Subject Instructor

MODULE 3:
FINANCIAL markets

Lesson
1

4
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Lesson 1:
FINANCIAL MARKETS: AN OVERVIEW

Learning Objectives

After studying Lesson 1, you should be able to:

Explain what financial market is.

Distinguish between “primary” market and “secondary” market.
Explain the main function of financial markets
Enumerate and discuss the activities of financial markets.
Enumerate and explain the attributes of financial markets that investors look for.
Distinguish between “debt market” and equity market”

Introduction

A developed economy relies on financial markets and institutions for efficient transfer of funds
from savers to borrowers.

Financial markets are the meeting place for people, corporations and institutions that either
need money or have money to lend to invest. The financial markets exist as a vast global network of
individuals and financial institutions that may be lenders, borrowers or owners of public companies
worldwide.

Participants in the financial markets also include national, state and local governments that
are primarily borrowers if funds for highways, education, welfare and the public activities; their
markets are referred to as public financial markets. Large corporations raise funds in the corporate
financial markets.

FINANCIAL MARKETS IN ACTION

Thanks to the global financial markets, money flows around the world between investors,
businesses, customers and stock markets. Investors are not restricted to placing their money with
companies in the country where they live, and big business now have international offices, so money
needs to move efficiently between countries and continents.

When a corporation uses the financial markets to raise new funds, the sale of securities is said
to be made in the primary market by way of a new issue.

After the securities are sold to the public (institutions and individuals), they are traded in the
secondary market between investors. It is in the secondary market that prices are continually
changing as investors buy and sell securities based on their expectations of a corporation’s
prospects.

FUNCTIONS OF FINANCIAL MARKETS

Financial markets (bonds and stock markets) and financial intermediaries (banks, insurance
companies among others) have the basic function of getting people together by moving funds form
those who have a surplus of funds to those who have a shortage of funds.

The function that financial markets perform is shown schematically in the chart below.
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Indirect Finance

Funds Financial Funds

Funds

Lender-Savers Funds Financial Funds Borrower-Spenders

1. Households Markets 1. Business Firms
2. Business Firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

Direct Finance

Discussion:

Those who have savings and are lending funds (the lender – savers), are at the left and those
who must borrow funds to finance their spending (the borrowers – spenders), are at the right.

The principal lender – savers are households, but business enterprises and the government as
well as foreigners and their government, sometimes also finds themselves with excess funds and so
lend them out.

The most important borrower – spenders are businesses and the government (particularly the
material government) but household and foreigners also borrow to finance their purchases of cars,
furniture and houses.

The arrow show that funds flow from lenders – savers to borrowers – spenders, both directly
and indirectly.

Funds flow from lenders to borrowers indirectly through financial intermediaries such as banks
or directly through financial markets, such as the Philippine Stock Exchange.

WHAT FINANCIAL MARKETS DO

 Raising capital. Firms often require funds to build new facilities, replace machinery or expand
their business in other ways. Shares, bonds and other types of financial instruments make this
possible.

 Commercial transactions. As well as long-term capital, the financial markets provide the
grease that make many commercial transactions possible. This include such thing as
arranging payment for the sale of a product abroad, and providing working capital so that
a firm can pay employees if payments from customers run late.

 Price setting. Markets provide price discovery, a way to determine the relative values if
different items, based upon the prices at which individuals are willing to buy and sell them.

 Asset valuation. Market prices offer the best way to determine the value of a firm or of the
firm’s assets, or property. This is important not only to those buying and selling business, but
also to regulators.

 Arbitrage. In counties with poorly developed financial markets, commodities and currencies
may trade at very different prices in different locations. As traders in financial markets
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attempt to profit from this divergences, prices move towards a uniform level, making the
entire economy more efficient.

 Investing. The stock, bond and money markets provide an opportunity to earn a return on
funds that are not needed immediately, and to accumulate assets that will provide an
income in future.

 Risk management. Futures, options and other derivatives contracts can provide protection
against many type of risks, such as the possibility that a foreign currency will lose value against
the domestic currency before an export payment is received.

STRUCTURE OF FINANCIAL MARKETS

Debt and Equity Markets

Funds in a financial market can be obtained by a firm or an individual in two ways:

1. The most common method us to issue a debt instrument, such as a bond or a

mortgage, which is a contractual agreement by the borrower to pay the holder of
the instrument fixed peso amounts at regular intervals (interest and principal
payments) until a specified date (the maturity date), when a final payment is made.

2. The second method of raising funds us by issuing equity instruments, such as common
or ordinary stock, which are claims to share in the net income (income after expenses
and taxes) and the assets of a business. Equities often make periodic payments
(dividends) to their holders and are considered long-term securities because they
have no maturity date.

The following markets are of most interest to the financial manager:

Financial market functions as both primary and secondary markets for debt and equity
securities.

 Primary Market

o It refers to original sale of securities by governments and corporations. The primary

markets for securities are not well known to the public because the selling of
securities to initial buyers often takes place behind closed doors.
o An important financial institution that assist in the initial sale of securities in the
primary markets is the investment bank. It does this by underwritings securities. It
guarantee a price for a corporation’s securities and then sell them to the public.

 Secondary Market

o After the securities are sold to the public (institutions and individuals) they can be
traded in the secondary market (Between investors. Secondary market is
popularly known as Stock Market or Exchange.

o Brokers are agents of investors who match buyers with sellers of securities; dealers
link buyers and sellers by buying and selling securities and stated prices.

THE RISE OF THE FORMAL MARKETS

Investors have many reasons to prefer financial markets to street-corner trading. Yet not all
formal markets are successful, as investor gravitate to certain markets and leave others underutili zed.
The busier ones, generally, have important attributes that smaller markets often lack:
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 Liquidity, the ease with which trading can be conducted. Trading is easier and spreads
are narrower in more liquid markets. Because liquidity benefits almost everyone, trading
usually concentrates in markets that are already busy.

 Transparency, the availability of prompt and complete information about trades and
prices. Generally, the less transparent the market, the less willing people are to trade
there.

 Reliability, particularly when it comes to ensuring that trades are completed quickly
according to the terms agreed.

 Legal procedures adequate to settle disputes and enforce contracts.

 Suitable investor protection and regulation. Excessive regulation can stifle a market.
However, trading will also be deterred if investors lack confidence in the available
information about the securities they may wish to trade.

 Low transaction costs. Many financial-market transactions are not tied to a specific
geographic location, and the participants will strive to complete them in places where
trading costs, regulatory costs and taxes are reasonable.

CODE OF ETHICS GOVERNING MARKET ACTIVITIES IN THE PHILIPPINES

On February 24, 2010, Former Deputy Governor Nestor A. Espenilla, Jr. issued Circular Letter
No. CL 2010-013 addressed to all banks, their subdivision and other affiliates to non-bank which
contains financial institutes supervised by the BSP.
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ASSIGNMENT

R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. Describe what financial markets are.

2. Distinguish between primary market and secondary market.

3. What are the two principal sources if funds in the financial market? Explain
briefly.

4. What benefits could be achieved if the Code of Ethics governing Financial

Market Activities would be implemented and followed by the participants?
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Lesson 2:
MONEY MARKETS AND CAPITAL MARKETS

Learning Objectives

After studying Lesson 2, you should be able to:

MONEY MARKETS

Explain what money market is and how money market works

Discuss who the users of money market are
Explain how money market facilitates the development of a market for long-term
securities
Enumerate and explain the features of money market instruments

CAPITAL MARKETS

Explain what capital market is

Discuss the role of the various capital market participants
Discuss capital market trading
Enumerate and explain the types of bonds
Discuss ordinary (common) equity shares and preferred shares

MONEY MARKETS

The term “money market” refers to the network of corporations, financial institutions, investors
and governments which deal with the flow of short-term capital. When a business needs cash for a
couple of months until a big payment arrives, or when a bank wants to invest money that depositors
may withdraw at any moment, or when a government tries to meet its payroll in the face of big
seasonal fluctuations in tax receipts, the short-term liquidity transactions occur in the money market.

How it Works

The money markets exists to provide the loans that financial institutions and governments
need to carry out their day-to-day operations. For instance, banks may sometimes need to borrow
in the short term to fulfill their obligations to their customers, and they use the money market to do
so.

The money markets are the mechanisms that bring these borrowers and investors together
without the comparatively costly intermediation of banks. They make it possible for borrowers to
meet short-run liquidity needs and deal with irregular cash flows without resorting to more costly
means of raising money.

Who Uses the Money Market?

Companies Banks Investors

a. When companies need a. If demand for long-term a. Individuals seeking to
to raise money to cover loans and mortgages is invest large sums of
their payroll or running not covered by deposits money at relatively low
costs, they may issue from savings accounts, risk may invest in
commercial paper – banks may then issue financial instruments.
short-term, unsecured certificates of deposit, Sums of less than P50,000
loans for P100,000 or with a set interest rate can be invested un
more that mature within and fixed-term maturity money market funds.
1-9 months. of up to five years.
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b. A company that has a

cash surplus may “park”
money for a time in
short-term. Debt-based
financial instruments
such as treasury bills and
commercial paper,
certificates of deposit, or
bank deposits.

What Money Markets Do

A well-functioning money market facilitates the development of a market for longer-term

securities. Money markets attach a price to liquidity, the availability of money for immediate
investment. The interest rates for extremely short-term use of money serve as benchmarks for longer-
term financial instruments.

If the money markets are active, or “liquid”, borrowers and investors always have the option
of engaging in a series of short-term transactions rather than in longer-term transactions, and this
usually holds down longer term rates.

Types of Money-Market Instruments

1. Commercial Paper

 It is a short-term debt obligation of a private sector firm or a government-

sponsored corporation. Only companies with good credit ratings issue
commercial paper because investors are reluctant to bring the debt of financially
compromised companies.
 In most cases, the paper has lifetime, or maturity, greater than 90 days but less
than nine months.

2. Bankers’ Acceptances

 Before the 1980s, bankers’ acceptances were the main way for forms to raise
short-term funds in the money markets. An acceptance is a promissory note issued
by a non-financial firm to a bank in return for a loan.
 Bankers’ acceptances are nit issued at all by financial-industry firms. They do not
bear interest; instead, an investor purchases the acceptance at a discount from
face value and them redeems it for face value at maturity.

3. Treasury Bills

 It is often referred to as T-bills, are securities with a maturity of one year or less,
issued by national governments. Treasury bills issued by a government in its own
currency are generally considered the safest of all possible investments in that
currency.

4. Government Agency Notes

 National government agencies and government-sponsored corporations are

heavy borrowers in the money markets in many countries. These include entities
such as development banks, housing finance corporations, education lending
agencies and agricultural finance agencies.
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5. Local Government Notes

 Local government notes are issued by, provincial or local governments, and by
agencies of these governments such as schools authorities and transport
commissions.
 In some case, the approval of national authorities is required; in others, local
agencies are allowed to borrow only from banks and cannot enter the money
markets.

6. Interbank Loans

 Interbank loans are loans extended from one bank to another with which it has
no affiliation. Many of these loans are across international boundaries and are
used by the borrowing institutions to re-lend to its own customers.

7. Time Deposits

 Time deposits, another name for certificates of deposit or CDs, are interest-
bearing bank deposits that cannot be withdrawn without penalty before a
specified date. Interest rates depend on length of maturity, with longer terms
getting better rate.

8. Repos

 Repurchase agreements known as repos, play a critical role in the money

markets. They serve to keep the markets highly liquid, which in turn ensures that
there will be a constant supply of buyers for new money-market instruments.

CAPITAL MARKETS

The capital market is a financial market in which longer-term debt (original maturity of one
year or greater) and equity instruments are traded. Capital markets securities include bonds, stocks
and mortgages.

Capital Market Participants

The primary issuers of capital market securities:

 The national government issues long-term notes and bonds to fund the national debt
while local governments issue notes and bonds to finance capital projects.

 Corporations issue both bonds and stock to finance capital investment expenditures
and fund other investment opportunities.

Capital Market Trading

Capital market trading occurs in either the primary market or the secondary market. The
primary market is where new issues of stocks and bonds are introduced. Investment funds,
corporations and individual investors can all purchase securities offered in the primary market.

The capital markets have well developed secondary markets. A secondary market is where
the sale of previously issued securities take place, and it is important because most investors plan to
sell long-term bonds before they reach maturity and eventually sell their holdings of stock as well.

A. BONDS

A bond is any long-term promissory note issued by the firm. A bond certificate is the tangible
evidence of debt issued by a corporation or a governmental body and represents a loan
made by investors to the issue.
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Types of Bonds:

1. Unsecured Long-Term Bonds

Debentures
 These are unsecured long-term debt and backed only by the reputation and
financial stability of the corporation. Because these bonds are unsecured, the
earning ability of the issuing corporation is of great concern to the bondholder.

Subordinated Debentures
 Claims of bondholders of subordinated debentures are honored only after the
claims of secured debt and unsubordinated debentures have been satisfied.

Income Bonds
 An income bond requires interest payments only if earned and non-payment of
interest does not lead to bankruptcy. Usually issued during the reorganization of
a firm facing financial difficulties, these bonds have longer maturity and unpaid
interest is generally allowed to accumulate for some period of time and must be
paid prior to the payment of any dividends to stockholders.

2. Secured Long-Term Bonds

Mortgage Bonds
 A mortgage bond is a bond secured by a lien on real property. Typically, the
market value of the real property is greater than that of the mortgage bonds
issued.

 Mortgage bonds can further be sub-classified as follows:

o First Mortgage Bonds. It have the senior claim on the secured assets if the
same property has been pledged in more than one mortgage bond.

o Second Mortgage Bonds. These bonds have the second claim on assets
and are paid only after the claims of the first mortgage bonds have been
satisfied.

o Blanket or General Mortgage Bonds. All the assets of the firm are used as
security for this type of bonds.

o Closed-end Mortgage Bonds. It forbid the further use of the pledged assets
security for other bonds. This protects the bondholders from dilution of their
claims on the assets by any future mortgage bonds.

o Open-end Mortgage Bonds. These bonds allow of additional mortgage

bonds using the same secured assets as security.

o Limited Open-end Mortgage Bonds. These bonds allow the issuance of

additional bonds up to a limited amount at the same priority level using
the already mortgaged assets as security.

Other Types of Bonds:

1. Floating Rate or Variable Rate Bonds

A floating rate bonds is one in which the interest payment changes with market
conditions. In periods of unstable interest rates this type of debt offering becomes
appealing to issuers and investors.
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A common feature if all the floating rate bonds is that an attempt is being made to
counter uncertainty by allowing the interest rate to float. In this way a change in cash
inflows to the firm may be offset by an adjustment in interest payments.

2. Junk or Low-rated Bonds

Junk or low-rated bonds are bonds rated BB or below. The major participants of this
market are new firms that do not have an established record of performance, although
in recent years, junk bonds have been increasingly issued to finance corporate buyouts.

3. Eurobonds

These are bonds payable or denominated in the borrower’s currency, but sold
outside the country if the borrower, usually by an international syndicate of investment
bankers. This market is denominated by bonds stated in U.S. dollars.

An example might be a bond of a U.S. company payable in dollars and sold in

London, Paris, Tokyo or Frankfurt.

Eurobonds are also referred to as bonds issued in Europe by an American company

and pay interest and principal to the lender in U.S. dollars.

4. Treasury Bonds

Treasury bonds carry the “full-faith-and credit” backing of the government and
investors consider them among the safest fixed-income investments in the world. The BSP
sells Treasury securities through public auctions usually to finance the government’s
budget deficit.

When the deficit is large, more bonds come to auction. In addition, the BSP uses
Treasury securities to implement monetary policy.

B. ORDINARY (COMMON) EQUITY SHARES

Ordinary equity shares is a form of long0term equity that represents ownership interest
of the firm. Ordinary equity shareholders are called residual owners because their claims to
earnings and assets is what remains after satisfying the prior claims to various creditors and
preferred shareholders.

Ordinary (common) equity shareholders are the true owners of the corporation and
consequently bear the ultimate risks and rewards of ownership. As owners of the firm, ordinary
shareholders are considered to be residual domains. This means that ordinary shareholders
have the right to claim any cash flows or value after all other claimants have received what
they are owed.

Features of Ordinary Equity Shares:

1. Par value/No par value

Ordinary equity share may be sold with or without par value. Par value of ordinary
equity share is the stated value attached to a single share at issuance. If ordinary equity
share is initially sold for more than its par value, the issue price in excess of par is recorded
as additional paid-in capital, capital surplus, or capital in excess of par.

2. Authorized, issued and outstanding

Authorized shares is the maximum number of shares that a corporation may issue
without amending its charter. Issued shares is the number of authorized shares that have
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been sold. Outstanding shares are those share held by the public. Previously issued shares
that are reacquired and held by the firm are called treasury shares.

3. No maturity

Ordinary equity share has no maturity and is a permanent form of long-term

financing. Although ordinary shares is neither callable nor convertible, the firm can
repurchase its shares in the secondary markets either through a brokerage firm a tender
offer. A tender offer is a formal offer to purchase shares of a corporation.

4. Voting rights

Each share of ordinary equity generally entitles the holder to vote on the selection of
directors and in other matters. Shareholders unable to attend the annual meeting to vote
may be vote by proxy. A proxy is a temporary transfer if the right to vote to another party.

There are two common systems of voting:

a. Majority voting. A voting system that entitles each shareholder to cast one
vote for each share owned. If a group controls over 50% of the votes, it can
elect all of the directors and prevent minority shareholders from electing any
directors.

b. Cumulative voting. A voting system that permits the shareholder to cast

multiple votes for a single director. It assist minority shareholders in electing at
least one director.

5. Book value per share

The accounting value of an ordinary equity share is equal to the ordinary share equity
(ordinary share plus plaid-in capital plus retained earnings) divided by the number of
shares outstanding.

6. Numerous voting rights of stockholders

a. Right to vote on specific issues as prescribed by the corporate charter such as

election of the board of directors, increasing the amount of authorized stock,
amending the articles of incorporation and bylaws, and etc.

b. Right to receive dividends if declared by the firm’s board of directors.

c. Right to share in the residual assets in the events of liquidation.

d. Right to transfer their ownership in the firm to another party.

e. Right to examine the corporate banks.

f. Right to share proportionally in the purchase of any new issuance of equity

shares. This is known as pre-emptive right.

C. PREFERRED SHARE

Preferred share is a class of equity shares which has preference over ordinary
(common) equity shares in the payments of dividends and in the distribution of corporation
assets in the event of liquidation.

Preference means only that the holders of the preferred share must receive a
dividend (in the case of a going concern firm) before the holder of ordinary (common) equity
shares are entitle to anything.
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Preferred Shares Features:

1. Par value

Par value is the face value that appears in the stock certificate. In some cases, the
liquidation value per share is provided for in the certificate.

2. Dividends

Dividends are stated as a percentage if the par value and are commonly fixed and
paid quarterly but are not guaranteed by the issuing firm.

3. Cumulative and Noncumulative dividends

If preferred dividends are cumulative and are not paid in a particular year, they will
be carried forward as an arrearage. Usually, both accumulated (past) preferred
dividends and the current preferred divided must be paid before the ordinary equity
shareholders receive anything.

If the preferred dividends are noncumulative, dividends not declared in any

particular year are lost forever and the preferred shareholders cannot claim such
anymore.

4. Convertible preferred share

Owners of convertible preferred share have the option of exchanging their preferred
share for ordinary (common) equity share based in specified terms and conditions.

5. Voting rights

Preferred share does not ordinarily carry voting rights. Special voting procedures may
take effect if the issuing firm omits its preferred dividends for a specific time period.

6. Participating features

Participating preferred share entitles its holders to share in profits above and beyond
the declare dividend, along with ordinary (common) equity shareholders.

7. Call provision

A call provision gives the issuing corporation the right to call in the referred share for
redemption.

8. Maturity

Three decades ago, most preferred share was perpetual – it had no maturity and
never needed to be paid off. However, today most new preferred share has a sinking
fund and this an effective maturity date.

COMPARATIVE FEATURES OF ORDINARY EQUITY SHARES, PREFERRED SHARES AND BONDS

Ordinary Equity
Preferred Shares Bonds
Shares
a) Ownership and Belongs to ordinary Limited rights under
Limited rights when
control of the equity shareholders default in interest
dividends are missed.
firm through voting right payments
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and residual claim to

income
Must receive payment
b) Obligation to Contractual
None before ordinary
provide return obligation
shareholder
Bondholders and
c) Claim to assets Lowest claim of any
creditors must be Highest claim
in bankruptcy security holder
satisfied first
d) Cost of
Highest Moderate Lowest
distribution
Highest risk, highest
e) Risk-return trade Moderate risk, Lowest risk, moderate
return (at least in
off moderate return return
theory)
f) Tax status of
payment by Not deductible Not deductible Tax deductible
corporation
A portion of dividend
g) Tax status of
paid to another Same as ordinary Government bond
payment to
corporation is tax shares interest is tax exempt
recipient
exempt
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ASSIGNMENT

R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. Describe how the money market mechanism works to bring g providers and
users of short-term fund together.

2. Explain how banks, companies and investors use financial instruments in the
money market.

3. Who are the primary issuers if capital market securities? Explain each.

4. Enumerate the advantages and disadvantages of issuing bonds as a source

of long-term funds.
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Lesson 3:
FOREIGN EXCHANGE MARKET

Learning Objectives

After studying Lesson 3, you should be able to:

Discuss what factors significantly influence the currency exchange rates of a country.
Explain how foreign exchange market provides the mechanism for the transfer
purchasing power from one currency to another.
Explain what exchange rate is.
Distinguish between spot transactions and forward transactions; spot exchange rate
and forward exchange rate.
Discuss the significance of foreign exchange risks

Introduction

Most countries of the world have their own currencies. The United Sates has its dollar; France,
the euro; Brazil, its real; India, its rupee and in the Philippines its peso. Trade between countries
involves the mutual exchange of different currencies. Firms that do business internationally must be
concerned with exchange rates, which are the relationships among values of currencies.

The constant change in exchange rates causes problems for financial managers as the
change in relative purchasing power between countries affects imports and exports, interest rates
and other economic variables. The relative strength of particular currency to other currencies
changes many times over a business cycle.

RECENT HISTORICAL PERSPECTIVE OF EXCHANGE RATES

From the end of World War II until the early 70’s, the world was on a fixed exchange rate
system administered by the International Monetary Fund (IMF). Under this system, all countries were
required to set a specific parity rate for their currency vis-à-vis the United States dollar. A country
could effect a major adjustment in the exchange rate by changing the parity rate with respect to
the dollar. Then the currency was made cheaper with respect to the dollar, the adjustment was
called a devaluation. An upvaluation or revaluation resulted when a currency became more
expensive with respect to the dollar.

A floating rate international currency system has been operating since 1973. Most major
currencies fluctuate freely depending upon their values as perceived by the traders in foreign
exchange markets.

THE FOREIGN CURRENCY EXCHANGE MARKET

The forex market provides a service to individuals, businesses and governments who need to
buy or sell currencies other than that used in their country. This might be in order to travel abroad, to
make investments in another country, or to pay for import products or convert export earnings.

The foreign exchange (or forex) market provides a mechanism for the transfer of purchasing
power dorm one currency to another. This is where traders convert one foreign currency into another
and is one of the largest financial markets in the world. They communicate using electronic networks.
Any firm’s banks or experts within the firm, can access this market to exchange one currency for
another.
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EXCHANGE RATES

An exchange rate is simply the price of one country’s currency expressed in terms of another
country’s currency. In practice, almost all trading of currencies takes place in terms of the U.S dollar.
For example, both the Euros, the Swiss franc, and the Japanese yen are traded with prices quoted
in U.S dollar. Exchange rates are constantly changing.

Figure 3.1
BANGKO SENTRAL NG PILIPINAS

FINANCIAL MARKETS

REFERENCE EXCHANGE RATE BULLETIN

April 26, 2024

COUNTRY COUNTRY COUNTRY COUNTRY COUNTRY COUNTR

I. CONVERTIBLE CURRENCIES WITH BANGKO SENTRAL:

1 UNITED 1 UNITED 1 UNITED 1 UNITED 1 UNITED 1 UNI

STATES STATES STATES STATES STATES STA

2 JAPAN 2 JAPAN 2 JAPAN 2 JAPAN 2 JAPAN 2 JA

3 UNITED 3 UNITED 3 UNITED 3 UNITED 3 UNITED 3 UNI

KINGDOM KINGDOM KINGDOM KINGDOM KINGDOM KING

4 HONGKONG 4 HONGKONG 4 HONGKONG 4 HONGKONG 4 HONGKONG 4 HONGK

5 5 5 5 5
SWITZERLAND SWITZERLAND SWITZERLAND SWITZERLAND SWITZERLAND SWITZERL

6 CANADA 6 CANADA 6 CANADA 6 CANADA 6 CANADA 6 CAN

7 SINGAPORE 7 SINGAPORE 7 SINGAPORE 7 SINGAPORE 7 SINGAPORE 7 SINGAP

8 AUSTRALIA 8 AUSTRALIA 8 AUSTRALIA 8 AUSTRALIA 8 AUSTRALIA 8 AUSTR

9 BAHRAIN 9 BAHRAIN 9 BAHRAIN 9 BAHRAIN 9 BAHRAIN 9 BAHR

10 KUWAIT 10 KUWAIT 10 KUWAIT 10 KUWAIT 10 KUWAIT 10 KUW

11 SAUDI 11 SAUDI 11 SAUDI 11 SAUDI 11 SAUDI 11 SA

ARABIA ARABIA ARABIA ARABIA ARABIA AR

12 BRUNEI 12 BRUNEI 12 BRUNEI 12 BRUNEI 12 BRUNEI 12 BRU

13 INDONESIA 13 INDONESIA 13 INDONESIA 13 INDONESIA 13 INDONESIA 13 INDON

14 THAILAND 14 THAILAND 14 THAILAND 14 THAILAND 14 THAILAND 14 THAIL

15 UNITED 15 UNITED 15 UNITED 15 UNITED 15 UNITED 15 UNI

ARAB ARAB ARAB ARAB ARAB A
EMIRATES EMIRATES EMIRATES EMIRATES EMIRATES EMIRA
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BANGKO SENTRAL NG PILIPINAS

FINANCIAL MARKETS

REFERENCE EXCHANGE RATE BULLETIN

April 26, 2024

COUNTRY COUNTRY COUNTRY COUNTRY COUNTRY COUNTR

16 EUROPEAN 16 EUROPEAN 16 EUROPEAN 16 EUROPEAN 16 EUROPEAN 16 EUROP

MONETARY MONETARY MONETARY MONETARY MONETARY MONET
UNION UNION UNION UNION UNION UN

17 KOREA 17 KOREA 17 KOREA 17 KOREA 17 KOREA 17 KO

18 CHINA 18 CHINA 18 CHINA 18 CHINA 18 CHINA 18 CH

II. OTHERS (NOT CONVERTIBLE WITH BSP)

19 19 19 19 19
ARGENTINA ARGENTINA ARGENTINA ARGENTINA ARGENTINA ARGEN

20 BRAZIL 20 BRAZIL 20 BRAZIL 20 BRAZIL 20 BRAZIL 20 BR

21 DENMARK 21 DENMARK 21 DENMARK 21 DENMARK 21 DENMARK 21 DENM

22 INDIA 22 INDIA 22 INDIA 22 INDIA 22 INDIA 22 IN

23 MALAYSIA 23 MALAYSIA 23 MALAYSIA 23 MALAYSIA 23 MALAYSIA 23 MALA

24 MEXICO 24 MEXICO 24 MEXICO 24 MEXICO 24 MEXICO 24 MEX

25 NEW 25 NEW 25 NEW 25 NEW 25 NEW 25

ZEALAND ZEALAND ZEALAND ZEALAND ZEALAND ZEAL

26 NORWAY 26 NORWAY 26 NORWAY 26 NORWAY 26 NORWAY 26 NOR

27 PAKISTAN 27 PAKISTAN 27 PAKISTAN 27 PAKISTAN 27 PAKISTAN 27 PAKIS

28 SOUTH 28 SOUTH 28 SOUTH 28 SOUTH 28 SOUTH 28 SO

AFRICA AFRICA AFRICA AFRICA AFRICA AFR

29 SWEDEN 29 SWEDEN 29 SWEDEN 29 SWEDEN 29 SWEDEN 29 SWE

30 SYRIA 30 SYRIA 30 SYRIA 30 SYRIA 30 SYRIA 30 SY

31 TAIWAN 31 TAIWAN 31 TAIWAN 31 TAIWAN 31 TAIWAN 31 TAI

32 32 32 32 32
VENEZUELA VENEZUELA VENEZUELA VENEZUELA VENEZUELA VENEZU

BSP Buying BSP Buying BSP Buying Rate (T/T):

Rate (T/T): Rate (T/T): PHP
PHP
 19

BANGKO SENTRAL NG PILIPINAS

FINANCIAL MARKETS

REFERENCE EXCHANGE RATE BULLETIN

April 26, 2024

COUNTRY COUNTRY COUNTRY COUNTRY COUNTRY COUNTR

BSP Selling BSP Selling BSP Selling Rate (T/T):

Rate (T/T): Rate (T/T): PHP
PHP

BSP BSP Reference BSP Reference Rate:

Reference Rate: PHP
Rate: PHP

PDS PDS Closing PDS Closing Rate (25-Apr-2024):

Closing Rate (25-Apr-
Rate (25- 2024): PHP
Apr-2024):
PHP

SDR Rate: SDR Rate: $ SDR Ra

$

GOLD GOLD GOLD BUYIN

BUYING: $ BUYING: $

SILVER SILVER SILVER BUYIN

BUYING: $ BUYING: $

**** THB On-shore price

Source: REUTERS' FOREX CLOSING PRICES as of NY Time - 25-Apr-2024

* Various banks in Bahrain as quoted in Reuters' Screen

** Asian Time Closing Rate as of 25-Apr-2024

*** Effective 01 October 2021, Venezuela has removed six zeros from their official exchange rate (e.g.
0.000004 bolivars per dollar to 0.162215 bolivars per dollar)

WHY ARE EXCHANGE RATES IMPORTANT?

Exchange rates are important because they affect the relative prices of domestic and
foreign goods. The dollar price of French goods to an American is determined by the interaction of
two factors: the price of French goods in euros and the euro/dollar exchange rate.

When a country’s currency appreciates (rises in value relative to other currencies), the
country’s goods abroad become more expensive and foreign goods in that country become
cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s
 20

currency depreciates, its goods abroad become cheaper and foreign goods in that country
become more expensive.

Appreciation of a currency can make it harder for domestic manufacturers to sell their goods
abroad and can increase competition from foreign goods because they cost less.

FACTORS INFLUENCING EXCHANGE RATES

The major reasons for exchange rates movements which includes:

1. Inflation. Inflation tends to deflate the value of a currency because holding the currency
results in reduced purchasing power.

2. Interest rates. If interest returns in a particular country are higher relative to other countries,
individuals and companies will be enticed to invest in that country. As a result, there will
be an increased demand for the country’s currency.

3. Balance of payments. Balance of payments is used to refer to a system of accounts that

catalogs the flow of goods between the residents of two countries.

4. Government intervention. Through intervention (e.g., buying or selling the currency in the
foreign exchange markets), the central bank of a country may support or depress the
value of its currency.

5. Other factors. Other factors that may affect exchange rates are political and economic
stability, extended stock market rallies and significant declines in the demand for major
exports.

WHAT ARE THE FOREIGN CURRENCY EXCHANGE RATE TRANSACTIONS?

The two kinds of Foreign Exchange Rate Transactions are:

A. Spot Transactions

Spot transactions are those which involve immediate two-day) exchange of bank deposits.
The spot exchange rate is the exchange rate for the spot transactions.

B. Forward Transactions

Forward transactions involve the exchange of bank deposits at some specified future date.
The forward exchange rate is the exchange rate for the forward transaction.

SPOT EXCHANGE RATES

If we are exchanging one currency for another immediately, we participate in spot

transaction. A typical spot transaction may involve a Philippine firm buying foreign currency from its
bank and paying for it in Philippine pesos.

The price of the foreign currency in terms of the domestic currency is the exchange rate – in
this instance, the Philippine peso. Another case is when a Philippine firm receives foreign currency
from abroad. The firm would typically sell the foreign currency to its bank Philippine peso. There are
both spot transactions, where one currency is exchanged for another currency immediately.

The spot rate for a currency is the exchange rate at which the currency is traded for
immediate delivery.
 21

DIRECT AND INDIRECT QUOTES

In the spot exchange market, the quoted exchange rate is typically called a direct quote. A
direct quote indicates the number of units of the home currency required to buy one unit of the
foreign currency. An indirect quote indicates the number of units of foreign currency that can be
bought for one unit of the home currency.

In summary, a direct quote is the peso/foreign currency rate, and an indirect quote is the
foreign currency/peso rate. Therefore, an indirect quote is the reciprocal of a direct quote and vice
versa.

Illustrative Case:

Compute the indirect quote from the Philippine direct quotes of spot rates for US dollars, UK
pound, EU euros, and Japanese yen as of April 26, 2024 given in Figure 3.1. The related indirect quotes
are computes as follows:

Indirect = 1_
Quote Direct quote

Thus:
US dollars = 1 = .01728 (dollar/P1)
57.8690

UK pounds = 1 = .01380 (pound/P1)

72.4346

EU euros = 1 = .01610 (euro/P1)

62.0992

Japan yen = 1 = 2.68817 (yen/P1)

0.3720

The direct and indirect quotes are useful in computing foreign currency requirements. Consider the
following examples:

a) A Filipino businessman wanted to remit 1,000 UK pounds to London on April 26, 2024. How
much in pesos would have been required for this transaction?

P72.4346/pounds x 1,000 pounds = P 72,434,60

b) A Filipino businessman paid P112,148.20 to an Italian supplier on April 26, 2024. How many
euros did the Italian supplier receive?

P112,148.20 x .01610 = € 1,805.59 euros

CROSS RATES

Also important in understanding the spot-rate mechanism is the cross rate. A cross rate is the
indirect computation of the exchange rate of one currency from the exchange rate of two other
currencies.
 22

For instance:

The peso/pound and the euro/peso rates are given in Figure 3.1. From this
information, we could determine the euro/pound and pound/euro exchange rates.

We see that:

P72.4346 = £1
P62.0992 = €1
P72.4346 / P62.0992 = 1.1664 euro per 1 pound

Thus, the pound/ euro exchange rate is:

P62.0992 / P72.4346 = .87342 pound per 1 euro

Cross rate computations make it possible to use quotation in New York to compute, the
exchange rate between pounds, euros and so forth in other foreign currency exchange markets. If
the rates prevailing in London and Paris were different from the computed cross rates, using quotes
from New York, a trader could use three different markets and make arbitrage profits. The arbitrage
condition for the cross rates is called triangular arbitrage.

FORWARD RATES

The forward rate for a currency is the exchange rate at which the currency for future delivery
is quoted. The trading of currencies for future delivery is called a forward market transaction.

Suppose Sta. Lucia Corporation expects to pay US$1.0 million to a US supplier 30 days from
now. It is not certain however, what these dollars will be worth in Philippine pesos 30 days from today.
To eliminate this uncertainty, Sta. Lucia Corporation calls a bank and offers to buy US$1.0 million to
a US supplier 30 days from now. In their negotiation, the two parties may agree on an exchange rate
of P46 million to the bank and receives $1 million.

FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN

1. Relative Price Levels

In the long run, a rise in a country’s price level (relative to the foreign price level)
causes its currency to depreciate, and a fall in the country’s relative price level causes its
currency to appreciate.

2. Trade Barriers

Increasing trade barriers causes a country’s currency to appreciate in the long run.

3. Preferences for Domestic Versus Foreign Goods

Increased demand for a country’s exports causes its currency to appreciate in the
long run; conversely, increased demands for imports causes the domestic currency to
depreciate.

4. Productivity

In the long run, as a country becomes more productive relative to other countries, its
currency appreciates.
 23

EXCHANGE RATES IN THE SHORT RUN

The key to understanding the short run behavior of exchange rates id to recognize that an
exchange rate is the price of domestic bank deposits )those denominated in the domestic currency)
in terms of foreign bank deposits (those denominated in the foreign currency).

Earlier approaches to exchange rate determination emphasized the role of import and
export demand. The more modern asset market approach used here does not emphasize the flows
of purchase of exports and imports over short periods because these transactions are quite small
relative to the amount of domestic and foreign bank deposits at any given time.

MANAGING FOREIGN EXCHANGE RISK

Foreign exchange risk refers to the possibility of a drop in revenue or an increase in cost in an
international transaction due to a change in foreign exchange rates. Importers, exporters, investors
and multinational firms are all exposed to this foreign exchange risk.

In today’s global monetary system, the exchange rates if major currencies are fluctuating
rather freely. These “freely” floating exchange rates expose multinational business firms to foreign
exchange risk. To deal with this foreign currency exposure effectively, the financial manager must
understand foreign exchange rates and how they are determined. Foreign exchange rates are
influenced by differences in inflation rates among countries, differences in interest rates, government
policies and the expectations of the participants in the foreign exchange markets.
 24

ASSIGNMENT

R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. List the factors that affect the value of a currency in foreign exchange
markets.

2. Explain how imports and exports tend to influence the value of a currency.

3. Differentiate between the spot exchange rate and the forward exchange
rate.
 25

Lesson 4: INTERNALIZATION OF FINANCIAL MARKETS

Learning Objectives

After studying Lesson 4, you should be able to:

Discuss the importance of global financial markets

Familiarize yourself of the largest financial markets in the world
Explain the factors affecting the long-run trends of increased financial market activity
Distinguish between individual and institutional investors
Explain the types of institutional investors
Discuss the major types of international credit markets

Introduction

The flow of money around the world is essential for business to operate and grow. Stock
markets are places where individuals as well as institutional (corporation) investors can trade
currencies, invest in companies and arrange loans.

Without the global financial markets, governments would not be able to borrow money,
companies would not have access to the capital they need to expand and, investors and individuals
would be unable to buy and sell foreign currencies.

FINANCIAL MARKETS AROUND THE WORLD

New York, US

The New York Stock Exchange (NYSE) is the largest in the world (market capitalization – the
market value of its outstanding shares: $14.14 trillion), followed by the NASDAQ, which is also based
in New York, ($5.63 trillion).

Toronto, Canada

The Toronto Stock Exchange (TSE) in Canada is run by the TMX Group ($1.45 trillion).

Tokyo, Japan

The Japan Exchange Group (JPX), based in Tokyo, is the largest exchange in Asian ($3.73
trillion).

China

China has three stock exchanges: the Shanghai Stock Exchange (SSE), ($2.9 trillion); Shenzhen
Stock Exchange (SZSE) ($2.36 trillion); and the Stock Exchange of Hong Kong (SEHK) ($3.32 trillion)

London, UK

The London Stock Exchange (LSE) is Europe’s largest ($2.68 trillion).

 26

European Union

Euronext has headquarters in Amsterdam, Brussels, Lisbon, London and Paris ($2.56 trillion).

Frankfurt, Germany

Deutsche Borse is based in Frankfurt (FWB) ($1.24 trillion).

FACTORS AFFECTING THE LONG-RUN TRENDS OF INCREASED FINANCIAL MARKET ACTIVITY

A. Lower Inflation

Inflation rates around that have fallen markedly since the 1990s. Inflation erodes the value
of financial assets and increases the value of physical assets, such as houses and machines,
which will cost far more to replace than they are worth today. In a low inflation environment,
however, financial-market investors require less of an inflation premium, as they do not expect
general increases in prices to devalue their assets.

B. Pensions

A significant change in pension policies occurred many countries starting in the 1990s.
Changes in demography and working patterns have made pay-as-you-go schemes increasingly
costly to support, as there are fewer young workers relative to the number of pensioners. This has
stimulated interest in pre-funded individual pensions, whereby each worker has an account in
which money must be saved, and therefore invested, until retirement.

C. Stock and bond market performance

Stock markets, after several difficult years, rose steeply on many countries in 20212 and
2013 and again in 20916 and 2017. A rapid increase in financial wealth feeds on itself: investors
whose portfolios have appreciated are willing to reinvest some of their profits in the financial
markets. And the appreciation in the value of their financial assets gives investors the collateral
to borrow additional money, which can then be invested.

D. Risk management

Innovation has generated many new financial product, such as derivatives and asset-
backed securities, whose basic purpose is to redistribute risk. This led to enormous growth in the
use of financial markets for risk-management purposes. The credit crisis that began in 2007,
however, revealed that the pricing of many of these risk-management products did not properly
reflect the risks involved. As a result, these products have become more costly, and are being
used more sparingly, then in earlier years.

E. The Investors

The driving fierce behind financial markets is the desire of investors to earn a return on
their assets. This return has two distinct components:

 Yield is the income investor receives while owning an investment.

 Capital gains are increase in the value if the investment itself, and are often not
available to the owner until the investment is sold.
 27

THE CATEGORIES OF INVESTORS

Individuals

Collectively, individuals own a small proportion of financial assets. Most household in the
wealthier countries own some financial assets, often on the form of retirement savings or of shares in
the employer of a household member.

Institutional Investors

Insurance companies and other institutional investors, including high-frequency traders, are
responsible for cost of the trading in financial markets. The size of institutional investors varies greatly
from country to country, depending on the development of collective investment vehicles.

Types of Institutional Investors:

 Mutual funds. Mutual funds and unit are investment companies that typically accept an
unlimited number of individual investments. The fund declares the strategy it will pursue,
and as additional money is invested the fund managers purchase financial instruments
appropriate to that strategy.

 Hedge funds. It can accept investments from only a small number of wealthy individuals
or big institutions. Hedge funds are able to employ aggressive investment strategies, such
as using borrowed money to increase the amount invested and focusing investment in
one or another type of asset rather than diversifying.

 Insurance companies. It is the most important type of institutional investor, owning one-
third of all the financial assets owned by institutions. In recent years, a growing share of
insurers’ business has consisted of annuities, which guarantee policy holders a sum of
money each year as long as they live, rather than merely paying their heirs upon death.

 Pension funds. Pension funds aggregates the retirement savings of a large number of
workers. In the Philippines, the SSSS and GSIS represent the largest investors of pension
fund. Unlike individual pension accounts, pension funds do not give individuals control
over how their savings are invested, but they do typically offer a guaranteed benefit
once the individual reaches retirement age.

 Algorithmic traders. It also known as high-frequency trading and has expanded

dramatically in recent years as a result of increased computing power and the availability
of low-cost, high-speed communications. Algorithmic trading firms control only a tony
proportion of the world’s financial assets, but they account for a large proportion of the
trading in some markets.

INTERNATIONAL MONEY AND CAPITAL MARKETS

There are three major types of international credit markets:

1. Eurocredits

This is the market for floating-rate bank loans whose rates are tied to LIBOR, which stands
for London Interbank Offer Rate. LIBOR is the interest rate offered by the largest and strongest
banks on large deposits. Eurocredits exist for major trading currencies. An example of a
Eurocredits is a Eurodollar deposit, which is a U.S. dollar deposited in a bank outside the United
States.
 28

2. Eurobond Market

A Eurobond is an international bond underwritten by an international syndicate of banks

and sold to investors in countries other than the one in whose money unit the bond is
denominated.

3. Foreign Bond Market

Foreign bonds are international bonds issued in the country whose currency the bond is
denominated, and they are underwritten by investment bank in that country. The borrower may
be located in a different country.
 29

ASSIGNMENT

R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. In what way do global financial markets help government

individuals, businesses and investors?

2. Explain the development of financial instruments in the international markets.

3. Is it easy to estimate the worldwide size of its financial markets? Discuss.

 30

Subject Instructor
 1

MODULE 4: FINANCIAL
INSTITUTIONS
AND
INTERMEDIARIES

Lesson
1

3
 2

Lesson 1:
FINANCIAL INSTITUTIONS AND INTERMEDIARIES: AN OVERVIEW

Learning Objectives

After studying Lesson 1, you should be able to:

Explain what a financial institution is.

Discuss the channels through which savers and borrowers are matched in a financial
system
Explain what a financial intermediaries is
Enumerate the primary assets and liabilities of the various Financial Institutions and
Intermediaries

Introduction

What is a Financial Institution?

A financial institution is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans and investments and currency exchange. Financial
institutions can operate at several scales from local community credit unions to international
investment banks.

The financial system matches savers and borrows through two channels:
1. Financial markets, and
2. Banks and other financial intermediaries

These two channels are distinguished by how funds flow from savers or lenders, to
borrowers and by the financial institutions involved. Funds flow from lenders to borrowers directly
through financial markets such as the NYSE and PSE or indirectly through financial intermediaries,
such as banks.

Figure 4-1: MOVING FUNDS THROUGH THE FINANCIAL SYSTEM

 3

FINANCIAL INTERMEDIAIRES

A financial intermediary is a financial firm, such as a bank, that borrows funds from savers
and lends them to borrowers.

BASIC STRUCTURES OF FINANCIAL INSTITUTIONS/INTERMEDIARIES:

A. Depository Institutions
1. Commercial Banks/ Universal Banks
2. Savings and Loans Associations
3. Mutual Savings Bank
4. Credit Union

B. Contractual Savings Institutions

1. Insurance Companies
2. Pension Funds

C. Investment Institutions
1. Investment Banks
2. Mutual Funds
3. Hedge Funds
4. Finance Companies
5. Money Market Mutual Funds

A. DEPOSITORY INSTITUTIONS

Commercial banks are the most important intermediaries. Commercial banks play a key role
in the financial system by taking in deposits from households and firms and investing most of those
deposits, either by making loans to households and firms or by buying securities such as government
bonds, or securitized loans.

Universal bank is also referred as a full-service financial institutions. It provides a large array of
services including those of commercial banks and investment banks.

The types of services offered include:

 Deposit accounts such as checking and savings

 Loans and credit
 Asset and wealth management
 Buying and selling securities
 Financial and investment advice
 Insurance products

Examples of universal banks:

 Deutsche Bank, ING Bank, UBS, Credit Service, HSBC, Banks of America, JP Morgan
Chase, Wells Fargo, BPI, BDO

Savings and Loans Associations, Mutual Savings Bank, Credit Unions are the other depository
institutions and are introduced in Module 2 – Lesson 2.

These financial intermediaries are legally different from banks, although these “nonbanks”
operate in a very similar way by taking in deposits and making loans.
 4

B. CONTRACTUAL SAVINGS INSTITUTIONS

These are financial intermediaries that receive payments from individual as a result of a
contract and uses the funds to make investments.

Insurance Companies specializes in writing contracts to protect policy holders from the risk of
financial losses associated with particular events, such as automobile accidents or fires. Insurance
companies collect premiums from policy holders, which the companies then invest to obtain the
funds necessary to pay claim to policy holders and to cover their other costs.

The insurance industry has two segments:

a) Life insurance companies sell polices to protect households against a loss of earnings
from the disability; retirement or death of the insurance person. Examples are Insular Life
Corporation and Philam Life Insurance Corporation.

b) Property and casualty companies sell policies to protect households and firms from the
risks of illness, theft, fire, accidents and natural disasters. Examples are Standard Insurance
Company and Malayan Insurance Corporation.

Pension funds is a financial intermediary that invests contributions of workers and firms in
stocks, bonds and mortgages to provide pension benefit payments during workers’ retirements.

For many people, saving for retirement is the most important form of savings. People can
accumulate retirement savings in two ways: through pension funds sponsored by employers or
through personal savings accounts. Most notable examples of pension funds are Social Security
System (SSS) for employees of private companies and Government Service Insurance System (GSIS)
for government employees.

The two basic types of pension plans are:

A. Defined contribution plan

B. Defined benefit plan

 Defined contribution plan has the following features:

(a) Employer places contributions from employer into investments such as mutual funds,
chosen by the employees. Employees own the value of the funds in the plan. They
also bear the risk of poor investment returns.

(b) If the employee’s investments are profitable, employer’s income during retirement
will be high. On the other hand if the employee’s investment are not profitable,
employee’s income during retirement will be low.

(c) Most private employers “defined contribution plans” in the United States are 401 (k)
plans. Some employers match employee’s contribution up to a certain amount.
Many 401 (k) participants invest through mutual funds, which enable them to hold a
large collection of assets at a modest cost.

 Defined benefit plan

(a) An employer promises employees a particular peso benefit payment, based on each
employee’s earnings and years of service. The benefit payments may or may not be
indexed to increase with inflation.

(b) If the funds in the pension plan exceed the amount promised, the excess remains with
the employer managing the fund.

(c) If the funds in the pension plan are insufficient to pay the promised benefit, the plan
is underfunded and the employer is liable for the different.
 5

C. INVESTMENT INTERMEDIARIES

In late 2016, Goldman Sachs begun engaging in fintech online lending, offering loans of up
to $30,000 to households with high credit card balances but good credit histories. In the late 1990s,
investment banks increased their importance as financial intermediaries by becoming heavily
involved in the securitization of loans, particular mortgage loans. Investment banks also begun to
engage in propriety trading, which involves earning profits buying and selling securities.

Mutual Funds. These financial intermediaries allow savers to purchase shares in portfolio of
financial assets, including stocks, bonds, mortgages, and money market securities. Mutual funds offer
savers the advantage of reducing transactions costs. Mutual funds provide risk-sharing benefits by
offering a diversified portfolio of assets and liquidity benefits because savers can easily sell the shares.
Moreover, the company managing the fund – for example, BPI Mutual funds, specializes in gathering
information about different investment.

Types of mutual funds:

1. Closed-end mutual funds

This mutual funds issues a fixed number of nonredeemable shares, which investors
may then rode in over – the counter markets just as stocks are traded. The price of a share
fluctuates with the market value of the assets – often called the net asset value (NAV) in the
fund.

2. Open – end mutual fund

This mutual funds issues share that investors can redeem each day after the markets
close for a price tied to the NAV.

Many mutual funds are called no-load funds because they do not charge buyers a
commission, or “load.” Mutual fund companies earn income on no-loads funds by charging
a management fee – typically about 0.5% of the value of the fund’s assets – for running the
fund. The alternative, called load funds, charge buyers a commission to both buy and sell
shares.

Hedge Funds are financial firms organized as a partnership of wealthy investors that make
relatively high risk, speculative investments. Hedge funds are similar to mutual funds in that they
accept money from investor and use the funds to buy a portfolio of assets. However, a hedge fund
typically has no more than 99 investors, all of whom are wealthy inviduals or institutions such as
pension funds. Hedge funds usually make riskier investments than do mutual funds, and they charge
investors much higher fees.

Finance Companies are nonbank financial intermediaries that raise funds through sales of
commercial paper and other securities and use the funds to make small loans to households and
firms? Finance companies raise funds by selling commercial paper (a short – term debt investment)
and by issuing stocks and bonds. They lend these funds to consumers, who make purchases of such
items as car, furniture and home improvements, and to small business. Some finance companies are
organized by a parent corporation to help sell its product.

The three main types of finance companies are:

A. Consumer Finance Companies

B. Business Finance Companies
C. Sales Finance Companies
 6

Consumer Finance Companies

 These companies make loans to enable consumer to buy cars, furniture and appliances;
to finance home improvement and to refinance households dept.
 Examples are Toyota finance company make loans to consumer who purchase Toyota
automobiles and mega world finance company who extend loans to purchases of mega
world condominium units.

Business Finance Company

 These companies engaged in factoring that is, purchasing at a discount the accounts
receivable of small business firms. Some business finance companies purchase expensive
equipment, such as airplanes or construction equipment and then leave the equipment
to firms over fixed length of time.

Sales Finance Companies

 These companies are affiliated with department stores and companies that manufacture
and sell high-priced goods.
 Large department stores issue credit cards that consumers can use to finance purchases
at those stores. Example is SM department store has established tie-ups with banco de
oro (BDO) – Credit Card Company. This convenient access to credit is part of the stores
marketing.

Money Market Mutual Funds. These are relatively new financial institutions that have the
attributes of a mutual fund but also function to some extent as a depositing institutions because they
offer deposit – type accounts. Like most mutual funds, they sell shares to acquire funds that are then
used to buy money market instruments that are both safe and very liquid. The interest on these assets
is then paid out to the shareholders.

PRIMARY ASSETS AND PRIMARY LIABLITIES OF FINANCIAL INTERMEDIARIES

The previous section discusses how financial intermediaries play an important role in the
economy. Now we look at the principle financial intermediaries and how they perform the
intermediation function. They fall into three categories: depository institutions (banks), contractual
savings institutions, and investment intermediaries. Figure 4-2 provides a guide to the discussion of
the financial intermediaries that fit into these three categories by describing their primary liabilities.

Figure 4-2: Primary Assets and Liabilities of Financial Intermediaries

Primary Liabilities Primary Assets

Type of Intermediary
(Sources of Funds) (Use of Funds)
Depository Institutions
Business and consumer loans,
mortgages, National
government securities and
Commercial Banks Deposits municipal bonds

Savings and Loan Associations Deposits Mortgages

Mutual Savings Bank Deposits Mortgages
Credit Unions Deposits Consumer Loans

Contractual Savings Institutions

 7

Corporate bonds and

Life Insurance Companies Premiums from policies mortgages
Government bonds,
Fire and Casualty Insurance corporate bonds and stock,
Companies Premiums from policies
National government
securities
Pension Funds, Government Employer and Employee
Retirement Funds Contributions Corporate bonds and stock

Investment Intermediaries
Mutual Funds Shares Stocks, bonds
Hedge Funds Shares Stocks, bonds, derivatives
Commercial paper, stocks,
Finance Companies bonds Consumer and business loans
Money Market Mutual Funds Shares Money Market Instruments
 8

ASSIGNMENT

R E V I E W Q U E S T I O N S

1. Describe the nature of the basic services of financial institutions.

2. What is considered the most important and significant financial

intermediary in our financial system.

3. Give some services offered by a universal bank.

4. What is the nature of the services of “Pension funds” as a financial

intermediary?

5. Give and explain briefly the three main types of finance companies.
 9

Lesson 2:
BASICS OF COMMERCIAL BANKING

Learning Objectives

After studying Lesson 2, you should be able to:

Discuss the primary sources and uses of funds of a commercial bank.

Enumerate and explain the basic and important assets of the commercial bank.
Enumerate and explain the basic liabilities of a commercial bank.
Explain how banks manage their assets, liabilities and capital
Explain how banks manage liquidity risk, credit risk and interest rate risk.

Introduction

Commercial banking is a business. Banks fill a market need by providing a service, and they
earn a profit by charging customers for that service. The key commercial banking activities are taking
in deposits from savers and making loans to households and firms. To earn a profit, a bank needs to
pay less for the funds it receives from depositors than it earns on the loans it makes. We begin our
discussion of banking by looking at a bank’s source of funds – primarily deposits – and uses of funds
– primarily loans.

THE BANK BALANCE SHEET

A bank’s sources and uses of funds are summarized on its balance sheet, which is a statement
that lists an individual’s or a firm’s assets and liabilities to indicate the individual’s or firm’s financial
position on a particular day. An asset is something of value that an individual or firm owns. A liability
is something that an individual or a firm owes, particularly a financial claim on an individual or a firm.
Bank capital also called shareholder’s equity is the difference between the value of the bank’s assets
and the value of its liabilities.

BANK ASSETS

Banks acquire bank assets with the funds they receive from depositors, the funds they borrow,
the funds they acquire from their shareholders purchasing the bank’s new stock issues, and the profits
they retain from their operations. The following are the most important bank assets:

1. Reserves and Other Cash Assets

 The most liquid asset that banks hold is reserves, which consist of vault cash – cash on
hand and in the bank (including in ATMs) or in deposits at other banks – and deposits
banks have with the BSP. As authorizes by the Congress, the BSP mandates that banks
hold a percentage of their demand deposits and NOW accounts (but not Money
Market Deposits Accounts (MMDAs)) as required reserves. Reserves that banks hold
over and above those that are required are called excess reserves.

2. Securities

 Marketable securities are liquid assets that banks trade in financial markets. Banks are
allowed to hold securities issues by the government. Treasury and other government
agencies, corporate bonds that received investment-grade rating when they were
first issued, and some limited amounts of municipal bonds, which are bonds issued by
state and local government.
 Because of their liquidity, bank holding of government treasury securities are
sometimes called secondary reserves. Commercial banks cannot invest checkable
 10

deposits in corporate bonds (although they may purchase them using other funds) or
in common stock in nonfinancial corporations.

3. Loans receivable

 By far the largest of bank assets is loans. Loans are illiquid relative to marketable
securities and entail greater default risk and higher information costs. As a result, the
interest rests banks receive on loans are higher than those they receive on marketable
securities.

1. Loans to business – called commercial and industrial, or C&I, loans

2. Consumer loans, made to households primarily to buy automobiles, furniture and

other goods

3. Real estate loans, which include mortgage loans and any other loans backed
with real estate as collateral. Mortgage loans made to purchase homes are
called residential mortgages, while mortgage made to purchase stores, offices,
factories, and other commercial buildings, are called commercial mortgages.

4. Other assets

 Other assets include banks physical assets, such as computer equipment and
buildings. This category also includes collateral received from borrowers who have
defaulted on loans.

BANK LIABILITIES

The most important bank liabilities are the funds a bank acquires from savers. The bank uses
the funds to make investments, for instance, by using bonds, or to make loans to households and
firms curtains advantages over other ways in which they might hold their funds. For the example,
compared with holding cash, deposits offer greater safety against theft and may also pay interest.
The following are the main types of deposit accounts:

a. Demand or Current Account Deposits

 Bank offer savers demands or current accounts deposits, which are accounts against
which depositors can write checks. Current account deposits come in different
varieties, which are determined partly by banking regulations partly by the desire
bank managers to tailor the checking accounts they offer to meet the needs the
households and firms. Demand deposits and NOW (negotiable order withdrawal)
accounts are the most important categories of checkable deposits.

 Demand deposits are current account deposits on which banks do not pay interest.
NOW accounts are checking accounts that pay interest. Businesses often holds
substantial balances in demand deposits because demand deposits represent liquid
asset than can be accessed with very low transactions costs.

b. Nondemand Deposits

 Savers use only some of their deposits for day to day transaction. Banks offer
nondemand deposits for savers who are willing to sacrifice immediate access to their
funds in exchange in higher interest payments.

 The most important types of nonstruction deposits are saving accounts, money
market deposits accounts (MMDAs), and time deposits, or certificates of deposit
(CDs).
 11

c. Borrowings

 Banks often have more opportunities to make loans than they can finance with funds
they attract form depositors. To take advantage of these opportunities, banks raised
funds from borrowing. A bank can earn a profit from this borrowing of the interest
rate it pays to borrow funds is lower than interest it earns by lending the funds to
households and firms.

 Borrowings include short-term loans in the BSP funds market, loans from a bank’s
foreign branches or others subsidiaries or affiliates, repurchase agreements, and
discount loans from the BSP. The federal funds market is the market in which banks
make short term loans – often just overnight – to other banks. Although the name
indicates the government money is involved, in fact, the loans in the federal market
involve the bank’s own funds.

BANK CAPITAL

Bank capital, also called shareholders’ equity, or bank net worth, is the difference between
the value of a bank’s assets and the value of its liabilities.

Illustrative Case: Constructing a Bank Balance Sheet

The following entries are from the actual balance sheet of a domestic bank:

In millions
Cash, including cash items in the process of collection P 121
Non-interest-bearing deposits 275
Deposits with the Bangko Sentral ng Pilipinas 190
Commercial loans 253
Long-term bonds (issued by the bank) 439
Real estate loans 460
Commercial paper and other short-term borrowing 70
Consumer loans 187
Securities 311
Interest-bearing deposits 717
Buildings and equipment 16
Other assets 685
Other liabilities 491

Required:

a. Use the entries to construct a balance sheet, with assets on the left side of the balance
sheet and liabilities and bank capital on the right side.

b. The bank’s capital us what percentage of its assets?

Solution:

Requirement A

Using the given information, the bank’s balance sheet will be presented as follows:
 12

Assets In millions Liabilities and Bank Capital In millions

Cash, including cash items in the
process of collection P 121 Non-interest-bearing deposits P 275
Deposits with the Bangko Sentral ng
Pilipinas 190 Interest-bearing deposits 717
Commercial paper and other
Commercial loans 253 short-term borrowing 70
Long-term bonds (issued by the bank)
Real estate loans 460 439
Consumer loans 187 Other liabilities 491
Securities 311 Total Liabilities P 1,992
Buildings and equipment 16 Bank capital 231
Other assets 685
Total Assets P 2,223 Total Liabilities and Bank Capital P 2,223

Requirement B

Calculation of the bank’s capital as a percentage of assets follows:

Total assets = P 2,223 million

Bank capital = P 231 million

Bank capital as a = P 231 million = 0.104 or 10.4%

percentage of assets P 2,223 million

BASIC OPERATIONS OF A COMMERCIAL BANK

Banks make profit through the process assets transformation: they borrow short (accept
deposit) and lend long (make loans). When a bank takes in additional deposit, it gains an equal
amount of reserves; when it pays out deposits, it loses an equal amount of reserves.

When a depositors puts money in a checking account and the bank uses the money to
finance loans, the bank has transformed a financial asset (a deposit) for a saver into liability (a loan)
for borrower. Like other businesses, a bank takes input, adds value to them, and delivers outputs. To
analyze further the basics of the banks operations, we will work with an accounting tool known as a
T- account, which shows changes in balance sheet items that result from particular transaction.

 To take a simple example, suppose you use 100 in cash to open a checking account at
Philippines= commercial bank (PCB) acquires 1,000 in vault cash, which it list as an asset and,
according to banking regulations, anytime and withdrawal your deposit, Philippines
commercial bank (PCB) list you 100 as a liability in the form if current account (CA) deposit.
We can use a T-account to illustrate the changes in PCB’s balance sheet result.

PCB
Assets Liabilities
Vault Cash + P 1,000 Current account deposits + P 1,000

 Note that PCB’s balance sheet will have much larger amounts of vault cash and
current account deposits than the 1,000 shown here. The t-account shown only the
changes in these items. Not their levels.
 13

 What happens to the 1,000 that you deposits in PCB? By answering this question, we can see
how a bank earn profit. Suppose that PCB held no excess reserves before receiving your 1000
deposit and that that banking regulations require banks to hold 10% of their current account
deposit as reserves. Therefore, 100 of the 1000 is required reserves, and the other 900 is excess
reserves, we rewrite the amount that PCB holds as reserves follows

PCB
Assets Liabilities
Vault Cash + P 1,000 Current account deposits + P 1,000
Excess reserves +P 900
 Reserves that a bank keeps as a cash pay no interest, and those the bank keeps in
deposit at the BSP pay a low rate of interest. In addition, current account deposit
generate expenses for the bank: the bank must pay interest to depositors and pay
the costs of maintaining checking accounts, including record keeping, operating a
web site, and servicing ATM’s. Therefore, the bank will typically want to use excess
reserves to make loans or buy securities to generate income. Suppose that bsp uses
its excess reserves to buy treasury bills worth 300 and make a loan worth 600. For
simplicity, the units in this example are very small. (Thinking In thousands of dollars
would be more realistic) we can illustrate these transaction with the following t-
account.

PCB
Assets Liabilities
Reserves + P 100 Current account deposits + P 1,000
Securities + P 300
Loans + P 600

 PCB has used you 1000 deposit to provide funds to the national treasury and to the
person or business it granted the loan to. By using your deposit, the bank acquired
interest-earning asset. If the PCB earns on the other costs of servicing your deposit,
then PCB will earn a profit on these transactions. The difference between the average
interest rate banks receive on their assets and the average interest rate they pay on
their liabilities is called the banks spread.

 To be successful, a bank must make prudent loans and investment so that it earns a high
enough interest rate to cover its cost and to make a profit. This plan may sound simple, but it
hasn’t been easy for banks to earn profit in the past decade.

MANAGEMENT OF BANK ASSETS

To maximize its profits, a bank must simultaneously seek the highest returns possible on loans
securities, reduce risk and make adequate provisions for liquidity by holding liquid assets.

Although more liquid assets tend to earn lower returns, banks still desire to hold them.
Specifically, banks hold excess and secondary reserves because they provide insurance against the
cost deposit outflow.

Banks try to accomplish these objectives by using the following strategy:

1. Banks try to find borrower who will pay high interest rates and will most likely settle their
loans on time. By adopting consecutive loan polices, banks avoid high default rate but
may miss out attractive lending opportunities that can earn high interest rates.

2. Banks try to purchase securities with high returns and low risk. By diversifying and
purchasing many different types of assets (short-term and long-term, treasury bills) banks
can lower risk associated with investment.
 14

3. Banks manages the liquidity of the assets so that its reserve requirements can be met
without incurring huge cost. This implies that liquid securities must be held even if they
earn somewhat lower return than other assets. The bank must balance its desire for
liquidity against the increased earnings that can be obtained from less liquid assets such
as loans.

MANAGEMENT OF BANK LIABLITIES

Before the 1960’s, bank liability management involved

a) Heavy dependence in demand deposit as sources of bank funds and,

b) Non-reliance on overnight loans and borrowing from other banks to meet their reserve needs

In the 60’s – large banks key financial centers such as New York, Chicago and San Francisco
in the United States. Begun to explore ways in which the liabilities on their balance sheets could
provide them with reserves and liquidity. Overnight loans market such as the federal funds market in
the United States expanded and new financial instruments enables to banks to acquire funds quickly.

Banks no longer depend on demand deposit as the primary source of bank funds. Instead
they aggressively set target goal in their asset growth and tried to acquire funds (by using liabilities)
as they were needed.

Hence, negotiable CD’s and bank borrowings greatly increased in importance as a source
of bank funds in recent years. Demand deposit have decreased in importance as source funds.

MANAGEMENT OF BANK CAPITAL

Banks manages the amount of capital they hold to prevent bank failure and to meet bank
capital requirements set by the regulatory authorities.

However, they do not want to hold too much capital because by so doing, they will lower
the returns by equality holders.

In determining the amount of bank capital, managers must decide how much of the
increased safety that covers with higher capital (the benefit) they are willing to trade off against the
lower return on equity that comes with higher capital ( the cost )

Because of the high cost of holding capital to satisfy the requirement by regulatory
authorities, bank managers often want to hold less capital than is required.

MANAGING BANK RISK

In addition to risk that banks may face from inadequate capital relative to their assets, banks
face several other types of risk. In this section, we examine how banks deals with the following three
types of risk: liquidity risk, credit risk, and interest-rate risk.

Managing Liquidity Risk

Liquidity risk is the possibilities that a bank may not be able to meet cash needs selling assets
or raising funds reasonable cost. For example, large deposit withdrawals might force as bank to sell
relatively illiquid securities and possibly suffer losses on the sales. The challenge to banks in managing
liquidity risk to reduce their exposure to risk without sacrificing too much profitability.

For example, a bank can minimize liquidity risk by holding fewer loans and securities and
more reserves. Such as strategy reduces the bank’s profitability, however, because the bank earns
no interest on vault cash only a low interest rate on its reserve deposits with the Fed. So, although the
 15

low interest rate environment during the years following the financial crisis caused many banks to
hold large amounts of excess reserves, more typically banks reduce liquidity risk through strategies
of asset management and liquidity management.

Managing Credit Risk

Credit risk is the risk that borrowers might default on their loans. One source of credit risk
asymmetric information, which often result in the problems of adverse selection and moral hazard.
Because borrowers know more about their financial health and their rule plan for using borrowed
money than do banks, banks may finds themselves inadvertently lending to poor credit risk or to
borrowers who intend to use borrowed funds for something other than their intended purpose. We
next briefly consider the different methods banks can use to manage credit risk.

a. Diversification investors – whether individuals or financial firms – can reduce their

exposure to risk by diversifying their holdings. If banks lend too much to one borrowers in
one industry, they are exposed to greater risk from those loans. For example, a bank that
had granted most of his loans to oil exploration and drilling firms in Texas would have likely
suffered serious losses on those loans following the decline in oil prices that begun in June
2014 and lasted through January 2016. By diversifying across borrowers, regions and
industries banks can reduce their credit risk.

b. Credit–Risk Analysis – in performing credit risk analysis, bank loan officers screen loan
applicants to eliminate potentially bad risk and to obtain a pool of credit worthy
borrowers. Individual borrowers usually must give loan officers information about their
employment, their current and projected profits and net worth. Banks often use credit
scoring system to predict statistically whether a borrower is likely to default. For example,
people who change jobs.

c. Collateral – to reduce problems of adverse selection, banks generally require that a

borrower put up collateral, or assets pledged to the bank in the event that the borrower
defaults. For example, if you are an entrepreneur who needs a bank loan to start business,
the bank will likely ask you to pledge some of your assets, such as your house, as collateral.
In addition, the bank might require you to maintain a compensating balance, a required
minimum amount that the business taking out loan must maintain in a checking out
account with the lending bank.

d. Credit Rationing - in some circumstances, banks minimize the cost of adverse selection a
moral hazard through credit rationing. In credit rationing, a bank either grants a borrowers
at the current interest rate. The first type of credit rationing occurs in response to possible
moral hazard by increasing the chance that the borrower will repay the loan to maintain
a sound credit rating.

e. Monitoring and Restrictive Covenant – to reduce the cost of moral hazard, banks monitor
borrowers to make sure they don’t use the funds borrowed to pursue unauthorized, risky
activities.

f. Long-Term Business Relationship – as we noted in the chapter opener, the ability of banks
access credit risk on the basis of private information on borrowers is called relationships
banking. One of the best ways for bank to gather information about a borrowers
prospects or to monitor a borrowers activities is through a long term business relationship.

Managing Interest-Rate Risk

Banks experience interest-rate risk if changes in market interest rates cause a bank’s profit or
its capital to fluctuate. The effect of a change in market interest rates on the value of a bank’s assets
and liabilities is similar to the market interest rate will lower the present value of a bank’s assets and
the liabilities, and a fall in the market interest rate will raise the present value of banks assets and
 16

liabilities. The effect of a change in interest rates on a banks profit depends in part on the extent to
which the bank’s assets and liabilities are variable rate or fixed rate.

Reducing Interest-Rate Risk

Bank manager can use a variety of strategies to reduce their exposure to interest rate risk.
Banks with negative gaps can make more adjustable rate or floating rate loans. That way, if market
interest rates rise and banks must pay higher interest rates on deposits, they will also receive higher
interest rates on their loans. Unfortunately for banks, many loans costumers are reluctant to take out
adjustable rate loans because while the loans reduce the interest rate risk banks face, they increase
the interest rate risk borrowers face.

Banks can also use interest-rate swaps on which that agree to exchange, or swap, the
payments from a fixed rate loan for the payment on an adjustable rate loan owned by a corporation
or another financial firm. Swaps allow banks to satisfy the demands of their loan costumer for fixed
rate loans while still reducing exposure to interest rate risk. Banks can also use futures contracts and
option contracts to help hedge interest rate risk.
 17

ASSIGNMENT

R E V I E W Q U E S T I O N S

1. What are the primary source and use of funds of a commercial banks?

2. Give and explain the nature of a commercial banks assets.

3. Give and explain briefly the primary liabilities of a commercial bank.

4. Discuss how compliance with reserve requirements of the BSP affects

the financial position of a commercial bank.

5. What basic strategy do commercial banks follows to maximize return

on its assets?
 18

Lesson 3:
EXPANDING THE BOUNDARIES OF BANKING

Introduction

The activities of banks have changed dramatically during the past five decades. Between
1960 and 2018, banks:

1. Increased the amount of funds they raise from time deposits and negotiable certificate
of deposits;
2. Increased their borrowings from repurchase agreements;
3. Reduced their reliance on commercial and industrial loans and on consumer loans;
4. Increased their reliance on real estate loans; and
5. Expanded into nontraditional lending activities and into activities where their revenue is
generated from fees rather than from interest.

OFF-BALANCE-SHEET ACTIVITIES

Banks have increasingly turned to generating fee income from off-balance-sheet activities.
Traditional banking activity, such as taking in deposits and making loans, affects a bank's balance
sheet because deposits appear on the balance sheet as liabilities, and loans appear as assets. Off-
balance-sheet activities do not affect the bank's balance sheet because they do not increase either
the bank's assets or its liabilities. For instance, when a bank buys and sells foreign exchange for
customers, the bank charges the customers a fee for the service, but the foreign exchange does not
appear on the bank's balance sheet. Banks also charge fees for private banking services to high-
income households.

1. Loan commitments. A bank earns a fee for a loan commitment. In a loan commitment, a
bank agrees to provide a borrower with a stated amount of funds during a specified period
of time. The fee is usually split into two positions:

a. Upfront fee when the commitment is written and

b. Non-usage fee on the unused portion of the loan.

Interest is charged for loans are actually made. It is usually marked up over a benchmark
lending rate.

2. Standby letters of credit. With a stand by letter of credit, the bank commits to lend funds to
the borrower the seller of the commercial paper- to pay off its maturing commercial paper.

This is also availed of in connection with importation of goods by the businessmen.

3. Loan sales. A loan sale is a financial contract in which a bank agrees to sell the expected
future returns from an underlying bank loans to a third party. Loan sales, also called
secondary loan participations involve sale of loan contract without recourse, which means
that the bank does not provide any guarantee on the value of the loan sold and no
insurance.

With securitization, instead of the bank holding the loans in their own portfolio, it converts
bundles of loans into securities that are sold directly to investors through financial markets.

Large banks sell loans primarily to domestic and foreign banks and to other financial
institutions.

4. Trading activities. Banks earns fees from trading in the multibillion - dollar markets for futures,
options, and interest-rate swaps. Bank trading in these markets is primarily related to hedging
 19

the banks' own loan and securities portfolios or to hedging services provided for bank
customers.

As the beginning of financial crisis of 2007-2009, most people were unfamiliar with such terms
are mortgage-backed securities (MBSs), collateralized obligation (CDOs), and credit default swaps
(CDDs).

During the financial crisis, these terms became familiar as economists, policymakers, and the
general public came to realize that commercial banks no longer played the dominant role in routing
funds from savers to borrowers. Instead a variety of "nonbank" financial institutions including
investment banks, mutual funds and hedge funds were acquiring funds that had previously been
deposited in banks.

They were then using these funds to provide credit that banks had previously provided. These
nonbanks were using newly developed financial securities that even long-time veterans of banking
did not fully understand.

These nonbank financial institutions have been labeled the "Shadow Banking" system
because while they match savers and borrowers, they do so outside the commercial banking
system.

In this chapter, we describe the different types of firms that make up the shadow banking
system.

INVESTMENT BANKS

Investment banks offer distinct financial services, dealing with larger and more complicated
financial deals than retail banks.

The smooth functioning of securities markets, in which bonds, stocks, and derivatives are
traded, involves several financial institutions including investment banks, securities brokers and
dealers and venture capital firms.

Investment banks assist in the initial sale of securities in the primary market, securities brokers
and dealers assist in the trading of securities in the secondary markets. Finally venture capital firms
provide funds to companies not yet ready to sell securities to the public.

ROLE OF INVESTMENT BANKS

Investment banks work with large companies, other financial institutions such as investment
houses, insurance companies, pension funds, hedge funds, governments, and individuals who are
very wealthy and have private funds to invest.

Investment banks have two distinct roles. The first is corporate advising, meaning that they
help companies take part in mergers and acquisitions, create financial products to sell, and bring
new companies to market. The second is the brokerage division where trading and market-making
in which the investment bank provides mediation between those who want to buy shares and those
who want to sell-take place. The two supposed to be separate and distinct, so within an investment
bank there is a so-called "wall" between these divisions to prevent conflict of interest.

An investment bank is a financial intermediary that performs various services, including

complex financial transactions as raising capital for corporations, governments or other entities,
underwriting, securities, facilitating mergers and other corporate reorganizations.

Investment banks employ professional investment bankers who help corporations,

governments and other groups plan and manage large projects saving their client time and money
by identifying risks associated with project before the client moves forward.
 20

Typical divisions within investment banks include

1. Industry Coverage Groups. Established to have separate groups within the bank each
having expertise in specific industries or market sections such as technology or health
care. They develop client relationships with companies within various industries to
bring financing, equity issue or merger and acquisition business to the bank.

2. Financial Products Groups. Provide investment banking financial products such as

IPOs, M&As, Corporation restructuring and various types of financing. There may be
separate product groups that specialize in asset financing, leasing, leveraged
financing and public financing.

TYPES OF FIRMS ENGAGED IN INVESTMENT BANKING

The classification of investment banks is primarily based on "size" which may refer to the size
of the banks in terms of the number of offices or employees or to the average size of M & A deals
handled by the bank.

 Bulge Bracket Banks

 Middle-Market Banks
 Boutique Banks

Discussion

a. Bulge Bracket Banks. The bulge bracket banks are the major, international investment
banking firms with easily recognizable names such as Goldman Sacks, Deutsche Bank, Credit
Suisse Group AG, Morgan Stanley and Bank of America. The bulge bracket banks are the
largest in terms of number of offices and employees and also in terms of handling the largest
deals and the largest corporate clients.

Each of the bulge bracket banks operates internationally and has the largest global as well
as domestic presence. They provide their clients with the full range of investment banking
services including

1. Trading, all types of financing, asset management services

2. Equity research and issuance
3. M&A services

Most bulge bracket banks also have commercial and retail banking divisions and generate
additional revenue by cross-selling financial products. One notable shift in that happened
after the financial crisis in the investment banking market place is the number of Fortune 500
and high- net-worth clients that opted to retain the services of elite boutique investment
banking firms over the bulge bracket firms.

b. Middle-Market Banks. Middle-market investment banks occupy the middle position

between smaller regional investment banking firms and massive bulge bracket investment
bank. They provide the same full range of investment banking services as bulge bracket
banks such as

1. Equity and debt capital market services

2. Financing and asset management services
3. M&A and restructuring deals

Deals could range from about $50 Million to $500 Million or more.

c. Boutique banks are further divided into:

1. Regional Boutique Banks. Smallest of the investment banks, both in terms of firm size
and typical deal size. They commonly serve smaller firms and organization but may
 21

have as clients major corporations headquartered in their areas. They generally

handle smaller M&A deals, in the range of $50 to $100 million or less.

2. Elite Boutique Banks. They are often like regional boutique in that they usually do not
provide a complete range of investment banking services and may limit their
operations to handling M&A related issues. They are more likely to offer restructuring
and asset management services. Most elite boutique banks begin as regional
boutiques and then gradually work up to elite status through handling successions of
larger and larger deals for more prestigious clients.

The other nonbank financial institutions (e.g., Mutual Funds, Hedge Funds and Finance
Companies) that make up the shadow-banking system are discussed in Module 4 – Lesson 1.

AREAS OF BUSINESS

While the brokerage and corporate advising divisions of an investment bank are theoretically
distinct, there is inevitably overlap between the two areas of, for example, market-making and
underwriting new share issue, or mergers and acquisitions advising and research.

A. Brokerage

 Proprietary trading. Investment banks have their own funds, and they can both invest
and trade their own money, subject to certain conditions.

 Acting as a broker. Banks can match investors who want to buy shares with
companies wanting to sell them, in order to create a market for those shares (known
as market-making).

 Research. Analysts look at economic and market trends, make buy or sell
recommendations, issue research notes, and provide advice on investment to high
net-worth and corporate clients.

B. Corporate advising

1. Bringing companies to market. Investment banks can raise funds for new issues,
underwriting Initial Public Offerings (IPOs) in exchange for a cut of the funds they
raised.
2. Bringing companies together. Banks facilitate mergers and acquisitions (M&A) by
advising on the value of companies, the best way to proceed, and how to raise
capital.
3. Structuring products. Clients who want to sell a financial product to the public may
bring in an investment bank to design it and target the retail or commercial banking
market.

HOW INVESTMENT BANKS MAKE OR LOSE MONEY

 Making money

 Banks receive fees in return for providing advice, underwriting services, loans and
guarantees, brokerage services, and research and analysis. They also receive
dividends from investments they hold, interest from loans, and charge a margin on
financial transactions they facilitate.
 22

 Losing money

 The advising division may end up holding unwanted shares if the take-up of an IPO is
lower than expected. The trading division of a bank may make the wrong decisions
and end up losing the bank money.

 In a year of little corporate activity, banks may have to rely on trading profits to bolster
their returns. Banks may create financial products which they fail to sell on to other
investors, leaving them holding loss-making securities or loans.
 23

ASSIGNMENT

R E V I E W Q U E S T I O N S

1. Give and explain the major activities of banks for the last 5 decades.

2. What is meant by "off-balance-sheet" activities of commercial banks? Give

examples.

3. Why are investment banks considered engaged in "shadows banking"?

4. What are sources of income of investment banks?

5. Distinguish between the industry coverage groups and financial services

group within the organization of investment banks.