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14. Nonbank Financial Institutions

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14. Nonbank Financial Institutions Powered By Docstoc
					Arab Academy for Science and Technology
Graduate School of Business
MBA- Financial Markets & Institutions




                                    Nonbank Financial Institutions 1
.Non bank financial institutions play an important role in channeling funds from investors
(lenders/savers) to end users/ producesrs (borrower –spenders).

The process of financial innovation has increased the importance of nonbank financial
institutions.through which the non bank financial institutions now compete with banks by
providing financial banklike services to their customers

Non-Banking market institutions:

The financial system has developed a wide variety of financial institutions to provide for
specialized financial needs. Many were developed because commercial banks initially did not
serve all financial markets. In particular, commercial banks initially concentrate on making
commercial loans and serving the needs of commercial customers . This mean that they did
not adequately serve the needs of “ small” savers , of home buyers, or borrowers.

Mutual Funds:

Mutual funds are financial intermediaries that pool the resources of many small investors by
selling them shares and using the proceeds to buy securities.

           I) Open–end fund: from which shares can be redeemed at anytime at a price
              that is tied to the asset value of the fund.

           II) Closed–end fund: in which a fixed number of no redeemable shares are sold at an
               initial offering and then traded in the over-the-counter market like a common
               stock .

Pension funds:

In performing the financial intermediation function of asset transformation, pension funds
provide the public with another kind of protection: income payments on retirement.
Employers , unions , or private individuals can set up pension plans, which acquire funds
through contributions paid in by the plan’s participants.

Because the benefits paid out of the pension fund each year are highly predictable , pension
funds invest in long-term securities. Therefore , pension fund managers try to hold assets with
high expected return and lower risk through diversification.

Insurance Companies

Insurance companies obtain funds by selling insurance policies that protect against loss of
income from premature death or retirement. In the event of death, the policyholder’s

1
    Excerpts from Chapter “ Nonbank Financial Institutions” of “The Economics of Money , banking & Financial
Institutions” by Fredric S. Mishkin, 4th Edition
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Arab Academy for Science and Technology
Graduate School of Business
MBA- Financial Markets & Institutions


beneficiaries receive the insurance benefits, and with retirement the policyholder receives the
benefits. In addition to risk protection, many life insurance policies provide some savings.

Because life insurance companies have a predictable inflow of funds and their outflows are
actuarially predictable, they are able to invest primarily in higher yielding, long term assets ,
such as corporate bonds and stocks. Stock companies are owned by stockholders; mutual are
technically owned by policyholders. Life insurance companies are regulated by the states in
which they operate, and, compared to deposit-type institutions , their regulation is less strict

Securities market institutions:

The smooth functioning of securities markets, in which bonds and stocks are issued and
traded , involves several financial institutions , including securities brokers and dealers ,
investment banks , and organized exchanges. They are important in the process of channeling
funds from savers to spenders. 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.

Investment banks:

When a corporation wishes to raise funds , its normally hires the services of an investment
bank to help sell its securities. Some of the well-known investment banking firms are Morgan
Stanley , Merrill Lynch & Salomon Brothers. They advise the corporation on whether it
should issue bonds or stock. When the corporation decides which kind of financial instrument
it will issue , it offers them to underwriters – investment banks that guarantee the
corporation a price on the securities and then sell them to the public.

Securities Brokers and (Dealers)

Security Brokers conduct trading in secondary markets. Brokers are pure middlemen who act
as agencies for investors in the purchase or sale of securities. Their function is to match
buyers with sellers, a function for which they are paid brokerage commotion. In contrasts to
brokers, dealers link buyers by standing ready to buy and sell securities at given prices.
Therefore dealers hold inventories of securities and make their living by selling these
securities for a silently higher price than they paid for them- that is, on the “spread” between
the asked price and the bid price. This can be a high-risk business because dealers hold
securities that can rise or fall in price; in recent years, several firms’ specialization in bonds
have collapsed. Brokers by contrast, are not as exposed to risk because they do not own the
securities involved in their business dealings.

Organized Exchanges

Secondary markets can be organized either as over-the-counter markets, in which trades are
conducted using dealers, or as organized exchanges, in which trades are conducted in one
central location.




                                                                                                2
Arab Academy for Science and Technology
Graduate School of Business
MBA- Financial Markets & Institutions

Organized stock exchange actually function as a hybrid of an auction market (in which buyers
and sellers trade with each other in a central location) and a dealer market (in which dealers
make the market by buying and selling securities at given prices). Securities are traded on the
floor the exchange with the help of a special kind of dealer-broker called a specialist.

Clearing, Settlement , Central Depository& Custody for Securities:

    1. Clearing agent: the institution role is to accept , record and report trade obligation
       received from the trading source. The Clearing Agent should maintain lists of failed
       obligations , calculate , monitor, and manage risk. In addition , the settlement
       instructions should be prepared with delivery of securities taking place on settlement
       date. Any default situations as a result of insufficient securities or insufficient funds
       need to be managed and resolved promptly without injury to either buyer or seller. To
       sum up , Clearance proves that the buyer and seller are committed for the transaction.
    2. Depositary: the depository should act as custodian of the securities on behalf of its
       members and should report activity and closing position information. Corporate
       Action announcements and payments should also be a part of this functionality. Book
       entry transfer of security positions must be allowed on a delivery versus payment
       basis.
    3. Registry: this entity maintains the books and records of the shareholders on behalf
       of its issuers and provides corporate action announcement and payment information
       to the investors and to the depository. The Registry provides any change in ownership
       information, such as name and address changes as well.
    4. Settlement: the role of this process is to make sure that the cash was transferred to
       seller and securities was transferred to the buyer.

Securitization companies

Securitization of assets refers to the issuance of securities that have a pool of assets as
collateral. The Securitization of home mortgage loans to create mortgages-backed securities
was the first example of this process. More recently, investment banking firms and other
private entities can create mortgage-backed securities that are not guaranteed by the
government or a government agency.

Financial leasing companies
Financial leasing companies are defined to mean non-banking financial institutions that
engaged primarily in financial leasing operations. “Financial leasing operations” are defined
to mean transactions wherein the Lessor purchases equipments to be leased from the seller
based on the lessee’s selection of the seller and the equipments to be leased, provides the
equipments to the lessee and collects rentals from the lessee. The transaction lets the lessee
obtain the rights of possession, use and benefit of the leased equipments during the term of
the leasing contract under the condition that the Lessor retains ownership and collects rentals.

Rating Agencies
Theses agencies provide creditworthiness reporting on companies that intend to issue bonds.
The rating could be of the issue or the issuer. Following is the international symbols used by
rating agencies.



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Arab Academy for Science and Technology
Graduate School of Business
MBA- Financial Markets & Institutions

Bond issuers are required to inform their investors of the rating they acquire from rating
agencies. The rating report is disclosed as part of the prospectus. The rating is renewed every
year to reflect any changes in the creditworthiness of the issuing company.




LONG TERM BOND RATINGS

   Moody's           S&P            Fitch           DCR                  Definitions
    Aaa              AAA            AAA             AAA            Prime. Maximum Safety

      Aa1            AA+            AA+             AA+           High Grade High Quality
      Aa2            AA             AA              AA
      Aa3            AA-            AA-             AA-

       A1             A+             A+              A+             Upper Medium Grade
       A2             A              A               A
       A3             A-             A-              A-

     Baa1           BBB+           BBB+            BBB+             Lower Medium Grade
     Baa2           BBB            BBB             BBB
     Baa3           BBB-           BBB-            BBB-

      Ba1            BB+            BB+             BB+            Non Investment Grade

      Ba2            BB             BB              BB                   Speculative
      Ba3            BB-            BB-             BB-

       B1             B+             B+              B+              Highly Speculative
       B2             B              B               B
       B3             B-             B-              B-

     Caa1           CCC+            CCC             CCC                Substantial Risk

     Caa2           CCC               -               -               In Poor Standing
     Caa3           CCC-              -               -




                                                                                             4
 Arab Academy for Science and Technology
 Graduate School of Business
 MBA- Financial Markets & Institutions


 Finance companies 2

 These companies raise funds by issuing financial tools, stocks, bonds, and use the
 proceeds to make loans that are particularly suited to consumers and business needs.
 Virtually unregulated in comparison to commercial banks and thrift institutions,
 finance companies have been able to tailor their loans to customer needs very quickly
 and have grown rapidly. Because commercial finance companies typically offer only
 loans secured by commercial assets, these institutions are used primarily by
 established businesses, not startups.

 There are three types of finance companies

       A) Sales finance companies:
           Are owned by a particular retailing or manufacturing company and make loans
          to customers to purchase items from that company. Sales finance companies
          compete directly with banks for consumer loans and are used by consumers
          because loans can frequently be obtained faster and more conveniently at the
          location where an item is purchased.
       B) Consumer finance companies:
          Make loans to consumer to buy particular items such as furniture or home
          appliances. Consumer finance companies are separate corporation or are owned
          by banks. Typically , these companies make loans to consumers who cannot
          obtain credit from other sources and charge high interest rates.
       C) Business finance companies :
          Provide specialized forms of credit to business by making loans and purchasing
          A/R at a discount ; this provision of credit is called factoring. Beside factoring,
          business finance companies also specialize in leasing equipment , which they
          purchase and then lease to business for a set number of years.




  2
      The Egyptian Market doesn’t know this type of companies.
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