nbfi and securities market institutions znonbank financial intermediaries (nbfi) -- financial...

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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

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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?