FINANCIAL INSTITUTIONS

Economic System
Economic System deals with procurement of right amount of scarce resources to provide the raw materials of production and combining the same at the right time with labor, management, and capital to generate the products and services demanded by the consumers.
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Economic System
In short, any economic system must combine inputs- land and other natural resources, labor and management skill, and capital equipment to produce output: goods and services.

A Transformation of the Economy

TYPE OF ECONOMY AGRICULTURE INPUTS PROCESS OUTPUTS INNOVATION

LAND, LABOR CAPITAL

CULTIVATION

CROPS

USE OF ANIMALS MECHANISATION MECHANISATION RESEARCH (S & T) SPECIALIZATION

INDUSTRIAL

LAND, LABOR CAPITAL ENTREPRENEURS TECHNOLOGY

MANUFACTURING PROCESSING

CAPITAL ASSETS INDUSTRIES PHYSICAL PRODUCTS KNOWLEDGE PRODUCTS KNOWLEDGE INDUSTRIES KNOWLEDGE CAPITAL

INFORMATION

LAND, LABOR CAPITAL ENTREPRENEURS TECHNOLOGY INFORMATION KNOWLEDGE

MANIPULATION CONTROL

INFORMATINALISM VIRTUAL PROCESSES NETWORKS

Financial System
The financial system provides the essential channel necessary for the creation and exchange of financial assets between savers and borrowers so that real assets can be acquired.

Primary functions of financial systems.

To facilitate the trading, hedging, diversifying and pooling of risks; To allocate resources; To monitor managers and exert corporate control; To mobilize savings; To facilitate the exchange of goods and services; To accumulate capital and promote technological innovation.
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Primary functions of financial systems Contd.

The financial system determines both the cost of credit and how much credit will be available to pay for the thousands of different goods and services that are transacted daily.

Market
In most economies around the world, markets are used to carry out this complex task of allocating resources and producing goods and services. Market is an institution set up by society to allocate resources that are scarce relative to the demand for them. Markets are the channel through which buyers and sellers meet to exchange goods, services and resources.
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Market
There are essentially three types of markets at work within the economic system. These are:

Factor markets; Product markets, and Financial markets.

Factor Markets
In factor markets, consuming units sell their labor and other resources to those producing units offering the highest prices. The factor markets allocate factors of production land, labor, and capital and distribute incomewages, rental payments , and so on to the owners of productive resources.
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Product Markets
In product markets consuming units use most of their income from factor markets. They buy, among other things, food, clothing, shelter, automobiles, Medicare and other services sold in product market.

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Financial Market
The financial market performs a vital functions within the economic system. The financial market channel savings to those individuals and institutions needing more funds for spending that could not be met out of their current income.

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Types of Financial Transactions

Direct finance- there is no intermediary between borrower and lender; Semi-direct financethere exists an intermediary for a very brief period but ultimate obligation between the borrower and lender, and Indirect finance- no relationship exists between the ultimate borrower and lender. All risks including credit risks are borne by intermediary.
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Categories of Financial assets

Cash and bank deposit; Quoted govt. stock & bonds; Quoted corporate shares & bond; Mutual fund/unit trust units Security of unlisted companies Unquoted stock and bonds; Derivatives.
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Features of Financial Instruments

A form of document; Marketable/liquid Have general acceptability as a store of value; Debt instruments require credit rating; Secured by charge of substantial assets; Generally made homogenous; Easily understandable; Standard form; Standard issuers obligation; Quality and price of instrument is known.

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Types of Shares
Ordinary Shares Preference shares

Ordinary Shares/Stock
Smallest unit of capital. variable-income security since dividend is not specified and guaranteed and declaration of which depends on board of directors. dividends may be increased or decreased, depending on earnings. represents equity or ownership. includes voting rights. Priority: lower than debt and preferred. Bundle of shares is called stock.

Components of Shareholders Equity

Book Value Formula: Cumulative retained earnings +Capital Contributed in excess of par i.e premium + face value/paid up value BOOK VALUE OF THE EQUITY

Preferred/Preference Shares
A hybrid security: its like common stock - no fixed maturity. technically, its part of equity capital. its like debt - preferred dividends are fixed. missing a preferred dividend does not constitute default, but preferred dividends are cumulative. Priority lower than debt security but higher than ordinary shares.

Preference Shares
Cumulative preference shares Non-cumulative preference shares Redeemable preference shares; Non-redeemable preference shares; Convertible preference shares; Non-convertible preference shares; Participating preference shares; Non-participating preference shares.

Rights of Ordinary Shareholders as specified in Companies Act, 1994

Right to request a copy of the M/A and a copy of A/A by paying taka fifty or lesser fee as may be fixed by the company and company shall within fourteen days from the date of request send the copy to the member.

Debenture/Bonds
Means a financial obligation of an entity that promises to pay a specified sum of money at specified future date under stated conditions. Debenture- the smallest unit of unsecured loan Bond- the smallest unit of secured loan.

Liabilities, or publicly traded IOUs

Also called fixed income securities since payments are fixed amounts Borrower agrees to repay a fixed amount of principal at a predetermined maturity date Borrower agrees to pay a fixed amount of interest over a specified period of time

Attributes that affects bonds value

Length of Time to Maturity Coupon Rate Call Provisions Tax Status Marketability Likelihood of Default

Bonds Versus Stocks

Compared to stocks, bonds offer lower returns
Main benefits of bonds in portfolio:

Lower risk High levels of current income Diversification

Bonds add an element of stability to a portfolio

Bonds and Risk

Interest Rate Risk is the chance that changes in interest rates will affect the bonds value
Purchasing Power Risk is the chance that bond yields will lag behind inflation rates

Business/Financial Risk is the chance the issuer of the bond will default on interest and/or principal payments
Liquidity Risk is the risk that a bond will be difficult to sell at a reasonable price

Call Risk is the risk that a bond will be called (retired) before its scheduled maturity date

Essential Features of a Bond

Coupon is the amount of annual interest income
Principal (par value) is the amount of capital that must be repaid at maturity Maturity Date is the date when a bond matures and the principal must be repaid Term Bond is a bond that has a single maturity date Serial Bond is a bond that has a series of different maturity dates Note is a debt security originally issued with a maturity of from 2 to 10 years

Essential Features of a Bond (contd)

Call feature allows the issuer to repurchase the bonds before the maturity date

Freely callable Noncallable Deferred call

Call premium is the amount added to bonds par value and paid upon call to compensate bondholders
Call price is the bonds par value plus call premium

Refunding provision prohibits the premature retirement of an issue from proceeds of a lower-coupon refunding bond

Essential Features of a Bond (contd)

Sinking fund stipulates how a bond will be paid off over time

Applies only to term bonds

Issuer is obligated to pay off the bond systematically over time

Types of Secured Debt

Secured debt is backed by pledged collateral.
Senior bonds are backed by legal claim to specific assets. Mortgage bonds are backed by real estate. Collateral trust bonds are backed by securities (stocks, bonds) held in trust by a third party. Equipment trust certificates are backed by specific pieces of equipment, such as railcars or airplanes.

Types of Unsecured Debt

Unsecured debt is backed only by the promise of the company to pay.
Junior bonds are backed only by promise and good faith of the issuer to pay. Debenture is an unsecured (junior) bond. Subordinated debentures are unsecured bonds whose claim is secondary to other claims. Income bond requires interest to be paid only after a specific amount of income has been earned.

Principles of Bond Price Behavior

Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates.
Longer maturities move more with changes in interest rates.

Premium bond has a market value that is above par value.

Occur when market interest rates are below bonds coupon rate

Discount bond has a market value that is below par value.

Occur when market interest rates are above bonds coupon rate

The Market for Debt Securities

Bonds are traded mainly over-the-counter.
Bond price activity is remarkably stable compared to stock market.

Bond market is larger than the stock markets of numbers of developed jurisdictions
Bond market is growing rapidly.

Treasury Bonds
Considered risk freeno risk of default Sold in Tk 100,000 denominations Types of Treasury Bonds

Govt/Treasury notes: mature in over 1year to 10 years coupon bearing Treasury bills: mature in 4 weeks to one year issued at discount Govt. Bonds: over 10 years either coupon bearing or deep discount

Agency Bonds
Issued by government agencies

House Building Finance Corporation Bond Biman Bangladesh Corporation Bond; Agrani Bank Industrial Bond etc. High quality securities with almost no risk of default

Interest rates usually higher than Treasury issues

Municipal Bonds

Issued by states, counties, cities, city corporations and any other political subdivision or local authority Issued to fund public projects Two basic types

General obligation bonds are paid from general fund of the issuer Revenue bonds are paid from revenues from the project being financed

Often guaranteed by private insurers to lower risk and interest rates

Municipal Bonds
Interest is tax-exempt for Federal taxes.
Yield on municipal bond Taxable equivalent yield = 1 - Federal tax rate

Interest can be tax-exempt from state taxes

Corporate Bonds
Issued by companies registered under the Companies Act, 1994
Provide higher returns than government bonds due to higher risk of default Wide variety of bond quality and bond types available

Zero-Coupon Bonds
Do not pay interest
Sold at deep discount from par value Value increases over time

Subject to tremendous price volatility as interest rates fluctuate

Interest must be reported as it is accrued for tax purposes, even though no interest is actually received.

Mortgage-Backed Securities
Bond backed by pool of residential mortgages
Principal and interest are paid monthly Governmental agencies are major issuers: In USA following authorities issue these types of securities: Government National Mortgage Association (GNMA) Federal Home Loan Mortgage Corporation (FHLMC) Federal National Mortgage Association (FNMA)

Self-liquidating investment since portion of principal is received each month

Collateralized Mortgage Securities

Mortgage-back bond pool that is divided into tranches, or classes of investors
All principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid Allows investors to choose short-term, mediumterm or long-term investment

Potentially complex; interest rate fluctuations may have significant impact upon bond prices

Asset-Backed Securities
Issued by corporations and backed by pools of loans

Auto loans Credit card loans Home equity loans

Provide relatively high yields

Short maturities, typically 3 to 5 years

Interest and principal payments are monthly High credit quality In Bangladesh number of financial institutions issued asset backed securities obtaining consent from SEC Bangladesh

Junk Bonds (High-Yield Bonds)

Highly speculative, usually subordinated debentures
Have low, sub-investment grade ratings

Typically offer very high yields

Prices tend to behave more like stocks than bonds

Global Bonds
Potentially higher returns than bonds issued at local jurisdictions
Offer broader diversification opportunities

Interest rate trends in other countries may not follow home country rates Currency exchange rate fluctuations can impact returns in local currency

Dollar-Denominated Bonds
Bonds issued by foreign governments or corporations and denominated in dollars
Based on U.S. dollars Yankee bonds are registered with the SEC and issued and traded in U.S. Eurodollar bonds are not registered with the SEC and are issued and traded outside of the U.S. No currency exchange rate risk since bonds are in U.S. dollars

Foreign-Pay Bonds
Bonds issued by foreign governments or corporations
Based on currency other than U.S. dollars

Subject to currency exchange rate risk

Cost of financial intermediation

Brokerage cost- fee charged by the broker for execution of order or transaction; Evaluation cost- cost of feasibility study, inspection, survey carried out by FIs to assess the creditworthiness of the loan applicant or borrower; Cost of monitoring performance- cost of supervision. Supervision is necessary to ensure that the money borrowed has actually been used for the purposed for which it was obtained/ sanctioned; Cost of enforcing the contract litigation cost for enforcing the contract.
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Risk Free Assets - Features

Fixed Income- there is certainty of return; No possibility of default- the borrower will be able to pay back the principal and pay interest; No interest rate risk interest rate is fixed; and No reinvestment risk interest or return received could be invested at rate similar to original investment.
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Risk Free Assets

An investment with a certain rate of return and no chance of default. Although various investment [for example, saving accounts and certificates of deposit at insured institutions] meet these requirements, a Treasury bill is the most common example of risk free investment.

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Risk Premium

The extra yield over the risk free rate owing to various types of risk inherent in a particular investment. For example, any issuer other than the Govt. usually must pay investors a risk premium in the form of a higher interest rate on bonds/loans to account for the fact that the risk of default is less on Govt. securities than on securities of other issuers.
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Investment

Property acquired for the purpose of producing income for the owner. Just as plants and equipment are investment for manufacturers, stocks and bonds are investments for individuals and institutions. Investment is essentially expenditures made for income producing assets.

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Types of Investor
True Investor investment held for a lengthened period for getting dividend and/ or capital gain; Speculator- A person who is willing to take a large risks and sacrifice the safety of principal in return for potentially large gains. Certain decisions regarding securities clearly characterize a speculator. For example, purchasing a very volatile stock in hopes of making a quick profit based on speculation. Arbitrageur-one who engages in arbitrage. Arbitrage is the simultaneous purchase and sale of substantially identical assets in order to profit from a price difference between two assets. The price difference must be sufficiently great to offset commissions. Hedger- one who engages in security transaction that reduces the risk on an already existing investment position. An example is the purchase of a put option in order to offset at least partially the potential losses from owned stock.
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Efficient Market -Features

Allocationally Efficient i.e distributes funds to the most promising investments; Internally efficient i.e. - Broker/dealer compete fairly; - Low transaction cost; - High speed transactions By searching for inefficiencies, investor ensure market efficiency.
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Asymmetric Information
Asymmetric information: Much of the information used to value securities issued by firms is provided by the managers of those firms. A firm s managers possess information about its financial condition that is not necessarily available to investors. This situation is referred to as asymmetric information. In an information asymmetry situation one party does possess insufficient knowledge about the other party involved in a transaction that result in inaccurate decision on his part. Asymmetric information problems occur before the transaction occurs.

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Asymmetric Information
Due to information asymmetry investor makes adverse selection i.e. chooses alternative investment opportunity that is not the best alternative investment opportunity; meaning the investment might be a bad credit risks in the market place that would result moral hazard.

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Money
A generally accepted medium for the exchange of goods and services, for measuring value, or making payments. Money is a legal tender as defined by a government and consisting of currency and coin. In a more general sense, money is synonymous with cash, which includes negotiable instruments, such as checks, based on bank balances.

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Evolution of money
Barter system; Precious gem/pearl; Gold/ silver; Paper money; Electronic money-smart card, credit/debit card; Cyber cash- where a customer can have money transferred from his normal bank account to an electronic money account.
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Functions of Money
Standard of value or unit of account; Medium of exchange; Store of value; Only perfectly liquid asset.

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Money Supply
The amount of money that is in circulation in an economy. There are alternative definition of money supply. Narrow definitions of money include assets that immediate liquidity. Broad definitions of money include assets that are somewhat less liquid. Various definitions/alternative forms are- Mo, M1, M2, M3, M4 and M5.

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Alternative forms of money

M0: Currency plus till money plus operational balance with reserve bank; M-1: The most restrictive measure of the domestic money supply that incorporates only money that is ordinarily used for spending on goods and services. M1 includes currency, checking account balances, and travelers checks. M-2: A measure of the domestic money supply that includes M-1 plus saving and time deposits, overnight repurchase agreements and personal accounts of money market accounts. Basically, M2 includes money that can be used for spending plus items that can quickly be converted to M1. M-3: A very broad measure of domestic money supply that includes M-2 items plus any large time deposits and money market fund balances held by institutions. L: M-3 plus other liquid assets viz. Treasury bills, saving bonds, commercial papers, bankers acceptances, Eurodollar holdings citizens.

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Money Market
The money market is a market for financial assets that are close substitutes for money and that mature in one year or less. Its basic function is to maximize the satisfaction of financial asset holders and debt issuers.
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Money Market Contd.

It is a market for short term debt instruments, negotiable certificates of deposit, commercial paper, banker acceptances, repurchase agreements, Treasury bills, and discount notes of the Quasi Sovereigns. These instruments have better safety and liquidity over capital market instruments.

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Money Market Contd.

Money markets trade instruments with maturities < 1 year

Market segments include

Interbank market (clearing or settlement balances) Overnight market (secured/unsecured call loans & repos) Term market (Treasury bills, bankers acceptances, commercial paper, asset-backed commercial paper, term repos, etc.)
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INTERBANK MARKET Funds held immediately prior to final settlement to enable banks Initial impact of Indirect Monetary to meet obligations to each other and to the central bank. Only Policy Instruments institutions with accounts at the CB & the CB participate.

CALL LOAN or REPO MARKET Market for funds with overnight maturity. Transactions take place during the day. Banks and large organizations participate. FOREIGN EXCHANGE MARKET

PRIMARY MARKET Initial sale of T-bills by the Governments agent, usually the CB. Sold by auction or tap issue.

TERM MONEY MARKET Market for funds with maturities >1 day and <1 year. Includes secondary market in T-bills & other paper. Banks & large financial organizations participate.

Liquidity of the Money Market affects the functioning of the Foreign Exchange Market.

Money Market liquidity and stabili affects the liquidity of the Bond Market. PRIMARY GOVERNMENT BOND MARKET BOND MARKET Market for paper of over 1 year remaining to maturity. Banks and other financial and institutional investors participate.

Initial sale of government bonds by Governments agent, usually the CB. Sold by auction or tap issue.

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Repurchase Agreement [Repos]

A word about repos

Buyer agrees to buy securities from the seller for a prespecified period of time, with an agreement upfront to resell them back to the seller at the pre-specified future date at a pre-agreed resale price. Difference between initial price and resale price reflects interest rate paid by seller for use of cash received. In effect, repos are equivalent to a collateralized loan Most transactions conducted under a single legal agreement between two partiesMaster Repurchase Agreement
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Benefits of Money Markets

More effective monetary policy
Promote financial stability & market development

Reduce cost of government borrowing

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Benefits: More effective monetary policy

Desired liquidity settings can be achieved without distorting prevailing market prices First step of transmission of monetary actions to economy Money market interest rates are a useful indicator of market expectations regarding future monetary actions

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Benefits: Promote financial stability & market development

Help financial institutions manage their short-term liquidity flows

Facilitate development of well-functioning debt, equity, and foreign exchange markets

Money markets enable market makers in other markets to fund their holdings of securities and foreign exchange so they can trade with other participants

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Benefits: Reduce cost of Govt. borrowing

Existence of liquid debt markets Reduce risk of auction failure (more certainty in funding) Lower borrowing costs (government captures liquidity premia)

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Financial Institutions
The institution that collect funds from the public to place in financial assets such as stocks, bonds, money market instruments, bank deposits, or loans. Financial institutions profit from the spread between the amount they pay for the funds and the rate they charge for the funds..
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Types of Financial Institutions

Depository: banks, savings and loans, saving banks, credit unions. Non-depository: insurance companies, mutual funds, pension funds.

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Characteristics of Depository Financial Institutions

They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units; Repackage funds received from deposits to provide loans of the size and maturity desired by deficit units; Accepts the risk on loans provided; Have more expertise in evaluating the credit worthiness of deficit units; Diversify their loans among numerous deficit units and can absorb defaulted loans better than individual surplus units.
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Characteristics Non-depository Financial Institutions

Non-depository: Non-depository FIs collects money by selling insurance policies or receiving employer contributions and pay it out for legitimate claims or for retirement benefits. Many institutions perform both depository and non-depository functions. For instance, brokerage firms very often place customers money in certificates of deposit and money market funds and sell insurance.
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The Principal Factors that Affect Investment Decision of FIs

The Expected Rate of Return; Degree of Tax Exposure; Exposure to Credit or Default Risk; Exposure to Liquidity Risks; Exposure to Call Risk; Exposure to Prepayment Risk; Exposure to Inflation Risk; Desired Maturity Range.
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