Banking  and  Financial  institutions

(IF1204)

Dr  Angela  Gallo
Angela.gallo.1@city.ac.uk
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Topic  5:  Non-­bank  financial  intermediaries  

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Objectives
• To  understand  the  crucial  role  of  non-­bank  financial  
intermediaries  in  the  financial  system  
• To  examine  their  activities  and  business  models
• To  understand  recent  trends  in  the  industry
• To  discuss  their  role  in  pre-­ and  post-­ crisis  economy

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Outline
I. Finance  Companies  and  Securities  Firms
II. Mutual  Funds  and  Hedge  Funds
III. Insurance  and  Pension  Funds
IV. Shadow  Banking

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II.  Mutual  Funds  and  Hedge  Funds

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 Institutional  investors
Institutional investors are specialised financial institutions that
manage collectively savings of small investors and invest in
diversified portfolios of assets.
They are well placed to perform the key functions of trade,
manage, and diversify risk, and reduce information and trading
costs.
üMutual funds, pension funds and life insurance companies
are the main types of institutional investors in Europe.
üMost countries in southern Europe are characterized by low
institutional savings, while the role of institutional investors in
northwestern Europe is more important.
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 Institutional  investors
• Institutional investors are pooling funds from individual
households. Due to economies of scale, they are able to invest
these funds more efficiently than individuals (lower transaction
costs and commissions).
• Moreover, they are able to invest in assets that are indivisible
(such as property) and therefore often not available to small
investors.
• Having access to a larger investment opportunity set than
individuals, they provide diversified portfolios at low cost to
households.
• Costs of asset management are low, as they are shared among
many households, so that the risk-­return profile is more
attractive than other investment.
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 Classification  of  Institutional  investors
Short  term                                          Long  term

PFs  DB
PFs  DC
Life
Insurance

Mutual  
Funds
Hedge
funds

Individual  decision   Institutional  decision

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 Institutional  investors
The role of institutional investors in the financial markets:
• Because of their policy to hedge exposures and to diversify
their investments, they increase the demand for risk-­
management tools (as derivatives).
• Because of their active trading policies, they enhance the
liquidity in the markets, leading to higher efficiency and lower
transaction costs.
• They are often important shareholders in companies and can
influence or be active players in the corporate governance,
having more “bargaining power” than individual investors.

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 Institutional  investors
Institutional investors have made banks less important as
intermediaries of financial assets, also in countries with a
bank-­dominated financial system (France, Germany, Italy).
• Both in the EU and in the US, they have increased
enormously over the last two decades.
• Nevertheless, the largest EU countries are still mainly bank-­
oriented.
• In the US, institutional claims are twice as large as bank
claims.

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 Institutional  investors
However, the turmoil on the global financial markets revealed
their vulnerability (i.e. large investments in equities and ABS)
to downward market pressure.
Theoretically, they are viewed as long-­term investors that tend
to keep their holdings during stressed market conditions until
the market recovers, thus helping stabilise the markets.

Practically, risk-­based regulations and other constraints forced

them to sell assets during the crises, accelerating the “fire
sales”, thus harming the stability of the financial system.

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 Institutional  investors
(Assets  as  %  of  GDP,)  in  2012

Country Pension   Life Mutual  funds Total

funds Insurance
US 75 42 80 197
EU-­15 28 66 72 165
UK 92 94 49 236
Germany 6 44 51 101
France 0 102 53 155
Netherlands 168 78 98 344
Switzerland 114 90 82 286

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 Mutual  funds
Mutual funds have been major market-­share winners over the
past 40 years. The mutual fund industry is among the most
successful financial innovations (Khorana et al. 2005).

The rationale for MFs existence is to achieve superior

diversification through fund and risk pooling compared to what
individual small investors can achieve on their own.

MFs are the second most important FI group in the US by

asset size.
Common distinctions:
• Open-­end vs Closed-­end
• Long-­term vs Short-­term
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 Closed-­end  Mutual  Funds
Funds that have a pre-­established number of shares and the
fund’s initial resources typically are not augmented with the
subsequent sale of shares.

A closed-­end fund is typically traded as a single security on

organized exchanges and its shares are priced directly in the
market like the shares of any other company.

Therefore, the market price of closed-­end funds shares can

deviate, often widely, from the liquidation value of the
securities they hold.

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 Open-­end  Mutual  Funds
Funds that operate on very different rules.
The shares are continuously liquidated and augmented by a
specialised management company that offers shares for
cash, and cash for shares at the Net Asset Value (NAV).
NAV is the estimated liquidation or market value of the fund’s
assets divided by the number of shares the fund has
outstanding.
Thus, unlike closed-­end fund shares, the prices of open-­end
fund shares cannot deviate from the value of underlying
assets.

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 Long-­term  Funds
• Bond funds (comprised of fixed income securities with a
maturity of over one year)

• Equity funds (comprised of common and preferred stock

securities)

• Hybrid funds (comprised of both bond and stock securities)

Mutual fund sponsors usually offer multiple funds of each type,

differentiated by the securities held and the fund’s objective.
For instance, “capital appreciation funds” hold mainly equities
of high-­risk, high-­growth firms.
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 Long-­term  Funds
The investment objective of the fund is specified in a
prospectus available to potential investors.
• Growth
• Balanced
• Income
• Small cap
• International

The prospectus should increase the ability of the investors to

understand the risks related to the investment objective and
reduce the agency problem between the agent (fund
manager) and the principal (investor).
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 Risk  and  Return
The return an investor gets from investing in mutual fund
shares reflects three aspects of the underlying portfolio of
mutual fund assets:

• Income and dividends earned on those assets;;

• Capital gains, obtained when assets are sold at prices higher
than the purchase price.
• Capital appreciation, in the underlying values of the assets
held in the fund’s portfolio.

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 Net  asset  value
The fund managers calculate the current value of each mutual
fund share by computing the daily market value of the fund’s
total asset portfolio and then dividing this amount by the
number of mutual fund shares outstanding.

This is the price the investor gets when selling shares back to
the fund that day or buying any new shares in the fund on that
day.

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 NAV  – Example  (1)
Suppose a mutual fund contains 1,000 shares of Apple trading at
$105, 2,000 shares of Microsoft currently trading at $53 and
1,500 shares of Citigroup currently trading at $42.

The mutual fund currently has 15,000 shares outstanding held by

investors. Thus, today, the NAV of the fund is calculated as:

NAV = [(1,000 X $105) + (2,000 X $53) + (1,500 X $42)] /15,000

= $18.3

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 NAV  – Example  (2)
If next month, Apple shares increase to $107, Microsoft shares
increase to $55 and Citigroup shares increase to $45, the NAV
(assuming the same number of shares outstanding) would
increase to:
NAV = [(1,000 X $107) + (2,000 X $57) + (1,500 X $45)] /15,000
= $19.24

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 NAV  -­ Example
The shares outstanding can change in open-­end mutual funds
with the amount of share redemption and new purchases. In
other words, investors can buy and sell shares from and to the
mutual fund company.

üSuppose that, today, 1,000 additional investors are willing to

buy mutual fund shares at the current NAV. How does it affect
the NAV?

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 Net  Asset  Value
Closed-­end funds have a fixed number of shares outstanding
at any given time. Therefore, the NAV of the funds’ shares is
determined not only by the value of the underlying shares, but
also by the demand for the funds’ shares themselves.

• When the demand is high, the shares can trade at more than
the NAV of the securities held in the fund (trading at a
premium).

• When the value of the closed-­end funds’ shares are less

than the NAV of its assets, its shares are said to be trading
at a discount.
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 Closed-­end  investment  companies
Real estate Investment Trusts (REITs) are closed-­end
investment companies that specialize in investment in real
estate company shares and/or buying mortgages.

Similar to closed-­end funds are the Exchange-­traded funds

(ETF). An ETF is an investment company with shares that
trade intraday on stock exchanges at market-­determined
prices.

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 Short-­term  funds  -­ MMMFs
Introduced in the 1960s, they have gained popularity since the
1970s, when the high inflation and interest rates reduced the
attractiveness of traditional bank deposits.
MMMFs are managed conservatively, and in some case are
restricted to holding direct debt of the US government.

More commonly, they hold negotiable CDs, commercial paper,

mortgage, ABS and government agency debt.

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 Short-­term  funds  -­ MMMFs
Despite the competitive disadvantage of operating without a
government guarantee, money market funds offered a
compelling package of substitutes for them:
• low-­risk investment strategies;;
• higher yields than deposits;;
• implicit guarantee of reputable management companies;;

LINK! Before the crisis, banks bought mutual fund (and

MMMFs) companies and/or converted internally managed
trust funds into open-­end mutual funds.
In 2006, MMMFs held 67% of their assets in credit market
instruments (like ABCP and US gov. securities).
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 Mutual  Funds  Costs
MFs charge a price or fee for the services they provide, i.e.
the management of a diversified portfolio of financial
securities.
Two types of fees:
• Sales loads
• Fund operating expenses

The total cost to the shareholder of investing in a mutual fund

is the sum of the annualized sales load and other fees
charged.

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 Hedge  funds
It is a private investment pool subject to the terms of an
investment agreement between the sponsor of the fund and its
(wealthy) individuals and other investors (e.g. commercial
banks).
In contrast to mutual funds, hedge funds are actively managed
funds that pursue nontraditional investment strategies.
They take both long and short positions in a variety of financial
instruments – equities, fixed-­income securities, currencies,
etc.-­ to achieve the highest return commensurate to the fund’s
objective.

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 Hedge  funds
• Fund managers have incentives to limit disclosure to their
investors in order to reduce the likelihood that their
proprietary strategies can be identified and replicated.

• This creates an even bigger asymmetric information

problems between fund managers and investors than in
mutual funds.

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 Classification  of    Hedge  funds
• Market directional: HFs that seek high returns using
leverage, typically investing based on anticipated events.

• Market neutral or value orientation: HFs that have moderate

exposure to market risk, typically favoring a longer-­term
investment strategy.

• Market neutral: HFs that strive for moderate, consistent

return with low risk.

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 Hedge  funds
• Although the hedge fund industry has traditionally been far
less regulated than mutual funds, the gap is partially closed
now in the US and Europe.
• Less regulation is justified by the expectation that these
types of investors are able to make more informed decisions
and take on a higher level of risk.
• HFs grew in popularity in 1990s as investors saw returns of
over 40% after management fees (often more than 25%). But
then one of the largest hedge fund nearly collapsed in the
1998 (LTCM).
• Since then, hedge funds are often blamed to create financial
instability.
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 Hedge  funds  vs  Mutual  Funds
• MFs are restricted in their ability to leverage against the
value of securities in their portfolio, whereas leveraging and
other higher-­risk investment strategies are commonplace for
hedge funds.

• There are no limits in terms of charges and fees for HFs.

• HFs require a minimum investment (in the US $1 million or

more) so that the access is limited to wealthy investors.

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 Revision  Questions
•Discuss the role that institutional investors play in financial
markets.
•What is the rationale for the existence of Mutual funds?
•What is the rationale for the existence of Hedge funds?
•Discuss agency problems in the mutual funds’ operations.
•Discuss agency problems in the hedge funds’ operations.
•What is NAV?
•How are money market funds competing with banks?

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Essential  Readings  for  Topic  5

SC Chapter 5
******

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