SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis

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Money & Banking MGT411

Lesson 28

SECURITIES FIRMS (Continued)

Securities Firms

Investment Banks

Mutual Funds

Finance Companies

Government Sponsored Enterprises

Banking Crisis

Sources of Runs, Panics and Crisis

Government Safety Net

Government: Lender of Last Resort

Securities Firms

Investment banks are the conduits through which firms raise funds in the capital markets

Through their underwriting services, investment banks issue new stocks and a variety of other

debt instruments

In underwriting, the investment bank guarantees the price of a new issue and then sells it to

investors at a higher price;

However, this is not without risk, since the selling price may not in fact be higher than the price

guaranteed to the firm issuing the security

Information and reputation are central to the underwriting business;

Underwriters collect information to determine the price of the new securities and then put their

reputations on the line when they go out to sell the issues

In addition to underwriting, investment banks provide advice to firms that wish to merge with or

acquire other firms, for which advice they are paid a fee

Finance Companies

Finance companies raise funds in the financial markets by issuing commercial paper and

securities and use the funds to make loans to individuals and corporations

These companies are largely concerned with reducing the transactions and information costs

that are associated with intermediated finance

Most finance companies specialize in one of three loan types:

Consumer loans,

Business loans,

Sales loans (for example, the financing for a consumer to purchase a large-ticket item like an

appliance)

Some also provide commercial and home mortgages

Business finance companies provide loans to businesses, for equipment leasing

Business finance companies also provide short-term liquidity to firms by offering

Inventory loans (so that firms can keep the shelves stocked)

Accounts receivable loans (which provide immediate resources against anticipated revenue

streams)

Government-Sponsored Enterprises

The government is directly involved in the financial intermediation system through loan

guarantees and in the chartering of financial institutions to provide specific types of financing

Zarai Taraqiati Bank Limited (ZTBL)

Small and Medium Enterprise (SME) Bank

House Building Finance Corporation (HBFC)

Khushhali Bank

Money & Banking MGT411

Summary of the financial industry structure

Financial

Primary

Primary uses

Services provided

intermediary

sources of

of funds

funds

(assets)

(liabilities)

Cash

-Pooling of small savings to provide large

Checkable

Depository

Loans

loans

deposits

institution

Saving and time securities

-Diversified, liquid deposit accounts

(Banks)

-Access to payments system

deposits

Screening and monitoring of borrowers

Borrowing from

other banks

Expected claims Corporate bonds -Pooling of risk

Insurance

-Screening and monitoring of policy

Government

Company

holders

bonds

Stocks

Mortgages

-Management of asset pools

Short term loans Commercial

-Clearing and settling trades

paper

Securities Firm

Bonds

-Immediate sale of assets

Investment Bank

-Access to spectrum of assets, allowing

diversification

-Evaluation of firms wishing to issue

securities

-Research and advice for investors

Shares sold to Commercial

-Pooling of small savings to provide access

Mutual-Fund

customers

paper

to large, diversified portfolios, which can

Company

Bonds

be liquid

Mortgages

Stocks

Real estate

Bonds

Mortgages

-Screening and monitoring of borrowers

Finance

Bank loans

Consumer

Company

Commercial

loans

paper

Business loans

Commercial

Mortgages

-Access to financing for borrowers who

Government-

Farm loans

paper

cannot obtain it elsewhere

Sponsored

Bonds

Enterprises

Student loans

Loan

guarantees

Banking Crisis

Banking crises are not a new phenomena; the history of commercial banking over the last two

centuries is replete with period of turmoil and failure.

By their very nature, financial systems are fragile and vulnerable to crisis

Money & Banking MGT411

Table: Worst Banking Crises since 1980

Country

Crises Dates

Estimated cost of

Resolution (as %age of

GDP)

Argentina

1980-82

55%

South

Asian

Indonesia

1997-98

55%

Crises

China

1990s

47%

Jamaica

1994

44%

Chile

1981-83

42%

Thailand

1997

35%

Macedonia

1993-94

32%

Israel

1977-83

30%

Turkey

2000

30%

Uruguay

1981-84

29%

Korea

1998

28%

Cote d'ivoire

1988-91

25%

Japan

1990s

24%

Uruguay

1981-84

24%

Malaysia

1997-98

20%

Figure: Relationship between size of a financial crises and change in GDP Growth

Ghana

1982-89

Norway

Mexico

1990-93

Bulgaria

1994-2000

1996-97

Argentina

Jamaica

1980-82

1996-2000

-5

Finland

1991-94

Malaysia

-10

1997-2001

·Indonesia

Uruguay

1997-2002

1981-84

-15

Fiscal Cost as percentage of GDP (%)

The Sources and Consequences of Runs, Panics, and Crises

In a market based economy, the opportunity to succeed is also the opportunity to fail!

Banks serve some essential functions in the economy

Access to payment system

Screen and monitor borrowers to reduce information problems

So if bank fails, we lose ability to make financial transactions. Collectively, the economy is

endangered.

Banks' fragility arises from the fact that they provide liquidity to depositors, allowing them to

withdraw their balances on demand, on a first-come, first-served basis

If bank can not meet this promise of withdrawal, because of insufficient funds, it will fail

Reports that a bank has become insolvent can spread fear that it will run out of cash and close

its doors;

Money & Banking MGT411

Depositors will rush to convert their balances into cash

Such a run on a bank can cause it to fail

What matters during a bank run is not whether a bank is solvent but whether it is liquid

Here solvency means that the value of the bank's assets exceeds its liabilities (positive net

worth)

Liquidity refers to the sufficient reserves of the bank to meet withdrawal demands

False rumors that a bank is insolvent can lead to a run which renders it illiquid

When a bank fails, depositors may lose some or all of their deposits, and information about

borrowers' creditworthiness may disappear;

For this reason, governments take steps to try to minimize the risk of failure

A single bank failure can also turn into a system-wide panic; this is called contagion

While banking panics and financial crises can result from false rumors, they can also occur for

more concrete reasons;

Anything that affects borrowers' ability to repay their loans or drives down the market price of

securities has the potential to imperil the bank's finances

Recessions have a clear negative impact on bank's balance sheet

Low profitability of firm makes debt repayment much harder

People lose jobs and cant pay their loan

With the rise of default risk, bank's assets lose value and capital drops

With less capital, banks are forced to contract the balance sheet making fewer loans.

The overall business investment falls and bank failure is more possible

Historically, downturns in the business cycle put pressure on banks, substantially increasing the

risk of panics

Financial disruptions can also occur whenever borrowers' net worth falls, as it does during

deflation

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