Nut Khorn
Term II
Financial Institutions and Markets
(1)

Securities firms provide a wide variety of functions in financial markets.
o Broker function
 Execute securities transactions between two parties
 Charge a fee in the form of a bid-ask spread
o Investment banking function
 Underwrite newly issued securities
o Dealer function
 Securities firms make a market in specific securities by adjusting their
inventory
(4)
Mutual funds financial institutions that pool financial resources of individuals and
companies and invest those resources in diversified portfolios of asset.
o Sell shares to surplus units
o Use funds to purchase a portfolio of securities
 Some focus on capital market securities (e.g., stocks or bonds)
 Money market mutual funds concentrate on money market securities
A mutual fund is a professionally managed type of collective investment scheme that pools
money from many investors to buy stocks, bonds, short-term money market instruments,
and/or other securities.
In the United States, a mutual fund is registered with the Securities and Exchange
Commission (SEC) and is overseen by a board of directors (if organized as a corporation)
or board of trustees (if organized as a trust). The board is charged with ensuring that the fund
is managed in the best interests of the fund's investors and with hiring the fund manager and
other service providers to the fund. The fund manager, also known as the fund sponsor or
fund management company, trades (buys and sells) the fund's investments in accordance with
the fund's investment objective. A fund manager must be a registered investment advisor.
Funds that are managed by the same fund manager and that have the same brand name are
known as a "fund family" or "fund complex".
The Investment Company Act of 1940 (the 1940 Act) established three types of registered
investment companies or RICs in the United States: open-end funds, unit investment
trusts (UITs); and
closed-end funds. Recently, exchange-traded funds (ETFs), which are
open-end funds or unit investment trusts that trade on an exchange, have gained in popularity.
While the term "mutual fund" may refer to all three types of registered investment companies,
it is more commonly used to refer exclusively to the open-end type.
Hedge funds are not considered a type of mutual fund. While they are another type of
commingled investment scheme, they are not governed by the Investment Company Act of
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1940 and are not required to register with the Securities and Exchange Commission (though
many hedge fund managers now must register as investment advisors).
Mutual funds are not taxed on their income as long as they comply with certain requirements
established in the Internal Revenue Code. Specifically, they must diversify their investments,
limit ownership of voting securities, distribute most of their income to their investors
annually, and earn most of the income by investing in securities and currencies.[2] Mutual
funds pass taxable income on to their investors. The type of income they earn is unchanged as
it passes through to the shareholders. For example, mutual fund distributions of dividend
income are reported as dividend income by the investor. There is an exception: net losses
incurred by a mutual fund are not distributed or passed through to fund investors.
Outside of the United States, mutual fund is used as a generic term for various types of
collective investment vehicles available to the general public, such as unit trusts, open-ended
investment companies, unitized insurance funds, Undertakings for Collective Investment in
Transferable Securities, and SICAVs.
Advantages of mutual funds
Mutual funds have advantages compared to direct investing in individual securities.[3] These
include:

Increased diversification

Daily liquidity

Professional investment management

Ability to participate in investments that may be available only to larger investors

Service and convenience

Government oversight

Ease of comparison
Disadvantages of mutual funds
Mutual funds have disadvantages as well, which include [4]:

Fees

Less control over timing of recognition of gains

Less predictable income

No opportunity to customize
(6)

Role of nondepository financial institutions
o Nondepository institutions generate funds from sources other than deposits
o Finance companies
 Obtain funds by issuing securities
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 Lend funds to individuals and small businesses
Government or private organization (such as building society, insurance
company, investment trust, or mutual fund or unit trust) that serves as
an intermediary between savers and borrowers, but does not accept time deposits.
Such institutions fund their lending activities either by selling securities (bonds, notes,
stock/shares) or insurance policies to the public. Their liabilities (depending on the
liquidity of the liability) may fall under one or more money supply definitions, or may
be classified as near money.
The economy works best when there is money and credit
available to finance business or consumer purchases or
investments. When money is limited, such as during the 2007
– 2009 credit crisis, businesses can't finance their operations
nor invest in new projects, so unemployment rises, which
causes people to curtail their spending which further contracts
business. Tax receipts fall, so governments cut back on their
spending, adding to the recession.
Most of the money and credit readily available to the economy
comes from financial intermediaries. Depository
institutions—banks that accept deposits—contribute to the
economy by lending much of the money saved by depositors.
However, deposits do not provide all of an economy's funding,
since only the wealthy save a significant amount of money
and most of it is not in low-interest paying deposits which are
taxable as ordinary income. The wealthy put most of their
money into assets such as stocks, real estate, and municipal
bonds, which not only offer greater returns, but the returns
are often taxed less than ordinary income. People who are not
wealthy do not save very much, at least in the United States,
because they need the money for everyday wants and needs.
Although wealthy individuals have a lot more money than
lower-income individuals, there are many more people in the
lower-income classes; hence, the aggregate of the money
held by the lower-income classes is greater than the
aggregate held by the wealthy.
This greater aggregate wealth of the lower-income people is
made available to the economy through financial
nondepository institutions, which are financial
intermediaries that do not accept deposits but do pool the
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payments of many people in the form of premiums or
contributions and either invest it or provide credit to others.
Hence, nondepository institutions form an important part of
the economy. These institutions receive the public's money
because they offer other services than just the payment of
interest. They can spread the financial risk of individuals over
a large group, or provide investment services for greater
returns or for a future income.
Nondepository institutions include insurance companies,
pension funds, securities firms, government-sponsored
enterprises, and finance companies. There are also smaller
nondepository institutions, such as pawnshops and venture
capital firms, but they constitute a much smaller portion of
sources of funds for the economy.
Insurance Companies
Insurance companies protect their customers from the
financial distress that can be caused by unforeseen events,
such as accidents or premature death. They pool the small
premiums of the insured to pay the larger claims to those who
have losses. The premium payments are regular while the
losses are irregular, both in timing and amount. An insurance
company can profit because it can accurately estimate the
payment of claims over a large group by using statistics and it
can invest its surplus for greater returns, which helps to lower
premiums to be competitive.
Like banks, insurance companies are confronted with
the informational asymmetry problems of adverse selection
and moral hazard. An insurance company solves the problem
of adverse selection by screening applicants—verifying
information in the application, checking the applicant's
history, and by applying
restrictive covenants in the
insurance contract, such as not covering a pre-existing
condition. Adverse selection is also reduced by grouping—
placing the insurance applicant into specific classes where
there is a difference in claims history for the group, then
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charging the appropriate premium. One controversial example
is the use of credit scores for determining insurance
premiums, since several studies have shown that people with
lower credit scores file more claims than those with higher
scores.
The solution to moral hazard differs, depending on the type of
insurance offered. There are 2 major types of insurance:
property and casualty insurance and life insurance. How the
premiums are invested depends on what type of insurance the
company offers, which determines the amount of liquidity it
needs.
Property And Casualty Insurance
Property and casualty insurance offers financial protection
against damage or loss to property or people caused by
accidents, natural disasters, or from the action of others. The
most common type of this insurance isauto insurance, since it
is legally required by every driver in every state.
Although losses can be estimated by using statistics over a
large group, there is a larger standard deviation of
risk because property and casualty insurance covers many
more types of events, so claims can vary greatly in amount.
Hence, these insurance companies must maintain liquidity by
investing the premiums in short-term securities, most of
which are money market securities that can be sold quickly at
little cost and are very safe.
Although there are several methods to reducing moral hazard,
property and casualty insurers use the principle of indemnity,
which is to pay for financial losses suffered by the insured—
but no more. After all, if people could profit from insurance,
that would motivate them to cause losses for profits. For this
same reason, insurance companies will not pay for losses that
are covered by other insurance or other forms of
compensation.
Life Insurance
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While the death of a single individual is an uncertain event,
the number of deaths in a large group is very predictable.
Furthermore, the amount of the claim for any single death is
certain since it is specified in the contract.
There isn't much of a moral hazard problem in life
insurance because most people want to live and would not be
able to benefit directly from the proceeds unless it is a whole
life policy that also has a savings portion. However, this living
benefit is limited by what the insured has paid in.
The only real moral hazard to life insurance is the possibility
that the insurance applicant is buying insurance to provide for
his beneficiaries after he commits suicide. This moral hazard
is reduced by a suicide clause—not paying for suicides
within the 1st 2 years of the policy, or 1 year in some policies.
The reasoning behind this is that most people who commit
suicide are mentally ill, which is an affliction that should be
covered, while the waiting period prevents someone who is
suicidal from taking out a policy just before committing
suicide.
Because claim payments are more predictable, life insurance
companies invest mostly in long-term bonds, which pay a
higher yield, and some stocks. Their portfolios have a smaller
stock portion because the reduction in liquidity caused by a
stock market decline can last for years.
Pension Funds
Pension funds receive contributions from individuals and/or
employers during their employment to provide a retirement
income for the individuals. Most pension funds are provided
by employers for employees. The employer may also pay part
or all of the contribution, but an employee must work a
minimum number of years to be vested—qualified to receive
the benefits of the pension. Self-employed people can also set
up a pension fund for themselves through individual
retirement accounts (IRAs) or other types of programs
sanctioned by the federal government.
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While an individual has many options to save for retirement,
the main benefit of government-sanctioned pension plans is
tax savings. Pension plans allow either contributions or
withdrawals that are tax-free. For instance, for regular IRAs,
contributions are tax-free, but withdrawals are taxed, while
for Roth IRAs, contributions are taxed, but withdrawals are
tax-free.
As a consequence of the regular contributions and the tax
savings, pension funds have enormous amounts of money to
invest. And because their payments are predictable, pension
funds invest in long-term bonds and stocks, with more
emphasis on stocks for greater profits.
Securities Firms
Securities firms are companies that provide institutional
support for the buying and selling of securities. Investment
companies, brokerages, and investment banks are the major
types of securities firms. Investment companies pool the
investments of many people into a single portfolio that is
managed by professional managers. Investment companies,
such as mutual funds, provide expertise and economies of
scale that small individual investors would not be able to
afford otherwise. Brokerages provide an institutional
framework that allows retail investors to invest in stocks,
bonds, options, futures, and other financial
instruments directly. Brokers provide trading software that
allows traders to select their trades, and settlement and
clearing services to effect the transactions. Investment
banks help businesses and other organizations to sell their
own stocks and bonds to the investing public. Investment
banks offer advice to the issuer, register the securities with
the Securities and Exchange Commission, and sell the
securities to their customers.
Federal Government-Sponsored Enterprises (GSEs)
There are a number of government agencies or private
corporations chartered by the federal government that also
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act as financial intermediaries. These agencies were created
ad hoc by Congress to provide credit to specific constituencies
that Congress has argued were not being addressed
adequately by the free market. The largest of these include
the Government National Mortgage Corporation (Ginnie Mae),
the Federal National Mortgage Association (Fannie Mae), the
Federal Home Loan Mortgage Corporation (Freddie Mac), the
Student Loan Marketing Association (Sallie Mae), and the
Farm Credit System. These agencies are all involved in
providing credit to buy homes or farms, except for Sallie Mae,
which provides student loans.
Most of these agencies buy loans from private lenders, then
they securitize the loans into asset-backed securities and sell
them to the public. These agency securities are exempt
from state and local taxes, and they were considered very
safe, at least before 2008, since most investors believed that
they had the implicit backing of the federal government,
which has been demonstrated in September, 2008, when the
federal government placed Fannie Mae and Freddie Mac under
conservatorship, ousting its executives and turning over their
loan portfolios to the Federal Housing Finance Agency.
Finance Companies
Finance companies provide loans to people or businesses
using the issuance of short-term securities,
especially commercial paper, as a source of funds. Consumer
finance companies provide consumer loans and sometimes
mortgages. They also provide the instant credit offered by so
many retail stores, where the customer receives the item but
doesn't have to pay for a stipulated amount of time.
Business finance companies provide loans to businesses
but are especially prominent in the equipment leasing
business, where the finance company will buy equipment that
a particular business wants, and lease it to the business. This
saves the business the upfront purchase cost, and allows it to
treat the equipment as a current deduction for taxes rather
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than as a capital expense that has to be depreciated over a
number of years.
Business finance companies also provide businesses with
short-term liquidity by financing inventory until it is sold and
with accounts receivable loans, which are short-term loans
backed by accounts receivable.
Sales finance companies finance specific types of major
purchases or finance the purchases of a specific retailer. For
instance, most of the financing provided by automobile
dealers is provided by these companies, so that the potential
buyer can buy right away.
(10)

Role of depository institutions
o Depository institutions accept deposits from
o surplus units and provide credit to deficit units
 Depository institutions are popular because:
 Deposits are liquid
 They customize loans
 They accept the risk of loans
 They have expertise in evaluating creditworthiness
 They diversify their loans
Depository institutions (for simplicity, we refer to these as banks throughout this text) are
financial intermediaries that accept deposits from individuals and institutions and make loans.
The study of money and banking focuses special attention on this group of financial
institutions, because they are involved in the creation of deposits, an important component of
the money supply. These institutions include commercial banks and the so-called thrift
institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions.
 Depository institutions, which are usually just called
banks, are categorized as such because their primary
source of funding is the deposits of savers. Their savings
accounts are insured by the Federal Deposit Insurance
Corporation (FDIC) up to certain limits. Banks are further
subcategorized depending on the markets they serve, their
primary sources of funding, type of ownership, how they
are regulated, and the geographic extent of their market.
 These categories of banks arose because they were
established to serve different markets at different times.
What state and federal regulations governed a particular
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bank also depended on its type, and whether it had a state
or federal charter. States, especially, restricted the banks'
ability to compete and to expand geographically. However,
modern technology and deregulation are blurring these
traditional distinctions, with categories overlapping even
more than in the past.
 Savings Institutions
 Savings institutions, sometimes called thrift
institutions, are banks that serve a local community.
They take the deposits of local residents and lend the
money back in the form of consumer loans, mortgages,
and small business loans. Savings institutions include
savings and loan institutions, savings banks, and credit
unions. Most savings institutions are regulated by
the Office of Thrift Supervision (OTS), which was
created by the Financial Institutions Reform, Recovery
and Enforcement Act of 1989 (FIRREA). The FIRREA
empowered the OTS to enact rules and regulations for
savings institutions, manage the Savings Association
Insurance Fund (SAIF), which insures the deposits of
savings institutions, and to charter federal savings banks
and savings and loans associations.
 Prior to 1980, savings institutions were mostly limited to
the residential mortgage market, but the Depository
Institutions Deregulation and Monetary Control Act of
1980 deregulated banking by removing interest rate
ceilings and allowing savings institutions to offer more
services, including commercial and consumer lending. The
Act also eliminated dollar limits on mortgages, allowed
second mortgages, and eliminated the territorial
restrictions on mortgage lending and permitted savings
institutions to offer interest-paying Negotiable Order of
Withdrawal (NOW) accounts—basically, checking
accounts paying interest.
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 Savings and Loan Associations (SLAs, S&Ls) first
appeared in the 1800s so that factory workers could save
money to buy a home. They were loosely regulated until
the Great Depression, when Congress passed several
major laws to shore up the banking industry and to restore
the public's trust in them. Before 1980, SLAs were
restricted to mortgages and savings and time deposits, but
the Monetary Control Act extended their permitted
activities to commercial loans, non-mortgage consumer
lending, and trust services.
 Many S&Ls have been owned by depositors, which was
their main source of funding—thus they were calledMutual
Savings and Loans Associations or just Mutual
Associations. Mutual S&Ls, like credit unions, used their
earnings to lower future loan rates, raise deposit rates, or
to reinvest while corporate S&Ls either reinvested profits
or returned profits to their owners by paying dividends.
Nowadays, most S&Ls are corporations, giving them
access to additional capital funding to compete more
successfully and to facilitate mergers and acquisitions.
 Savings banks (aka mutual savings banks, MSBs)
began as mutual companies first chartered in 16 states,
with most in New York and New Jersey, that were owned
by the depositors and were restricted to mortgages. They
were governed by a local board of trustees. When interest
rates were limited by law, mutual savings banks
distributed their earnings back to the depositors.
The Garn-St. Germain Depository Institutions Act of
1982 gave savings banks the option of a federal charter
and allowed them to convert to corporations, which many
of them did since it extended their funding options and
facilitated mergers and acquisitions.
 Credit unions are nonprofit depository institutions that
are financial cooperatives owned by people belonging to a
particular group, such as the employees of a particular
company, a union, or a religious group, or who live in a
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specific area such as a county, and they are governed by a
board of volunteers. Because they are nonprofits and
owned by their customers, they charge lower loan rates
and pay higher interest rates on savings, and they offer a
wide variety of financial services for their owners. All credit
unions with federal charters and most with state charters
are regulated and insured by the National Credit Union
Administration. Deposit insurance is provided by
the National Credit Union Share Insurance Fund.
 Commercial Banks
 The primary business of commercial banks is to serve
businesses, although with banking deregulation they have
entered into the consumer business as well. Commercial
banks provide the widest variety of banking services. In
addition to savings accounts, checking services, consumer
loans, commercial and industrial (C&I) loans, and credit
cards, commercial banks may also offer trust services,
trade financing, investment banking and management for
corporations, governments and their agencies, and
treasury services.
 Before 2005, deposits were insured by the Bank Insurance
Fund (BIF), but it was merged with the SAIF, the fund
used to insure thrifts, into a single fund—the Deposit
Insurance Fund (DIF).
 Commercial banks are the largest banks, both in assets
and in geographic extent. Community banks, however,
are smaller commercial banks with assets of less than $1
billion that generally serve their immediate community of
consumers and small businesses. Community banks are
also the most numerous by a large margin.
 Some commercial banks, often called regional and superregional banks, cover a much wider geographic area and
usually have assets in the hundreds of billions of dollars.
They have many branches that extend into several states
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and many ATM machines at convenient locations
throughout their area. Global banks also offer
international services, such as letters of credit, and
currency exchange. These larger banks use short-term
borrowing in the money markets to supplement their
deposits and often require loans from the smaller
community banks. These correspondent banks have
accounts at the larger banks, which facilitates the frequent
transfers of funds with the big banks. Some banks—
money center banks—borrow for their funding instead of
relying on deposits. However, the recent credit crisis has
forced money center banks to become depository
institutions because they could not sell their commercial
paper or bonds in financial markets that have been greatly
diminished by investors' fear of defaults.
 Bank And Financial Holding Companies
 Many of the largest banks are actually bank holding
companies, which is a company that controls 2 or more
banks. A holding company is a company whose only
purpose is to own a controlling interest in other
companies. A bank holding company can more easily
expand its market through acquisitions than a bank can.
The Bank Holding Company Act of 1956 requires that
bank holding companies register with the Board of
Governors of the Federal Reserve System. A 1966
amendment to the Act set standards for acquisitions and a
1970 amendment restricted bank holding companies to
banking.
 Another benefit enjoyed by bank holding companies is the
removal of the geographic restriction imposed by most
state laws on banks that required all branches of a bank to
be within a certain geographic location. The advantages of
bank holding companies are evidenced by the fact that, in
2000, 76% of banks were owned by bank holding
companies.
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 The Financial Services Modernization Act of
1999 deregulated the financial industry even more by
creating the legal entity known as the financial holding
company that can control banks, securities firms, and
insurance companies. Previous to this Act, banks were
restricted to banking by the Glass-Steagall Act of
1933 and the Bank Holding Company Act. The primary
purpose of restricting banks to banking is to limit their risk
because the federal government insures their customers'
deposits and because solvent banks are essential to any
modern economy as best evidenced by the 2007-2009
credit crises. Consequently, for a bank holding company to
qualify as a financial holding company, its subsidiaries
must be well managed and well capitalized. All of its
depository institutions must have satisfactory Community
Reinvestment Act (CRA) ratings, which requires banks to
lend back to the community of its depositors. The bank
holding company must register with the Federal Reserve,
declaring and certifying that it is qualified as a financial
holding company under the Act.
 The largest financial holding company is J.P. Morgan Chase
& Co., with assets totaling $2.1 trillion in 2009. According
to the Federal Reserve, at the end of 2007, the top 10
banks held 53% of all assets held by banks, while the top
100 banks held 80%.
 Conclusion
 The deregulation of financial institutions caused many to
take outsized risks in the hope of earning huge profits.
Many took these risks because they considered
themselves too big to fail and because they could pass
their credit default risks to investors of their securitized
loans. Of course, it was deregulation that allowed these
companies to become so large, so the government could
not allow them to fail since it could cause many other
financial institutions to fail through a domino effect caused
by credit default swaps. Consequently, many governments
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were forced to pump trillions of dollars into their banks
and their economy to prevent a death spiral of deflation
caused by limited credit. There will probably be more
restrictions on banks in the future to limit their risk both to
themselves and to the economy. One thing that seems
certain is that the different regulatory agencies will be
consolidated to prevent banks from shopping around for
the most lenient regulator.
(15)
A financial market is a market in which financial assets (securities) can be purchased or sold
 Financial markets facilitate financing and investing by households, firms, and
government agencies
 Participants that provide funds are called surplus units (suppliers of funds) e.g.,
households, investors…
 Participants that enter markets to obtain funds are deficit units
(demanders of funds) e.g., government, companies…
 A major participant in financial markets is the Fed, because it controls the money
supply
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