Download Chapter 13 - Patrick M. Crowley

Chapter 13
Nonbank
Finance
Preview
• This chapter examines how institutions
which engaged in nonbank finance operate
and how they are regulated.
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Learning Objectives
• Summarize the different types of insurance
products and the ways in which insurance
companies can reduce asymmetric
information problems.
• Summarize the distinctions between
defined-benefit and defined-contribution
pensions and the key features of private and
public pension plans.
• List and describe the different types of
finance companies.
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Learning Objectives
• Summarize the roles of investment banks,
securities brokers and dealers, and organized
exchanges.
• Describe the role and activities of mutual funds
in financial intermediation.
• Summarize the key distinctions between hedge
funds and mutual funds.
• Define private equity and venture capital, and
summarize their advantages as investment
funds.
• Describe the two types of government financial
intermediation.
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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
• Competitive threat from the banking
industry
• Credit insurance
– Credit default swaps
• AIG blowup
– Monoline insurance
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Table 1 Relative Shares of Total Financial
Intermediary Assets, 1970–2013 (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
• Public pension plans
– Social Security
• Pay as you go system
• Massive underfunding
• Possible reforms proposed
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FYI: Should Social Security Be
Privatized?
• Privatization proposals take three basic
forms:
– Government investment of trust fund assets in
corporate securities
– Shift of trust fund assets to individual accounts
that can be invested in private assets
– Individual accounts in addition to those in the
trust fund
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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
• 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
• 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:
–
–
–
–
–
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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.
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FYI: The Global Financial Crisis and the
Bailout of Fannie Mae and Freddie Mac
• Legislation passed in 1992 assigned Fannie
and Freddie a federal regulator and
supervisor, the Office of Federal Housing
Enterprise Oversight (OFHEO), but this
regulator was quite weak.
• With weak regulation and strong incentives to
take on risk, Fannie and Freddie grew wildly,
and by 2008 these firms had purchased or
were guaranteeing over $5 trillion of
mortgages and mortgage-backed securities.
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FYI: The Global Financial Crisis and the
Bailout of Fannie Mae and Freddie Mac
• Amidst the losses that came with the
subprime mortgage default, the federal
government was ultimately forced to
takeover both institutions.
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