NBFI and
Securities Market Institutions
Nonbank Financial Intermediaries (NBFI) -Financial Intermediaries other than banks.
Experience “nightmares” of
disintermediation and loan default, like
banks.
In particular, we cover Securities Market
Institutions (e.g. investment banks)
Less regulated than banks
better able to handle problems?
disadvantages of not being banks
Securities
Market Institutions
Investment Banks –
buys and sells securities (stocks and
bonds)
generator of significant financial
innovation (financial derivatives),
including mortgage-backed securities
An important behavior for their
business operation: underwriting -buying the entire issue then selling it in
the market when they choose
Securities Brokers and Dealers -conduct trading in the secondary
market
Brokers -- arrange sales between
buyers and sellers
Dealers -- “play the market” with bonds
and/or stock
The Securities Industry
Versus the Banking Industry
The Glass-Steagall Act (1933) -separation of banking industry
from the securities industry
Arguments for
Repealing Glass-Steagall
Brokerage firms invaded banking
industry with “bank-type” accounts.
Benefits from increased competition.
Financial markets are more
sophisticated and liquid.
Arguments for
Keeping Glass-Steagall
Securities market activity is risky,
could mean significant losses for
banks.
Potential conflicts of interest between
banking division and trading division.
Financial Services in the
Post Glass-Steagall Era
2000 -- Repeal of the Glass-Steagall Act
(Gramm-Leach-Bliley Act)
A series of mergers of large banks and
securities market institutions to
increase economies of scale (e.g.
Chase and J.P. Morgan).
Nonbank
Financial Intermediaries
Structured as a financial intermediary –
pooling small savers’ funds (liabilities)
to make large loans to borrowers
(assets).
Makes profits off the difference in
liquidity and default risk between their
assets and liabilities.
Can experience the “bank nightmares”
of disintermediation and loan default.
Insurance Companies
Life Insurance Companies
-- Assets: Corporate Bonds,
Commercial Mortgages, Stock
-- Liabilities: promised payouts
upon death
Property and Casualty Insurance
Companies
-- Assets: Municipal Bonds,
Treasury Bonds, Corporate
Bonds, Stock
-- Liabilities: promised payouts
upon fire, accidents, etc.
Mechanisms to Reduce
Moral Hazard and Adverse Selection
Offering insurance to relatively narrow
(low-risk) segment of population
Risk-based premiums
Lowering limits of coverage to cover
just “the basics”
Deductibles and co-payments
Pension Funds
Assets: different types of Bonds
or Stocks
Liabilities: promised payouts upon
retirement
Defined
Contribution Pensions
Defined Contribution Pensions -Employee contributes amounts over
his/her working years to an identified
fund, with possibly employer
contributions as well. Upon retirement
or leaving the firm, employee receives
the fund. Taxes are typically deferred
until the fund is withdrawn from.
Examples of Defined
Contribution Pensions
Individual Retirement Accounts (IRAs) - Classic IRAs and Roth IRAs
Keough Plans -- Self-Employed
individuals
401(k) Plans (and 403(b) Plans) -increasing in frequency
Defined Benefit Pensions
Defined Benefit Pensions -Employee does not contribute over
his/her working years, is promised
a fixed monthly payment upon
retirement.
Characteristics of
Defined Benefit Plans
Vesting -- How long the employee
has to work at the firm to be
eligible for pension.
Fully Funded Versus Underfunded
-- Fully Funded: employer
contributions plus returns fully
cover promised benefits
-- Underfunded: employer
contributions plus returns do not
cover promised benefits
Employee Retirement
Income Security Act
(ERISA)
Regulates Pensions
-- degree of underfunding
-- how pension is invested
-- reporting and examination
Creation of Pension Benefit
Guarantee Corporation -- pension
insurance
Examples of
Defined Benefit Pensions
Some Corporate, (more frequently)
Federal and State and Local
Government Pension Plans
Social Security -- “pay as you go”
plan
The Trend Toward Defined
Contribution Pensions
Employers moving away from defined
benefit to defined contribution plans,
largely for convenience.
To the employee – potential losses and
(big) wins.
Will it affect the retirement decision of
individuals?
Finance Companies
Assets -- Consumer loans
Liabilities -- (their own) Commercial
Paper, Stock, and Corporate Bonds
Not subject to bank regulation (due to
not being an issuer of deposits)
In general, not eligible for Discount
Window
Mutual Funds
Assets -- bonds, stocks, as
advertised in prospectus
Liabilities -- mutual fund shares
Regulated by Securities Exchange
Commission (SEC)
Some have insurance against
dishonest practices (SIPC).
Mutual Funds
Can offer unique features based
upon characteristics of asset
portfolio
Tax-exempt mutual funds
Checkability and money market
mutual funds (MMMF)
Subprime Mortgages, NBFI,
and Investment Banks
Large amount of high default risk mortgagebacked securities (MBS) held by investment
banks and other NBFI (e.g. insurance
companies, pension funds worldwide).
Defaults in MBS adversely affects all the
holders.
2008 – collapse of Bear Stearns and Lehman
Brothers (investment banks).
AIG and
Credit Default Swaps
AIG – large insurance company.
Credit Default Swaps (CDS) – financial
derivative which provides insurance against
a defaulted MBS.
Key property of CDS – anyone could buy
these policies in almost unlimited quantities,
even if they were not the holders of the MBS.
Defaults in MBS  huge payoffs to holders
of CDS  significant disintermediation.
2008 – collapse of AIG.
Regulatory Actions, NBFI, and
the Credit Crunch
Federal Reserve opened the Discount
Window to investment banks, and some
other nonbanks
With the FDIC, Fed helped to arrange some
mergers of failing investment banks with
banks (e.g. Bear Stearns and Chase-JP
Morgan)
Bailout of AIG, Fannie Mae, and Freddie Mac.
Fed franted bank holding company status to
some NBFI (GMAC) and investment banks
(Goldman Sachs, Morgan Stanley)
Underlying Issues:
The Credit Crisis
Bailouts -- necessary to avoid financial and
economic depression or increasing Moral
Hazard/Adverse Selection?
What about the banks that remained
conservative and adhered to fundamentals?
Consistency in response – Bear Stearns
versus Lehman Brothers.
Where was (and is) the SEC?
Underlying Issues:
Beyond the Credit Crisis
The end of stand-alone investment banks?
Extinction of finance companies?
Harsher regulations after the crisis passes
for banks and investment banks (extension
of Dodd-Frank Act, like FIRREA)?
Tougher regulation of financial derivatives?
Other players entering banking and financial
services (e.g. Walmart, K-Mart, AAA)?
Time for a totally revamped regulatory
structure for banking, NBFI, and securities
market institutions?