1. Exam I Review
Chapter 1: Why Are Financial Intermediaries Special?
Introduction
Financial Intermediaries Specialness
- Corporations issue securities to finance their investments in real assets and cover the gap
between their investment plans and their internally generated savings such as retained
earnings.
- Price Risk: The risk that the sale price of an asset will be lower than the purchase price of that
asset.
FIs Function as Brokers
- When acting as a pure broker, an FI acts as an agent for the saver by providing information and
transaction services.
- Economies of Scales: The concept that the cost reduction in trading and other transaction
services results from increased efficiency when FIs perform these services.
FIs Function as Asset Transformers
- Asset Transformer: An FI issues financial claims that are more attractive to household savers
than the claims directly issued by corporations.
- Primary securities: Securities issued by corporations and backed by the real assets of those
corporations.
- Secondary securities: Securities issued by FIs and backed by primary securities.
Information Costs
- Agency costs: Costs relating to the risk that the owners and managers of firms that received
saver’s funds will take actions with those funds contrary to the best interest of the savers.
 FI’s Role as Delegated Monitor
- An economic agent appointed to act on behalf of smaller agents in collecting information and/or
investing funds on their behalf.
- FI is likely to have informational advantage.
- Economies of scale in obtaining information.
- Acting as DM, FIs reduce information asymmetry between borrowers and lenders.
 FI’s Role as Information Producer
- Shorter term debt contracts easier to monitor than bonds.
- Greater monitoring power and control.
Liquidity and Price Risk
- Diversify: Reducing risk by holding a number of securities in a portfolio.
Other Special Services
 Reduced Transaction Costs
 Maturity Intermediation

2. Other Aspects of Specialness
The Transmission of Monetary Policy
- Depository institutions are the conduit through which monetary policy actions impact the rest of
the financial sector and the economy in general.
Specialness and Regulation
- Negative Externalities: Action by an economic agent imposing costs on other economic agents.
- Redlining: The procedure by which a banker refuses to make loans to residents living inside
given geographic boundaries.
- Net regulatory burden: The difference between the private costs of regulations and the private
benefits for the producers of financial services.
Safety and Soundness Regulation
- Regulations to increase diversification. No more than 10 percent of equity to single borrower.
- Minimum capital requirements: TARP and Capital Purchase Program.
- Guaranty Funds: Deposit Insurance Fund (DIF), Securities Investors Protection Fund (SIPC).
- Monitoring and surveillance: FDIC monitors and regulates DIF participants.
- Increase regulatory scrutiny following crises.
- Regulation is not costless
Monetary Policy Regulation
- Outside money: The part of the money supply directly produced by the government or central
bank, such as notes and coin.
- Inside Money: The part of the money supply produced by the private banking system.
- Reserve requirements facilitate transmission of monetary policy.
Credit Allocation Regulation
- Supports socially important sectors such as housing and farming.
- Requirements for minimum amounts of assets in a particular sector or maximum interest rates
or fees.
- Qualified Thrift Lender Test (QTL): 65 percent of assets in residential mortgages.
Consumer Protection Regulation
- Consumer Reinvestment Act (CRA)
- Home Mortgage Disclosure Act (HMDA)
- Effect on net regulatory burden: FFIEC processed info on as many as 17 million mortgage
transactions in 2009.
- The CRA has been widely criticized as imposing a greater regulatory burden than the sum of any
social benefits.
- Hedge funds are also coming under far greater scrutiny since the Long Term Capital
Management crisis.
- Potential extensions of regulations : CRA to other FIs such as insurance companies in light of
consolidation and trend toward universal banking

3. - New additions: Consumer Financial Protection Agency (2009) and Credit card reform bill
effective 2010.
Investor Protection Regulation
- Protections against abuses such as insider trading, lack of disclosure, malfeasance, breach of
fiduciary responsibility
- Securities Acts of 1933, 1934
- Investment Company Act of 1940
Entry Regulation
- Level of entry impediments affects profitability and value of charter.
- Regulations define scope of permitted activities.
- Financial Services Modernization Act of 1999.
- Affects charter value and size of net regulatory burden.
- Regulations affecting the scope of activities vary widely across countries. New Zealand for
example, has historically had very few restrictions. Most countries however, are reluctant to
allow the commingling of industrial and banking activities due to the inherent risks to the
banking system and the potential for cross subsidization of the industrial activities by the bank.
The Changing Dynamics of Specialness
Trends in the United States
- Decline in share of depository institutions and insurance companies.
- Increases in investment companies
- May be attributable to net regulatory burden imposed on depository FIs: Financial Services
Modernization Act.
- Financial services holding companies
 Reactions to FSM Act and other factors:
- Shift from “originate and hold” to “originate and distribute”
o Affects incentives to monitor and control risk.
o Shift to off balance sheet risks
o Degraded quality and increased risk
- Housing market bubble
o Encouraged subprime market and more exotic mortgages
Future Trends
- US FIs facing increased competition from foreign FIs.
- Only 2 of the top ten banks are US banks.
- Foreign bank assets in the US typically more than 10 percent
o As high as 21.9 percent
Financial Crisis
- DJIA fell 53.8 percent in less than 1 ½ years as if mid-March 2009
- Record home foreclosures
o 1 in 45 in default in late 2008
- Goldman Sachs and Morgan Stanley

4. o Only survivors of the major firms
- AIG bailout
- Citigroup needed government support
- Chrysler and GM declared bankruptcy in 2009
- Unemployment in excess of 10 percent
 Home prices plummeted in 2006-07
– Mortgage delinquencies rose
– Foreclosure filings increased 93 percent from July 2006 to July 2007
– Securitized mortgages led to large financial losses
 Subprime mortgages
– Countrywide Financial bailed out and eventually taken over by Bank of America
– Bear Stearns funds filed for bankruptcy; Acquired by J.P. Morgan Chase
– Fed moved beyond lending only to Depository Institutions
– Government seizure of Fannie Mae and Freddie Mac
– Lehman Brothers failure
– Crisis spread worldwide
 Rescue Plan
- Federal Reserve and other central banks infused $180 billion
- $700 billion Troubled Asset Relief Program (TARP)
- Still struggling in 2009
- $827 billion stimulus program
– American Recovery and Reinvestment Act of 2009
Chapter 2: The Financial Services Industry: Depository Institution
Introduction
- In 1999, the U.S. Congress passed the Financial Services Modernization Act (FSMA), which
repealed regulations that set barriers between commercial banking, insurance, and investment
banking.
Commercial Banks
- A bank that accepts deposits and makes consumer, commercial, and real estate loans.
- Community banks: Banks that specialize in retail or consumer banking.
- Regional or superregional banks: Banks that engage in a complete array of wholesale
commercial banking activities.
- Federal funds market: An interbank market for short-term borrowing and lending bank
reserves.
- Money center banks: Banks that have a heavy reliance on nondeposit or borrowed sources of
funds.
- Spread: The difference between lending and deposit rates
- Shrinking number of banks: 14,416 commercial banks in 1985, 12,744 in 1989, 6,911 in 2009.

5. - Mostly the result of Mergers and Acquisitions; M&A prevented prior to 1980s, 1990s
- Consolidation has reduced asset share of small banks
Size, Structure, and Composition of the Industry
- Differences in operating characteristics and profitability across size classes. Notable differences
in ROE and ROA, as well as the spread.
- Mix of very large banks with very small banks.
- Functions of depository institutions: Regulatory sources of differences across types of
depository institutions.
- Structural changes generally resulted from changes in regulatory policy. Example: Changes
permitting interstate branching (Reigle-Neal Act).
- Financial Services Modernization Act 1999: Allowed full authority to enter investment banking
(and insurance).
- Limited powers to underwrite corporate securities have existed only since 1987.
Balance Sheet and Recent Trends
- Business loans have declined in importance.
- Offsetting increase in securities and mortgages.
- Increased importance of funding via commercial paper market.
- Securitization of mortgage loans.
- Temporary effects: credit crunch during recessions of 1989-92 and 2001-02.
- Transaction accounts: The sum of noninterest-bearing demand deposits and interest-bearing
checking accounts.
- Negotiable Order of Withdrawal (NOW) accounts: Interest-bearing checking accounts.
- Money Market Mutual Fund: Specialized mutual funds that offers deposit like interest bearing
claim to savers.
- Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that
can be resold in the secondary market.
 Equities
Commercial Banks equity capital
- 11.08 percent of total liabilities and equity (2009)
- TARP program 2008-2009 intended to encourage increase in capital
- Citigroup $25 B
- BOA $20 B
- Through 2009: $300 B in capital injections through TARP
 Off-Balance-Sheet Activities
- Heightened importance of off-balance-sheet items.
- OBS assets: An item that moves onto the asset side of the balance sheet when a contingent
event occurs.
- OBS liabilities: An item that moves onto the liability side of the balance sheet when a
contingent event occurs.
- Regulatory incentives
- Risk control and risk producing: Role of mortgage backed securities, “Toxic” assets, Expansion of
oversight.

6. - Major OBS activities:
a. Loan commitments
b. Standby letters of credit and letters of credit
c. Futures, forwards, and swaps
d. When-issued securities
Other Fee-Generating Activities
 Trust Services
 Correspondent Banking
- Check clearing
- Foreign exchange trading
- Hedging
- Participation in large loan and security issuances: Payment usually in terms of noninterest
bearing deposits
Regulation
 The Regulations
 FDIC
- DIF
- Role in preventing contagious runs or panics.
 OCC
- Primary function is to charter national banks
- Examines national banks and has the power to approve or disapprove
their merger applications
- Dual banking system: The coexistence of both nationally chartered and
state chartered banks in the United States
 FRS
- Monetary policy; lender of last resort.
 State Banking Regulators
 Regulations
- Importances of Bank Holding companies are exceeding; regulated by
FRS.
- 1927 McFadden Act: Controls branching of national banks
- 1933 Glass-Steagall: Separates securities and banking activities,
established FDIC, prohibited interest on demand deposits
- 1956 Bank Holding Company Act and subsequent amendments specifies
permissible activities and regulation by FRS of BHCs
- 1970 Amendments to the Bank Holding Company Act: Extension to one-
bank holding companies
- 1978 International Banking Act: Regulated foreign bank branches and
agencies in USA
- 1980 DIDMCA and 1982 DIA (Garn-St. Germain Depository Institutions
Act)
Mainly deregulation acts

7. Phased out Regulation Q
Authorized NOW accounts nationwide
Increased deposit insurance from $40,000 to $100,000
Reaffirmed limitations on bank powers to underwrite and distribute
insurance products
- 1987 Competitive Equality in Banking Act (CEBA)
Redefined bank to limit growth of nonbank banks
1989 FIRREA
Imposed restrictions on investment activities
Replaced FSLIC with FDIC-SAIF
Replaced FHLB with Office of Thrift Supervision
Created Resolution Trust Corporation
- 1991 FDIC Improvement Act
Introduced Prompt Corrective Action
Risk-based deposit insurance premiums
Limited “too big to fail”
Extended federal regulation over foreign bank branches and agencies
- 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act
Permits BHCs to acquire banks in other states
Invalidates some restrictive state laws.
Permits BHCs to convert out-of-state subsidiary banks to branches of
single interstate bank
Newly chartered branches permitted interstate if allowed by state law
- Financial Services Modernization Act
Allowed banks, insurance companies, and securities firms to enter each
others’ business areas
Provided for state regulation of insurance
Streamlined regulation of BHCs
Prohibited FDIC assistance to affiliates and subsidiaries of banks and
savings institutions
Provided for national treatment of foreign banks
- Financial Services Regulatory Overhaul Bill
Financial Services Oversight Council
Power to break up FIs that pose a risk to the system
Consumer Financial Protection Agency
GAO audit of Federal Reserve Activities
Nonbinding proxy on executive pay
Clearinghouses for some derivatives
Industry Performance
- Economic expansion and falling interest rates through 1990s
- Brief downturn in early 2000 followed by strong performance improvements
- Record earnings $106.3 billion 2003

8. - Performance remained strong through mid 2000s as interest rates rose
- Late 2000s: Strongest recession since 1930s
Savings Institutions
- Comprised of:
a. Savings and Loans Associations
b. Savings Banks
- Effects of changes in Federal Reserve’s policy of interest rate targeting combined with
Regulation Q and disintermediation
- Effects of moral hazard and regulator forbearance
- Qualified Thrift Lender (QTL) test
Balance Sheet and Recent Trends
- Industry is smaller overall
- Intense competition from other FIs : Mortgages, for example
Regulation
- Office of Thrift Supervision (OTS)
 Charters and examines all federal S&Ls
- FDIC-DIF Fund
 FDIC Oversaw and managed Savings Association Insurance Fund (SAIF)
 SAIF and BIF merged in January 2007 to form DIF
 Same regulatory structure applied to commercial banks
Industry Performance
- Also like commercial banks, experienced substantial consolidation in the 1990’s.
Credit Unions
Size, Structure, and Composition of the Industry
- Nonprofit DIs owned by member-depositors with a common bond
- Exempt from taxes and Community Reinvestment Act (CRA)
- Expansion of services offered in order to compete with other FIs
- Claim of unfair advantage of CUs over small commercial banks
- They tend to hold large amount of government securities, and relative small of residential
mortgages.
Global Issues: Europe, Japan, and China
- Spread of US financial crisis to other countries
- Many European banks saved from bankruptcy through support of governments and central
banks
- Interest rates at or below 1 percent
Chapter 3: The Financial Services Industry: Insurance Companies

9. Introduction
- The industry is classified into two major groups: live and property-casualty.
- Insurance companies as investors in securities
- Subprime mortgage pools fell in value
- Credit default swaps (CDS) fell
- AIG was a major writer of CDS securities
- Potential impact on other companies used to justify AIG bailout
- Increased risk exposure
Life Insurance Companies
Size, Structure, and Composition of the Industry
- In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion
- Mid 2000s: 1,300 companies
- In early 2006: $4.5 trillion in assets
- 3 largest wrote 25% of new premium business in 2008
- In 2009: $0.7 trillion in assets
- Increasing involvement of commercial banks. In 2008: Commercial banks sold 30.5 percent of
fixed annuity insurance contracts and 12 percent of variable rate insurance contracts
- Significant consolidation in life insurance industry although not to the same extent witnessed in
banking
- Competition from within industry and from other FIs
- Conversion to stockholder controlled companies
- Demutualization
- Adverse selection: Insured have higher risk than general population, alleviated by grouping of
policyholders into risk pools.
 Products:
- Ordinary life
 Term life, whole life, endowment life
 Variable life, universal life, variable universal life
- Group life
- Industrial life
- Credit life
 Other Life Insurer Activities
- Annuities
o Reverse of life insurance activities
o Topped $347.4 billion in 2008
o Ethics: Conseco, 2004
- Private pension funds
o Compete with other financial service cos.
o In 2009, managing over $2.2 trillion (43% of all private pension plans)
- Accident and health insurance

10. o Morbidity insurance
o Over 167.1 billion in premiums in 2008
Balance Sheet and Recent Trends
 Assets
- Need to generate competitive returns on savings components of life insurance policies
- Bonds, equities, government securities
- Policy loans
 Liabilities
- Net policy reserves to meet policyholders’ claims
- Separate account business 3 represented 0.1% of total liabilities and capital in 2009
 Recent Trends
- Impact of financial crisis:
o Drop in value of securities: Capital losses from bonds and stocks exceeded $35 billion.
- Historically low short term interest rates
o Adverse impact on ability to lower rates on new policies
o Incentive to surrender existing policies
- Dwindling reserves led to Treasury Department extending bailout funds
- Late 2009 showed improvement
Regulation
o McCarran-Ferguson Act of 1945: Confirms primacy of state over federal regulation
o State insurance commissions : Coordinated examination system developed by the
National Association of Insurance Commissioners (NAIC)
o States promote life insurance guaranty funds: Not permanent funds (like FDIC),
Required contributions from surviving within-state firms
o Fear of systemic risk posed by AIG
o 2009: Proposals to create optional federal charter
o Complaints of inconsistent regulation and barriers to innovation
Property-Casualty Insurance
- It involves insurance coverages related to the loss of real and personal property. Casualty – or,
perhaps more accurately, liability – insurance concerns protection against legal liability
exposures.
Size, Structure, and Composition of the Industry
 Products
- Fire insurance and allied lines
- Homeowners multiple peril insurance
- Commercial multiple peril insurance
- Automobile liability and physical damage insurance
- Liability insurance (other than automobile)
Balance Sheet and Recent Trends
- Similar to life insurance companies (smaller asset base): Requirement for liquid assets.

11. - Major liabilities: Loss reserves, Loss adjustment expense, unearned premiums.
 Loss Risk
- Underwriting risk may result from:
o Unexpected increases in loss rates
o Unexpected increases in expenses
o Unexpected decreases in investment yields or returns
- Property versus liability
o Losses from liability insurance less predictable
o Example: Claims due to asbestos damage to workers’ health
 Loss Rate
- Severity versus frequency
o Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto,
homeowners peril) than on high-severity, low-frequency lines (such as earthquake,
hurricane, financial guaranty)
o Claims in high-severity, low-frequency lines may not be independent
o Higher uncertainty forces PC firms to invest in more short-term assets and hold larger
capital and reserves than life insurance firms
- Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in
2002
- Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002
(TRIA)
- Caps losses for insurance companies
- Long-tail risk exposure
o Arises where peril occurs during coverage period but claim is made many years later
o Examples: Asbestos cases and Dalkon shield case
o Efforts to contain long-tail risks within subsidiaries
o Example: Halliburton
- Product inflation versus social inflation
o Unexpected inflation may be systematic or line-specific
o Social inflation: Unexpected changes in awards by juries
- Reinsurance
o Approximately 75 percent of reinsurance by US firms is written by non-US firms such as
Munich Re
 Underwriting Ratios
- Loss ratios have generally increased
- Expense ratios have generally decreased
- Trend toward selling directly through their own brokers rather than independent brokers
- Combined ratio: Includes both loss and expense experience. If greater than 100, premiums are
insufficient to cover losses and expenses.
 Investment Yield / Return Risk
- Operating ratio = combined ratio after dividends minus investment yield

12. - Importance of investment income: Causes PC managers to place importance on measuring and
managing credit risk and interest rate risks.
 Recent Trends
- Several catastrophes over 1985 - 2009
o Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane
Andrew 1991
o 2004, Hurricanes Charley, Frances, Ivan, Jeanne in rapid succession generated claims
comparable to Andrew.
o Hurricane Katrina, 2005
- Trough of underwriting cycle
o September 11, 2001 terrorist attacks created an insurance crisis (and heightened
demand).
o Potential for crowding out market solutions via government actions
Regulation
- PC insurers chartered and regulated by state commissions
- State guaranty funds
- National Association of Insurance Commissioners (NAIC) provides various services to state
commissions
o Includes Insurance Regulatory Information System (IRIS)
- Some lines face rate regulation
- Criticism over Katrina-related claims
Global Issues
- Insurance industry increasingly global
- Worldwide, 2008 was a bad year
o 130 natural catastrophes, 174 manmade
o 2008 earthquake in China: Almost half of worldwide insurance losses
o Global financial crisis
- Improvement in 2009 as financial markets and economies recover
o Higher premiums and better investment results
Chapter 4: The Financial Services Industry: Securities Firms and Investment Banks
Introduction
- Investment Banking involves the raising of debt and equity securities for corporations or
governments.
Size, Structure, and Composition of the Industry
- Securities trading and underwriting is a profit-generating activity that does not require FIs to
actually hold or invest in the securities they trade or issue for their customers, except for very
short periods.

13. - Asset value is not traditionally a measure of the size of a firm in this industry.
- Growth in domestic M&A:
o Less than $200 billion in 1990
o $1.83 trillion in 2000
o In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide)
o Topped $1.7 trillion 2007 ($4.5 trillion worldwide)
o Effects of financial crisis: fell to $808 billion in 2009 ($1.7 trillion worldwide)
o Worst financial crisis since 1930s, but M&A activity still greater than early 2000s
- Acquisition of Bear Stearns by J.P. Morgan Chase
- Bankruptcy of Lehman Brothers
- Acquisition of Merrill Lynch by Bank of America
- Only two remaining major firms:
o Goldman Sachs and Morgan Stanley: Converted to commercial bank holding companies
in 2008
- Dramatic increase in number of firms from 1980 to 1987; Decline of 37% following the 1987
crash, to year 2006
- 1987: Salomon Brothers held $3.21 billion in capital
- 2006: Merrill Lynch held capital of $35.5 billion
- Many recent inter-industry mergers (i.e., insurance companies and investment banks)
o Role of Financial Services Modernization Act, 1999
- Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end
of 2008
 Types and Relative Sizes of Firms
- National full-line firms are largest: BOA (via acquisition of Merrill Lynch) Morgan Stanley
- National full-line firms specializing in corporate finance are second in size: Goldman Sachs,
Salomon Brothers/Smith Barney (Citigroup)
- Remainder of industry:
o Large investment banks (Lazard Ltd. And Greenhill & Co.)
o Regional securities firms (subdivided into large, medium and small)
o Specialized discount brokers, electronic trading firms, venture capital firms, and other
firms
 Key Activities:
1. Investing: Since this business generates fees that are based on the size of the pool
of assets managed, it tends to produce a more stable flow of income than does
either IB or trading.
2. Investment Banking: Activities related to underwriting and distributing new (IPOs)
and secondary (seasoned) issues of debt and equity.
- Public offerings & private placements
3. Market Making: Increasing importance of online trading (Technology risk).
Decimalization
4. Trading: Position trading, pure arbitrage, risk arbitrage, program trading.
5. Cash Management

14. - Cash management accounts: Money market mutual funds sold by investment banks; most
CMAs offer check-writing privileges.
6. Mergers and Acquisitions
7. Back-Office and Other Service Functions
Balance Sheet and Recent Trends
Balance Sheet
 Key assets:
- Long positions in securities and commodities
- Reverse repurchase agreements: Securities purchased with agreements to resell.
- Implications: Market, interest rate & F/X risks
 Key liabilities:
- Repurchase agreements major source of funds
- Securities and commodities sold short
- Broker call loans from banks
 Capital levels much lower than in banks
Recent Trends
- Decline in trading volume and brokerage commissions. Particularly since crash of 1987, although
some recovery since 1992; Record volumes 1995-2000
- Declines in market values--and commission income 2001-2002
- Resurgence in market values and commissions during mid-2000s
- New lows in 2008
- Pretax net income over $9 billion per year 1996-2000
- Pretax profits soared to $21.0 billion in 2000. Curtailed by economic slowdown and September
11 attacks 2001
- Worries over securities law violations and investor confidence
- Financial crisis, 2008
- Profits recovered, 2009
Regulation
 Primary regulator: SEC
- Reiterated by National Securities Markets Improvement Act (NSMIA) of 1996
- Prior to NSMIA, regulated by SEC and states
 Early 2000s erosion of SEC dominance
- Increased vigilance by State Attorneys General
- Criminal cases brought mainly by states against securities law violator: New York State vs.
Merrill Lynch
- Spring 2003, $1.4 billion in penalties over investor abuses
- New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest
 Sarbanes-Oxley Act of 2002
- Independent auditing oversight board under SEC

15. - Instigated by Enron, Global Crossings, Tyco, WorldCom
 SEC sets regulatory standards
- Day-to-day regulation: Financial Industry Regulatory Authority (FINRA)
o Example: Floor trader at Fleet specialist fined $25,000 for mishandling customer orders
(10,000 shares of GM sold from Fleet’s account on rumors of problems at GM)
 Additional oversight from US Congress
- Hearings focused on role of investment banks in the financial crisis
o Goldman Sachs bundling of toxic assets
 2010 Financial Services Regulatory Overhaul Bill
o Financial Services Oversight Council
o New authority for Federal Reserve to oversee payment, clearing, and settlement
systems
 Executive compensation in the financial crisis culminated in “pay czar” (Feinberg)
 Securities Investors Protection Corporation (SIPC)
o Protection level of $500,000
 October 2003 implementation of provisions of Patriot Act to combat money
laundering
o Scrutiny of individual identities and affiliations with terrorists
Global Issues
 Global nature of securities firms
- Competition between US and European firms
- Foreign investors’ transactions in US securities and US investors’ transactions in foreign
securities exchanges increased
- Global concern about capital, liquidity and leverage following the financial crisis
o Implications for global competitiveness: Strategic alliances, Exits from foreign
markets.
Chapter 5: The Financial Services Industry: Mutual Funds and Hedge Funds
Introduction
- Mutual funds and hedge funds are financial intermediaries that pool the financial resources of
individuals and companies and invest in diversified portfolios of assets.
- Diversification opportunities enhanced for small investors
o Economies of scale
o Predominantly open-ended funds
- Rapid growth in funds during the 1990s
- Slower rate of growth in the industry in early 2000s than in 1990s
- Trading abuses contributed to slowdown
- 20 percent drop in assets during 2008
Size, Structure, and Composition of the Industry

16. Historical Trends
- The mutual fund industry is larger than the life insurance industry but smaller than the
commercial banking industry. This makes mutual funds the second most important FI group in
the USA as measured by asset size.
- Low barriers to entry in the US mutual fund industry has allowed new entrants to offer funds to
compete for investor attention and has kept the industry from being increasingly concentrated.
- Institutional funds
o 80 percent of retirement plan investments
o Low costs: No additional distribution fees
o Risk levels set by retirement plan sponsors
- Recent inroads by commercial banks and insurance companies
o Mellon purchase of Dreyfus
o State Farm (more than 9,000 agents)
o As of 2009, insurance companies managed approximately 10% of mutual fund assets
- Types of Mutual Funds
 Bond funds
 Equity funds
 Hybrid Funds
 Money Market mutual funds
 If MMFs uninsured:
o Higher returns
o September 2008:
- Risk aversion of investors changed
- Run on Lehman Brothers’ Primary Reserve Fund
o Temporary extension of government insurance to MMFs during the crisis
Mutual Funds Objectives
- A fund objective provides general information about the types of securities a mutual fund will
hold as assets. For example, “Capital appreciation” funds hold securities (mainly equities) of high
growth, high-risk firms.
- Examples:
a. Capital appreciation funds
b. World equity
c. Corporate bond
d. High-yield bond
e. World bond
f. Government bond
Investor Returns from Mutual Fund Ownership
- Income and dividends of underlying portfolio
- Capital gains on trades by mutual fund management
- Capital appreciation in values of assets held in the portfolio

17. o Marked-to-market: Adjusting asset and balance sheet values to reflect current market
prices.
o Net-asset value (NAV)
 Types of funds:
1. Open-ended funds: Comparable to most corporate securities traded on stock exchanges
2. Closed-end investment companies
o Fixed number of shares
o Example: REITs
o May trade at premium or discount
o Exchange traded funds (ETFs)
3. Load versus no-load funds
Mutual Fund Costs
- Two types of fees:
1. Sales loads
o Generally, negative effect on performance outweighs benefits
o Short term versus long term investment alters impact of loads on cost
2. Fund operating expenses
o Management fee
o 12b-1 fees
o Front end and back end fees
Class A, Class B and Class C differences
SEC creation of new rules
Sweeping decreases in fees, 2005 and 2006
Balance Sheet and Recent Trends
Money Market Funds
- Key assets are short-term securities (consistent with deposit-like nature)
o 2009: $2,722.6 billion (81% of total assets)
o 2008: flight to safety, out of corporate and foreign bonds
- Most have share values fixed at $1 and adjust number of shares owned by the investor
- Significant liquidity risk highlighted during crisis
Long-Term Funds
- Stocks comprised over 70.0 % of asset portfolios in 2007 versus 55.5% in 2008
- Credit market instruments 27.2% of asset portfolios in 2007 versus 41.9 in 2008
- Shift to other securities such as credit market instruments, U.S. Treasuries, municipal bonds etc.
when equity markets not performing as well
Regulation of Mutual Funds
- One of the most closely regulated among non-depository FIs.
- Primary regulator: SEC
o Emphasis on full disclosure and anti-fraud measures to protect small investors

18. o NASD supervises mutual fund share distributions
- Prosecutions in light of trading abuses in early 2000s
o Market timing
o Late trading
o Directed brokerage
o Improper fee assessments
- Changes include SEC requirements for independent board members, reporting and disclosure
requirements
- Increase in requirements for disclosure
- Enhanced transparency
- Requirement for firms to have a compliance officer
o Reports directly to mutual fund directors, not executives of the fund
o Responsible for reporting any wrongdoings
o Policing personal trading of fund managers
o Ensuring accuracy or reporting to regulators
o Reviewing fund business practices
- Legislation:
o Securities Act 1933, 1934
o Investment Advisers Act, 1940
o Insider Trading and Securities Fraud Enforcement Act of 1988
o Market Reform Act of 1990
o Allows SEC to halt trading and introduce circuit breakers
o National Securities Markets Improvement Act of 1996
Exempts mutual fund sellers from state securities regulatory oversight
o Sarbanes-Oxley Act of 2002
Global Issues
- Worldwide growth in mutual fund investment curtailed by financial crisis
- Greatest development in countries with most advanced markets
- Late 1990s and early 2000s: declining Japanese markets
- Efforts to reduce barriers for U.S. mutual fund sponsors
China and other Asian countries
Hedge Funds
- Type of investment pool that solicits funds from (wealthy) individuals and other investors and
invests these funds on their behalf.
- Not required to register with the SEC. Thus they are subject to virtually no regulatory oversight
and generally take significant risk.
- They do not have to disclosure their activities to third parties. In the USA, they avoid legislation
by limiting the number of investors to less than 100 individuals.
- Prior to 2010, not subject to SEC regulation

19. o Bernard Madoff Investment Securities, Bear Stearns High Grade Structured Credit
Strategies Fund
o Concern over systemic threats
- Organized as limited partnership
o Small number of sophisticated investors
- Common feature is use of leverage
- High returns in 1990s
- Near collapse of long-term capital management
o $3.6 billion bailout
o Precipitated SEC scrutiny of hedge funds
Types of Hedge Funds
1. More risky: Market directional
2. Moderate risk: Market neutral or value orientation
3. Risk avoidance: Moderate, consistent returns with low risk as objectives
- Fees: Generally management fees and performance fees
Offshore Hedge Funds
- Major centers include Cayman Islands, Bermuda, Dublin, and Luxembourg
- Rules:
o Generally not burdensome
o Anonymity
o Tax advantages
- Europe is the fastest growing area for offshore hedge funds
Regulation of Hedge Funds
 Prior to 2010: Generally unregulated
– Exemption for less than 100 investors
– Exemption if accredited
 Scandals:
– Illegal trading with mutual funds
– 2007: UBS Securities, Morgan Stanley
– 2008: Bernard Madoff’s “ponzi scheme”
– 2009: Galleon Group LLC
– Resulted in heightened scrutiny