nbfi and securities market institutions znonbank financial intermediaries (nbfi) -- financial...
Post on 20-Dec-2015
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NBFI and Securities Market Institutions
Nonbank Financial Intermediaries (NBFI) -- Financial Intermediaries other than banks.
Experience “nightmares” of disintermediation and loan default, like banks.
In particular, we cover Securities Market Institutions (e.g. investment banks)
Less regulated than banks better able to handle problems? disadvantages of not being banks
Securities Market Institutions
Investment Banks – buys and sells securities (stocks and bonds) generator of significant financial innovation
(financial derivatives), including mortgage-backed securities
An important behavior for their business
operation: underwriting -- buying the entire issue then selling it in the market when they choose
Securities Brokers and Dealers -- conduct trading in the secondary market
Brokers -- arrange sales between buyers and sellers
Dealers -- “play the market” with bonds and/or stock
The Securities Industry Versus the Banking Industry
The Glass-Steagall Act (1933) -- separation of banking industry from the securities industry
Arguments for Repealing Glass-Steagall
Brokerage firms invaded banking industry with “bank-type” accounts.
Benefits from increased competition.Financial markets are more
sophisticated and liquid.
Arguments for Keeping Glass-Steagall
Securities market activity is risky, could mean significant losses for banks.
Potential conflicts of interest between banking division and trading division.
Financial Services in the Post Glass-Steagall Era
2000 -- Repeal of the Glass-Steagall Act (Gramm-Leach-Bliley Act)
A series of mergers of large banks and securities market institutions to increase economies of scale (e.g. Chase and J.P. Morgan).
Nonbank Financial Intermediaries
Structured as a financial intermediary – pooling small savers’ funds (liabilities) to make large loans to borrowers (assets).
Makes profits off the difference in liquidity and default risk between their assets and liabilities.
Can experience the “bank nightmares” of disintermediation and loan default.
Insurance Companies
Life Insurance Companies
-- Assets: Corporate Bonds,
Commercial Mortgages, Stock
-- Liabilities: promised payouts
upon death
Property and Casualty Insurance Companies
-- Assets: Municipal Bonds,
Treasury Bonds, Corporate
Bonds, Stock
-- Liabilities: promised payouts
upon fire, accidents, etc.
Mechanisms to Reduce Moral Hazard and Adverse Selection
Offering insurance to relatively narrow (low-risk) segment of population
Risk-based premiumsLowering limits of coverage to cover
just “the basics”Deductibles and co-payments
Pension Funds
Assets: different types of Bonds or Stocks
Liabilities: promised payouts upon retirement
Defined Contribution Pensions
Defined Contribution Pensions -- Employee contributes amounts over his/her working years to an identified fund, with possibly employer contributions as well. Upon retirement or leaving the firm, employee receives the fund. Taxes are typically deferred until the fund is withdrawn from.
Examples of Defined Contribution Pensions
Individual Retirement Accounts (IRAs) -- Classic IRAs and Roth IRAs
Keough Plans -- Self-Employed individuals
401(k) Plans (and 403(b) Plans) -- increasing in frequency
Defined Benefit Pensions
Defined Benefit Pensions -- Employee does not contribute over his/her working years, is promised a fixed monthly payment upon retirement.
Characteristics of Defined Benefit Plans
Vesting -- How long the employee has to work at the firm to be eligible for pension.
Fully Funded Versus Underfunded
-- Fully Funded: employer
contributions plus returns fully
cover promised benefits
-- Underfunded: employer
contributions plus returns do not
cover promised benefits
Employee Retirement Income Security Act (ERISA)Regulates Pensions
-- degree of underfunding
-- how pension is invested
-- reporting and examinationCreation of Pension Benefit
Guarantee Corporation -- pension insurance
Examples of Defined Benefit Pensions
Some Corporate, (more frequently) Federal and State and Local Government Pension Plans
Social Security -- “pay as you go” plan
The Trend Toward Defined Contribution Pensions
Employers moving away from defined benefit to defined contribution plans, largely for convenience.
To the employee – potential losses and (big) wins.
Will it affect the retirement decision of individuals?
Finance Companies
Assets -- Consumer loansLiabilities -- (their own) Commercial
Paper, Stock, and Corporate Bonds
Not subject to bank regulation (due to not being an issuer of deposits)
In general, not eligible for Discount Window
Mutual Funds
Assets -- bonds, stocks, as advertised in prospectus
Liabilities -- mutual fund shares
Regulated by Securities Exchange Commission (SEC)
Some have insurance against dishonest practices (SIPC).
Mutual Funds
Can offer unique features based upon characteristics of asset portfolio
Tax-exempt mutual fundsCheckability and money market
mutual funds (MMMF)
Subprime Mortgages, NBFI, and Investment Banks
Large amount of high default risk mortgage-backed securities (MBS) held by investment banks and other NBFI (e.g. insurance companies, pension funds worldwide).
Defaults in MBS adversely affects all the holders.
2008 – collapse of Bear Stearns and Lehman Brothers (investment banks).
AIG and Credit Default Swaps
AIG – large insurance company.Credit Default Swaps (CDS) – financial
derivative which provides insurance against a defaulted MBS.
Key property of CDS – anyone could buy these policies in almost unlimited quantities, even if they were not the holders of the MBS.
Defaults in MBS huge payoffs to holders of CDS significant disintermediation.
2008 – collapse of AIG.
Regulatory Actions, NBFI, and the Credit Crunch
Federal Reserve opened the Discount Window to investment banks, and some other nonbanks
With the FDIC, Fed helped to arrange some mergers of failing investment banks with banks (e.g. Bear Stearns and Chase-JP Morgan)
Bailout of AIG, Fannie Mae, and Freddie Mac.Fed franted bank holding company status to
some NBFI (GMAC) and investment banks (Goldman Sachs, Morgan Stanley)
Underlying Issues: The Credit Crisis
Bailouts -- necessary to avoid financial and economic depression or increasing Moral Hazard/Adverse Selection?
What about the banks that remained conservative and adhered to fundamentals?
Consistency in response – Bear Stearns versus Lehman Brothers.
Where was (and is) the SEC?
Underlying Issues: Beyond the Credit Crisis
The end of stand-alone investment banks?Extinction of finance companies?Harsher regulations after the crisis passes for
banks and investment banks (extension of Dodd-Frank Act, like FIRREA)?
Tougher regulation of financial derivatives?Other players entering banking and financial
services (e.g. Walmart, K-Mart, AAA)?Time for a totally revamped regulatory structure
for banking, NBFI, and securities market institutions?