reflect
liabilities or the insurance products
underwritten and should consider
– The expected average time to payout

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -84

 – The actuarial accuracy of estimates of when
and how much the payouts will be
– Other factors
Insurance Company
Investment Strategies
• Difference between L&H and P&C
Portfolios
– Less common stock
– Less municipal bonds
– Less longer maturity bonds

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -85

 – More private placement
– More commercial mortgages
Summary
• Insurance companies bear risk from those
seeking to avert risk by transferring that risk
to insurance companies
• Premiums are the revenues invested for
positive returns for future payout
• Different types of coverage demand
different types of investment portfolios

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -86

 Depository Institutions

1
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -87
 Objectives
• What is a depository institution
• What is the asset/liability problem faced
by depository institutions
• How does a depository institution
generate income
• What are the differences between
commercial banks, savings and loan
associations, savings banks, and credit
unions
Objectives
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -88
 • The asset/liability problem all
depository institutions face
• The risks faced by depository
institutions
• The funding sources available to
commercial banks and thrifts
• Risk-based capital requirements
Asset/Liability Problem of
Depository Institutions
• Spread Income or Margin

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -89

 – Difference in the cost between
investments (loans and securities)
and the cost of funds (deposits and
other sources)
• Credit Risk
– Possibility of loan default or
untimely payments
Asset/Liability Problem of
Depository Institutions
• Regulatory Risk

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -90

 – Changes that could affect operations
• Funding Risk
– Changes in interest rates
• Liquidity Concerns
– Withdrawal and loan demands
Concerns of Regulators
• Credit Risk
– Obligations of a financial instrument
that fail to be met

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -91

 • Settlement Risk
– The expected transfer of a trade or
obligation that fails to occur
Concerns of Regulators
• Market Risk
– Adverse price move or a large increase
in the price volatility of assets (debt
obligations, equities, commodities,
currencies)
• Liquidity Risk

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -92

 – Market liquidity
– Funding liquidity
Concerns of Regulators
• Operational Risk
– Inadequate or failed internal processes
• Orange County, California
• Barings Bank, U.K.
• Enron, U.S.
– GARP Operational Risk Classification of Loss
Employee Business Process

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -93

 Relationships Technology
External
Concerns of Regulators
• Legal Risk
– Failure to comply with laws
– Failure to apply ethical standards
– Failure to fulfill contractual obligations
Commercial Banks
• Bank Services

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -94

 – Individual banking
– Institutional banking
– Global banking
Commercial Banks
• Bank Funding
– Deposits
– Nondeposit borrowing
– Common stock and retained earnings
Commercial Banks
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -95
 • Deposits
– Demand deposits (checking accounts)
– Time deposits (certificates of deposit)
– Money market demand account
(MMDA)

Copyright © 2009 Pearson Education,

Commercial Banks
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -96
 • Non-deposit borrowing
– BSP
• Discount window
– Reserve Requirements
• BSP
• Penalty for failure to satisfy reserve
requirements
Capital Requirements for
Banks

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -97

 • Basil Committee on Banking
Supervision
– Basil I Framework July 1988
• Minimum capital standards
– Basil II Framework June 2004
• Addressed risks faced by banks in
formulating risk-based capital requirements
Capital Requirements for
Banks

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -98

 • Credit Risk and Risk-Based Capital
Requirements
– Tier 1
• Core capital
– Tier 2
• Supplementary capital
Capital Requirements for
Banks
• Philippine Deposit Insurance
Corporation

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -99

 – Intent is to protect small depositors
(currently accounts up to PhP 500,000)
– Safety net for Banks
• Creates the potential for a ‘moral hazard’
among banking institutions
Capital Requirements for
Banks
• Philippine Deposit Insurance
Corporation
– Reform proposals

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -100

 • Connecting deposit premiums to riskiness
of assets
• Decreased insurance coverage
• Insurance premiums based on expected
loss
Savings and Loans
Associations
• Assets • Consumer loans
• Non - consumer loans
Savings and Loans
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -101
 Associations
• Funding
– Negotiable order of withdrawal (NOW)
accounts
– Money market deposit accounts (MMDA)
Savings and Loans
Associations
• Regulation
– Bank Sentral ng Pilipinas (BSP)

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -102

 • Supervised by the Office of Thrift
Supervision (OTS)
– State chartered S&L
Savings and Loans
Associations
• Regulation
• Phased out maximum permitted interest
rates
Savings and Loans
Associations
Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -103
 • Regulations
• Ability to raise funds in the money market
• Permission to form finance subsidiaries
Savings and Loans
Associations
• The S&L Crisis
– Regulation helped in creating funding risk
– High interest rate volatility in 1970’s –
S&L’s faced difficulties of borrowing
short and lending long

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -104

 – Regulators were slow to respond and to
understand the deteriorating situation
Savings Banks
• Similar to S&L’s
• Greater portfolio diversification
– Corporate bonds
– Treasury and government securities
– Common stock
– Consumer loans

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -105

 Savings Banks
• Were able to handle funding risk better
than S&L’s
• Principal source of funds
– deposits
Credit Unions
• Smallest and youngest of the
depository institutions

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -106

 • “Common bond” requirement for
membership
• Member owned
– Member deposits are called shares
Credit Unions
• State chartered
– Philippine Deposit Insurance
Corporation
• Funds primarily from member deposits

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -107

 Credit Unions
• Lender of Last Resort
– Central Liquidity Facility (CLF)
– Administered by the BSP
Summary
• Depository institutions raise funds,
make loans and invest in securities

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -108

 • They seek to earnings through positive
spread between assets and cost of
funds
• Basil Committee on Banking
Supervision establishes risk and
management guidelines for banks
Summary
• Commercial banks may be classified
as individual, institutional and global

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -109

 • The BSP establish reserve
requirements for banks

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -110

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -111
 • Most people need to borrow to buy a house.
• Mortgage payment will be your biggest
monthly expense so shop around.
• Many offers are from mortgage brokers -
firms that have access to pools of funds
earmarked for use as mortgages.
• Who offers your mortgage is not important get
the best rate you can.

Bobby G. Gonzales CPA, Ph.D. FINANCIAL MANAGEMENT – LECTURE 01 -112