FNAN 321: Financial Institutions

1. Chap 1, Class 1 FNAN 321:Financial Institutions

2. Today • Course Overview • Syllabus • Organization • Introduction to Financial Institutions (FI) • What role do FIs perform • What costs do FIs reduce • How FIs are special

3. Syllabus

4. Syllabus • 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

5. Syllabus 1 • 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,

6. Syllabus 2 • 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

7. Syllabus 3 • Grading:

8. Syllabus 4 • Homework: • Weekly homework assignments must be completed individually • Assignments total points for each module are specified on the assignment • Grading: • 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. Assignments are due one week after they are assigned in class unless otherwise stated • Weight = 30% of your final grade

9. Syllabus 5 • 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 problem set with the lowest grade (percentage score) will be droppd • 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 full homework assignments • Graded on the basis of accuracy

10. Syllabus 6 • 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.

11. Syllabus 7 • 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

12. Syllabus 8 • 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.

13. Syllabus 9 • Grading Scale: Percentages will be rounded to 3 decimal places prior to assigning the final letter grade

14. Syllabus 10 • Absences and Late Assignments • There are no excused absences • Exams: If you miss one of the first two exams your final exam will become cumulative. You will sit for the final and take the midterm after you finish the final. • 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

15. Syllabus 11 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”.

16. Syllabus 12 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.

17. Syllabus 13 • 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.

18. Course Organization

19. Course Breakdown (organization) web page Getting to know Financial Institutions Interest rate risk – the fundamental risk of banking Introduction to Banking Measuring and Managing Interest Rate Risk Off-Balance Sheet Activity Capital Adequacy Measuring and Managing Banking Risks Credit Risk Liquidity Risk Market Risk

20. What to Expect

21. Introduction to Financial Institutions

22. What is the Basic Function of Financial Institutions (FI) in the Economy? • 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

23. What is the Basic Function of Financial Institutions (FI) in the economy? 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

24. What Makes This Role So Special? • Why study financial institutions instead of auto manufactures or healthcare providers? • What is special about the services they provide? Savers Borrower

25. What Makes This Role So Special? • Why study financial institutions instead of auto manufactures or healthcare providers? • What is special about the services they provide? Cash Debt & Equity Securities Savers Buy Financial Assets Borrower Buy Real Assets

26. Consider a world without Financial Institutions

27. Would “Savers” Lend Money to Borrowers in This World? • 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! Why

28. Would “Savers” Lend Money to Borrowers in This World? • Real World: In reality investors face three types of costs when directly lending to companies • Information Costs • Liquidity Risk • Price Risk

29. Information Costs Prior to investing 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 After Investing

30. Information Cost Examples

31. Moral Hazard or Adverse Selection? Moral Hazard Adverse Selection Who was facing the risk? How were they managing it?

32. Managing information risk • 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 Not Likely!

33. Free Rider Problem Example • 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

34. Liquidity Risk • 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

35. Price Risk • 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

36. Flow of Funds Without FIs Conclusion: • Without FIs funds would flow slowly from households to businesses because of: • Information costs • Liquidity risk • Price Risk

37. Now Let’s Put FIs Back Into the Economy

38. What if We Add FIs Back Into the Mix? FI Functions Broker Savers Borrower Equity & Debt Cash Asset Transformer Deposits/Insurance Policies Cash

39. Brokerages FIs act as agents for “savers” - Perform 2 services • Transaction Services • Purchase or sell securities for a commission or fee • 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 How dose this help investors?

40. Asset Transformation Purchase “Primary Securities” (stocks, bonds) from firms and sell “Secondary Securities” (transformed assets) to individuals. Secondary Assets (Transformed Assets) • Certificates of deposit • Insurance claims • Mutual funds

41. How Does Asset Transformation Help “Savers” (deliver value)? • Reduces Information Costs • Due Diligence • Delegated Monitoring • Reduce Liquidity Risk • Reduce Price Risk

42. How Does Asset Transformation Reduce Information Risk? • FIs specialize in doing “due diligence” – Collecting information prior to investing. • Example • Does this reduce adverse selection or moral hazard? • 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 – An asset manager investigates a companies prior to investing – Bank Loan

43. How Does Asset Transformation Reduce Liquidity Risk? 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

44. How Does Asset Transformation Reduce Price Risk? • 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. • 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

45. Conclusion FIs add value by reducing • Information Risk • Liquidity Risk • Price Risk Through their roles as: • Brokers • Asset Transformers

46. Other Reasons FIs are Special • Transmission of monetary policy • Banks control deposits, which are a large part of the money supply. Therefore, FI activity can affect inflation • Credit Allocation • FIs are the main and sometimes only source of financing for some sectors of the economy (residential real estate, farming) • Intergenerational wealth transfer • Life insurance, trusts, pension funds … allow savers to transfer wealth across generations.

47. Other Reasons FIs are Special (continued) • Payment Services • Without the payment services that DIs provide (ATMs, checking, wire transfer), it would be very difficult to conduct business. • 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. • 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

48. FI Specialness and Regulation • Safety and soundness regulation • Meant to enhance FI stability – include: diversification requirements, guaranty funds, monitoring and surveillance, equity capital requirements • Monetary policy regulation • Regulations meant to ensure that monetary policies can be transmitted through FIs – quantitative easing or reserve requirements • Credit allocation regulation • Provide special treatment for certain sectors to ensure that financing is available (farming … ) • Consumer protection regulation • Regulations to prevent discriminatory lending practices • Investor protection regulation • Reduce moral hazard problem – insider trading, lack of disclosure … • Entry and charter regulation • Limits the entry of new FIs through charting by state or federal agencies

49. Lecture Summary • 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