Introduction and Financial Institutions I

Introduction:
1. What are financial assets?
2. What are financial markets?

Financial Institution I:
1. Financial intermediaries
2. Depository institutions
3. Nondepository institutions

Dr. YEO Wee Yong for FIN3103 (Semester I 2014/2015)
1.1 Assets: Any possession that has value in an
exchange
Tangible assets: value is based on physical
properties
Examples:

Intangible assets: legal claims to future benefits
Examples:

Derivative Instruments: Value is derived from
the value of the underlying financial assets
Examples:
1. What are financial assets?
Introduction
1.2 Financial assets:
1.2.1 Role of financial assets:
Transfer funds from surplus spending
units to deficit spending units
Reallocation of scarce resources from
non-productive to productive use
Pooling of funds
Management of risk: pooling, sharing,
transferring
1. What are financial assets?
Introduction
1.2.2. Types: Mainly two types
1.2.2.1. Debt
Fixed payment
Examples:



1.2.2.2. Equity
Payment is based on earnings
Examples:


1. What are financial assets?
Introduction
1.2.3. Properties of financial assets
Moneyness (money or near money)
Money: medium of exchange : cash or check
(demand deposit or current account)
Near money: saving deposits, fixed (or time)
deposits, T-Bills

Divisibility and denomination (minimum size for
liquidation or exchange for money)
Deposits: infinitely divisible
Lots of shares: 100 share (US)
1000 share (Singapore)
T-bills and bonds: $1,000
1. What are financial assets?
Introduction
1.2.3. Properties of financial assets
Reversibility or round-trip cost

Bid-ask spread
Difference between the price where the
market (or market marker) is willing to
buy and sell
Function of risk
Commission or brokerage fee
Stamp fee/duty
Loadings

1. What are financial assets?
Introduction
1.2.3. Properties of financial assets
Term to maturity (time interval to final payment)
Demand instruments: Payment at anytime
checking (demand) and savings account deposits
Infinte to maturity: Perpetuities
Consol
Equities
Short term:
Long term:

Liquidity (thickness of the market)
Loss due to immediate liquidation
Number of ready buyers and sellers
Affects the bid-ask spread
1. What are financial assets?
Introduction
1.2.3. Properties of financial assets
Currency
Example: US$, , , , S$
Exchange rate exposure and risk

Risk
Risk and Uncertainty:
Some define risk as probabilistic and
uncertainty as not. My definition: Risk is the
assumption of uncertainty
Measure of risk:

1. What are financial assets?
Introduction
A structure where financial assets are exchanged or traded
2.1 Role of financial markets
2.1.1. discovery process
Determination of of
financial assets
Influence by many factors (eg. liquidity, risk,
information, transaction process)
2.1.2. Provision of
Provide a place of gathering of willing buyers
and sellers
2.1.3. Reduction of transaction costs
Reduce search time and cost
Reducing contracting cost and risk
2. What are financial markets?
Introduction
2.2. Types of financial markets
Many different ways to classify
2.2.1. Primary and secondary
Primary:
New Issues of securities
Private placement

Secondary:

2.2 .2 Debt and equity
2. What are financial markets?
Introduction
2.2.3. Money and capital
Money
Short-term: less than 1 year
Federal funds and discount windows
Certificates of deposits (negotiable and
nonnegotiable)
Repurchase agreement: acquires
immediately available funds by selling
securities and simultaneously agreeing
to repurchase the same or similar
securities after a specified time at a
given price
2. What are financial markets?
Introduction
2.2.3. Money and capital
Money
T-bills
Short-term municipal securities
Commercial papers: short-term
unsecured promissory notes issued by
corporations and foreign governments
Bankers/trade acceptances
Capital
Stocks and bonds

2.2.4. Exchange or OTC
2.2.5. Spot or forward, future
2. What are financial markets?
Introduction
What are financial institutions?
Institutions or business entities which provide
financial services
Financial Institutions I
Financial intermediaries
Financial intermediation: Intermediate between
suppliers and demanders of funds
Maturity intermediation
Denomination intermediation
Risk intermediation
Financial Institutions I
1. Financial intermediaries
Commercial banks
Full banks (33)
locally- incorporated
DBS Bank
Oversea-Chinese Banking Corp
United Overseas Bank
2. Depository institutions
Financial Institutions I
Commercial banks
Full banks (33)
28 branches of foreign-incorporated banks
10 QFB: 25 places of business (10
branches), share ATMs among themselves,
tap ATMs of local banks
A&Z Banking Group, BNP Paribas,
Citibank (Singapore), HSBC, ICICI Bank,
MayBank, Standard Chartered Bank
(Singapore), State Bank of India, Bank of
China, Industrial and Commercial Bank of
China
The retail arm of 2 has been incorporated
locally so far: Citibank Singapore Limited
and Standard Chartered Bank Singapore
Limited
2. Depository institutions
Financial Institutions I
Commercial banks
Wholesale banks (54):
Formerly known as restricted banks
No S$ retail banking
Offshore banks (37): Most transaction in ACU very
limited DBU business

Savings banks
POSB: 1972
Encourage savings
No Forex activity
No deposits from corporate
No financing of foreign trade
Restricted lending activities: Credit POSB
Bought over by DBS on Nov 1998
2. Depository institutions
Financial Institutions I
Savings and loan associations (US)
S & L crisis in the 80s
Short term deposits
Long term fixed mortgage loans
Fluctuation of interest rates
Lifting of deposit rate ceiling (Regulation Q)
Increase risk of loan portfolio
Decrease in real estate prices => default
2. Depository institutions
Financial Institutions I
Credit Unions (US)
No corporate stock ownership
Owner by members: mutuals
Deposits => shares
Membership limited to groups having a common
bond of occupation or association

Finance companies (Singapore)
No checking account
No unsecured personal loan > S$5,000
Restricted (capital > $100 m) dealing in foreign
currency, gold or other precious metal
2. Depository institutions
Financial Institutions I
Insurance companies
Human
Term life (no payment unless death within policy
period)
Whole life
Critical illnesses, permanent disability
Endowment
Health
Hospital
Accident
3. Nondepository institutions
Financial Institutions I
Insurance companies
Property
Houses
Cars
Boats
Liability
Product
Professional
Third party
Exotic
Dancers legs
Pianist fingers
3. Nondepository institutions
Financial Institutions I
Insurance companies
Revenues and costs
Initial premium income is invested
Payments to the insured are contingent on
potential future events

Risk
Timing and magnitude of payments are
uncertain: The randomness of natural disasters
Long lag between receipts and payments
3. Nondepository institutions
Financial Institutions I
Pension funds
Pension plans: by government, employers, unions
Defined contribution plans: specify the amount
(or percentage) contributed by employer and
employees. Amount payable at retirement is
not guaranteed but depends on the results of
the investments.
Defined benefit plans: The amount payable is
guaranteed
Insured vs non-insured:

Portable vs non-portable: whether the
employee will lose the benefits if he leave the
company
3. Nondepository institutions
Financial Institutions I
Pension funds
CPF
Defined contribution plan
Portable
Contributions: Cap at $5,000 (80th percentile)
3. Nondepository institutions
Financial Institutions I
25
Table A:


Employee
Age
(years)
Contribution
By Employer
(% of wage)
Contribution
By
Employee
(% of wage)
Total
Contribution
(% of wage)
Credited Into
Ordinary
Account
%
Special
Account
%
Medisave
Account
%
35 & below 16 20 36 23 6 7
Above
35 - 45
16 20 36 21 7 8
Above
45 - 50
16 20 36 19 8 9
Above
50 - 55
14 18.5 32.5 13.5 9.5 9.5
Above
55 - 60
10.5 13 23.5 12 2 9.5
Above
60 - 65
7 7.5 14.5 3.5 1.5 9.5
Above 65 6.5 5 11.5 1 1 9.5
US: social security scheme
Put in money (not designated); for people who retire
A pool of money for people who retire
Current situation: current generation may not have enough money for their
retirement


Singapore CPF:
Interest rates:
Ordinary Account: market-related interest
rate based on the 12-month fixed deposit
and month-end savings rates of the major
local banks.
From 1 Jan 2008: Special Account,
Medisave Account and Retirement Account
is pegged to the 12-mth avg yield of the
10-yr SGS + 1%.
To help members adjust to the floating
interest rate, a 4% floor will be maintained
for the first two years.
Ordinary account: 2.5%
Others: 4%
First $ 60,000 (up to $20,000 from
Ordinary Account) will earn 1 % more
3. Nondepository institutions
Financial Institutions I
Singapore CPF:
Withdrawal at 55 (less CPF Minimum Sum)
CPF Minimum Sum (MS): OA + SA =
Retirement Acc = $155,000 from 1 July 2014
and will be increased gradually to $120,000
(2003 dollars) in 2015
CPF Minimum Sum will be paid monthly from
the draw-down age (DDA) until exhausted
(about 20 years)
Currently, Singapore citizens and PRs will be
automatically enrolled in CPF LIFE
Pay throughout remaining life
Basic Plan or Standard Plan
3. Nondepository institutions
Financial Institutions I
Singapore CPF:
The Minimum Sum draw-down age will be
raised gradually from 62 in 2011 to reach 65
by 2019







It might be increased to 67 in the future
3. Nondepository institutions
Financial Institutions I
Year of Birth Applicable draw-
down age (DDA)
1944 to 1949 62
1950 and 1951 63
1952 and 1953 64
1954 and thereafter 65
30
Singapore CPF:
Medisave Minimum Sum (MMS): $43,500 from 1 July 2014
2 minimum sum we need to fulfill before withdrawing any
At 55: Medisave < MMS
Ordinary Acc + Savings Acc > CPF MS: top-up Medisave before withdrawing
At 55: Medisave > MMS
OA + SA < CPF MS: top-up CPF MS before withdrawing from Medisave
Medisave Contribution Ceiling (MCC): $48,500 from 1 July 2014
Medisave > MCC: transferred to Special Account

Many other schemes: Home Protection, Asset Enhancement, Education,
etc
Lending from parents cpf account for education need to pay back after
working + interest
Singapore 3 vehicles: POSB, CPF and MAS
- Funds for SG govt to develop Sg (invest)
3. Nondepository institutions
Financial Institutions I
Investment banks and merchant banks
Underwriting of securities
Glass Steagall Act replealed by Gramm Leach Bliley Act (Nov 12, 1999)
1933 Glass Steagall Act to curb conflict of interest (decide if you are
commercial or IB)
1930s: Great Depression
Example: JP morgan and morgan stanley
JP Morgan was broken up IB: Morgan Stanley, JP Morgan: commercial
banking
1999: drop the Act as many banks find that they were unable to compete
overseas due to their small size
Do you think the repeal of the Glass Steagall Act contributed to the financial
crisis in 07-08?
Many believed that the financial crisis would not happen; at least not as severe
as it was
UK: implementing glass steagall Act
Big 5: Goldman Sach, Merrill lynch (bought by bank of america), lehman brothers,
Morgan stanley, bear stearns
3. Nondepository institutions
Financial Institutions I
Investment banks and merchant banks
Main function: Help corporations to raise funds
IPOs:
Helping companies to issue equity shares to
the general public for the first time
Private placement:
Sell (or place) securities to selected investors
3. Nondepository institutions
Financial Institutions I
Investment banks and merchant banks
Merges and Acquisitions:
Find candidates: e.g. white horse
Valuation
Advice on method of payment: cash, shares,
both
Creation and trading of financial products
Options, futures, swaps, etc
Fund management:
Manage funds for individuals and institutions
3. Nondepository institutions
Financial Institutions I
Investment banks and merchant banks
Asset securitization:
Issue securities backed by a pool of assets
Everything can be securitized: mortgages, credit card debts, auto
loans etc
Creating of products such as CDOs, CBO etc
Fuel economy by giving users money

Securities Trading:
Making the market (market making)
Arbitrage: riskless and risky
Speculation: in US (proprietary trading; broker rule; trade in their
own account)
Help clients in block trading and program trading
Provide research
3. Nondepository institutions
Financial Institutions I
35
Investment companies
Mutual Funds
Open-end: buys and sells (at NAV = (market cap - liabilities) per
share) an unlimited number of shares
Closed-end: sell a limited number of shares once which can be
traded
Unit trust:
Similar to closed-end funds in that the number of unit certificate is
fixed
Assets are placed with trustee (issue units to people who wants to
invest)
Fixed termination date
Specific collection of assets
No professional fund managers
3. Nondepository institutions
Financial Institutions I
36
Hedge Funds
Private partnership
Located offshore for tax and regulatory purposes
Operate through private placement to rich individuals and institutions
Short overvalued (as a hedge for market going down) and long
undervalued
Investment techniques, including short positions and leverage (a lot of
derivatives trading)
Leverage to amplify returns
3. Nondepository institutions
Financial Institutions I
37
Hedge Funds
According to eVestment, at the end of the first
half of 2014, the AUM (asset under management)
of global hedge fund is at US$3.03 trillion.
Funds flow in 2013: US$ 62 billion
Funds flow in H1 2014: US$100 billion
Annualized growth rate: 7.1%
Fastest post-crisis
Pre-crisis (3 years before crisis): 19%

3. Nondepository institutions
Financial Institutions I
38
Hedge Funds
Performance:
Hedge fund: 2013 and H1 2014: 8.93% and 3.06%
respectively
S&P: 2013 and H1 2014: 32.4% and 7.14%
respectively
Risk appetite
Compare to mutual fund
Investors: Accredited investor (high net worth individual
or investor base on the countrys regulation)
Regulations: lightly regulated Mutual fund: highly
regulated
Redemption: lock-in period. Mutual fund: no lock-in
period; anytime
Transparency: low do not know what they do with the
money Mutual fund: you know exactly what stock they
buy @ what percent
3. Nondepository institutions
Financial Institutions I
39
Hedge Funds
Typified by high fee
Management fee
Performance fee
2 and 20: 2% of NAV per annum and 20% of profit of the game
Withdrawal fee
Hedge Funds Hall of fame:
LTCM: Merton and Scholes
Bear Stearns: High-Grade Structured Credit Fund and Stearns High-
Grade Structured Credit Enhanced Leveraged Fund (June 2007)

3. Nondepository institutions
Financial Institutions I
40
Private Equity Funds
Private partnership
General Partner: a private equity firm holding the control power
(private equity!) (can be publicly listed company; public buy-out;
convert a public firm to a private firm)
Limited Partner: institutions or wealthy individuals (passive
partners)
Types of investments: Equity investments
Leverage buy-outs: buying a major equity stake
Venture capital: major stake in less mature firm when the
start-up go to IPO, the private equity firms will earn
Growth Capital: minor stake in more major firm; about to IPO
but need a little more capital
3. Nondepository institutions
Financial Institutions I
41
Private Equity Funds
According to 2014 Preqin Global Private Equity
Report, the private equity industry has an AuM
of US$3.5 trillion at June 2013 of which around
US$1 trillion is dry powder (cash that has not
been invested yet; nth to invest)
The financial crisis has put a huge toll on the
industry
IRR for the industry is around 10% for the
median fund in June 2013 (peak was about
12.5%)
3. Nondepository institutions
Financial Institutions I
42
Private Equity Funds
According to studies by Pitchbook, by comparing
to public market equivalent,
PE has underperformed since 2007
VC has underperformed since 2001
3. Nondepository institutions
Financial Institutions I
43
Private Equity Funds
Big names: Blackstone Group, Carlyle Group, Goldman Sachs, TPG,
KKR, Bain Capital, Apollo Global Management
The Blackstone Group is now listed in NYSE ($4 billion IPO) on July 22,
2007 peak of the market
KKR has tried to list a month later but failed (the need to be transparent)
Later listed in Euronext
Transferred listing to NYSE in July 15, 2010
Carlyle Group went public on May 3, 2012
LBO (leverage buy-out) boom in the 1980s: corporate raiders
Kohlberg Kravis Roberts (KKR) bought RJR Nabisco for $31.1 billion
(1989): Barbarians at the Gate
3. Nondepository institutions
Financial Institutions I
44
Private Equity Funds
LBO boom 2006-2007: Syndicated purchase
Nov 2006: Hospital Corporation of America (HCA) by KKR,
Bain Capital, and Merrill Lynch for $33 billion
Feb 2007: Equity Office Properties Trust by Blackstone group
for $23 billion + $16 billion in assume debt
Oct 2007: Hilton Hotels by Blackstone for $26 billion (one of
the most successful buy-outs)
3. Nondepository institutions
Financial Institutions I
45
Private Equity Funds
LBO boom 2006-2007: Syndicated purchase
Oct 2007: Texas Utilities (TXU) by KKR, TPG
Capital and Goldman Sachs for $45 billion. It
is now known as Energy Future Holdings
Corporation (biggest deal to date)
Currently: file for chapter 11
Mar 2008: Bell Canada Enterprises (BCE) by
Ontario Teachers' Pension Plan, Providence
Equity, Madison Dearborn, Merrill Lynch, and
Toronto-Dominion Bank for $51.7 billion
(didnt went through)
3. Nondepository institutions
Financial Institutions I
46
SWF: Sovereign Wealth Fund
State-owned investment funds
Gain attention lately due to high profile purchase
amid the credit crisis
Examples: Singapore (Temasek claim that
they are not SWF and GIC), Middle East (Qatar,
Bahrain, Dubai, Abdu Dhabi), China
Investments: Citibank, UBS, Morgan Stanley,
Merrill Lynch, Chrysler Tower
Causing concerns due to lack of transparency
Various meetings between SWF and
government officials to iron out issue
3. Nondepository institutions
Financial Institutions I
47
SWF: Sovereign Wealth Fund
High profile failures!!!
Total estimated losses in 2008
US$600 billion (from US$3.6 to 3 trillion)
Most has recovered since then
Estimates AUM at July 2014 is US$6.6 trillion
US$ 50-60 trillion(mutual funds)
3. Nondepository institutions
Financial Institutions I