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MGT411 - Money & Banking - Lecture Handout 28

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NON- DEPOSITORY INSTITUTIONS (CONTINUED)

  • Securities Firms
  • Investment Banks
  • Mutual Funds
  • Finance Companies
  • Government Sponsored Enterprises
  • Banking Crisis
  • Sources of Runs, Panics and Crisis
  • Government Safety Net
  • Government: Lender of Last Resort

Securities Firms

  • Investment banks are the conduits through which firms raise funds in the capital markets
  • Through their underwriting services, investment banks issue new stocks and a variety of other debt instruments
  • In underwriting, the investment bank guarantees the price of a new issue and then sells it to investors at a higher price;
  • However, this is not without risk, since the selling price may not in fact be higher than the price guaranteed to the firm issuing the security
  • Information and reputation are central to the underwriting business;
  • Underwriters collect information to determine the price of the new securities and then put their reputations on the line when they go out to sell the issues
  • In addition to underwriting, investment banks provide advice to firms that wish to merge with or acquire other firms, for which advice they are paid a fee

Finance Companies

  • Finance companies raise funds in the financial markets by issuing commercial paper and securities and use the funds to make loans to individuals and corporations
  • These companies are largely concerned with reducing the transactions and information costs that are associated with intermediated finance
  • Most finance companies specialize in one of three loan types:
  • Consumer loans,
  • Business loans,
  • Sales loans (for example, the financing for a consumer to purchase a large-ticket item like an appliance)
  • Some also provide commercial and home mortgages
  • Business finance companies provide loans to businesses, for equipment leasing
  • Business finance companies also provide short-term liquidity to firms by offering
  • Inventory loans (so that firms can keep the shelves stocked)
  • Accounts receivable loans (which provide immediate resources against anticipated revenue streams)

Government-Sponsored Enterprises

  • The government is directly involved in the financial intermediation system through loan guarantees and in the chartering of financial institutions to provide specific types of financing
  • Zarai Taraqiati Bank Limited (ZTBL)
  • Small and Medium Enterprise (SME) Bank
  • House Building Finance Corporation (HBFC)
  • Khushhali Bank
Summary of the financial industry structure
Financial
intermediary
Primary
sources of
funds
(liabilities)
Primary uses
of funds
(assets)
Services provided
Depository
institution
(Banks)
Checkable
deposits
Saving and time
deposits
Borrowing from
other banks
Cash
Loans
securities
-Pooling of small savings to provide large
loans
-Diversified, liquid deposit accounts
-Access to payments system
Screening and monitoring of borrowers
Insurance
Company
Securities Firm
Expected claims
Short term loans
Corporate bonds
Government
bonds
Stocks
Mortgages
Commercial
paper
Bonds
-Pooling of risk
-Screening and monitoring of policy holders
-Management of asset pools
-Clearing and settling trades
Investment Bank     -Immediate sale of assets
-Access to spectrum of assets, allowing
diversification
-Evaluation of firms wishing to issue
securities
-Research and advice for investors
Mutual-Fund
Company
Shares sold to
customers
Commercial
paper
Bonds
Mortgages
Stocks
Real estate
-Pooling of small savings to provide access
to large, diversified portfolios, which can be
liquid
Finance
Company
Bonds
Bank loans
Commercial
paper
Mortgages
Consumer
loans
Business loans
-Screening and monitoring of borrowers
Government-
Sponsored
Enterprises
Commercial
paper
Bonds
Loan
guarantees
Mortgages
Farm loans
Student loans
-Access to financing for borrowers who
cannot obtain it elsewhere

Banking Crisis

  • Banking crises are not a new phenomena; the history of commercial banking over the last two centuries is replete with period of turmoil and failure.
  • By their very nature, financial systems are fragile and vulnerable to crisis

Worst Banking Crises since 1980

Fiscal Cost as percent age of GDP

The Sources and Consequences of Runs, Panics, and Crises

  • In a market based economy, the opportunity to succeed is also the opportunity to fail!
  • Banks serve some essential functions in the economy
  • Access to payment system
  • Screen and monitor borrowers to reduce information problems
  • So if bank fails, we lose ability to make financial transactions. Collectively, the economy is endangered.
  • Banks’ fragility arises from the fact that they provide liquidity to depositors, allowing them to withdraw their balances on demand, on a first-come, first-served basis
  • If bank can not meet this promise of withdrawal, because of insufficient funds, it will fail
  • Reports that a bank has become insolvent can spread fear that it will run out of cash and close its doors;
  • Depositors will rush to convert their balances into cash
  • Such a run on a bank can cause it to fail
  • What matters during a bank run is not whether a bank is solvent but whether it is liquid
  • Here solvency means that the value of the bank’s assets exceeds its liabilities (positive net worth)
  • Liquidity refers to the sufficient reserves of the bank to meet withdrawal demands
  • False rumors that a bank is insolvent can lead to a run which renders it illiquid
  • When a bank fails, depositors may lose some or all of their deposits, and information about borrowers’ creditworthiness may disappear;
  • For this reason, governments take steps to try to minimize the risk of failure
  • A single bank failure can also turn into a system-wide panic; this is called contagion
  • While banking panics and financial crises can result from false rumors, they can also occur for more concrete reasons;
  • Anything that affects borrowers’ ability to repay their loans or drives down the market price of securities has the potential to imperil the bank’s finances
  • Recessions have a clear negative impact on bank’s balance sheet
  • Low profitability of firm makes debt repayment much harder
  • People lose jobs and cant pay their loan
  • With the rise of default risk, bank’s assets lose value and capital drops
  • With less capital, banks are forced to contract the balance sheet making fewer loans.
  • The overall business investment falls and bank failure is more possible
  • Historically, downturns in the business cycle put pressure on banks, substantially increasing the risk of panics
  • Financial disruptions can also occur whenever borrowers’ net worth falls, as it does during deflation

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