student notes - chapter 01

Financial Institutions (FIs) 1. Characterization 2. Classification 3. Why needed: specialness of FIs 4. Risk & risk management 5. Negative externalities 6. Regulations 7. Changing dynamics & trends

BU433/633: Chapter 01

FIs: corporate entities whose primary business are financial intermediation activities

Bank Act of Canada (originated in 1871, revised in 1992) defines The Four Pillars of financial intermediation functions as: 1. banking 2. investment banking & securities trading 3. trust or fiduciary 4. insurance


FIs are uniquely different (from other corporate entities) in 5 ways:

1. Business (or operational) focus: business operations overlap with financial focus

2. Accounting (or balance sheet) structure: very high leverage (debt) in capital structure

3. Debt as an instrument: as a strategic business tool

4. Risks & risk management: extensive & different

5. Regulations: far higher degree & wider variety BU433/633: Chapter 01

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i.e. revenues also come from financial activities

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very high debt on liability side -> high-tech firms: debt is 0-10% since revenues are volatile -> "typical" corporations: debt is 40-60% -> financial institutions: debt is 90-95% => risk is very high

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banks issue debt to generate revenues (from mortgage etc.) => debt affects assets

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due to #2,3

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due to high risk

1. Deposit-Taking Institutions: A. Chartered Banks:

Schedule I, II & III banks B. Credit Unions or caisse

populaire

2. Finance Companies

3. Securities & Brokerage Firms and Investment Banks

4. Investment Funds: A. Mutual Funds B. Hedge Funds C. Pension Funds D. Others: Exchange Traded

Funds, Sovereign Wealth Funds, Trusts, etc.

5. Insurance Companies: A. Life Insurance

Companies B. Property & Casualty

Insurance Companies


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I = domestic II, III = foreign

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Chartered Banks: high risk, high regulation Credit Unions: low/no risk, low regulation Note: credit unions give higher rates on deposits! for smaller customers

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non-depository credit/loan agencies i.e. can give loans but cannot accept deposits e.g. credit card companies, OSAP

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pension funds are most regulated, least risk hedge funds are least regulated, take most risks

Each (type) FI is characterized by unique set of A. functions & services offered B. size, structure & composition of industry C. balance sheet structure & recent trends D. risks & risk management E. regulation & monitoring


Till 1970’s/80’s: strict functional demarcation of FIs with very few cross-functional activities

However, due to (a) increased deregulation, (b) technological and financial innovations, and (c) competitive pressures in last 20-25 years, the same FI often offers a wide set of financial services and functions

Attained via formation of either Universal Banks or Holding Companies

Today: (a) Functional boundaries between financial sub-sectors are blurred; (b) Competition: ↑ & global


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mainly 1987 market crash was responsible

Canada’s largest 6 banks are structured as Universal Banks

Offer a full range of financial services

Advantages: (1) cross-selling benefits, (2) diversification


Royal Bank of Canada

Royal Trust RBC Dominion Securities

Royal Mutual Funds RBC Insurance

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Pros: -US global banking crisis of 2007-09 did not impact Canadian banks much. Due to diversification: losses in one department did not impact other department. Cons: - in "good" times, profitability is low

Some FIs (usually non-banks) are structured as financial Holding Companies with controlling ownership of multiple subsidiaries offering multiple products

Subsidiaries are distinct corporate entities


Power Financial Corporation

IGM Financial (Mutual Funds)

Great-West Lifeco (Life & Health

Insurance)

Banking Services offered

Through arrangement With National Bank

1. FIs link the demand side and the supply side of the financial markets A. Demand side: corporations with perpetual need

for capital (for investments, growth) B. Supply side: households (investors) with

surplus disposable income

2. FIs facilitate flow of funds between financial (demand-supply) counterparties and overall market through several special roles



Corporations

(net borrowers)

Households

(net savers or investors) Cash (via buying

stocks & bonds)

Interest & dividends (via equity & debt

claims)

Consequences for investors: 1. Information asymmetry & high information costs 2. Lack of monitoring (of investments) 3. Very less liquidity (difficulty in transactions) 4. High price risk (risk of not getting the “fair” price) 5. Investment risks outweigh investment returns

Outcomes: 1. Very low levels of fund flows 2. High risks & capital losses



Cash

Households Corporations

Interest & dividends

FI

(Brokers)

FI

(Asset Transformers)

Cash + Financial products:

e.g., deposits, insurance policies

Cash

1. Brokerage or Facilitator role act as passive agents on behalf of customers (1) provide info & (2) facilitate transactions e.g., investments & transactions for clients Benefits: (a) reduction of costs through economies of scale & (b) encouragement of higher savings/investments

2. Asset Transformation active agents transform primary securities into specialized products for customers, e.g., 1. accept deposits & transform the collected capital into loans 2. sell insurance policies & invest sale proceeds in portfolios of

securities Benefits: (a) creation of value by offering more attractive products & (b) transformation/reduction of financial risks

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segregated funds: sell insurance and reinvest premiums

1. Assuage information asymmetry, provide info and monitor investments at low costs

2. Generate liquidity by facilitating transactions and reduce price risk

3. Reduce transaction costs through economies of scale and scope

4. Provide maturity intermediation by matching desirable maturities for customers

5. Provide denominational intermediation by allowing small investors to buy assets with large minimum denomination size


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risk of not getting fair price

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e.g. mutual fund allows you to buy fractional shares of Berkshire Hathaway

6. Transmit monetary policy by acting as conduits through which central banks’ (e.g., Bank of Canada’s) monetary policy is disseminated across financial system and economy

7. Facilitate flow of payments and transfer of funds via various payment services (cheque clearing, credit card payments, e-transactions etc.)

8. Conduct credit allocation via lending and controlling credit quality and volume in economy

9. Facilitate risk pooling & redistribution via insurance products

10. Offer intergenerational wealth transfer by providing funds at a much later period or to a different generation


FIs are special: play very crucial, indispensable and unique roles in the economy

However, specialness comes at a price; FIs are: susceptible to risks ⇒ need for risk management sources of negative externalities

⇒ need for regulation

FIs warrant (a) more diligent risk management & (b) strict regulation to a far greater extent than other corporations


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performance of FIs spreads impact to economy i.e. TD collapse would cause economy collapse

Risk: any adverse event that affects firm’s (equity) value

Risks: (a) internal vs. external; (b) anticipated vs. unexpected; (c) systematic vs. firm-specific; (d) financial vs. non-financial

Types of FI risks: Major risks: interest rate risk, credit risk, liquidity risk,

insolvency risk Moderate risks: market risk, foreign exchange risk, off-balance

sheet risk, sovereign risk Minor risks: operational & technology risk, event risk, various

human factor risks

Management of Financial Institutions is a 3-step exercise: (I) identification of risk, (II) measurement of risk & (III) hedging of risks

1. FIs face more (in variety as well as extent) risks than other corporations

2. Value/profitability of FIs are extremely sensitive to risks faced

3. If risks not managed ⇒ severe consequences to FIs’ worth (and very existence) and on overall economy

⇒ Crucial need for risk management in FIs


Value Maximization through Risk Management

1. Maximize value for investors (shareholders & debtholders) clients (retail customers & corporations) financial institution itself (management)

2. Minimize impact of any form of risk(s) on value


Negative Externality: “bad” actions of one economic participant bear negative consequences for other economic participants

Negative externality: adverse conditions faced by one big FI or a small subsection of FIs ⇒ adverse impact on a large number and wide variety of FIs ⇒ cascading negative impact on entire economy

Origin of almost all systemic financial crisis events can be pinpointed to collapse of 1 or a few major FIs: 1929 depression; 1990-91 recession; 1996-98 Asian crisis; 2007-09 financial crisis; etc. e.g., collapse of Lehman Brothers and Bear Stearns

precipitated the 2007-2009 financial crisis

Why do FI-specific risk events spread? 1. FIs share common operational and risk factors 2. Very large volume of inter-FI borrowings/lendings and

financial transactions ⇒ strong interdependence of cash flows & interlinking

of financial fortunes 3. Panic Runs or Bank Runs: if one major bank fails,

customers of other banks panic and market becomes bearish

Remedies: 1. proper risk management of FIs 2. better regulations 3. bailouts & rescue packages

FIs are special but FIs may collapse or fail to deliver

FIs need to be (strictly) regulated because failure of FIs ⇒ 1. loss of special functions in economy 2. very costly to investors, customers and firms through loss of

bank accounts, investment portfolios, insurance policies, etc. 3. cascading effect on whole economy

Regulations: preventive measures against FI failures


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e.g. payment services, monetary policy transmissions, credit allocation, etc.

Imposing (new or more) regulations is not the default or an automatic decision

Why? Because regulations are costly 1. design, implementation, monitoring & enforcement costs

for regulators 2. compliance & bonding costs for FIs 3. social costs through interference in business operations

Net Regulatory Burden = Cost of regulation – Benefits from regulation

Implement a regulation only if Net Regulatory Burden < 0

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= -NPV (negative of NPV)

Variety and extent of the regulations faced depends on the type of FI

e.g., pension funds are very strictly regulated, banks face moderate to high regulations, hedge funds are almost unregulated

2 key factors that define the degree of regulation 1. what is the economic role of the FI in the financial

system and systematic consequences if the FI fails? 2. who are the key customers of the FI and the

consequences they face if the FI fails? BU433/633: Chapter 01

1. Safety and soundness regulation: e.g., banks need to diversify, maintain reserves and liquidity, disclose info, etc.

2. Monetary policy regulation: e.g., controls inside and outside money of banks • outside money: produced by Central Bank as bills, notes & coins • inside money: produced by private FIs, often ‘virtual money’

3. Credit allocation regulation: e.g., banks must make loans to socially important sectors

4. Consumer protection regulation: e.g., protect customer deposits and investments via insurance

5. Investor protection regulation: e.g., regulation of trading activities of FIs to prevent frauds and insider trading

6. Entry regulation: e.g., regulation of new startup FIs or foreign entrants BU433/633: Chapter 01

1. Decline in depository institutions, but increases in investment companies

2. Decline in traditional banking (e.g., deposits, loans), increase in non-traditional (e.g., underwriting) and investment activities

3. Significantly riskier activities (on asset as well as liability sides)

4. Increasing merger activity within and across sectors

5. For US/Canadian FIs: greater competition from foreign FIs

6. Growth in online activities

7. Many new financial innovations, sometimes misused (e.g., CDO, MBS, CDS)

8. Shifting regulations (trends towards higher as well less regulation) BU433/633: Chapter 01

1. Collapse of a few major investment banks and many hedge funds

2. Ethics issues, weakening of government and public trust

3. Significant number of mergers & acquisitions

4. Increasing trend of deleveraging: decline in debt-to-equity ratios

5. Increasing reliance on “safer” debt and credit insurance

6. Increased regulations

7. Greater reliance on risk management practices

[More discussions later] BU433/633: Chapter 01

student notes - chapter 01

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