Slide 1: The Financial Services Industry and Risks of Financial Institutions
Instructor: Dr. QU Baozhi Phone: (852) 27887312 Email: baozhiqu@cityu.edu.hk Office: ACAD-P7407
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Slide 2: Today’s Topics
Securities Firms and Investment Banks (Ch. 4) Mutual Funds and Hedge Funds (Ch. 5) Finance Companies (Ch. 6) Risks of Financial Intermediation (Ch. 7)
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Slide 3: Securities Firms and Investment Banks
Investment banking: the raising of debt and equity securities for corporations or governments. Nature of business:
• Underwrite securities. • Market making. • Advising (example: M&A, restructurings).
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Slide 4: Size, Structure and Composition (U.S.)
Dramatic increase in number of firms from 1980 to 1987. Decline of 31% following the 1987 crash, to year 2003. 1987: Salomon Brothers held $3.21 billion in capital. 2003: Merrill Lynch held capital of $24.8 billion. Many recent inter-industry mergers (i.e., insurance companies and investment banks).
• Role of Financial Services Modernization Act, 1999 2-4
Slide 5: Top U.S. Underwriters, 2006
Manager SSB J.P. Morgan Deutsche Bank Morgan Stanley Lehman Bros. Amount (Billions) $668.8 506.1 475.0 454.6 446.5 Market Share 8.7% 6.6 6.2 6.0 5.8
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Slide 6: Key Activities
Investing Investment banking
• Activities related to underwriting and distributing new issues of debt and equity.
Market making
• Increasing importance of online trading
Trading
• Position trading, pure arbitrage, risk arbitrage, program trading
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Slide 7: Key Activities (continued)
Cash management Assisting with mergers and acquisitions Back-office and service functions
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Slide 8: Balance Sheet
Key assets:
• Long positions in securities and commodities. • Reverse repurchase agreements.
Key liabilities:
• Repurchase agreements major source of funds. • Securities and commodities sold short. • Broker call loans from banks
Capital levels much lower than levels in banks
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Slide 9: Global Issues
Global nature of securities firms
• Demonstrated by recent mergers such as Deutsche Bank/Bankers Trust • Dominance of UBS in U.S. mortgage backed securities markets
Growth in securities trading and underwriting is a global event
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Slide 10: Pertinent Websites
Federal Reserve: www.federalreserve.gov NASD: www.nasd.com NYSE: www.nyse.com SEC: www.sec.gov Securities Industry Association: www.sia.com SIPC: www.sipc.org The Banker: www.thebanker.com Thompson Fin. Securities Data: www.tfibcm.com
Wall Street Journal www.wsj.com
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Slide 11: Mutual Funds
Mutual Funds: financial intermediaries that pool the financial resources of individuals and companies and invest in diversified portfolios of assets.
• Open-ended • Closed-end
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Slide 12: Size, structure and composition (U.S.)
• • • • First mutual fund: Boston, 1924. Slow growth, initially. Advent of money market mutual funds, 1972. Total assets in stock and bond mutual funds:
» 1940: $0.5 billion. » 1990: $1,065.2 billion » 2000: $6,964.6 billion » 2006: $10,413.7
• Institutional funds
» 80 percent of retirement plan investments 2-12
Slide 13: Size, Structure and Composition (U.S.)
• By asset size, mutual fund industry second most important FI group. • Recent inroads by commercial banks and insurance companies
» Mellon purchase of Dreyfus » State Farm (9,000 agents) » As of 2006, insurance companies managed approximately 10% of mutual fund assets
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Slide 14: Unit Trusts and Mutual Funds in Hong Kong
First Unit Trust in Hong Kong: funded by HSBC in 1960 Slow growth initially Rapid growth since 1980s
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Slide 15: Unit Trusts and Mutual Funds in Hong Kong
Year Number of Unit Trusts and Mutual Funds Authorized by SFC 69 504 1,219 1,872 Total Net Asset Value (US$ million) -10,600 97,594 534,288
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1980 1987 1996 2003
Slide 16: Unit Trusts and Mutual Funds in Hong Kong
Year Number of Unit Trusts and Mutual Funds Authorized by SFC 1,942 1,998 1,980 2,123 Total Net Asset Value (US$ million) 551,219 667,585 910,254 1,077,160
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2004 2005 2006 2007
Slide 17: Funds by Type
Number of Total Net Asset Value (US Funds (3/2008) $ million,3/2008) 342 224,116 1,042 157 46 637,641 79,882 81,472
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Bond Funds Equity Funds Diversified Money Market
Slide 18: Web Resources
Hong Kong Securities and Futures Commission (HKSFC): http://www.hksfc.org.hk/eng/html/index.html Hong Kong Investment Funds Association (HKIFA): http://www.hkifa.org.hk
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Slide 19: Returns to Mutual Funds
Income and dividends of underlying portfolio. Capital gains on trades by mutual fund management. Capital appreciation in values of assets held in the portfolio.
• Marked-to-market. • Net-asset value (NAV).
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Slide 20: Types of Funds
Open-ended funds: contrast with most corporate securities traded on stock exchanges. Closed-end investment companies:
• Fixed number of shares
» Example: REITs (Real Estate Investment Trusts) » May trade at premium or discount
Load versus no-load funds.
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Slide 21: Mutual Fund Costs
Two types of fees:
• Sales loads
» Generally, negative effect on performance outweighs benefits
• Fund operating expenses
» Management fee, etc.
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Slide 22: Balance Sheet and Trends
Money Market Funds
• Key assets are short-term securities (consistent with deposit-like nature)
» 2006: $1,514.9 billion (65.5% of total assets)
• Most have share values fixed at $1 and adjust number of shares owned by the investor.
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Slide 23: Balance Sheet and Trends
Long-term Funds
• Stocks comprised over 70.7 % of asset portfolios in 2006. • Credit market instruments 27.2% of asset portfolios • Shift to other securities such as credit market instruments, U.S. Treasuries, municipal bonds etc. when equity markets not performing as well.
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Slide 24: Regulation
One of the most closely regulated among nondepository FIs. Primary regulator:
• SEC in U.S.: Emphasis on full disclosure and antifraud measures to protect small investors • SFC in Hong Kong
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Slide 25: Global Issues
Worldwide growth in mutual fund investment not as great as in the U.S.
• $2.575 trillion in 1996 to $10.490 trillion in 2006
» Over 307% growth
• Larger returns in U.S.stock markets • Greatest development in countries with most advanced markets • Opportunities from declining Japanese markets • Efforts to reduce barriers for U.S. mutual fund sponsors
» China and other Asian countries
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Slide 26: Hedge Funds
Not technically mutual funds
• Not subject to SEC regulation • Organized as limited partnership
» Small number of sophisticated investors
• Common feature is use of leverage
High returns in 1990s
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Slide 27: Hedge Funds
Near collapse of Long-Term Capital Management
• $3.6 billion bailout • 2003 SEC scrutiny of hedge funds • Scandals such as Canary Capital Partners involving trades with mutual funds
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Slide 28: Finance Companies
• Activities similar to banks, but no depository function. • May specialize in installment loans (e.g. automobile loans) or may be diversified, providing consumer loans and financing to corporations, especially through factoring. • Commercial paper is key source of funds. • Captive Finance Companies: e.g. GMAC
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Slide 29: Major Types of Finance Companies
Sales finance institutions
• Ford Motor Credit and Sears Roebuck Acceptance Corp.
Personal credit institutions
• Household Finance Corp. and American General Finance.
Business credit institutions
• CIT Group and Heller Financial. • Equipment leasing and factoring.
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Slide 30: Largest Finance Companies
Company Name General Electric Capital Services Citigroup GMAC Ford Motor Credit Company J. P. Morgan Chase Total Assets (Millions) $333,780 164,205 154,764 153,000 144,835
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Slide 31: Balance Sheet and Trends (U.S.)
Business and consumer loans are the major assets
• 52.8% of total assets, 2006. • Reduced from 95.1% in 1977.
Increases in real estate loans and other assets. Growth in leasing Finance companies face credit risk, interest rate risk and liquidity risk.
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Slide 32: Balance Sheet and Trends (U.S.)
Consumer loans
• Primarily motor vehicle loans and leases. • Anomalous low auto finance company rates are anomalous following 9/11 attacks.
» Attempts to boost new vehicle sales via 0.0% loans lasted into 2005. » By 2003, rates 3.5% lower than banks on new vehicle rates
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Slide 33: Balance Sheet and Trends
Mortgages
• Recent addition to finance company assets • Smaller regulatory burden than banks • May be direct mortgages, or as securitized mortgage assets. • Growth in home equity loans
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Slide 34: Business Loans
Business loans comprise largest portion of finance company loans. Advantages over commercial banks:
• Fewer regulatory impediments to types of products and services. • Not depository institutions hence less regulatory scrutiny and lower overheads. • Often have substantial expertise and greater willingness to accept riskier clients.
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Slide 35: Liabilities
Major liabilities: commercial paper and other debt (longer-term notes and bonds). Finance firms are largest issuers of commercial paper (frequently through direct sale programs).
• Commercial paper maturities up to 270 days.
Consequently, management of liquidity risk differs from commercial banks relying on deposits.
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Slide 36: Global Issues
In countries other than the U.S., Finance companies are generally subsidiaries of commercial banks or industrials. In Japan, ownership of finance companies by banks created opportunities when banks hit by increase in nonperforming loans
• GE Capital/Japan Leasing Corporation
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Slide 37: Risks of Financial Intermediation
Risks associated with financial intermediation: • Interest rate risk, market risk, credit risk, offbalance-sheet risk, technology risk, operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk Note that these risks are not unique to FIs
• Faced by all global firms
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Slide 38: Interest Rate Risk
Interest rate risk resulting from intermediation:
• Mismatch in maturities of assets and liabilities.
» Interest rate sensitivity difference exposes equity to changes in interest rates
• Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.
» Inconsistent with asset transformation role
Refinancing risk. Reinvestment risk.
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Slide 39: Market Risk
Incurred in trading of assets and liabilities (and derivatives).
• Examples: Barings & decline in ruble. • DJIA dropped 12.5 percent in two-week period July, 2002. • Heavier focus on trading income over traditional activities increases market exposure.
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Slide 40: Market Risk
Distinction between Investment Book and Trading Book of a commercial bank
• Heightened focus on Value at Risk (VAR) • Heightened focus on short term risk measures such as Daily Earnings at Risk (DEAR)
Role of securitization in changing liquidity of bank assets and liabilities
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Slide 41: Credit Risk
Risk that promised cash flows are not paid in full.
• Firm specific credit risk • Systematic credit risk
High rate of charge-offs of credit card debt in the 1980s, most of the 1990s and early 2000s Credit card loans (and unused balances) continue to grow
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Slide 42: Implications of Growing Credit Risk
Importance of credit screening Importance of monitoring credit extended Role for dynamic adjustment of credit risk premiums Diversification of credit risk
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Slide 43: Off-Balance-Sheet Risk
Striking growth of off-balance-sheet activities
• Letters of credit • Loan commitments • Derivative positions
Speculative activities using off-balance-sheet items create considerable risk
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Slide 44: Technology and Operational Risk
Risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events.
• Some include reputational and strategic risk
Technological innovation has seen rapid growth
• Automated clearing houses (ACH) • CHIPS • Real time interconnection of global FIs via satellite systems
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Slide 45: Technology and Operational Risk
Risk that technology investment fails to produce anticipated cost savings. Risk that technology may break down.
• CitiBank’s ATM network, debit card system and on-line banking out for two days • Wells Fargo • Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded
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Slide 46: Technology and Operational Risk
Operational risk not exclusively technological
• Employee fraud and errors • Losses magnified since they affect reputation and future potential • Merrill Lynch $100 million penalty
Economies of scale. Economies of scope.
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Slide 47: Foreign Exchange Risk
FI may be net long or net short in various currencies Returns on foreign and domestic investment are not perfectly correlated. FX rates may not be correlated.
» Example: $/€ may be increasing while $/¥ decreasing
Undiversified foreign expansion creates FX risk.
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Slide 48: Foreign Exchange Risk
Note that completely hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities (durations) as well.
• Otherwise, exposure to foreign interest rate risk remains.
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Slide 49: Country or Sovereign Risk
Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Lack usual recourse via court system.
• Examples: South Korea, Indonesia, Thailand. • More recently, Argentina.
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Slide 50: Country or Sovereign Risk
In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans
» Weak position if currency collapsing or government failing
Role of IMF
» Extends aid to troubled banks » Increased moral hazard problem if IMF bailout expected 2-50
Slide 51: Liquidity Risk
Risk of being forced to borrow, or sell assets in a very short period of time.
• Low prices result
May generate runs.
• Runs may turn liquidity problem into solvency problem • Risk of systematic bank panics • Role of deposit insurance policy (see Chapter 19)
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Slide 52: Insolvency Risk
Risk of insufficient capital to offset sudden decline in value of assets to liabilities.
• Continental Illinois National Bank and Trust
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.
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Slide 53: Risks of Financial Intermediation
Other Risks and Interaction of Risks
• Interdependencies among risks.
» Example: Interest rates and credit risk.
• Discrete Risks
» Examples include effects of war, market crashes, theft, malfeasance. » Changes in regulatory policy
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Slide 54: Macroeconomic Risks
Increased inflation or increase in its volatility.
• Affects interest rates as well.
Increases in unemployment
• Affects credit risk as one example.
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Slide 55: In-class Exercise
Characterize the risk exposure(s) of the following FI transactions by choosing one or more of the risk types listed:
a. Interest rate risk b. Credit risk c. Off-balance-sheet risk d. Technology risk e. Foreign exchange rate risk f. Country or sovereign risk
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Slide 56: Exercise
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A bank finances a $10 million, six-year fixedrate commercial loan by selling one-year certificates of deposit. An insurance company invests its policy premiums in a long-term municipal bond portfolio.
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Slide 57: Exercise
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A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a British entrepreneur. A Japanese bank acquires an Austrian bank to facilitate clearing operations. A bond dealer uses his own equity to buy Mexican debt on the less-developed country (LDC) bond market.
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