Financial Intermediaries - Business Finance - ثاني ثانوي

PL 58 " Link digitalest 2.2 Financial Intermediaries www.en.edu.sa Key Terms Money market mutual fund Commercial paper Repurchase agreement (repo) Banker's acceptances As has been discussed, one purpose of financial markets is to facilitate the transfer of funds from individuals (and firms and governments) with funds to invest to those individuals (and firms and governments) that need funds. One method is an indirect transfer through a financial intermediary such as a commercial bank. The other method is the direct investment in the firm by the general public. This transfer occurs when an individual starts a business and invests their savings in the operation. But the direct transfer is not limited to investing in one's own business. Firms (and governments) also raise funds by selling securities directly to the general public. Business Finance 2.2a The Investment Bank The majority of securities sales are executed through investment bankers. In effect, an investment banker serves as an intermediary that brings together individuals and investment companies with funds to invest and the firms that need financing. If this sale is the first sale of common stock, it is referred to as an initial public offering (IPO). The firm in need of funds approaches the investment bankers to discuss an underwriting. If the investment bankers guarantee the sale, they make a 'firm commitment' to raise a specified amount of money. In effect, the underwriters buy the securities with the intention to sell them to the general public. By agreeing to buy the securities, the underwriters guarantee the sale and bear the risk associated with the sale. A syndicate is a group of brokerage houses that join together to underwrite and market a specific sale of securities. The use of a syndicate has several advantages. The syndicate has access to more potential buyers, and using a syndicate reduces the number of securities that each firm must sell, which also increases the probability that the entire issue will be sold.

Why is investment often essential to help a business grow? Thus, syndication makes possible both the sale of a large offering and a reduction in the risk borne by each member of the selling group. If the investment bankers do not want to bear the risk of the sale, they can agree to sell the securities through a best efforts agreement. The investment bankers do not underwrite the sale and do not guarantee that a specified amount of money will be raised. Instead, the investment bankers agree to make their best efforts to sell the securities, but the risk of the sale is borne by the issuing firm. If the securities do not sell, the firm does not receive the funds. While most sales of new securities are by underwriting, small issues of risky securities are often best efforts sales. Because most sales of new securities are underwritings, the pricing of securities is crucial. If the initial offer price is too high, the syndicate will be unable to sell the securities. When this occurs, the investment bankers have two choices: (1) to maintain the offer price and to hold the securities in inventory until they are sold, or (2) to let the market find a lower price level that will induce investors to purchase the securities. Neither choice benefits the investment bankers. If the underwriters purchase the securities and hold them in inventory, they must either tie up their own funds, which could be earning a return elsewhere, or borrow funds to pay for the securities. Thus, the decision to support the offer price of the securities prevents the investment bankers from investing their own capital elsewhere or (more likely) requires that they borrow the funds. In either case, the profit margin on the underwriting is decreased, and the investment bonkers may even experience a loss on the underwriting. وزارة التعليم CHAPTLH 2 The Role of Financial Markets and Financial Intermediaries 59

ليم 帥 Instead of supporting the price, the underwriters may choose to let the price of the securities fall. The inventory of unsold securities can then be sold at the lower price. The underwriters will not tie up capital or have to borrow money from their sources of credit. If the underwriters make this choice, they force losses on themselves when they sell the securities at less than cost. But they also cause the customers who bought the securities at the initial offer price to lose. The underwriters certainly do not want to inflict losses on these customers, because the underwriters' market for future new security issues will vanish. Therefore, the investment bankers try not to overprice a new issue of securities, for overpricing will ultimately result in them suffering losses. There is also an incentive to avoid underpricing new securities. If the issue is underpriced, all the securities will readily be sold, and their price will rise because demand will have exceeded supply. The buyers of the securities will be satisfied, for the price of the securities will have increased as a result of the underpricing. The initial purchasers of the securities reap windfall profits, but these profits are really at the expense of the company whose securities were underpriced. If the underwriters had assigned a higher price to the securities, the company would have raised more capital. Business Finance 2.2b The Indirect Transfer Through Financial Intermediaries When new securities are issued, funds are directly transferred from savers to firms. While the ultimate effect is the same, the transfer through financial intermediaries is less direct. The funds are initially lent to the intermediary, and the intermediary subsequently lends the funds to the ultimate users (see Figure 2.7). To obtain the funds, the financial intermediaries create claims on themselves. This creation of claims is an important distinction. An investment banker facilitates an initial sale; securities brokers and secondary markets facilitate subsequent sales. Investment bankers, brokers, and securities exchanges do not create claims on themselves. They are not financial intermediaries but rather function as brokers who facilitate the buying and selling of new and existing securities. When a saver deposits funds in a financial intermediary such as a bank, that individual receives a claim on the bank (the account) and not on the firm (or individual or government) to whom the bank lends the funds. If

the saver had lent the funds directly to the ultimate users and they failed, the saver would sustain a loss. This loss may not occur if the saver lends the money to a financial intermediary. If a financial intermediary makes a bad loan, the saver does not sustain the loss unless the financial intermediary fails. Even then the saver may not sustain a loss if the deposits are insured. The combination of the intermediary's diversified portfolio of loans and the insurance of deposits has made financial intermediaries a primary haven for the savings of many risk-averse investors. Diversification is an important topic in finance. To tap these savings, a variety of intermediaries has evolved. These include commercial banks, savings and loan associations, mutual savings banks, and insurance companies. Many savers are probably not aware of the differences among these financial intermediaries. They offer similar services and pay virtually the same rate of interest on deposits. 晶 2.2c Commercial Banks In terms of size, commercial banks (such as the Saudi National Bank) are the most important depository institution. A hypothetical example of the total amount of deposits and loans made by commercial banks is given in Figure 2.8. Commercial banks' importance to business is evident, with loans to firms typically accounting for a substantial proportion of commercial banks' total assets. Commercial banks are also a prime source of funds to consumers. وزارة التعليم FIGURE 2.7 Direct and indirect Transfe CHAPTUH 2 The Role of Financial Markets and Financial Intermediaries 61

FIGURE 2.8 Exemple of Assets and Labilities of Commercial Ranks in ultions) Business Finance Most loans to firms and households are for à relatively short period (for instance, "short term" loans under one year, or "medium term" loans, over one and up to five years to maturity). Commercial banks tend to endorse loans that must be paid off ("mature") quickly. This emphasis on short maturities is the result of the rapid tumover of bank deposits (especially demand deposits) and the need for banks to coordinate their portfolios with changes in the economic environment and the level of interest rates. The primary liabilities of commercial banks are their deposits: checking accounts (demand deposits) and various types of savings and time deposits. Demand deposits are payable on demand. The owner of a checking account may demand Immediate cash, and funds in the account may be readily transferred by check. Typically, across the globe, savings accounts and money market accounts are interest bearing accounts. Funds deposited in a regular savings account may be withdrawn at will. The remaining liabilities of the commercial bank include other borrowings from a variety of sources. For example, commercial banks borrow from each other and borrow from the Saudi Central Bank. The last entry on the commercial bank's balance sheet in Figure 2.8 is stockholders' equity, which represents the stockholders' investment in the firm. Cash concy and coils cash msin pices, and deposits wiU Ueceral Dam Government securities 2615 14.5% 2.442.5 153 Cilier securities 899.5 5.6 Loans Commercial industral 2,096.9 13.1 4,131 258 Loans to and duals 13877 86 Inbank and other load 52:0 04 One assots 2.8393 180.148 100.0% Dumand dupts and sayings accounts 10,109 61% Large mine deposi 1,498-2 90 Oier oorrowings and alles 2,669.0 157 Equity (net worth 1,738 2 108 16018 100%

While Figure 2.8 shows the various sources of funds available to commercial banks, it also illustrates that the various types of deposits are typically the most important. Checking and savings accounts and time deposits constitute approximately 60% of the banks' sources of finance. The exhibit also indicates that total deposits greatly exceed stockholders' equity. Commercial banks have a large amount of debt outstanding when it is realized that the deposits are loans to the banks by households, firms, and governments. 2.2d Other Financial Intermediaries The following sections describe a range of other financial institutions and intermediaries that you may be likely to encounter. Mutual Savings Banks and Savings & Loan Associations Mutual savings banks and savings & loan associations (S&Ls) provide a place for savers, especially individuals with modest sums, to deposit funds. The money is then loaned to borrowers in need of the funds. A mutual savings bank is owned by its depositors, but the bank itself is managed by a board of trustees. While a mutual savings bank may view its depositors as owners and not creditors, the owners may readily withdraw their funds. Thus, mutual savings banks must have sufficient liquidity to meet withdrawals. Savings and loan associations developed primarily as a source of mortgage loans. Today the S&L has evolved into an institution that accepts deposits from anyone and makes a variety of loans. S&Ls, however, continue to place more emphasis on mortgage loans than do commercial banks. To attract deposits, S&Ls tend to pay a rate of interest that is slightly higher than the rates paid by commercial banks. Insurance Companies There are many insurance companies operating in Saudi Arabia, including Tawuniya and Al Rajhi Takaful, offering a wide range of insurance services. Some of these services are illustrated in Figure 2.9. Insurance companies can also act as financial intermediaries. Both individuals and organizations make regular payments, which are used as securities against a range of risks in divisions including cars and motor vehicles, home and property, travel, and healthcare. One particular way in which insurance companies might perform the role of a financial intermediary is by receiving the funds of savers, creating a claim on themselves, and then lending the funds to borrowers. The price of the insurance is related to the cost of the product, just as the cost of any service, such as an electrician, is related to the cost of producing the service. وزارة التعليم CHAPTER 2 The Role of Financial Markets and Financial Intermediaries 2822-1889 63

p 64 FIGURE 2.9 Some Types of Insurance Avariable Saudi Arab Insurance Travel Business Finance Pension Plans In line with the Saudi Vision 2030, a program of reform has been initiated to help improve efficiency of Saudi Arabia's pension administration, which includes a merger of GOSI (the General Organization for Social Insurance) and the Public Pension Agency. This is one of several measures being enacted across government organizations to reinforce Saudi Arabia's infrastructure for a successful and prosperous future. While the specific pension arrangements vary from country to country, according to a range of factors, the essential role of a pension plan is to accumulate assets for workers so that they will have funds for retirement. Funds are periodically put in the pension plan by the saver, the employer, or both. The money deposited with the fund then is used to purchase income-earning assets. The saver's funds grow over time as additional contributions are paid into the pension plan, and the funds already in the plan earn income and appreciate in value. Many pension plans exist, but few of them really perform the function of financial intermediaries. Many pension plans do not invest or lend the money directly to borrowers. Instead they may purchase existing securities, such as the stock of an oil company, for example; that is, the pension plan participates in the secondary, not the primary, market for securities. For a pension plan to serve as a financial intermediary, it must pass the funds directly to a borrower or invest them directly in a firm.

2.2e Money Market Mutual Funds and Money Market Instruments One of the most important financial institutions found around the world is the mutual fund that invests on behalf of individuals (see Figure 2.10). However, most of these funds are not financial intermediaries in the sense that they borrow from savers and lend the funds to the ultimate users. It is true that they do create claims on themselves, since investors own shares in the funds (in other words, the investors own equity claims). Whether the fund is a financial intermediary depends on what it does with the money raised by selling the shares: Does it acquire newly issued securities or buy previously issued securities? Mutual funds that invest on behalf of individuals are one of the most important financial institutions in the world If the fund buys securities in the secondary markets, it is not serving as a financial intermediary. No money is transferred to a firm, govemment, or individual seeking to borrow funds. Instead, the money is transferred to another investor who is seeking to liquidate a position in the particular security. Of course, a mutual fund could buy newly issued securities. Some funds specialize in purchasing shares of emerging and new firms, and to the extent that these funds participate in the primary market, they are operating as financial intermediaries. Other mutual funds specialize in government securities, which may be purchased when the bonds are issued. Such funds also serve as financial intermediaries, transferring the money of savers to the ultimate users of the money. Most mutual funds, however, do not serve as financial intermediaries, as they primarily buy and sell existing securities. وزارة التعليم FIGURE 2.10 Money Market Mutual Funds CHAPTUH 2 The Role of Financial Markets and Financial Intermediaries 65

Mong market mutual An investment comparty that invests solely in short term money market instruments Comercial pap Unsecured short-term promissory notes issued by the most creditworthy corporations Reporches agreement The sale of a short-term security in which the seller agrees to buy back the security at a specified price at a specified date Even though most mutual funds are not financial intermediaries, there is one major exception-the money market mutual fund that acquires short-term securities. While these are secondary markets in some money market instruments, money market mutual funds tend to acquire newly issued short-term debt instruments. These securities are then held until they are redeemed at maturity, at which time the process is repeated. The worldwide development of these funds and their explosive growth was one of the most important developments in the financial markets. This immediate popularity may be explained by three factors: safety of principal, liquidity, and interest rates that exceed the rates paid by banks. The shares are safe since the money funds acquire short-term debt obligations whose values are subject to minimal price fluctuations. In addition, these debt obligations tend to have high credit ratings, so there is minimal risk of default. Individuals may withdraw money invested in the money funds (that is, redeem shares) at will. This ease of converting to cash with minimal chance of loss means these shares are among the most liquid assets available to savers. The money funds invest in a variety of short-term securities. Other money market instruments, which can vary from country to country, include the short-term debt of the government (Treasury bills), commercial paper issued by corporations, repurchase agreements (commonly referred to as repos), and banker's acceptances. Of course, the individual investor may also directly acquire these securities, but the large denomination of some short-term securities excludes most investors. Commercial paper is an unsecured short-term note issued by a corporation as an alternative to borrowing funds from commercial banks. Since the paper is usually unsecured, only firms with excellent credit ratings are able to sell it; hence, the risk of default is small, and the repayment of principal is virtually assured. A repurchase agreement (repol is a sale of a security in which the seller agrees to buy back (repurchase) the security at a specified price at a specified date. Repos are usually executed using government securities, and the repurchase price is higher than the initial sale price. The difference between the initial sale price and the repurchase price is the source of the return to the holder of the security. By entering into the repurchase agreement, the investor (the buyer) knows exactly how much will be made on the investment and when the funds will be returned. MIT Business Finance

Banker's acceptances are short-term promissory notes guaranteed by a bank. These acceptances arise through international trade. Suppose a firm ships goods abroad and receives a draft that promises payment after two months. If the firm does not want to wait for payment, it can take the draft to a commercial bank for acceptance. Once the bank accepts the draft (and stamps it "accepted"), the draft may be sold. The buyer purchases the draft for a discount, which becomes the source of the return to the holder. Bankers' acceptances are considered to be good short-term investments because they are supported by two parties: the firm on which the draft is drawn and the bank that accepts the draft Although the money funds as a whole own a wide spectrum of money market instruments, some of the funds do specialize. 2.2f Competition for Funds A commercial bank or any financial intermediary can lend only what has been lent to it. Unless the bank is able to induce individuals, firms, and governments to make deposits, that bank will be unable to grant loans and make investments. This general statement holds for all financial intermediaries. None can make investments without a source of funds. Whether these claims on the intermediaries are called insurance policies or savings accounts or shares in money market mutual funds, the essential point remains the same. No financial intermediary can exist without its sources of funds. Conversely, if funds flow out of financial intermediaries, all intermediaries will be able to hold fewer assets (that is, make fewer loans). Unless the outflow is reversed, it will tend to increase the cost of credit as the intermediaries raise the rates of interest they charge in order to ration their remaining lending capacity. In addition to the aggregate flows into and out of all financial intermediaries, credit markets may feel the impact of flows among financial intermediaries. Funds deposited in one particular bank are not deposited in another competitive bank. If an individual saver has funds to invest and chooses a money market mutual fund instead of the local savings and loan association, it is the mutual fund that can lend the funds and not the savings and loan association. Benver's Accentiace Shorem promissory notes for payment guaranteed by a bank وزارة التصليح CHAPTER 2 The Role of Financial Markets and Financial Intermediaries 67

BEAR Why is the source of junk mat to every financial tamady From the standpoint of the borrowers, it would not matter which intermediary makes the loans if all financial intermediaries had similar portfolios. But the portfolios of various financial intermediaries do vary. These differences can have an important implication. A transfer of funds from one intermediary (for example, a savings and loan association) to another (such as a money market mutual fund) can have an important impact on the supply of credit available to a particular sector of the economy. Although the total supply of credit is unaffected (because the money market fund can lend only what the savings and loan association loses), there will be a redistribution of credit from those who borrow from savings and loan associations to those who borrow from the money funds. The money market mutual fund now has more funds to acquire short-term securities. Simultaneously, the flow of funds out of the savings and loan association reduces its capacity to grant mortgage loans. Such a redistribution of funds from savings and loan associations to money market mutual funds can be felt by the construction industry and home buyers as the supply of mortgage money declines. Business Finance

As this discussion implies, financial intermediaries compete with each other for funds. This competition occurs through yields and services offered. If a particular intermediary did not offer competitive rates, funds would flow from it to those intermediaries offering higher yields. Thus, differentiation among the intermediaries on the basis of yields tends to be small. Historically, across the world, financial intermediaries have been categorized on the basis of services or products offered. Today, however, this is only partially true. In the past, savers bought insurance through insurance agents, bought stocks through securities brokers, and invested funds in a savings account in a bank. Those days of specialization are disappearing. Insurance agents, stockbrokers, and bankers today offer a wide spectrum of services and financial products. For example, many commercial banks offer savers not only the traditional services of savings and checking accounts but other products as well, such as brokerage services (to compete with stockbrokers), money market accounts (to compete with money market mutual funds), and pension plans (to compete with insurance companies and mutual funds). Such product competition also applies to savings banks. Savings and loan associations offer a variety of savings accounts as well as checking accounts, insurance, and brokerage services. Exercises Choose the correct answer. 1. The first sale of common stock for a company is referred to as an initial public offering (IPO). True/False 2. Financial intermediaries, such as commercial banks, insurance companies, and stock brokerages do not compete against each other's services. True/False 3. A sale of a security in which the seller agrees to buy back (repurchase) the security at a specified price at a specified date is a: a. commercial paper b. banker's acceptance. c. repurchase agreement. d. mutual fund وزارة التعليم 1921-1889 CHAPTUR 2 The Role of Financial Markets and Financial Intermediaries 69