PRINCIPLES OF BANKING AND FINANCE

INTRODUCTION
WHY FINANCE?
 Finance is NOT about money
 Finance is about VALUE! Almost everything can be valued! The value doesn’t
come from money only!
 Value creation has two main aspects:
 Time
 Uncertainty
 FINANCE:
 Set of tools
 Way of thinking! (makes all your decisions more rational)

Finance – BEST APPLICABLE DECISION-MAKING SYSTEM

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WHY BANKING?
 Banking is about HOW?
 How to exploit your financial opportunities in the BEST way?
 Lend money or borrow money?
 How? Direct financing or through financial intermediaries?
 Which intermediary suits best? How to choose the best option available? (e.g. best interest
rates)
 Russian banking sector was in the top-10 countries around the world in terms of digital
banking technologies
 https://www2.deloitte.com/ru/ru/pages/research-center/articles/digital-banking-maturity-
2020.html
 New ecosystems and value added services:
 Commercial  Mobility  Public services 3

 Auxiliary services  Entertainment

SYLLABUS

Intro Part I: Finance Part II: Banking

 Functions of the  Capital Budgeting and  Role of financial
financial system Valuation intermediation
 Types of financial  Valuation of Fixed-  Risk management and
intermediaries Income Securities internal control in banks
 Financial instruments  Stock valuation  Regulation
 Market structures  Asset pricing theories  Financial Systems
Compared
 Efficient markets
 Crises

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HOW DOES THE LEARNING HAPPENS?

Your role is to be: My role is:

 HAPPY  To show you that finance is cool
 CURIOUS  To motivate you
 OPEN-MINDED  To show you WHY everything
 RESPONSIBLE works in the way it does

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TECHNICAL DETAILS
Prerequisites Reading
 Economics
 Corporate finance, Berk, J., DeMarzo, P.
 Maths & Statistics
 Financial institutions management : a
 Accounting risk management approach, Saunders,
A., Cornett, M. M.
 Desire to learn 
 Financial markets and institutions,
Mishkin, F. S., Eakins, S. G.

Grade
 Classwork 10% Team
 HAs 30%  Irina Dergunova
([email protected])
 Quizes 20%
 Veronika Chistotinova 6

 Final Exam 40%

INTRO

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FINANCIAL SYSTEM – A BIRD’S EYE VIEW

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FUNCTIONS OF THE FINANCIAL SYSTEM

1. Transfer funds from suppliers of funds to users of funds

 directly through financial markets or indirectly through financial intermediaries

2. Provide payment mechanisms (monetary function)

3. Help share risk
 Across time (e.g. save for your retirement)
 Across space (e.g. banks transfer some risks to other agents in the system)

4. Help agents adjust their portfolios

 to share risk (as in point 3)
 to speculate 9
INDIRECT VS DIRECT FINANCING
- markets where funds are moved
Financial markets from suppliers of capital to users
of capital who have investment
opportunities
securities
securities

securities
- financial claims
Suppliers of funds on the issuers’ Users of funds
future income
or assets

loans
deposits
- economic agents specialized in
- Indirect Financial intermediaries trading financial contracts (e.g.
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- Direct loans) and or securities
 FINANCIAL MARKETS (1/4)
The NATURE of financial securities traded

Primary Secondary
 New issues of securities are sold to initial  Securities that have been previously issued
buyers are resold
 Facilitates new financing to corporations  Provide liquidity to the financial asset and to
and government assist in determining prices for subsequent
issues
 Main players – investment banks, thus
markets are not well known to the public  Set the price of the securities based on
similar instruments traded
 NASDAQ, NYSE, LSE, AMEX

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 FINANCIAL MARKETS (2/4)
The MATURITY of financial securities traded

Money Capital
 Short-term debt instruments with maturity  Instruments with maturities of 1 year or more:
less than 1 year:  Long – term debt
 Overnight interbank loans  Stocks
 Commercial paper
 Main players:
 Repo and reverse repo transactions
 Pension funds & insurance companies
 Main players:
 Market is less liquid, more volatile
 Corporations and banks seeking to earn
interest on short – term surplus funds
 Market is more liquid, less volatile 12
 FINANCIAL MARKETS (3/4)
The FORMS of organization
Exchanges Over-the-counter (OTC) markets
 Buyers and sellers (through their brokers) meet in  Dealers at different locations have an inventory
one central location to conduct sales of securities, and are ready to buy or sell these
securities to anyone who accepts their price
 Strict requirements for listing
 OTC markets are less transparent and regulated
 Special institutions that organize trading. Provide
a set of institutional rules that govern trading and  A large fraction of bond and derivatives trading is
informational flows regarding that trading. This still done on OTC markets
type of exchange centralizes the communication
 Many wholesale funding markets such as the
of bid and ask prices to all direct market
interbank market are OTC
participants .
 US government bond market, OTC Markets Group
 NYSE, LSE
 https://www.youtube.com/watch?v=it5G8rZtT1k&
 https://www.nyse.com/why-nyse
feature=youtu.be 13
 FINANCIAL MARKETS (4/4)
FORMS of trade intermediation
Quote-driven Order-driven Brokered
 A dealer or market-maker  Buyers and sellers trade  Brokers perform a search
is on one side of every directly without role
trade intermediation
 They hold no inventories,
 Dealers hold an inventory  Buyers and sellers can as they don’t participate
of securities place various types of in the trade themselves
orders in the order book
 Dealers charge the Bid-  Brokers try to match
Ask spread  Various rules formalize the buyers and sellers
trading process
 Dealers also receive
commission on trades
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FINANCIAL INSTRUMENTS/ SECURITIES

1. Fixed Income instruments (bonds, notes and bills)

2. Equity instruments (stocks/shares)

3. Derivatives (options, forwards, futures, swaps) – out of

scope
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FIXED INCOME SECURITIES

Debt instruments promise the payment of given sums of money to the

investor according to a pre-specified schedule
 Usually pay periodic interests (coupons) until maturity
 At maturity, pay back the par value (also called face value or
principal)
 Some instruments have no maturity
 Coupons are usually based on an interest rate of the par value
 Examples: Bonds (>10 years), bills (<1year), notes (from 1 to 10 years)
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EQUITY

Equity represents claims to shares of the net income and assets of a firm
 No maturity
 The payment of dividends is a discretionary decision of the firm: (no fixed schedule
and no fixed amount)
 Equity holders are residual claimants to the firm (they get paid after debt holders)
 Equity claims are riskier than debt instruments
 Equity holders have ownership of the firm
 Equity holders can benefit from the increase in value of the firm

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TAXONOMY OF FINANCIAL INTERMEDIARIES

1.Depository institutions

2.Contractual Savings Institutions

3.Investment Intermediaries
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1. DEPOSITORY INSTITUTIONS

 Commercial Banks take (often) short-term deposits to

make (usually) long term loans
 the retail branches of VTB, Alfabank, etc.
 Saving and loans associations: historically focused on the
mortgage market (assets) and savings accounts
(liabilities)
 Credit unions: organized and owned by their members
(depositors)
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2. CONTRACTUAL SAVINGS INSTITUTIONS

Collect funds periodically on a contractual basis,

usually invest their funds in long-term securities (bonds,
stocks, mortgages)
 Insurance companies (e.g. Ingosstrakh, Allianz, etc.)
 Pension funds (e.g. CALPERS, SBER NPF, etc.)

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3. INVESTMENT INTERMEDIARIES

 Mutual funds pool resources from individuals and firms to

invest in securities
 Short-term (money market funds) or long term
 Specialized geographically or by asset class
 Open-end or closed-end
 Leveraged or not (most of them are not)
 E.g. Fidelity, Vanguard, etc.
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3. INVESTMENT INTERMEDIARIES

 Hedge funds pool funds from institutions or wealthy

individuals to invest often in more complex strategies
 Less regulated than mutual funds
 More leveraged
 Typically rely on wholesale funding
 E.g. Citadel, Man Group, AQR, etc.
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3. INVESTMENT INTERMEDIARIES

 Invesment banks help and advise corporations and

governments in:
 Underwriting stocks & bonds, IPO process
 Advisory (M&A, ways to raise capital)
 Wealth management
 Research
 Trading
 e.g. IB division of JP Morgan, VTB, BNP Paribas, SBER CIB, etc.
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3. INVESTMENT INTERMEDIARIES

 Securities firms assist in trading of existing securities

 Brokers match buyers and sellers against a fee
 Dealers help markets function by holding inventories of securities. They earn
the bid-ask spread the difference between the best ask and the best bid
 E.g. Trading arms of GS or Morgan Stanley, Charles Schwab, etc.

 The biggest “investment banks” comprise both investment banking activities

and brokerage and dealership activities
 Some universal banks have investment banking divisions alongside trading
and brokerage and commercial banking activities (e.g. Citigroup, Deutsche
Bank, etc.)
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INVESTMENT INTERMEDIARIES

Other intermediaries:
 Finance companies: (e.g. GE Capital, Ford Motor Credit)
 Offer sales financing, personal credit, and / or leasing
 Do not take deposits
 Raise funds by issuing short-term commercial paper and other longer-term debt on wholesale markets
 Private equity firms: (e.g. KKR)
 Pool resources from institutions and wealthy individuals
 Buy the equity of privately owned firms, or take publicly traded firms out of the market
 Often use leverage

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Thank you!

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