Chapter 3

Financial Intermediaries

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Deficit Sectors
$
Claims

$ Claims

Surplus Sectors
$
Claims

Financial Intermediaries

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Advantages of Financial Intermediaries

Pooling of small savings. Diversification of risks. Economies of scale in monitoring information and evaluating risks. Lower transactions costs. Special reasons. The above are not mutually exclusive.
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Primary Market vs. Secondary Market

The primary market for securities involves the initial sale. The secondary market for securities involves the resale.

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Investment Banking
Investment banking is the marketing of securities when they are initially sold. Some securities are sold to private buyers. Others are sold to the public. The exact difference is a technical legal issue. Public offerings must be registered with the Securities and Exchange Commission (SEC).
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Public Offerings
Investment banking firms sell public offerings. They are essentially marketers of securities and charge a fee for their services. This is often called an underwriting fee. Syndicates of investment banks are often involved in public offerings. This spreads the resale risk.
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Types of Public Offerings

Firm Commitments. The investment banker purchases the security issue outright and bears the resale risk. Best Efforts. The investment bankers sell whatever theyre able. Fees for firm commitments are much higher. Most bond issues are sold by firm commitment.
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 Shelf Registration. Some securities are sold by shelf registration. This is essentially a preregistration of a security issue. Anytime during the next two years the securities can be brought to market very rapidly. Rule 144A. They do not have to be registered with the SEC and can be resold to other qualified financial institutions.
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Underwriter Spread
4% 3% 2% .75% AAA AA A BBB BB B

Bond Rating
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Secondary Market
Many securities are traded on organized exchanges such as the New York Stock Exchange or NASDAQ. Most bonds are traded over-thecounter (OTC). The OTC market is a network of dealers located throughout the country. Some securities are traded over anonymous electronic trading 3-10 systems.

Security Dealers
Dealers are marketmakers for securities. They maintain an inventory and buy and sell from that inventory. A dealer offers to buy at the bid price and offers to sell at the asked price. The size of the bid-asked spread depends upon two major factors. Volume of trading. Inherent price risk.
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Security Brokers
Brokers are agents who carry out transactions for buyers or sellers. Brokers charge commissions for their services. There are different types of brokers. Full-service brokers provided execution and advice and charge the highest fees. Discount brokers provided execution only.
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Mutual Funds
Mutual funds represent a pooling of funds by many investors. Open-end vs. closed-end funds. Net Asset Value (NAV) = liquidating value. For closed end funds, typically Price < NAV.
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Advantages of Mutual Funds

Information Economies. Diversification. Lower transactions costs.

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Mutual Fund Costs Sales Fees

Front End Load Rear End Load 12b-1 Fees (Annual)

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Mutual Fund Costs

Expense ratio includes: Management fee. Administrative fee. Other fees. Additional Costs: Brokerage commissions.
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Insurance Companies
Life insurance. Casualty insurance. Insurance companies are large investors in fixed income securities. Adverse selection. Moral hazard. Coinsurance.

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Pension Funds
Defined benefit plans. Dollars paid out usually set by some formula, e.g., Pension = (# Years)(Average) (X%). Pension Benefit Guarantee Corporation. Employer bears the reinvestment risk. Defined contribution plans. Dollars paid in are specified. Dollars paid out depend upon returns. Employee bears the reinvestment risk.
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Pension Funds Cash Flows

0 1 2

Horizon Date $ Out Time

$ In

Reinvestment

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Pension Benefit Guaranty Corporation

Insures pensions of private defined benefit plans. Does not ensure government defined benefit plans. Collects premiums from covered plans. Underfunded. Limited benefits.
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Commercial Banks and Thrifts

Heavily regulated. Safety. Widespread effects. Competition. Regulatory agencies. The Federal Reserve. The FDIC. The comptroller of the currency. State banking authorities. Charters. Branches. Insurance. Capital. Failure.
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Important Regulations
Glass Steagall Act separated commercial banking from investment banking, dealers, brokers, mutual funds, insurance.

Restrictions lifted beginning in 1980s and repealed in 1999.

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Important Regulations
RESTRICTIONS ON BRANCHING Banks used to be restricted to operating in one state. Within states, there were three types of branching rules: one office, limited branching, unrestricted branching.

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Bank Economies of Scale

Cost per Dollar of Assets

High Cost

Low Cost

Small Bank

Large Bank

Size

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Federal Deposit Insurance Corporation

FDIC has the power to close failing banks. FDIC insurance covers depositors up to $250,000 for any shortfalls.

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Bank Balance Sheet

Liabilities & Assets Equity Book Market Book Market Value Value Value Value Cash 20 20 Deposits 150 150 Loans 170 100 Bonds 40 0 Building 10 10 Equity 10 0 200 130 200 150

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