Arab Academy for Science and TechnologyGraduate School of BusinessMBA- Financial Markets & Institutions

Nonbank Financial Institutions 1

.Non bank financial institutions play an important role in channeling funds from investors (lenders/savers) to end users/ producesrs (borrower –spenders).

The process of financial innovation has increased the importance of nonbank financial institutions.through which the non bank financial institutions now compete with banks by providing financial banklike services to their customers

Non-Banking market institutions:

The financial system has developed a wide variety of financial institutions to provide for specialized financial needs. Many were developed because commercial banks initially did not serve all financial markets. In particular, commercial banks initially concentrate on making commercial loans and serving the needs of commercial customers . This mean that they did not adequately serve the needs of “ small” savers , of home buyers, or borrowers.

Mutual Funds:

Mutual funds are financial intermediaries that pool the resources of many small investors by selling them shares and using the proceeds to buy securities.

I) Open–end fund: from which shares can be redeemed at anytime at a price that is tied to the asset value of the fund.

II) Closed–end fund: in which a fixed number of no redeemable shares are sold at an initial offering and then traded in the over-the-counter market like a common stock .

Pension funds:

In performing the financial intermediation function of asset transformation, pension funds provide the public with another kind of protection: income payments on retirement. Employers , unions , or private individuals can set up pension plans, which acquire funds through contributions paid in by the plan’s participants.

Because the benefits paid out of the pension fund each year are highly predictable , pension funds invest in long-term securities. Therefore , pension fund managers try to hold assets with high expected return and lower risk through diversification.

Insurance Companies

Insurance companies obtain funds by selling insurance policies that protect against loss of income from premature death or retirement. In the event of death, the policyholder’s

1 Excerpts from Chapter “ Nonbank Financial Institutions” of “The Economics of Money , banking & Financial Institutions” by Fredric S. Mishkin, 4th Edition

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Arab Academy for Science and TechnologyGraduate School of BusinessMBA- Financial Markets & Institutions

beneficiaries receive the insurance benefits, and with retirement the policyholder receives the benefits. In addition to risk protection, many life insurance policies provide some savings.

Because life insurance companies have a predictable inflow of funds and their outflows are actuarially predictable, they are able to invest primarily in higher yielding, long term assets , such as corporate bonds and stocks. Stock companies are owned by stockholders; mutual are technically owned by policyholders. Life insurance companies are regulated by the states in which they operate, and, compared to deposit-type institutions , their regulation is less strict

Securities market institutions:

The smooth functioning of securities markets, in which bonds and stocks are issued and traded , involves several financial institutions , including securities brokers and dealers , investment banks , and organized exchanges. They are important in the process of channeling funds from savers to spenders. Investment banks assist in the initial sale of securities in the primary market ; securities brokers and dealers assist in the trading of securities in the secondary markets.

Investment banks:

When a corporation wishes to raise funds , its normally hires the services of an investment bank to help sell its securities. Some of the well-known investment banking firms are Morgan Stanley , Merrill Lynch & Salomon Brothers. They advise the corporation on whether it should issue bonds or stock. When the corporation decides which kind of financial instrument it will issue , it offers them to underwriters – investment banks that guarantee the corporation a price on the securities and then sell them to the public.

Securities Brokers and (Dealers)

Security Brokers conduct trading in secondary markets. Brokers are pure middlemen who act as agencies for investors in the purchase or sale of securities. Their function is to match buyers with sellers, a function for which they are paid brokerage commotion. In contrasts to brokers, dealers link buyers by standing ready to buy and sell securities at given prices. Therefore dealers hold inventories of securities and make their living by selling these securities for a silently higher price than they paid for them- that is, on the “spread” between the asked price and the bid price. This can be a high-risk business because dealers hold securities that can rise or fall in price; in recent years, several firms’ specialization in bonds have collapsed. Brokers by contrast, are not as exposed to risk because they do not own the securities involved in their business dealings.

Organized Exchanges

Secondary markets can be organized either as over-the-counter markets, in which trades are conducted using dealers, or as organized exchanges, in which trades are conducted in one central location.

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Arab Academy for Science and TechnologyGraduate School of BusinessMBA- Financial Markets & InstitutionsOrganized stock exchange actually function as a hybrid of an auction market (in which buyers and sellers trade with each other in a central location) and a dealer market (in which dealers make the market by buying and selling securities at given prices). Securities are traded on the floor the exchange with the help of a special kind of dealer-broker called a specialist.

Clearing, Settlement , Central Depository& Custody for Securities:

1. Clearing agent: the institution role is to accept , record and report trade obligation received from the trading source. The Clearing Agent should maintain lists of failed obligations , calculate , monitor, and manage risk. In addition , the settlement instructions should be prepared with delivery of securities taking place on settlement date. Any default situations as a result of insufficient securities or insufficient funds need to be managed and resolved promptly without injury to either buyer or seller. To sum up , Clearance proves that the buyer and seller are committed for the transaction.

2. Depositary: the depository should act as custodian of the securities on behalf of its members and should report activity and closing position information. Corporate Action announcements and payments should also be a part of this functionality. Book entry transfer of security positions must be allowed on a delivery versus payment basis.

3. Registry: this entity maintains the books and records of the shareholders on behalf of its issuers and provides corporate action announcement and payment information to the investors and to the depository. The Registry provides any change in ownership information, such as name and address changes as well.

4. Settlement: the role of this process is to make sure that the cash was transferred to seller and securities was transferred to the buyer.

Securitization companies

Securitization of assets refers to the issuance of securities that have a pool of assets as collateral. The Securitization of home mortgage loans to create mortgages-backed securities was the first example of this process. More recently, investment banking firms and other private entities can create mortgage-backed securities that are not guaranteed by the government or a government agency.

Financial leasing companiesFinancial leasing companies are defined to mean non-banking financial institutions that engaged primarily in financial leasing operations. “Financial leasing operations” are defined to mean transactions wherein the Lessor purchases equipments to be leased from the seller based on the lessee’s selection of the seller and the equipments to be leased, provides the equipments to the lessee and collects rentals from the lessee. The transaction lets the lessee obtain the rights of possession, use and benefit of the leased equipments during the term of the leasing contract under the condition that the Lessor retains ownership and collects rentals.

Rating AgenciesTheses agencies provide creditworthiness reporting on companies that intend to issue bonds. The rating could be of the issue or the issuer. Following is the international symbols used by rating agencies.

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Arab Academy for Science and TechnologyGraduate School of BusinessMBA- Financial Markets & InstitutionsBond issuers are required to inform their investors of the rating they acquire from rating agencies. The rating report is disclosed as part of the prospectus. The rating is renewed every year to reflect any changes in the creditworthiness of the issuing company.

LONG TERM BOND RATINGS

Moody's S&P Fitch DCR Definitions

Aaa AAAAAA

AAAPrime. Maximum Safety

Aa1 AA+ AA+ AA+ High Grade High QualityAa2 AA AA AAAa3 AA- AA- AA-

A1 A+ A+ A+ Upper Medium GradeA2 A A AA3 A- A- A-

Baa1 BBB+ BBB+ BBB+Lower Medium Grade

Baa2 BBB BBB BBBBaa3 BBB- BBB- BBB-

Ba1 BB+ BB+ BB+ Non Investment Grade

Ba2 BB BB BB SpeculativeBa3 BB- BB- BB-

B1 B+ B+ B+Highly Speculative

B2 B B BB3 B- B- B-

Caa1 CCC+ CCC CCC Substantial Risk

Caa2 CCC - - In Poor StandingCaa3 CCC- - -

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Arab Academy for Science and TechnologyGraduate School of BusinessMBA- Financial Markets & Institutions

Finance companies 2

These companies raise funds by issuing financial tools, stocks, bonds, and use the proceeds to make loans that are particularly suited to consumers and business needs. Virtually unregulated in comparison to commercial banks and thrift institutions, finance companies have been able to tailor their loans to customer needs very quickly and have grown rapidly. Because commercial finance companies typically offer only loans secured by commercial assets, these institutions are used primarily by established businesses, not startups.

There are three types of finance companies

A) Sales finance companies: Are owned by a particular retailing or manufacturing company and make loans to customers to purchase items from that company. Sales finance companies compete directly with banks for consumer loans and are used by consumers because loans can frequently be obtained faster and more conveniently at the location where an item is purchased.

B) Consumer finance companies:Make loans to consumer to buy particular items such as furniture or home appliances. Consumer finance companies are separate corporation or are owned by banks. Typically , these companies make loans to consumers who cannot obtain credit from other sources and charge high interest rates.

C) Business finance companies :Provide specialized forms of credit to business by making loans and purchasing A/R at a discount ; this provision of credit is called factoring. Beside factoring, business finance companies also specialize in leasing equipment , which they purchase and then lease to business for a set number of years.

2 ? The Egyptian Market doesn’t know this type of companies. 5