FIN 3244 Chapter 5 Commercial Banks How and what do Banks do Commercial Banks Basic Operations Take in deposits from Individuals and Small Businesses Make Loans Mostly mortgages and loans to small firms Who do Commercial Banks Typically Deal with Individuals Small Firms What Kinds of Money Problems can this cause Mismatched Loans Short term money makes long term loans Liquidity Problems Mismatched loans can lead to Liquidity Problems Bank Runs The process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close Contagion The process by which a run on one bank spreads to other banks resulting in a bank panic Adverse Select Problems Problems that investors experience in distinguishing low risk borrowers from high risk borrowers before making an investment The Past Banks were concerned with a borrower s creditworthiness o Securitization has caused the times to change Now banks care less about a borrower s creditworthiness Moral Hazard Problems Problems that investors experience in verifying that borrowers are using their funds as intended The Great Depression Great Depression The Great Depression was caused by a tightening of money policy Raise Interest Rate too high people stop borrowing people don t buy prices go down inflation is reduced o Spring of 1928 Began to increase interest rates hoping to deflate inflation rates kept raising interest rates during a recession and that is what made the market crash o Gold Standard Selling gold for dollars 1 Fed Raised interest rates on dollars FDIC Federal Deposit Insurance Corporation Great Depression solution Monitoring Moral hazard problems were mitigated by monitoring Unintended Consequences 2007 2009 Financial Crisis 1st time in US history that a major financial crisis had not started in the commercial banking system o Nonbank financial institutions played a larger role in moving funds between borrowers and savers than commercial banks o People have more money in pensions mutual funds invest more in bonds and New Types of Securities Complex more complex the less transparent harder to tell stock what is really worth Too Big to Fail Policy The policy under which the federal government does not allow large financial firms to fail for fear of damaging the financial system Investment banks recognized as Bank Holding Co Fewer and Larger investment banks than before the crisis Dow Jones Industrial Average Great Depression Stock Market Crash The Great Depression Dow High 381 pts Sep 3 1929 Black Monday Drops to 260 64 31 6 Oct 28 1929 Black Tuesday Drops to 230 pts 11 8 Oct 29 1929 Nov 13 1929 Drops to 198 6 pts Apr 17 1930 Secondary Peak Rises to 294 07 pts 48 Apr 1931 Jul 8 1932 Slides to 41 22 pts Total Drop Over 3 Years 89 2 Doesn t remake peak until Nov 23 1954 2007 2009 Great Recession Comparison Dow High 14 164 53 pts Oct 9 2007 March 5 2009 Drops to 6 594 44 pts 53 4 March 11 2013 Reaches new high of 14 254 38 pts 116 12 Multiple Historic Highs Over 18 000 pts in December 2014 Feb 13 2015 Dow closed at 18 019 35 All Time High S P 500 closed at 2 096 99 on Feb 13 2015 Investment Banks 2 Investment Bank Activities 1 Providing Advice on New Security Issues 2 Underwriting New Security Issues Firms will typically turn to investment banks for advice on how to raise funds by issuing stocks or bonds or by taking out loans Investment banks have information about the current willingness of investors to buy different types of securities and on the price that investors will likely require o This information would be difficult for firms to gather on their own but it is necessary if they want to raise funds at a low cost Underwriting An activity in which an investment bank guarantees the price of a new security to an issuing corporation and then resells the security for a profit o One way in which investment bankers earn income is by underwriting firms sales of new stocks or bonds to the public o Underwriting can lower information costs between lenders and borrowers because investment banks put their reputations behind the firms they underwrite o During the financial crisis of 2007 2009 investor confidence was shaken when investment banks underwrote mortgage backed securities that turned out to be poor investments Initial Public Offering IPO The first time a firm sells stock to the public o Investment banks typically earn 6 8 of the total dollar amount raised Secondary Offering Seasoned Offering Security sales by a firm that has o Investment banks typically earn 2 4 of the dollar amount raised in a Syndicate A group of investment banks that jointly underwrite a security issue o In a syndicated sale the lead investment bank acts as a manager and keeps part of the spread and the remainder of the spread is divided among the syndicate members and brokerage firms that sell the issue to the public for an IPO previously sold securities secondary offering 3 Providing Advice and Financing for Mergers and Acquisitions Larger firms expand by acquiring or merging with other firms Smaller firms see that the fastest way of expanding is to be acquired by a larger firm o For example in 2006 the online video company YouTube was concerned that it lacked the financial resources to deal with legal issues arising from people uploading copyrighted material to its site 3 4 Financial Engineering Including Risk Management Financial Engineering The process of designing new securities or investment strategies using sophisticated mathematical models developed by people with advanced degrees in economics finance and mathematics o Those people became to be known as rocket scientists or quants During the financial crisis some policymakers and economists criticized investment banks because they believed the banks had financially engineered securities particularly those based on mortgages Most of these new securities were not well suited to hedging risks but it eventually became clear that many senior managers at commercial and investment banks had not fully understood the newly created derivative products 5 Research Investment banks conduct several types of research for example banks assign research analysis to individual larger firms such as Apple or General Electric Research analysts often provide advice to investors to buy sell or hold popular stocks In recent years some analysts have used the term overweight for a stock they recommend and underweight for a stock they do not recommend The opinions of senior
View Full Document
Unlocking...