Chapter 13

Nonbank Finance

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Insurance

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

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

companies– Reinsurance

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Insurance (cont’d)

• Competitive threat from the banking industry

• Credit insurance– Credit default swaps

• AIG case.

– Monoline insurance

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Table 1 Relative Shares of Total Financial Intermediary Assets, 1970–2010 (percent)

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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

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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)

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Pension Funds (cont’d)

• Public pension plans– Social Security

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

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Finance Companies

• Virtually unregulated compared to commercial banks and thrifts institutions

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

– Factoring – Leasing equipment

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Securities Market Operations

• Financial facilitators– Investment banks

– Securities brokers and dealers

– Organized exchanges

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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

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Investment Banking (cont’d)

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

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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

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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

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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

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Mutual Funds (cont’d)

• Load funds and no-load funds

• Regulated by Securities and Exchange Commission

• Money market mutual funds– Function as checkable deposits that

earn interest.

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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

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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

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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.