Copyright © 2006 Pearson Addison-Wesley. All rights reserved. BANKING SYSTEM AND I.T. PART I THE...

Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

BANKING SYSTEM AND I.T.

PART I

THE FINANCIAL SYSTEM:

AN OVERVIEW


Segments of Financial Markets

1. Direct Finance• Borrowers borrow directly from lenders in financial

markets by selling financial instruments which are claims on the borrower’s future income or assets

2. Indirect Finance• Borrowers borrow indirectly from lenders via financial

intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets


Figure 2.1 Flow of Funds Through the Financial System

Function of Financial Markets


Importance of Financial Markets

• Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy, as well as economic security for everyone as a whole

• Financial markets also improve the lot of individual participants by providing investment returns to lender-savers and profit and/or use opportunities to borrower-spenders


Classifications of Financial Markets

There are two ways a firm or an individual can obtain funds in a financial markets.

1. Debt Markets (debt instruments such as bonds)

– Short-Term (maturity < 1 year) – Money markets

– Intermediate-term (1 year<maturity<10 years) Capital markets

– Long-Term (maturity > 10 year) Capital Markets

2. Equity Markets

– Common Stock (which pays dividends, no maturity date)


Characteristics of Debt Markets Instruments

• Debt instruments

– Buyers of debt instruments are suppliers (of capital) to the firm, not owners of the firm

– Debt instruments have a finite life or maturity date

– Advantage is that the debt instrument is a contractual promise to pay with legal rights to enforce repayment

– Disadvantage is that return/profit is fixed or limited


Characteristics of Equity Markets Instruments

• Equity instruments (common stock is most prevalent equity instrument)

– Buyers of common stock are owners of the firm

– Common stock has no finite life or maturity date

– Advantage of common stock is potential high income since return is not fixed or limited

– Disadvantage is that debt payments must be made before equity payments can be made


Characteristics of Financial Markets

1. Debt Markets

– Although less well-known by the average person, debt markets in U.S. are much larger in total dollars than equity markets due to greater number of participant classes (households, businesses, government, and foreigners) and size of individual participants (businesses, and government)


Characteristics of Financial Markets

2. Equity Markets

– Although U.S. markets are highly efficient, the world’s largest, and more familiar to the average person, they are far smaller than the U.S. debt markets largely due to the fact that the only applicable participants are businesses



1. Primary Market– New issues of a security such as a bond or a

stock are sold to initial buyers

2. Secondary Market– Securities previously issued are bought

and sold



Secondary markets can be organized in two ways.

Exchanges

– Trades conducted in central locations (e.g., New York Stock Exchange, London)

Over-the-Counter Markets

– Dealers at different locations buy and sell

NYSE home pagehttp://www.nyse.com

http://www.nyse.com/


Internationalization of Financial Markets

• International Bond Market– Foreign bonds

– Eurobonds (now larger than U.S. corporate bond market)

• World Stock Markets– U.S. stock markets are no longer always the

largest—at one point, Japan's was larger


Function of Financial Intermediaries (FIs)

• Financial Intermediaries

1. Engage in process of indirect finance

2. More important source of finance than securities markets

3. Needed because of transactions costs and asymmetric information


Function of Financial Intermediaries

• Transactions Costs

1. Financial intermediaries make profits by reducing transactions costs

2. Reduce transactions costs by developing expertise and taking advantage of economies of scale



• A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions

1. Banks provide depositors with checking accounts that enable them to pay their bills easily

2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary



• Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing

– FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party

– This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors


THE FINANCIAL SYSTEM


CommercialBanks

Stock Savings and Loan

Associations

Private Development

Banks

Savings & Mortgage

Banks

Thrift Banks

Mutual Bldg. and Loan

Associations

Non-Stock Savings &

Loan Assns.

Non-bank Thrift Institutions

Development Bank of the Philippines

Specialized Government

Banks

RuralBanks

Non-bank Financial

Intermediaries

Central Bank of the Philippines

Land Bank of the

Philippines

Philippine Export-Import

Agency

Financing Companies

Fund Managers

Investment Houses

Investment Companies

Lending Investors

Money Brokers

Securities Dealers/Brokers

PawnshopsNOTE: Insurance Companies are under the supervision of the Insurance Commission

Financial Institutions in The Philippines


Financial Institutions in MalaysiaBank Negara Malaysia

Financial Markets Non-bank Financial Intermediaries

Labuan Int’l. Offshore Financial Centre

Money & Foreign Exchange

Malaysian Gov’t. Securities

DFIs

Insurance Companies Leasing Companies

Factoring Companies Savings Institutions Venture

Capital Cos. Credit Token Cos.

Provident/Pension Funds Unit Trust

Property Trusts Housing Credit Inst. Gov’t. Housing Division

Cagamas Berhad Pilgrims Fund Credit Guarantee Corp.

MECIB

Securities Commission• Private Debt Securities

• Options & Futures Exchange

• Stock Exchanges

Banking Institutions

Islamic Banks Commercial Banks

Merchant BanksFinance Companies

Discount HousesForeign Bank Rep.

Offices


Financial Insitutions in Thailand

Commercial Banks

International Banking Facilities

(IBFs)

Finance Companies

Finance Securities

Companies

Credit Companies

Asset Management Companies

CentralBank of Thailand

Ministry of Finance

GovernmentSpecializedFinancial

Institutions


Financial Institutions in India

All India Development Banks IDBI, SIDBI, IIBI,

IFCI

All-India Financial Institutions

State Level Institutions Other Institutions

All Financial Institutions

SFCs SIDCs ECGC DICGC

Specialized Financial Institutions EXIM Bank,

IVCF, ICICI Venture, TFCI, IDFC

Investment Institutions UTI, LIC, GIC & its

erstwhile four subsidiaries

Refinance Institutions NABARD, NHB

* *

*

* Regulatory & supervisory domain of the Reserve Bank of India (Central Bank)


Financial Institutions in Korea

CENTRAL BANK

BANKING INSTITUTIONS

NON-BANKING FINANCIAL

INSTITUTIONS

THE BANK OF KOREA

COMMERCIAL BANKS

SPECIALIZED BANKS

SECURITIES INSTITUTIONS

NON-BANK DEPOSITORY INSTITUTIONS

INSURANCE INSTITUTIONS

OTHER INSTITUTIONS


Financial Institutions in Japan

Central Bank (Bank of Japan)

Policy-based Financial Institutions

Development Banks (2) Government Finance (9)

Private Financial Institutions

Ordinary Banks (231)

Trust Banks (33)

Credit Cooperatives (363)

Insurance Companies (77)

Long-term Credit Banks (3)

Credit Associations (412)

Agricultural & Fishery

Cooperatives (3,580)

Securities Companies (265)


Banks vs. Nonbanks in US: Disintermediation


Insurance Companies

Life Insurance Companies1. Regulated by states, not federal government, as no widespread failures2. Hold illiquid long-term assets, as death rates predictable: mortgages3. Since 1970s, restructure to become also managers of pension funds4. Recently, OCC encourages banks to enter the insurance field

Property & Casualty Insurance Companies1. Losses from fire, theft, auto-accident, negligence, natural disaster2. Regulated by states3. Hold more liquid assets: 50% US Government securities4. Reinsurance: a portion of the risk is allocated to another insurance company in

exchange for a portion of the premium, Lloyd’s association of insurersInsurance Management: adverse selection (1.-2.) and moral hazard (3.-8.)

1. Screening: (medical) evaluation; similar to credit score in lending2. Risk-based premiums: young males more likely to have auto-accidents3. Restrictive provisions: helmets when renting motor scooters; covenants4. Prevention of fraud: claim when restrictive provisions not complied with5. Cancellation of insurance: a driver gets too many speeding tickets6. Deductible: a fixed amount by which the insured’s loss is reduced7. Coinsurance: 80% of medical bills covered by insurer, 20% by insured8. Limits on amounts of insurance: cannot insure a car more than its value


Institutional Investors

Pension Funds: ensure income payments on retirement1. Rapid growth: contributions tax-deductible for both employers and employees2. Bigger role in stock market: payments predictable => buy LT securities3. Problem of underfunding: contributions and earnings less than benefits4. Private

– regulated by Department of Labor– insured by the Pension Benefit Guarantee Corporation (Penny Benny) under the

Employment Retirement Income Security Act (ERISA) of 19745. Public

A. Social Security– since 1935, covers all individuals employed in the private sector– “pay as you go” benefits paid out of current contributions => underfunding

B. State and local pension plansMutual Funds: pool resources of many small investors selling them shares

1. Regulated by SEC2. Open-end vs. closed-end: shares can be redeemed at a price tied to the asset value of the

fund or not3. Load vs. no-load: commission paid to selling broker or not4. Money market mutual funds: shares function as checkable deposits5. Hedge funds: 1998, near collapse of Long-Term Capital Management


Finance Companies, Governments, Markets

Finance Companies: borrow in large amounts to lend in small amounts– Minimal regulation by states– Rapid growth– Three types

1. Sales finance companies: loans to buy items from a particular company2. Consumer finance companies: loans for furniture, home improvements3. Business finance companies

– factoring: form of specialised credit by making loans and purchasing accounts receivable (bills owed to the firm) at a discount

– leasing: railroad cars, jet planes, computersGovernment Financial Intermediation

1. Federal credit agencies: mostly, helping residential housing and agriculture2. Government guarantees to private loans: moral hazard problem

Securities Market Institutions: all are regulated by SEC1. Investment bank(er)s: primary markets, initial public offerings (IPOs) vs seasoned

issues, underwriters guarantee a price and sell to the public2. Securities brokers (agents for investors), dealers (hold inventories of securities and

trade on their own account) and specialists: secondary markets3. Brokerage firms: investment bank(er)’s, broker’s and dealer’s activities4. Organised exchanges (NYSE, AMEX) vs OTC markets (NASDAQ)


Trust Services• A trust institution: a legal entity that can hold and manage assets for one or more

beneficiaries over time– Grantor is the creator of the trust– Trustee is the manager of the trust– Beneficiaries receive the benefits of the trust

• Business trusts historically were formed among firms in the same industry to avoid competition and gain monopoly power– The Sherman Antitrust Act of 1890 in US and other legislation struck down such anti-

competitive behavior– Today holding companies (ownership of affiliated firms) and consortiums (association

or partnership of financial institutions but no cross ownership) have replaced trusts as a common form of business organisation

• Trust institutions now handle employee benefit programmes, personal trusts and estates, and corporate trusts– Real estate investment trusts (REITs) is a trust that purchases real estate and offers

shares of ownership to investors– Trust companies can be within or outside a bank for purposes of estate planning to

distribute assets of an individual after death and reduce taxes for beneficiaries: US federal estate tax rates range from 37% to 55%!


Financial Innovations

• 1933: Glass-Steagall Act, which was part of the 1933 Banking Act, separated commercial banking from investment banking

• 1987: the Federal Reserve reinterpreted this Act to mean that bank holding companies could own nonbank securities subsidiaries if approved by the Fed

• 1999: the Financial Services Modernization (Gramm-Leach-Bliley) Act dropped barriers under Glass-Steagall: now financial ( bank) holding companies can offer securities and insurance services

• Some related financial innovations

– Sweep accounts (at banks or nonbanks) for temporary transfer of funds from non-interest bearing accounts into an investment account earning higher yields

– Private banking provides custom-tailored services to high net worth individuals: wealth management (tax optimisation), art banking (jewellery)

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