Summary Financial Management Notes.

Financial Management Notes. Bank Financial Management Notes Chapter 1: Why are Financial Institutions Special o Banking industry operated as a full service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock investing services) o Following deregulation, the industry increased services to mutual funds, brokerage funds - separated financial service functions - regulatory barriers, technology and financial innovation has changed financial services offered by companies - competition changed in nature as well o As competitive environment changed, attention to profit and risk became important o Financial institutions (banks, credit unions, insurance companies and mutual funds) perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds) o All Financial institutions 1. Hold assets that are subject to default or credit risk 2. Tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are exposed to interest rate risk o Financial institutions are subject to liability withdrawal or liquidity risk, depending on claims of the liability holder - also exposed to underwriting risk, whether through the sale of securities or issue of various types of credit guarantees on or off the balance sheet - also exposed to operating risks because the production of financial services requires the use of real resources and back office support systems (labour and technology combined to provide services) o Financial institutions are singled out for special regulatory attention Areas of Financial intermediaries specialness in the provision of services o Information costs – the aggregation of funds in an FI provides greater incentive to collect information about customers (e.g. corporations) and to monitor their actions. The relatively large size of the FI allows the collection of information to be accomplished at a lower average cost (so-called economic of scale) that would be the case for individuals o Liquidity and price risk – Fis provide financial claims to households savers with superior liquidity attributes and with lower price risk o Transaction cost services – similar to economies of scale in information production costs, an FIs size can result in economies of scale in transaction costs o Maturity Intermediation – Fis can better bear the risk of mismatching the maturities of their assets and liabilities Downloaded by Maks Austin () lOMoARcPSD| o Transmission of monetary supply – depository institutions are the conduit through which monetary policy actions by the country’s central bank (The Federal Reserve) impact the rest of the financial system and the economy o Credit allocation – Fis are often viewed as the major and sometimes only, source of financing for particular sectors of the economy, such as farming or real estate o Intergenerational wealth transfers – Fis especially life insurance companies and pension funds, provide savers with the ability to transfer wealth from one generation to the next o Payment services – the efficiency with which depository institutions provide payment services such as check clearing directly benefits the economy o Denomination intermediation – Fis such as mutual funds, allow small investors to overcome constraints to buying assets imposed by large minimum denomination size Financial Institutions Specialness o Corporations issue securities to finance their investments in real assets and cover the gap between their investment plans and their internally generated savings such as retained earnings o Savings flows from households to corporations - financial claims (equity and debt securities) flow from corporations to household savers o In a world without FIs - less fund flow - households must monitor actions of the firm to whom they lent - must be sure the firm’s management doesn’t abscond or waste funds - costly for households and require time and high quality information - lack of monitoring reduces the attractiveness and increases the risk of investment in debt and equity o Long term nature of corporate equity and debt and lack of a secondary market in which households can sell these securities, creates a disincentive for households to hold direct financial claims issued by corporations - households choose to hold cash for liquidity reasons - liquidity – the ease of converting an asset to cash o To provide liquidity services by allowing households to trade corporate debt and equity securities, investors face a price risk on sale of securities and the secondary market trading of securities involves various transaction costs - price investors can sell securities will differ from price their paid from securities - price risk – the risk that the sale price of an asset will be lower than the purchase price of that asset o Because of 1) monitoring costs, 2) liquidity costs and 3) price risk, the average household saver may view direct investment in corporate securities as an unattractive proposition and prefer either not to save or to save in the form of cash - economy developed an alternative and indirect way to channel household Downloaded by Maks Austin () lOMoARcPSD| savings to the corporate sector - savings via FIs Function as Brokers o FIs act as an agent for the saver by providing information and transaction services - carry out investment research and make investment recommendations for their retail clients as well as conduct the purchase or sale of securities for commission or fees o Discount brokers carry out the purchase or sale of securities at better prices with greater efficiency than household savers could achieve by trading on their own - this efficiency results in reduced costs of trading or economies of scale - economies of scale – the concept that the cost reduction in trading and other transaction services results in increased efficiency when FIs perform these services o Independent insurance brokers identify the best types of insurance policies household savers can buy to fit their savings and retirement plans o FIs play important role by reducing transactions and information costs or imperfections between households and corporations o FIs encourage higher rates of savings FIs function as asset transformers o Asset transformer – an FI issues financial claims that are more attractive to household savers than the claims directly issued by corporations - financial claims issued by FIs dominate those issued directly by corporations as a result of lowering monitoring costs, lower liquidity costs and lower price risk o FIs purchase the financial claims issued by corporations (equities and bonds or primary securities) and finance these purchased by selling financial claims to households investors in the form of deposits or insurance policies (secondary securities) o Primary securities – securities issued by corporations and backed by the real assets of those corporations o Secondary securities – securities issued by FIs and backed by primary securities o FIs are independent market parties that create financial products whose value to their clients is the transformation of financial risk o FIs purchase primary securities and transform them into secondary securities through resolving information costs, delegated monitoring and liquidity Information costs o High cost for information collection for households Downloaded by Maks Austin () lOMoARcPSD| o Savers must monitor actions of firms in complete fashion after purchasing securities - failure will result in exposure to agency costs o Agency costs – costs relating to the risk that the owners and managers of firms that receive savers funds will take actions with those funds contrary to the best interests of the savers - arise when economic agents enter into contracts with incomplete information o The more difficult the information collection, the more likely the contract will be broker - the saver could be harmed by actions taken by the borrowing firm (agent) FIs role as delegated monitor o Can solve agency costs by large savers placing funds with a single FI - this FI groups the funds together and invests in primary financial claims issued by firms - funds resolves problems o Large FI has greater incentive to collect information as there is more at stake - appointed as a delegated monitor on households behalf o Delegated monitor – an economic agent appointed to act on behalf of smaller agents in collecting information and/or investing funds on their behalf FIs role as information producer o Greater incentive to monitor and the costs involved in failing to monitor appropriately - FIS may develop new secondary securities that enable them to monitor more effectively o Bank loans are generally short term debt contracts as opposed to bond contracts - short term nature allows FI to exercise monitoring power and control over the borrower - information generated is constantly updated as loan renewal decisions are made o When loan contracts are short, the banker becomes an insider to the firm regarding information familiarity with its operations and financial conditions - more frequent monitoring often replaces the need for inflexible and hard to enforce covenants found in bond contracts o By acting as a delegated monitor and producing better and more timely information, FIs reduce degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy Liquidity and Price Risk Downloaded by Maks Austin () lOMoARcPSD| o FIs provide financial or secondary claims to household or other savers - claims have superior liquidity attributes compared to primary securities such as corporate equity or bonds - e.g. depository institutions issue transaction account deposit contracts with fixed principle value that can be withdrawn on demand by household savers o Money market mutual funds issue shares to households savers that allow savers to enjoy fixed principal contracts while often earning interest rates higher than those on bank deposits o Fis diversify portfolio risk o Diversify – reducing risk by holding a number of different securities in a portfolio o As long as returns on investments aren’t perfectly positively correlated, by exploiting benefits of size, FIs diversify portfolio risk, relating to specific individual firms o As the number of securities in an FIs asset portfolio increased beyond 15 securities, portfolio risk falls at a diminishing rate o Risk diversification allows an FI to predict accurately its expected return on its asset portfolio o Domestically and globally diversified FI may generate risk free return on assets - can fulfill its promise to households to supply liquid claims with little price or capital value risk - as long as FI is large to gain from diversification or monitoring, its financial claims are viewed as liquid and attractive to small savers compared with direct investments in the capital market Other Special Services o Services of FI: - reducing household savers, monitoring costs, increasing liquidity and reducing price risk exposure Reduced Transaction costs o Provide potential economies of scale in transaction costs - retail buyers face high commission charges - by grouping assets in FI that purchase assets in bulk, household savers can reduce transaction costs of their asset purchases - bid-ask spreads are normally lower for assets bought and sold in larger quantities Maturity Intermediation o FIs can bear risk of mismatching maturities of assets and liabilities - offer maturity intermediation services to the economy Downloaded by Maks Austin () lOMoARcPSD| o Through maturity mismatching, FIs produce long term contracts, such as long term fixed rate mortgage loans to households, while still raising funds with short term liability contracts o While mismatches can be subject to FI interest rate risk, a large FI is able to manage risk through superior access to markets and instruments for hedging such as loan sales and securitization, options, caps, floors and collars Other aspects of specialness Transmission of monetary policy o Highly liquid nature of depository institution deposits have resulted in their acceptance by the public as the most widely used medium of exchange in the economy o Money supply, M1 and M2, allow liabilities of depository institutions to play a part in monetary policy o Depository institutions are the conduit through which monetary policy actions impact the financial sector o Monetary policy includes open market operations (purchase and sale of government bonds), setting interest rates and reserve requirements (minimum amount of reserve assets of depository institutions must hold to back liabilities on their balance sheets) Credit allocation o FIs viewed as special as they are the source of financing for sectors of the economy - identify residential real estate as needing special subsidies - enhanced specialness of common service in the economy o Savings associations and banks have served credit needs of residential real estate sector Intergenerational Wealth Transfers or Time Intermediation o Ability of savers to transfer wealth across generations is important through accommodating needs (e.g. life insurance and pension funds) Payment services o Depository institutions are special as they have efficiency with which they provide payment services directly to the economy o Two important payment services: 1. Check clearing 2. Wire transfer services o Breakdown in systems would produce gridlock in payment system with harmful effects on the economy Downloaded by Maks Austin () lOMoARcPSD| Denominated Intermediation o Money market and debt equity mutual funds are special as they provide services relating to denomination intermediation - sold in large denominations, assets are either out of reach of individual savers or would result in savers holding highly undiversified asset portfolios o E.g. minimum size for negotiable certificate of deposit is $100,000 o Savers are unable to purchase instruments o Buying shares in money market mutual fund with other investors allows for savers to overcome constraints in buying assets imposed by large minimum denomination sizes o Indirect access to these markets may allow small savers to generate higher returns on their portfolios Specialness and Regulation o Failure to provide services or breakdown in efficient provision can be costly to sources (households) and users (firms) of savings o Negative externalities – action by an economic agent imposing costs on other economic agents o FIs are regulated to protect against disruption in the provision of services and costs imposed on the economy and society o FI failure creates doubts in savers minds regarding stability and solvency of FIs in general and cause panics o While regulation is socially beneficial, it imposes private costs or regulatory burden on FI owners and managers - prohibitions of commercial banks from making loans to individual borrowers exceeding 10% of their equity capital despite positive net present value to the bank - regulation attempts to enhance social welfare benefits and mitigate social costs of provision of FI services - private costs of regulation relative to private benefits for the producers of financial services is called net regulatory burden o Net regulatory burden – the difference between the private costs of regulations and the private benefits for the producers of financial services o Six types of regulation enhance net social welfare benefits of financial intermediaries 1. Safety and soundness regulation 2. Monetary policy regulation 3. Credit allocation regulation 4. Consumer protection regulation 5. Investor projection regulation 6. Entry and charting regulation o Regulations are imposed on various FIs - deposit taking institutions most heavily regulated o Regulation can be imposed at federal or state level Downloaded by Maks Austin () lOMoARcPSD| Safety and Soundness Regulation o To protect depositors and borrowers against risk of FI failure due to a lack of diversification in asset portfolios, regulators have developed layers of protective mechanisms - intended to ensure safety and soundness of FI and maintain credibility of FI in eyes of borrowers and lenders - regulations are in place to protect depositors from losing their money - while depository institutions failures increased during GFC, depositors felt little need to withdraw funds o First layer of protection requires FIs to diversify assets - banks required not to make loans exceeding more than 10% of their owned equity capital funds - a bank with 1% of assets funded by capital funds can lend no more than 1% of assets to any party o Second layer concerns minimum level of capital or equity funds that the owners of an FI need to contribute to funding of its operations - concerned with minimum ratio of capital to risk assets - the higher the proportion of capital contributed by owners, the greater the protection against insolvency risk to outside liability claim holders such as depositors and insurance policyholders - losses on asset portfolio due to the lack of diversification are borne by equity holders and only after by liability holders o FIs can affect the degree of risk exposure by non-equity claim holders in FIs o Third layer of protection is the provision of guaranty funds such as Deposit Insurance Funds (DIF) for depository institutions, the security Investors Protection Corporation (SIPC) for securities firms and the state guaranty funds established with regulator encouragement to meet insolvency losses to small claim holders - by protecting FI claim holders, when an FI fails and owners equity is wiped out, funds create a demand for regulation of the insured institutions to protect funds resources o Fourth layer of regulation is monitoring and surveillance - subject all FIs to monitoring - involves on site examinations and production of accounting statements and reports on timely basis - as savers appoint FIs as delegated monitors to evaluate the behaviour and performance of FIs o Regulation is not without costs for those regulated - FIs have more equity capital than private owners as this is in their best interests - producing information requested by regulators is costly for FIs because it involves the time of managers, lawyers and accountants - socially optimal amount of information differ from an FIs privately optimal amount o Net regulatory burden – the differences between private benefits to an FI from being regulated and the private costs it faces from adhering to regulation Downloaded by Maks Austin () lOMoARcPSD| o The higher the net regulation burden, the more inefficiently they produce financial services from a private owner’s perspective Monetary policy regulation o Central banks directly controls quantity of notes in the economy, whereas bulk of money supply consists of deposits o Outside money – the part of the money supply directly produced by the government or central bank such as notes and coin o Inside money – the party of the money supply produced by the private banking system o Central bank can vary the quantity of cash or outside money and directly affect a bank’s reserve position as well as amount of loans and deposits it creates without regulating the bank’s portfolio o Regulators impose minimum level of required cash reserves to be held against deposits - imposing reserve requirements makes the control of money supply and transmission predictable - add to net to FIs net regulatory burden if they are more than the institution believes are necessary for its own liquidity purposes o FIs choose to hold some cash reserves to meet liquidity and transaction needs of customers directly o Optimal level is normally low, especially if central bank doesn’t pay interest or pays little interest on required reserves - FIs often view required reserves as similar to tax and as a position cost of undertaking intermediation Credit Allocation Regulation o Credit allocation regulations support FIs lending to socially important sectors such as housing and farming - regulations may require an FI to hold minimum amount of assets in one particular sector of the economy or set maximum interest rates, prices or fees to subsidize certain sectors o Examples of asset restrictions include: qualified thrift lender (QTL test) which required thrifts (i.e. savings institutions) to hold 65% of their assets in residential mortgage related assets to retain a thrift charter o Price and quantity restrictions may have justification on social welfare grounds - especially if society has preference for strong housing and arming sectors - can be harmful to FIs that have to bear the private costs of meeting many of these regulations - to the extent that the net private costs of restrictions are positive, they add to the costs and reduce the efficiency with which FIs undertake intermediation