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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 28
SECURITIES FIRMS (Continued)
Securities Firms
Investment Banks
Mutual Funds
Finance Companies
Government Sponsored Enterprises
Banking Crisis
Sources of Runs, Panics and Crisis
Government Safety Net
Government: Lender of Last Resort
Securities Firms
Investment banks are the conduits through which firms raise funds in the capital markets
Through their underwriting services, investment banks issue new stocks and a variety of other
debt instruments
In underwriting, the investment bank guarantees the price of a new issue and then sells it to
investors at a higher price;
However, this is not without risk, since the selling price may not in fact be higher than the price
guaranteed to the firm issuing the security
Information and reputation are central to the underwriting business;
Underwriters collect information to determine the price of the new securities and then put their
reputations on the line when they go out to sell the issues
In addition to underwriting, investment banks provide advice to firms that wish to merge with or
acquire other firms, for which advice they are paid a fee
Finance Companies
Finance companies raise funds in the financial markets by issuing commercial paper and
securities and use the funds to make loans to individuals and corporations
These companies are largely concerned with reducing the transactions and information costs
that are associated with intermediated finance
Most finance companies specialize in one of three loan types:
Consumer loans,
Business loans,
Sales loans (for example, the financing for a consumer to purchase a large-ticket item like an
appliance)
Some also provide commercial and home mortgages
Business finance companies provide loans to businesses, for equipment leasing
Business finance companies also provide short-term liquidity to firms by offering
Inventory loans (so that firms can keep the shelves stocked)
Accounts receivable loans (which provide immediate resources against anticipated revenue
streams)
Government-Sponsored Enterprises
The government is directly involved in the financial intermediation system through loan
guarantees and in the chartering of financial institutions to provide specific types of financing
Zarai Taraqiati Bank Limited (ZTBL)
Small and Medium Enterprise (SME) Bank
House Building Finance Corporation (HBFC)
Khushhali Bank
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Money & Banking ­ MGT411
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Summary of the financial industry structure
Financial
Primary
Primary uses
Services provided
intermediary
sources of
of funds
funds
(assets)
(liabilities)
Cash
-Pooling of small savings to provide large
Checkable
Depository
Loans
loans
deposits
institution
Saving and time  securities
-Diversified, liquid deposit accounts
(Banks)
-Access to payments system
deposits
Screening and monitoring of borrowers
Borrowing from
other banks
Expected claims  Corporate bonds  -Pooling of risk
Insurance
-Screening and monitoring of policy
Government
Company
holders
bonds
Stocks
Mortgages
-Management of asset pools
Short term loans  Commercial
-Clearing and settling trades
paper
Securities Firm
Bonds
-Immediate sale of assets
Investment Bank
-Access to spectrum of assets, allowing
diversification
-Evaluation of firms wishing to issue
securities
-Research and advice for investors
Shares sold to Commercial
-Pooling of small savings to provide access
Mutual-Fund
customers
paper
to large, diversified portfolios, which can
Company
Bonds
be liquid
Mortgages
Stocks
Real estate
Bonds
Mortgages
-Screening and monitoring of borrowers
Finance
Bank loans
Consumer
Company
Commercial
loans
paper
Business loans
Commercial
Mortgages
-Access to financing for borrowers who
Government-
Farm loans
paper
cannot obtain it elsewhere
Sponsored
Bonds
Enterprises
Student loans
Loan
guarantees
Banking Crisis
Banking crises are not a new phenomena; the history of commercial banking over the last two
centuries is replete with period of turmoil and failure.
By their very nature, financial systems are fragile and vulnerable to crisis
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Money & Banking ­ MGT411
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Table: Worst Banking Crises since 1980
Country
Crises Dates
Estimated cost of
Resolution (as %age of
GDP)
Argentina
1980-82
55%
South
Asian
Indonesia
1997-98
55%
Crises
China
1990s
47%
Jamaica
1994
44%
Chile
1981-83
42%
Thailand
1997
35%
Macedonia
1993-94
32%
Israel
1977-83
30%
Turkey
2000
30%
Uruguay
1981-84
29%
Korea
1998
28%
Cote d'ivoire
1988-91
25%
Japan
1990s
24%
Uruguay
1981-84
24%
Malaysia
1997-98
20%
Figure: Relationship between size of a financial crises and change in GDP Growth
15
10
Ghana
5
1982-89
·
·
Norway
Mexico
1990-93
0
Bulgaria
1994-2000
1996-97
·
·
Argentina
·
Jamaica
1980-82
·
1996-2000
·
-5
Finland
1991-94
·
Malaysia
-10
1997-2001
·
·Indonesia
Uruguay
1997-2002
1981-84
-15
10
20
30
40
50
60
0
Fiscal Cost as percentage of GDP (%)
The Sources and Consequences of Runs, Panics, and Crises
In a market based economy, the opportunity to succeed is also the opportunity to fail!
Banks serve some essential functions in the economy
Access to payment system
Screen and monitor borrowers to reduce information problems
So if bank fails, we lose ability to make financial transactions. Collectively, the economy is
endangered.
Banks' fragility arises from the fact that they provide liquidity to depositors, allowing them to
withdraw their balances on demand, on a first-come, first-served basis
If bank can not meet this promise of withdrawal, because of insufficient funds, it will fail
Reports that a bank has become insolvent can spread fear that it will run out of cash and close
its doors;
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Money & Banking ­ MGT411
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Depositors will rush to convert their balances into cash
Such a run on a bank can cause it to fail
What matters during a bank run is not whether a bank is solvent but whether it is liquid
Here solvency means that the value of the bank's assets exceeds its liabilities (positive net
worth)
Liquidity refers to the sufficient reserves of the bank to meet withdrawal demands
False rumors that a bank is insolvent can lead to a run which renders it illiquid
When a bank fails, depositors may lose some or all of their deposits, and information about
borrowers' creditworthiness may disappear;
For this reason, governments take steps to try to minimize the risk of failure
A single bank failure can also turn into a system-wide panic; this is called contagion
While banking panics and financial crises can result from false rumors, they can also occur for
more concrete reasons;
Anything that affects borrowers' ability to repay their loans or drives down the market price of
securities has the potential to imperil the bank's finances
Recessions have a clear negative impact on bank's balance sheet
Low profitability of firm makes debt repayment much harder
People lose jobs and cant pay their loan
With the rise of default risk, bank's assets lose value and capital drops
With less capital, banks are forced to contract the balance sheet making fewer loans.
The overall business investment falls and bank failure is more possible
Historically, downturns in the business cycle put pressure on banks, substantially increasing the
risk of panics
Financial disruptions can also occur whenever borrowers' net worth falls, as it does during
deflation
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY