Lec1+2+3 introductionfundamentals of FIs

Lecture Topic Readings1 Introduction Fundamentals of Financial institutions Central bank and Monetary policy Commercial Banks Financial regulation 12 Mid-­‐term exam Mutual Fund, Hedge F

Lecture Topic Readings

1 Introduction

Fundamentals of Financial institutions Central bank and Monetary policy Commercial Banks

Financial regulation

12 Mid-­‐term exam

Mutual Fund, Hedge Fund and ETF Insurance Companies and Pension Funds Investment banks and Venture Capital firms Group presentation

22 Course Review

Lecture  1+2+3

Introduction  and  fundamentals  

1 Why  study  financial  institutions?

2 Overview  of  financial  institutions

2.1  Overview  of  Financial  system

2.2  The  importance  of  FIs

2.3  Types  of  FI

2.4  Regulation  of  the  Financial  system

3 Why  do  financial  crises  occur?

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• Have  the  FIs  not  functioned  properly,  they  would  

cause  great  risk  to  the  economy

• At  times,  financial  crises  occurred  with  a  sharp  

decline  in  asset  prices  and  the  failures  of  many  

financial  and  non  financial  institutions

• Study  of  FIs  and  the  financial  crises  is  also  crucial  to  

understand  how  to  manage  the  risks

OVERVIEW  OF  FINANCIAL  

INSTITUTIONS

Securitization

interest corporation

them.

systems.

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• In  Primary  markets:  FIs  helping  the  firms  (issuers)  to  

obtain  fund  from  issuing  certain  types  of  securities  by  

underwriting

• In  Secondary  markets:  two  functions:

ØTo  provide  liquidity:  making  it  easy  to  purchase  and  

sell  the  securities  of  the  companies

ØTo  establish  a  price:  through  market  making  or  for  the  securities  in  the  Seasoned-­Equity  Offering  

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• List  of  fact  to  be  explained  later:

1 Stocks  are  not  the  most  important  source  of  external  financing

2 Marketable  securities  are  not  the  primary  source  of  finance

3 Indirect  finance  is  more  important  than  direct  finance

4 Banks  are  the  most  important  source  of  external  funds

5 The  financial  system  is  heavily  regulated

6 Only  large,  well-­established  firms  have  access  to  securities  markets

7 Collateral  is  prevalent  in  debt  contracts

8 Debt  contracts  have  numerous  restrictive  covenants

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cost

• Example  of  a  loan  contract

§ A  $1,000  loan  that  costs  $500

§ High  costs  freeze  out  individual  lenders

• How  to  deal  with  the  problem?

many  loans!

üThus,  the  FIs  could  provide  the  customers  with  

liquidity  services

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• Risk  sharing:

üFIs  help  reduce  the  risk  exposure  of  investors

üA  benefit  from  “Low  transaction  cost”

üAssets  transformation:  Risky  assets  (loans)  are  

turned  into  safer  assets  (deposits)  for  investors

• Example  of  risk  sharing:

üBanks  (deposits)

üInsurance  companies  (insurance  policies)

üMutual  funds  (fund  shares)

• In financial markets, one party often does not know enough about the other party to make accurate

information.

• In  financial  markets,  often  the  borrowers  has  better  

information  about  the  investment  projects  (potential  

risk/return)  than  the  lenders

• Asymmetric  information  creates  two  problems:  

Adverse  selection and  Moral  Hazard

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• Before  transaction  occurs

• Potential  fund  spenders  most  likely  to  produce  

adverse  outcomes  are  those  most  likely  to  seek  funds

• Adverse  selection  could  be  found:

üUsed  car  market

üFinancial  markets

üInsurance

• Adverse  selection:

Take  in  example  in  Insurance:  

-­ A  Healthy  person  only  have  to  pay  $1,000/year  for  a  

life  insurance

-­ An  Unhealthy  person  have  to  pay  $5,000/year  for  a  

life  insurance

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• Adverse  selection:

If,  due  to  the  lack  of  information,  the  insurance  

company  could  not  decide  whether  a  person  is  healthy  

or  not  They  will  assign  an  average  premium  for  the  

insurance  at  $3,000/year

Who  do  you  think  will  be  willing  to  buy  the  insurance?

• The  lemon  problem  of  securities  markets

1 If  one  could  not  distinguish  good  from  bad  securities  

(stocks,  bonds),  one  would  be  willing  to  pay  only  the  average  of  good  and  bad  values

2 Good  securities  are  utterly  undervalued  and  thus,  

would  not  be  issued,  only  bad  securities  issued  due  

to  overvaluation

3 Investors  won’t  buy  bad  securities,  the  market  will  

not  function  well

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• After  the  transaction  occurs

• The  risk  (hazard)  that  the  fund  user  has  incentives  to  

engage  in  undesirable  (immoral)  activities  making  it  

unlikely  for  the  funds  to  be  paid  back

• Also  called  “conflict  of  interest”

• “Principal-­agent”  or  “Agency  problem”

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Screw it!

I’m insured anyway

YOLO!

• Agency  problem  (equity  market):

You  and  Mr  Thomas  open  an  ice-­cream  store  in  Banking  Academy   You  provide  $9,000  (or  90%  equity  capital)  while  Thomas  provides  

$1,000  and  act  as  a  manager.

If  Mr  Thomas  works  hard,  the  ice-­cream  store  make  $50,000   net  

profit  You  are  entitled  $45,000  

Mr  Thomas  would  not  appreciate  his  share  of  $5,000  So  he  goes  to   the  beach,  relaxes  and  spends  some  of  your  profit  to  decorate  his  

office  with  art  of  pretty  women.

How  do  you,  as  an  owner,  give  Thomas  the  incentive  to  work  hard?

• Agency  problem  (equity  market):

ØResults  from  the  separation  of  ownership  by  stockholders  

(principals)  from  control  by  manager  (agent)

ØManagers  act  in  their  own  interest  rather  than  stockholder’s  interest   (especially  when  their  compensation  only  comprises  of  salaries  and   bonuses  and  nowhere  tied  to  the  company’s  profit).

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• Agency  problem  (debt  market):

Suppose  you  lend  Mr  Thomas  $9,000  (with  10%  interest  rate)  to  set  

up  his  business  of  an  ice-­cream  shop  in  banking  academy.

Instead  of  concentrating  on  the  main  business,  Thomas  use  it  on  an   innovation  of  ice-­cream  that  never  melt  (riskier  project)

You  may  decide  not  to  make  the  loan

ØIf  Thomas  succeeds:  You  only  get  10%,  Thomas  gets  a  lot  more

ØIf  Thomas  fails:  You  loss  $9,000

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• How  do  FIs  help  reduce  asymmetric  information?

good  ones  (reduce  loss  from  adverse  selection)

(reduce  loss  from  moral  hazard)

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Why  do  Financial  crises  

occur  ?

A financial crisis occurs when an increase

the financial system from channeling funds

efficiently from savers to households and

opportunities.

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