©christoffersen 2000 1 capital markets and institutions introduction text: financial institutions...

©Christoffersen 20001

Capital Markets and Institutions

Introduction

Text: Financial Institutions Management

Anthony Saunders and Hugh Thomas


1.1 Functions of Institutions

• Information Sharing: Akerlof’s lemons• Monetary Policy• Risk Transfer• Smoothing consumption across time• Denominations• Liquidity


1.2 Information Sharing: Akerlof’s Lemon

• What would happen if there were good and bad investment projects?

» Investors can’t tell the difference» Project managers know if it’s a lemon or not» Good project managers cannot signal if they are good

• How does a bank remove this asymmetric information problem? How do you insure a bank provides the correct information?


1.3 Risk Transfer

• What would happen if people had to suffer the financial consequences of death, theft, earthquakes?

• What financial institutions remove this risk?

• What other types of risks are exchanged?


1.4 Timing

• What would happen if Bill received $1million today and didn’t want to work? What could he do?

(1) No bank

(2) With bank


Today’s Consumption

FutureConsumption

Present Value of Available Resources

1.4.1 Timing: No Bank

» Plotting investment opportunities

» Selecting best to worst investments implies diminishing marginal rates



Future

Consumption

= -|1+r|

Increased Savings

Increased Borrowing

1.4.2 Timing: With Capital Markets and Bank

» Capital market opportunity lines

» Horizontal intercept = Present value

» Vertical intercept = Future value

» With capital markets everyone is at least as well off as before, and some are better off.


Future Consumption

Borrower

Lender

Zero Lending and Borrowing

Amount Lent

Amount Borrowed

1.4.3 Timing: Benefits from Capital Markets

» Capital flows from savers to investors to maximize total wealth. Both lenders and borrowers gain.

»

» Show how lenders and borrowers gain through capital markets» What happens in this framework when a disaster strikes a region or a country? »


Future Consumption

Borrower

Lender

Zero Lending and Borrowing

Interest Rate Spread

No Spread

1.4.4 Timing Interest Rate Spreads

» The effect of different borrowing and savings rates

Question: What is the implication of rate spreads on social welfare? What is the gain from their elimination?

»


1.5 Denominations and Diversification

• What happens if you have $2500 to invest and would like to invest in a well-diversified portfolio?

• Minimum investment in a security is $10,000 • Trading small accounts is costly

• What eliminates this problem? What is the effect of the internet?


1.6 Raising Capital

• What if you have a great idea but need money to implement? What can you do if dad won’t lend you the cash?

• What eliminates this problem?


1.7 Monetary Policy

• Why do we need money? What would happen if it couldn’t be dispersed?

• How is this problem removed?


1.8 Liquidity

• What problems arise if you are uncertain if you need money later on?

• How is this problem removed?


1.9 Globalization

• What could you do if you are in a poor country where there is little savings and no well-established banking sector to provide loans to potential investments?

• What would happen if the government is corrupt?

• How are these problems removed?


1.10 Are Capital Markets Good or Bad?

• Capital Markets and Institutions have arisen to remove or improve some market imperfection such as asymmetric information, segmented markets, etc...

• Capital Markets and Institutions are special because of the important role they play funneling funds from lenders to borrowers, from risk averse to risky entities, from governments to individuals, from country to country.

• Are Capital Markets necessary for economic stability or do they destabilize?

• Why is it important for lenders to know where their money is invested? Does this always happen in capital markets ie. LTCM?


1.11 Why Regulate?• Reflects the importance of institutions and capital

markets

• A collapse of financial institutions can lead to economic turmoil

• Limit and control persons entering this market

• Social objectives met through regulation that markets will not address. Examples?


1.12 The Course

• If so many people worry about regulating and controlling capital markets and institutions, maybe this is something worth studying……..

• Regulators, investors, and institutional managers worry about the risks of capital markets and institutions so these are the focus of the course……

1. Canadian Financial Institutions and the players

2. Measuring Risks

3. Managing Risks


2. Banks and Deposit-Taking Institutions

2.1 OVERVIEW

• Big Six

• Schedule I

• Schedule II

• 63 banks in Canada compared to thousands of banks in the US

• Very concentrated market -- The question of mergers?

• Profitability measures (ROE and ROA)

2.2 Banking Balance Sheet

Assets Liabilities

Deposits 76%

Non Deposits 16.3%

BAs 4.1%

Other 12.2%

Subordinated Debt 2.2%

Shareholder Equity 5.5%

Cash 8.3%

Securities

US government 9.3%

Other 9%

Loans

Interbank 1%

Mortgage 23%

Other 41.4%

Fixed and other

Customer BAs 4.1%

Real Estate 3.9%


2.3 Liabilities of Commercial Banks

• Liabilities are very short term and highly liquid, especially compared to the assets carried by the bank.

• All deposits are guaranteed up to US$100,000 by the FDIC and CDN$60,000 by the CDIC.

• In Canada, most deposits are fixed term (54%). In the US, most deposits are transaction based demand deposits.

• Equity capital is regulated and under the Banking of International Settlements Basle Accord, a bank must have at least 8% of risk-weighted assets in equity capital. Equity capital includes subordinated debt, common and preferred stock, retained earnings, and loan loss provisions.

• Why do BAs show up the same on Assets and Liabilities?

• What are Non-Deposits?


2.4 Assets

• The amount of cash held by the commercial banks used to be regulated and referred to as required reserves. Required reserves must be in one of two forms: (1) Vault Cash or (2) Clearing account at the Bank of Canada.

• The reserve requirement are approximately 10% and are now phased out. They still exist in the US. Why did Canada get rid of reserve requirement?

• Required reserves are a “tax” for banks because no income is earned on them. This places banks at a disadvantage over other institutions.


2.4 Assets

• Loans account for almost 65% of a bank’s assets. These are very illiquid.

Exposure to Credit Risk

Duration Mismatching

• Over time, increased importance of mortgage loans and decreased importance of corporate loans. WHY?

• Why is equity/asset low and debt/equity high for banks compared to firms?


2.5 OBS Activities

• OBS activities are a method to earn fees without having to claim them on the balance sheet subject to capital requirements.

• OBS activities include:

Forward Rate Agreements, Stand-by letters of Credit, Revolving Credit (type of loan commitment), Underwriting, Advisory Services, Investment Management Services, Brokerage Services, NIFs

• Because OBS was not subject to capital requirements, they were considered risky

• Why is ROA not a good measure of profitability?


2.6 Regulation of Canada: OSFI and Provincial Regulators

• Provincial and federal banks.

• Provinces have no explicit regulatory power over federal banks. Each province has exclusive jurisdiction over local credit unions and caisses populaires. Each province has a superintendent of deposit-taking institutions and a superintendent of insurance and securities commission.

• Federal banks are controlled by the federal Office of the Superintendent of Financial Institutions (OSFI). This office was established in 1987 as a result of the Estey Report. It replaced the Inspector General of Banks and Department of Insurance.

• OSFI and Bank for International Settlements (BIS)

• Charges banks for its quarterly assessments. Those in violation of OSFI’s restrictions are monitored more closely.


2.7 Bank of Canada

• Bank of Canada was established in 1934 as a private institution. The Bank of Canada is run independently of the federal government. Why?

• Mandate of the Bank of Canada:

Monetary Policy

Creation of bank notes

Central Banking Services

Debt management of the government

• Direct clearers (14) hold an account with the Bank of Canada.

• What is the difference between the Discount Rate and the Fed Funds (or Bank of Canada) Rate?


2.7 Bank of Canada

• Treasury Auction» The primary market of treasury bills and debt is an auction. In the US, 3-

and 6-month T-bills are auctioned weekly, and 1-year bills are auctioned every four weeks. In Canada, a package of 3 mo, 6mo, and 1 yr T-bills are auctioned every two weeks.

» Two types of bids: competitive and non-competitive. Non-competitive bids pay the weighted average of winning bids.

» Sealed-bids are submitted on a YDB with an amount of desired funds attached to the bid. Lowest bid (YDB) wins with the winner’s curse

» For notes and bonds, coupons are decided based on yield determined in the auction.


2.7 Bank of Canada

• An Example of a Treasury Auction (February 2, 1999)

3Mo bills

$4.0 bil Bank of Canada purchased $725mil

Average Yield: 4.74%

Low Yield: 4.732%

High Yield: 4.744%

“Bidders received 72% of the value of their bids at high accepted yield.”


2.7 Bank of Canada

• An Example of a Treasury Auction (February 2, 1999)

6Mo bills

$1.8 bil Bank of Canada purchased $175 mil

Average Yield: 4.848%

Low Yield: 4.845%

High Yield: 4.850%

“Bidders received 93% of the value of their bids at high accepted yield.”


2.8 Regulation in Canada: CDIC

• Insures depositors in federal financial institutions up to $60,000 per account

• Provincial deposit insurance is set up for trust and loan companies and credit coops

• How would the mergers help increase the amount insured?

• What problems do you foresee with deposit insurance?


Organization of Banks in Canada

• In Canada, there is no law like the Glass-Steagall Act. However, Canada’s regulatory environment was characterized by four pillars.

• Canadian banks cannot distribute insurance products through their branches and they cannot provide leases on vehicles. The MacKay report discusses the allowance of banks into these areas.

• Schedule I banks cannot form Bank Holding Companies as in the US. Why have Canadian regulators been reluctant to allow Bank Holding Companies?

• Chinese Walls


2.10 Regulation in US• State and National banks

• State banks are controlled by the Superintendent of Banks. National banks are controlled by the Comptroller of the Currency.

• All national banks are part of the Federal Reserve System. State banks can choose to be part of the Federal Reserve System.

• Most banks in the US are traditionally state banks since they have been prohibited from crossing state lines. These barriers are eroding as US banks nationalize.

• FDIC (Federal Deposit Insurance Company) introduced in 1933.


2.11 Organization of Banks in the US

• In 1933, the Glass-Steagall Act legally separated commercial and investment banks in the US. This strictly prevented commercial banks from underwriting.

• QUESTION: Why would the regulators want to make it illegal for commercial banks to underwrite new companies?

• The Glass-Steagall Act has slowly been eroded by loopholes. (Section 20 Subsidiary). Likely to be abolished this year.

• Firewalls separate the Section 20 Sub and the lending activities of the institution. A firewall is a legal barrier separating the activities of a bank from those of its subsidiaries.


2.12 MacKay Report

Web address: finservtaskforce.fin.gc.ca/rpt/report.htm#rep

• Evaluated Canadian financial institutions along four themes:

» Enhancing competition and competitiveness

» Empowering consumers

» Canadians’ Expectations and Corporate conduct

» Improving the Regulatory Framework


2.12.1 Issues Facing MacKay Task Force

• 10% widely held rule

• Bank Holding Companies

• Dissatisfied Canadians

• Taxation of capital

• Accounting of goodwill

• Automobile leasing

• Demutualization of insurance companies

• Insurance distribution through commercial banks

• Competition and the need for scale

• Unfair protection of banks which was not available to insurance companies CDIC vs. CompCorp.


2.12.2 Issue of the Bank Holding Company

• 3 problems with unregulated BHC:» Capital difficult to determine» BHC can hold entities banks would otherwise be forbidden to hold» BHC can own regulated subsidiaries although it is unregulated

• Issues concerning the Parent Financial Institutions structure:» Do the entities allowed as subsidiaries have a broad enough base?» Capital has to be calculated according to the BIS regulations» Contagion and reputation effects directly affect the bank if a subsidiary weakens» Do not want CDIC to be transferred to all entities in the Parent structure

• Why the MacKay Task Force wanted a BHC» Greater flexibilitiy raising capital» Regulatory burden of bank placed subs at competitive disadvantage» Makes it easier for medium-sized firms to join as a conglomerate


2.13 Recommendations of the MacKay Report

• Strengthen existing participants and encourage new domestic participants

• Remove the accounting disadvantages faced by Canadian vs. US banks

• Increase the 10% limit on ownership to 20% where no more than 45% can be owned by holders over 10%.

• Allow regulated Bank Holding Companies to exist

• Make lending more available and affordable to high-risk borrowers

• Transfer responsibilities from CDIC to OSFI, eliminate overlap between federal and provincial jurisdictions, integrate CDIC and CompCorp (life insurance protection plan run by the industry)


2.14 Other Depository Institutions

» Savings and Loans

» Savings

» Credit Unions (member-owned)

» Trusts (Canadian)

» Caisse Populaires (closest to a financial supermarket)


Summary• Outlined the basic structure of a commercial banks and other deposit

taking institutions in our economy.

• Canada faces a cross-roads in the structure of its financial institutions. The MacKay Report outline makes recommendations for desired changes.

• Importance of banks has been diminished by the growth of other institutions.

• Disintermediation of these other institutions has resulted in competition for the banks making it more difficult for them. Good-bye 3-6-3.

©christoffersen 2000 1 capital markets and institutions introduction text: financial institutions...

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