chapter 13 nonbank finance. © 2016 pearson education, inc. all rights reserved.13-2 preview this...

Chapter 13

Nonbank Finance

© 2016 Pearson Education, Inc. All rights reserved. 13-2

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• This chapter examines how institutions which engaged in nonbank finance operate and how they are regulated.


Learning Objectives

• Summarize the different types of insurance products and the ways in which insurance companies can reduce asymmetric information problems.

• Summarize the distinctions between defined-benefit and defined-contribution pensions and the key features of private and public pension plans.

• List and describe the different types of finance companies.


Learning Objectives

• Summarize the roles of investment banks, securities brokers and dealers, and organized exchanges.

• Describe the role and activities of mutual funds in financial intermediation.

• Summarize the key distinctions between hedge funds and mutual funds.

• Define private equity and venture capital, and summarize their advantages as investment funds.

• Describe the two types of government financial intermediation.


Insurance

• Life insurance– Permanent (whole, universal, and variable)– Term

• Property and Casualty– Hold more liquid assets than life insurance

companies– Reinsurance


Insurance

• Competitive threat from the banking industry

• Credit insurance– Credit default swaps

• AIG blowup

– Monoline insurance


Table 1 Relative Shares of Total Financial Intermediary Assets, 1970–2013 (percent)


Application: Insurance Management

• To lower moral hazard and adverse selection– Screening

– Risk-based premiums

– Restrictive provisions

– Prevention of fraud

– Cancellation of insurance

– Deductibles

– Coinsurance

– Limits on the amounts of insurance


Pension Funds

• Defined-contribution plan

• Defined-benefit plan– Fully-funded; underfunded

• Private pension plans– Employee Retirement Income Security Act

(ERISA) of 1974• Pension Benefit Guarantee Corporation

(PBGC, Penny Benny)


Pension Funds

• Public pension plans– Social Security

• Pay as you go system• Massive underfunding• Possible reforms proposed


FYI: Should Social Security Be Privatized?

• Privatization proposals take three basic forms: – Government investment of trust fund assets in

corporate securities– Shift of trust fund assets to individual accounts

that can be invested in private assets– Individual accounts in addition to those in the

trust fund


Finance Companies

• Virtually unregulated compared to commercial banks and thrifts institutions

• Sales finance companies• Consumer finance companies• Business finance companies

– Factoring – Leasing equipment


Securities Market Operations

• Financial facilitators– Investment banks

– Securities brokers and dealers

– Organized exchanges


Investment Banking

• Assist in the sale of securities– Advise the corporation on whether it should

issue bonds or stock. – Bonds: advise on maturity and interest

payments– Stocks: advice on price

• Seasoned issues or initial public offering

– Underwrites


Investment Banking

• Regulated by SEC– Registration statement– Provide potential investors with a prospectus– 20 day waiting period


Securities Brokers and Dealers

• Securities brokers and dealers conduct trading in secondary markets

• Brokers– Agents for investors, match buyers and sellers– Paid brokerage commission

• Dealers– Stand ready to buy and sell– Hold inventories– Paid by the ‘spread’

• Brokerage firms– Act as brokers, dealers, and investment bank– Regulated by SEC


Organized Exchanges

• NYSE: largest organized exchange in the world.

• Hybrid of auction market and dealer market.

• Specialist

• Regulated by SEC– Authority to impose regulation and to alter the rules set by

the exchanges

• Securities Amendments Act of 1975

• Growing internationalization


Mutual Funds

• Pool the resources of many small investors by selling shares and using the proceeds to buy securities

• Sovereign wealth funds– Estimated to hold $3 trillion in assets

– Concerns• Size (can cause market instability)

• National security issues

• Provide very little information about their operations

• Open-end fund and closed-end fund


Mutual Funds

• Load funds and no-load funds

• Regulated by Securities and Exchange Commission

• Money market mutual funds– Function as checkable deposits that

earn interest.


Hedge Funds

• Similar to mutual funds but:– Minimum investment typically $1 million– No more than 99 investors– Net worth requirement for investors– Long-term commitment– Speculates on spreads


Private Equity and Venture Capital Funds

• Private equity fund– Long-term investments in companies that are

not traded in public markets.

• Two types– Venture capital funds– Capital buyout funds (leveraged buyout)

• Carried interest


Government Financial Intermediation

• Mortgage market– GNMA, Ginnie Mae– FNMA, Fannie Mae (GSE)– FHLMC, Freddie Mac (GSE)

• Farm Credit System

• Federal Credit Reform Act of 1990

• The creation of GSEs has led to conflict of interest and moral hazard problems.


FYI: The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac

• Legislation passed in 1992 assigned Fannie and Freddie a federal regulator and supervisor, the Office of Federal Housing Enterprise Oversight (OFHEO), but this regulator was quite weak.

• With weak regulation and strong incentives to take on risk, Fannie and Freddie grew wildly, and by 2008 these firms had purchased or were guaranteeing over $5 trillion of mortgages and mortgage-backed securities.


FYI: The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac

• Amidst the losses that came with the subprime mortgage default, the federal government was ultimately forced to takeover both institutions.

chapter 13 nonbank finance. © 2016 pearson education, inc. all rights reserved.13-2 preview this...

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nonbank finance

investment funds

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liquid assets

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investment bankingassist

roles of investment