Chap 1, Class 1

Course Overview Syllabus Organization

Introduction to Financial Institutions (FI) What role do FIs perform What costs do FIs reduce How FIs are special

2

Syllabus

3

The syllabus can be found on the course web page:

http://somfin.gmu.edu/~anderson/321

A print friendly version is available by clicking the “Print Friendly Version” link at the top of the syllabus page

Time & Location: --- Here … Now

Instructor: Mike Anderson Office: 237 Enterprise Hall Office Phone: 993-5816 e-mail: mander19@gmu.edu Office Hours: Walking/By appointment

4

Prerequisites A strong understanding of basic financial concepts Successful completion of FNAN 301. Students should have an operational knowledge of MS-Excel. 

Required Reading Saunders and Cornett, Financial Institutions Management: A Risk

Management Approach, 8th Edition,

5

Supplemental Readings Recommended Reading on the course web page  Students are also strongly encouraged to read financial press, such as the

Wall Street Journal or Financial Times

Lecture Material Handouts are available on the course webpage. Handouts do not contain all the information that you will be held

responsible for on exams. THIS IS NOT A CORRESPONDENCE COURSE AND THE

COURSE MATERIAL IS NOT DESIGNED TO EDUCATE STUDENTS IN THIS MANNER

Students may be tested on any information made available through course-required material - including lectures and the book

6

Grading:

7

Category Allocation

Homework 30%

Participation 5%

Exams

Exam I 15%

Exam II 25%

Exam III 25%

Homework: Homework assignments must be completed individually Grading:

▪ Each homework problem set is scored out of a pre-designated number of points which is listed on the cover page.

▪ To receive full credit for a any given problem:▪ Answers must be correct

▪ Answers must be handwritten in a clear and legible manner

▪ You must show all your work (Listing inputs to your calculator does not constitute showing your work)

▪ Solutions must be identified by drawing a circle or box around your answer

▪ Electronic copies of homework will receive no-credit

▪ Homework must be submitted in class on the due date.

▪ Weight = 30% of your final grade

8

Homework (continued) Your final homework grade will be calculated as a percent of the total

points received over all homework assignments. For example, if you received 50% of the points 1440 points available on homework your, final homework score would be (.50)(.30) = .15

The 2 problem sets with the lowest grade (percentage score) will be dropped

You will have two weeks from the day the homework is recorded on blackboard to contest the grade.

Capital Adequacy Project Will count as one homework assignments but it cannot be dropped Graded on the basis of accuracy

9

Exams: There will be three exams 2 mid-terms and 1 final Dates are listed on the lecture schedule available on the web page Questions: Are the exams cumulative?

▪ Midterms are implicitly cumulative in that the course material builds on itself

▪ The final may be cumulative (if the performance on the first two exams is poor)

▪ Total weight = 65%

YOU ARE REQUIRED TO TAKE ALL 3 EXAMS.

10

Exams

Exam I 15%

Exam II 25%

Exam III 25%

Participation: Your participation grade is based on daily quizzes Quizzes are not graded – you will receive full credit for attempting to

complete the exercise

Missed quizzes cannot be made up but you will be allowed to drop▪ your 2 lowest scores for classes that meet 2 times a week

▪ Your lowest score for classes that meet once a week

Extra credit may be awarded to students who consistently and actively participate in class discussion

You must attend class to be able to participate

11

Extra Credit: Extra credit can be earned for demonstrating extraordinary effort in the

course. These points are rarely awarded. However, if a student exerts significant effort and/or demonstrates a mastery

of material far beyond the minimum level required by the course, they may be awarded extra credit upon calculation of the final grade.

Extraordinary effort and mastery of the material is evaluated on a case-by-case basis entirely determined at the discretion of the professor.

12

Grading Scale:

Percentages will be rounded to 3 decimal places prior to assigning the final letter grade

13

Grade less than Greater than or equal to

A+ Reserved for exceptional performance

A 93%

A- 93% 90%

B+ 90% 87%

B 87% 83%

B- 83% 80%

C+ 80% 77%

C 77% 73%

C- 73% 70%

D+ 70% 67%

D 67% 63%

F 63%

Absences and Late Assignments There are no excused absences Exams:

If you are physically incapacitated or some catastrophic event prevents you from attending one of the first two exams, I may allow you to make it up as part of your final exam. In this case, you will be required to take both the midterm and final at the university scheduled final exam time. Makeup exams will be granted on a case by case basis.

If you miss the final, you will receive a score of zero for that exam. Missing two or more exams will result in a failing grade for the course Homework/Quizzes: lost points on homework and quizzes resulting from

absences cannot be made up Late assignments will not be accepted

14

Regrading Policy Errors: Grading errors will be corrected.

These include mechanical or mathematical errors such as an incorrect tally of points, incorrect calculation of percentage points, etc.

Appeals: Regrade appeals are appropriate when you feel that an answer has been graded incorrectly. These must be submitted in writing within one week after the graded

test is returned. The appeal must include:

▪ A description of the question(s) that needs to be reexamined as well as an explanation of why the original grade is incorrect.

▪ A reference to the location, in the required course material, that supports the argument that your answer is correct. For example, “My answer to test question 5 is taken directly from page 534 paragraph 3 of the Saunders and Cornett Text”.

15

Regrading Policy Any exam submitted for regrading of a question is subject to a complete

regrade. As a result, the regraded score may increase, stay the same, or decrease after careful consideration .

I will not consider any regrade requests after the one week deadline has passed.

Conflicts: The required text (Saunders and Cornett, Financial Institutions

Management: A Risk Management Approach, 8th Edition) is the main resource for this course. Therefore, if for any reason information in other required materials (handouts, readings …) conflicts with the information in the text, the text will take precedence unless explicitly stated.

16

Academic Conduct   Honor Code: Students are expected to follow the University Honor Code:

“Student members of the George Mason University community pledge not to cheat, plagiarize, or lie in matters related to academic work.”

Lectures: Students are expected to be courteous and respectful while attending lectures. Conduct that will not be permitted in class includes but is not limited to: ▪ Inappropriate outbursts

▪ Sleeping.

▪ Reading newspapers, magazines, or other material unrelated to the course.

▪ Use of computers in class unless otherwise stated.

▪ Trying to complete your homework

Email: I expect emails to be written in a professional manner. This includes appropriate use of language and tone. In appropriate emails will not be answered.

17

Course Organization

18

19

Introduction to Banking

Measuring and Managing

Banking Risks

Getting to know Financial Institutions

Interest rate risk – the fundamental risk of banking

Measuring and Managing Interest Rate Risk

Off-Balance Sheet Activity

Capital Adequacy

Credit Risk

Liquidity Risk

Market Risk

web page

20

Introduction to Financial Institutions

21

22

FIs provide a conduit to channel funds from savers to borrowers

Savers: entities with a surplus of funds Borrowers: entities with a deficit of funds

Savers Borrower

This course is about:

The role that the financial institutions play in channeling funds from savers to borrowers

How financial institutions profit from filling this role

23

Why study financial institutions instead of auto manufactures or healthcare providers?

What is special about the services they provide?

24

Savers Borrower

Why study financial institutions instead of auto manufactures or healthcare providers?

What is special about the services they provide?

25

SaversBuy Financial Assets

BorrowerBuy Real Assets

Cash

Debt & Equity Securities

Consider a world without Financial Institutions

26

Ideal World: Investors are perfectly informed – they know everything about the company

and its actions Information is costless There are no market frictions – liquidity, transaction costs There would probably be no need for FIs

Do we live in an ideal world? Investors are never perfectly informed Information is costly There are costs associated with investing (market frictions)

Without FIs: Low level of fund flows!

27

Why

Real World: In reality investors face three types of costs when directly lending to companies

1. Information Costs

2. Liquidity Risk

3. Price Risk

28

Adverse Selection Companies who are always in need of money are usually companies who

make poor investments and continuously lose money Prior to purchasing a firm’s equity or lending to the firm, individuals must

incur costs to investigate the firm’s quality. If not, they are likely to lend to the poorest (adverse) quality firms.

Moral Hazard A company takes on excessive risk because managers (equity holders) are

compensated for good outcomes but they do not bear the full losses for bad outcomes (agency cost!).

After a company receives a loan, managers may elect to invest in a riskier project than what was agreed on.

Investors can try to monitor the firms actions ▪ Monitoring is very costly▪ Free rider problem

29

Prior to investing

After Investing

30

Moral Hazard Adverse Selection

Who was facing the risk?

How were they managing it?

31

How can investors reduce information risk? Screening – reduces adverse selection Monitoring – reduces moral hazard

Will individual investors screen and monitor?

Why Not? There is a “free rider” problem

32

Not Likely!

Investment Project: Everyone gives me $100 I am going to invest in stocks and alternative investments Every Saturday night at 10:00 pm we will meet here and discuss the

investment allocation and portfolio performance

How many people plan to attend all the meetings?

Ideally, would you want everyone to screen and monitor? No, it is inefficient

▪ ideally the screening and monitoring costs will be incurred one time. If everyone screens and monitors these costs will be incurred several times

33

If FIs didn’t exist there would be no secondary market for companies’ debt or equity

There would be no easy way to convert securities to cash – investors would have to wait for them to mature

Investors who plan to use the money in the near future would have to hold cash

34

If investors could sell securities in a market without FIs, they would not likely get the full value of their securities

Transaction Costs: The price of taking out an advertisement The price of listing on an exchange Delivery costs

Supply and demand: The buyer may not want to purchase the security as much as the seller

needs to sell it

35

Conclusion:

Without FIs funds would flow slowly from households to businesses because of:

Information costs Liquidity risk Price Risk

36

Now Let’s Put FIs Back Into the Economy

37

38

Savers Borrower

Broker

Asset Transformer

Cash

Deposits/Insurance Policies

Equity & Debt

Cash

FI Functions

FIs act as agents for “savers” - Perform 2 services

1. Transaction Services▪ Purchase or sell securities for a commission or fee

2. Information Services▪ Research Securities ▪ Provide Recommendations

Reduce costs through economies of scale (lower costs by expanding output) Fixed costs (exchange membership) are spread out over more

transactions Cost per trade is lower – bulk discount or standardization 39

How dose this help

investors?

Purchase “Primary Securities” (stocks, bonds) from firms and sell “Secondary Securities” (transformed assets) to individuals.

Secondary Assets (Transformed Assets) 1. Certificates of deposit2. Insurance claims 3. Mutual funds

40

1. Reduces Information Costs a. Due Diligenceb. Delegated Monitoring

2. Reduce Liquidity Risk

3. Reduce Price Risk

41

1. FIs specialize in doing “due diligence” – Collecting information prior to investing.

Example Does this reduce adverse selection or moral hazard?

2. FIs are appointed “delegated monitoring” – watches over the borrower, their actions and how they perform

Example Does this reduce adverse selection or moral hazard?

Where does the cost reduction come from?Investors now share the cost of collecting information

Example: Bloomberg Subscription Secondary securities that the bank creates, are easier to monitor

Example: Bank loans, are shorter term and have covenants – allow for more frequent updating of information as firms refinance their loans

42

– An asset manager investigates a companies prior to investing

– Bank Loan

FIs specialize in engineering securities to have desirable properties.

Increase Liquidity: Deposit contracts – can be withdrawn immediately▪ They pay a higher interest rate than holding cash because banks

“finance” these accounts using longer-term mortgages with higher rates. Banks are better able to bear the risk of mismatching maturities of their assets and liabilities (e.g. long maturity assets vs. demand deposits)

Mutual funds – easier to trade than a individual asset

43

1. Through diversification:

Asset diversification: FIs offer investors shares in diversified portfolios (mutual funds). The portfolio and thus the price of its shares are less exposed to fluctuations in the price of any individual asset.

Claim diversification: Insurance companies pool different types of risk faced by individuals to offer claims that are contingent on certain events.

2. Through a decrease in transaction costs

It cost less for an investor to buy shares in a mutual fund than to buy all the assets in a portfolio.Several individuals pay premiums but only a small subset file claims at any given time therefore the pool of funds should be relatively unaffected by individual claims

FIs add value by reducing Information Risk Liquidity Risk Price Risk

Through their roles as: Brokers Asset Transformers

45

1. Transmission of monetary policy Banks control deposits, which are a large part of the money supply.

Therefore, FI activity can affect inflation

2. Credit Allocation FIs are the main and sometimes only source of financing for some

sectors of the economy (residential real estate, farming)

3. Intergenerational wealth transfer Life insurance, trusts, pension funds … allow savers to transfer

wealth across generations.

46

4. Payment Services Without the payment services that DIs provide (ATMs, checking, wire

transfer), it would be very difficult to conduct business.

5. Denomination Intermediation Some assets trade in large amounts (commercial paper $250,000;

Negotiable CD $100,000). FIs give small investors access to these assets by selling shares of a portfolio.

6. Maturity Intermediation FIs are in the business of collecting short term deposits and pooling them to

issue long-term loans (mortgages) Long-term loans have higher interest rates and generate profit for the bank FIs hold a fraction of the deposits in reserve to satisfy depositor liquidity

needs

47

1. Safety and soundness regulation Meant to enhance FI stability – include: diversification requirements, guaranty funds, monitoring and

surveillance, equity capital requirements

2. Monetary policy regulation Regulations meant to ensure that monetary policies can be transmitted through FIs – quantitative easing or

reserve requirements

3. Credit allocation regulation Provide special treatment for certain sectors to ensure that financing is available (farming … )

4. Consumer protection regulation Regulations to prevent discriminatory lending practices

5. Investor protection regulation Reduce moral hazard problem – insider trading, lack of disclosure …

6. Entry and charter regulation1. Limits the entry of new FIs through charting by state or federal agencies

48

FIs allow funds to easily flow from savers to borrowers FIs reduce

Information risk Liquidity risk Price risk

They reduce risks through their roles as brokers and asset transformers

FIs also provide Payment services Denomination Intermediation Maturity Intermediation

Because they are special FIs are subject to special regulation

49