NBFI and Securities Market Institutions

Nonbank Financial Intermediaries (NBFI) -- Financial Intermediaries other than banks.

Experiences same fundamental “nightmares” as banks.

Also covers Securities Market Institutions (e.g. investment banks)

Less regulated than banks better able to handle problems? disadvantages of not being banks

(investment banks)

Securities Market Institutions

Investment Banks -- buy and sell securities on the primary market

Profits come from 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 as well as stock

Brokerage Firms -- engage in investment banking, brokering, and dealing

The Securities Industry Versus the Banking Industry

The Glass-Steagall Act (1933) -- separation of banking industry from the securities industry

Arguments to Repeal Glass-Steagall

Brokerage firms have invaded banking industry with “bank-type” accounts (MMMFs, Cash Management Accounts).

Benefits from increased competition.Financial markets are more

sophisticated and liquid today.

Arguments to Keep Glass-Steagall

Banks would have unfair advantage -- FDIC.

Securities market activity is risky, could mean significant losses for banks.

Potential conflicts of interest between banking department and securities department

Financial Services in the Post Glass-Steagall Era

2000 -- Repeal of the Glass-Steagall Act.

Some large banks merging with securities market institutions to increase economies of scale (e.g. Chase and J.P. Morgan).

In general much more overlap between banks and securities market institutions.

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 disintermeidation 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.

Pension Funds

Assets: different types of Bonds or Stocks

Liabilities: promised payouts upon retirement

Defined Contribution PensionsDefined 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, 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 regulationNot 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), most are not insured.

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.

Defaults in MBS adversely affects entire industry

2008 – collapse of Bear Stearns, Lehman Brothers (investment banks), and AIG (insurance company).

The Federal Reserve, Financial Firms,and the Credit Crunch

2008 – established a lending service between the Fed, investment banks, and some other nonbanks -- analogous to the Discount Window.

Arrangement of mergers with some investment banks with banks (e.g. Bear Stearns and Chase-JP Morgan)

Bailout of AIG, Fannie Mae, and Freddie Mac.Granted bank holding company status to some

NBFI (GMAC) and investment banks (Goldman Sachs, Morgan Stanley)

Underlying Issues: The Credit CrunchBailouts -- necessary or increasing Moral

Hazard/Adverse Selection?Consistency in response – Bear Stearns versus

Lehman Brothers.The end of stand-alone investment banks?Where is the SEC?Harsher regulations after the crisis passes for

banks and others (like FIRREA)?Possibly other players entering banking?Time for a totally revamped regulatory structure for

banking, NBFI, and securities market institutions?