Financial Service and Industry

Asset Transformation Purchase primary securities by selling financial claims (secondary securities) to households Secondary securities are more marketable BECAUSE Less information asymmetry Less monitoring costs More liquid Less risky Without financial intermediaries, households will find direct investments in corporate securities unattractive due to information/monitoring costs, liquidity cost and price risk.Thus flow was funds are less, little monitoring and risk of investments would increase.Specializes of financial institutions General areas (LIP TM) Liquidity services Information services Price- risk reduction services Transaction cost services Maturity intermediation services Institution- specific (McCall) Money supply transmission Credit allocation Denomination intermediation Intergenerational transfers Payment services Information costs Agency costs 0 costs relating to the risk that firm owners and managers use savers' ends not in the best interest of the savers Financial ins titutions collect funds from households in order to avoid free- rider problem (incentive for information collection and monitoring), reduce costs of information collection and monitoring and to develop new secondary securities to more effectively monitor borrows.Liquidity and price risk Financial intermediaries provide secondary claims to household savers – high liquidity and low price risk and invest in these illiquid and risky sectors Advantage of financial institutions managing liquidity and price risk Diversification (due to size of funds) Development of better risk management techniques Disadvantage of delegated institutions Intermediary services are not free Agency issues Risk management Monitoring financial institutions Other special services Reduced Transaction Cost, I. E. Economies of scale Maturity Intermediation 0 Ability to bear the risk of mismatched maturities of assets and liabilities.Credit Allocation (Depository Flu) – Financial intermediaries are the major source of finance in particular sectors of an economy: residential real estate (US and UK), farming (Australia) . Intergenerational Wealth Transfer or Time Intermediation (life insurance, superannuation and pension funds) Payment Services – IFS provide efficient payment services to the society. Denomination Intermediation – Give individuals indirect access to large denomination markets (Money market managed funds, Debt-equity managed funds, Unit trusts) The Transmission of Monetary Policy (Banks) Financial intermediaries are widely used medium of exchange in the economy.Intermediaries' liabilities play significant role in the transmission of monetary policy Money supply in Australia (Don't need to know these term 0) MI : currency + bank rent deposits by private non-bank sector MM: currency + all bank deposits by private non-bank sector Broad money: MM + net borrowing of Non-bank IFS from private sector Specializes and Regulation Financial institutions receive spe cial regulatory attention Negative externalities caused by IFS is costly to households and firms using financial services Special services provided by IFS Institution- specific functions Example: money supply transmission, credit allocations, payment services Australian Regulation System The traditional industry- based regulation entailed separate regulators for individual industry sectors – banking, insurance and security firms. Asses 0 Australia's current financial regulatory framework originated from ‘Financial System Enquiry (Wallis Committee), Australia switched from industry-based regulation to function- based regulation. This introduced 3 regulatory agencies, each in charge of specific functional responsibilities. This reform was necessary as the distinction between the activities of different types of financial institutions was becoming more vague and also because of the overlap in regulation and grey areas.Reserve Bank of Australia (ARAB) 0 Responsible for the development and implementation of monetary policy and for overall financial system stability Australian Prudential Regulation Commission (PARA) 0 Responsible for the prudential regulation and supervision of the financial services industry Regulation of deposit- taking institutions Life and general insurance Superannuation Australian Securities and Investments Commission (ASIA) 0 Responsible for market integrity, consumer protection across the financial system and ensures equal and fair access to financial services. Protects against abuses (example: insider trading), lack of disclosure, malfeasance, breach of fiduciary responsibility.Major types of regulation(Scale) Safety and soundness regulation Consumer protection regulation Credit allocation regulation Investor protection regulation Monetary policy regulation Entry and chartering regulation 1. Risk reduction Encouragement for intermediaries to diversify assets Disclosure of large credit exposure 2. Minimum capital requirements 3. Safety valve Central banks' open market operations to provide exchange settlement fund 4. Monitoring and surveillance The ARAB directly controls outside money and the bulk of the money supply is inside money (deposits). Regulators commonly impose a minimum level of cash reserves to be held against deposits. Cash reserves add to intermediaries' net regulatory burden. There is no explicit liquidly requirement in Australia but Flu' liquidity management policy need to be approved by PARA.Supports lending to socially important sector Example: US' Qualified Thrift Lender test (QUIT) set a minimum amount of loans made to residential mortgages to quality as Thrift Entry Regulation Regulations define scope of permitted activities under a given charter Increasing/ Decreasing entry barriers affect profitability of existing competitors. High direct/ indirect entry costs result in larger profits for existing companies Future of Regulation Implications of SGF questioned – more regulations or more efficient regulations The major provisions include expanding and centralizing powers for Federal agencies, more restrictions and disclosures about risk taking activities by financial institutions and enhancing protection of investors and consumers. The changing dynamics of specializes Potential secular trend away from intermediation by investing directly in primary securities Decline in the relative cost of direct securities investment Growing sophistication of investorsFalling costs of information acquisition and transaction Credit Risk: Individual Loan Risk Types of loans 1. Commercial and industrial loans Short term (1 year) – financing the purchase of real assets, new venture start up costs Syndicated loans 0 financing provided by a group of lenders, usually to finance large commercial and industrial loans Secured/Unsecured loans Fixed/Floating rate Spot loan 0 borrower takes down the entire loan amount immediately Loan commitment 0 can taken down anytime any amo unt, as long as within a maximum loan amount and a maximum period of time predetermined Commercial paper 0 unsecured short- term debt instrument 2. Real estate loans 3. Individual (consumer) loans 4.Other loans, such as, government loans, farms loans Calculating the gross return on a loan Factors affecting the promise loan return Loan interest rate = Base/Prime lending rate (BRB) + Credit risk premium (m) Direct fees (f), such as loan origination fee Indirect feeds, such as, compensating balance requirement (b), reserve requirement Credit Risk and the Expected Return on a Loan 1 -p = probability of default 0MAYBE there is a negative relationship between k and p, however k and p are not independent. As return (k) increases, the probability (p) that the borrower pays the promised return may decrease. Simply increasing k does not lead to a higher return (r). As a result, IFS usually have to control for credit risk – price/promised return and the quantity or credit availability d imensions. Retails Loans Size = Small Higher cost associated with collection of borrower's personal credit information Control credit risk through credit rationing – limit the total exposure/amount loaned Wholesale Loans Different interest rates to compensate for different levels of risks Credit rationing to limit credit exposure Measuring credit risk 1.Qualitative credit risk models Borrower- specific factors Example: reputation, leverage, volatility of earnings, collateral Market- specific factors Example: business cycle, level of interest rate 2. Credit scoring models Calculate a score as a proxy of borrower's default probability Sort borrowers into efferent default classes The scoring model should establish factors the help explain default risk and evaluate the relative importance of these factors Major models 1. Linear probability model 1 if default, otherwise Weakness: the estimated default probability Z may lie outside of [0,1] Employing linear probability model is not often used as superior statistical 2.Logic model Overcomes weakness of the linear probability model using a transformation that restricts the probability to the [0,1] interval 3. Linear discriminate models Altar's Z score model for manufacturing firms Z 2. 9, highly quality loans, low default risk Z Term structure based methods Under market equilibrium, expected return of a risky loan = risk- free rate (after accounting for probability of default (1 -p)) Assuming a zero default recovery rate 0 p(l+k) = 1+1 p: probability of repayment k: return on the corporate debt I: expect return on the risk- free treasury security Example: What is the default probability for a one- year corporate bond? 10% expected return on the risk- free treasury bond k= 15. 8% expected return on the risky corporate debt p = 0. 95 Therefore the probability of default is 0. 05 Realistically, the Fl lender can expect to receive some partial repayment even if the borrower becomes bankrupt. Alton and Ban estimated that when firms defaulted on their bonds in 2002, the investor loses 74. % on average. = recovery rate when default occurs (1 – p) y (1 + k) = payoff to Fl when default occur p (1 + k) = payoff when no default Marginal default probability 0 probability that a bond will default in any given year t Conditional on the fact that the default has not occurred earlier = Marginal probability of default in individual periods Example: 2-period bond Default probability in period 1 Marginal default probability in period 2 Cumulative probability of default over 2 periods We can extract from these yield curves the market's expectations of the multi- period default rates for corporate borrowers Example: Yield Yield Year 1 Year 2 T- Bonds Corporate Bonds 15. 8% One year forward rate on risk- free T-bonds One- year forward rate on corporate bonds 0 The expect probability of default in year 2 0 4.Mortality rate models Marginal mortality rate (MR.) Forward- looking 0 extract expected default r ates from the current term structure of interest rates Backward looking 0 analyses the historic or past default risk experience, the mortality rates, of bonds and loans of a similar quality Non- default probability in year 1 the probability of the loan surviving in the 2nd year given that default has not occurred during the firs year, I. E. Prop(default in year 2 | survive yearly) Cumulative mortality rate (CM) Cumulative probability of default MR. is based on historic or backward-looking data, and it is highly sensitive to the period over which the Fl calculates the Mars. 5. RAZOR models It is based on market data.ROAR concept – balanced expected interest income against expected loan risk Loan approval 0 RAZOR > benchmark return on capital, example: return on equity One year net income on a loan 0 (spread + fees) * dollar value of loans outstanding Loan risk 0 duration or loan default rate Method 1: Use Duration to estimate loan risk The percentage change in the market value of an asset such as a loan is related to the duration of the loan and the size of the interest rate shock Capital at risk (Vary approach) 0 the potential loan Los under adverse credit scenarios 0 Increase in risk premium under adverse credit scenarios Example: Suppose we want to evaluate the credit risk off $1 million loan with duration of 2.