FNCE 4000
Why are Financial Institutions Special?
1-1

•Primary difference is direct transacting versus transformation
•Example of direct below:
Equity & Debt
Households
(net savers)
Corporations
(net borrowers)
Cash
1-2

 Without FIs: Low level of fund flows.
– Information costs
 Economies of scale reduce costs for FIs to screen and monitor borrowers
– Less liquidity
– Substantial price risk
1-3

Households
Cash
Deposits/Insurance
Policies
FI
(Brokers)
FI
(Asset
Transformers)
Corporations
Equity & Debt
Cash
1-4

FIs are Middlemen!
 Why should they exist?
– Reduce information costs
– Spread of risk
– Economies of scale
– Maturity intermediation
– Payment services
– <transfer monetary policy>
1-5

 FIs receive special regulatory attention.
Reasons:
– Negative externalities of FI failure
– Special services provided by FIs
– Institution-specific functions such as money supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks, thrifts), etc.
1-6

 Important features of regulatory policy:
– Protect ultimate sources and users of savings
 Including prevention of unfair practices such as redlining and other discriminatory actions
– Primary role:
Ensure soundness of the overall system
1-7

Regulation of FIs
 Safety + soundness
 Monetary policy
 Credit allocation
 Consumer protection
 Investor protection
 Entry
 Consumer protection
 Regulation is not costless
1-8

 Safety and soundness regulation:
– Regulations to increase diversification
 No more than 10 percent of equity to single borrower
– Minimum capital requirements
– Guaranty funds:
 Deposit insurance fund (DIF):
 Securities Investors Protection Fund (SIPC)
– Monitoring and surveillance.
 FDIC monitors and regulates DIF participants.
1-9

 Consumer protection regulation
– Community Reinvestment Act (CRA)
– Home Mortgage Disclosure Act (HMDA)
 Effect on net regulatory burden
– FFIEC processed info on as many as 17 million mortgage transactions in 2009
– Analysts questioning the net benefit
1-10

 Potential extensions of regulations
– CRA to other FIs such as insurance companies in light of consolidation and trend toward universal banking
 New additions:
– Consumer Financial Protection Agency
(2009)
– Credit card reform bill effective 2010
1-11

Additional Terms
 Redlining
 Negative externality
 Disintermediation
 Liquidity
 Solvency
 Information costs
 Payment Services
1-12

 US FIs facing increased competition from foreign FIs
 Securitization of assets (30 year trend)
 Only 2 of the top ten banks are US banks
 Foreign bank assets in the US typically more than 10 percent
– As high as 21.9 percent
1-13

1-14

 DJIA fell 53.8 percent in less than 1 ½ years as if mid-March 2009
 Record home foreclosures
– 1 in 45 in default in late 2008
 Goldman Sachs and Morgan Stanley
– Only survivors of the major firms
1-15

 Reactions to FSM Act and other factors:
– Shift from “originate and hold” to
“originate and distribute”
 Affects incentives to monitor and control risk.
 Shift to off balance sheet risks
 Degraded quality and increased risk
 Housing market bubble
– Encouraged subprime market and more exotic mortgages
1-16

 AIG bailout
 Citigroup needed government support
 Chrysler and GM declared bankruptcy in 2009
 Unemployment in excess of 10 percent
1-17

 Home prices plummeted in 2006-07
– Mortgage delinquencies rose
– Forelosure filings increased 93 percent from July 2006 to July 2007
– Securitized mortgages led to large financial losses
 Subprime mortgages
– Countrywide Financial bailed out and eventually taken over by Bank of America
1-18

 Bear Stearns funds filed for bankruptcy
– Acquired by J.P. Morgan Chase
– Fed moved beyond lending only to
Depository Institutions
 Government seizure of Fannie Mae and Freddie Mac
 Lehman Brothers failure
 Crisis spread worldwide
1-19

 Federal Reserve and other central banks infused $180 billion
 $700 billion Troubled Asset Relief
Program (TARP)
 Still struggling in 2009
 $827 billion stimulus program
– American Recovery and Reinvestment
Act of 2009
1-20

Types of FIs
 Depository institutions
 Insurance Companies
 Pension Funds
 Investment Banks
 Mutual Funds
 Finance Companies
1-21

Trends in Assets Held by FIs
1-22

Pertinent Websites
The Banker
Federal Reserve
FDIC
FFIEC
Investment Co.
Institute www.thebanker.com
www.federalreserve.gov
www.fdic.gov
www.ffiec.gov
www.ici.com
OCC
SEC
SIPC
Wall Street Journal www.occ.treas.gov
www.sec.gov
www.sipc.org
www.wsj.com
1-23