FN1024 SUMMARY OF CHAPTER 6 - RISK MANAGEMENT IN BANKIN
Guidance on answering end of chapter questions in
subject guide
FN1024 PRINCIPLES OF BANKING AND FINANCE
Chapter 2: Introduction to financial systems
1. (a) What is a financial system? Frame your answer both from a structural
and a functional perspective.
A financial system can be described both in terms of its structure and the functions
it undertakes. In terms of its structure, a financial system essentially consists of
financial institutions operating in financial markets using a variety of financial
instruments (securities). A brief description of each of these is needed. A diagram
is a useful way of presenting a typical structure for a financial system.
The main functions undertaken by a financial system include:
(1) Channeling of funds from surplus to deficit units. This function can
be broken down further into (a) mobilization of funds from surplus
units – maximizing the flows from surplus units by providing
securities with characteristics that surplus units like, (b) allocation of
funds to their most productive use. This allocation function links
with the discussion of allocative efficiency in chapter 9 of this
subject guide.
(2) The monetary function – provision of money and payment
mechanisms that allow agents to settle debts.
(3) Risk transfer – the financial system provides a variety of
mechanisms for those who face a risk but don’t want to bear it to
transfer it to those who are better able to manage it. Examples of
such mechanisms include the provision of insurance policies by
insurance institutions and the provision of derivatives.
(4) Portfolio adjustment – the existence of financial markets allows
agents to adjust their portfolios (for example to switch out of equities
into bonds) in response to changing circumstances.
(b) What is the primary function of depository institutions? How does this
function compare with the primary function of insurance companies?
Depository institutions such as banks, savings associations and credit unions have
,the primary function of collecting in funds by issuing deposits and lending out
funds in the form of loans. Deposits are very short term in maturity whereas loans
have a much longer term to maturity. Insurance companies issue insurance policies
which savers pay premiums on a contractual basis. Long term insurance policies –
mainly life policies – have a maturity of 20/30 years. Insurance companies invest
premiums in securities such as bonds and equities.
One essential difference between depository and insurance companies is therefore
the extent to which they match maturities of assets and liabilities. Depository
institutions mismatch maturities whereas insurance companies tend to match their
long term liabilities (policies) with long term assets.
(c) (What is a mutual fund? What are the differences between short- term and
long-term mutual funds? Where do mutual funds rank in terms of asset size
among all financial intermediaries in the USA?
A mutual fund is a type of investment intermediary. Mutual funds pool resources
from many savers and invest these resources in diversified portfolios of bonds,
stocks and money market instruments. The most common type of mutual fund is
an open-ended mutual fund that continuously allows shareholders to sell (redeem)
outstanding shares, and investors to buy new shares at any time. The value of these
shares is determined by the value of the mutual fund’s assets. Two main
advantages characterise mutual funds. Mutual funds provide two main advantages
to small investors (i) to diversify risk and (ii) lower transaction costs when buying
larger blocks of financial securities.
2. (a) Explain how securities firms differ from investment banks. Which
categories of firms are there in this industry? In what way are they financial
intermediaries?
Investment banks are institutions that assist companies in raising new capital (debt
and equity). They do this by advising on the timing/pricing of the issue as well as
underwriting the issue and possibly arranging some associated derivative
transaction. As they are assisting in the arranging of new capital they operate in the
primary market.
Securities firms, in contrast, operate in the secondary capital markets assisting
investors in the trading of already issued securities. The two main types of
securities firms are brokers and dealers. Essentially brokers bring together buyers
and sellers whereas dealers sell securities to buyers and buy securities off dealers.
Both investment banks and securities firms are intermediaries in that they both
enable the channeling of funds from savers to borrowers.
, (b) What distinguishes stocks from bonds? What are the differences with
reference to the risk/return relationship?
Stocks are equity claims issued by companies that represent for an investor, an
ownership stake in the issuer of the claim. Equity claims are generally never
repaid and so are assumed to have an infinite maturity. They are called common
stocks in the US and ordinary shares in the UK. Bonds are debt claims issued by
companies and governments. These have a finite life. They are called corporate
bonds if issued by companies and sovereign bonds if issued by companies.
The risk, from the viewpoint of the investor, in an equity claim is high as there is
uncertainty about the return (both dividend and capital gain). Stocks therefore
generally earn a high return to compensate investors for the risk faced. Bonds are
seen to be lower risk as the issuer has an obligation to pay interest. Also the prices
of bonds are less volatile. This lower risk translates into a relatively lower return
compared to stocks.
(c) ‘Because corporations do not actually raise any funds in secondary markets,
they are less important to the economy than primary markets’. Comment.
Although secondary market trading does not lead to new capital raising by
companies, these markets provide an important underpinning to the primary
markets where new capital is raised. The ability to sell in the secondary market
enhances the liquidity of the securities making it more likely that the securities
will be bought when first issued. Trading in the secondary market also provides a
pricing benchmark for similar new securities issued in the primary market.
3. (a) With reference to examples, discuss globalisation of the financial markets
around the world.
Institutional investors have increasingly diversified their investment portfolios to
include securities listed on overseas exchanges over the last thirty years. In
addition, issuers of securities have tapped into pools of liquidity in overseas
markets and issued securities in markets outside the country they are based.
These development have led to a growing trend towards globalized financial
markets where capital flows across national boundaries. As part of this trend,
organized securities markets in different countries have merged to form
conglomerates. Examples include NYSE Euronext where the New York Stock
Exchange merged with Euronext, itself a conglomerate incorporating the stock
and derivative markets of a number of European countries including the Paris
Bourse and the London International Financial Futures and Options Exchange
(LIFFE).
, (b) Compare and contrast quote- and order-driven markets
Quote-driven markets involve a dealer or market maker on one side of every
deal. Dealers will quote bid and ask prices at which they stand ready to buy or
sell a security. Dealers thus supply liquidity to the market (as investors know
the dealer will always be willing to buy/sell at the quoted prices).
Order-driven markets are where buyers and sellers submit orders that are then
matched according to a set of rules. Most order-driven financial markets are
now electronic order matching (e.g. for the NYSE and LSE).
(c) Explain the purpose of money markets and give examples of the types of
money markets and their users.
Money markets are where securities with a maturity of less than one year
are traded. They allow companies and financial institutions to manage
their liquidity. Funds can be borrowed for short periods by issuing
securities and funds can be lent for short periods by buying securities.
Examples of money markets include the inter-bank market where banks
and large companies manage liquidity and the commercial paper market
where firms manage liquidity.
Chapter 3: Comparative Financial Systems
1 (a) Analyse the historical evolution of financial systems in order to explain the
reasons for the existence of market-based and bank-based systems.
2 In market-based financial systems such as the UK and US, capital markets play
a more important role in terms of companies capital raising. In bank-based
financial systems such as Germany and Japan, banks play a more important
role when companies look to raise long-term capital. To understand the
evolution of these different types of financial system it is helpful to look at
their historical development. In the US, the Civil War helped to develop
New York’s financial market (as wars between England and France did in
the eighteenth century with regard to the London capital markets. In
addition, the prohibition on banks’ holding equity and the fragmentation of
the banking system (particularly with regard to providing services to the
corporate sector) lead to a more important role for the capital markets.
Guidance on answering end of chapter questions in
subject guide
FN1024 PRINCIPLES OF BANKING AND FINANCE
Chapter 2: Introduction to financial systems
1. (a) What is a financial system? Frame your answer both from a structural
and a functional perspective.
A financial system can be described both in terms of its structure and the functions
it undertakes. In terms of its structure, a financial system essentially consists of
financial institutions operating in financial markets using a variety of financial
instruments (securities). A brief description of each of these is needed. A diagram
is a useful way of presenting a typical structure for a financial system.
The main functions undertaken by a financial system include:
(1) Channeling of funds from surplus to deficit units. This function can
be broken down further into (a) mobilization of funds from surplus
units – maximizing the flows from surplus units by providing
securities with characteristics that surplus units like, (b) allocation of
funds to their most productive use. This allocation function links
with the discussion of allocative efficiency in chapter 9 of this
subject guide.
(2) The monetary function – provision of money and payment
mechanisms that allow agents to settle debts.
(3) Risk transfer – the financial system provides a variety of
mechanisms for those who face a risk but don’t want to bear it to
transfer it to those who are better able to manage it. Examples of
such mechanisms include the provision of insurance policies by
insurance institutions and the provision of derivatives.
(4) Portfolio adjustment – the existence of financial markets allows
agents to adjust their portfolios (for example to switch out of equities
into bonds) in response to changing circumstances.
(b) What is the primary function of depository institutions? How does this
function compare with the primary function of insurance companies?
Depository institutions such as banks, savings associations and credit unions have
,the primary function of collecting in funds by issuing deposits and lending out
funds in the form of loans. Deposits are very short term in maturity whereas loans
have a much longer term to maturity. Insurance companies issue insurance policies
which savers pay premiums on a contractual basis. Long term insurance policies –
mainly life policies – have a maturity of 20/30 years. Insurance companies invest
premiums in securities such as bonds and equities.
One essential difference between depository and insurance companies is therefore
the extent to which they match maturities of assets and liabilities. Depository
institutions mismatch maturities whereas insurance companies tend to match their
long term liabilities (policies) with long term assets.
(c) (What is a mutual fund? What are the differences between short- term and
long-term mutual funds? Where do mutual funds rank in terms of asset size
among all financial intermediaries in the USA?
A mutual fund is a type of investment intermediary. Mutual funds pool resources
from many savers and invest these resources in diversified portfolios of bonds,
stocks and money market instruments. The most common type of mutual fund is
an open-ended mutual fund that continuously allows shareholders to sell (redeem)
outstanding shares, and investors to buy new shares at any time. The value of these
shares is determined by the value of the mutual fund’s assets. Two main
advantages characterise mutual funds. Mutual funds provide two main advantages
to small investors (i) to diversify risk and (ii) lower transaction costs when buying
larger blocks of financial securities.
2. (a) Explain how securities firms differ from investment banks. Which
categories of firms are there in this industry? In what way are they financial
intermediaries?
Investment banks are institutions that assist companies in raising new capital (debt
and equity). They do this by advising on the timing/pricing of the issue as well as
underwriting the issue and possibly arranging some associated derivative
transaction. As they are assisting in the arranging of new capital they operate in the
primary market.
Securities firms, in contrast, operate in the secondary capital markets assisting
investors in the trading of already issued securities. The two main types of
securities firms are brokers and dealers. Essentially brokers bring together buyers
and sellers whereas dealers sell securities to buyers and buy securities off dealers.
Both investment banks and securities firms are intermediaries in that they both
enable the channeling of funds from savers to borrowers.
, (b) What distinguishes stocks from bonds? What are the differences with
reference to the risk/return relationship?
Stocks are equity claims issued by companies that represent for an investor, an
ownership stake in the issuer of the claim. Equity claims are generally never
repaid and so are assumed to have an infinite maturity. They are called common
stocks in the US and ordinary shares in the UK. Bonds are debt claims issued by
companies and governments. These have a finite life. They are called corporate
bonds if issued by companies and sovereign bonds if issued by companies.
The risk, from the viewpoint of the investor, in an equity claim is high as there is
uncertainty about the return (both dividend and capital gain). Stocks therefore
generally earn a high return to compensate investors for the risk faced. Bonds are
seen to be lower risk as the issuer has an obligation to pay interest. Also the prices
of bonds are less volatile. This lower risk translates into a relatively lower return
compared to stocks.
(c) ‘Because corporations do not actually raise any funds in secondary markets,
they are less important to the economy than primary markets’. Comment.
Although secondary market trading does not lead to new capital raising by
companies, these markets provide an important underpinning to the primary
markets where new capital is raised. The ability to sell in the secondary market
enhances the liquidity of the securities making it more likely that the securities
will be bought when first issued. Trading in the secondary market also provides a
pricing benchmark for similar new securities issued in the primary market.
3. (a) With reference to examples, discuss globalisation of the financial markets
around the world.
Institutional investors have increasingly diversified their investment portfolios to
include securities listed on overseas exchanges over the last thirty years. In
addition, issuers of securities have tapped into pools of liquidity in overseas
markets and issued securities in markets outside the country they are based.
These development have led to a growing trend towards globalized financial
markets where capital flows across national boundaries. As part of this trend,
organized securities markets in different countries have merged to form
conglomerates. Examples include NYSE Euronext where the New York Stock
Exchange merged with Euronext, itself a conglomerate incorporating the stock
and derivative markets of a number of European countries including the Paris
Bourse and the London International Financial Futures and Options Exchange
(LIFFE).
, (b) Compare and contrast quote- and order-driven markets
Quote-driven markets involve a dealer or market maker on one side of every
deal. Dealers will quote bid and ask prices at which they stand ready to buy or
sell a security. Dealers thus supply liquidity to the market (as investors know
the dealer will always be willing to buy/sell at the quoted prices).
Order-driven markets are where buyers and sellers submit orders that are then
matched according to a set of rules. Most order-driven financial markets are
now electronic order matching (e.g. for the NYSE and LSE).
(c) Explain the purpose of money markets and give examples of the types of
money markets and their users.
Money markets are where securities with a maturity of less than one year
are traded. They allow companies and financial institutions to manage
their liquidity. Funds can be borrowed for short periods by issuing
securities and funds can be lent for short periods by buying securities.
Examples of money markets include the inter-bank market where banks
and large companies manage liquidity and the commercial paper market
where firms manage liquidity.
Chapter 3: Comparative Financial Systems
1 (a) Analyse the historical evolution of financial systems in order to explain the
reasons for the existence of market-based and bank-based systems.
2 In market-based financial systems such as the UK and US, capital markets play
a more important role in terms of companies capital raising. In bank-based
financial systems such as Germany and Japan, banks play a more important
role when companies look to raise long-term capital. To understand the
evolution of these different types of financial system it is helpful to look at
their historical development. In the US, the Civil War helped to develop
New York’s financial market (as wars between England and France did in
the eighteenth century with regard to the London capital markets. In
addition, the prohibition on banks’ holding equity and the fragmentation of
the banking system (particularly with regard to providing services to the
corporate sector) lead to a more important role for the capital markets.
