Subject Instructor

MODULE 4:
FINANCIAL INSTITUTIONS
AND INTERMEDIARIES

Lesson
1

3
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Lesson 1:
FINANCIAL INSTITUTIONS AND INTERMEDIARIES: AN OVERVIEW

Learning Objectives

After studying Lesson 1, you should be able to:

Explain what a financial institution is.

Discuss the channels through which savers and borrowers are matched in a financial
system
Explain what a financial intermediaries is
Enumerate the primary assets and liabilities of the various Financial Institutions and
Intermediaries

Introduction

What is a Financial Institution?

A financial institution is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans and investments and currency exchange. Financial
institutions can operate at several scales from local community credit unions to international
investment banks.

The financial system matches savers and borrows through two channels:
1. Financial markets, and
2. Banks and other financial intermediaries

These two channels are distinguished by how funds flow from savers or lenders, to
borrowers and by the financial institutions involved. Funds flow from lenders to borrowers directly
through financial markets such as the NYSE and PSE or indirectly through financial intermediaries,
such as banks.

Figure 4-1: MOVING FUNDS THROUGH THE FINANCIAL SYSTEM

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FINANCIAL INTERMEDIAIRES

A financial intermediary is a financial firm, such as a bank, that borrows funds from savers
and lends them to borrowers.

BASIC STRUCTURES OF FINANCIAL INSTITUTIONS/INTERMEDIARIES:

A. Depository Institutions
1. Commercial Banks/ Universal Banks
2. Savings and Loans Associations
3. Mutual Savings Bank
4. Credit Union

B. Contractual Savings Institutions

1. Insurance Companies
2. Pension Funds

C. Investment Institutions
1. Investment Banks
2. Mutual Funds
3. Hedge Funds
4. Finance Companies
5. Money Market Mutual Funds

A. DEPOSITORY INSTITUTIONS

Commercial banks are the most important intermediaries. Commercial banks play a key role
in the financial system by taking in deposits from households and firms and investing most of those
deposits, either by making loans to households and firms or by buying securities such as government
bonds, or securitized loans.

Universal bank is also referred as a full-service financial institutions. It provides a large array of
services including those of commercial banks and investment banks.

The types of services offered include:

 Deposit accounts such as checking and savings

 Loans and credit
 Asset and wealth management
 Buying and selling securities
 Financial and investment advice
 Insurance products

Examples of universal banks:

 Deutsche Bank, ING Bank, UBS, Credit Service, HSBC, Banks of America, JP Morgan
Chase, Wells Fargo, BPI, BDO

Savings and Loans Associations, Mutual Savings Bank, Credit Unions are the other depository
institutions and are introduced in Module 2 – Lesson 2.

These financial intermediaries are legally different from banks, although these “nonbanks”
operate in a very similar way by taking in deposits and making loans.
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B. CONTRACTUAL SAVINGS INSTITUTIONS

These are financial intermediaries that receive payments from individual as a result of a
contract and uses the funds to make investments.

Insurance Companies specializes in writing contracts to protect policy holders from the risk of
financial losses associated with particular events, such as automobile accidents or fires. Insurance
companies collect premiums from policy holders, which the companies then invest to obtain the
funds necessary to pay claim to policy holders and to cover their other costs.

The insurance industry has two segments:

a) Life insurance companies sell polices to protect households against a loss of earnings
from the disability; retirement or death of the insurance person. Examples are Insular Life
Corporation and Philam Life Insurance Corporation.

b) Property and casualty companies sell policies to protect households and firms from the
risks of illness, theft, fire, accidents and natural disasters. Examples are Standard Insurance
Company and Malayan Insurance Corporation.

Pension funds is a financial intermediary that invests contributions of workers and firms in
stocks, bonds and mortgages to provide pension benefit payments during workers’ retirements.

For many people, saving for retirement is the most important form of savings. People can
accumulate retirement savings in two ways: through pension funds sponsored by employers or
through personal savings accounts. Most notable examples of pension funds are Social Security
System (SSS) for employees of private companies and Government Service Insurance System (GSIS)
for government employees.

The two basic types of pension plans are:

A. Defined contribution plan

B. Defined benefit plan

 Defined contribution plan has the following features:

(a) Employer places contributions from employer into investments such as mutual funds,
chosen by the employees. Employees own the value of the funds in the plan. They
also bear the risk of poor investment returns.

(b) If the employee’s investments are profitable, employer’s income during retirement
will be high. On the other hand if the employee’s investment are not profitable,
employee’s income during retirement will be low.

(c) Most private employers “defined contribution plans” in the United States are 401 (k)
plans. Some employers match employee’s contribution up to a certain amount.
Many 401 (k) participants invest through mutual funds, which enable them to hold a
large collection of assets at a modest cost.

 Defined benefit plan

(a) An employer promises employees a particular peso benefit payment, based on each
employee’s earnings and years of service. The benefit payments may or may not be
indexed to increase with inflation.

(b) If the funds in the pension plan exceed the amount promised, the excess remains with
the employer managing the fund.

(c) If the funds in the pension plan are insufficient to pay the promised benefit, the plan
is underfunded and the employer is liable for the different.
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C. INVESTMENT INTERMEDIARIES

In late 2016, Goldman Sachs begun engaging in fintech online lending, offering loans of up
to $30,000 to households with high credit card balances but good credit histories. In the late 1990s,
investment banks increased their importance as financial intermediaries by becoming heavily
involved in the securitization of loans, particular mortgage loans. Investment banks also begun to
engage in propriety trading, which involves earning profits buying and selling securities.

Mutual Funds. These financial intermediaries allow savers to purchase shares in portfolio of
financial assets, including stocks, bonds, mortgages, and money market securities. Mutual funds offer
savers the advantage of reducing transactions costs. Mutual funds provide risk-sharing benefits by
offering a diversified portfolio of assets and liquidity benefits because savers can easily sell the shares.
Moreover, the company managing the fund – for example, BPI Mutual funds, specializes in gathering
information about different investment.

Types of mutual funds:

1. Closed-end mutual funds

This mutual funds issues a fixed number of nonredeemable shares, which investors
may then rode in over – the counter markets just as stocks are traded. The price of a share
fluctuates with the market value of the assets – often called the net asset value (NAV) in the
fund.

2. Open – end mutual fund

This mutual funds issues share that investors can redeem each day after the markets
close for a price tied to the NAV.

Many mutual funds are called no-load funds because they do not charge buyers a
commission, or “load.” Mutual fund companies earn income on no-loads funds by charging
a management fee – typically about 0.5% of the value of the fund’s assets – for running the
fund. The alternative, called load funds, charge buyers a commission to both buy and sell
shares.

Hedge Funds are financial firms organized as a partnership of wealthy investors that make
relatively high risk, speculative investments. Hedge funds are similar to mutual funds in that they
accept money from investor and use the funds to buy a portfolio of assets. However, a hedge fund
typically has no more than 99 investors, all of whom are wealthy inviduals or institutions such as
pension funds. Hedge funds usually make riskier investments than do mutual funds, and they charge
investors much higher fees.

Finance Companies are nonbank financial intermediaries that raise funds through sales of
commercial paper and other securities and use the funds to make small loans to households and
firms? Finance companies raise funds by selling commercial paper (a short – term debt investment)
and by issuing stocks and bonds. They lend these funds to consumers, who make purchases of such
items as car, furniture and home improvements, and to small business. Some finance companies are
organized by a parent corporation to help sell its product.

The three main types of finance companies are:

A. Consumer Finance Companies

B. Business Finance Companies
C. Sales Finance Companies
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Consumer Finance Companies

 These companies make loans to enable consumer to buy cars, furniture and appliances;
to finance home improvement and to refinance households dept.
 Examples are Toyota finance company make loans to consumer who purchase Toyota
automobiles and mega world finance company who extend loans to purchases of mega
world condominium units.

Business Finance Company

 These companies engaged in factoring that is, purchasing at a discount the accounts
receivable of small business firms. Some business finance companies purchase expensive
equipment, such as airplanes or construction equipment and then leave the equipment
to firms over fixed length of time.

Sales Finance Companies

 These companies are affiliated with department stores and companies that manufacture
and sell high-priced goods.
 Large department stores issue credit cards that consumers can use to finance purchases
at those stores. Example is SM department store has established tie-ups with banco de
oro (BDO) – Credit Card Company. This convenient access to credit is part of the stores
marketing.

Money Market Mutual Funds. These are relatively new financial institutions that have the
attributes of a mutual fund but also function to some extent as a depositing institutions because they
offer deposit – type accounts. Like most mutual funds, they sell shares to acquire funds that are then
used to buy money market instruments that are both safe and very liquid. The interest on these assets
is then paid out to the shareholders.

PRIMARY ASSETS AND PRIMARY LIABLITIES OF FINANCIAL INTERMEDIARIES

The previous section discusses how financial intermediaries play an important role in the
economy. Now we look at the principle financial intermediaries and how they perform the
intermediation function. They fall into three categories: depository institutions (banks), contractual
savings institutions, and investment intermediaries. Figure 4-2 provides a guide to the discussion of
the financial intermediaries that fit into these three categories by describing their primary liabilities.

Figure 4-2: Primary Assets and Liabilities of Financial Intermediaries

Primary Liabilities Primary Assets

Type of Intermediary
(Sources of Funds) (Use of Funds)
Depository Institutions
Business and consumer loans,
mortgages, National
Commercial Banks Deposits government securities and
municipal bonds

Savings and Loan Associations Deposits Mortgages

Mutual Savings Bank Deposits Mortgages
Credit Unions Deposits Consumer Loans

Contractual Savings Institutions

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Corporate bonds and

Life Insurance Companies Premiums from policies
mortgages
Government bonds,
Fire and Casualty Insurance corporate bonds and stock,
Premiums from policies
Companies National government
securities
Pension Funds, Government Employer and Employee
Corporate bonds and stock
Retirement Funds Contributions

Investment Intermediaries
Mutual Funds Shares Stocks, bonds
Hedge Funds Shares Stocks, bonds, derivatives
Commercial paper, stocks,
Finance Companies Consumer and business loans
bonds
Money Market Mutual Funds Shares Money Market Instruments
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ASSIGNMENT

R E V I E W Q U E S T I O N S

1. Describe the nature of the basic services of financial institutions.

2. What is considered the most important and significant financial

intermediary in our financial system.

3. Give some services offered by a universal bank.

4. What is the nature of the services of “Pension funds” as a financial

intermediary?

5. Give and explain briefly the three main types of finance companies.
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Lesson 2:
BASICS OF COMMERCIAL BANKING

Learning Objectives

After studying Lesson 2, you should be able to:

Discuss the primary sources and uses of funds of a commercial bank.

Enumerate and explain the basic and important assets of the commercial bank.
Enumerate and explain the basic liabilities of a commercial bank.
Explain how banks manage their assets, liabilities and capital
Explain how banks manage liquidity risk, credit risk and interest rate risk.

Introduction

Commercial banking is a business. Banks fill a market need by providing a service, and they
earn a profit by charging customers for that service. The key commercial banking activities are taking
in deposits from savers and making loans to households and firms. To earn a profit, a bank needs to
pay less for the funds it receives from depositors than it earns on the loans it makes. We begin our
discussion of banking by looking at a bank’s source of funds – primarily deposits – and uses of funds
– primarily loans.

THE BANK BALANCE SHEET

A bank’s sources and uses of funds are summarized on its balance sheet, which is a statement
that lists an individual’s or a firm’s assets and liabilities to indicate the individual’s or firm’s financial
position on a particular day. An asset is something of value that an individual or firm owns. A liability
is something that an individual or a firm owes, particularly a financial claim on an individual or a firm.
Bank capital also called shareholder’s equity is the difference between the value of the bank’s assets
and the value of its liabilities.

BANK ASSETS

Banks acquire bank assets with the funds they receive from depositors, the funds they borrow,
the funds they acquire from their shareholders purchasing the bank’s new stock issues, and the profits
they retain from their operations. The following are the most important bank assets:

1. Reserves and Other Cash Assets

 The most liquid asset that banks hold is reserves, which consist of vault cash – cash on
hand and in the bank (including in ATMs) or in deposits at other banks – and deposits
banks have with the BSP. As authorizes by the Congress, the BSP mandates that banks
hold a percentage of their demand deposits and NOW accounts (but not Money
Market Deposits Accounts (MMDAs)) as required reserves. Reserves that banks hold
over and above those that are required are called excess reserves.

2. Securities

 Marketable securities are liquid assets that banks trade in financial markets. Banks are
allowed to hold securities issues by the government. Treasury and other government
agencies, corporate bonds that received investment-grade rating when they were
first issued, and some limited amounts of municipal bonds, which are bonds issued by
state and local government.
 Because of their liquidity, bank holding of government treasury securities are
sometimes called secondary reserves. Commercial banks cannot invest checkable
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deposits in corporate bonds (although they may purchase them using other funds) or
in common stock in nonfinancial corporations.

3. Loans receivable

 By far the largest of bank assets is loans. Loans are illiquid relative to marketable
securities and entail greater default risk and higher information costs. As a result, the
interest rests banks receive on loans are higher than those they receive on marketable
securities.

1. Loans to business – called commercial and industrial, or C&I, loans

2. Consumer loans, made to households primarily to buy automobiles, furniture and

other goods

3. Real estate loans, which include mortgage loans and any other loans backed
with real estate as collateral. Mortgage loans made to purchase homes are
called residential mortgages, while mortgage made to purchase stores, offices,
factories, and other commercial buildings, are called commercial mortgages.

4. Other assets

 Other assets include banks physical assets, such as computer equipment and
buildings. This category also includes collateral received from borrowers who have
defaulted on loans.

BANK LIABILITIES

The most important bank liabilities are the funds a bank acquires from savers. The bank uses
the funds to make investments, for instance, by using bonds, or to make loans to households and
firms curtains advantages over other ways in which they might hold their funds. For the example,
compared with holding cash, deposits offer greater safety against theft and may also pay interest.
The following are the main types of deposit accounts:

a. Demand or Current Account Deposits

 Bank offer savers demands or current accounts deposits, which are accounts against
which depositors can write checks. Current account deposits come in different
varieties, which are determined partly by banking regulations partly by the desire
bank managers to tailor the checking accounts they offer to meet the needs the
households and firms. Demand deposits and NOW (negotiable order withdrawal)
accounts are the most important categories of checkable deposits.

 Demand deposits are current account deposits on which banks do not pay interest.
NOW accounts are checking accounts that pay interest. Businesses often holds
substantial balances in demand deposits because demand deposits represent liquid
asset than can be accessed with very low transactions costs.

b. Nondemand Deposits

 Savers use only some of their deposits for day to day transaction. Banks offer
nondemand deposits for savers who are willing to sacrifice immediate access to their
funds in exchange in higher interest payments.

 The most important types of nonstruction deposits are saving accounts, money
market deposits accounts (MMDAs), and time deposits, or certificates of deposit
(CDs).
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c. Borrowings

 Banks often have more opportunities to make loans than they can finance with funds
they attract form depositors. To take advantage of these opportunities, banks raised
funds from borrowing. A bank can earn a profit from this borrowing of the interest
rate it pays to borrow funds is lower than interest it earns by lending the funds to
households and firms.

 Borrowings include short-term loans in the BSP funds market, loans from a bank’s
foreign branches or others subsidiaries or affiliates, repurchase agreements, and
discount loans from the BSP. The federal funds market is the market in which banks
make short term loans – often just overnight – to other banks. Although the name
indicates the government money is involved, in fact, the loans in the federal market
involve the bank’s own funds.

BANK CAPITAL

Bank capital, also called shareholders’ equity, or bank net worth, is the difference between
the value of a bank’s assets and the value of its liabilities.

Illustrative Case: Constructing a Bank Balance Sheet

The following entries are from the actual balance sheet of a domestic bank:

In millions
Cash, including cash items in the process of collection P 121
Non-interest-bearing deposits 275
Deposits with the Bangko Sentral ng Pilipinas 190
Commercial loans 253
Long-term bonds (issued by the bank) 439
Real estate loans 460
Commercial paper and other short-term borrowing 70
Consumer loans 187
Securities 311
Interest-bearing deposits 717
Buildings and equipment 16
Other assets 685
Other liabilities 491

Required:

a. Use the entries to construct a balance sheet, with assets on the left side of the balance
sheet and liabilities and bank capital on the right side.

b. The bank’s capital us what percentage of its assets?

Solution:

Requirement A

Using the given information, the bank’s balance sheet will be presented as follows:
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Assets In millions Liabilities and Bank Capital In millions

Cash, including cash items in the
P 121 Non-interest-bearing deposits P 275
process of collection
Deposits with the Bangko Sentral
190 Interest-bearing deposits 717
ng Pilipinas
Commercial paper and other
Commercial loans 253 70
short-term borrowing
Long-term bonds (issued by the
Real estate loans 460 439
bank)
Consumer loans 187 Other liabilities 491
Securities 311 Total Liabilities P 1,992
Buildings and equipment 16 Bank capital 231
Other assets 685
Total Assets P 2,223 Total Liabilities and Bank Capital P 2,223

Requirement B

Calculation of the bank’s capital as a percentage of assets follows:

Total assets = P 2,223 million

Bank capital = P 231 million

Bank capital as a = P 231 million = 0.104 or 10.4%

percentage of assets P 2,223 million

BASIC OPERATIONS OF A COMMERCIAL BANK

Banks make profit through the process assets transformation: they borrow short (accept
deposit) and lend long (make loans). When a bank takes in additional deposit, it gains an equal
amount of reserves; when it pays out deposits, it loses an equal amount of reserves.

When a depositors puts money in a checking account and the bank uses the money to
finance loans, the bank has transformed a financial asset (a deposit) for a saver into liability (a loan)
for borrower. Like other businesses, a bank takes input, adds value to them, and delivers outputs. To
analyze further the basics of the banks operations, we will work with an accounting tool known as a
T- account, which shows changes in balance sheet items that result from particular transaction.

 To take a simple example, suppose you use 100 in cash to open a checking account at
Philippines= commercial bank (PCB) acquires 1,000 in vault cash, which it list as an asset and,
according to banking regulations, anytime and withdrawal your deposit, Philippines
commercial bank (PCB) list you 100 as a liability in the form if current account (CA) deposit.
We can use a T-account to illustrate the changes in PCB’s balance sheet result.

PCB
Assets Liabilities
Vault Cash + P 1,000 Current account deposits + P 1,000

 Note that PCB’s balance sheet will have much larger amounts of vault cash and
current account deposits than the 1,000 shown here. The t-account shown only the
changes in these items. Not their levels.
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 What happens to the 1,000 that you deposits in PCB? By answering this question, we can see
how a bank earn profit. Suppose that PCB held no excess reserves before receiving your 1000
deposit and that that banking regulations require banks to hold 10% of their current account
deposit as reserves. Therefore, 100 of the 1000 is required reserves, and the other 900 is excess
reserves, we rewrite the amount that PCB holds as reserves follows

PCB
Assets Liabilities
Vault Cash + P 1,000 Current account deposits + P 1,000
Excess reserves + P 900

 Reserves that a bank keeps as a cash pay no interest, and those the bank keeps in
deposit at the BSP pay a low rate of interest. In addition, current account deposit
generate expenses for the bank: the bank must pay interest to depositors and pay
the costs of maintaining checking accounts, including record keeping, operating a
web site, and servicing ATM’s. Therefore, the bank will typically want to use excess
reserves to make loans or buy securities to generate income. Suppose that bsp uses
its excess reserves to buy treasury bills worth 300 and make a loan worth 600. For
simplicity, the units in this example are very small. (Thinking In thousands of dollars
would be more realistic) we can illustrate these transaction with the following t-
account.

PCB
Assets Liabilities
Reserves + P 100 Current account deposits + P 1,000
Securities + P 300
Loans + P 600

 PCB has used you 1000 deposit to provide funds to the national treasury and to the
person or business it granted the loan to. By using your deposit, the bank acquired
interest-earning asset. If the PCB earns on the other costs of servicing your deposit,
then PCB will earn a profit on these transactions. The difference between the average
interest rate banks receive on their assets and the average interest rate they pay on
their liabilities is called the banks spread.

 To be successful, a bank must make prudent loans and investment so that it earns a high
enough interest rate to cover its cost and to make a profit. This plan may sound simple, but it
hasn’t been easy for banks to earn profit in the past decade.

MANAGEMENT OF BANK ASSETS

To maximize its profits, a bank must simultaneously seek the highest returns possible on loans
securities, reduce risk and make adequate provisions for liquidity by holding liquid assets.

Although more liquid assets tend to earn lower returns, banks still desire to hold them.
Specifically, banks hold excess and secondary reserves because they provide insurance against the
cost deposit outflow.

Banks try to accomplish these objectives by using the following strategy:

1. Banks try to find borrower who will pay high interest rates and will most likely settle their
loans on time. By adopting consecutive loan polices, banks avoid high default rate but
may miss out attractive lending opportunities that can earn high interest rates.

2. Banks try to purchase securities with high returns and low risk. By diversifying and
purchasing many different types of assets (short-term and long-term, treasury bills) banks
can lower risk associated with investment.
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3. Banks manages the liquidity of the assets so that its reserve requirements can be met
without incurring huge cost. This implies that liquid securities must be held even if they
earn somewhat lower return than other assets. The bank must balance its desire for
liquidity against the increased earnings that can be obtained from less liquid assets such
as loans.

MANAGEMENT OF BANK LIABLITIES

Before the 1960’s, bank liability management involved

a) Heavy dependence in demand deposit as sources of bank funds and,

b) Non-reliance on overnight loans and borrowing from other banks to meet their reserve needs

In the 60’s – large banks key financial centers such as New York, Chicago and San Francisco
in the United States. Begun to explore ways in which the liabilities on their balance sheets could
provide them with reserves and liquidity. Overnight loans market such as the federal funds market in
the United States expanded and new financial instruments enables to banks to acquire funds quickly.

Banks no longer depend on demand deposit as the primary source of bank funds. Instead
they aggressively set target goal in their asset growth and tried to acquire funds (by using liabilities)
as they were needed.

Hence, negotiable CD’s and bank borrowings greatly increased in importance as a source
of bank funds in recent years. Demand deposit have decreased in importance as source funds.

MANAGEMENT OF BANK CAPITAL

Banks manages the amount of capital they hold to prevent bank failure and to meet bank
capital requirements set by the regulatory authorities.

However, they do not want to hold too much capital because by so doing, they will lower
the returns by equality holders.

In determining the amount of bank capital, managers must decide how much of the
increased safety that covers with higher capital (the benefit) they are willing to trade off against the
lower return on equity that comes with higher capital ( the cost )

Because of the high cost of holding capital to satisfy the requirement by regulatory
authorities, bank managers often want to hold less capital than is required.

MANAGING BANK RISK

In addition to risk that banks may face from inadequate capital relative to their assets, banks
face several other types of risk. In this section, we examine how banks deals with the following three
types of risk: liquidity risk, credit risk, and interest-rate risk.

Managing Liquidity Risk

Liquidity risk is the possibilities that a bank may not be able to meet cash needs selling assets
or raising funds reasonable cost. For example, large deposit withdrawals might force as bank to sell
relatively illiquid securities and possibly suffer losses on the sales. The challenge to banks in managing
liquidity risk to reduce their exposure to risk without sacrificing too much profitability.

For example, a bank can minimize liquidity risk by holding fewer loans and securities and
more reserves. Such as strategy reduces the bank’s profitability, however, because the bank earns
no interest on vault cash only a low interest rate on its reserve deposits with the Fed. So, although the
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low interest rate environment during the years following the financial crisis caused many banks to
hold large amounts of excess reserves, more typically banks reduce liquidity risk through strategies
of asset management and liquidity management.

Managing Credit Risk

Credit risk is the risk that borrowers might default on their loans. One source of credit risk
asymmetric information, which often result in the problems of adverse selection and moral hazard.
Because borrowers know more about their financial health and their rule plan for using borrowed
money than do banks, banks may finds themselves inadvertently lending to poor credit risk or to
borrowers who intend to use borrowed funds for something other than their intended purpose. We
next briefly consider the different methods banks can use to manage credit risk.

a. Diversification investors – whether individuals or financial firms – can reduce their

exposure to risk by diversifying their holdings. If banks lend too much to one borrowers in
one industry, they are exposed to greater risk from those loans. For example, a bank that
had granted most of his loans to oil exploration and drilling firms in Texas would have likely
suffered serious losses on those loans following the decline in oil prices that begun in June
2014 and lasted through January 2016. By diversifying across borrowers, regions and
industries banks can reduce their credit risk.

b. Credit–Risk Analysis – in performing credit risk analysis, bank loan officers screen loan
applicants to eliminate potentially bad risk and to obtain a pool of credit worthy
borrowers. Individual borrowers usually must give loan officers information about their
employment, their current and projected profits and net worth. Banks often use credit
scoring system to predict statistically whether a borrower is likely to default. For example,
people who change jobs.

c. Collateral – to reduce problems of adverse selection, banks generally require that a

borrower put up collateral, or assets pledged to the bank in the event that the borrower
defaults. For example, if you are an entrepreneur who needs a bank loan to start business,
the bank will likely ask you to pledge some of your assets, such as your house, as collateral.
In addition, the bank might require you to maintain a compensating balance, a required
minimum amount that the business taking out loan must maintain in a checking out
account with the lending bank.

d. Credit Rationing - in some circumstances, banks minimize the cost of adverse selection a
moral hazard through credit rationing. In credit rationing, a bank either grants a borrowers
at the current interest rate. The first type of credit rationing occurs in response to possible
moral hazard by increasing the chance that the borrower will repay the loan to maintain
a sound credit rating.

e. Monitoring and Restrictive Covenant – to reduce the cost of moral hazard, banks monitor
borrowers to make sure they don’t use the funds borrowed to pursue unauthorized, risky
activities.

f. Long-Term Business Relationship – as we noted in the chapter opener, the ability of banks
access credit risk on the basis of private information on borrowers is called relationships
banking. One of the best ways for bank to gather information about a borrowers
prospects or to monitor a borrowers activities is through a long term business relationship.

Managing Interest-Rate Risk

Banks experience interest-rate risk if changes in market interest rates cause a bank’s profit or
its capital to fluctuate. The effect of a change in market interest rates on the value of a bank’s assets
and liabilities is similar to the market interest rate will lower the present value of a bank’s assets and
the liabilities, and a fall in the market interest rate will raise the present value of banks assets and
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liabilities. The effect of a change in interest rates on a banks profit depends in part on the extent to
which the bank’s assets and liabilities are variable rate or fixed rate.

Reducing Interest-Rate Risk

Bank manager can use a variety of strategies to reduce their exposure to interest rate risk.
Banks with negative gaps can make more adjustable rate or floating rate loans. That way, if market
interest rates rise and banks must pay higher interest rates on deposits, they will also receive higher
interest rates on their loans. Unfortunately for banks, many loans costumers are reluctant to take out
adjustable rate loans because while the loans reduce the interest rate risk banks face, they increase
the interest rate risk borrowers face.

Banks can also use interest-rate swaps on which that agree to exchange, or swap, the
payments from a fixed rate loan for the payment on an adjustable rate loan owned by a corporation
or another financial firm. Swaps allow banks to satisfy the demands of their loan costumer for fixed
rate loans while still reducing exposure to interest rate risk. Banks can also use futures contracts and
option contracts to help hedge interest rate risk.
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ASSIGNMENT

R E V I E W Q U E S T I O N S

1. What are the primary source and use of funds of a commercial banks?

2. Give and explain the nature of a commercial banks assets.

3. Give and explain briefly the primary liabilities of a commercial bank.

4. Discuss how compliance with reserve requirements of the BSP affects

the financial position of a commercial bank.

5. What basic strategy do commercial banks follows to maximize return

on its assets?
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Lesson 3:
EXPANDING THE BOUNDARIES OF BANKING

Introduction

The activities of banks have changed dramatically during the past five decades. Between
1960 and 2018, banks:

1. Increased the amount of funds they raise from time deposits and negotiable certificate
of deposits;
2. Increased their borrowings from repurchase agreements;
3. Reduced their reliance on commercial and industrial loans and on consumer loans;
4. Increased their reliance on real estate loans; and
5. Expanded into nontraditional lending activities and into activities where their revenue is
generated from fees rather than from interest.

OFF-BALANCE-SHEET ACTIVITIES

Banks have increasingly turned to generating fee income from off-balance-sheet activities.
Traditional banking activity, such as taking in deposits and making loans, affects a bank's balance
sheet because deposits appear on the balance sheet as liabilities, and loans appear as assets. Off-
balance-sheet activities do not affect the bank's balance sheet because they do not increase either
the bank's assets or its liabilities. For instance, when a bank buys and sells foreign exchange for
customers, the bank charges the customers a fee for the service, but the foreign exchange does not
appear on the bank's balance sheet. Banks also charge fees for private banking services to high-
income households.

1. Loan commitments. A bank earns a fee for a loan commitment. In a loan commitment, a
bank agrees to provide a borrower with a stated amount of funds during a specified period
of time. The fee is usually split into two positions:

a. Upfront fee when the commitment is written and

b. Non-usage fee on the unused portion of the loan.

Interest is charged for loans are actually made. It is usually marked up over a benchmark
lending rate.

2. Standby letters of credit. With a stand by letter of credit, the bank commits to lend funds to
the borrower the seller of the commercial paper- to pay off its maturing commercial paper.

This is also availed of in connection with importation of goods by the businessmen.

3. Loan sales. A loan sale is a financial contract in which a bank agrees to sell the expected
future returns from an underlying bank loans to a third party. Loan sales, also called
secondary loan participations involve sale of loan contract without recourse, which means
that the bank does not provide any guarantee on the value of the loan sold and no
insurance.

With securitization, instead of the bank holding the loans in their own portfolio, it converts
bundles of loans into securities that are sold directly to investors through financial markets.

Large banks sell loans primarily to domestic and foreign banks and to other financial
institutions.

4. Trading activities. Banks earns fees from trading in the multibillion - dollar markets for futures,
options, and interest-rate swaps. Bank trading in these markets is primarily related to hedging
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the banks' own loan and securities portfolios or to hedging services provided for bank
customers.

As the beginning of financial crisis of 2007-2009, most people were unfamiliar with such terms
are mortgage-backed securities (MBSs), collateralized obligation (CDOs), and credit default swaps
(CDDs).

During the financial crisis, these terms became familiar as economists, policymakers, and the
general public came to realize that commercial banks no longer played the dominant role in routing
funds from savers to borrowers. Instead a variety of "nonbank" financial institutions including
investment banks, mutual funds and hedge funds were acquiring funds that had previously been
deposited in banks.

They were then using these funds to provide credit that banks had previously provided. These
nonbanks were using newly developed financial securities that even long-time veterans of banking
did not fully understand.

These nonbank financial institutions have been labeled the "Shadow Banking" system
because while they match savers and borrowers, they do so outside the commercial banking
system.

In this chapter, we describe the different types of firms that make up the shadow banking
system.

INVESTMENT BANKS

Investment banks offer distinct financial services, dealing with larger and more complicated
financial deals than retail banks.

The smooth functioning of securities markets, in which bonds, stocks, and derivatives are
traded, involves several financial institutions including investment banks, securities brokers and
dealers and venture capital firms.

Investment banks assist in the initial sale of securities in the primary market, securities brokers
and dealers assist in the trading of securities in the secondary markets. Finally venture capital firms
provide funds to companies not yet ready to sell securities to the public.

ROLE OF INVESTMENT BANKS

Investment banks work with large companies, other financial institutions such as investment
houses, insurance companies, pension funds, hedge funds, governments, and individuals who are
very wealthy and have private funds to invest.

Investment banks have two distinct roles. The first is corporate advising, meaning that they
help companies take part in mergers and acquisitions, create financial products to sell, and bring
new companies to market. The second is the brokerage division where trading and market-making
in which the investment bank provides mediation between those who want to buy shares and those
who want to sell-take place. The two supposed to be separate and distinct, so within an investment
bank there is a so-called "wall" between these divisions to prevent conflict of interest.

An investment bank is a financial intermediary that performs various services, including

complex financial transactions as raising capital for corporations, governments or other entities,
underwriting, securities, facilitating mergers and other corporate reorganizations.

Investment banks employ professional investment bankers who help corporations,

governments and other groups plan and manage large projects saving their client time and money
by identifying risks associated with project before the client moves forward.
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Typical divisions within investment banks include

1. Industry Coverage Groups. Established to have separate groups within the bank each
having expertise in specific industries or market sections such as technology or health
care. They develop client relationships with companies within various industries to
bring financing, equity issue or merger and acquisition business to the bank.

2. Financial Products Groups. Provide investment banking financial products such as

IPOs, M&As, Corporation restructuring and various types of financing. There may be
separate product groups that specialize in asset financing, leasing, leveraged
financing and public financing.

TYPES OF FIRMS ENGAGED IN INVESTMENT BANKING

The classification of investment banks is primarily based on "size" which may refer to the size
of the banks in terms of the number of offices or employees or to the average size of M & A deals
handled by the bank.

 Bulge Bracket Banks

 Middle-Market Banks
 Boutique Banks

Discussion

a. Bulge Bracket Banks. The bulge bracket banks are the major, international investment
banking firms with easily recognizable names such as Goldman Sacks, Deutsche Bank, Credit
Suisse Group AG, Morgan Stanley and Bank of America. The bulge bracket banks are the
largest in terms of number of offices and employees and also in terms of handling the largest
deals and the largest corporate clients.

Each of the bulge bracket banks operates internationally and has the largest global as well
as domestic presence. They provide their clients with the full range of investment banking
services including

1. Trading, all types of financing, asset management services

2. Equity research and issuance
3. M&A services

Most bulge bracket banks also have commercial and retail banking divisions and generate
additional revenue by cross-selling financial products. One notable shift in that happened
after the financial crisis in the investment banking market place is the number of Fortune 500
and high- net-worth clients that opted to retain the services of elite boutique investment
banking firms over the bulge bracket firms.

b. Middle-Market Banks. Middle-market investment banks occupy the middle position

between smaller regional investment banking firms and massive bulge bracket investment
bank. They provide the same full range of investment banking services as bulge bracket
banks such as

1. Equity and debt capital market services

2. Financing and asset management services
3. M&A and restructuring deals

Deals could range from about $50 Million to $500 Million or more.

c. Boutique banks are further divided into:

1. Regional Boutique Banks. Smallest of the investment banks, both in terms of firm size
and typical deal size. They commonly serve smaller firms and organization but may
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have as clients major corporations headquartered in their areas. They generally

handle smaller M&A deals, in the range of $50 to $100 million or less.

2. Elite Boutique Banks. They are often like regional boutique in that they usually do not
provide a complete range of investment banking services and may limit their
operations to handling M&A related issues. They are more likely to offer restructuring
and asset management services. Most elite boutique banks begin as regional
boutiques and then gradually work up to elite status through handling successions of
larger and larger deals for more prestigious clients.

The other nonbank financial institutions (e.g., Mutual Funds, Hedge Funds and Finance
Companies) that make up the shadow-banking system are discussed in Module 4 – Lesson 1.

AREAS OF BUSINESS

While the brokerage and corporate advising divisions of an investment bank are theoretically
distinct, there is inevitably overlap between the two areas of, for example, market-making and
underwriting new share issue, or mergers and acquisitions advising and research.

A. Brokerage

 Proprietary trading. Investment banks have their own funds, and they can both invest
and trade their own money, subject to certain conditions.

 Acting as a broker. Banks can match investors who want to buy shares with
companies wanting to sell them, in order to create a market for those shares (known
as market-making).

 Research. Analysts look at economic and market trends, make buy or sell
recommendations, issue research notes, and provide advice on investment to high
net-worth and corporate clients.

B. Corporate advising

1. Bringing companies to market. Investment banks can raise funds for new issues,
underwriting Initial Public Offerings (IPOs) in exchange for a cut of the funds they
raised.
2. Bringing companies together. Banks facilitate mergers and acquisitions (M&A) by
advising on the value of companies, the best way to proceed, and how to raise
capital.
3. Structuring products. Clients who want to sell a financial product to the public may
bring in an investment bank to design it and target the retail or commercial banking
market.

HOW INVESTMENT BANKS MAKE OR LOSE MONEY

 Making money

 Banks receive fees in return for providing advice, underwriting services, loans and
guarantees, brokerage services, and research and analysis. They also receive
dividends from investments they hold, interest from loans, and charge a margin on
financial transactions they facilitate.
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 Losing money

 The advising division may end up holding unwanted shares if the take-up of an IPO is
lower than expected. The trading division of a bank may make the wrong decisions
and end up losing the bank money.

 In a year of little corporate activity, banks may have to rely on trading profits to bolster
their returns. Banks may create financial products which they fail to sell on to other
investors, leaving them holding loss-making securities or loans.
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ASSIGNMENT

R E V I E W Q U E S T I O N S

1. Give and explain the major activities of banks for the last 5 decades.

2. What is meant by "off-balance-sheet" activities of commercial banks?

Give examples.

3. Why are investment banks considered engaged in "shadows banking"?

4. What are sources of income of investment banks?

5. Distinguish between the industry coverage groups and financial

services group within the organization of investment banks.