Lecture 2: Financial Mobilization

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Lecture 2Financial Mobilization

• Development Finance
• Spring Semester
• 2002

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Financial Mobilization Through Intermediaries

• Banks
• Commercial banks
• Deposit money banks whose liabilities include
  checkable deposits which can be used as means of
  payments
• Deposit money banks whose liabilities can not be
  used as means of payments
• Banks that finance themselves mainly through
  issuance of negotiable bonds
• Development banks
• Non-bank financial institutions
• Insurance companiesCông ty b?o hi?m
• Pension funds
• Mutual funds

These non-bank financial institutions are also
called as institutional investors
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Commercial Banks

• Functions
• Provide a payment system.
• Transer funds from savers (those with surplus
  money) sang to borrwers (those in need of money).
• Liabilities
• Demand deposits transferable by checks and can
  be withdrawn on demand.
• Time and savings deposits pay higher interests
  but have notice periods before money can be
  withdrawn.
• Assets
• Short-term credit to companies (e.g. overdrafts
  or credit lines)
• Short-term loans to individuals for consumption
• Longer-term credit (for housing finance, capital
  equipment,)

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Risks Faced by Commercial Banks

• Maturity risk
• Banks maturiry of loans are longer than their
  maturiy of deposits ? banks perform maturity
  transformation.
• Therefore, banks may face liquidity problems and
  fail when they experience a bank run.
• Credit risk
• Banks face the possibility that borrowers will be
  unable to repay their loans. These loans then
  become bad debt.
• Banks lose capital in order to write off bad
  loans. This can lead to a situtation where a
  banks networth is negative then the bank is
  said to be technically bankcrupt.
• Interest rate risk
• Interest rates on deposits are generally
  variable, while those on loans are usually
  fixed..
• When interest rates rise sharply, banks may
  suffer heavy losses since they have to pay more
  to depositors than they can earn from their
  loans.

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Investment Banks

• Support companies mobilizing capital in
  securities markets
• Advise on stock and bond issues
• Act as underwriters
• Trade in securities
• Act as brockers
• Act as dealers
• Manage investment funds
• Advise on mergers and acquisitions
• Commercial bank vs. investment bank
• The existing trend is that investment banks
  expand their activities to the field of
  commercial banking that is, they also accept
  deposits and provide loans, creating a
  competitive pressure on commercial banks.
• In many countries, commercial banks are not
  allowed to do investment banking. (Why?)

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Universal banking in Europe

• Perform functions of a tradition commercial
  banks.
• Expand to other financial services, such as
• Insurance
• Long-term savings (e.g. pension)
• Securities investment
• Universal banking was first developed in
  Continental Europe (e.g. Deutsche and Commerzbank
  ? Ð?c) and later expanded to the UK and US which
  for a long time followed the model of traditional
  commercial banking.
• Universal banking puts more competitive pressure
  on commercial banking. Responses of commercial
  banks
• Expand to investment banking
• Increase efficiency through cost reduction and
  mergers.

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Japans Main Banks

• Japanese companies have a custom to establish a
  closed relationship with a bank (called as a
  main bank). This main bank extend loans to and
  invest in the shares of the company.
• Keiretsu (i.e. Japans conglomerates) often
  comprise of a group of financial institutions
  linked with a group of industrial companies
  through cross-share ownership.
• The argument in favor of the main bank model is
  that the main bank is very effective in
  monitoring managers of industrial companies.
• Negative effects
• Bad debt problems
• Little support to insdustrial restructuring

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Development Banks

• Many countries in their efforts to develop the
  financial system have tried to establish
  long-term credit institutions and other
  specialized financial institutions providing
  loans to strategic industries, agriculture,
  small-scale enterprises, housing, etc. The
  objective is to
• Complement loans provided by private financial
  institutions
• Meet long-term financial needs when securities
  markets are either absent or inefficient and
• Actively search, appraise, and manage investment
  projects (particularly development projects).
• Sources of Funds
• Capital contributed by the government and private
  sector
• Bonds
• Borrowings from foreign governments and
  multilateral credit agencies
• Uses of Funds
• Long-term loans
• Share investments

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Development Banks (continued)

• Government role
• Establish development banks and contribute
  capital directly
• Buy bonds issued by development banks
• Encourage other financial institutions to buy
  bonds issued by development banks
• Direct investment made by development banks
• Subsidize interest rates on loans made by
  development banks
• Private development banks
• The majority of the development bank shares are
  held by the private sector
• The government invest some or buy bonds or
  provide policy incentive only
• Rationale private development banks can operate
  more independently and provide loans based on
  commercial criteria (although they are still
  subject to some government intervention).
• Example Japanese Industrial Bank can invest or
  provide loans based on their own commercial
  criteria, but they still have to select projects
  from the government priority list.

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Effects of Development Banks

• Positive effects
• Complement commercial banks loans by longer-term
  development loans
• Finance large-scale projects, coordinate
  syndicate lending, and facilitate risk sharing.
• Support enterprises having short-term financial
  difficulties, but long-term viability.
• Negative effects
• Under heavy political pressure to finance
  unproductive projects
• Lack incentives in screening and monitoring
  investment projects (when loans have implicit
  government guarantees).
• Trends
• Universal banking.
• Privatization.

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Institutional Investors

• Pension funds

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Commercial Banksand Institutional Investors

• Both banks and institutional investors are
  intermediaries between savers and users of
  capital.

• Banks take deposits and pay interests to
  depositors.
• Banks make loans and charge borrowers interest.

• Life insurers or pension funds receive premiums
  or contributions.
• Life insurers or pension funds invest received
  money in securities and share the investment
  returns with policyholders or plan members in the
  form of annuities or endowments.

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Commercial Banksand Institutional Investors
Both banks and institutional investors are
intermediaries between savers and users of
capital.
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Dominance of Institutional Investors

• Institutional investors are the biggest owners of
  stocks and bonds in developed countries.
• A growing influence in corporate finance and
  corporate governance is being exerted by
  institutional investors.

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Mutual Funds

• Mobilize money by selling units (i.e. shares) to
  (retail) investors.
• Invest money in various types of securities.
• Advantages of mutual funds compared to direct
  individual investments
• For small investors, diversification is dificult
  due to transaction and search costs.
• For mutual funds, investors enjoy wholesale rate,
  instant portfolio diversification and
  professional advice.
• Mutual funds are in the form trusts or companies
  managed by a board of directors or by trustees.
  (All activities are outsourced.)

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Types of Mutual Funds

• Open-ended funds
• New shares or units are issued when investors
  contribute more money or existing ones are
  retired when investors take money out.
• The fund value is equal to the current market
  value of all its investmens.
• Closed-ended funds
• Number of shares is fixed.
• Shares are traded in an exchange whose value can
  be above or below the funds net asset value.
• Passive funds
• Try to track a broad market index and have lower
  management fees.
• Active funds
• Try to outperform the market and have higher
  management fees.
• Emprical evidence passive funds typically
  succeed in following the market and many active
  funds underperform the market.

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Pension Funds

• Receive contributions from employees of companies
  and governments.
• Invest money in securities.
• Money is paid back to plan members in the form of
  endowments.
• In some countries (e.g. US UK), the government
  role in the pension business is limted. The
  burden of retirement planning falls on employees.
  In other countries (e.g France Italy), the
  government plays an active role.
• Pension schemes often take the form of a trust
  fund.
• An employer sets up a trust managed by a trustee
  for the benefit of plan members.
• Plan assets are separated from the sponsoring
  employers and do not appear in its balance sheet.

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Types of Pension Funds

• Traditional Plan
• Member benefits are determined by final salaries.
• It is called defined benefit or final salary.
• Both the employer and the employees pay monthly
  contributions in to a pension fund.
• The trustee has the responsibility to ensure that
  a funds assets cover its liabilities.
• Sponsoring employers bear the residual risks e.g
  if the stock market crashes, the pension assets
  will go down (compared to its liabilities), and
  more contributions may be required from the
  employer.
• New Plan
• Only employers contributions are defined.
• The ultimate pension depends on what the
  investment is worth at retirement.
• If the funds investments perform well, plan
  members get rich if not they end the days poor.

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Life Insurance Companies

• Receive money in the form of premiums.
• Invest money in securities.
• Endowment policies pay out at a fixed date and so
  have a cash value (or link payout with investment
  performance).
• Life insurers are as much about saving as about
  protection.
• They increasingly compete with banks and mutual
  funds for savings.
• Traditional Type
• Pay fixed annuities.
• Investment risks are born by the insurers.
• New Type
• Pay variable annuities (in the US) or unit-linked
  policies (in the UK).
• Resemble mutual funds.

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Financial mobilization in financial markets

• A financial market is a place when buyers and
  sellers of financial assets directly meet to
  conduct transactions.
• Money and capital markets
• Money markets trade short-term instruments
  (lass than 1 year).
• Capital markets trade longer-term instruments
  (more than 1 year).
• Primary and secondary markets
• Primary markets securities are first issued to
  the market.
• Secondary markets Issued securities are traded.
• Centralized and over-the-counter markets
• Centralized markets trading place for listed
  securities.
• Over-the-counter markets trading place for
  unlisted securities.

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Financial Markets and Economic Development

• Improve allocative efficiency by
• Reducing transation costs
• Reducing problems of asymmetric information
• Facilitate information acquisition and
  dissemination
• When markets are expanded, players find it more
  profitable to invest in information search.
• Developed markets provide instruments (based on
  information) to monitor companies.
• Help diversifying risks and reducing liquidity
  risks.
• Savers can invest in different assets in the
  market and therefore can enjoy risk
  diversification.
• Highly liquid markets increase the attractiveness
  of lont-term investment projects more investors
  are willing to invest in these projects when the
  know that financial assets based on the projects
  cash flows can be readily converted into cash

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Market Efficiency

• Market Efficiency Hypothesis Securities prices
  reflect all available information. In other
  words, securities prices follow a random walk.
• Fama (1970) gives three types of efficient
  markets in an attemp to define available
  information.
• Weak form efficiency securities prices already
  reflect all historical information no investor
  can enjoy supernormal profits by trading in
  securities based on their historical information.
• Semi-strong form efficiency securities prices
  already reflect all available information no
  investor can enjoy supernormal profits by trading
  in securities based on their publicly available
  information.
• Strong form efficiency securities prices already
  reflect all types information whether public or
  private no investor can enjoy supernormal
  profits by trading in securities based on either
  publicly availble information or insider
  information.
• Are securities markets in developing countries
  efficient or inefficient? And in what form? What
  are the implications of market efficiency for
  financial and economic development?

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Non-intermediated finance versus intermediated
finance
Tài chính gián ti?p
Các t? ch?c trung gian tài chính

• Ngu?i vay ti?n
• H? gia dình(vay n?)
• Doanh nghi?p (vay n?, v?n c? ph?n, thuê mua)
• Chính ph?(vay n? du?i hình th?c trái phi?u)
• Nu?c ngoài (vay n?, v?n c? ph?n)

• Ngu?i ti?t ki?m
• H? gia dình
• H? gia dình thông qua qu? d?u tu, qu? luong huu,
  b?o hi?m
• Doanh nghi?p
• Chính ph?
• Nu?c ngoài

Các th? tru?ngtài chính
Tài chính tr?c ti?p
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Intermediated Finance

• Finance made through financial intermediaries,
  such as banks? Bank-based finance
• Financial intermediaries like banks pool and
  diversify risks by lending to many different
  projects and companies, and reap economies of
  scale by eliminating duplications in appraisal
  and monitoring.
• Intermediated finance is necessary when
  information about borrowers creditworthiness can
  be easily interpreted but costly to obtain.

Non-intermediated Finance

• Finance made directly in the form of securities
  sale from borrowers to savers in the market ?
  market-based finance
• If there are different opinions regarding the
  prospective of businesses then non-intermediate
  finance is a better financial mechanism since it
  allows providers of capital to select investment
  opportunities which suit their own preference.
• For non-intermediated finance to be effective,
  financial assets need to be transferable and
  liquid .

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Risks Are Treated Differently inBank-based and
Market-based Finance

• Banks stand between savers and borrowers.
• Since deposits do not want to bear high risks and
  deposits are usually short-term, banks tend to
  provide short-term loans and concentrate their
  lending on safe borrowers.
• Depositors enjoy low risks but also low interest
  rates on their deposits.

Deposits
Loans
Banks
Interests
Interests

• Accept losses on some of the loans
• Pay lower interests to depositors as compared to
  those earned on loans
• Provide payment services

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Risks Are Treated Differently in Bank-based and
Market-based Finance (continued)

• Financial markets directly bring savers and
  borrowers together
• Investment opportunities are divided into many
  small securities which are sold to different
  types of investors.
• Securities buyers enjoy gains or suffer losses
  according to the performance of the issuing
  compnies. They therefore ask higher rate of
  returns to compensate for larger risks.
• Securities buyers can invest in many different
  securities to diversify risks.

Buying securities
Securties Markets
Issuing securities
Dividends
Reselling securities
Dividends

• Price risks
• Manage risks
• Do not reduce risks

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Financial Structure in Developed Countries
Commercial bank assets/Stockmarket
capitalization (1992-1997)

• Market-based financial system
• UK US
• The financial system is dependent on markets to
  provide capital and monitor companies.
• Bank-based financial system
• Germannys universal banks
• Japans main banks
• Which model should developing countries follow?

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Cross-country comparison of the relative stock
market and bank development

• Banks dominate the financial system in almost all
  of the developing countries.
• There is ageneral tendencyfor
  themarket-to-bankratio to increasewith the
  level ofdevelopment both over time and
  cross-sectionally.

Source WB, Finance for Growth, 2001.
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Arguments in Favorof Bank-based Finance

• Financial intermediaries improve information
  acquisition and monitoring of managers by
  creditors, and provide standard channels for fund
  mobilization and risk reduction.
• Market-based financical system is not effective
  in information acquisition
• Developed markets reveal information very quickly
  so that investors have little incentives to
  search and select investment opportunities. Banks
  can provide finance without the need to reveal
  information immediately (Stiglitz 1985).

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Arguments in Favorof Bank-based Finance
(continued)

• Financial markets are not effective in monitoring
  managers
• Insider information insiders know more about
  their companies than outsiders do. Moreover, the
  board of directors may be controlled the
  management and does not represent shareholders
  interests.
• Liquid markets encourage hostile takeovers which
  can have adverse social consequences.
• The high liquidity of financial markets results
  in a diversed ownership structure which inturn
  reduces the incentive to monitor managers on the
  part of each individual shareholder..
• Managers can employ poison pills to prevent
  hostile takeovers, the effect of which is to
  permit the existence of weak management.

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Arguments in Favorof Market-based Finance

• A market-based financial system provides many
  instruments for risk management, which are suited
  for both standard and non-standard transactions.
  In contrast, a bank-based system only provides
  basic risk management solutions (although at
  lower costs).
• In a bank-based system, banks can have too much
  power on companies permitting them to charge high
  fees.
• Banks tend to limit themselves in lending safe
  projects. This behavior can stifle innovation and
  growth opportunities of young enterprises.
• Banks may collude with companies that they lend
  money to and help the managers of those companies
  to keep their positions even though their
  performance is poor.

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Banks and Financial Markets Are Complementary
The Financial Service View

• Market imperfections in a financial system create
  the need to establish financial contracts,
  markets, and intermediaries.
• In return, various components of the financial
  system provide financial services including fund
  mobilization, project appraisal and evaluation,
  company monitoring, risk management, etc.
• The task of a financial system is to provide
  financial services through banks or markets or
  both.
• Financial markets and banks can provide the same
  financial services or service which are
  complementary to one another.
• For example, securities markets can increase
  competition in the provision of company
  monitoring instruments they can also reduce the
  negative effects created by the excessive power
  of banks as they provide an alternative
  investment channel.

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Empirical Study Levine (2000)

• Cross-sectional econometric model
• (1) G aX bS U(1)
• (2) G cX dF U(2)
• (3) G fX hS jF U(3)
• G is the growth rate of GDP per capita
• X is the conditioning set (i.e. determinants in a
  standard growth model)
• S is the set of financial structure indicators
  (larger S means that the system is more tilted
  towards bank-based finance, and vice versa).
• F is the set of financial development indicators.
• U(i) is the error term.
• Bank-based finance view blt0, dgt0, hlt0, jgt0
• Market-based finance view bgt0, dgt0, hgt0, jgt0
• Financial service view b0, h0, dgt0, jgt0

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Empirical Results

• The empirical results support the financial
  service view.
• Both bank-based and market-based finance support
  economic growth.
• Firms in successful economies have found a
  mixture of equity market and bank development
  that suits their own particular financing needs
  and institutional structure.
• The trend for a general increase in the share of
  market finance with economic development does not
  appear to be causal.
• Differences in the financial structure (i.e.
  finance based more on banks or on markets) are
  not statistically significant in explaining the
  economic growth variations across countries.