ECON 335 Mid Sem Notes

8/6/2019 ECON 335 Mid Sem Notes

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Chapter 14

1. Non bank financial institutions in Australia

Building societies

Credit Unions

Finance companies

2. Building societies

ADIs

Promote themselves as alternative to banks

Historically concentrated on consumer products funded from deposits but recently

pursued corporate business to facilitate growth and product diversification How building societies have responded to competition: (MDRST)

Achieve critical mass and economies of scale through merging with other societies

Diversified product base to compete with banks

Reducing costs by adopting technology such as internet banking and electronic

transfers

Securitisation programs to improve balance sheets

Transform into corporations and then banks

i. Regulation of building societies:

ADIs- regulated by APRA Regulated in same way as banks

Removes any competitive advantage that one may have over another in terms of

regulatory bias

Sources and uses of funds:

Assets

Loans and advances- mostly residential mortgages

Reflects traditional business of mortgage lending

Also some investment securities (bank bills, short-term government securities and

commercial paper of various types) These are used to satisfy legal reserverequirements and provide liquidity also to invest surplus funds.

Liabilities

Most significant funding source being deposits

Reflects traditional operations- accepting retail deposits and using these to fund

lending

Composition of assets and liabilities makes building societies vulnerable to interest raterisk. Focus on long term residential mortgages and fund them with short term consumer

deposits.Creates management challenges. If interest rates increase sharply, cost of funds

will rise. Also rising interest rates put pressure on variable rate loan customers whose


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interest rates will rise, putting more loans at risk of falling behind. Also there will be

expected reduced new loan demand because of the higher rates.

To manage this:

Attract more capital by becoming corporations with contributing equity investors

Used securitisation to shift interest and credit risk to third parties

Australian regulatory environment requires minimum amounts of capital. Requirements

for suitable controls and monitoring of interest rate risk

Capital:Due to legislative changes many building societies have turned into companies and others

into banks. These institutions have shareholders that contribute capital.

Income and expenses:

Main source of income is interest income earned from deposits with financial institutions,

interest from investment securities and interest on loans and advances made to clients.

Main source of interest income is interest on loans and advances to clients

Sources of non-interest income: (FFC)

Financial planning

Fees on mortgages and other loans (application fees, service fees)

Commissions and dividends from investments

Main expense: cost of financing loan portfolios.

Interest expense is interest paid to deposit customers and holders of other borrowings

and subordinated debt

Other expenses: income tax, bad debts expense, personnel costs, depreciation of

property, plant and equipments and administration costs


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3. Credit Unions

ADIs- regulated by APRA

Originated in Germany mid 1800s, Australia in 1940s

Started to provide an outlet for savers to deposit small amounts of funds and provideloans on relatively lenient terms to members

Focus on consumer lending

Owned and operated by members

Members pool savings and loan them to one another

Traditionally common bond of association (occupation, association, residence)

Over time the common bond has been relaxed

Kevin Yates introduced credit union in Australia in 1946

Developed into diversified financial institutions that offer a full range of financial products,

compete directly with building societies, banks and other financial institutions

Like building societies market themselves on basis of customer service, alternative tobanks, however unlike building societies becoming a member--> say in how business

operates

Reasons for joining a credit union:

Being a member, having the opportunity to vote

Excellent service: credit unions are for their members, not driven by profits

Community involvement and support

Strong local and international movement

Commitment to consumer education

Wide range of products and services Low fees and charges

Safety and security

Substantial market share

Ease of joining

Regulation of credit unions:

APRA

Generally carry levels of capital relative to risk weighted assets in excess of the major

banks- offering greater security to members

Credit Union Financial Support Scheme (CUFSS)- pool of funds used to supportcredit union should it become financially distressed

Assets

Primarily loans to members (2009- almost 80% of assets were residential and personal

loans)

Exposed to interest rate risk because many liabilities are shorter maturity than assets

Loans are primarily consumer and mortgage loans

Actively seeking to grow commercial lending portfolios in recent years

Also hold liquid assets and investment securities

Expanded holdings in government securities- increased opportunities to invest as the

government has expanded its issuance due to credit crisis


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Most invest in relatively safe government securities and securities offered by other ADIs

Other assets include: property, plant and equipment, accrued receivables, deferred tax

assets and the sundry account other assets

Liabilities:

Primarily member savings accounts

Maintaining traditional funding model

Capital:

Do not hold shareholders equity

Membership shares are recorded as liabilities because they are refundable upon

resigning members.

Capital thus is mostly retained profits

Outside equity interests: general insurance, travel, financial planning and health fund

business

Corporations Act 2001 requires that member shares be treated as redeemable

preference shares and withdrawn from retained profits

4. Finance companies

Finance companies more diverse than building societies and credit unions

Unlike building societies and credit unions they are NOT ADIs

Obtain funds in large amounts by borrowing from banks or selling securities in capitalmarkets

Some obtain funds from a parent company (which may be a bank)

Emerged largely in response to restrictive regulations over banks

Finance companies were established by the bans and others to get around restrictions

However with deregulation in the 1990s the industry has contracted through mergers and

takeovers

Sector characterised by several major players and other smaller entities:

Three large finance companies dominate: Esanda owned by ANZ, CBFC owned by

the Commonwealth Bank and one large multinational GE Money

Types of finance companies: (CND)

Three categories: captive, niche and diversified

Captive sales finance companies: finance companies that finance goods sold by their

parent companies

Sales finance companies: captive sales finance companies that are subsidiaries of major

retailers and car manufacturers

Niche finance companies: finance companies that specialise in a particular type of

finance product. Types include: Large factoring companies- lend to clients by buying and collecting accounts

receivable


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Payday lenders- small finance companies that offer very short term loans at very high

interest rates. Generally used by those who can least afford it

Debt consolidation companies- finance companies that target individuals with

excessive levels of personal debt or those with several different loans, then

consolidate these into one loan that is easier to manage or has lower principalrepayment than the individual debts combined

Diversified finance companies: e.g. GE capital which offer a range of financial products

including credit cards, personal loans, car loans and even mortgages

Consumer finance companies: specialise in making cash loans to consumers

Assets:

Divide lending between consumer and business lending. Loan and lease receivables

amount to more than 70% of net assets

Other assets consist of cash, balances with financial institutions, investment securities,

buildings and computers

Consumer receivables

Personal loans

Motor vehicle credit

Revolving consumer installment credit (READ about)

Other consumer installment loans

Real estate lending- fastest growing area of finance company lending (READ WHY)

Business credit

Wholesale financing Retail financing

Lease financing

Other business credit

Securitisation of receivables

Liabilities and net worth:

Overall net worth very small relative to total assets

Total liabilities account for 81% of total assets- highly leveraged

Income can fluctuate substantially if they experience loan losses or interest rate changes Need to have adequate capital to maintain credit ratings and borrow easily from banks.

Many smaller finance companies have much larger capital ratios than large finance

companies

Major sources of funds: (BLIB)

Borrowing from related companies

Loans from other Australian financial institutions

Issuing debentures and unsecured notes

Borrowing from foreign entities in the international capital markets

Finance companies hold a mixture of both short and long term debt however the majorportion of liabilities, like their assets are short term


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Regulation of finance companies

Lack of regulation led to their massive increase in numbers in 1970s and 1980s, however

a change in regulations led to gradual demise in recent years

Primary regulator is ASIC

Finance company consumer lending is heavily regulated under consumer credit code,

however finance company business lending is not. Business people are presumed to bebetter able to act in their own interest than consumers

Do not control the nature of lending or interest rates or fees that must be charged to

consumers but regulation concentrates on the information that must be provided to

borrowers and standard business procedures


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Chapter 15 Large banks in particular are active in the international market both through direct

ownership of foreign based banks, offshore operations and as a source of capital

International banking- banking in which transactions where one or more parties arelocated outside the banks home country

This includes transactions such as:

Depositing in and borrowing funds from foreign banks

Dealing in foreign currencies

International funds management

Facilitating international payments and settlements

1. Development of international banking

Foreign banks effectively prohibited from business in Australia from 1940s to 1985

This has changed- innovation of government desires to develop a strong, competitive

and efficient financial system and a strong economy

Origins of international banking

11th century- trade and war with Islamic states and North Africa put pressure of western

Europe to move beyond localised trade.

At this time Italy became a major commercial and banking power- connection between

western Europe and Lebanon, Syria and Israel 12th - mid 16th century Italian banks dominated international finance

With development of trade and international credit Antwerp became the financial hub of

Europe in the 1500s due to geographical location. Also it had one of the worlds two stockmarkets at the time, on which capital and credit were tradeable

This stopped when war broke out in Belgium and Netherlands. In 1585, spanish troops

ransacked Antwerp, ending its reign

Amsterdam Exchange bank in 1609 and Amsterdam stock exchange in 1611. Throughout

most of the 17th century Dutch dominated international finance. Britain in 19th century

Bank of England 1694. With defeat of Napoleon in 1814, political stability, economic

growth, sound fiscal policy etc the BoE became the worlds banker Implementation of global free trade system and gold standard- BoE

American banks rise to power in late 1800s and early 1900s when US developed an

industrialised, self sufficient, market economy

1913 the US federal reserve was established

After WWII American banks dominate global financial markets. US industry survived the

war intact (unlike European and Japanese), American banks became an important source

of capital to fund the reconstruction of Europe and US economy grew

1944- Bretton Woods- established rules, institutions and procedures to regulate

international monetary system Obligation for members to adopt monetary policy that maintain exchange rates within a

fixed value of the value of gold


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US dollar was the reserve currency- currency used as the international pricing currency

for products traded in international markets. Countries therefore hold substantial reserves

of this currency

IMF initial role:

Promote international monetary cooperation and foreign exchange stability in addition to

facilitating the balanced growth of international trade

World Banks role:

Provide long term finance for postwar reconstruction

General Agreement on Tariffs and Trade (GATT):

Designed to promote free trade through tariff reduction. Eventually became WTO

Bretton Woods system came to an end in 1971: US government could no longer afford to

provide a reserve currency because of

BoP deficits

Inflationary pressures

Growing expense of Vietnam

1973- floating exchange rate system

Decade of expansion

Recent decline in US banks and branches is partly due to mergers

Reasons for dramatic growth in US banking overseas:

Expansion of US trade

Growth of multinational corporations

Government regulations on domestic profit opportunities

Recent activity

No US banks in top 15 international banks (by asset size) in 1997

Major drivers of international banking in recent years: (GMIDF)

Increasing globalisation (G)

Large scale cross border mergers between banks creating large multinationals (M) Rapid innovation and use of technology (I)

Deregulation of national banking regulations

Impact of financal crisis (asset values, consumer confidence, legislative changes)

Contagion:

Risk of the effects of a financial crisis in one region or country spreading to another

This risk has increased because of increasing interdependence of systems and institions

Many international banks concentration on fee based business e.g. Consulting etc

Australia:

4th largest pool of investment fund assets


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10th financial centre in the world


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2. Structuring overseas banking services

Organisational forms of banks: (ROSFFC)

Representative offices

Offshore banking units

Shell branches Foreign subsidiaries and affiliates

Foreign branches

Correspondent banking

Representative offices:

Offices established in a foreign country primarily to assist the parent banks customers in

that country

Cannot: accept deposits, make loans, transfer funds, accept drafts, transact in

international money market

Can: Provide information and assist parent banks clients and business contacts inforeign country

Primary vehicle for establishing initial presence

Offshore banking units:

Foreign branch that has limited access to that countrys domestic market

Purposes: Tax effective presence to conduct international banking business including

foreign exchange transactions

Vehicle for attracting nonresident business to the bank and provides a source of foreign

exchange reserves and investments

Shell branches:

Easiest and cheapest way to enter international banking

Effectively a booking office for bank transactions located abroad, no contact with the

public and no staff

Activities: limited to interbank money-market transactions, foreign currency transactions

and the purchase of small shares of syndicate loans

Environment is almost entirely tax free, liberal rules and simple banking regulations.

Modern communication systems linked to financial centres and stable political environment

Little use to Australian banks because of global approach to corporate taxation etc which

limits tax advantages

Foreign subsidiaries and affiliates

A separately incorporated bank owned entirely or in part by a domestic bank

Provides identity and visibility of a local bank in the eyes of potential customers in the

host country, increased ability to attract local deposits

Management typically composed of local national, giving the subsidiary bank better

access to local business community


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Foreign branches

A legal and operational part of the parent bank

Subject to two banking regulations:

Subject to all legal limitations that exist for Australian banks

Subject to regulations of home country

Foreign governments may fear that branches of large foreign banks hamper growth of

their countrys domestic industry. Nationalism has slowed expansion of foreign banksabroad

Major advantages:

Worldwide name identification

Customers of foreign branch have full access to range of parent banks services.

Disadvantages:

Costs of establishing them and legal limits placed on their activities

Correspondent banks

Most major banks maintain correspondent banking

It is a business arrangement between two banks in which one agrees to provide the other

with special services such as cheque clearing or trust department services

3. International banking activities

International lending

Greatest amount of income from international operations is mainly through foreign

branches or affiliate banks European banks collectively hold the most claims almost $14 trillion

10 banks or so dominate the market

Characteristics of international loans

Similar to domestic business loans

Differences in:

Funding

Syndication

Pricing

Collateral Can be denominated in any major currency (US dollars favourite)

Tend to be larger in size than typical domestic loans ( borrowers governments or large

multinationals)

Most large international loans are in eurocurrency market

Loans priced with respect to LIBOR, a non bank borrower priced at premium above

LIBOR

Eurocurrency favour market because: volume of credit available, low cost of funds,

service available

Large international bank loans are syndicated- several banks participate in funding the

loan which is packaged by one or more lead banks. Allows banks to spread risk andborrowers to obtain larger amounts of capital


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Most international bank loans are unsecured (without collateral) business loans generally

only made to large credit worthy multinationals

International lending products (PSTIC)

Project finance

Ship financing

Trade financing

International leasing

Commodities finance

Project finance

Structuring and finance of large scale projects and developments

Often involves many parties: financiers, development and construction companies,

government agencies, customers etc

It is the project that is financed not the company or companies involved

Ship financing

One of the riskiest forms of lending

Financing large vessels

Risks derive from ship owners having very little equity interest in the vessel and the value

of used ships being little more than scrap value

Risk depends on type of charter used:

Bare boat charter: operating company is responsible for all operating, insurance and

maintenance costs associated with the ship. Character and standing of the operator

is of importance Time charter: operator rents ship for specific period and owner bears costs and risk

Trade finance

Short term financing of importing and exporting activities across the globe

Less risky than project and ship financing

Backbone of many banks international lending operations and a source of profitable

lending

Three basic forms: (TBL)

Trade accounts: involving the importer paying for the goods only after they are

received and title has been transferred, exporter bears the risk. 75% of Aus imports50% of exports

Banks drafts: a financial instrument that provides an exporter with a written guarantee

that a financial institution will honour payment once the goods have been delivered.

Bank drafts are prepared by the exporter and sent to the importer as a request to pay

before the actual export of the goods.

Sight drafts: bank draft that requires payment when goods are received

Term drafts: a bank draft that requires payment some time (specified) after the

goods are received

Letters of credit: greatest security for parties, commonly used. Importers bank issues

LOC that agrees to honour the importers obligation

International lease financing


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Two kinds of leases:

Operating: short term arrangements where the asset is maintained by the lessor for

the duration of the lease, with the asset returned to lessor at the end

Finance: longer term, at the end of which ownership is usually transferred to lessee

Leasing is usually tax driven


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Commodity financing

Short term debt used to purchase commodities that are on sold hopefully with a profit

margin to service debt and produce a net profit

High risk for banks because success of traders depends on movements in commodity

prices

Investment banking

Provision of a range of services and products including underwriting and selling shares

and bonds, making markets in securities, advisory services and structured financing

Euro fundraising

Raising of funds in international markets is important activity of banks

Major source of these funds is eurocurrency market

Instruments:

Euronotes (Short term secured securities)

Euro commercial paper (short term unsecured)

Euro medium term notes (unsecured 3-5 years)

Eurobonds (unsecured long term, fixed maturities and interest rates)

International retail and private banking

Retail banking services such as deposit accounts and consumer loans on a global scale

has been one of the last areas banks sought to develop

Barriers to entry are high: domestic banking regulations, differing types of financial

products across countries and established local banks making it difficult for new entrants

to establish themselves


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4. International banking risks

Face credit, market, liquidity, interest rate and operational risk

Country risk Possibility that future returns from international activities may be impaired by economic or

political events surrounding the foreign currency

Types: (TCPS)

Transfer risk

Currency risk

Political risk

Sovereign risk

Transfer risk

Not being able to convert domestic currency into foreign currency Usually occurs because of government imposed exchange controls

Not uncommon in developing nations

Currency risk

Concerned with currency value changes and exchange controls

Loans denominated in foreign currencies, if currency in which loan is made loses value

against the banks domestic currency during the course of the loan, the repayment will be

worth less in domestic currency terms

Can be hedged in developed markets however in developing markets this may not

always be the case

Political risk

Possibility that political factors may impair a borrowers ability to meet debt servicing

obligations

Includes civil unrest, political turmoil, corruption and governmental nationalisation or

expropriation of assets (Only really Chile and Cuba)

Sovereign risk

Possibility that a sovereign country as a borrower may become unable or unwilling to

service its foreign obligations or meet guarantees of nongovernmental or privateborrowings

Risk Evaluation

Evaluations of expected inflation, fiscal and monetary policy, countrys trade policy,

capital flows and political stability and credit standing of individual borrower

When in depth analysis too expensive- turn to on site reports, checklists and statistical

indicators


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Methods of reducing risk (TPD)

Third party help

Third party agree to pay back principal and interest if borrower defaults.

Typically done by foreign governments and central banks but if the nation is politically

unstable this may not mean much

Alternative is external guarantee from outside institution

Pooling risk

Banks join together to provide the funds for loans and so directly reduce the risk

exposure for individual banks

Diversification

Portfolio diversification- if a borrower defaults earnings from other investments will

minimise the effect of the loan loss on the banks total earnings

Loans that are less correlated with the banks existing portfolio would be more

attractive

Geographic diversification reduces political risk but diversification for diversifications

sake not always good a bank develops expertise in certain countries and cultivates

sources of primary information that may not be available to other banks. This type ofinformation, plus longstanding experience with a particular borrower, may allow the

bank to formulate better estimates of the risk involved in a particular loan.

5. Regulation of overseas banking activities

Banking traditionally highly regulated- need to promote financial system safety, supports

economic stability Net regulatory Burden (NRB)

Banking regulation a matter of national sovereignty, no supranational institution to make

laws for all

Basel Accord- minimum capital adequacy requirements for banks of member nations

The Financial Action Task Force on Money Laundering, which examines and makes

recommendations on action to combat money laundering.

Differing level of regulatory intervention into a national financial system may be a factor

that influences the decision of a foreign institution to set up operations in that country

Representative offices of foreign banks are not ADIs, cannot accept deposits

Money laundering: the processing of the financial proceeds of criminal activities todisguise the illegal origin of the funds.

6. International activities of Australian banks

Reasons banks engage in international activities (DASFO)

Diversify business as a means of risk management and business growth

Access different products, expertise and technology

Service the needs of multinational clients around the globe

Follow clients as they expand their operations internationally and to be able to providethem advice on operating in these regions

Obtain favourable regulatory and tax environments


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This last point is of little advantage to Australian banks because of Australia's

international approach to corporate taxation and the Basel Accord.

7. Foreign banks in Australia Significant competition for Australias domestic banks

Technology driven: without having to create branches, a website and phone centre is fine

Offer advantages such as improved access to foreign capital, employment and training

opportunities, increased product choice for consumers and increased competition

Foreign banks in 2008 controlled approximately 21.4% of all banking assets in Australia

8. Future directions of international banking

Industry faces significant challenges and opportunities:

Recent consolidation of the European economy

Capital needs of developing nations likely to put pressure on world credit markets

Asian financial crisis and other shocks have increased financial institutions awareness of

operational risks

Restriction of capital flows as a result of GFC and near halt to securitisation

Impact of climate change


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Chapter 16 Individuals and business face risk, which is uncertainty concerning the occurrence of

loss

Methods of dealing with risk: (RLR) Retention: individual or business is responsible for the loss (e.g. Uninsured risk)

Loss control: includes any effort to reduce the frequency and severity of risk (e.g.

Smoke detectors, seat belts)

Risk transfer: risk transferred to another party through contract e.g. Insurance

1. The insurance mechanism

Insurance is the transfer of pure risk to an entity that pools the risk of loss and provides

payment if loss occurs

Risk transfer: shifting the responsibility of bearing the risk from one party to another

Pooling: Spreading losses suffered by a few insured over the entire group so that

insurance purchasers substitute the average loss for the uncertainty that they might suffera large loss

Pure risk: Situations where there may be two outcomes: loss or no loss

Speculative risks: There may be three outcomes: loss, no loss or gain

Insurance benefits society:

Reduces fear and worry

Provides an incentive for loss control because insurance premiums are determined bythe chance of loss, and loss control reduces the chance of loss

Facilitates credit by protecting collateral pledged to secure loans

Insurers and objective risk

Objective risk is the risk that an insurer faces once it has accepted the transfer of risk

from insurance purchasers. It is the deviation between actual losses and expected losses

Sources of catastrophic losses include natural disasters and terrorism

Methods of reducing objective risk1. Law of large numbers: as the number of insured risks increases the deviation betweenactual and expected results will decline. Although an insurance companies underwriting

risk increases as more units are insured (more potential claims to pay), objective riskdeclines

2. Careful underwriting: Selection and classification of insurable risks3. Make the insured pay a portion of any loss that occurs (excess). Makes the insured

responsible for the first portion. Co-insurance: insured pays portion of the loss4. Charging higher premiums where the risk of loss is higher (aged based, smokers etc)

5. Restrictive covenants: legal obligation to do or not do something (e.g a minimum level

of security on a property)6. Reinsurance: insurers shift some of the risk they have insured to another insurance

company


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Requirements of privately insurable risks

Many similar exposure units

Losses that occur should be accidental and unintentional by the insured

Losses must not be catastrophic - usually excluded from policy

Losses should be determinable and measurable

Chance of loss must be calculable

Premium for insurance must be affordable

Regulation of insurance industry

APRA regulated insurance industry

Life insurance Act 1995

Insurance Act 1973

ASIC regulates legislative requirements applied to insurance companies

2. How insurance companies make money

If total premiums collected are worth more than the total claims, the insurer has made an

underwriting profit

This is bolstered by investment income earned on the pooled premiums

Pricing insurance

Charge enough to cover claims and admin expenses Competitive markets

Insurance regulators require that rates are adequate to pay losses

If interest rates are expected to be high and investment income expected to be large,

lower rate will be charged

If interest rates are expected to decline and investment income less, rates charged will

be higher

Some cases excesses are imposed, some they are optional (trade off higher excess for

lower premium)

Interest rate risk and insurance companies Underwriting cycle

High premiums and tight underwriting standards (hard insurance market)

Low premiums and loose underwriting standards (soft insurance market)

Cash- flow underwriting: writing of insurance on just about any risk to get the premium

dollars to invest at high interest rates


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3. Types of insurance

Three broad types of insurance: Life, general and health

Life policies Provide financial support to dependants in case of premature death (when others are

financially dependent)

Replace lost income and cover expenses that may coincide with death

Policyholder pays regular premium in return for a payment upon death, disablement or

on specified maturity date

Term insurance

Most popular

Pure life insurance for a specified period of time, less than all of life

Paid if insured dies while policy is in force, if policyholder does not die, no payment

Premiums low at younger ages but increase at increasing rate based on risk of death Straight term insurance: written for certain period then terminates

Decreasing term insurance: face amount decreases while premium stays level

Increasing term insurance: face amount increases

Renewable term insurance: policy may be placed back in force at end of coverage

period. This is usually limited at a specified age to protect against adverse selection

Convertible term insurance: permits term coverage to be switched to whole life insurance

without providing evidence of insurability

Whole life insurance

Provides coverage for all of life Level premium policy

Policyholders overpay the cost of mortality in early years and underpay in later years

Insurers pay interest on the cash value that is returned to policyholders as a bonus

An endowment policy is a variation that has a fixed term

Popular but popularity has declined

Disability policies

Total and permanent disablement insurance Provides benefit if insured becomes TPD through accident or injury, preventing work

Either lump sum or annuity

Definition of TPD is critical

Trauma insurance

Lump sum insurance if insured suffers a specified trauma

Income protection

Provides regular payment to policyholders if unable to work for extended period because

of accident or illness Based on income earned, paid as a percentage


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Business overhead insurance

Provides cover for eligible business expenses (leases, rent, taxes, phones, rates) as

agreed when policy is taken out whilst person is incapacitated

General insurance policies

Predetermined payment should a specified peril occur

No investment component, pure insurance: no money repaid

Fee for a service

Property and liability insurance

Direct and indirect loss caused by perils

Direct losses: fire, windstorm, explosion, flood, earthquake

Indirect losses: profits that could have been made in a business

Property insurance is financial loss associated with destruction or loss of property

Liability insurance protects against the peril of legal liability (negligent insured that

causes bodily injury etc)

Property insurance

Named perils coverage: list of perils that are covered

All risks coverage: or open perils insures against all loses except those excluded

Most common: house and contents and motor vehicle

Liability insurance

Legal responsibility for bodily injury, property damage etc

Damages awarded have no upper limit: difficult to gauge

Health insurance policies

Cover over and above provided by government: Medicare

Private health insurance provides coverage for nonessential procedures: choice of

doctor, avoidance of waiting lists

High income earners that do not take out higher cover are required to pay higher

Medicare levy

Issues in insurance

Adverse selection Results in poor products or consumers being more likely to be selected because of

information asymmetries between buyers and sellers

Those at greatest risk of loss more likely to insure than others

Higher premiums because the insurers will increase them as more claims are made

Thus it is less likely that those with lower risk will insure: cost-benefits

Information asymmetry: two parties do not have equal information

Moral hazard

The risk of immoral behaviour that has negative consequences because the person does

not suffer any loss or perhaps benefits Complacency or inappropriate action

Problem when assets are overinsured


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Can be mitigated: (IICPE)

Sufficient investigation of claims made

Sufficient information is obtained to assess the value and condition of insured items

Impose covenants: provision of security systems, fire safety equipment

Premium restrictions for the provision of covenants and premium restrictions for those

who do not claim on policies: no claims bonus

The use of an excess discourages moral hazard, insured is responsible for first

portion

Viability of insurance companies

Insurance premium is paid in advance to provide loss coverage in the future

If insurance company fails coverage and premium lost

Complexity of insurance contracts

Concern: consumers select inappropriate polices for their circumstances, not

understanding the conditions of their policy or decide not to take out policy because of a

lack of confidence in insurance products

Negative media coverage of insurance companies refusing to pay claims on basis of

technicalities

Redlining

Insurance companies refusing insurance in particular geographical areas

Reasons: crime rates, risk of flood, fire, earthquake

Also due to factors as age, gender, education etc

E.g. Young male drivers paying much more in insurance premiums

Patents

Patenting insurance products to protect them being copied by competitors

Argued to promote innovation because investments in R+D are protected

E.g. Pay as you drive car insurance with GPS system, also identify location of car if

stolen

Securitisation of risk

Insurance risk is transferred to the capital markets through the creation of a financial

instrument such as a catastrophe bond or futures or options contract

4. Investment companies

Gather funds from savers for investment in capital and money market instruments or

investment in specialised assets such as real estate

Advantage of providing investors with risk intermediation by investing in a diversified

portfolio of assets

Denomination intermediation: investing in large blocks of assets and selling shares to

customers in smaller amounts

Main categories:

Statutory funds of life insurance offices


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Superannuation funds

Public unit trusts

CMTs

Common funds

Friendly societies

Closed-end investment companies

First started in Belgium in 1822

A fund that initially sells its shares to the public to obtain cash to invest and then operates

with a fixed number of shares outstanding

Typically does not offer more

Most property property funds are listed, closed-ended

Two important values for shares in closed-end investment companies:

Net asset value (NAV) per share: the sum of total current value of funds assets -

value of debts divided by total number of shares

Premium or discount to NAV: price at which funds shares can be bought or sold in

stock market, vaires from 10% above to 20% below NAVs

Reasons why premium or discount:

Premium: people want to invest in a specific country may be willing to pay a premium.

Fund with a superior manager

Discount: Poor managers who cannot easily be replaced, fund with unrecognised tax

liabilities

Open-end investment companies

Started in US in 1924

Allows investors in the fund to redeem some or all of their investment at NAV on any

given day

In US: mutual funds

In Aus: Managed funds

Unit investment trust: trust with pro rata interests in a managed pool of assets. Shares or

units are sold to the public to obtain the funds needed to invest in a portfolio of securities

Trustee administers the trust which holds the assets and liabilities of the fund

When an investor buys shares or unit in the trust the fund issues new shares or units inthe fund

No limit to the number of shares or units other than market demand

Popular because it is guaranteed that investors could redeem shares at NAV

Reasons for explosive growth in investment companies:

Many new types of managed funds and investment companies

Deregulation of international capital markets

Government policies that give incentives for additional payments to super

Increased interest in investments by ageing baby boomers

Knowledge and investment sophistication of investors High rates of return available on common stocks


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5. Types of managed funds in Australia

Investment strategies

Strategies determine mix of assets held by funds

Trust deed sets out mix of asset classes in terms of target percentages

Product disclosure statement (PDS) contains details in relation to the management of thefund, fees it charges, how the manager will communicate with unit holders and options for

withdrawing and switching funds

Fund strategy Risk profile Recommended minimum

investment horizon

Cash management low No minimum

Fixed interest low No minimum

Balanced medium 3-4 years

Property medium 3-5 years

Diversified Medium-high 4-5 years

Domestic shares Medium-high 4-6 years

International shares high 5-7 years

Growth funds high 5-7 years

Important decision is amount of cash to hold for liquidity without sacrificing performance

Usually 4-10%

Stock and bond oriented managed funds typically hold more liquid assets when market

interest rates are high, yield on liquid assets is high and stock prices are expected to fall

Growth and income funds Seek a balanced return, consisting of both capital gains and current income

Hold high quality common stocks

Growth funds

Focus of capital appreciation

Invests primarily in common stocks that judged to have above average growth potential

Aggressive growth funds

Stocks of small companies with high price/earnings ratios or companies whose stock

price is volatile

Balanced funds Balanced portfolio of stocks and bonds

Current income and capital appreciation


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Typically generate higher income than growth and income fund will be less volatile

Opportunity for capital gains is less

International and global equity funds

Diversify asset holdings internationally

Global funds can invest anywhere in the world

International funds tend to invest outside their home nation

Socially responsible investment funds

An investment process that considers the social and environmental consequences of

investments, both positive and negative within the context of rigorous financial analysis

Income- equity

Seek higher income by investing in stocks with relatively high dividend yields

Speciality funds

Index funds: designed to match the return from a particular market index

Single segment of the market, industries such as telecommunications, oil, biotech, health

6. Superannuation

A government-controlled investment strategy aimed at providing resources that can be

used upon retirement

Deals with the risk of outliving ability to earn a living Several problems with retirement savings:

Many delay retirement saving, spending financial resources today for current

consumption rather than saving for retirement

Some do not earn enough to afford retirement savings

Period of retirement saving is shortening while period that the funds are required is

lengthening

Super schemes among the fastest growing financial intermediaries in the past 25 years

99% of funds are small self managed funds (SMSFs)

History of superannuation Originally established by banks to provide a pension to long serving employees

1986 this changed as the government decided superannuation was to be a condition of

employment

3 per cent employer super payment was added to industrial awards

This did not cover all workers, but in 1992 the governments Superannuation Guarantee

Charge (SGC) Act made it compulsory for all employees

2003- grew to 9%

World Banks 3 pillars model:

Provision of basic pension- antipoverty measure and minimum standard of living for

elderly

Forced contribution from income to a super scheme

Voluntary savings of individuals over and above second pillar


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In NZ there is no compulsory super savings

Singapores Central Provident Fund 3 accounts:

Ordinary account: can be used to buy a home, pay for insurance, investment and

education

Special account: For old age, contingency purposes and investment in old age related

financial products

Medisave account: hospital expenses and medical insurance

Aims:

Sufficient retirement savings

Property is fully owned before retirement

Sufficient savings to pay for medical costs in retirement

Types of super funds

Defined benefits plan Employer states benefits that employee will receive at retirement: flat dollar amount,

percentage of average salary over specified period or unit benefit formula

Difficult to administer and place investment risk on employer

Accumulation fund

Super fund that pays out the sum of the contributions made by the employee and the

earnings on those funds

Shift away from defined benefits plans to accumulation funds with growing risk to

employers of having to pay lifetime pensions to defined benefits plan holders with

increasing life expectancies Once employee has retired, super is paid out and no further obligation on employer

Self managed super fund

Funds with fewer than 5 members

Regulated by the ATO whilst other funds report to APRA

Advantages: control the individual has over their super investments, potentially lower cost

of running the fund relative to paying super fund managers

Disadvantages: costs, reporting requirements and time required to comply with

regulations

Public offer fund

Offer super products to the public, on commercial basis

One of the following:

Not a standard employer-sponsored fund

A standard employer sponsored fun that has some non-standard employer sponsored

members

A fund whose trustee has elected for it to become a public offer fund

Non-public offer fund

APRA regulated, not public offer and have greater than 4 members Include:


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Eligible rollover fund (ERF): fund eligible to receive benefits automatically rolled over

from other funds

Pooled superannuation trust (PSF): a trust in which assets of super funds, approved

deposit funds and other PSTs can only be invested

Approved deposit fund (ADF): can receive, hold and invest certain types of rollovers

until such funds are withdrawn or a condition of release is satisfied

Small APRA fund (SAF): a super fund managed by an approved trustee that is

regulated by APRA, less than 5 members

Self managed super fund (SMSF)- super fund regulated by ATO, less than 5

members

Corporate fund: company super fund, either non public or public offer. Largely non public

Industry funds: draw members from a range of employers across a single industry,

established under agreement between parties to an award. Traditionally non-public offer,

recently more becoming public offer

Public sector funds: Sponsoring employer is a government agency or business enterprise

that is majority government owned. Typically non-public offer

Retail fund: offer super products to public on a commercial for profit basis. Usually run

by large financial institutions

Small funds: < 5 members, include small APRA funds, single member approved deposit

and SMSFs

Regulation of superannuation

Responsibility of APRA- prudential supervision

ASIC- market integrity and consumer protection

Concessional rate of tax (15%) on super contributions- motivating factor for individuals to

invest in super

7. Cash management trusts

CMTs are managed funds that invest in wholesale money-market securities such as

short and medium term Commonwealth government securities, international government

securities and banking and corporate debt

Established in early 1980s: banks had interest rate controls imposed on them, limited

return to investors of cash savings CMTs could purchase securities in the wholesale markets and provide improved returns

Deregulation throughout 1980s CMTs lost competitive advantage as banks began to offer

products with higher interest rates

Public unit trusts

Governed by a trust deed

Units sold to investors, proceeds invested in accordance with guidelines in trust deed

Types:

Equity trusts

Fixed interest trusts Mortgage trusts

Property trusts


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Equity trusts

Invest in a range of equity stocks across a range of markets to form a portfolio

Some funds focus on: domestic stock, international stocks, industry stocks, firms in

particular stage in life cycle, high dividends, high growth potential

Fixed interest trusts

Invest in a range of securities with fixed rates of coupon interest: govt bonds etc

Mortgage trusts

Process of securitisation has allowed banks and other financial intermediaries to on sell

lending assets

Mortgage trusts are one of major purchasers

These trusts purchase a variety of mortgages and package them into a trust

Buy the rights to the principal and interest payments that you make on a loan from the

bank

Property trusts

A trust that pools the resources of investors to purchase commercial, industrial and retail

property with a view to generating both income and capital gains for investors

8. Hedge funds

Investment pools that use a combination of market philosophies and analytical

techniques to develop financial models that identify, evaluate and execute trading

decisions. Goal is to provide above market rates while substantially reducing the risk of

loss

Traditionally investing in long and short positions, buying stocks long and selling

borrowed shares short.

Growth in hedge funds fueled by need to manage risk and generate returns

Target absolute not relative rates of return

Hedge fund strategies

Domestic hedge strategies

Value and growth strategies. Tend to be short term

Managers select long and short positions through research

Global hedge strategies

Specialise in specific geographic regions

Global macro strategies

Based on shifts in global economies

Managers speculate on changes in countries economic policies and shifts in currency

and interest rates by the use of derivatives and leverage


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Market neutral strategies

Seeks to eliminate market risk by equally balancing long and short positions

Sector strategies

Invest long and short in specific sectors of the economy

Examples: technology companies, financial institutions, health care, utilities

Short selling

Sale of securities that are overvalued from either a technical or fundamental viewpoint.

Investor does not own shares sold but borrows them from a broker in the expectation that

the share price will fall and the shares may be bought later at a lower price to replace

those borrowed

Fixed income arbitrage

Taking long and short positions in bonds with the expectation that the yield spreads

between them will return to historical levels

Index arbitrage

Buying and selling a basket of stocks or other securities and taking a counter position in

index futures contracts to capture differences due to inefficiencies in the market

Closed-end fund arbitrage

Buys or sells a basket of stocks

Convertible arbitrage

The fund manager simultaneously goes long in the convertible securities and short in the

underlying equities of the same insurers

Event driven investing

Risk arbitrage: long position in the stock of a company being acquired in a merger. If the

takeover fails, this strategy may result in large losses because the target companys stockprice likely will return to its previous price

Distressed securities: invest in the securities of companies undergoing bankruptcy or

reorganisation: financial rather than operational distress

Special situations: take advantage of unusual events with a significant position in the

equity or debt of a firm. Depressed stocks, impending mergers or acquisitions or emerging

bad news that may temporarily cause a companys stock or bond price to decline

ECON 335 Mid Sem Notes

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