Note:

This topic has more questions than can be covered in a 1 tutorial hour session. The questions to be covered by your tutor are indicated by an asterisk (*); the rest should be viewed as extra practice problems.

Question 1*. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions.

Answer:

In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs.

In this economy, the level of fund flows between household savers and the corporate sector is likely to be quite low.

In  this  world,  households  generally  are  averse  to  directly  purchasing  securities  because  of (a) monitoring costs, (b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns which may be available. Finally, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.

Question 2*. Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users.

Answer:

FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services or they also may offer advisory services which help reduce information costs. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities.

Question 3. Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?

Answer:

By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. This agglomeration of funds resolves a number of problems. First, the large FI now has a much greater incentive to collect information and monitor actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. Such economies of scale of information production and collection tend to enhance the advantages to savers of using FIs rather than directly investing themselves. Second, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy.

Question 4. Explain how financial institutions act as an information producer

Answer:

They develop of secondary securities that allow for updating information and improving the monitoring process. An example is the bank loan that is renewed more quickly than long-term debt. When bank loan contracts are sufficiently short term, the banker becomes almost like an insider to the firm regarding informational  familiarity with  its  operations  and  financial  conditions.  Indeed, this more  frequent monitoring often replaces the need for the relatively inflexible and hard-to-enforce covenants found in bond contracts. Thus, by acting as a delegated monitor and producing better and timelier information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy.

Question 5*. Why can FIs offer highly liquid and low price risk securities while investing in relatively illiquid and higher price risk securities issued by corporations?

Answer:

FIs  exploit  the  law  of large  numbers  in  their  investments,  achieving  a  significant  amount  of diversification, whereas because of their small size, many household savers are constrained to holding relatively undiversified portfolios. This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk- free return on its assets. Further, by acting as a delegated monitor and producing better and timelier information, FIs have lower information cost or lower monitoring cost, that is, they are better at monitoring the actions and the performance of the firms who have borrowed or issued securities. As a result, it can credibly fulfill its promise to households to supply highly liquid claims with little price or capital value risk.

Question 6. What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial institutions?

Answer:

If corporations (borrowers) and households (savers) have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets. A dimension of FIs’ ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, through maturity mismatching, FIs can produce long-term contracts, such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts. By investing in a portfolio of long- and short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and other derivative products.

Question 7. If financial markets operated perfectly and costlessly, would there be a need for financial institutions?

Answer:

To a certain extent, financial institutions exist because of financial market imperfections. If information is available costlessly to all participants, savers would not need FIs to act as either their brokers or their delegated monitors. However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections.

Question 8*. How does the liability maturity structure of a bank’s balance sheet compare with the maturity structure of the asset portfolio? What risks are created or intensified by these differences?

Answer:

The liability structure of bank balance sheets tends to reflect a shorter maturity structure than does the asset portfolio with relatively more liquid instruments, such as deposits and interbank borrowings, used to fund less liquid assets such as loans. Thus, maturity mismatch or interest rate risk and liquidity risk are key exposure concerns for bank managers.

Question 9. What types of activities are normally classified as off-balance-sheet (OBS) activities? What are the benefits of OBS activities to a bank? What are the risks of OBS activities to a bank?

Answer:

OBS activities include issuing various types of guarantees (such as letters of credit), which often have a  strong insurance underwriting element, and making future commitments to lend. Both services generate  additional  fee  income  for  banks.  Off-balance-sheet  activities  also  involve  engaging  in derivative transactions—futures, forwards, options, and swaps.

OBS activities generate fee income for banks. The initial benefit is the fee that the bank charges when making the commitment. By moving activities off the balance sheet, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. At the same time, they can avoid regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet activities. Thus, banks have both earnings and regulatory “tax avoidance” incentives to undertake activities off their balance sheets.

Off-balance-sheet activities, however, can involve risks that add to the overall insolvency exposure of an FI. Indeed, at the very heart of the financial crisis were losses associated with off-balance-sheet mortgage-backed securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some ofthe largest FIs and a near meltdown ofthe world’s financial and economic systems. However, off-balance-sheet activities and instruments have both risk-reducing as well as risk-increasing attributes, and, when used appropriately, they can reduce or hedge an FI’s interest rate, credit, and foreign exchange risks.

Question 10*. What advantages do finance companies have over commercial banks in offering services to small business customers?

Answer:

Finance companies have advantages in the following ways. Because they do not accept deposits, they do not have the extensive regulatory monitoring. They are likely to have more product expertise because they generally are subsidiaries of industrial companies. Finance companies are more willing to take on riskier customers. Finance companies typically have lower overhead than commercial banks.

Question  11*. Explain how securities firms differ from investment banks. In what ways are they financial intermediaries?

Answer:

Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while investment  banks  primarily  engage  in  originating,  underwriting,  and  distributing  issues  of securities.  In  recent  years,  investment  banks  have  undertaken  increased  corporate  finance activities such as advising on mergers, acquisitions, and corporate restructuring. In both cases, these firms act as financial intermediaries in that they bring together economic units who need money with those units who wish to invest money.

Question 12. What are the key activity areas for investment banks and securities firms? How does each activity area assist in the generation of profits and what are the major risks for each area?

Answer:

The seven major activity areas of security firms are:

a)      Investment Banking: Investment banks specialize in underwriting and distributing both debt and equity issues in the corporate market. New issues can be placed either privately or publicly and can represent either a first issued (IPO) or a secondary issue. Secondary issues of seasoned firms typically will generate lower fees than an IPO. Securities underwritings can be undertaken through either public offerings or private offerings. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the firm acts as the agent and receives a fee based on the success of the offering. The firm serves as a principal by actually takes ownership of the securities in a firm commitment underwriting. Thus, the risk of loss is higher. Finally, the firm may perform  similar functions in the  government markets  and the  asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue.

b)      Venture Capital: A difficulty for new and small firms in obtaining debt financing from commercial banks is that CBs are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners.

c)      Market Making: Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. Market making can involve either agency or principal transactions. Agency transactions are two-way transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee or commission. In principal transactions,  the  market  maker  seeks  to profit  on  the  price  movements  of securities and takes either long or short inventory positions for its own account. (Or an inventory position may be taken to stabilize the market in the securities.) These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets.

d)      Trading: Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, program trading, stock brokerage, and electronic brokerage. Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market. Pure arbitrage involves the purchase and simultaneous sale of an asset in different markets because of different prices in the two markets. Risk arbitrage involves establishing positions prior to some anticipated information release or event. Program trading involves positioning with the aid of computers and futures contracts to benefit from small market movements. In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment  banks.  Stock  brokerage  involves  the  trading  of  securities  on  behalf  of individuals who want to transact in the money or capital markets. Electronic brokerage, offered by major brokers, involves direct access, via the Internet, to the trading floor, therefore bypassing traditional brokers.

e)      Investing: Securities firms act as agents for individuals with funds to invest by establishing and managing mutual funds and by managing pension funds. The securities firms generate fees that affect directly the revenue stream of the companies.

f)       Cash Management: Cash management accounts are checking accounts that earn interest. The accounts have been beneficial in providing full-service financial products to customers, especially at the retail level.

g)      Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions. This activity has been extremely beneficial from a fee standpoint during the 1990s and 2000s.

h)      Back-Office and Other Service Functions: Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis.

Question 13. What are the risk implications to an investment bank from underwriting on a best-efforts basis versus a firm commitment basis?

Answer:

In a best efforts underwriting, the investment bank acts as an agent of the company issuing the security and receives a fee based on the number of securities sold. With a firm commitment underwriting, the investment bank purchases the securities from the company at a negotiated price and sells them to the investing public at what it hopes will be a higher price. Thus, the investment bank has greater risk with the firm commitment underwriting, since the investment bank will absorb any adverse price movements in the security before the entire issue is sold.

Question 14*. What are the advantages and disadvantages to a new or small firm of getting capital funding from a venture capital firm?

Answer:

A difficulty for new and small firms in obtaining debt financing from banks is that banks are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to venture capital firms to get capital financing as well as advice. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be fully informed about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met.

Venture capital firms look for two things in making their decisions to invest in a firm. The first is a high return. Venture capital firms are willing to invest in high-risk new and small firms. However, they require high levels of returns (sometimes as high as 700 percent within five to seven years) to take on these risks. The second is an easy exit. Venture capital firms realize a profit on their investments by eventually selling their interests in the firm. They want a quick and easy exit opportunity when it comes time to sell. Basically, venture capital firms provide equity funds to new, unproven, and young firms. This separates venture capital firms from commercial banks and investment firms, which prefer to invest in existing, financially secure businesses.

Question 15*. How do the operating activities, and thus the balance sheet structures, of securities firms differ from the operating activities of commercial banks? How are the balance sheet structures of securities firms similar to commercial banks?

Answer:

Securities firms and investment banks primarily help net suppliers of funds (e.g., households) transfer funds to net users of funds (e.g., businesses) at a low cost and with a maximum degree of efficiency. Unlike other types of FIs, securities firms and investment banks do not transform the securities issued by the net users of funds into claims that may be “more” attractive to the net suppliers of funds (e.g., banks and their creation of bank deposits and loans). Rather, they serve as brokers intermediating between fund suppliers and users.

The short-term nature of many of the assets in the portfolios of securities firms demonstrates that an important activity is trading/brokerage. As a broker, the securities firm receives a commission for handling the trade but does not take either an asset or liability position. Thus, many of the assets appearing on the balance sheets of securities firms are cash-like money market instruments, not capital market positions. In the case of banks, assets tend to be medium-term from the lending positions.

A major similarity between securities firms and all other types of FIs is a high degree of financial leverage. That is, all of these firms use high levels of debt that is used to finance an asset portfolio consisting primarily of financial securities. A difference in the funding is that securities firms tend to use liabilities that are extremely short term (see the balance sheet in Table 4-7). Nearly 36 percent of the total liability financing is payables incurred in the transaction process. In contrast, banks have fixed-term time and savings deposit liabilities.

Question 16*. What are the economic reasons for the existence of mutual funds? Why do individuals rather than corporations hold most mutual funds?

Answer:

A mutual fund represents a pool of financial resources obtained from individuals and companies, which is invested in the money and capital markets. This process represents another method for economic savers to channel funds to companies and government units that need extra funds.

One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors. By pooling investments from a large number of small investors, fund managers are able to hold well-diversified portfolios of assets. In addition, managers can obtain lower transaction costs because of the volume of transactions, both in dollars and numbers, and they benefit from research, information, and monitoring activities at reduced costs.

Many small investors are able to gain benefits of the money and capital markets by using mutual funds. Once an account is opened in a fund, a small amount of money can be invested on a periodic basis. In many cases, the amount of the investment would be insufficient for direct access to the money and capital markets. On the other hand, corporations are more likely to be able to diversify by holding a large bundle of individual securities and assets, and money and capital markets are easily  accessible  by  direct  investment.  Further,  an  argument  can  be  made  that  the  goal  of corporations should be to maximize shareholder wealth, not to be diversified.

Question 17. What is the difference between open-end and closed-end mutual funds? Which type of fund tends to be more specialized in asset selection? How does a closed-end fund provide another source of return from which an investor may either gain or lose?

Answer:

Open-end funds allow shares to be purchased and redeemed according to investor demand. The NAV of open-ended funds is determined only by changes in the value of the assets owned. In closed-end funds, the number of shares of the fund is fixed. If investors need to redeem their shares, they sell them to another investor. Thus, the demand for the fund shares can provide another source of return for the investors as the market price of the fund may exceed the NAV of the fund. Closed-end funds, such as real estate investment trusts, tend to be more specialized.

Question 18*. What is a hedge fund and how is it different from a mutual fund?

Answer:

Hedge funds are a type of investment pool that solicits funds from (wealthy) individuals and other investors (e.g., commercial banks) and invests these funds on their behalf. Hedge funds are similar to mutual funds in that they are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis.

Hedge funds are, however, not subject to the numerous regulations that apply to mutual funds for the protection  of individuals,  such  as regulations requiring  a  certain  degree  of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in the pricing of funds  shares,  disclosure regulations,  and regulations limiting the use of leverage. Further, hedge funds do not have to disclose their full activities to third parties. Thus, they offer a high degree of privacy for their investors so they often focus on wealthy clients and charge performance fees, in addition to management fees. Because hedge funds have been exempt from many of the rules and regulations governing mutual funds, they can use aggressive strategies that are unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading.