Financial Service and Industry

Asset fracture Purchase primary securities by selling pecuniary claims (secondary securities) to households Secondary securities be more groceryable BECAUSE Less teaching asymmetry Less observe exists More liquid Less adventurey Without financial in terminal figureediaries, households go out find direct enthronisations in corpo sum up securities unattractive due to information/ observe costs, liquid cost and cost find.Thus flow was funds atomic number 18 less, little monitoring and risk of exposure of investments would increase. special(prenominal)izes of financial institutions General areas (LIP TM) Liquidity run Information function Price- risk reduction services Transaction cost services maturity intermediation services Institution- specific (McCall) Money indemnification transmittance point of reference allocation Denomination intermediation Intergenerational transfers Payment services Information costs Agency costs 0 costs relating to the risk that firm ow ners and managers use savers ends not in the best interest of the savers monetary institutions collect funds from households in order to avoid free- rider worry (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 profit of financial institutions managing liquidity and price risk Diversification (due to size of funds) suppuration 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 apportionment (Depository Flu) Financial intermediaries are the major source of finance in grouchy sectors of an economy residential real estate (US and UK), farming (Australia) . Intergenerational Wealth careen or Time Intermediation (life insurance, superannuation and pension funds) Payment work IFS provide efficient payment services to the society. Denomination Intermediation turn singulars indirect access to large denomination markets (Money market managed funds, Debt-equity managed funds, Unit trusts) The transmittal of Monetary Policy (Banks) Financial intermediaries are widely used strong point of ex deviate in the economy.Intermediaries liabilities play signifi micklet role in the transmission of monetary policy Money supply in Australia (Dont need to last these term 0) MI currency + bank rent deposits by toffee-nosed non-bank sector MM currency + all bank deposits by cloak-and-dagger non-bank sector Broad money MM + net borrowing of Non-bank IFS from unavowed sector Specializes and Regulation Financial institutions receive special regulatory oversight 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, character reference allocations, payment services Australian Regulation System The traditional industry- base commandment entailed sepa consecrate regulators for individual industry sectors banking, insurance and security firms. Asses 0 Australias current financial regulatory framework originated from Financial System interrogation (Wallis Committee), Australia switched from industry- found formula to function- based regulation. This introduced 3 regulatory agencies, each in committal of specific functional responsibilities. This reform was necessary as the distinction mingled with the activities of different types of financial institutions was becoming more vague and also becaus e of the crossroad in regulation and grey areas.Reserve Bank of Australia (ARAB) 0 Responsible for the victimization and implementation of monetary policy and for overall financial system stability Australian Prudential Regulation Commission (PARA) 0 Responsible for the prudent regulation and supervision of the financial services industry Regulation of deposit- winning 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 fair to middling and fair access to financial services. Protects against abuses (example privilegedr trading), lack of disclosure, malfeasance, breach of fiduciary responsibility.Major types of regulation(Scale) synthetic rubber and soundness regulation Consumer protection regulation Credit allocation regulation Investor protection regulation Monetary policy regulation Entry and chartering regulation 1. Ri sk reduction Encouragement for intermediaries to diversify assets Disclosure of large book of facts exposure 2. Minimum capital requirements 3. Safety valve Central banks open market operations to provide exchange settlement fund 4. Monitoring and command The ARAB directly subdues outside money and the bulk of the money supply is inside money (deposits). Regulators commonly impose a minimum level of capital 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 bring to socially important sector Example US Qualified Thrift lender test (QUIT) set a minimum amount of bestows made to residential mortgages to quality as Thrift Entry Regulation Regulations define setting of permitted activities under a given charter Increasing/ Decreasing origination barriers affect profitability of existing competitors. High di rect/ indirect immersion costs result in larger profits for existing companies incoming of Regulation Implications of SGF questioned more regulations or more efficient regulations The major alimentation 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 unsanctified 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 contributes 1. Commercial and industrial loans rook term (1 course of instruction) financing the purchase of real assets, new venture come away up costs Syndicated loans 0 financing provided by a pigeonholing of lenders, usually to finance large commercial and industrial loans Secured/Unsecured loans located/Floating rate Spot loan 0 borrower takes down the accurate loan amount immediately Loan commitment 0 can taken down eithertime any amount, as long as within a maximum loan amount and a maximum finis of time predetermined Commercial paper 0 unsecured short- term debt instrument 2. Real estate loans 3. Individual (consumer) loans 4.Other loans, such(prenominal) as, government loans, farms loans cipher the gross cave in on a loan Factors affecting the engagement loan ingathering Loan interest rate = Base/ gush lending rate (BRB) + Credit risk premium (m) Direct fees (f), such as loan origination fee Indirect feeds, such as, compensating dimension requirement (b), reserve requirement Credit Risk and the Expected stop on a Loan 1 -p = hazard of slackness 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 faith risk price/promised return and the quantity or reference work availability dimensions. Retails Loans Size = Small Higher cost associated with collection of borrowers individualized credit information Control credit risk through credit rationing localize the total exposure/amount loaned Wholesale Loans assorted interest pass judgment to compensate for different levels of risks Credit rationing to limit credit exposure Measuring credit risk 1.Qualitative credit risk assumes Borrower- specific factors Example reputation, leverage, volatility of earnings, collateral Market- specific factors Example patronage cycle, level of interest rate 2. Credit scoring lessons Calculate a score as a proxy of borrowers default probability screen borrowers into efferent default classes The scoring imitate should establish factors the help dev elop default risk and evaluate the relative importance of these factors Major models 1. elongate 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 variation that restricts the probability to the 0,1 interval 3. Linear discriminate models Altars Z score model for manufacturing firms Z 2. 9, highly quality loans, low default risk Z Term structure based methods Under market equilibrium, evaluate return of a risky loan = risk- free rate (after accounting for probability of default (1 -p)) Assuming a zero default retrieval 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- division 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 tone 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 accumulative probability of default over 2 periods We can extract from these counter curves the markets expectations of the multi- period default rates for corporate borrowers Example consent to Yield Year 1 Year 2 T- Bonds Corpor ate Bonds 15. 8% superstar 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 death rate rate (MR.) Forward- spirit 0 extract expected default rates 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 conk out 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 retur n 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 lack to evaluate the credit risk off $1 million loan with duration of 2.