Financial Markets for corporate and retail clients

J. Cologni – Financial markets for corporate and retail clients

Financial markets for corporate and retail clients.

Functions of financial system, financial markets, intermediaries, corporate finance, financial statement analysis, capital budgeting (way for corporations to understand how an investment works, how to invest in a new project, …).

Value stocks (poste di bilancio): debt (debiti) and equity (p. netto).

Content

• First part: Financial markets and institutions
• Second part: Credit risk (on balance sheet)
• Third part: Off-balance sheet risk
• Fourth part:
  • Financial statement analysis
  • Capital budgeting
  • Valuing stocks
  • Short-term and long-term finance

First part: Why are financial institutions special?

Before: the bank industry operated as a full-services industry performing all financial services: commercial banking, investment banking, stock investing services, insurance providers, …

After: separation of those activities; new financial services industries sprang up (sono sorte).

Financial institutions are: banks, credit unions, insurance companies, mutual funds.

Situation without financial institutions

Households/savers (risparmiatori) give cash or funds to corporations and corporations give equities and debt claims to households.

The amount of savings is very limited in corporations and for this reason they are considered net borrowers (debitori, richiedenti prestiti). Governments are net borrowers: by their standing decisions they influence the amount of savings available in the financial system, for example by introducing or reducing taxes.

Ex. One of the reasons why the interest rate in the international market is increased is because the federal government increased spending: by rising taxes or by issuing debt.

The government is raising funds from the net savers and giving it to corporations. There is a limited amount of money available in the system, so: if the government increases spending, the amount of available funds go down and the cost of funds go up.

Net borrower issue (emettono) equity and debt claims in exchange of cash.

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Without FIs there will be a low level of funds flow between households and corporations, because of:

• Monitoring costs: you have to monitor the borrower to make sure that he will repay the loan in the future. Financial institutions are better in monitoring: they can screen each borrower and reduce costs by economies of scale.
• Liquidity costs: if you make a loan to someone, your money is blocked/committed for the life spent on the loan.
• Substantial price risk: if you invest in stocks or bonds you’re exposed to price risk. It’s important to diversify: reducing risk by holding different securities (titoli) in a portfolio.

Financial institutions make the flows of funds between savers and borrowers easier (intermediary).

The role of brokers is to facilitate the matching (incontro) between savers and borrowers. The intermediary reduces costs and risks.

Es. Banks: they collect deposits (commercial banks) and then make loans. They make loans using money deposited at the bank; so, you don’t have risks of value changing or higher costs. There is a balance sheet (bilancio) in the middle.

There is no changing in the value of your deposits: the money you deposit today is the money you withdraw tomorrow. The bank is responsible also for monitoring the borrowers.

Direct finance: I buy funds and bonds directly on the financial market (primary securities).

Indirect finance: there is an intermediary between net savers and net borrowers (secondary securities).

What happens when the financial system doesn’t work correctly? Economic crash (financial crisis). It has a big impact on political stability because of the severe economic hardship.

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Financial institutions functions

• Brokers: brokerage function. A broker facilitates the matching between investors and sellers. He provides information to savers (investments research, recommendations) and he reduces costs by producing economies of scale.
• Asset transformation: the FI issues financial claims (strumenti finanziari) that are more attractive to savers (less risky and more liquid) than the claims issued by corporations.
• Information providers: the bank monitor everything. They can monitor the performances of different clients and by that they create economies of scale in the collection of information. There are a lot of new technological products that can be used to monitor.
• Information producers: FIs build information by the relationship w/ clients.
• Credit allocator: credit bring votes, credit boosts economy.
• Providers of payment services.

So, how to reduce costs?

• By delegating the monitoring.
• By taking information from FIs.

Liquidity and price risk

• Secondary claims have less price risk, because since they are loans, their value remains the same, it doesn't change. So banks are less exposed to price risk.

Deposits are more liquid so they are more attractive to small investors.

Financial position of the main economic actors

Financial position (difference between savings and borrowers) of the main economic actors in the financial system:

• Households and no-profit organisation: the position is always positive because they are net savers.
• Government: financial position is always negative so the government is a net borrower.
• Domestic businesses: financial position sometimes is positive, sometimes is negative. It depends on business development and other factors.

Net regulatory burden (onere): difference between the private costs of regulations and the private benefits for the producers of financial services.

Debt instruments and equity instruments

Difference between “debt instruments” and “equity instruments” (only corporations can issue equities, stocks):

Debt instruments (ex. Bond or mortgage): they provide fixed payments (interest and principal payment) at regular intervals to the investor.

• Maturity date: there is a final date on the contract.
• Maturity: short-term (less than 1 y); intermediate-term (1-10 y), long-term (more than 10 y). Short-term instruments are considered as liquidity.

Equities (ex. Common stocks): they are used to share the net income (utile) and the assets (patrimonio) of a business. The investor receives periodic payments (dividends) at specific dates – only if the business decides to distribute the net income. In case the business is liquidated the assets are shared between owners. Equities give to the owner the right to vote and to elect directors.

What about the risk of investing in equities? The first risk is that the flow of payments is uncertain but also because we have union: if the business goes bankrupt, we sell the assets and we first give the money to debt holders and then to equity holders (owners).

Primary market: markets used by corporations to raise funds; where new issues of a security (stock and bonds) are sold.

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Often assisted by investment banks (ex. In Italy Mediobanca): they support the issuing of new stocks and bonds by services of finding new potential investors and they commit to underwrite some of the issue: it means that to make sure that the new issue is successful, they commit to underwrite part of the issue, so they say “in case we are not able to allocate all the investments we commit to buy part of them”.

Secondary market: where securities can be resold.

It is well known. It is where stocks and bonds are treated. Some financial institutions support the transfer of stocks and bonds between sellers and borrowers:

• Brokers: they match buyers and sellers (Ex. Borsa Italiana).
• Dealers: they buy and resell stocks and bonds.

Functions of secondary markets

• To make financial instruments more liquid, because by facilitating the exchange of securities they allow investors to resell their securities in the market.
• Contribute to determine the price of the security: an efficient price (that really reflects the value of the security) is important because is the representation not only of the value of the corporation in the market but also of the money I can raise if I issue new bonds or new stocks.

Secondary markets can be organized in two ways: exchanges and over-the-counter markets.

• Exchanges: we have one centre location (es. Borsa Italiana in Milan).
• Over-the-counter markets (OTC): dealers at different locations who have an inventory of securities and buy and sell securities OTC. Thanks to computers, nowadays the liquidity (the efficiency of prices) in the OTC is much more than the efficiency of prices in organised exchanges.

Nasdaq is an OTC: electronic system of exchange.

Examples of OTC markets:

• U.S. government bond market: 40 dealers all around the world that make the market of US government bonds.
• Certificates of deposits: debt instruments issued by my banks; there is no secondary market.
• Federal funds (funds deposited at regional Federal Reserve banks: these funds can be lent to other market participants): interbank markets in the US.
• Banker’s acceptances (short-term debt instrument issued by a company that is guaranteed by a bank).
• Foreign exchange: market for euros, market for dollars… there are dealers making exchanges of deposits accounts of different values.

Differences in money and capital markets

On the base of maturity:

Money markets: markets where short-term debt instruments are treated.

Characteristics:

• They are very liquid so they can be sold very quickly.
• They suffer of smaller fluctuations in prices (safer investments).
• They are used by corporations, governments and banks to earn interest on surplus funds. They have expenses and they collect taxes to cover expenses; but if the taxes aren’t enough to cover them.
• Keeping money idle (immobile) means a higher opportunity cost, so it earns more than keeping your money in pocket.

Capital markets: long-term debt and equity instruments. Equity instruments don’t have a maturity so if a company invests in equity the company can live 2 years as well as 100 years.

Characteristics:

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• They are less liquid: so, if you want to sell a long-term debt or an equity tomorrow it is not easy, so you have to wait for someone who is willing to pay the same price, and if you don’t find someone you have to sell it at a lower price. The number of transactions per day is less than in the money market.
• Greater fluctuations in prices, much more volatility. More risks.
• Often used by financial institutions (such as insurance companies – that sells long-term insurance policies - and pension funds), which have little uncertainty about the funds they will have available in the future. They care much more about the future, not about tomorrow. They care about long-term growth.

To sum up: financial institutions

Why so important? Understand the role of:

• Transaction costs.
• Risk sharing.
• Information costs.

Transaction costs

Time and money spent in carrying out financial transactions (ex. Write the contracts, monitoring the borrower, ...).

Financial institutions are experts. They use a simple contract for all the contracts they make (economies of scale: very low transaction costs).

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Risk sharing

Every transaction you make includes a cost/risk.

Financial intermediaries collect shares from investors (invested in securities).

Low transaction costs allow financial intermediaries to share risk at low cost.

Asset transformation: risky assets are turned into safer assets for investors because of diversification.

Diversification: overall risk (collection of assets in a portfolio) is lower than for individual assets. Financial institutions can collect a huge amount of money and they can diversify much more the risks.

Deposits insurance: it allows to prevent the risk of a bank run.

Asymmetric information

One party does not know enough about the other party to make accurate decisions.

When you make a loan to another person it is necessary to have information about her past performance.

Listed companies (società quotate) are obliged to provide much more information than cooperatives.

Financial institutions provide information to savers that are necessary to credit someone (dare credito).

Types of asymmetric information:

• Adverse selection (selezione avversa): if a bad borrower has hidden information (informazioni nascoste) the saver could grant a loan to him even if he should have higher interest rates or a denial of credit request.
• Moral hazard (hidden actions): after the transaction occurs. It is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back.

You take the money but you misuse it. For this reason, it’s important to have insurance.

Exercise: adverse selection - 1970, George Akerlof

Sellers know the exact quality of the cars they sell. Buyers can only identify the quality by purchasing the good. Buyers cannot get their money back if they buy a bad car.

There are two types of cars: high and low quality.

• High quality cars are worth 15.000 euros.
• Low quality cars are worth 3.000 euros.

Buyers know that 30% of used cars are high quality (strong assumption).

Buyers do not know the quality of the car until they purchase.

How much are buyers willing to pay for a high-quality car?

There is a 70% probability that I buy a lower quality car.

There is a 30% probability that I buy a higher quality car.

30%*15.000+70%*3.000=4500+2100= 6600 euros. It is the average price due to the probability.

Consequences: sellers of good cars know their cars are good, but they don’t know how to sell them to the clients. So, the potential buyers offer this amount of money because they are not sure their car will be good. The consequence is that most of the trades will be done with low quality cars; so, the second-hand cars market will be made up only by low quality cars.

To sum up, the average price will prevent HQ sellers from selling since they are not offered enough money. LQ sellers will be very happy they are offered much more than their cars are worth. This will lead to an only-LQ used cars market. Reducing the chances of buying a HQ car, it will increase the LQ in the market.

So, if you cannot distinguish between bad and good borrowers, savers will make less loans, and if they don’t make loans the system breaks down.

Economies of scope and conflicts of interest

Financial intermediaries provide multiple financial services to their customers (loans, selling bonds for them, money transfers, payment services, insurance, etc.) by collecting the same information.

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By providing multiple services, financial intermediaries can also achieve economies of scope: they can lower the cost of information production for each service by applying one information resource to many different services.

However, the presence of economies of scope can create conflicts of interest: a type of moral hazard problem that arises when a person or institution has multiple objectives in conflict.

Conflicts of interest reduce the quality of information.

Economies of scale: the degree to which an FI’s average unit costs of producing financial services fall as its outputs of services increase.

Economies of scope: the degree to which an FI can generate cost synergies by producing multiple financial service products.

FIs are subject of special regulation

FIs are considered by many governments. Credit is an easy way to implement money. Without credit most of the people cannot buy home, buy a car, … They play an important role in credit allocation.

Failure of FIs can produce negative externalities.

Key functions such as money supply transmission (banks), credit allocation (thrifts, farm banks. Es. School loan), payment services (banks, thrifts – most of the transaction through the bank system. Even when you make a payment w/ your bank account you are using the bank system), etc.

Roles of regulations

• Protect savers, in particular retail savers. Savers deposit money in the bank and they trust the bank (hanno fiducia nella banca). If savers lose trust in the bank, it causes bank runs. At the same time it is important to protect deposits to prevent bank failure.
• Prevent unfair practices (ex. Parmalat: the general manager of the company stocked the money in very risky investment).
• Ensure soundness of the financial system: when a bank falls, all the system can be affected.

Safety and soundness regulation

Safety and soundness regulation (to protect depositor and borrowers against the risk of failure):

• Asset diversification: the banks in the US are prevented to invest no more than 5% of equity to a single borrower to avoid concentrations of risk. They are obliged to diversify through different borrowers.
• Minimum capital requirements: the capital will absorb an unexpected loss. TARP (buying toxic assets from banks) and Capital Purchase Program – Basel Accords: accord taken by a central banker (so the manager of a central bank); they are complex and they are based on the idea that the bank has to maintain a minimum level of capital requirement. It is also important to reduce the exposure of the banks to low quality assets.
• Guaranty funds: Deposit Insurance Fund (DIF – fondo tutela depositi), Securities Investors Protection Corporation (SIPC). There are insurance funds in Europe, in the US, .... Our bank shares the risk with us.
• Monitoring and surveillance: On-site examinations and review of accounting statements to make sure that account statements are trustable and correct, FDIC monitors and regulates DIF participants, increased after crises.
• Regulation can imply a net regulatory burden: it reduces the competitiveness of financial institutions. The cost for banks to comply w/ the regulation can be very higher than the benefits they enjoy.

In the US security investors have an insurance fund (SIPC).

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