NBFI and Securities Market Institutions

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NBFI and Securities
Market Institutions

• Nonbank Financial Intermediaries (NBFI) --
  Financial Intermediaries other than banks.
• Experiences same fundamental nightmares as
  banks.
• Also covers other securities market institutions
  (e.g. investment banks)
• Less regulated than banks
• better able to handle problems?
• disadvantages of not being banks (investment
  banks, GMAC)

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Examples of Nonbank Financial Intermediaries

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Insurance Companies

• Life Insurance Companies
• -- Assets Corporate Bonds,
• Commercial Mortgages, Stock
• -- Liabilities promised payouts
• upon death

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• Property and Casualty Insurance Companies
• -- Assets Municipal Bonds,
• Treasury Bonds, Corporate
• Bonds, Stock
• -- Liabilities promised payouts
• upon fire, accidents, etc.

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Pension Funds

• Assets different types of Bonds or Stocks
• Liabilities promised payouts upon retirement

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Defined Contribution Pensions

• Defined Contribution Pensions -- Employee
  contributes amounts over his/her working years to
  an identified fund, with possibly employer
  contributions as well. Upon retirement or
  leaving the firm, employee receives the fund.
  Taxes are typically deferred until the fund is
  withdrawn from.

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Examples of Defined Contribution Pensions

• Individual Retirement Accounts (IRAs) -- Classic
  IRAs and Roth IRAs
• Keough Plans -- Self-Employed individuals
• 401(k) Plans (and 403(b) Plans) -- increasing in
  frequency

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Defined Benefit Pensions

• Defined Benefit Pensions -- Employee does not
  contribute over his/her working years, is
  promised a fixed monthly payment upon retirement.

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Characteristics of Defined Benefit Plans

• Vesting -- How long the employee has to work at
  the firm to be eligible for pension.

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• Fully Funded Versus Underfunded
• -- Fully Funded employer
• contributions plus returns fully
• cover promised benefits
• -- Underfunded employer
• contributions plus returns do not
• cover promised benefits

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Employee Retirement Income Security Act (ERISA)

• Regulates Pensions
• -- degree of underfunding
• -- how pension is invested
• -- reporting and examination
• Creation of Pension Benefit Guarantee Corporation
  -- pension insurance

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Examples of Defined Benefit
Pensions

• Some Corporate, Federal and State and Local
  Government Pension Plans
• Social Security -- pay as you go plan

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The Trend Toward Defined Contribution Pensions

• Employers moving away from defined benefit to
  defined contribution plans, largely for
  convenience.
• To the employee potential losses and (big)
  wins.
• Will it affect the retirement decision of
  individuals?

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Finance Companies

• Assets -- Consumer loans
• Liabilities -- (their own) Commercial Paper,
  Stock, and Corporate Bonds
• Not subject to bank regulation
• Not eligible for Discount Window

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Mutual Funds

• Assets -- bonds, stocks, as advertised in
  prospectus
• Liabilities -- mutual fund shares
• Regulated by Securities Exchange Commission (SEC)
• Some have insurance against dishonest practices
  (SIPC), most are not insured.

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Mutual Funds

• Can offer unique features based upon
  characteristics of asset portfolio
• Tax-exempt mutual funds
• Checkability and money market mutual funds (MMMF)

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Securities Market
Institutions

• Investment Banks -- buy and sell securities on
  the primary market
• Profits come from underwriting -- buying the
  entire issue then selling it in the market when
  they choose

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• Securities Brokers and Dealers -- conduct trading
  in the secondary market
• Brokers -- arrange sales between buyers and
  sellers
• Dealers -- play the market with bonds as well
  as stock

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• Brokerage Firms -- engage in investment banking,
  brokering, and dealing

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The Securities Industry Versus the Banking
Industry

• The Glass-Steagall Act (1933) -- separation of
  banking industry from the securities industry

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Arguments to Repeal Glass-Steagall

• Brokerage firms have invaded banking industry
  with bank-type accounts (MMMFs, Cash Management
  Accounts).
• Benefits from increased competition.
• Financial markets are more sophisticated and
  liquid today.

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Arguments to Keep Glass-Steagall

• Banks would have unfair advantage -- FDIC.
• Securities market activity is risky, could mean
  significant losses for banks.
• Potential conflicts of interest between banking
  department and securities department

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Financial Services in the Post Glass-Steagall Era

• 2000 -- Repeal of the Glass-Steagall Act.
• Some large banks merging with securities market
  institutions to increase economies of scale (e.g.
  Chase and J.P. Morgan).
• In general much more overlap between banks and
  securities market institutions.

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Subprime Mortgages, NBFI, and Investment Banks

• Large amount of high default risk mortgage-backed
  securities held by investment banks and other
  NBFI.
• Defaults in MBS adversely affects entire industry
  
• 2008 collapse of Bear Stearns, Lehman Brothers
  (investment banks), and AIG (insurance company).

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The Federal Reserve, Financial Firms,and the
Credit Crunch

• 2008 established a lending service between the
  Fed, investment banks, and some other nonbanks --
  analogous to the Discount Window.
• Arrangement of mergers with some investment
  banks with banks (e.g. Bear Stearns and Chase-JP
  Morgan)
• Bailout of AIG
• Granted bank holding company status to some NBFI
  (GMAC) and investment banks (Goldman Sachs,
  Morgan Stanley)

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Underlying Issues The Credit
Crunch

• Bailouts -- necessary or increasing Moral
  Hazard/Adverse Selection?
• Consistency in response Bear Stearns versus
  Lehman Brothers.
• The end of stand-alone investment banks?
• Where is the SEC?
• Harsher regulations after the crisis passes for
  banks and others (like FIRREA)?
• Possibly other players entering banking?
• Time for a totally revamped regulatory structure
  for banking, NBFI, and securities market
  institutions?