FIN3244 Test 2 Study Guide Chapter 5 COMMERCAIL BANKS How do they basically operate o Accept deposits and reinvest in short term securities to invest long term What kinds of money problems can this cause o Mismatched loans maturity of liabilities commercial paper or repos is shorter than the maturity of their assets mortgage backed securities or loans Great Depression solution o Too big to fail problem Moral hazard problem Gov t regulation problems INVESTMENT BANKS Until the 1980s large Investment Banks were partnerships then converted to corporations by the time of the financial crisis Traditional activities o New security issues Advice Investment banks provide advice on raising funds Underwriting IPOs seasoned offerings Investment bank guarantees price to issuing firm and sells it at a higher price making profit off of the difference o Promote Assist in mergers acquisitions M As More recent activities o Financial innovation engineering designing new securities Complexity o Firm research analysis Adverse selection problem Did rating agencies have conflicts of interest Due diligence Proprietary trading o Brings up 2 types of risk Interest rate risk Investment bank hold bonds and other securities so interest risk rises More credit more risk Borrowers may default on Credit risk o Repos repurchase agreements their loans Investment bank buys treasury bills short term loans and agrees to buy them back at a higher price interest What kind of problems resulted Investments in short term loans by investment banks are not backed up by FDIC If the investment bank fails lenders can suffer heavy losses o Moral hazard more separation from ownership and control o Greed By whom The managers Leverage borrowed funds to finance proprietary trading o Reputation problems Shadow bank runs o Insufficient government regulations o No FDIC o No borrowing from the Fed SHADOW BANKING 2007 09 Crisis 1st in US history for a major financial crisis not to start in the commercial banking system Investment banks o Non bank financial institutions now move more money between borrowers and savers than commercial banks AIG swamps Investment banks reorganized to be bank holding co o Because of the financial crisis of 07 no stand alone Investment Banks remain They were either bought by commercial banks or backed by the Fed 1999 Gramm Leach Bliley Act repealed Glass Steagall Financial Holding Companies Regulated by the Fed o Investment banks insured by the Fed as part of the Troubled Asset Relief Program TARP NONBANK FINANCIAL INSTITUTIONS Financial institutions financial firms that raise money to invest in loans and securities Mutual funds hold a portfolio of securities o Reduce investor transaction costs o Diversification risk sharing o Liquidity savers can easily sell shares Money Markets high quality short term assets o Firms start depending on commercial paper sales to Mutual Funds for short term loans rather than get bank loans Interest rates paid on paper was lower than what banks charged on loans Investment banks relied on these For long term investments o Problem Mutual funds stop buying commercial paper Commercial paper risky Panicked withdrawals from the money market funds led the U S Treasury to announce that it would guarantee the holdings against losses In 2008 the Fed stepped in to stabilize the market by buying commercial paper Hedge funds large amounts of assets Finance companies lower regulation o Sell commercial paper and make small loans Consumer finance firms finance company customers have higher default risk so they may be charged a higher interest rate Business finance firms factoring purchasing at a discount Sales of finance firms A R of small firms o Advantages Monitoring collateral value Receive higher interest rates Little regulation allows non standardized loans Pension Funds retirement accounts 20 of all US financial assets o 10 trillion in 2010 Insurance Firms specialize in contracts o Premiums for protection of specific events most profit comes from investing the money made in premiums Mitigate adverse selection Law of large numbers risk pooling statistical concept that states that although the death illness or injury risks of an individual can t be predicted the average occurrences of any event for large numbers of people generally can be predicted Diversification Risk based premiums info gathering o Risk based premiums charge higher premiums on auto insurance policies for drivers with multiple accidents and speeding tickets Moral Hazard if you bought fire insurance you may not have as much an incentive to get the sprinklers replaced Deductibles specified amount of a claim that an insurance company doesn t pay Co insurance requires policyholders to pay a certain percentage of the costs of a claim after the deductible has been satisfied Restrictive covenants limit risky activities by the insured if a subsequent claim is to be paid A fire insurance company may refuse to pay a claim if smoke detectors were not installed in accordance with the contract Systematic risk risk to the entire financial system o In enacting FDIC congress was more concerned with systematic risk Now that firms are backed they might have the incentive to make riskier investments Systematic risk exists when the failure of one firm may topple others and destabilize the entire financial system Chapter 8 Security Markets and Transactions CLASSIFIED BY MATURITY Money Markets where short term debt securities are bought and sold o Short term Matures in less than 1 year Capital Markets where long term debt and equity securities are bought ad sold o Long term Matures in over 1 year CLASSIFIED BY WHO GETS THE MONEY Primary and secondary markets o Primary market where new equity debt security issues are sold o Secondary Market where securities are re traded Who is the main recipient of funds from security sales o In the primary market The corporation o In the secondary market Sellers of seasoned equity issues PRIMARY MARKETS Ways to market new security issues o Public offerings Initial Public Offering IPO 1st public sale of the companies stock going public Seasoned equity offerings The sale of additional stock by already public o Private placements firm sells securities without SEC registration to companies private investors o Rights offering firm offers shares to existing stockholders on a pro rata basis IPO PROCEDURE Issuing firm gets existing shareholder s investors who own it s privately issued stock approval Selects
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