Chapter 3: Investment Banks and Finance Companies

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Chapter 3 Investment Banks and Finance Companies

• Business 4039

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Question 3 - 1

• Contrast the balance sheet of banks with that of
  a typical investment bank.
• The assets of an investment dealer are far more
  liquid than those of a bank. Typically,
  investment dealers do not book assets to
  maturity, but maintain trading inventories in
  marketable securities.
• Banks invest in less liquid loans that, although
  they may be sold before maturity, are not public
  securities traded in deep and liquid markets.
• Investment dealers fund much of their inventories
  with repurchase agreements and call loans and
  take no deposits, while banks take deposits to
  fund most of their loans.
• Investment dealers also have liabilities for
  securities that they borrow to sell short as part
  of their normal market making activities.

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Question 3 - 2

• Contrast the business activities and culture of
  investments with those of depository FIs.
• This question can best be answered by simply
  reciting the contents of Table 3-3.
• You should be aware that these characteristics
  are a bit of a caricature. The trading culture
  of a foreign exchange trading room is really the
  same, whether it is in a bank or an investment
  bank. Back office functions of both institutions
  are roughly the same. As investment banks are
  merged into universal banks, there is a tendency
  for cultures to merge as well, with each
  organization resolving the differences in
  different ways.

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Question 3 - 3

• Distinguish between market making and trading
  activities of FIs.
• Market making is maintaining a secondary market
  in a marketable security (whether it be acting as
  a broker or a dealer) whereas trading is
  intentional position-taking in marketable
  securities for a profit.
• Often practitioners use the terms interchangeably.

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Question 3 - 4

• What is a repo and why is it important to
  investment dealers?
• A repo is a repurchase agreement, a short term
  loan collateralized by marketable securities,
  where the legal title to the collateral actually
  passes from the borrower to the lender during the
  term of the loan.
• Repos are important to investment dealers because
  they form a very cost-effective way of financing
  their inventories.

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Question 3 - 5

• What accounts for the rapid growth of finance
  companies in recent years?
• Finance companies have grown rapidly because they
  can provide many of the same services as
  regulated FIs without having to pay the same
  regulatory burden (eg., periodic filings,
  submission to inspections, restrictions of
  activities).
• They may also have niche expertise that allows
  them to price industry specific expertise that
  will allow it
• to price the equipment to be leased or financed
  against a lien more accurately, and
• to dispose of the equipment in the event of
  default with less loss than a bank.

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Question 3 - 6

• Why do finance companies have higher
  capital-assets ratios than other FIs even though
  they are unregulated?
• Finance companies must finance themselves in
  money and capital markets by issuance of
  commercial paper (finance company paper) and
  other notes. This paper has no guarantees and
  must have the highest credit ratings in order to
  be accepted by investors. That requires that
  comfortable cushions of capital be maintained.

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Question 3 - 7

• In terms of size, the government-owned FIs are
  generally not very important. Total assets of
  all four together are less than 47 billion
  (I.e., smaller than any of the Big Six). Both
  the CMHC and the EDC have had substantial
  guarantees and insurance outstanding.
• CMHC has about 200 billion, mainly backing NHA
  mortgages. Its guarantees underpin most of the
  mortgage-backed securities in Canada. The EDC
  has about 28 billion in guarantees and insurance
  outstanding, making it a large player in export
  finance.
• ...

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Question 3 - 7 ...

• In terms of role, each of the four provides
  subsidized financial services to a sector of the
  economy considered critical from a political
  perspective.
• CMHC helps first-time home buyers
• EDC helps exporters
• FCC helps farmers
• BDBC helps small businesses
• all sectors that substantial portions of the
  Canadian public feel have been under served by
  private sector FIs.

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Question 3 - 8

• Venture capital firms provide capital to young,
  privately owned firms with superior growth
  potential.
• A venture capitalist typically looks to a future
  initial public offering (IPO) in order to realize
  its return on investment.
• It generally takes several years between the
  injection of venture capital and the
  establishment of a successful track record by the
  young firm (assuming it succeeds) sufficiently
  credible to allow the firm to go public at a
  reasonable IPO price. During this period, the
  venture capitalist usually can not profitably
  sell its stake in the young firm to private
  investors either. This period of growth
  determines the longer investment horizon of the
  venture capitalist.