introduction on financial institutions

7/28/2019 Introduction on Financial Institutions

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FINANCIAL INSTITUTIONS



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Economic System

Economic System deals with procurement

of right amount of scarce resources toprovide the raw materials of production andcombining the same at the right time withlabor, management, and capital to

generate the products and servicesdemanded by the consumers.



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Economic System

In short, any economic system must

combine inputs- land and other naturalresources, labor and management skill, andcapital equipment – to produce output:goods and services.



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A Transformation of the Economy

TYPE OF INPUTS PROCESS OUTPUTS INNOVATION

ECONOMY

AGRICULTURE

INDUSTRIAL

INFORMATION

• LAND, LABOR

• CAPITAL

• LAND, LABOR

• CAPITAL

• ENTREPRENEURS

• TECHNOLOGY

• LAND, LABOR

•

CAPITAL• ENTREPRENEURS

• TECHNOLOGY

• INFORMATION

• KNOWLEDGE

• CULTIVATION

• MANUFACTURING

• PROCESSING

• MANIPULATION

•

CONTROL

• CROPS

• CAPITAL

ASSETS

• INDUSTRIES

• PHYSICAL

PRODUCTS

• KNOWLEDGE

PRODUCTS• KNOWLEDGE

INDUSTRIES

• KNOWLEDGE

CAPITAL

• USE OF

ANIMALS

• MECHANISATION

• MECHANISATION

• RESEARCH (S & T)

• SPECIALIZATION

• INFORMATINALISM

•

VIRTUALPROCESSES

• NETWORKS



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Financial System

The financial system provides the essential

channel necessary for the creation andexchange of financial assets betweensavers and borrowers so that real assetscan be acquired.



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Primary functions of financial systems.

To facilitate the trading, hedging, diversifying andpooling of risks;

To allocate resources;To monitor managers and exert corporate control;

To mobilize savings;

To facilitate the exchange of goods and services;

To accumulate capital and promote technologicalinnovation.



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Primary functions of financial systems Contd.

The financial system determines both the costof credit and how much credit will be available

to pay for the thousands of different goodsand services that are transacted daily.



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Market

In most economies around the world, marketsare used to carry out this complex task of allocating resources and producing goods andservices. Market is an institution set up bysociety to allocate resources that are scarcerelative to the demand for them. Markets are

the channel through which buyers and sellersmeet to exchange goods, services andresources.



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Market

There are essentially three types of markets atwork within the economic system. These are:

Factor markets;

Product markets, and

Financial markets.



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Factor Markets

In factor markets, consuming units sell theirlabor and other resources to those producing

units offering the highest prices. The factormarkets allocate factors of production – land,labor, and capital – and distribute income-wages, rental payments , and so on – to theowners of productive resources.



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Product Markets

In product markets – consuming units usemost of their income from factor markets.

They buy, among other things, food, clothing,shelter, automobiles, Medicare and otherservices sold in product market.



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Financial Market

The financial market performs a vital functionswithin the economic system. The financial

market channel savings to those individualsand institutions needing more funds forspending that could not be met out of theircurrent income.



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Types of Financial Transactions

Direct finance- there is no intermediarybetween borrower and lender;Semi-direct finance- there exists anintermediary for a very brief period butultimate obligation between the borrower andlender, andIndirect finance- no relationship exists

between the ultimate borrower and lender. Allrisks including credit risks are borne byintermediary.



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Categories of Financial assets

Cash and bank deposit; –

Quoted govt. stock & bonds;

Quoted corporate shares & bond;Mutual fund/unit trust units

Security of unlisted companies

Unquoted stock and bonds;Derivatives.



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Features of Financial Instruments

A form of document;

Marketable/liquid

Have general acceptability as a store of value;

Debt instruments require credit rating;

Secured by charge of substantial assets;Generally made homogenous;

Easily understandable;

Standard form;

Standard issuer’s obligation;

Quality and price of instrument is known.



Types of Shares

Ordinary Shares

Preference shares



Smallest unit of capital.variable-income security since dividend is notspecified and guaranteed and declaration of which depends on board of directors.

dividends may be increased or decreased,depending on earnings.

represents equity or ownership.

includes voting rights.

Priority: lower than debt and preferred.

Bundle of shares is called stock.

Ordinary Shares/Stock



Components of Shareholders Equity

Book Value Formula:

Cumulative retained earnings

+Capital Contributed in

excess of par i.e premium

+ face value/paid up value

BOOK VALUE OF THE EQUITY



A hybrid security:

it’s like common stock - no fixedmaturity.

technically, it’s part of equity capital.

it’s like debt - preferred dividends arefixed.

missing a preferred dividend does notconstitute default, but preferreddividends are cumulative.

Priority lower than debt security buthigher than ordinary shares.

Preferred/Preference Shares



Preference Shares

Cumulative preference sharesNon-cumulative preference shares

Redeemable preference shares;

Non-redeemable preference shares;Convertible preference shares;

Non-convertible preference shares;

Participating preference shares;Non-participating preference shares.



Rights of Ordinary Shareholders as specified inCompanies Act, 1994

Right to request a copy of the M/A and acopy of A/A by paying taka fifty or lesserfee as may be fixed by the company and

company shall within fourteen days fromthe date of request send the copy to themember.



Debenture/Bonds

Means a financial obligation of an entity that promises to pay aspecified sum of money at specified future date under statedconditions.

Debenture- the smallest unit of unsecured loan

Bond- the smallest unit of secured loan.

Liabilities, or “publicly traded IOUs”

Also called “ fixed income securities ” since payments are fixedamounts

Borrower agrees to repay a fixed amount of principal at apredetermined maturity date

Borrower agrees to pay a fixed amount of interest over a specifiedperiod of time



Attributes that affects bond’s value

Length of Time to Maturity

Coupon Rate

Call ProvisionsTax Status

Marketability

Likelihood of Default



Bonds Versus Stocks

Compared to stocks, bonds offerlower returns

Main benefits of bonds in portfolio: Lower risk High levels of current income Diversification

Bonds add an element of stability toa portfolio



Bonds and Risk

Interest Rate Risk is the chance that changes ininterest rates will affect the bond’s value

Purchasing Power Risk is the chance that bond yieldswill lag behind inflation rates

Business/Financial Risk is the chance the issuer of thebond will default on interest and/or principal payments

Liquidity Risk is the risk that a bond will be difficult tosell at a reasonable price

Call Risk is the risk that a bond will be “called” (retired)before its scheduled maturity date



Essential Features of a Bond

Coupon is the amount of annual interest income

Principal (par value) is the amount of capital that mustbe repaid at maturity

Maturity Date is the date when a bond matures and theprincipal must be repaid

Term Bond is a bond that has a single maturity date

Serial Bond is a bond that has a series of differentmaturity dates

Note is a debt security originally issued with a maturity of from 2 to 10 years



Essential Features of a Bond (cont’d)

Call feature allows the issuer to repurchase the bondsbefore the maturity date Freely callable Noncallable Deferred call

Call premium is the amount added to bond’s par valueand paid upon call to compensate bondholders

Call price is the bond’s par value plus call premium

Refunding provision prohibits the premature retirementof an issue from proceeds of a lower-coupon refundingbond



Essential Features of a Bond (cont’d)

Sinking fund stipulates how a bond willbe paid off over time

Applies only to term bonds

Issuer is obligated to pay off the bondsystematically over time



Types of Secured Debt

Secured debt is backed by pledgedcollateral.

Senior bonds are backed by legal claim to

specific assets.Mortgage bonds are backed by real estate.

Collateral trust bonds are backed by securities(stocks, bonds) held in trust by a third party.

Equipment trust certificates are backed by specificpieces of equipment, such as railcars or airplanes.



Types of Unsecured Debt

Unsecured debt is backed only by thepromise of the company to pay.

Junior bonds are backed only by promise and

good faith of the issuer to pay.Debenture is an unsecured (junior) bond.

Subordinated debentures are unsecured bondswhose claim is secondary to other claims.

Income bond requires interest to be paid onlyafter a specific amount of income has beenearned.



Principles of Bond Price Behavior

Price of a bond is a function of its coupon rate, itsmaturity, and market movements in interest rates.

Longer maturities move more with changes ininterest rates.

Premium bond has a market value that is above par value. Occur when market interest rates are below bond’s coupon rate

Discount bond has a market value that is below par value. Occur when market interest rates are above bond’s coupon rate



The Market for Debt Securities

Bonds are traded mainly over-the-counter.

Bond price activity is remarkably stablecompared to stock market.

Bond market is larger than thestock markets of numbers of developed

jurisdictions

Bond market is growing rapidly.



Treasury Bonds

Considered risk free —no risk of default

Sold in Tk 100,000 denominations

Types of Treasury Bonds

Govt/Treasury notes: mature in over 1year to 10 yearscoupon bearing

Treasury bills: mature in 4 weeks to one year issued atdiscount

Govt. Bonds: over 10 years either coupon bearing or

deep discount



Agency Bonds

Issued by government agencies

House Building Finance Corporation Bond

Biman Bangladesh Corporation Bond;

Agrani Bank Industrial Bond etc.

High quality securities with almost no risk of default

Interest rates usually higher than

Treasury issues



Municipal BondsIssued by states, counties, cities, city

corporations and any other political subdivision orlocal authority

Issued to fund public projects

Two basic types General obligation bonds are paid from general fund of

the issuer

Revenue bonds are paid from revenues from theproject being financed

Often guaranteed by private insurers to lower risk and interest rates



Municipal Bonds

Interest is tax-exempt for Federal taxes.

Interest can be tax-exempt from state taxes

Taxable equivalent yield =

Yield on municipal bond

1 - Federal tax rate



Corporate Bonds

Issued by companies registered under theCompanies Act, 1994

Provide higher returns than governmentbonds due to higher risk of default

Wide variety of bond quality and bondtypes available



Zero-Coupon Bonds

Do not pay interest

Sold at deep discount from par value

Value increases over time

Subject to tremendous price volatility as interestrates fluctuate

Interest must be reported as it is accrued for taxpurposes, even though no interest is actuallyreceived.



Mortgage-Backed Securities

Bond backed by pool of residential mortgages

Principal and interest are paid monthly

Governmental agencies are major issuers:

In USA following authorities issue these types of securities:

Government National Mortgage Association (GNMA)

Federal Home Loan Mortgage Corporation (FHLMC)

Federal National Mortgage Association (FNMA)

Self-liquidating investment since portion of principal is

received each month



Collateralized Mortgage Securities

Mortgage-back bond pool that is divided into“tranches,” or classes of investors

All principal payments go first to the shortest

tranche until it is fully retired, then the next insequence is paid

Allows investors to choose short-term, medium-term or long-term investment

Potentially complex; interest rate fluctuations mayhave significant impact upon bond prices

Asset-Backed Securities



Asset-Backed SecuritiesIssued by corporations and backed by poolsof loans Auto loans Credit card loans Home equity loans

Provide relatively high yields

Short maturities, typically 3 to 5 years

Interest and principal payments are monthly

High credit quality

In Bangladesh number of financial institutionsissued asset backed securities obtaining consentfrom SEC Bangladesh



Junk Bonds (High-Yield Bonds)

Highly speculative, usuallysubordinated debentures

Have low, sub-investment grade ratings

Typically offer very high yields

Prices tend to behave more like stocks

than bonds



Global Bonds

Potentially higher returns than bondsissued at local jurisdictions

Offer broader diversification opportunities

Interest rate trends in other countries maynot follow home country rates

Currency exchange rate fluctuations canimpact returns in local currency



Dollar-Denominated Bonds

Bonds issued by foreign governments orcorporations and denominated in dollars

Based on U.S. dollars

Yankee bonds are registered with the SEC andissued and traded in U.S.

Eurodollar bonds are not registered with theSEC and are issued and traded outside of the U.S.

No currency exchange rate risk since bonds are inU.S. dollars



Foreign-Pay Bonds

Bonds issued by foreign governmentsor corporations

Based on currency other than U.S. dollars

Subject to currency exchange rate risk



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Cost of financial intermediation

Brokerage cost- fee charged by the broker for executionof order or transaction;

Evaluation cost- cost of feasibility study, inspection,survey carried out by FIs to assess the creditworthiness of the loan applicant or borrower;

Cost of monitoring performance- cost of supervision.Supervision is necessary to ensure that the moneyborrowed has actually been used for the purposed forwhich it was obtained/ sanctioned;

Cost of enforcing the contract –

litigation cost forenforcing the contract.



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Risk Free Assets - Features

Fixed Income- there is certainty of return;

No possibility of default- the borrower will be

able to pay back the principal and pay interest;No interest rate risk – interest rate is fixed; and

No reinvestment risk – interest or returnreceived could be invested at rate similar to

original investment.



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Risk Free Assets

An investment with a certain rate of return andno chance of default. Although various

investment [for example, saving accounts andcertificates of deposit at insured institutions] meetthese requirements, a Treasury bill is the mostcommon example of risk free investment.



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Risk Premium

The extra yield over the risk free rate owing tovarious types of risk inherent in a particular

investment. For example, any issuer other thanthe Govt. usually must pay investors a risk premium in the form of a higher interest rate onbonds/loans to account for the fact that the risk

of default is less on Govt. securities than onsecurities of other issuers.



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Investment

Property acquired for the purpose of producingincome for the owner. Just as plants and

equipment are investment for manufacturers,stocks and bonds are investments for individualsand institutions. Investment is essentiallyexpenditures made for income producing assets.



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Types of Investor

True Investor – investment held for a lengthened period for getting dividendand/ or capital gain;

Speculator- A person who is willing to take a large risks and sacrifice thesafety of principal in return for potentially large gains. Certain decisionsregarding securities clearly characterize a speculator. For example,purchasing a very volatile stock in hopes of making a quick profit based onspeculation.

Arbitrageur-one who engages in arbitrage. Arbitrage is the simultaneouspurchase and sale of substantially identical assets in order to profit from aprice difference between two assets. The price difference must be sufficientlygreat to offset commissions.

Hedger- one who engages in security transaction that reduces the risk on analready existing investment position. An example is the purchase of a putoption in order to offset at least partially the potential losses from ownedstock.



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Efficient Market -Features

Allocationally Efficient i.e distributes funds to themost promising investments;

Internally efficient i.e.

- Broker/dealer compete fairly;

- Low transaction cost;

- High speed transactions

By searching for inefficiencies, investor ensuremarket efficiency.

A i I f i



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Asymmetric Information

Asymmetric information: Much of the information usedto value securities issued by firms is provided by themanagers of those firms. A firm’s managers possessinformation about its financial condition that is notnecessarily available to investors. This situation is referred

to as asymmetric information.In an information asymmetry situation one party doespossess insufficient knowledge about the other partyinvolved in a transaction that result in inaccurate decisionon his part. Asymmetric information problems occur

before the transaction occurs.

A t i I f ti



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Asymmetric Information

Due to information asymmetry investormakes adverse selection i.e. choosesalternative investment opportunity that is

not the best alternative investmentopportunity; meaning the investment mightbe a bad credit risks in the market placethat would result moral hazard.

M



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Money

A generally accepted medium for the exchange of goods and services, for measuring value, or makingpayments. Money is a legal tender as defined by a

government and consisting of currency and coin. In amore general sense, money is synonymous withcash, which includes negotiable instruments, such aschecks, based on bank balances.

E l ti f



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Evolution of money

Barter system;

Precious gem/pearl;

Gold/ silver;

Paper money;Electronic money-smart card, credit/debit card;

Cyber cash- where a customer can have moneytransferred from his normal bank account to an

electronic money account.

F ti f M



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Functions of Money

Standard of value or unit of account;

Medium of exchange;

Store of value;

Only perfectly liquid asset.



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Money Supply

The amount of money that is in circulation in an

economy. There are alternative definition of moneysupply. Narrow definitions of money include assets

that immediate liquidity. Broad definitions of moneyinclude assets that are somewhat less liquid. Variousdefinitions/alternative forms are- Mo, M1, M2, M3,M4 and M5.



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Alternative forms of money

M0: Currency plus till money plus operational balance with reserve bank;M-1: The most restrictive measure of the domestic money supply thatincorporates only money that is ordinarily used for spending on goods andservices. M1 includes currency, checking account balances, and travelerschecks.M-2: A measure of the domestic money supply that includes M-1 plus

saving and time deposits, overnight repurchase agreements and personalaccounts of money market accounts. Basically, M2 includes money thatcan be used for spending plus items that can quickly be converted to M1.M-3: A very broad measure of domestic money supply that includes M-2items plus any large time deposits and money market fund balances heldby institutions.L: M-3 plus other liquid assets viz. Treasury bills, saving bonds,

commercial papers, banker’s acceptances, Eurodollar holdings citizens.

Money Market



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Money Market

The money market is a market for financialassets that are close substitutes for money

and that mature in one year or less. Itsbasic function is to maximize thesatisfaction of financial asset holders anddebt issuers.

Money Market Contd



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Money Market Contd.

It is a market for short term debt instruments,negotiable certificates of deposit, commercial

paper, banker’

acceptances, repurchaseagreements, Treasury bills, and discount notes of the Quasi Sovereigns. These instruments havebetter safety and liquidity over capital marketinstruments.



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Money Market Contd.

Money markets trade instruments with maturities< 1 year

Market segments include

Interbank market (clearing or settlement balances)

Overnight market (secured/unsecured call loans &repos)

Term market (Treasury bills, bankers acceptances,

commercial paper, asset-backed commercial paper,term repos, etc.)

INTERBANK MARKET

Funds held immediately prior to final settlement to enable banks

to meet obligations to each other and to the central bank. Only

institutions with accounts at the CB & the CB participate

Initial impact of Indirect Monetary

Policy Instruments



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institutions with accounts at the CB & the CB participate.

CALL LOAN or REPO MARKETMarket for funds with overnight maturity.

Transactions take place during the day. Banks

and large organizations participate.

TERM MONEY MARKET

Market for funds with maturities >1 day and<1 year. Includes secondary market in T-bills

& other paper. Banks & large financial

organizations participate.

y

BOND MARKET

Market for paper of over 1 year remaining to

maturity. Banks and other financial and

institutional investors participate.

PRIMARY MARKET

Initial sale of T-bills by the

Government’s agent, usually the CB.

Sold by auction or tap issue.

PRIMARY GOVERNMENT BOND

MARKET

Initial sale of government bonds by

Government’s agent, usually the CB.

Sold by auction or tap issue.

FOREIGN

EXCHANGE

MARKET

Liquidity of the Money Market

affects the functioning of the Fore

Exchange Market.

Money Market liquidity and stab

affects the liquidity of the Bond

Market.

R h A t [R ]



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Repurchase Agreement [Repos]

A word about repos

“Buyer ” agrees to buy securities from the “seller ” for a pre-

specified period of time, with an agreement upfront to resell them

back to the “seller ” at the pre-specified future date at a pre-agreed

resale price.

Difference between initial price and resale price reflects interest

rate paid by “seller ” for use of cash received.

In effect, repos are equivalent to a collateralized loan

Most transactions conducted under a single legal agreementbetween two parties—Master Repurchase Agreement

B fit f M M k t



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Benefits of Money Markets

More effective monetary policy

Promote financial stability & market development

Reduce cost of government borrowing

Benefits: More effective monetary policy



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Desired liquidity settings can be achieved without distorting

prevailing market prices

First step of transmission of monetary actions to economy

Money market interest rates are a useful indicator of market

expectations regarding future monetary actions

B fit P t fi i l t bilit & k t d l t



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Benefits: Promote financial stability & market development

Help financial institutions manage their short-term liquidity flows

Facilitate development of well-functioning debt, equity, and foreign

exchange markets

Money markets enable market makers in other markets to fund

their holdings of securities and foreign exchange so they can trade

with other participants

Benefits: Reduce cost of Govt borrowing



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Benefits: Reduce cost of Govt. borrowing

Existence of liquid debt markets

Reduce risk of auction failure (more certainty in funding)

Lower borrowing costs (government captures liquidity premia)

Financial Institutions



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Financial Institutions

The institution that collect funds from thepublic to place in financial assets such as

stocks, bonds, money market instruments,bank deposits, or loans.

Financial institutions profit from the spreadbetween the amount they pay for the funds

and the rate they charge for the funds..

Types of Financial Institutions



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Types of Financial Institutions

Depository: banks, savings and loans,saving banks, credit unions.

Non-depository: insurance companies,mutual funds, pension funds.

Characteristics of Depository Financial Institutions



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Characteristics of Depository Financial Institutions

They offer deposit accounts that can accommodate theamount and liquidity characteristics desired by mostsurplus units;

Repackage funds received from deposits to provide loansof the size and maturity desired by deficit units;

Accepts the risk on loans provided;

Have more expertise in evaluating the credit worthiness of deficit units;

Diversify their loans among numerous deficit units and

can absorb defaulted loans better than individual surplusunits.

Characteristics Non-depository Financial Institutions



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Characteristics Non-depository Financial Institutions

Non-depository: Non-depository FIs collects

money by selling insurance policies or receivingemployer contributions and pay it out forlegitimate claims or for retirement benefits.

Many institutions perform both depository andnon-depository functions. For instance, brokeragefirms very often place customers ’ money incertificates of deposit and money market fundsand sell insurance.

The Principal Factors that Affect InvestmentDecision of FIs



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Decision of FIs

The Expected Rate of Return;

Degree of Tax Exposure;

Exposure to Credit or Default Risk;

Exposure to Liquidity Risks;Exposure to Call Risk;

Exposure to Prepayment Risk;

Exposure to Inflation Risk;

Desired Maturity Range.

introduction on financial institutions

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