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FIN 353 – Financial Institutions and Markets

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INDIVIDUAL PROJECT GUIDLINE – 10% of course grade

DUE DATE – May 20th

Make a 2-3 pages written report on the topic that you has chosen. Provide insights to your topic. Specifically, you should cover the following content. If some contents are not very appropriate for your topic, please provide what you feel comfortable in that part. For example, if you plan to study the COVID-19, the brief history sector won’t be so appropriate, as it just broke out in 2020. But you can cover how it started and spread out worldwide.

(Note: the below contents are only a template for students who are not sure how to develop their topic and ideas. It is NOT a MUST list for all students or all topics. For students who have their own idea regarding the structure of their report, please feel free to follow your own idea)

• What is interesting about your topic: why it is important to study this, and specifically what events/phenomenon that motivate you to pick this topic

• Brief development: This part needs to be brief, and not the focus of your topic

• What are the impacts of this problem, or phenomenon on financial industries (banks, insurance, brokerage firms, pension plans…etc.) and financial market (stock market, bond market, foreign exchange market…etc.). Could be industry specific here.

• What are the impacts of this problem, or phenomenon on business (companies, schools…etc.) and individuals/household (consumers, investors, depositors… etc.). Could be industry specific here.

• How this problem is being tackled by relevant parties, such as government, response from private sectors (regular companies, banks, insurance, brokerage…etc.), from the market (stock market, bond market… etc.) and from the public (consumers, lobbyists, investors, depositors… etc.) Please also be specific here.

• Issues / problems / weakness, etc. that your think the current solution is insufficient (or things that needs to be addressed but not yet). How do you think things can be improved? If nothing, please discuss instead the strength the current solution has.

• What’s the expectation/forecasts for the future? NO one can be accurate about the forecast, just write down what you think will happen, and list the reasons you come to this forecasts.

Each student will submit a written report. The written report should be at a minimum 2 pages, with font size 12, and single line spacing.

Your grade is based on the soundness of analysis, the quality of written communication, and overall professionalism and neatness) .

Financial Institutions & Market

FIN 353 –Summer 2020

Snow Han

SFSU

Classification of Financial Markets

By nature of claim/type of securities.

Debt market; Equity market

By seasoning of claim.

Primary market; Secondary market

By organizational structure

Exchange market; Over-the-counter market

By maturity of claim.

Money market; Capital market

By immediate delivery or future delivery

Cash or spot market; Derivative market

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Why Study Financial Institutions

Indirect financing accounts for a much larger share in the U.S. financial system, which means you will have to deal with financial institutions ALL THE TIME.

Financial institutions are among the largest employers in the U.S. and often pay high salaries.

The answers are:

1. Diversify risk/Risk sharing

2. Reduce transaction costs

3. Mitigate problem of information asymmetry

1. Diversify Risk

What is risk???

Risk is uncertainty

Think about gambling

Think about stocks

Think about bonds

Do you like risk? WHY?

Interest rate

Impact of RISK

Changes in stock prices:

Affect the economy’s perception of wealth:

Influence spending decisions

Affect the market value of companies/financial institutions

Affect the IPO market and M&A market (P/E multiples)

Changes in interest rates (YTMs):

Affect the cost of borrowing (end users and intermediaries) & Affect bond/loan/mortgage prices

Influence the returns (and profit margins) to interest sensitive financial institutions (e.g., banks) and the borrowings/investments of non-financial sectors (household and companies).

Impact on the M&A market (leveraging activities)

Impact on mortgage markets (residential, commercial…etc.)

EG: GOOGLE rescind 2000 offers from contractors, CEO announce that investment activities and hiring activities will slow down.

Private debt market see default coming up.

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Diversification

Individual has limited wealth – confine you investment scale

E.g., a $5,000 investment only allows you to purchase 100 shares @ $50 / share (equity) – e.g.: APPLE- $331.5/share-BRK.B $200/share BRK.A – $300,920 – Tesla – $855/share

No diversification

What makes it worse? You have to pay the broker commission for trading

Bonds even worse—most have $1,000 as their face value (some will be $5000)

Only less than half of US household own any type of securities (stocks or bonds)

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Diversification

Diversification

Hold a portfolio – a basket full of different securities

e.g.: hedge funds, mutual funds, pension fund…etc.

Asset Transformation

Create and sell assets with preferable characteristics to investors by pulling all capital together

e.g.: Bank loans…etc.

2. Reduce Transaction Costs

Transaction costs include direct and indirect costs.

Direct Costs

Pay commission/service fee/ membership…etc.

Some are fixed cost (flat fee), some are variable costs (% costs)

Indirect Costs (legal costs, opportunity costs…etc.)

Spend time , money and energy to find you matched lenders (stocks or bonds, mortgage…etc.)

Once you find it, you have to hire lawyer to write contract…

Reduce your wealth! –Economy of Scale

Financial Institutions reduce transaction costs

Economy of Scale

The reduction of transaction cost per unit as the size (scale) of transactions increases

E.g.: mutual fund – reduce transaction costs via reducing fixed costs per unit, such as flat-fee commission

Expertise – advantages of expert management

Money managers could pick the stocks and trade for you (buy-side) – reduce your opportunity costs

*Analyst report could be sold to lots of people (sell-side)

Why when scale increases, you can reduce cost – this is true for most economy

A plant produce equipment

Usually it comes with both fixed cost, and variable cost

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3. Asymmetric Information

Asymmetric information arises when one party‘s insufficient knowledge about the other party involved in a transaction; makes it impossible to make accurate decisions when conducting the transaction

Asymmetric information can take on many forms, and is quite complicated. However, to begin to understand the implications of asymmetric information, we will focus on two specific forms:

Adverse selection

Moral hazard

3. Asymmetric Information

Adverse Selection

Happens before transaction

Potential borrowers might be the people who are most likely to produce undesirable outcomes

Lemon problem in used car market

Moral Hazard

Happens after transaction

The borrower might engage in activities that are undesirable from the lender’s perspective, and might hurt the lender’s interest

Principle-Agent problem / agency problem

Lemon Problem- adverse selection

By Nobel Prize Winner – George Akerlof

“Lemon” in the used car market

“Lemon”s in the bond and stock market

Hard to distinguish between good-quality firms vs. bad-quality firms

Investor only wish to pay the price for average-quality firms

Good quality firms will get underpaid and quit the market, while bad-quality firms get overpaid and stay in the market

Reduce the efficiency and effectiveness of financial system

How to solve adverse selection

Private collection of information and sale of information

Standard & Poor’s, Moody’s , ValueLine, Morning Star…etc. collect & sell information

Free Rider Problem

people who don’t pay for information take advantage of other people’s information

Government regulation to increase information disclosure

SEC (Security and Exchange Commission) – Auditing

Accounting Scandals – Enron 2001 – Arthur Anderson

Financial Intermediation

Expertise

E.g.: instead of buying a used car directly, you might want to go to a dealer and buy a certified used car

why more bank loans

Private BANK loans than public transaction – no free rider problem

Auditing – auditing firms certify that the firm compose their financial statements adhering to the standard accounting principles (GAAP). And make sure the firm is disclosing accurate information about sales, assets, and earnings, losses.

The big 4 – Pricewaterhouse, Earnest & Young, Deloitte, KPMG

When compare banks with other private firms that collect information, banks don’t sell their information, they use the information to initiate private loan. This means no one knows which company they are negotiating with and they are lending their money to. This can help mitigate the free-rider problem.

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Moral Hazard

Occurs when borrowers have incentives to behave differently (engage in activities that are undesirable to the lenders’ benefit) after an agreement is made between parties

After transaction occurs – misuse of the fund/money (hide information)

Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back – usually this involves risk taking e.g.: Gambling, or personal spending – agency problem

E.g.: You lend someone your money for him to start a business, but he used it for lottery instead

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Agency Theory

The analysis of how asymmetric information problems (specifically, moral hazard) affect managers’ behavior is known as agency theory.

Principal-agent problem (usu. Equity)

Stock holders – owners – principals

Managers – agents

The separation of ownership and control

Example: CEO myopia behavior

If managers have a larger share of the firms, it could help lessen agency problem

CEO could cut their R&D expenses to realize more profit for the term they work for the company,

Since usually the CEO’s bonus are directly related to the firms’ current performances, not future performances.

but it is not good for the company in the long run.

Enron – pocket their money for their own use

Also some bad mergers and acquisitions to boost the power of the CEO, but not necessarily a good thing for the company.

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How to solve agency problem?

Private Monitoring – another form of collecting information

Via shareholder monitoring (board) – expensive and time consuming

Any free rider problem?

Government regulation to increase information (same as adverse selection)

Regulations and CRIMINAL penalties for people who commit fraud or stealing profit (hard to justify)

Financial Intermediation

Venture capital – having several of their own people participate as members of the management teams (*PE)

Any free rider problem?

If you know other stock holders are monitoring the manage team, you tend to take a free ride on their monitoring activities. You could go on a vacation while have the other shareholders monitoring the management team. If you can do this, other shareholders can also do so. Eventually nobody will monitor the management team.

Venture capital. – They use the money they pooled from those venture capitalist or large investors to help entrepreneurs to start new business. In return for this, they receive the shares of the new firms (However at this time, those new shares are only available to VCs, not public available share – not an IPO) – thus no free rider problem//

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Financial Institutions

There are many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc.

Add investment banks (including broker and dealer), venture capitals

Example 2: Haidi 2010 Earthquake San Francisco Earthquake in the 1989, same scope and magnitude, but the one in Haidi cause my economic losses and more deaths

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Depository Institutions

Depository Institutions (Banks): accept deposits from individuals or institutions, and make loans.

Commercial banks

Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans

the largest financial intermediary and have the most diversified asset portfolios

Depository Institutions (cont.)

S&L , Mutual Saving Banks

Raise funds primarily by issuing savings, time, and checkable deposits which used to make residential housing mortgage

More and more similar to commercial banks

Credit Union

very small – require membership

issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company’s workers

All three are called depository institutions and they are not allowed to hold stocks , only debt instrument . And government bond.

S&L, mutual saving banks were not allowed to issue commercial loans, due to expertise, scale.

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Contractual Savings Institutions (CSIs)

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements

Life Insurance Companies

receive funds from policy premiums, and sell annuity (annual payments upon retirement)

Liquidity is not an issue for CSIs, thus they can invest in relative illiquid securities, such as mortgages and corporate bonds

Largest CSI

Contractual Savings Institutions (Cont.)

Fire and Casualty Insurance Companies

receive funds from policy premiums,

must invest most in liquid government and corporate securities, since loss events are harder to predict

Pension and Government Retirement Funds

hosted by corporations and state and local governments

acquire funds through employee and employer payroll contributions

invest in corporate securities, and provide retirement income via annuities

Tax incentives

Pension – fixed contribution – 401(K)

,. Fixed benefit.

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Investment Intermediaries

Finance Companies

issue commercial papers /bonds to raise funds to lend to consumers to buy durable goods, and to small businesses for operations.

E.g.: Ford Motor Credit Company, Chrysler Capital

Mutual Funds

acquire funds by selling shares to individual investors

use the proceeds to purchase large, diversified portfolios of stocks and bonds, take advantage of reduced transaction costs

*money market mutual funds – checkable, and short term

Investment Banks

advise companies on securities to issue (bonds vs. stocks),

underwriting security offerings, also usually serve as brokers after the stock is listed publicly

offer M&A assistance,

act as dealers in security markets

Research department vs. trading department

Examples?

Investment Intermediaries (Cont.)

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Key Facts about Financial System

F1: Direct Finance is not the primary way of finance for businesses

(either in the US, or worldwide), Indirect Finance is, esp. BANK LOAN!

F2: Stocks are not the most important tool of direct finance, bond is

F3: When direct finance is involved, institutions play a more important role than individuals (businesses raise funds directly from lenders in financial markets)

F4: Banks are the most important resources of external funds

-But the lending role of banks is declining

F5: Only large, well established firms have easy access to securities markets for finance

F6: Collateral is an important feature of debt contracts

F7: Financial system is heavily regulated

The better known a firm is, the more information it is available to the market – analyst. Thus investors can evaluate the firms’ quality relatively easier. – less information asymmetry

You are large is to some extent evidence that you have been successful

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Other Key Facts – Collateral

Collateral is a prevalent feature of debt contracts for both households and businesses

Property promised to the lender (pledged to the lender) if the borrower default (can’t make the loan/debt payment)

Reduce lenders’ losses in the event of default

Reduce information asymmetry (both adverse selection, and moral hazard)

Debt with collateral – secured debt

Debt w/o collateral – unsecured debt -debenture

Example of secured debt vs. unsecured debt?

Corporate bonds are usually secured debt

Credit card is unsecured debt, while house mortgage/ and car loan are secured debt

The more valuable the collateral is, the less likelihood for debt holders generating large losses during the events of default.

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Net Worth

Net Worth = equity /equity capital= assets-liability

Debt holders (lenders) have prior claim than share holders.

In the cases that the firm defaults, debt holders can take title of the company’s net worth, sell it, and get compensated

The more value the net worth has, the smaller the losses the debt holders will incur at the event of default

“cushion”

Similar to collateral, net worth help lessen asymmetric information problem

Debt Indenture & Covenants

Reason why debt contracts are more prevalent than equity

Covenants are requirements put into the debt contract (Indenture) to constrain borrower’s behavior:

Covenants that discourage undesirable behavior (e.g. M&A, Dividends issuance)

Covenants that encourage desirable behavior (e.g. house mortgage) Usually for a firm, it will specify some minimum holdings of certain assets

Covenants that keep collateral value (e.g. car loan)

Covenants that provide information

Undesirable – M&A

Specify what type of investment you can use the loan to finance – only use it for certain type of equipment…etc.

For example – house mortgage with the bank. Usually the bank will require the head of the household to purchase life insurance. In case some emergency happens, loan could still be paid off.

Usually for a firm, it will specify some minimum holdings of certain assets – eg; cash

Keep collateral value – car loan – require you certain collision coverage and insurance on the car

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Economies of Scope

Lower the cost of information production for each service by applying one information resource to many different services

E.g.: make loan and underwriting bonds

The potential problem :

Conflicts of interests, when there is competition among different services

Financial intermediaries can help us collect information right? And after they collect the information, they can use it again and again.

For example, banks, when banks try to make a loan to a certain firm, it collects all sorts of information from the firm, and asses its credit risk.

After this, the bank can keep using the information to decide whether it is easy to issue bond for this company. By providing multiple services to the firms, they can establish long term relationship, reduce the cost of information production, and also realize economy of scope.

Hide information or conceal information

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The Dark Side of Financial Institutions

Conflicts of Interest

a type of moral hazard that occurs when a person or institution has multiple interests, and serving one interest is detrimental to the other

More likely to happen when a financial institution provide multiple services to a client

Three conflicts developed in financial institutions.

Share my own experience. You can teach in the summer, but then you can not travel back.

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1. Underwriting and Research in Investment Banks

Investment banks both research companies with public securities, as well as underwrite securities for companies going public.

Research is expected to be unbiased and accurate, reflecting the facts about the firm. It is used by the public to form investment decisions – (analyst report).

Underwriters will have an easier time if research is positive. if the firm’s outlook is optimistic, Underwriters can better serve the firm going public, and demand a better offer price from the market

What if the firm’s outlook is not optimistic?

Then, the investment bank acting as both a researcher and underwriter of securities for companies clearly has a conflict—serve the interest of the issuing firm or the public?

Chinese wall – between the research and underwriting/buy side department

an information barrier within an organization that was erected to prevent exchanges or communication that could lead to conflicts of interest.

between the corporate-advisory area and the brokering department in order to separate those giving corporate advice on takeovers from those advising clients about buying shares

Example: Tech Booms, Spinning

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Rating agencies assign a credit rating to a security issuance of a firm based on projected cash flow, assets pledged, etc. The rating helps investors determine the riskiness of a security, and thus the price of a security

Consultants, for a fee, help firms with variety of managerial, strategic, and operational projects, as well as design security.

An rating agency acting as both a rater and consultant for a firm clearly is not objective, especially if the consulting fees exceed the rating fees.

Example: Standard & Poor’s , and Moody’s during the housing crisis 2007-2009 – Mini case (page 158)

2. Credit Assessment and Consulting in Credit Rating Agencies

Besides this, there is also one problem with credit rating agency. The issuer of the securities will have to pay to the rating agency to have their securities rated. Investors and government are always concerned about the credit rating agency may bias its ratings upward to attract more business from the issuer.

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Auditors check the assets and books of a firm for the quality and accuracy of the information. The objective in an unbiased opinion of the firm’s financial health.

Consultants, for a fee, help firms with variety of managerial, strategic, and operational projects.

An auditor acting as both an auditor and consultant for a firm clearly is not objective, especially if the consulting fees exceed the auditing fees.

Example: Enron Scandal (Page 157)

SOX (Sarbanes-Oxley Act)

3. Auditing and Consulting in Accounting Firms

SOX – in reaction to the Enron (2001) Scandal

Sarbanes-Oxley Act – 2002 as a reaction to Enron 2001

cover responsibilities of a public corporation’s board of directors, adds criminal penalties for certain misconduct, and required the SEC to create regulations to define how public corporations are to comply with the law.

2002 as a reaction to Enron 2001

cover responsibilities of a public corporation’s board of directors, adds criminal penalties for certain misconduct, and required the SEC to create regulations to define how public corporations are to comply with the law. – 11 titles

PCAOB –

Board member-

Independent auditing (auditor can’t provide the firm with consulting services at the same time)

Internal control

Enhanced disclosure (pro-forma)

Corporate fraud as criminal offenses

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Financial Institutions & markets

FIN 353 – Summer 2020

Snow Han

SFSU

Lecture 7 – Financial Crisis

Review

Central Bank – Federal Reserve System

Goal – Max employment, stabilizing prices, &moderating long-term interest rates

Independence of Central Banks

Why we have financial crisis?

2

Agenda

What is financial Crisis?

Why financial crisis occur?

Dynamics (theory) of Financial Crises

Why are financial crises almost always followed by severe contractions in economic activity financial crisis => economic recession

Are crisis so bad?

Bubbles are events where people get really excited about something., they drive the price really high

They have to break sometime

After 2003 ,On another boom , like on a roller coaster – and claps again

In 2007, failure of companies invested in home mortgages

Run of banks in the Britain, Bank runs in US, and then we see international cooperation, Government all around the world bail out all these institutions

Crisis – is not a single event, is a accumulation about a lot of events (small events)- big shocks

3

Financial Crisis – Introduction

Asymmetric information creates barriers between savers and firms with productive investment opportunities.

However, both moral hazard and adverse selection are still present, impact efficiency of the system!

When this problem accumulate, and get more severe, information flows in financial markets experience a particularly large disruption

Financial system could stop functioning – Economic contraction

This is financial crisis

4

Stage 1: Initiation of Financial Crisis

Lessons from the past~

Financial crisis can begin in several ways:

Credit Boom and Bust

Asset-Price Boom and Bust

Increase in Uncertainty

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1. Credit Boom & Bust

A credit boom or “lending spree” is the rapid expansion of lending by financial institutions.

Mismanagement of financial liberalization

– elimination of restrictions (over-lending)

And/or Financial innovation:

-introduction of new types of loans or other financial products

Either can lead to a credit boom, where risk management is lacking

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How?

1. Government safety nets (FDIC) – weaken incentives for risk management

2. With Financial Liberalization & Innovations , sometime we don’t have the necessary expertise to forecast/predict credit risk – we hedge

Eventually, over-lending problems – credit boom

Consequence – Bust: loan losses accumulate =>asset values fall, driving down financial institutions’ net worth

Probability is a mathematical concept that try to forecast a certain events – fancy models, but rely on the past

We have mathematical theories and laws, it is similar as weather forecast / hurricane forecast.

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Continuing

leading to a reduction in capital – deleveraging

Eventually – credit freeze

No incentive to making loans &* no need to collect information

A. loans become scarce

B. Economic spending contracts

C. The financial system losses its primary incentive to address adverse selection and moral hazard

2. Asset Boom & Bust

A pricing bubble starts, where asset values exceed their fundamental values.

E.g.: Tech Bubble in the late 1990s – investment companies

When the bubble bursts, prices fall

Corporate net worth falls as well (similar as banks after credit booms).

Bubbles are events where people get really excited about something., they drive the price really high

They have to break sometime

Example: this is more like the financial crisis we have in 1997-2002 Tech Bubble

World.com

The Taxpayer Relief Act of 1997, which lowered the top marginal capital gains tax in the United States, also made people more willing to make more speculative investments.[10] Alan Greenspan, the former Chair of the Federal Reserve, allegedly fueled investments in the stock market by putting a positive spin on stock valuations.

https://en.wikipedia.org/wiki/Dot-com_bubble

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Continuing

Moral hazard increases as firms have little to lose (less skin in the game).

Firms take risk, and eventually default

FIs also see a fall in their asset value & net worth (credit freeze & deleverage)

Asset Booms are often related to credit booms (not necessarily), in which the large increase in credit is used to fund purchases of assets, therefore, driving up asset prices

E.g.: housing crisis in 2008

3. Increase in Uncertainty

Periods of high uncertainty can lead to crises, such as stock market crashes or the failure of a major financial institution

E.g.: Great Depression (1929-1933)

Information flows in financial markets experience a particularly large disruption. Financial markets may stop functioning completely – can lead to Bank runs

Reducing lending and economic activity (credit freeze & deleverage)

Sum of Stage 1: Initiation

Credit Boom & Bust

Asset Boom & Bust

Deleverage, Credit Freeze

Stage 2: Banking Crisis

Deteriorating balance sheets of financial institutions (FI)

some Banks might become insolvency.

AND, the effect is contagious

If severe enough, these factors can lead to a bank panic, where several banks fail simultaneous due to depositor panic

Fire sale of banks’ assets (far below their value) – lead to the decline of other banks’ asset

=> full-pledged bank crisis (contagion the entire industry)

Adverse selection and moral hazard become severer, since fewer institutions are collecting information

Develop and exacerbate financial crisis

Sum of Stage 2: Bank Crisis

Deleverage, Credit Freeze

Stage 3: Debt Deflation

Sometimes, the crisis ends after stage 2. With bad firms/ institutions go out of business, uncertainty in the financial markets decline (restore people’s confidence and trust), stock market recover, and the balance sheet of financial institutions improve – usually take years.

BUT, if the crisis leads to a sharp decline of price level, then the crisis will continue to the third stage

(how to prevent…?)

This is also one reason sometime people think crisis is a way that the market try to regulate/ adjust itself

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What will happen if price level decline?

Example:

Consider a firm in 2015 with assets of $100 million (in 2015 dollars), $90 million of long-term liabilities, and so $10 million in net worth.

Price levels fall by 10% in 2016. Real value of assets (in 2015 dollars) remains the same.

Real value of liabilities rise to $99 million (in 2016 dollars), and so net worth falls to just $1 million!

Mismatch of your income and liability

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Stage 3: Debt Deflation

Debt deflation can occur, if price level falls, but debt levels (nominal) do not adjust, increasing debt burdens (real term)

Firms’ net worth will fall

Moral hazard or adverse selection become more severe less “skin” in the game

Economic activities will keep declining for a even longer time

What about our financial crisis in 2008 (the great recession)?

What about the Great Depression?

Which come with price deflation

Why the fed is important – try to keep the price level stable

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Sum of Stage 3: Debt Deflation

The Great Depression

In 1928 and 1929, stock prices doubled in the U.S.

The Fed tried to curb this period of excessive speculation with a tight monetary policy.

This lead to a stock market collapse of more than 20% in October of 1929, and losing an additional 20% by the end of 1929. (altogether more than 40%)

Severe droughts in 1930 in the Midwest led to a sharp decline in agricultural production

Defaults on Agriculture Loans, combined with stock market collapse led to many bank failures (Nov & Dec 1930)

loan amount decrease by half, investment decline (Stage 2 -> bank crisis)

Roosevelt – Bank Holiday – March 1933

Famous talks – Roosevelt – The only thing we have to fear is fear itself

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The Great Depression

The Great Depression

Debt Deflation (Stage 3)

Price level fell by 25% during this period

Debt Burden increased.

Prolonged the Economic contraction.

– Internationally

the contraction of the U.S. economy decreased demand for foreign goods

The worldwide depression caused great hardship, and the resulting discontent led to the rise of fascism and WWII

Initiation of the recent financial crisis (07-09)?

Information asymmetry in the mortgage market

Principal-Agent Problem (moral hazard)

Adverse selection

Financial Innovation Leads to credit boom, then asset boom

*Credit Score (FICO score)-2000

Credit Default Swap (CDS) – AIG eventually in trouble

Mortgage Backed Securities (MBS) – securitization

Subprime Mortgages – borrowers with lower credit score

Conflicts of Interest in Credit Rating Agencies

Ben Bernanke try to refinance his house in 2013/2014 – can’t do that!

makes a reported $250,000 for giving a speech and has signed a book contract that is surely in the seven figures

Mortgage originators did not hold the actual mortgage, but sold the note in the secondary market

Mortgage originators earned fees from the volume of the loans produced, not the quality

In the extreme, unqualified borrowers bought houses they could not afford through either creative mortgage products or outright fraud (such as inflated income)

They can walk away with no hurt

Agencies consulted with firms on structuring products to achieve the highest rating, creating a clear conflict

Further, the rating system was hardly designed to address the complex nature of the structured debt designs

The result was meaningless ratings that investors had relied on to assess the quality of their investments

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Collateralized Debt Obligations (CDOs) – MBS

First, a corporate called special purpose vehicle (SPV) is created to buy assets, create securities from those assets, and then sell those securities to investors.

based on default priorities, SPV separated these assets (loans) into different categories – called tranches

The highest rated tranches suffer defaults if most of the assets default, while the first defaults go to the lowest rated tranches.

Super senior, Senior, the mezzanine, … the equity tranch

There are even and

Too complicated to determine exactly what they are worth and who has the rights to what cash flows.

increased complexity of structured products can actually reduce the amount of information in financial markets

Before continuing with the crisis, let’s take a detour and see how Collateralized Debt Obligations (CDOs) played a role in the crisis

In a speech in the middle of the crisis, Ben Bernanke, the chairman of the Federal Reserve, joked that he “would like to know what those damn things are worth.

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Effects of the Great Recession (07-09)

1. Housing Market

the housing boom was lauded by economics and politicians. The housing boom helped stimulate growth

However, underwriting standard fell. You can almost get 100% financing (CDOs, loan sold)

No down payment – once you default, you can just ‘walk away’ – foreclosure of loans

Part Business, Part Government

Goal – allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market

Buying mortgages from banks and turns them into mortgage backed securities (MBS) and sell them to investors

Provide liquidity for banks

Fannie Mae- Commercial Banks; Freddie Mac – Thrift Banks

Thrift banks are also known as “savings and loan associations. They are smaller than major retail or commercial banks, and more community-focused. In practice, this means that thrifts place a greater emphasis on serving their customers, compared to major banking institutions that are more focused on providing returns for shareholders.

Thrift banks are structured either as corporate entities owned by shareholders, or as mutual associations owned by their customers, both borrowers and depositors. local, basic-service banking institutions. They do not typically offer the same range of financial services available from major money center banks, such as brokerage and investment services, wealth management and insurance products.

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Crisis

Part Government – meet government requirement – increase loan amount to below-median household, and subprime household

Part Business – compete for profits with investment banks

Lower underwriting standard.

a lawsuit has been filed against the federal government by the shareholders of Fannie Mae and Freddie Mac, for creating an environment by which Fannie and Freddie would be unable to meet their financial obligations

Thrift banks are also known as “savings and loan associations. They are smaller than major retail or commercial banks, and more community-focused. In practice, this means that thrifts place a greater emphasis on serving their customers, compared to major banking institutions that are more focused on providing returns for shareholders.

Thrift banks are structured either as corporate entities owned by shareholders, or as mutual associations owned by their customers, both borrowers and depositors. local, basic-service banking institutions. They do not typically offer the same range of financial services available from major money center banks, such as brokerage and investment services, wealth management and insurance products.

29

Bailouts – Fannie & Freddie

By 2008, the two had purchased or guaranteed over $5 trillion in mortgages or mortgage-backed securities

As these mortgages defaults, large losses mounted for both agencies.

Fannie Mae received $117 billion in bailout, Freddie Mac received $72 billion in bailout (Sept. 2008, Conservatory)

In 2013, Fannie Mae repaid $59.4 billion. In 2014, repaid another $20.6 billion. Through December 31, 2014 a cumulative total of $134.5 billion in dividends.– approximately $18 billion more than Fannie Mae received in support

Freddie Mac has paid back about $37 billion of the $72 billion it received, completely paid back in 2014.

2. Financial Institutions

Default loans lead to the deterioration of financial institutions balance sheets

Net worth declines

Deleverage – Credit Freeze (Stage 2)

3. Shadow Banking system

Hedge funds, investment funds, non-depository financial institutions

Those hold MBS have their asset value dropped significantly

Fire sale of their assets, Reduce their activities – contagious

Effects of the Great Recession (07-09)

31

4. Stock Markets

Effects of the Great Recession (07-09)

The decline in investment activities and consumption, along with fire sale of assets, leads to great economic contraction

5. international financial market

Following the downgrade of MBS ($10 bil), the shadow banking systems in the Europe began to fail

Major bank failure in UK – Northern Rock

Government bail out financial institutions

Eventually, leads to European Sovereign Debt Crisis (e.g. Greece)

Effects of the Great Recession (07-09)

Greece with huge cost of bailing out financial institutions, but lower tax revenue, post deficits in 2009, and a debt-to-GDP ratio of 100%

In October, 2009, new government was elected and find the situation was even worse , actually double deficit, and more debt than GDP

Greece was forced to write-down its debt (partial default)

Civil unrest broke out as unemployment rates climbed

The prime minister was eventually forced to resign

Ireland, Portugal, Spain, and Italy followed

Governments forced to embrace austerity measures to shore up their public finances (increase tax, but cut spending)

Interest rates climbed to double-digit levels

Severe recessions resulted, despite assurances from the ECB to help

Unemployment rates rose to double-digits (25% in Spain)

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6. Failure of High-Profile firms

March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its value only 1 year ago (hold MBS)

September 2008: both Freddie and Fannie put into conservatorship after heaving subprime losses (provide insurance to MBS)

September 2008: Lehman Brothers files for bankruptcy.

September 2008: Merrill Lynch sold to Bank of America at “fire” sale prices.

AIG also experiences a liquidity crisis (government bail out)

Effects of the Great Recession (07-09)

Financial services firm Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. The filing remains the largest bankruptcy filing in U.S. history, with Lehman holding over $600 billion in assets

Lehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investment was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007.[2] While generating tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in the value of its assets would entirely eliminate its book value of equity.[3] Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking.[4]

In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction in goodwill. The firm said that poor market conditions in the mortgage space “necessitated a substantial reduction in its resources and capacity in the subprime space”

plan for Barclays to acquire the core business of Lehman Brothers (mainly Lehman’s $960 million Midtown Manhattan office skyscraper), was approved. Manhattan court bankruptcy Judge James Peck, after a 7-hour hearing, ruled: “I have to approve this transaction because it is the only available transaction. Lehman Brothers became a victim, in effect the only true icon to fall in a tsunami that has befallen the credit markets. This is the most momentous bankruptcy hearing I’ve ever sat through. It can never be deemed precedent for future cases. It’s hard for me to imagine a similar emergency.”

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The GREAT RECESSION

Stock market keep falling, almost 50% during 2007-2009

The fall in real GDP and increase in unemployment to over 10% in 2009 impacted almost everyone.

The recession that started in December 2007 became the worst economic contraction in the United States since World War II, and is now called the “Great Recession.”

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Financial Institutions & markets

FIN 353 – Summer 2020

Snow Han

SFSU

Agenda

Money Market

Why money market is important

Different bond instruments traded in Money Markets

Time value of money/discount of cash flow for one period

How to compute investment returns in money market bonds (investment rate vs. discount rate)

Examples

Cash (Cash Equivalent) & Short Term Securities Apple Inc.

– 2013 Annual report

$18 billion in short-term securities + $11 billion in cash & cash equivalents

(TA=207 billion)

– 2014 Annual report

12 billion in short term securities + 14 billion in actual cash & cash equivalent (TA=232 billion)

– 2015 Annual report

20 billion in short term securities + 21 billion in actual cash & cash equivalent (TA=290 billion)

Microsoft

– “ we consider all highly liquid interest-earning investments with a maturity of 3 months or less at the date of purchase to be cash equivalents”

Money Market Definition

The securities in the money market are short term with high liquidity; therefore, close to being money *– cash equivalent (m<3 months)

Major Characteristics

Mature in 1 year or less from their issue date, most mature in less than 120 days

Low default risk (short term, and high quality issuer) – safe, anything else???

Sold in large denominations (wholesale market) – Usually ($1,000,000 or more)

Usually transactions don’t happen in an exchanges (location), but over the phone (OTC)

Usually there are regular buyers, and it is easy to match buyers with sellers

Very flexible for firms to storage their money, or find money to finance their short term investment, usually financing their working capital

4

Purpose of Money Markets – Flexibility

“warehouse” surplus fund till they need it (short period of time)

Low cost borrowing for government, firms, & intermediaries who need immediate infusion of fund for a short period of time (temporary)

Good tool for firms to “storage” or “warehouse” their money when there is no investment opportunities. Also flexible enough for firms to fill their short term financial need

What’s the reason behind all these?

Cash inflows and outflows are not synchronized…

5

Development of Money market

Short term loans vs. Money Market securities

1. Banks have lower interest rates for deposits

Glass-Steagall Act of 1933

Forbid interest payments on corporate checking accounts

And limit the interest payment on time deposits (set a ceiling rate for deposits)

When market interest rates rose, depositors moved their money from banks to money markets

2. Banks are heavily regulated – more legal costs

The bank usually don’t want to make short-term loans. – unprofitable – try to concentrate their asset in the area that provides higher profit margin.

From 1933 until 1986 it also imposed maximum rates of interest on various other types of bank deposits, such as savings accounts and NOW accounts. Incorprated in to regD

The motivation for the deposit interest restrictions was the perception that the bank failures of the early 1930s, during the first part of the Great Depression, had been caused in part by excessive bank competition for deposit funds, driving down the margin between lending rates and borrowing rates and encouraging overly speculative investment behavior on the part of large banks

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COST ADVANTAGEs

Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets,

especially in the 1970s and 1980s.

They removed the ceiling in 1986 March, but by then the money market has already well established

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What securities are traded on the market?

Treasury Bills (<1 yr federal government bonds)

Federal Funds (=reserves) for banks

Certificate of Deposits (CDs)- Large denomination

Commercial Papers

*Euro Dollars

*Banker’s Acceptances

Money Market Instrument 1- T-Bills

Sold with 28, 91, and 182 day maturities (1, 3, or 6 months)

Usually dominated in $1,000 (after 2008, some are dominated $100)

After 1976, “Book Entry”

After 1998, individuals can directly purchase t-bills online

NO INTEREST PAYMENT

Sell at Discount of face value (price < face value/ par value)

A credit market instrument that pays the owner only the face value of the security at the maturity date and nothing prior to then is called a discount bond

ownership is recorded electronically. Book-entry securities eliminate the need to issue paper certificates of ownership. Ownership of securities is never physically transferred when they are bought or sold; accounting entries are merely changed in the books of the commercial financial institutions where investors maintain accounts.

When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks

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Risk & Return

The interest rate for T-bills is one of the lowest

T-bills has such a low return, mainly because they are close to risk-free

High liquidity – Deep secondary market

The federal government can hardly go bankruptcy. They can always issue t-bills to make up for their deficit. They can even print out money.

Why they move together?

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Money Market Instrument 2 – Federal Funds

Short-term funds transferred (loaned or borrowed) b/w financial institutions (banks), usually for a period of one day (overnight)

Why called federal funds? –reserve saved in the federal reserve banks

0.3 trillion everyday

Unsecured

Same as T-Bills, highly liquid, and extremely low risk

Which means the interest rate for T-bills and federal funds should follow each other closely.

Federal Funds Rate

Money Market Instrument 3 -Repurchase Agreements (Repos)

Pretty similar to Federal Funds, but non-bank can participate

-Agreement A firm sells (usu. Treasury) securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price.

This is similar to use the (usu. Treasury) securities as collateral for a short term loan

*Fed purchases/sells Treasury securities in the repo market –open market tool

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Money Market Instrument 4- Negotiable Certificates of Deposit (CD)

A bank-issued certificate that documents a deposit and specifies the interest rate and the maturity date

Not a demand deposit (with maturity)

Usually mature in 1-4 months, or 6 month

Denomination ranges from $100,000 to $10 million

CD itself can be bought and sold until maturity

The second most popular money market instrument, behind only T-bills

It appeared first since bank try to counter the declining demand for deposit, invented by Citibank in 1960..

Larger savers were saving their money in other money market securities , they tried to attract their customer back, so they pay a higher interest rate. – Still bank deposit, the interest they can be are still be regulated by regulation

Later they try to offer CDs overseas, where they can circumpass the regulation

Until 1970s, regulation release the constraints on the interest rate. And the CD markets began to grow rapidly

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Negotiable CD Rates

What does this mean??????

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Money Market Instrument 5 – Commercial Papers

Unsecured promissory notes, issued by corporations, that mature in no more than 270 days.

Only the largest, most creditworthy corporations issue commercial papers (non-bank)

Backed by line of credit at the banks

Like T-bills, most commercial papers is issued on a discount basis

However, commercial papers doesn’t have a strong secondary market. Most of the time, commercial papers are sold directly by the issuers to the buyers.

In cases that buyers has a need for cash, the issuer can redeem the commercial paper

Mainly issued by finance companies

Hold by commercial banks, insurance companies, pension fund….

It started due to the tight economy in 1960s. Banks have to issue Commercial paper to get money and issue loan. However, the Fed try to control money supply by adding reserve requirement on this commercial papers in 1970 s– so now, banks stopped issue commercial papers.

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Commercial Paper Rate

Commercial Paper Volume

Banker’s Acceptances

These are often used when buyers / sellers of expensive goods live in different countries.

Bank intervene

An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods.

Before the maturity, Banker’s acceptances could be trade for immediate cash at a discount

Active secondary market

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Who Participates in the Money Markets?

Treasury Department

Federal Reserve System (FOMC)

Commercial Banks

Businesses/firms (e.g: Apple Inc., Microsoft…etc.)

Finance Companies (eg. GMAC, Chrysler Capital…etc.)

Insurance Companies

Investment companies (Brokerage)

Pension Fund

Mutual Fund

Individuals

Individual can participate through the development of Mmmutual fund, introduced in the 1970s.

It is hard to differentiate or to list who are the buyer/sellers. Because most of these will be buyers and sellers at the same time. They operate on both sides of the market

Except one – the treasury, who is always a demander of money – largest money market borrower around the world!

To ad just their tax revenue

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T-bill – Discount Bond

When an investor pays less for the security than it will be worth when it matures (par value/face value), the bond is called a discount bond.

Below are some T-bill price quotes in 2013 May.

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What is the rate of returns for T-bills?

cost of borrowing money, profit for people who lending money

We have two ways to measure the returns on T-bills

Discount Rate – Annualized

Investment Rate – Annualized

Example

How much do you pay – Price – 99.999222*10 = 999.99222

How much is your face value/par value –F =100*10=1000

What is your Discount rate?

= 0.00010 =0.01%

What is your investment rate?

= 0.00010 =0.01%

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Exercise

Q: Why investment rate is always higher than discount rate?

The denominator is smaller (you use price (P) for investment rate instead of face value)

You multiply the actual number of days in the year(365 or 366 for leap year instead of 360…)

Q: which is a better measure for your return?

The two rates follow each other closely, but investment rate is more accurate measure for investment return.

Treasury Bill Auctions

Every Thursday, the Treasury announce how many treasury bills it will offer for sale, and the maturities of each

The Treasury may accept both competitive and noncompetitive bids

In a competitive bid, the bidder specify the price they would like to pay, and the amount they would like to buy (no buying responsibility)

In a noncompetitive bid, the bidder doesn’t specify price, only the amount! (buying responsibility)

The treasury accept competitive bids in ascending order of yield (or descending order of price) until it reach the offering amount-noncompetitive bid amount

The price is set by the highest yield in the competitive bid (the last one get offered)!

Submit their bid by next Monday. And the results will be announced on The next morning

To ensure proper level of competition, no one dealer is allowed to purchase more than 35% of any one issue.

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Auction Example

BidderBid AmountPrice
1$500 million$0.9940
2$750 million$0.9901
3$1.5 billion$0.9925
4$1 billion$0.9936
5$600 million$0.9939

In a Treasury auction of $2.1 billion par value 91-day T-bills, the following bids were submitted:

These are all competitive bids!

Auction Example

BidderBid AmountPrice
1$500 million$0.9940
2$750 million$0.9901
3$1.5 billion$0.9925
4$1 billion$0.9936
5$600 million$0.9939

What will be the price ? And interest rate?

The price will still be the lowest price among all accepted competitive bids

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Auction Example

What if there are also $750 million in non-competitive bids?

All noncompetitive bids will be received, first

The rest of the amount goes to competitive bid

(2.1 bil- 750 mil=1.35 bil)

BidderBid AmountPrice
1$500 million$0.9940
2$750 million$0.9901
3$1.5 billion$0.9925
4$1 billion$0.9936
5$600 million$0.9939

The price will still be the lowest price among all accepted competitive bids

Then why not everybody submit non competitive bid – because it is limited to 5 million

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Another Auction

The T-bill Auction is pretty competitive to ensure the low interest rate, thus no one dealer is allowed to hold more than 35% of the entire issue.

Then why not everybody submit non competitive bid – because it is limited to 5 million

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Why interest rates move together?

These instruments share similar characteristics: short term, and low risk

They are substitute for each other

If one interest rate deviate from the other, the demand-supply movement in the market will soon correct the differences

Liquidity! – Secondary market

For commercial papers, with limited secondary market, the rates are bit high…T-bills are the most liquid, and lowest rate

T-Bill Rate

Real vs. Nominal Interest Rates

Nominal interest rate – no allowance for inflation

Real Interest rate – adjusted for expected changes in inflation

(ex ante)Real interest rate=nominal interest rate – (expected) changes in the price level

ir = i – pe (Fisher Equation)

=> more accurately reflects true cost of borrowing

(ex post)Real interest rate=nominal interest rate – (actual) changes in the price level

When real rate is low, there are greater incentives to borrow and less to lend

Example

If i = 5% and pe = 0% then

If i = 10% and pe = 20% then

Three-Month T-Bills

TIPS

Treasury Inflation-Protected Securities, or TIPS

Semi-Annual coupon at fixed rate

The coupon rate will not change.

However, the principal increases with inflation as measured by the Consumer Price Index (CPI).

vice versa, the principal decreases with deflation

At maturity, you are paid the greater of adjusted principal or original principal

Summary

What are the disadvantages of money market?

The disadvantages of money market shows up when you try to finance a long-term project.

How?

Think about you have a project that will last for 10 years, and you have to provide consistent funding for that project until it is completed after 10 years.

If you use money market to finance the project, you have to renew your contract every year. When market interest rate goes up, your interest goes up – you have more cost borrowing money! – This is INTEREST RATE RISK! (Refinancing risk)

But if you use capital market, you are locked in the interest rate at today. The fluctuation of market interest rates doesn’t affect your borrowing.

The bottom line here is : MONEY MARKET HAVE LOWER DEFAULT RISK, BUT HIGHER INTEREST RATE RISK.

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Financial Institutions & markets

FIN 353 –Summer 2020

Snow Han

SFSU

z

1

Central Bank

Financial industry is one of the most heavily regulated industry

Esp. banking industry

The next question is:

Who’s regulating / monitoring our financial system? Specifically banks.

What’ the problem? – Financial crisis

z

2

Central Banks

z

Every country in the world has a central bank (either developing or developed).

And every country in the world has a money/currency that has their central bank’s name on it.

Take you back to the origins of these things, so that we can get a better understanding of what these institutions are and what their function is.

3

Central banks are the government authorities in charge of monetary policy (currency)

In the U.S., the central bank is the Federal Reserve System

Contents:

Origins of the Central bank

Role/ Function of the Federal Reserve System

Structure of the Federal Reserve System

How Independent is the Fed?

Should the Fed Be Independent?

Structure and Independence of other Foreign Central Banks

Origins – why?

z

Financial Innovation is an important process.

If you think about our financial system today, and financial systems 100/80 years ago, they are entirely different

Financial innovation is similar as engineering innovation.

If someone find something and it is proved to work, it get copied everywhere around the world

It is just how our human species work. When some one figure out something and it works, it will soon spreads all over the world ,

Not because we are copy cats, but simply because it works, it solves problem.

it is the same with central banks

Modern banking traced back to the gold smith bankers – made jewelry/ they have safe, so people will just put/deposit their gold at the gold smith’s safe

The gold smith will issue a paper, with this paper, you can withdraw your gold

Eventually this paper begins to circulate – paper money / 1970s always backed by gold, or silver

Private business, no government involved

Problem from the very beginning – the gold smith won’t do good

Have too many papers, I don’t have any gold any more.

The rest UK banks are just limited liabilities partnership

Get so large – so easily to let the other bank bankrupt. They got a lot of notes issued by the other banks, present them for payments- bank run

Reserve help stabilize the system – since they have money to pay them out when they need

Bank of England was nationalized in 1946, become part of a government…

Tendency for banking system s to overlend to create booms, false prosperity and then the crashes, banking panic, recession

Source of stability and sense

Federal reserve chairs “William Joseph McDonough ”– is to take away the punch ball as soon as the party gets going – parents

4

UK – Bank of England – largest, dominant

Established in 1694, not government

Special charter from the Parliament – issue shares

In charge of government’s accounts/balances, and issue bank notes

Keep deposits from the other bank – “reserve”

Model of all countries’ central bank

1997 – independent central bank

In the US

Suffolk bank in Boston 1819 – 1860

Private bank

Copy the Bank of England

Help stabilize the currency in Boston,“Boston money”

First Bank of United States – 1791 (Hamilton)-1811

Second bank of United States – 1816-1836

z

Invention of people

First half of 19 century , repeated bank crisis

The financial system was so unstable

You go to a grocery store, you want to buy something. They say, let’s see you money.

You take out all you money, and lay down all the money

New haven money, Hartford money, charlotte money

The first bank is created as a facility of the government, help the government pay off war debts, and try to establish a common currency

George Washington initially declared that he was hesitant to sign the “bank bill” into law – unconstitutional

Both were private banks with public duties

Second bank of united states, 20% shares owned by federal government, the bank’s single largest stockholder

But they are not independent – answerable for its performance to the U.S. Treasury and Congress

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Federal Reserve System

1863 – National Banking Act

Successful in stabilizing the currency ( at par)

But still banking crisis (e.g. 1893, 1907…etc.)

1913 – Federal Reserve Act – Federal Reserve System

Create 12 banks all over the country, BOG headquarter @ DC

Require deposits with the Federal Reserve

Lender of Last Resort (e.g. Discount window)

z

The US hesitate for a long time of having a central bank

They just don’t like government to involve too much in private business, feared of centralized power

They try to innovate something, which is not a central bank, but have some functions as the central bank

Government passed – 1863 National Banking Act (revision in 1864)

Every city create a nation banks called national bank of sth

The treasury require them to have capital saved in the treasury to

Put money with the treasury to back up their currency

Federal Reserve Act – 1913 – Following The Panic of 1907 –secured by J.P. Morgan

The Panic of 1907 – also known as the 1907 Bankers’ Panic or Knickerbocker Crisis[1] – was a United States financial crisis that took place over a three-week period starting in mid-October, when the New York Stock Exchange fell almost 50% from its peak the previous year. Panic occurred, as this was during a time of economic recession, and there were numerous runs on banks and trust companies. The 1907 panic eventually spread throughout the nation when many state and local banks and businesses entered bankruptcy. Primary causes of the run included a retraction of market liquidity by a number of New York City banks and a loss of confidence among depositors, exacerbated by unregulated side bets at bucket shops.[2] The panic was triggered by the failed attempt in October 1907 to corner the market on stock of the United Copper Company. When this bid failed, banks that had lent money to the cornering scheme suffered runs that later spread to affiliated banks and trusts, leading a week later to the downfall of the Knickerbocker Trust Company—New York City’s third-largest trust. The collapse of the Knickerbocker spread fear throughout the city’s trusts as regional banks withdrew reserves from New York City banks. Panic extended across the nation as vast numbers of people withdrew deposits from their regional banks.

The panic might have deepened if not for the intervention of financier J. P. Morgan,[3] who pledged large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. At the time, the United States did not have a central bank to inject liquidity back into the market.

Federal Reserve system, which opens its door in 1914.

In the US. We always feel we are unique, and different, so we have to make it a little different from the UK system

The founders decided against concentrating the federal banking system in NYC or D.C. in order to maintain public support for the idea, increasing its effectiveness.

The 12 branches are spread across the country to make sure all regions of the country are represented in policy deliberations.

Headquarter in DC, which is called the board – Board of Governor (BOG)

Discount window- bring asset/securities as collateral ; discount the collateral and lend the money

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z

7

*Deposit Insurance

Even with reserve requirement, the system began to fail in 1929, banking crisis reached the peak in 1933

People’s confidence in financial institutions was rapidly eroded

President Roosevelt – “Banking holiday”

Banking Act of 1993 (Glass-Steagall Act)

Set up FDIC (Federal Deposit Insurance Corporation)-1933

No big banking crisis till 2007

z

The Great Depression in the United States began as an ordinary recession in the summer of 1929, but became increasingly worse over the latter part of that year, continuing until 1933. At its lowest point, industrial production in the United States had declined 47 percent, real gross domestic product (GDP) had fallen 30 percent and total unemployment reached as high as 20 percent.

In the wake of the stock market crash of October 1929, people were growing increasingly anxious about the security of their money. Wealthy people were pulling their investment assets out of the economy, and consumers overall were spending less and less money. Bankruptcies were becoming more common, and peoples’ confidence in financial institutions such as banks was being rapidly eroded. Some 650 banks failed in 1929; the number would rise to more than 1,300 the following year

The Glass-Steagall Act, also known as the Banking Act of 1933 (48 Stat. 162), was passed by Congress in 1933 and prohibits commercial banks from engaging in the investment business. It was enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression.

Banking crisis , right before president Roosevelt – banks were totally disarray

The first thing Roosevelt did was shut down the entire banking system in the US

Everyone runs to the bank – quite scary, nobody can get their money,

Everyone ran out of their money – MASS

Role

When eco is overheating, the inflation building up, raise interest, cool down eco

When eco is too soft, cut interest rate, encourage borrowing and spending and boost the economy

Charles DICe – FRS is the regulator of steam engine (1920)

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Federal Reserve System

The fed sees their role more of stabilize the economy rather than preventing the banking crisis

maximizing employment stabilizing prices &moderating long-term interest rates

Tools:

Reserve requirements

Open market operations – *Federal Funds Rate

Discount window – short term loan – *discount rate “Lender of Last Resort”

z

9

z

Structures of FED

·

Design was intended to diffuse power along the following dimensions:

Regions of the U.S.

Government and private sector interests

Needs of bankers, businesses, and the public

z

Setting Reserve Requirements – This is the amount of physical funds that depository institutions are required to hold in reserve against deposits in bank accounts. It determines how much money banks can create through loans and investments. Set by the Board of Governors, the reserve requirement is usually around 10%. This means that although a bank might hold $10 billion in deposits for all of its customers, the bank lends most of this money out and, therefore, doesn’t have that $10 billion on hand. Furthermore, it would be too costly to hold $10 billion in coin and bills within the bank. Excess reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve Bank Therefore, the reserve requirements ensure that depository institutions maintain a minimum amount of physical funds in their reserves.

All banks are subject to reserve requirements, but they frequently fall below requirements in carrying out of day-to-day business. To meet requirements they have to borrow from each other’s reserves. This creates a market in reserve funds, with banks borrowing and lending as needed at the federal funds rate. Therefore, the federal funds rate is important because by increasing or decreasing it, over time, the Fed can impact practically every other interest rate charged by U.S. banks.

The Fed constantly buys and sells U.S. government securities in the financial markets, which in turn influences the level of reserves in the banking system. These decisions also affect the volume and the price of credit (interest rates). The term open market means that the Fed doesn’t independently decide which securities dealers it will do business with on a particular day. Rather, the choice emerges from an open market where the various primary securities dealers compete. Open market operations are the most frequently employed tool of monetary policy.

Setting the Discount Rate – This is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The discount rate is usually lower than the federal funds rate, although they are closely related. The discount rate is important because it is a visible announcement of change in the Fed’s monetary policy and it gives the rest of the market insight into the Fed’s plans

Federal Funds rate – the rate at which banks borrow reserves from each other. The Federal Open Market Committee (FOMC) sets a target for this rate, but not the actual rate itself (because it is determined by the open market). This is what news reports are referring to when they talk about the Fed lowering or raising interest rates.

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Structure of Federal Reserve System

The system as it exists now includes:

12 Federal Reserve Banks (regional)

Board of Governors (BOG) of the Federal Reserve System

Federal Open Market Committee (FOMC) – 12

Federal Advisory Council

Member Banks (around 2,000) – 2014

z

11

z

12

Federal Reserve Banks – 12

Each Region has one regional Federal Reserve Bank (more than one branches)

z

The one in San Francisco, is located on Market street, pretty close to the Ferry building

The largest three accounts for more than 50% of Fed’s assets

New York alone has more than ¼ of the assets

13

Member Banks

Requirement of membership

National banks (banks chartered by the Office of the Comptroller of the Currency) are required to be members.

State commercials banks may elect to join.

Prior to 1980, only member banks were required to maintain reserves. By 1987, all depository institutions were required to maintain reserves, eliminating this downside of membership – all depository institutions were given access to discount window

No Interest rate on Reserves (cost for banks to be a member), only 1/3 of all banks

2008 _ with EESA (Emergency Economy Stabilizing Act) – TARP Obama government begin interest payments on reserve accounts

z

The 2008 EESA signed by Obama,agree to pay interests on reserve accounts , around 2011 , interest rate is 0.25% while the market interest rate is close to zero. Encourage banks to holding reserves.

14

Federal Reserve Banks – 12

The banks are “quasi-public”

Owned by member commercial banks in the district (stock requirement)

Member banks elect six directors, three more directors are appointed by the Board of Governors (6+3=9)

Directors are classified into A,B, & C

Directors represent:

professional bankers (3A) – banks – elected by member banks

prominent business leaders (3B) – business (industry, agriculture, labor, consumer …etc.) – elected by member banks

& public interests (3C) – public – elected by BOG, not allowed to be officers, employees, or stock holders of any bank

Directors appoint president (Dodd-Frank legislation 2010 exclude 3A)

z

The commercial banks – are just common private commercial banks

They have to purchase shares of the federal reserve banks to be a member – limited dividends by law to less than 6% annually

Before 2010, all directors participate in the decision of president. However after TF legislation, 3A directors are excluded from this decision, since the congress view they have conflicts of interests

15

FUNCTIONs of regional Federal Reserve Banks

Clear checks

Issue new currency and remove damaged currency

Directors “Establish” the discount rate at which member banks may borrow from the Federal Reserve Bank (subject to BOG review)

Administer and make discount loans to banks in their districts

Evaluate bank mergers and expansions

Perform bank examinations

Collect and examine data on local business conditions

Liaison between local community and the Federal Reserve System

Conduct research related to monetary policy

Elect one member commercial bank to the Federal Advisory Council

5 of the 12 bank presidents vote in the Federal Open Market Committee (FOMC) – NY Fed is the permeant member of FOMC, the other four votes allocated to district banks rotate annually among the rest 11 Federal Reserve Banks

z

16

Board of Governors (BOG)

z

FRS is designed to be separate from the government – set up independent

The government might want to boost inflation sometime

BOG – 14 year term, can’t be kicked out , the government couldn’t control

Long career in banking system, reputation for integrity, and you bring them in, you told them they are the custodian of the currency.

Who believe in the importance of currency,

Supreme court for currency

Once a new chair is chosen, the old one has to resigns from the BOG, even if there are many years left for his/her term.

17

Head of the Federal Reserve System

Seven governors appointed by the President, and confirmed by the Senate, for 14-year terms on a rotating schedule

One governor’s term expiring every other January

Come from different Federal Reserve District, to prevent one region’s interest being over-represented

The chair is chosen among the seven governor and severs a four-year renewable term

Duties of BOG

z

18

Sets reserve requirements and effectively “set” the discount rate

Sets the salary of the president and all officers of each Federal Reserve bank and reviews each bank’s budget.

All Board members are members of the FOMC (7+5)

Chair advises the President on Economic Policy

Serve in an advisory capacity to the President of the United States, and represent the U.S. in foreign economic matters.

Supervise the activities of foreign banks

Set margin requirements for stock purchases

Federal Open Market Committee (FOMC)

5 of the 12 bank presidents vote in the FOMC (5) NY Fed is the permeant member of FOMC, the other four votes allocated to district banks rotate annually among the rest 11 Federal Reserve Banks

All BOG members are members of the FOMC (7)

The chairman of the BOG is also the chair of this committee

Other district banks will participate, but not voting

Make decisions regarding open market operations, to influence the monetary base.

Open market operations are the most important tool that the Fed has for controlling the money supply (along with reserve requirements and the discount rate)

z

Why open market operation is the most important tool – since it is must

19

FOMC (Cont.)

Meet eight times each year (about every six weeks) in D.C.

Important agenda items include

Reports on open market operations (foreign and domestic)

National economic forecasts are presented

Discussion of monetary policy and directives, including views of each member

Formal policy directive made

Post-meeting announcements, as needed

z

20

Chair of the Federal Reserve System

Spokesperson for the entire Federal Reserve System

Supervises the Board’s staff

Negotiates, as needed, with Congress and the President of the United States

The chairman has effective control over the system, even though he doesn’t’t have legal authority to exercise control over the system and its member banks.

z

He is just one of the voting members

He also influence the Fed through force of statue and personality, strong personality and great power

21

Federal Reserve Bank of NY

Special – largest

The New York Fed District houses many of the largest commercial banks, and thus is responsible for oversight of some of the largest financial institutions headquartered in Manhattan and the surrounding area.

The New York Fed houses the open market desk. All of the Feds open market operations (sale and purchase of bonds) are directed through this trading desk.

The New York Fed also houses the foreign exchange desk, which conducts foreign exchange interventions on behave of Federal Reserve System

Working distance to major domestic financial market (NYSE, AMEX)

Only member of Bank for International Settlement (BIS) – monthly meeting with other major central bank

Repository of more than 100 mil world’s gold

z

The soundness operation of these FI will be paramount to US economy

If the fed wants to exercise some open market operations, it has to go through NY fed

If Fed NY is so important, its president must be. And we will discuss this in a bit

22

The Fed : The Books

Several research documents are by the Fed, and have been given official, colorful names:

Green book: national forecasts for the next three years

Blue book: projections of monetary aggregates

Teal Book:

Only distributed to FOMC participants

Beige book: districts’ “state of the economy” – surveys & talks – one that is publicly distributed

z

23

Inside the Fed: the Research Staff

The Federal Reserve System employs around 1000 research economists. What do all these researchers do:

Offer insight on incoming economic data and interpret where it suggests our economy is heading

Provide support for supervisory staff in decisions about bank mergers, lending activities, and other technical advice

Provide briefs for formal meetings on the economic outlook of the country

Produce reports on the developments in major foreign economies

z

24

z

25

Independence of the FED

A broad question of policy for the Federal Reserve Systems is how free the Fed is from presidential and congressional pressure in pursuing its goals.

Instrument Independence: the ability of the central bank to set monetary policy instruments.

Goal Independence: the ability of the central bank to set the goals of monetary policy.

Evidence suggests that the Fed is free along both dimensions. Further, the 14-year terms (non-renewable) limit incentives to curry favor with either the President or Congress.

z

However, Congress can enact legislation to gain control of the Fed, or at change the structure of FEd, a threat wielded as needed

Presidential appointment clearly sets the direction of the Fed. Issue monetary policy report to the Congress semiannually.

The Fed usually generates revenue in excess of its expenses, so it is not typically under appropriations pressure. For example, it generate 88 billion revenue in 2012. return them to the treasury. The control over money/ is close enough to overall control – which helps a lot to its independence.

Greenspan was appointed at first by Ronald Reagan, and then George Bush in 1992 (republican)

Cliton became president in 1993 – 1997, under pressure, reappoint Greenspan 1996-2000 – reappoint Greenspan again in 2004

26

Should the FED be Independent?

For

Away from political inflation biases

Prevent political business cycle

The Treasury may seek to finance the government through bonds purchased by the Fed. This may lead to an inflationary bias.

Politicians have repeatedly shown an inability to make hard choices for the good of the economy .

Independence allows the Fed to pursue policies that are politically unpopular, yet in the best interest of the public

Against

independence as “undemocratic”—an elite group controlling an important aspect of the economy but accountable in few ways.

we hold the President and Congress accountable for the state of the economy, yet they have little control over one of the most important tools to direct the economy

the Fed has not always been successful in the past. It has made mistakes during the Great Depression and inflationary periods in the 1960s and 1970s

z

Every few years, the question arises in Congress as to whether the independence of the Fed should be reduced in some fashion. This is usually motivated by politicians who disagree with current Fed policy.

For example, increase money supply might temporary cut interest rate down, but it might heat up afterwards in the long run when inflation and booms began

Expansionary monetary policy leads to lower unemployment and lower interest rates—a good idea just before elections.

Post-election, this policy leads to higher inflation, and therefore, higher interest rates—effects that hopefully disappear (or are forgotten) by the next election.

27

Foreign Central Bank

European Central Bank- ECB ( New & biggest)

Masstricht Treaty 1992 – European Union – plan for a new currency – Euros

ECB 1998, Frankfurt – Euro Zone (all countries want to participate), European System of Central Banks (ESCB)

1999 – Euros, Issuance – 2002

Bank of Japan

Become independent in 1997 (Bank of Japan Law)

z

Executive Board – BOG (6) – 8 year term

National central banks – 12 regional banks – president are appointed by each countries’ government (19 vs. 17)

Governing Council – FOMC

Differences with FED,: each national bank sets their own budget

No voting during meeting, but concensus (In case some national bank vote for their own countries’ benefit, not the Euro system)

Even more independent – since the charter won’t be changed by legislation

Some countries don’t belong to the Euro Zone, but use Euro un officially

Before that , every country in the Euro Zone has a central bank, but their original purpose seems gone

Bank of Japan is not independent in the sense that it is composed of two governonrs, and the other 6 members have to be appointed by these governor and approved by parliament

So many think that the US has such a stable currency is because of our independent central bank

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Financial Institutions & Market

FIN 353 –Summer 2019

Snow Han

SFSU

1

Types of Banks

2

Agenda

Traditional business – Balance Sheet

Performance – Income statement

*non traditional business Off –Balance Sheet activities

*Measuring bank performances

*Asset Management /Liability Management

we examine how banking is conducted to earn the highest profits possible.

In the commercial banking setting, we look at the bank’s balance sheet, balance sheet management, Off-Balance Sheet Activities, and how to Measuring Bank Performance

3

The Bank Balance Sheet

The Balance Sheet is a list of a bank’s assets and liabilities

Total assets = total liabilities + capital

Use of Fund = Source of Fund

Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers (shareholder) & debt holder

4

Sources of Capital

Liability

Debt claim

Deposit

Borrowing

Equity

Ownership claim

Stock

Retained earnings

Source: Liabilities

Liabilities come from

Deposits (Various Deposits)

a. Checkable Deposits / Demand Account

you can demand at any time

b. Non Transaction Deposits/ non-checkable account

you can’t write checks

b.1. Savings

b.2. Time deposit (fixed maturity)

Borrowing

from Federal Reserve Systems (central bank), other banks, Federal Home Loan Banks (FHLBank System), or other companies

Checkable Deposits/ Demand Account accounts that allow the owner (depositor) to write checks to third parties

6

Source: Capital

Bank Capital

the source of funds supplied by the bank owners

About 11% of assets.

Raised by selling equity or retained earnings from previous operation.

Bank Balance Sheet

Source: Liabilities

Liabilities come from

Deposits (Various Deposits)

a. checking account

you can write checks

Checkable Deposits / Demand Account

demand at any time

b. saving account

you can’t write checks

Non Transaction Deposits/ non-checkable Account

b.1. Savings

b.2. Time deposit (fixed maturity)

Checkable Deposits/ Demand Account accounts that allow the owner (depositor) to write checks to third parties

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accounts that allow the depositor to write checks to third parties

Depositor can demand the money at any time

non-interest earning checking accounts (reserve)

money-market deposit accounts (MMDAs) (no reserve requirement)

interest earning negotiable orders of withdrawal (NOW) accounts (reserve)

For depositor – safe and liquid, but offer low or no interest rate.

Lowest cost funds for bank

Make up about 2% of bank liabilities, >50% of banks’ operating expenses

Source: Liabilities

– Checkable Deposits

Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks.

The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent was set under the Monetary Control Act of 1980 at $25 million. This “low reserve tranche” is also adjusted each year (see table of low reserve tranche amounts and exemption amounts since 1982). Net transaction accounts in excess of the low reserve tranche are currently reservable at 10 percent.

It used to be the most important source of bank money during the 1960s.

MMDAs & checking accounts are payable on demand, that is if the depositor show up at the bank and request their money by making a withdraw, the bank must pay them immediately, Similarly for receiving a check. If someone present the check at a bank and ask for payment, the bank must pay the money immediately

Asset for depositor but liability for banks

Effective April 24, 1986, money market deposit accounts (MMDA), which had previously been subject to full reserve requirements, were made subject to the transitional phase-in program of the Monetary Control Act. In addition, the order of application of the exemption applied to reservable liabilities was changed. These actions reduced required reserves by about $260 million.

Investors can let go some interest benefit in exchange for the liquidity

NOW accounts are essentially checking accounts where you earn interest on the money you have deposited. With a NOW account, the bank or credit union has the right to require at least seven days written notice of a withdrawal, though this is rarely done.

10

Source: Liabilities – other deposits

Nontransaction Deposits (a.k.a. non-checkable deposits):

Can’t write check for purchase/transaction

accounts from which the depositor cannot write checks

savings accounts (you can withdraw your money at any time subject to restrictions)

time deposits (certificates of deposit – CDs)

a. < $100,000 /$250,000

b. >= $100,000 / $250,000

No immediate liquidity for depositor, but higher interest rates

Highest cost of funding, but most stable for bank

primary source of bank liabilities (69%)

Saving accounts were once the most common type of non transaction

make up to six pre-authorized transfers or withdrawals

For time deposits, the maturities ranges from several months to five years. You can not withdraw early unless you pay significant penalty.

11

Borrowings:

from central banks, other banks, FHLBank system, or other companies

discount loans/advances (from the Fed)

fed funds (from other banks)

interbank offshore dollar deposits (Eurodollars from other banks)

From bank holding companies (parent companies)

Advances / loans from FHLBank to support housing mortgage

Other arrangement with companies: repurchase agreements (e.g.: “repos”)

make up 12-18% of bank liabilities

Source: Liabilities

– borrowings

A bank holding company is a company that controls one or more banks, but does not necessarily engage in banking itself. – e.g: morgan Stanley (subject to Fed supervision). Banks – also subject to FDIC

12

Bank Balance Sheet

13

Usage: Assets

How banks use their money?

Banks use their capital (money) in order to create value for their capital providers (shareholder) & debt holder

In other words, to earn income

Assets reflect the bank’s operation , and how it makes money

Cash and Reserves

Securities (bonds) – investment

Loans (various loans)

Other assets

Bank Balance Sheet

15

Usage: Assets – Reserve

Reserves:

funds physically held in the bank’s account with the Fed

a.k.a. Vault cash/reserves/fed funds – most liquid

Two types of reserves

1. Required reserves:

represent what is required by law under current required reserve ratios , which is a certain fraction of the deposits the bank get

0, 3% , 10%

2. Excess Reserves: Any reserves beyond this amount.

Why banks hold reserves?

First, regulation reasons, second, cushion for banks to meet its obligation when depositor come to the bank to withdraw money or when a check is written on an account

https://www.federalreserve.gov/monetarypolicy/reservereq.htm

16

Usage: Assets – cash

Cash items in Process of Collection:

checks deposited at the bank

funds from other bank have not yet been transferred.

Deposits at Other Banks:

usually deposits from domestic banks (local) at international banks (large)

referred to as correspondent banking

Small banks’ assets in exchange for services (e.g.: foreign exchange transaction, assistance with securities purchases)

Sometimes checks can take days to transfer.

Generally speaking, the reasons domestic banks employ correspondent banks include limited access to foreign financial markets and the inability to service client accounts without opening branches abroad. Correspondent banks can act as intermediaries between banks in different countries or as an agent to process local transactions for clients when they are traveling abroad Most international wire transfers are executed through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network. Knowing there is not a working relationship with the destination bank, the originating bank can search the SWIFT network for a correspondent bank that has arrangements with both banks.

Upon finding a correspondent bank having arrangements with both sides of the transfer, the originating bank sends the transferred funds to its nostro account held at the correspondent bank. The correspondent bank deducts its transfer fee, usually $25 to $75, and transfers the funds to the receiving bank in Japan. In transactions such as this, the correspondent bank adds value in two ways. It alleviates the need for the domestic bank to establish a physical presence abroad and saves the work of setting up direct arrangements with other financial institutions around the world.

Not a recent development, but unique to the U.S.

Many small banks need “large bank” services

Large banks provide these services

In return, small banks deposit money with large banks

17

Usage: Assets – cash items

Reserves, Cash items in Process of Collection, and Deposits at Other Banks are collectively referred to as Cash Items in our balance sheet

Account for 16% of assets

The most liquid assets of a bank

Usage: Assets – securities (investment)

Securities (all debts):

U.S. government bond securities (t-bills, t-bonds, t-notes)

agency debt ?

municipal debt

other (non-equity) securities (e.g. commercial papers)

-* structured debt instrument

Short-term Treasury debt (t-bills) is a secondary reserve because of its high liquidity.

These make-up about 22% of assets (10% of commercial banks’ revenue)

banks are only allowed to hold debt-securities (commercial banks, S&L , credit union – thrifts)

So securities will be all debt instruments

Are bonds default free???

19

Usage: Assets – Loans

Loans:

commercial loans, real estate mortgages, consumer loans, interbank loans (federal funds)

Not very liquid- wait till maturity or sell

Not very safe – default risk

THUS, BANKS Charge higher interest rate

a bank’s primary income-earning assets

Generate More than half of banks’ revenue (highest return)

About 53% of assets

Differences in the balance sheets of different depository institutions is primarily in the type of loans in which they specialize

S&L and mutual savings banks, specialize in residential mortgage / house mortgage, while credit union specialize in consumer/car loans

20

Usage: Assets – others

Other Assets:

bank buildings, computer systems, and other equipment.

Bank Balance Sheet

22

Bank Balance Sheet

Asset Transformation

Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan

So now you’re asset (deposits) is transformed into the bank’s assets (mortgage loan)

Deposits are relatively short term (< = 10 years), while mortgage loans are long term (30, even 50 years)

Banks tend to “borrow short and lend long” (in terms of maturity).

T- Accounts Analysis

1. Deposit of $100 cash into First National Bank (checking account)

2. withdrawal of $100 cash from First National Bank (checking account)

When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount

25

T- Accounts Analysis

3. Deposit of $100 checks into First National Bank from Second National Bank

When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount

Later, for first national bank, the cash arrives;

So Cash item in process of collection reduce by 100, vault cash increase by 100

We could combine the two steps for first national bank in to one.

When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount

26

Reserve Requirement

This simple analysis gets more complicated when we add bank regulations to the picture.

Deposit of $100 cash into First National Bank (assume 10% reserve ratio with checkable accounts)

Bank is free to work with the $90. The bank loans the $90 to its customers

$10 of the deposit must remain with the bank to meeting federal regulations.

Bank is free to work with the $90

The bank loans the $90 to its customers

What will happen if the depositor come in and ask for his 100 dollars?

The bank have to give it immediately, – manage a bank

27

Off-Balance-Sheet Items

Off-balance-sheet items are contingent assets and liabilities that may affect a commercial bank’s balance sheet and/or income statement

OBS items become on-balance-sheet items only if some future event occurs

Loan commitments

Letters of credit

commercial letters of credit

standby letters of credit

Loans sold

Derivative contracts

OBS ACTIVITIES

LOAN COMMITMENT – Commitment to future lending

up-front fees are charged for making funds available

commitment fees are charged on the unused portion of a loan commitment

Fixed interest term

LETTER OF CREDITS

Commercial letter of credit

Standby letter of credit

LOANS SOLD

With vs. without recourse

DERIVATIVES

Hedging vs. speculating

Loan commitment – The bank must stand ready to supply the contractual amount at anytime over the commitment period.

Only when the borrower actually draws on the commitment do the loans made under the commitment appear on the balance sheet

Commercial letters of credit—

client buys goods and services

bank promises to pay seller on behalf of client

seller presents bank with draft

Standby letters of credit—

bank guarantees client’s financial performance of some contract

client’s counterparty relies on bank’s creditworthiness, not borrower’s

beneficiary presents draft to bank if client does not perform

Common uses of SLCs—

securities offerings

credit enhancement of other debts

completion of projects

Loans sold:

No recourse – if the loan the bank sold should go bad, the buyer of the loan must bear the full risk

With Recourse

– if the loan the bank sold should go bad, the buyer could put the loan back to the bank

– the loan sales always presents a contingent credit risk to the seller (bank)

In Reality, the recourse or nonrecourse nature of the loan sales is quite ambiguous

29

Other Fee-BASED SERVICES

Non-traditional services

Correspondent banking (item 3): sale of bank services to other financial institutions

Trust services: management of client wealth eg: assist in the management of pension fund

Non-banking financial services: investments and insurance (BHC)

TRUST services

Only the largest bank has sufficient staff to offer trust services

As fiduciary, bank manages assets for beneficiary

Over half of individuals’ assets are managed by bank trust services

Trust function is strictly segregated from other bank functions

Common trust services—

administration of estates

management of pension assets

registration and transfer of securities

administration of bond indenture

Glass Steagell Act – separate investment, insurances and traditional banking services

Investment services, insurance, and other financial products

Deregulation (Gramm-Leach- Bliley Act – 1999) allows these services, provided clients clearly understand they are not covered by deposit insurance

E.g: BOA & Merrill Lynch

Banks can compete directly with mutual funds and securities firms

30

Relationship between balance sheet & Income statement

Traditional business for banks are reflected in their balance sheet

Take deposit & borrowing

make loans and purchase securities (investments)

Interest expenses – from 1. deposit & borrowing

Interest income – from 2. securities and loans

Interest expenses, interest incomes, and other non-interest income and expenses (such as salaries, overheads…etc.) are reported in income statement

31

Banks’ Income Statement (a)

The Income Statement

Interest income (II) is the sum of interest and fees earned on all assets.

Interest on loans, interest earned on investment securities

Interest expense (IE) is the sum of interest paid on all interest bearing liabilities.

Interest paid on deposits,

payment for federal funds, repurchase agreements, and borrowed money (borrowings)

Gross interest income minus gross interest expense is labeled net interest income

33

The Income Statement – non traditional services

Non-Interest Income (NII) includes:

Fiduciary activities – trust service (i.e. asset management)

Deposit service charges

Trading, venture capital and securitization income

*Investment banking, advisory, brokerage and underwriting fees and commissions

*Insurance commission fees and income

Net servicing fees

Other net gains (losses) e.g: capital gains from securities transaction

Non-Interest Expense (NIE) consists of:

Personnel, occupancy and other operating expenses

Intangible amortizations and goodwill impairment

Gross non-interest income minus gross non-interest expense is labeled net non-interest income

34

Banks’ Income Statement (a)

Banks’ Income Statement (b)

The Income Statement

Net interest income = Interest income (II) – Interest expense (IE)

Net noninterest income = Noninterest income (NII) – Noninterest expense (NIE)

Income before taxes and extraordinary items (EBTEI) = Net interest income + Net noninterest income – Provision for loan losses

Net income = EBTEI – income taxes – extraordinary items

All together,

Net income = (II-IE) + (NII – NIE) – Provision for loan losses – income taxes – extraordinary items

Net interest margin is interest income minus interest expense divided by earning assets

Net non-interest margin is non-interest income minus non-interest expense divided by earning assets

37

Financial Institutions & Market

FIN 353 –Spring 2021

Snow Han

SFSU

1

Contents

Financial Systems

=institutions & markets

Financial Markets

money market, capital market, bond market, stock market, derivative market…etc.

Financial Institutions

e.g.: Banks, central banks, mutual funds, hedge funds

Pension fund, insurance… …etc.

Also about financial crisis, regulations…etc.

What it is about?

Stock Exchange

Banks

What it is about?

Dow Jones Index closes above 20,000

4

What it is about?

Financial Crisis – Bankruptcy

Bail outs

FORBES 400 RICHEST PEOPLE

9

Lecture 1 – INTRODUCTION

Why we need finance?

Why we need to understand financial market & institutions?

Both financial Market and Institutions facilitate things (financial system)

Allocate Resources (limited resources – optimization)

It is the structure that people do things, it is one of the fundamental pillars of the society

Allocate resources

– incentivize people to do thing

To sponsoring business to realize things

To manage risk /diversified vs. systematic

Andrew Carneige 1989 – Gospel of Wealth

It is in the details that things happen

About institutions, about securities, securities market, about regulations, and about financial crisis

Try my upmost effort to include a world perspective, G20

Capitalism

Big multinational institutions – dispersed all over the world – financial arrangement

Forbes 400 richest people – no celebrity. No athletes, no nobel prize winner, one book writer- bill gates

Oprah winfrey , steven spielsburg

Forbes highest paid celebrity

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What is Financial Market?

Financial Markets are markets where people trade

What to trade? – financial instruments

Thus, financial markets are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage

How this happens?

Through trading financial instruments

Market is where people trade products on a large scale

Finance is much more broad and general than trading and making money

Example1: borrowing and establish a lemonade stand for $1000

12

Financial Instruments – I

Aka. Securities

(Bond, Stocks, Foreign currency, derivatives, ETF, hedge fund…etc.)

Securities are claims on the issuer/borrower’s future income or assets

13

Flow of Funds Through the Financial System

Question !

Who participate in Financial Market?

MUTUAL BENEFICIAL

14

Flow of Funds Through the Financial System

Question !

Who participate in Financial Market?

15

Financial Instruments – II

Aka. Securities (Bond, Stocks, Foreign currency, derivatives…etc.)

Securities are claims on the issuer/borrower’s future income or assets

Why investor want to buy these securities?

What about funds (hedge fund, mutual fund, pension fund, ETFs…etc.)?

A portfolio of securities

16

Direct Financing vs. Indirect Financing

Direct Finance: Borrowers and Lenders meet directly to exchange securities, no involvement of any type of intermediaries.

Indirect Finance: Lenders provide funds to financial intermediaries (e.g.: banks) and intermediaries independently pass these funds onto borrowers

Examples?

Are hedge fund /pension fund/ mutual fund Indirect or direct finance?

What about our lemonade stand example? Does it belong to direct vs. indirect financing?

What about the house loan – indirect financing, the borrower and the lender don’t know each other. Car loan

17

Why Financial Market is Important?

Channeling funds from savers (lenders) to spenders (borrowers) – mutual beneficial

– affects personal wealth, business firms

– efficient allocation of capital (money) – promote economic growth

This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this – might as well put the money under your mattress.

However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she is willing to pay you some interest for the use of the funds.

Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them

18

Classification of Financial Markets

By nature of claim/type of securities.

Debt market; Equity market; Derivatives; foreign exchange…etc.

By seasoning of claim.

Primary market; Secondary market

By organizational structure

Exchange market; Over-the-counter market

By maturity of claim.

Money market; Capital market

By immediate delivery or future delivery

Cash or spot market; Derivative market

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Debt

Periodic payment at fixed frequency

Fixed amount of payment

Fixed maturity

Debt contract –* indenture

Principle at maturity or sold before maturity

No voting rights

Capital gain/loss when sold

Government could issue bonds

Priority claimant

Equity

Some pay dividends, but not for sure, and no specified frequency

Dividends amount is not fixed

Infinite maturity

Can only be sold and resold

Ownership claim

Voting rights

Capital gain/loss when sold

Government could not issue stocks

Residual Claimant

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Debt vs. Equity

Debt Markets (bond markets)

Short-Term (maturity < 1 year)

Long-Term (maturity > 10 year)

Intermediate term (maturity in-between)

Could be bond or mortgage (tradable)

Represented $38.2 trillion at the end of 2012.

Equity Markets (stock markets)

Could be common stocks, preferred stocks

infinite maturity (retire vs. repurchase)

Total value of all U.S. equity was $18.7 trillion at the end of 2012.

Debt markets, allow people (household, corporations, government to borrow money) .

It is a type of contract arrangement, which specify the issuer (borrower of money) get some initial amount of money , and the holder subsequently receive a fixed amount of payment in the future over a specified time period.

Many types of market interest rates: mortgage rates, car loan rates, credit card rates, etc.

They are different, but they tend to move together.

Company sell stocks to raise money

Equity entitles the holder of the securities a share of borrower’s future cash flow/income/profit

Some pay periodic payment, not necessarily

Even if they pay, they don’t specify frequency, or amount

Differences between debt market and equity market

Debt market is substantially larger than the equity market

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Bond & Stock Market

Both bond market and stock market belong to direct financing

Stock market is much smaller than bond market (18.7 trillion vs. 38.2 trillion)

But the stock market receives the most attention from the media.

WHY?

It capture the upside potential, and involve more individual investors

Bond market – Very infrequent trades; participants are mostly institutions

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Different Types of Interest Rate

Government Securities

Government can’t issue ownership claim ( in other words, stocks)

Government only issue debts

For the federal government – DEPARTMENT OF THE TREASURY: Treasuries

Short term: T-bills

Long terms: T-notes and T-bonds

For the state/local government – Municipal Bond

For government sponsored entities (GSEs) – Agency Bond

Bureau of Engraving and Printing (BEP)

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Corporate Securities

Ways for corporate to raise money from FINANCIAL MARKET (DIRECT FINANCING)

Issue Bonds (Debt Claim, the majority is long-term) or commercial papers (short term debt)

Or alternatively, Issue Stocks (Equity claim)

BALANCE SHEET : issue bonds – liability; issue stocks – equity

Both are source of company’s capital and are used to purchase assets and maintain operation: A= L+E

*What about indirect financing that corporates can take advantage of?

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Corporate Securities

1. Public issuance – Public Offering

Initial public offering (IPO) – could refer to stock issuances, as well as bond issuances

Register with SEC (Securities and Exchanges Commission)

Larger than 1.5 million and maturities > 270 days

SEOs (seasonal equity offering) – just stocks

2. Private Placement

Instead of selling the securities to the public, the company can sell it to only several parties (e.g.: parent companies, wealthy friends…etc.) rather than the public

E.g.: 144a bonds, reg D shares

https://www.statista.com/statistics/226152/largest-ipos-in-the-united-states-by-issue-volume/

GM 2010 – 20.1 billion

Visa – 18 billion in 2008

Agricultural Bank of China Ltd in 2010, when the lender raised $22.1 billion.

Facebook – 16 billion in 2012

Alibaba – initial public offering now ranks as the world’s biggest at $25 billion in 2014

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Primary vs. Secondary Market

Primary Market

New security issues sold to initial buyers

By corporates or government agency ultimately using the money

Typically involves an investment bank (underwriter) who underwrites the offering

Money received by the offering company = offer price * # shares offered

Secondary Market

Securities previously issued are bought and sold (so secondhand)

Examples include the NYSE, AMEX, and Nasdaq

Involves both brokers and dealers who help facilitate trading of these securities

What about venture capital?

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Primary

Initial issue of security

Raise funds for Borrower

Usually trade over-the-counter (OTC) – allocation of shares

Secondary

Transfer of titles of existing securities

No New Funds are raised for Issuers

Could be organized as exchanges, (e.g.: Amex, NYSE), or alternatively as over-the-counter (OTC) markets (e.g.: NASDAQ)

Why we need secondary market?

Two important function: a. Provides Liquidity for Seller b. Determines the price

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Exchanges vs. OTC Markets

Exchanges

Trades conducted in centralized locations (e.g., New York Stock Exchange, (NYSE, AMEX…etc.)

Standardized price and quote – broker/dealer needed

Regulatory Control

Relative high transaction costs (such as fees, and commissions)

Over-the-Counter Markets

investors at different locations buy and sell (e.g.: NASDAQ)

More price competition – market makers, less fee

Higher Risk (Fraudulent firms), less transaction costs

Best example: market for Treasury Securities

The NYSE is an auction-based market where traders meet on the floor of the exchange, using person-to-person, telephone orders or electronic orders.

The Nasdaq, on the other hand, is strictly an electronic exchange. The NASDAQ is a global electronic marketplace for buying and selling securities, as well as the benchmark index for U.S. technology stocks. NASDAQ was created by the National Association of Securities Dealers to enable investors to trade securities on a computerized, speedy and transparent system, and commenced operations on February 8, 1971. By Barry Norman, Investors Trading Academy.

Broker: scottrade, TD Ameritrade etrade, optionshouse Charles schwab, fidelity

No inventory

Their profit come from their collected fees, and commissions

Dealers: Financial companies

The buy and sell stocks for their own account

Market maker

They are the counter part of your trade

Open bell : https://www.youtube.com/watch?v=wNzJSEZvcSE https://www.youtube.com/watch?v=Wldmh_UJVrs

Closing bell :https://www.youtube.com/watch?v=DqMV4PH1JFg

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Broker vs. Dealer

Both brokers and dealers matches desired buyers and sellers for a security

Broker: Scottrade, TD Ameritrade etrade, optionshouse Charles schwab, fidelity

No inventory

Their profit come from their collected fees, and commissions

Dealers: Financial companies

The buy and sell stocks for their own account

Market maker

They are the counter part of your trade

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NYSE trading floor

Brokers

ann1num

TOP dealers in 2016 by Revenue

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Exchange

Visible Marketplace

All Members Trade with exchanges

Accounts with exchanges (specialist) less risk

Relatively costly

More oversight / regulation

OTC

Wired Network of Dealers, No Central, Physical Location

All Securities Traded directly with the counterpart

Risky trading with fraudulent firms

Larger amount

Less oversight / regulation – customized contract basis

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Money vs. Capital Market

We can also classify markets by the maturity of the securities:

Money Market:

Short-Term debt (maturity < 1 year) e.g.: treasury bills, federal funds, commercial papers, repos

Capital Market:

Long-Term debt (maturity > 1 year)

e.g.: commercial and consumer loans, corporate bonds, agency bonds…etc.

& equities (infinite maturity)

Principal Money Market Instruments

Principal Capital Market Instruments

Globalization of Financial Markets

Foreign exchange market

is where international currencies trade and exchange rates are determined.

Although most people know little about this market, it has a daily volume nearing $3 trillion!

However in recent years, USD keep weakening

1/10 of bond market, and 1/5 of stock market

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USD exchange rate Index

How Exchange Rate Affect us?

When the dollar (USD) strengthens,

USD becomes more expensive compared with other currencies

Thus, domestic goods become more expensive, reducing foreign purchase (exports)

Foreign currencies and goods become cheaper compared with USD increasing domestic purchase of foreign goods (Imports)

What about when USD weakens?

Other currencies become more expensive compared with USD

Thus, foreign goods become more expensive, reducing imports. Domestic goods become cheaper, increasing exports.

Major 6 currencies

USD, Euro, British Pound(GBP), CAD, Australian Dollars(AUD), and Japanese Yen (JPY), *Swiss Franc

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Global Perspective: Relative Decline of U.S. Capital Markets

The U.S. has lost its dominance in many industries: automobiles and consumer electronics, etc.

A similar trend appears at work for U.S. financial markets, as London and Hong Kong compete. Indeed, many U.S. firms use these markets over the U.S.

Why?

9-11 made U.S. regulations tighter

Greater risk of lawsuit in the U.S. – means higher cost of listing

Sarbanes-Oxley has increased the cost of being a U.S.-listed public company (legal and financial costs)

Globalization of Financial Markets

Foreign Bonds

Sold in foreign country, and denominated in that country’s currency

Foreign Stocks (via Overseas IPOs)

Stocks sold in foreign country, and denominated in that country’s currency

Eurobond (Now larger than U.S. corporate bond market)

Sold in foreign country, but denominated with different currency

Eurocurrencies

Foreign currencies deposited in banks outside the home country

Now more than 80% of new issued bonds are eurobonds

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Foreign Index

Russell 2000 and Russell 3000

Maintained by FTSE in London stock exchange. S&P 500 is the most popular with regard to big-cap mutual fund, while the Russell 2000 is the most popular with sml and mid-cap mutual fund.

45

Review

Why financial system is important?

Different types of financial markets

bond vs. stock

primary vs. secondary

exchanges vs. OTC market

money vs. capital

Foreign markets and foreign exchange market

Important trend in global financial market

Flow of Funds Through the Financial System

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