Week 3

Financial Institutions
Amelia Pais
125.220

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Learning objectives
Evaluate the functions and activities of
commercial banks
Identify the main sources and uses of
funds for commercial banks
Outline the nature and importance of
banks off-balance-sheet business
Examine the main risk exposures and
consider related issues of regulation and
prudential supervision of banks
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FIGURE 1 Flows of Funds

Through the Financial System

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Financial Intermediaries
Depository Banks, Savings institutions and
credit unions.
Non-depository insurance companies and
pension funds.

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4 Major types of financial intermediaries transform claims to meet

various needs.

Deposit-type or Depository Institutions

Contractual Savings Institutions
Investment Funds
Other Institutions

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Characteristics of Depository Financial Intermediaries

Depository Intermediaries take deposits and make loans.

Their liabilities (i.e. deposits) are specified for a fixed amount that is not
related to the performance of their portfolio
Their deposits are of a short-term nature and much shorter that their
assets
A high proportion of their liabilities are checkable
Neither their liabilities nor their assets are in the main transferable
(exceptions CDs, securitization)

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Types of depository intermediaries

Commercial Banks
Thrift Institutions
Building Societies
Savings Banks

Credit Unions

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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
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Thrift Institutions
Closely resemble commercial banks
Focus more on real estate loans, savings deposits, and
time deposits
Often mutual

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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
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Contractual Savings Institutions bring long-term savers and borrowers

together.

Life Insurance Companies

Casualty Insurance Companies
Pension Funds

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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.
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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
Also mono-line insurance companies, that
pay off if financial securities default.
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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)
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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

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Other Financial Institutions

Finance Companies
Make loans but do not take deposits; raise loanable
funds in debentures (bonds) and from shareholders
They usually make riskier loans than banks.
NZ financial companies sector has virtually disappeared
with the collapse of 65 finance companies since 2006,
and estimated losses of nearly $9 Billion to their
investors.

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THE INTERMEDIARY FUNCTION

Why do we need an intermediary to bring together depositors and borrowers?

Key role of information: in a world of imperfect information intermediaries provide
brokerage function and qualitative asset transformation.
Brokerage Function: the intermediary brings together unfamiliar but complementary
agents in a cheaper way than if agents were to find their counterparts on their own
(reusability of information and information economies of scope).
Costs of finding the other agent: search, verification, monitoring, enforcement.
Qualitative Asset Transformation: borrowers and lenders have different preferences,
specially different liquidity preferences. Intermediaries modify the attributes of deposits
to match the needs of borrowers.

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Requirements

Investors needs:
Security low risk.
Liquidity in / out.
High return.
Small
denominations.

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Borrowers
needs:
Long term.
Low cost.
Large sums.

Role of Financial Intermediaries:

Lower transaction costs (time and money
spent in carrying out financial transactions).
Economies of scale
Liquidity services

Reduce the exposure of investors to risk

Risk Sharing (Asset Transformation)
Diversification

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Intermediaries lower the cost of financial services as they pursue profit.

3 sources of comparative advantage:

Economies of scale
Transaction cost control
Risk management expertise

Competition pulls interest rates down

Financing less costly

Projects have higher NPVs
Investment in real assets boosts economy

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Role of Financial Intermediaries:

Deal with asymmetric information problems
(before the transaction) Adverse Selection: try to
avoid selecting the risky borrower.
Gather information about potential borrower.

(after the transaction) Moral Hazard: ensure

borrower will not engage in activities that will
prevent him/her to repay the loan.
Sign a contract with restrictive covenants.

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Main activities of commercial banking

Importance of banks
High level of regulation prior to the mid-1980s
constrained their development and led to growth
of non-bank financial institutions
Largest share of assets of all institutions, but
understated without considering off-balance-sheet
transactions, managed funds, superannuation
and subsidiary finance, insurance and companies
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Main activities of commercial banking

Asset management (1980s)

Loans portfolio is tailored to match the available
deposit base

Liability management (1980s)

Deposit base and other funding sources are managed
to meet loan demand
Borrow directly from domestic and international capital
markets
Provision of other financial services
Off-balance-sheet (OBS) business

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Sources of funds

Sources of funds appear in the balance sheet

as either liabilities or shareholders funds
Banks offer a range of deposit and
investment products with different mixes of
liquidity, return, maturity and cash flow
structure to attract the savings of surplus
entities
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Sources of funds
Current account deposits
Funds held in a cheque account
Highly liquid
May be interest or non-interest bearing

Call or demand deposits

Funds held in savings accounts that can be
withdrawn on demand
E.g. passbook account, electronic statement
account with ATM and EFTPOS
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Sources of funds

Term deposits
Funds lodged in an account for a
predetermined period at a specified interest
rate
Term: one month to five years
Loss of liquidity owing to fixed maturity
Higher interest rate than current or call accounts
Generally fixed interest rate
PENALTIES for early withdrawal!
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Sources of funds
Negotiable certificates of deposit (CDs)
Paper issued by a bank in its own name
Issued at a discount to face value
Specifies repayment of the face value of the CD
at maturity
Highly negotiable security
Short term (30 to 180 days)
Yields offered on new CDs can be adjusted
quickly
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Sources of funds
Bill acceptance liabilities
Bill of exchange
A security issued into the money market at a discount to the
face value. The face value is repaid to the holder at maturity

Acceptance
Bank accepts primary liability to repay face value of bill to
holder
Issuer of bill agrees to pay bank face value of bill, plus a fee,
at maturity date
Acceptance by bank guarantees flow of funds to its
customers without using its own funds

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Sources of funds
Debt liabilities
Medium- to longer term debt instruments issued
by a bank
Debenture
A bond supported by a form of security, being a charge over
the assets of the issuer (e.g. collateralised floating charge
over the assets of the bank)

Unsecured note
A bond issued with no supporting security
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Sources of funds
Foreign currency liabilities
Debt instruments issued into the international
capital markets that are denominated in a
foreign currency
Allows diversification of funding sources into
international markets
Facilitates matching of foreign exchange
denominated assets
Meets demand of corporate customers for foreign
exchange products
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Sources of funds
Loan capital and shareholders equity
Sources of funds that have characteristics of
both debt and equity (e.g. subordinated
debentures and subordinated notes)
Subordinated means the holder of the security has a
claim on interest payments or the assets of the issuer,
after all other creditors have been paid (excluding
ordinary shareholders)

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Uses of funds
Uses of funds appear in the balance
sheet as assets
The majority of bank assets are loans
that give rise to an entitlement to future
cash flows; i.e. interest and repayment
of principal:
Personal and housing finance
Commercial lending
Lending to government

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Uses of funds

Personal and housing finance

Housing finance
Mortgage loan with security
Risk?
Securitization of mortgages

Amortised loan

Investment property
Fixed-term loan up to 5 years
Credit card
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Securitization

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Uses of funds
Commercial lending
Involves bank assets invested in the business
sector and lending to other financial institutions
Fixed-term loan
A loan with negotiated terms and conditions
Period of the loan 3 to 7 years
Interest rates
Fixed or variable rates set to a specified reference rate
(e.g. BBSW bank bill swap rate), Libor or USCP
Timing of interest payments
Repayment of principal
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Uses of funds
Commercial lending (cont.)
Overdraft
A facility allowing a business to take its operating account
into debit up to an agreed limit

Bills of exchange
Bank bills held
Bills of exchange accepted and discounted by a bank and held as
assets

Commercial bills
Bills of exchange issued directly by business to raise finance

Rollover facility
Bank agrees to discount new bills over a specified period as
existing bills mature

Leasing
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Uses of funds
Lending to government
Treasury notes

Short-term discount securities issued by the Commonwealth

government

Treasury bonds

Medium- to longer-term securities issued by the

Commonwealth government that pay a specified interest
coupon stream

State government debt securities

Low risk and low return

Other bank assets

E.g. electronic network infrastructure and shares in

controlled entities

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Off-balance-sheet business
OBS transactions are a significant part of
a banks business
OBS transactions include:
direct credit substitutes
trade- and performance-related items
commitments
foreign exchange, interest-rate- and other
market-rate-related contracts
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Off-balance-sheet business
Direct credit substitutes
An undertaking by a bank to support the
financial obligations of a client (e.g.
stand-by letter of credit)
The bank acts as guarantor on behalf of a
client for a fee
Client has a financial obligation to a third party
Bank is required to make a payment only if
the client defaults on a payment to a third
party
Examples: guarantees, indemnities and
letters of comfort,
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Off-balance-sheet business

Trade- and performance-related items

A form of guarantee provided by a bank to a
third party, promising financial compensation
for non-performance of commercial contract
by a bank client, e.g.:
documentary letters of credit
performance guarantees

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Off-balance-sheet business

Commitments
The contractual financial obligations of a bank
that are yet to be completed or delivered
Bank undertakes to advance funds or make a
purchase of assets at some time in the future, e.g.:
forward purchases
underwriting

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Off-balance-sheet business

Foreign exchange, interest-rate- and other

market-rate-related contracts:
The use of derivative products to manage
exposures to foreign exchange risk, interest rate
risk, equity price risk and commodity risk (i.e.
hedging), e.g.:
futures, options, foreign exchange contracts, currency
swaps, forward rate agreements (FRAs)

Also used for speculating

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Off-balance-sheet business
To the extent that these OBS activities involve risk-taking and
positions in derivative securities, OBS activities raise some
concerns about bank regulation
This is a particularly important concern when the size of off
balance sheet activities is considered
The notional value of such activities is more than 5 times the
total value of assets held by the banks

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Bank regulation: Why regulation?

The banking industry relies on public
confidence
The fractional reserve banking system
vastly increases the potential profitability of
banks but also leaves at risk from the loss of
public confidence: deposit run
The risk of collapse is made greater by the
contrast between the liquid nature of bank
liabilities and the illiquid nature of their assets
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What is the big issue with bank collapse?

Three areas of concern in relation to bank

collapse;
First, Contagion: the collapse of one financial
institution leads to bad debts and/or a loss of
confidence in other financial institutions,
possibly causing their collapse; it has serious
consequences for the real economy

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What is contagion?
1.

Banks are collectively exposed to the same risks

2.

Financial fragility can provoke a loss of confidence in a bank(s)

and provoke a bank run preventing the bank from offering
liquidity

3.

Banking system vulnerable to contagion

4.

Bank runs can happen because of retail and/or wholesale

depositors.

5.

Vulnerability of contagion leads to systemic risk

6.

Bank failures have social costs

7.

How common are bank runs and contagion episodes?

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Run on Northern Rock 2007-UK

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Run on Greek Banks

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Wholesale runs
11 March 2008, a bank run began on the securities and banking
firm Bear Stearns. This was not a deposit-taking bank and was
mainly funded by short term asset-backed commercial paper.
Credit officers of rival firms began to say that Bear Stearns
would not be able to make good on its obligations. Within two
days, Bear Stearns's capital base of $17 billion had dwindled to
$2 billion in cash, and had to file for bankruptcy the following
day.
In the last few months as confidence in European banks and
European sovereign debt disappears, the European banks are
experiencing a bank run in the interbank market.

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How likely is a bank run in Europe given the

sovereign debt crisis?

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What is the big issue with bank collapse?

Second, Consumer Protection: The collapse of

financial institutions within a sophisticated
financial system is bound to affect a large number
of people, both small and large savers. Further
many people who participate in financial
transactions have little knowledge of the products
of processes of financial markets. Consumer
protection becomes a particularly sensitive issue
when small savers are threatened with the loss of
their life savings
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What is the big issue with bank collapse?

Third, banks liabilities form the means of

payment: thus, bank regulation aims to
guarantee the integrity of the transactions
medium and to prevent the process of
financial intermediation from failing.

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Objectives Regulation

There are nine basic categories of

financial regulation: safety net;
restrictions in asset holdings; capital
requirements; prompt corrective
action; chartering and examination;
assessment of risk management;
disclosure requirements, consumer
protection; and restrictions on
competition

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Government Safety Net:

Bank panics and the need for deposit

insurance:
Deposit insurance: short circuits bank failures and
contagion effect.
Tow ways to operate it: Payoff method, or
Purchase and assumption method (typically more
costly-used for large and /or complex banks).

Other form of government safety net:

Lending from the central bank to troubled
institutions (lender of last resort).
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Restrictions on Asset Holdings

Attempts to restrict financial institutions
from too much risk taking
Bank regulations
Promote diversification
Prohibit holdings of common stock

Liquidity requirements
Capital requirements
Minimum leverage ratio (for banks): Capital
Adequacy
Basel Accord: risk-based capital requirements
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Why international regulation of Capital Adequacy?

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The international co-ordination of prudential regulation at global level is

increasingly important.
First, policy-makers, bank management, and regulators recognise that problems
with the global institutions and markets could undermine the stability of the
international financial system, and therefore the environment in which all banks
operate.
Second, if a branch or subsidiary of a bank is located in another country,
there is the question of which supervisory authority should have jurisdiction
over the branch.
Third, if all multinational banks are required to meet the same global
regulations, compliance costs will be similar. Hence a global approach to
regulation can help to level the competitive playing field for banks with
international operations.

Basle Committee

Committee of bank supervisory authorities, from the G-10 countries (Belgium, Canada, France,
Germany, Italy, Japan, Netherlands, Spain, Sweden, the UK, and US) plus Luxembourg and
Switzerland. It has a permanent secretariat (of 15) based at the Bank for International
Settlements in Basel, and meets there about once every 3 months.
The Bank for International Settlements is owned by the central banks it does
not participate in Basels policy-making, provides a venue for the Committees secretariat and for
membership meetings. Traditionally, members came from Western central banks but since 1994,
there are 13 members central banks from emerging market.
The main purpose of the Basel Committee is to consider regulatory issues related to activities of
international banks in member countries. Their objective is to use concordats and agreements
prevent any international banking operation from escaping effective supervision,

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Capital ratio
Capital requirements apply to credit, market and
operational risks. I.e. Banks need to have a
minimum amount of capital to cover possible
losses on those three risk exposures.
Capital requirement at 8% but: common equity
needs to be 4.5% and tier 1 6%. There is a
buffer of 2.5% above the 8%: if the ratio goes
below the buffer there are restrictions on
distributions on capital until the buffer is
restored.
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Liquidity Ratios
Liquidity requirements
Liquidity coverage ratio for short term funding. In
NZ these are mismatches at one-week and onemonth
Net stable funding ratio (NSFR), for long term
funding. In NZ this is the core funding ratio
NZ: Liquidity prudential standard based on a
minimum liquidity gap for different maturities (zero
one week and one month) and a one year core
funding ratio initially at 65% but from 2013 it was
increased to 75%
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Conclusion
Financial institutions are the largest players in any
financial system.
They are classified as depository and non-depository
institutions. Bank are the main type of depository
institutions.
Asymmetric information and the important role of banks
in the financial system drive the need to regulate banks.
But regulation and supervision are not easy in practice
Financial innovation: regulation applies to a moving target

Financial liberalization allows banks to take more risks,

and competition pushes banks to be seek risk.
Government safety net creates moral hazard problems
and eliminated some market discipline.

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