Meeting 2
RISK MANAGEMENT: WHY ARE
FINANCIAL INSTITUTION
SPECIAL?
What are FI?
 Non depository
a financial institution that funds their
investment activities from the sale of
securities or insurance
 Depository
a financial institution that accepts deposits
and channels the money into lending
activities
What are the benefit of FI
for economy?












Fulfill Economic Goals
Economic Growth
Price Stable
Full Employment
Reduce Cost of Monitoring
High Liquidity
Reduce Price Risk
Reduced Transaction Costs
Provide Maturity Intermediation or Asset transformation
As Transmission of Monetary Policy
Major Source of Finance (Credit Allocation)
Provide Payment Mechanism
Without FI Function
Equity and
debt claim
HouseHold
Corporation
Cash
World Without FI
With FI Function
FI Function
FI Function
Denomination Divisibility – pool savings of many small SSUs
into large investments.
Currency Transformation – buy and sell financial claims
denominated in various currencies.
Maturity Flexibility – Offer different ranges of maturities to
both DSUs and SSUs.
Credit Risk Diversification – Assume credit risks of DSUs; spread
risk over many different types of DSUs.
Liquidity – Give SSUs and DSUs different choices about when,
to what extent, and for how long to commit to financial
relationships.
 The Functions of Intermediation: Financial intermediation can





improve economic efficiency in at least five ways, by:
1) facilitating transactions
2) facilitating portfolio creation
3) easing household liquidity constraints
4) spreading risks over time; and
5) reducing the problem of asymmetric information.
 Brokerage: Brokerage is acting as an agent to bring buyers and
sellers together in order to complete financial transactions.
 Externalities: Spillover effects, negative or positive, generated
by the actions of financial institutions in particular, and the
financial system in general, are called externalities.
Types of Financial
Institution
 Deposit-type or “Depository” Institutions
 Contractual Savings Institutions
 Investment Funds
 “Other” Institutions
Deposit type institutions
 called depository institutions,
 accept and manage deposits and make loans.
 two types : chartered banks and near banks.
 Chartered banks = large and federally regulated
 Near banks = regulated by a combination of
federal and provincial regulations. Consist of: 1)
trust companies; 2) mortgage loan companies;
and 3) credit unions (caisses populaires in Quebec).
Contractual Savings
Intitutions
 For example : Insurance companies provide
their clients with protection against a variety
of risks, while pension funds manage pension
funds or pension plans such as registered
retirement savings plans (RRSPs), registered
pension plans (RPPs), and public pension
plans.
Investment Fund
 Known as mutual funds, pool funds for
investment in a wide range of activities and
instruments.
 Consumer and business financial
intermediaries (i.e., sales, finance, and
consumer loan companies) and investment
dealers are also included in this category.
Depository Institutions take deposits and make
loans.
Commercial Banks
 Thrift Institutions


Savings & Loan Associations
Savings Banks
 Credit Unions
Copyright© 2006 John Wiley & Sons, Inc.
13
Regulation about FI
 1. Safety and soundness regulation
 2. Monetary policy regulation
 3. Credit allocation regulation
 4. Consumer protection regulation
 5. Investor protection regulation
 6. Entry regulation
Commercial Banks
 Largest single class of financial institution
 Issue wide variety of deposit products -
checking, savings, time deposits
 Carry widely diversified portfolios of loans,
leases, government securities
 May offer trust or underwriting services
Copyright© 2006 John Wiley & Sons, Inc.
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Thrift Institutions
 Closely resemble commercial banks
 Focus more on real estate loans, savings
deposits, and time deposits
Copyright© 2006 John Wiley & Sons, Inc.
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Credit Unions: Unique
Characteristics
 Mutual ownership -“owned” by depositors or
“members”
 “Common bond” - members must share
some meaningful common association
 Not-for-profit and tax - exempt
 Restricted mostly to small consumer loans
Copyright© 2006 John Wiley & Sons, Inc.
17
Contractual Institutions bring long-term savers and
borrowers together.
 Life Insurance Companies
 Casualty Insurance Companies
 Pension Funds
Copyright© 2006 John Wiley & Sons, Inc.
18
Life Insurance Companies insure against lost income at
death.
 Policyholders pay premiums, which are
pooled and invested in stocks, bonds, and
mortgages
 Investment earnings cover the costs and
reward the risks of the insurance company
 Investments are liquidated to pay benefits.
Copyright© 2006 John Wiley & Sons, Inc.
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Casualty Insurance Companies cover property against loss or
damage.
 Sources and uses of funds resemble those of
life insurers, but
 Casualty claims are not as predictable as
death claims; so
 More assets are in short-term, easily
marketable investments
Copyright© 2006 John Wiley & Sons, Inc.
20
Pension Funds help workers plan for retirement.
 Workers and/or employers make
contributions, which are pooled and invested
in stocks, bonds, and mortgages
 Net of administrative costs, investment
earnings are reinvested and compounded
 Retirement benefits replace paychecks (at
least partly)
Copyright© 2006 John Wiley & Sons, Inc.
21
Investment Funds help small investors share the benefits of
large investments.
 Mutual Funds provide intermediated access to
various capital markets
 shareholders’ money is pooled and invested in
stocks, bonds, or other securities according to
some objective
 Money Market Mutual Funds (“MMMFs”) are
uninsured substitutes for deposit accounts
 MMMFs buy money market instruments
wholesale, pay investors interest, and allow
 limited check-writing
Copyright© 2006 John Wiley & Sons, Inc.
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“Other” Financial
Institutions
 Finance Companies—
Make loans but do not take deposits; raise
loanable funds in commercial paper market and
from shareholders
 Federal Agencies—
Issue “agency securities” backed by government
and lend at sub-market rates for favored social
purposes
Copyright© 2006 John Wiley & Sons, Inc.
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Copyright© 2006 John Wiley & Sons, Inc.
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Financial Markets are classified in
several ways.
 Primary and Secondary
 Organized and Over-the-Counter
 Spot and Futures
 Options
 Foreign Exchange
 International and Domestic
 Money and Capital
Copyright© 2006 John Wiley & Sons, Inc.
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Primary and Secondary Markets
 Primary markets are where financial claims are
“born”: DSUs receive funds, claims are first
issued
 Secondary markets are where financial claims
“live”—are resold and repriced

Claims become more liquid because SSUs
 can set their own holding periods
 Trading sets prices and yields of widely held
securities
Copyright© 2006 John Wiley & Sons, Inc.
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Organized and Over-theCounter Markets
 Organized Exchanges: physical, relatively
exclusive.
 Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
 New York Stock Exchange
 Chicago Board of Trade (futures)
OTC Markets: virtual, relatively inclusive.
 Decentralized network available to any licensed dealer
willing to buy access and obey rules, for wide range of
securities.
2006 John
Wileymarket.
& Sons, Inc.
 The NASDAQ is aCopyright©
famous
OTC
27
Spot and Futures Markets
 Spot Markets: immediate payment for
immediate delivery
 Futures or Forward Markets: immediate
payment for promise of future delivery
“Futures” contracts: standardized as to amounts,
forms, and dates; trade on organized exchanges
“Forward” contracts: individualized between
parties with particular needs
Copyright© 2006 John Wiley & Sons, Inc.
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Option Markets
 Rights in underlying securities or commodities—
writer grants owner some exclusive right for
some certain time
 Main types of options: Puts (options to sell)
Calls (options to buy)
 Options on listed securities and widely held
commodities trade actively on organized
exchanges
Copyright© 2006 John Wiley & Sons, Inc.
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Foreign Exchange Markets
 Any currency is convertible to any other at some
exchange rate
 “Forex” involves spot, future, forward, and
option markets
Copyright© 2006 John Wiley & Sons, Inc.
30
International and Domestic
Markets
 Help participants diversify both sources and uses
of funds
 Examples of major international markets:
Eurodollars—US dollars deposited outside U.S.
Eurobonds—bonds issued outside US but
denominated in $US
Copyright© 2006 John Wiley & Sons, Inc.
31
Money and Capital Markets
 Money markets: wholesale markets for short-
term debt instruments resembling money itself
 Capital markets: where “capital goods” are
permanently financed through long-term
financial instruments
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)
Copyright© 2006 John Wiley & Sons, Inc.
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Money Markets
 Help participants adjust liquidity—
 DSUs borrow short-term to fund current
operations
 SSUs lend short-term to avoid holding idle cash
 Common characteristics of money market
instruments—




Short maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)
Dealer/OTC more than organized exchange
Copyright© 2006 John Wiley & Sons, Inc.
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Examples of Major Money Market
Instruments
 Treasury Bills
 Negotiable Certificates of Deposit
 Commercial Paper
 Federal Funds (“Fed Funds”)
Copyright© 2006 John Wiley & Sons, Inc.
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Capital Markets
 Help participants build wealth
DSUs seek long-term financing for capital projects
SSUs seek highest possible return for given risk
 Differences from money markets—
Long maturities (5 to 30 years)
Less liquidity
(secondary markets active but more volatile)
Higher risk in most cases
(with higher potential yield)
Traded “wholesale” and “retail” on organized
exchanges and in OTC markets
Copyright© 2006 John Wiley & Sons, Inc.
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Examples of
Major Capital Market Instruments
 Common stock
 Corporate bonds
 Municipal bonds
 Mortgages
Copyright© 2006 John Wiley & Sons, Inc.
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Copyright© 2006 John Wiley & Sons, Inc.
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Efficiency in financial
markets
 Allocational Efficiency: highest/best use of funds
 DSUs try to fund projects with best cost/benefit ratios
 SSUs try to invest for best possible return for given
maturity and risk
 Informational Efficiency: prices reflect relevant
information
 Informationally efficient markets reprice quickly on
new information;
 informationally inefficient markets offer opportunities
to buy “underpriced” assets or sell “overpriced” assets
 Operational Efficiency: transactions costs minimized
Copyright© 2006 John Wiley & Sons, Inc.
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Risks of Financial
Institutions
 Credit or default risk: risk that a DSU may not
pay as agreed
 Interest rate risk: fluctuations in a security's
price or reinvestment income caused by changes
in market interest rates
 Liquidity risk: risk that a financial institution may
be unable to disburse required cash outflows,
even if essentially profitable
Copyright© 2006 John Wiley & Sons, Inc.
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Risks of Financial
Institutions, cont.
 Foreign exchange risk: effect of exchange rate
fluctuations on profit of financial institution
 Political risk: risk of government or regulatory
action harmful to interests of financial
institution.
Copyright© 2006 John Wiley & Sons, Inc.
40
Things to do>>>
 Make a group report about Basel (Bank for
International Settlement) and its relation
with Risk Management in Bank
 Times New Roman, 12, 1.5 space, not more
than 5 pages.
CHAPTER 1
Why Are Financial Institutions Special?
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Why Are Financial Intermediaries
Special?
 Objectives:
 Explain the special role of FIs in the financial system and
the functions they provide
 Explain why the various FIs receive special regulatory
attention
 Discuss what makes some FIs more special than others
 Explain the crisis in financial markets
1-43
Without FIs
Equity & Debt
Households
Corporations
(net savers)
(net borrowers)
Cash
1-44
FIs’ Specialness
 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
1-45
With FIs
FI
Households
(Brokers)
Corporations
FI
Cash
(Asset
Transformers)
Equity & Debt
Deposits/Insurance
Policies
Cash
1-46
Functions of FIs
 Brokerage function
 Acting as an agent for investors:
 e.g. Merrill Lynch, Bank of America
 Reduce costs through economies of scale
 Encourages higher rate of savings
 Asset transformer:
 Purchase primary securities by selling financial
claims to households
 These secondary securities often more marketable
 Transformation of financial risk
1-47
Role of FIs in Cost
Reduction
 Information costs:
 Investors exposed to Agency Costs
 Role of FI as Delegated Monitor
 FI likely to have informational advantage
 Economies of scale in obtaining information.
 FI as an information producer
 Shorter term debt contracts easier to monitor than
bonds
 Greater monitoring power and control
 Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders
1-48
Specialness of FIs
 Liquidity and Price Risk
 Secondary claims issued by FIs have less price risk
 Demand deposits and other claims are more liquid
 More attractive to small investors
 FIs have advantage in diversifying risks
1-49
Other Special Services
 Reduced transactions costs
 Maturity intermediation
 Transmission of monetary policy.
 Credit allocation (areas of special need such as
home mortgages)
 Intergenerational transfers or time intermediation
 Payment services (FedWire and CHIPS)
 Denomination intermediation
1-50
Specialness and Regulation
 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.
1-51
Regulation of FIs
 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
1-52
Regulation
 Safety and soundness regulation:
 Regulations to increase diversification
 No more than 10 percent of equity to single
borrower
 Minimum capital requirements
 TARP and Capital Purchase Program
1-53
Regulation
 Guaranty funds:
 Deposit insurance fund (DIF):
 Securities Investors Protection Fund (SIPC)
 Monitoring and surveillance:
 FDIC monitors and regulates DIF participants
 Increased regulatory scrutiny following crises
 Regulation is not costless
 Net regulatory burden
1-54
Web Resources
 For information on regulation of DIs and
investment firms visit:
FDIC www.fdic.gov
SIPC www.sipc.org
Federal Reserve www.federalreserve.gov
Appendix 1B of text
www.mhhe.com/saunders7e
1-55
Regulation
 Monetary policy regulation
 Federal Reserve directly controls outside money
 Bulk of money supply is inside money (deposits)
 Reserve requirements facilitate transmission of
monetary policy
1-56
Regulation
 Credit allocation regulation
 Supports socially important sectors such as
housing and farming
 Requirements for minimum amounts of assets in a
particular sector or maximum interest rates or fees
 Qualified Thrift Lender Test (QTL)
 65 percent of assets in residential mortgages
 Usury laws and Regulation Q (abolished)
1-57
Regulation
 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
1-58
Consumer Protection
Regulation
 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
1-59
Regulation
 Investor protection regulation
 Protections against abuses such as insider trading,
lack of disclosure, malfeasance, breach of
fiduciary responsibility
 Key legislation
 Securities Acts of 1933, 1934
 Investment Company Act of 1940
1-60
Regulation
 Entry regulation
 Level of entry impediments affects profitability
and value of charter.
 Regulations define scope of permitted activities
 Financial Services Modernization Act of 1999
 Affects charter value and size of net regulatory
burden
1-61
Web Resources

For more information on regulation of
depository institutions visit:
FFIEC www.ffiec.gov
Federal Reserve www.federalreserve.gov
FDIC www.fdic.gov
OCC www.occ.treas.gov
1-62
Changing Dynamics of Specialness
 Trends in the United States
 Decline in share of depository institutions and
insurance companies
 Increases in investment companies
 May be attributable to net regulatory burden
imposed on depository FIs
 Financial Services Modernization Act
 Financial services holding companies
1-63
Risk and the Financial
Crisis
 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
1-64
Global Trends
 US FIs facing increased competition from
foreign FIs
 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
1-65
Largest Banks
1-66
Financial Crisis
 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
1-67
Financial Crisis
 AIG bailout
 Citigroup needed government support
 Chrysler and GM declared bankruptcy in 2009
 Unemployment in excess of 10 percent
1-68
Beginning of the Collapse
 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
1-69
Significant failures and
events
 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
1-70
Rescue Plan
 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
1-71
Pertinent Websites
The Banker
Federal Reserve
FDIC
FFIEC
Investment Co. Institute
OCC
SEC
SIPC
Wall Street Journal
www.thebanker.com
www.federalreserve.gov
www.fdic.gov
www.ffiec.gov
www.ici.com
www.occ.treas.gov
www.sec.gov
www.sipc.org
www.wsj.com
1-72