Lesson 8: What Financial Institutions Do

Upon completion of this lesson, you should be able to do the following:

• Explain the differences among the five categories of financial institutions: Securities market institutions, investments institutions, contractual saving, depository institutions, and government financial institutions
• Describe the purpose and benefit of the Dow Jones Industrial Average.
• Explain the impact of stock market crashes on the economy.

Introduction

This lesson introduces the financial institutions. The financial institutions are classified into five categories. Please do not think these categories are etched into stone and any financial company can be classified into only one category. One company may be defined in three or more categories, because the company offers services like a bank, sells insurance, and acts like a broker. Financial institutions have expanded into new activities, because the U.S. federal government deregulated the financial market during the 1980s and 1990s. Competition became very strong, causing financial institutions in one sector to start competing with other institutions in other sectors.

Securities Market Institutions

Securities market institutions includes investment bankers, brokers, dealers, and organized exchanges. The securities market institutions improve the liquidity of the secondary markets. These institutions are not financial intermediaries and do not link the savers to the borrowers. Instead, the securities market institutions help the savers locate the borrowers.

• Investment banks - for example, Ford wants to build a new factory and decides to issue new stock. The new stock will provide funds that Ford can use to build the factory. Ford will go to an investment bank and the investment bank will assist Ford in creating the new securities. This process is called underwriting . The investment bank will guarantee a stock price to Ford and the investment bank will try to sell the new Ford stock for a higher price. The difference between the higher price and the guaranteed price is the investment firm's profit. Essentially, the investment banker is nothing more than a marketing agent for new securities.

• Over-the-counter (OTC) market - does not have a physical location. Instead, dealers and brokers are connected together by telephones and computers. Either new or small firms are likely to be traded in the over-the-counter market. The largest OTC market is the National Association of Securities Dealers' Automated Quotation, otherwise known as NASDAQ. NASDAQ is very popular, because many new high-tech firms started in this market, such as Microsoft.

Investment Institutions

Investment institutions are made up of:

• Mutual funds - pool together funds from many people into a fund, and invest the money in a variety of stocks. This method allows the diversification of stocks, and lowers investors' risk. For example, you started your own mutual fund and offer investors a chance to invest in this fund. You take the money and buy 30 different corporate stock. The Coca-Cola stock may go up one day, while the value of my IBM stock goes down. Overall the average of the fund's 30 stock will probably earn a return to your fund and to the fund investors. If you bought only one type of corporate stock, like Apple Computers, you will loose your investment if this company bankrupts.

The most well-known mutual fund companies are Fidelity, Vanguard, and Dreyfres. Mutual fund companies have different strategies and characteristics. The mutual fund companies may only buy stock in certain industries, large companies, or foreign company stock.

• Closed-end mutual funds - the mutual fund company may issue a fixed number of shares to the fund. Then, investors may buy and sell these shares in over-the-counter markets, just like stock. The mutual fund company does not buy shares back for closed-end mutual funds.
• Open-ended mutual funds - the mutual fund company will buy back shares to the fund and the price of the shares is tied to the value of the stock in the fund. Mutual fund managers are paid in two ways.
  • No-load funds - the managers of the fund charge management fees, which are usually 0.5% of assets.
  • Load funds - the fund managers charge a commission for selling or purchasing of shares.

• Money market mutual funds are very similar to mutual funds. However, the fund manager buys only money market financial instruments and does not buy corporate stock. The theory behind money market mutual funds are simple. If you have five friends with $2,000 each who want to buy a Treasury bill and the minimum face value of a Treasury bill is $10,000, then your friends can pool their money together and buy one T-bill. When the T-bill matures, your friends split the interest among them.

Money market mutual funds are very popular, because these funds offer check writing privileges. The value of the fund does not change much, when interest rates changes. In 1998, money market mutual funds had assets of $1,154 billion. There is another financial instrument that is exactly identical to money market mutual funds. They are called money market deposit accounts and are offered by commercial banks. The only difference between these two fund are money market deposit accounts are insured by the federal government, while money market mutual funds are not insured. If your bank bankrupts and you invested in money market deposit accounts, you will get your money back from the federal government.

• Finance companies - raise money by selling stock, bonds, and commercial paper. Commercial paper is short-term loans issued by well-known banks and corporations for a maximum maturity of 270 days. Commercial paper is a form of direct finance and has no collateral. Finance companies make loans to consumers, so they can buy furniture, appliances, cars, home improvement loans, or the loan can be to a small business. Some corporations have started their own finance companies that help consumers buy their product. For example, General Motors Acceptance Corporation lends money to people, so they can buy cars from General Motors.

Contractual Saving

Contractual saving institutions are the third type of financial institutions and include:

• Insurance companies - provide protection for people who buy insurance policies. The insurance policy prevents financial hardship that results from a medical emergency, car accident, or the death of a family member. Insurance companies are financial intermediaries, because they link the funds from the policy holders to the financial markets. The policy holders will make periodical payments to the insurance company called premiums . The insurance company will invest the premiums in the financial markets. For the insurance company to earn a profit, the amount of interest earned in the financial markets plus the total amount of premiums have to be greater than the amount paid for claims. The largest insurance companies are Allstate, Aetna, and Prudential. Most states established commissions that regulate insurance companies. The commissions may limit premiums, minimize fraud, and prevent the insurance companies from investing in risky securities.
  • Law of large numbers - insure a large number of people. On average, statisticians can accurately predict how much the insurance company will pay out in claims, because on average the death, illness, injury, and property damage can be accurately predicted. Statisticians do not know which specific individuals will experience hardship, but they can predict how often it occurs.
  • Adverse selection - is a problem for insurance companies. It occurs when the person buying insurance has more information than the insurance company. For example, a person knows he has a heart problem and decides to buy a very large life insurance policy.
  • Moral hazard - is another problem. It occurs when the person buying insurance becomes more careless. For example, a person buys theft insurance for his home and this person stops locking his windows and doors when he leaves, increasing the risk that his home will be burglarized.
  • Insurance companies lower these problems by:
    • Risk-based premium - gather information about the policy holders, such as driving records, medical records, and credit histories. The insurance company will charge a higher premium to a person who is more likely to make claim.
    • Deductible - when a person makes a claim, this person is responsible for the first $500. This passes some of the responsibility to the person holding the insurance policy.
• Life insurance companies - tend to purchase long-term corporate bonds and commercial mortgages, because they can predict with high accuracy future payments. Insurance companies are organized in two ways.
  • Mutual company - are owned by the insurance policy holders. The insurance policy functions as corporate stock.
  • Stock company - these companies issue stock. The insurance policy holders do not own these companies, the shareholders do. The stock company is more popular, because the company can raise more funding. They receive funding from stockholders by selling stock and receive funding from selling insurance policies. Most polices issued are called term life policies . The person buying the life insurance has to pay the premium for the rest of his life. These policies are popular, because the policyholder can borrow against the value of the life insurance policy, when he retires. This is called annuities . Annuities pay a retired person a specific amount of money each year.
• Property and casualty insurance companies - can be organized as a stock or mutual companies and insure against theft, illness, fire, earthquakes, and car accidents. These companies tend to purchase highly liquid, short-term assets, because these companies cannot accurately predict the amount of future claims. The premiums that are charged correspond to the chance of the event occurring. For example, a homeowner in California will pay a higher premium for earthquake insurance than a homeowner in the Midwest of the United State, because California has more earthquakes.
• Pension funds - pension funds are the most important form of saving for people. People save for retirement in two ways: Pension funds sponsored by employers or through personal savings accounts. Pension funds are managed by financial companies and the pension funds are invested in the financial market. The pension fund managers can accurately predict when people will retire and usually invest in long-term securities, such as stocks, bonds, and mortgages. A person can only receive benefits from the pension fund if the person is vested . Vesting is the time period required for a person to receive participate in the pension plan. The time period varies for the pension fund. Some city governments require a person to be employed by the city for 10 years before this person is 100% vested in the city's pension plan. Employers prefer to offer pension plans to employees for three reasons.
  • Pension fund managers can more efficiently manage the fund, lowering the pension funds' transaction costs.
  • The pension funds may offer benefits such as life annuities. Life annuities could be more expensive if the retire person bought them individually.
  • The pension fund is not taxed. If the employer offered higher wages and no pension plan to the employees, these wages are taxed.
  • Defined contribution plan - the employees own the value of the funds in the pension plan. If the pension fund is profitable, retired employees will receive higher pension income. If the pension fund is not profitable, then the retired employees will receive a low pension income. Companies that have a defined contribution plan like to invest the pension funds into the companies' own stock. That way, employees have an incentive to be more productive, because the value of their pension plan depends on their company's profitability.
  • Defined benefit plan - the most common type of plan and an employee is promised a specific amount of benefits based on the employee's earnings and years of service to the company. If this pension fund is profitable, the company pays the promised benefits and keeps the remaining funds from the pension plan that is not paid to the employee. If the pension fund is unprofitable, the company has to pay the promised benefit out of its own pocket.
  • 401(k) plans - a recent trend in pension funds allows the employees to manage their own pension plans. (401(k) is a section of law in the Internal Revenue Service's regulations). The benefit of this pension plan is the employee can take his pension plan with him when he finds a new job. There is one risk. The amount of money a person has at retirement depends how much money he invested in the plan and how well the investments have done.

The pension funds are regulated by federal and state governments. The regulations require the managers of the pension funds to disclose all investment. That way, employees know which securities the pension fund is invested in. The regulations prevent fraud and mismanagement. Many pension funds will bankrupt, when the companies where the employees work bankrupt. Congress created the Pension Benefit Guaranty Corporation, which insures pension fund benefits up to a limit if the company cannot meet its obligations. Some economists believe a pension fund disaster will occur.

Depository Institutions

Depository institutions are intermediaries and link savers to borrowers.

• Commercial banks - accept deposits from the public. Many depositors prefer to put their savings in a bank than directly into the financial markets, because of three reasons: Liquidity, lower investment risk, and bank collects information about borrowers more efficiently.

Many borrowers seek bank loans, because it costs too much to issue stock or bonds. To issue stock and bonds, the company has to follow SEC regulations and pay commissions to the investment bankers. For a small loan of $500,00 and less, these fees can average 20% of the loan.

• Savings institutions - originally, these institutions would take deposits and only would lend for home mortgages. These institutions provided low-cost financing for home buyers. During the 1980s and 1990s, many savings institutions experienced financial crisis, because of higher interest rates. For example, if you borrowed $10,000 at 5% interest rate and loaned it out at 10%, you can earn a profit. If you borrowed $10,000 at 10% interest rate and loaned it out at 5%, you will earn a loss. This is what happened to the saving institutions. During the 1980s, the interest rates rose, so the savings institutions had to pay a greater interest rate to the depositors than what these institutions were earning on the mortgages. Mortgages are usually 30-year loans and these loans were locked into low interest rates from the 1960s.
• Credit unions - are very similar to commercial banks except membership is restricted. Membership is only extended to people who share a common interest, usually the people work for a particular company or industry. For example, many states have credit unions for school teachers. These institutions will only allow school teachers to open accounts. Originally credit unions offered savings deposits and made consumer loans for cars and boats. Now, credit unions are very similar to banks and offer the same services, such as checking accounts and mortgages. There is conflict between commercial banks and credit unions, because a credit union's profit is not subjected to income taxes. The commercial banks want credit unions on equal grounds.

Government Financial Institutions

The U.S. government can lend funds to the public in two ways.

• Direct financing - the U.S. government sells bonds and commercial paper to investors in the financial markets. The U.S. government will take the investors' money and lend to borrowers directly.
  • Farm Credit System - a U.S. government agency, lends to farmers. The loans can be for crops, equipment, or mortgage loans.
  • Sallie Mae - the U.S. government lends money to students who are pursuing an education. The agency is the Student Loan Market Association, otherwise known as "Sallie Mae." This agency may lend directly to students or buy their student loans from banks.
• Loan guarantees - this is really a form of insurance. For example, a bank can lend to a student for an education and the Department of Education will guarantee the loan. If the student defaults, the U.S. Department of Education pays for the loan.
• Potential Problems - some people do question the federal government's role in financing. When the federal government directly grants loans, the government is squeezing the financial institutions out of the loan market. Also, federal government loan guarantees may increase the problem of moral hazard. The financial institutions receiving the loan guarantees may not screen borrowers as much, granting loans to borrowers with high risk of default. In the 1990s, the loan guarantees were about $100 billion. If many borrowers started defaulting on their loans, the federal government will have large losses.