financial intermediaries-ch 3-part i [compatibility mode]

CHAPTER 3

Financial intermediariesintermediaries

Financial Institutions

Functions of Financial Institutions� 1. Aids the flow of capital� 2. Credit allocation� 3. Provides economies of scale and scope� 4. Satisfies the needs of general public� 4. Satisfies the needs of general public� 5. Provides specialization and expertise� 6. Assists asset transformation� 7. Offers INTERMEDIATION

Intermediation� The process of transforming a secondary

security into a primary security by a financial institution.

� It relates to financial investments by savors

c a s h c a s h

S a v o r s F i n a n c ia l B o r r o w e r s

In s t i t u t i o n s

s e c o n d a r y p r im a r y

s e c u r i t ie s s e c u r i t ie s

Dis-intermediation

� The process of reversing or rejecting the transfer of funds into the financial institutions.

� This refers to the low deposit interest rates or high operating costs charge to customers.

Illustration of Disintermediation

� The removing of Middlemen� The dis- or re-channeling funds flow from the FI� Changing Role to the Servicing of Markets

� Security Investments� Security Investments� Mutual Funds� Insurance

Types of Intermediation

� 1. Liquidity� 2. Maturity� 3. Denomination� 4. Risk

Types of Financial Institutions

� By Banking Business Nature:� Banks� Non-Banks� Non-Finance� Non-Finance

� By Business Operations:

�Thrift type�Contractual type� Investment type� Investment type�Other type

Thrift-type Financial Institutions� Banks:

� Commercial Banks� Savings Banks� Investment Banks (Merchant Banks)� etc� etc

� Non-Banks:� Deposit-taking Company, Savings and Loan, Home

Loans, Building Society, � Credit Unions

Contract-type Financial Institutions� Insurance Companies:

� Life Insurance� Accident and Healthy Insurance

� Pension Funds:� Mandatory Providence Funds� Mandatory Providence Funds� Retirement Funds/Pension Funds

Investment-type Financial Institutions� Investment Companies:

� Closed-end Investment Companies - Investment Brokers

� Open-end Investment Companies - Mutual Funds/Unit TrustFunds/Unit Trust

� Real Estate Trust Investment Companies

Other Financial Institutions� Finance Companies� Factors Companies� Lease Companies� Mortgage Companies� Credit Card Companies� Non-finance Financial Institutions:

� General Electric, Ford Motors, Toyota Motors� wholesalers, Manufactures, Department Stores

Why Financial Institutions?� Fulfill economic goals� Reduce transaction and information costs� Provide liquidity� Prevent risks

As transmission of monetary policy� As transmission of monetary policy� Provide payment mechanism� Supply credit allocation

Analysis of Financial Institutions� 1. Transaction Costs� 2. Information Asymmetry -- Moral Hazard� 3. Financial Risks� 4. Financial Innovation

Financial Innovations:� Enhance Internal Control--� Planning, Control, and Administration� Tighten Asset Management and Quality

Modernized Operation System� Modernized Operation System� Strengthen Regulation and Monitoring

Duties of the Management of Financial Institutions� 1. Determining the optimal capital structure� Assets, Liabilities, and Capital� 2. Managing interest rate/currency/credit risks� 3. Electing/Pricing investments and liabilities� Maturity Matching, Profit Making� 4. Operating effectively � Information Processing� Communication Technology

Basic Concept -- Banking

�What is a Bank?�A bank is a financial intermediary which provides special types services relating to finance.services relating to finance.

�A bank is a company which carries on “banking business” with a valid banking license. (Banking Ordinance)

Banking BusinessBanking Ordinance� A. Receiving from the general public

money on current deposit, savings deposit or other similar account repayable on demand or within less than three months or at call or notice of less three months or at call or notice of less than three months;

� B Paying or collecting cheques drawn by orpaid in by customers.

Universal Definition of A Bank� A Bank is a licensed organization that � 1. Accepts Deposits from the general

public� 2. Grants Loans

Special Features of a Bank� 1. It is a regulated organization.� 2. It offers checking accounts (Demand

Deposit Accounts, or Current Accounts)� 3. It acts as payment mechanism.� 4. It can create money � 4. It can create money

Traditional Theory of the Role of BanksEight significant elements by Llewellyn (1998)

� information advantages,� imperfect information,� delegated monitoring,� control,� insurance role of banks,� commitment theories,� commitment theories,� regulatory subsidies and the special role of banks in the payment

systems.

� Banks solve problems associated with asymmetric informationbetween lenders: ex ante (adverse selection) and ex post (moralhazard) behavior of borrowers.

� With large investments in information technology and expertise, banksare able to evaluate a borrower’s credit worthiness and verify theborrower’s dealings at a lower cost than would individual savers.

Asymmetry Information: Adverse Selection and Moral Hazard

� Borrowers do not always provide all the information required.� Even if they do, not all information will be correct.

� Asymmetric information:� Banks face the problems of adverse selection and moral hazard.

� To alleviate adverse incentives (high interest ratesencouraging borrowers to undertake riskier activities), bankscan reduce the size of loans and may refuse loans to someencouraging borrowers to undertake riskier activities), bankscan reduce the size of loans and may refuse loans to someborrowers.

� Moral hazard arises as a result of changes in the two parties’incentives after entering into a contract such that the riskiness ofthe contract is altered. With bank close monitoring, borrowerswill not undertake to invest in more risky projects.

� Information asymmetries generate market imperfections

Delegated Monitoring� Contracts are necessarily incomplete

� borrowers need to be monitored to ensure maximumprobability that loaned funds will be repaid.

� Lending contracts are incomplete in that the value in largepart is determined by the behavior of the borrower after theissuance of the loan.

� Depositors delegate banks to monitor the behaviourof borrowers.

� Financial intermediaries act as delegated monitors ofdepositors to overcome problems of asymmetricinformation Diamond (1984)

Banks provide Liquidity

� Borrowers and lenders have different liquiditypreferences� banks pool funds together� banks rely on the law of averages to be

able to offer liquidity to their customers.able to offer liquidity to their customers.� The existence of banks can be derived from

the bank’s balance sheet.� liabilities side: banks accept deposits and in

turn provide transaction services,� asset side: banks issue loans, thereby

providing liquidity.

Small-Business Borrowers

� Small-business borrowers find bank lending importantbecause due to small size and relative opacity, fundingthrough public markets is virtual impossible.

� Banks build relationships with customers that give themvaluable information about their operations.valuable information about their operations.

� Enhanced bank-customer relationships help smallbusinesses access funding because the bank has gotspecial knowledge about the firm.

� In difficult times, e.g. economic recession, firms withstrong relationships with a bank are better able to obtainfinancing to endure the recession.

Payment System and Monetary Policy…

� ‘Payment and settlement systems are to economicactivity what roads are to traffic, necessary buttypically taken for granted unless they cause anaccident or bottlenecks develop’ Bank forInternational Settlements (1994).

� Banks administer payment systems which are core toan economy.an economy.

� Through payment system:� banks execute customers’ payment instructions by

transferring funds between their accounts.� customers receive payments and pay for the goods and

services by cheques, credit or debit cards or orders� funds to flow between individuals, retail business and

wholesale markets quickly and safely.� Banks are the transmission belt for Monetary Policy

Corrigan (1982)

Risk Pooling & Pricing…� Banks make riskier investments available through risk-

pooling mechanism.� risk averse investors focus in low-risk financial

instruments,� risk loving investors specialize in risk bearing assets.

� Riskier projects tend to yield higher returns than low-risk� Riskier projects tend to yield higher returns than low-riskprojects;� individuals might not want to take on much risk when

their available funds are too small to effectively insurethemselves.

� banks can offer this service at lower cost than saverscan manage individually.

� savers have access to economies of scale nototherwise available to them.

Risk Transformation…� With risk transformation borrowers’ promises are converted into

a single promise by the bank itself. � Depositors who hold the institutions’ liabilities must be able to

regard them as absolutely safe. � Banks’ loans inevitably bear some risk. � Banks’ ability to transform these risky assets into riskless � Banks’ ability to transform these risky assets into riskless

liabilities depends on several factors. � they control risk by incorporating an allowance for probable losses � they spread risk to guard against the probability that loans to some

customers or categories of customers will lead to unusually heavy losses.

� they ensure that their own capital is adequate to absorb any losses they may incur through a failure to control risk properly, adverse economic conditions, or concentration of lending in their portfolios.

Development Factorsin Financial Institutions� 1. Crossing Traditional Boundaries� 2. Global Competition� 3. New Opportunities� 4. Deregulation/Re-regulation

5. Corporate Restructuring� 5. Corporate Restructuring

The Development inBanking Industry

� 1. Institutionalization

� 2. Globalization

� 3. Securitization

Structural Change in Banking

� 1. Technological Change� 2. Regulation Change� 3. Economical Change - Interest Rate

FluctuationFluctuation� 4. Competition Induced Change� 5. Bank International Settlement

� Examples of Financial Innovations:� Negotiable Certificate Deposits� ZERO-Coupon Securities� Financial Futures� Negotiable Order of Withdrawal (NOW a/c)� Money Market Deposit Account (MMDA)� Euro-Dollar Deposits� Securitization

The Flow of Savings to Corporations

� The ultimate source of financing is individual’s savings

� Two forms of financing: internal and external� Internal-retained cash and selling new shares� External-loans and bondsExternal-loans and bonds

� Savings flow through financial markets (stock exchanges) and financial intermediaries (mutual funds, pension funds, insurance companies)

Financial MarketsFinancial market-a market where securities are

issued and traded� Securities – a traded financial assets (shares; bonds)� Shares-a proportion of ownership claim on the firm, with

no maturity� Bonds-debt securities issued by a company � Bonds-debt securities issued by a company

representing a obligation to investors to make regular interest payments and principal on a specified date in the future

� Stock market (stock exchange) is the most important financial market

� Stock market or equity market – trading own common equity (ordinary shares) of the firm

Financial Markets

� Primary market- market for sale of new issue of securities (shares, bonds); its organized in banks, brokerage co. (outside the exchange)

� Secondary market - market in which previously issued securities are traded among investors

� Secondary market: Stock exchange and OTC� Stock exchange-organized market for trading securities� OTC-over the counter market

Financial Markets

Primary OTC

Money

Primary

Markets

Secondary

Markets

OTC

Markets

Other Financial Markets� Fixed income market-market for debt securities

(bonds) � Capital market- market for long-term financing� Money market- market for short-term financing

(less than 1 year)� Foreign-exchange market- inter bank market

for trading foreign currencies� Commodities market- organized market for

trading commodities (corn, wheat, cotton, oil)� Derivatives market- organized market for

trading derivatives (options, futures, warrants, forwards, swaps)

Function of Financial Markets

� Financial markets channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”)

Improves economic efficiency� Improves economic efficiency

Function of Financial Markets Function of Financial Markets Function of Financial Markets

Segments of Financial Markets

1. Direct Finance• Borrowers borrow directly from lenders in

financial markets by selling securities (financial instruments) which are claims on the borrower’s future income or assets

• Securities are assets for the person who buys

Function of Financial Markets Function of Financial Markets

• Securities are assets for the person who buys them but they are liabilities for the individual or firm that sells (issues) them.

2. Indirect Finance• Borrowers borrow indirectly from lenders via

financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets

Direct Investing:�Direct Finance – Direct lending gives rise to direct

claims against borrowers.

Flow of funds(loans of spending power for an

Borrowers Lenders)

(loans of spending power for an agreed-upon period of time)

Primary Securities(stocks, bonds, notes, etc.,

evidencing direct claims against borrowers)

Indirect Investing:�Indirect Finance – Financial intermediation of funds.

Secondary Securities(indirect claims against ultimate

borrowers issued by financial intermediaries in the form of deposits, insurance policies,

Primary Securities(direct claims against

ultimate borrowers in the form of loan contracts,

Ultimate borrowers

Ultimate lenders

Flow of funds(loans of spending power)

Financial intermediaries(banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies,

pension funds)

deposits, insurance policies, retirement savings accounts, etc.)

form of loan contracts, stocks, bonds, notes, etc.)

Flow of funds(loans of spending power)

Importance of Financial Markets

� Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), allowing funds to move from people who lack productive investment opportunities to people who have them.

� Financial markets also improve the well-being of consumers, allowing them to time their purchases better.

Structure of Financial Markets

Different categorizations of financial markets� Debt and Equity Markets� Primary and Secondary Markets� Exchanges and Over-the-Counter Markets� Money and Capital Markets

Structure of Financial Markets

Debt and Equity Markets� A firm or an individual can obtain funds in a

financial market in two ways:1. To issue a debt instrument, such as a bond.

� A contractual agreement by the borrower to pay the � A contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made.

2. To issue equities, such as common stock� A claim to share in the net income (income after

expenses and taxes) and the assets of a business.

Structure of Financial Markets

Debt and Equity Markets

1. Debt Markets� Short-Term (maturity < 1 year)� Long-Term (maturity > 10 year)� Intermediate term (maturity in-between)� Intermediate term (maturity in-between)� Represented $41 trillion at the end of 2007.

2. Equity Markets� Pay dividends, in theory forever� Represents an ownership claim in the firm� Total value of all U.S. equity was $18 trillion at the

end of 2005.

Structure of Financial Markets

1. Primary Market� New security issues sold to initial buyers� Typically involves an investment bank who

underwrites the offering

2. Secondary MarketSecurities previously issued are bought � Securities previously issued are bought and sold

� Examples of stock markets include the NYSE and Nasdaq

� Involves both brokers and dealers � Brokers are agents of investors who match buyers with

sellers of securities� Dealers link buyers and sellers by buying and selling

securities at stated prices.

Structure of Financial Markets

Primary and Secondary Markets

� Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:

� Provide liquidity, making it easy to buy and sell the securities of the companies

� Establish a price for the securities

Structure of Financial Markets

We can further classify secondary markets as follows:

1. Exchanges� Trades conducted in central locations

(e.g., New York Stock Exchange, CBT)

2. Over-the-Counter Markets� Dealers at different locations buy and sell� Dealers are in computer contact and know

the prices set by one another� Best example is the market for Treasury

securities

Structure of Financial Markets

Money and Captial Markets

We can also further classify markets by the maturity of the securities:1. Money Market: Short-Term (maturity < 1 year) 2. Capital Market : Long-Term (maturity > 1 2. Capital Market : Long-Term (maturity > 1

year) plus equities

Internationalization of Financial Markets

The internationalization of markets is an important trend. The U.S. no longer dominates the world stage.

� International Bond Market� Foreign bonds

� Denominated in a foreign currency� Denominated in a foreign currency� Targeted at a foreign market� E.g. German automaker Porsche sells a bond in the U.S.

denominated in U.S. dollars.

� Eurobonds� Denominated in one currency, but sold in a different market� E.g. A bond denominated in U.S. Dollars sold in London

Internationalization of Financial Markets

� Eurocurrency Market� Foreign currency deposited outside of home country� Eurodollars are U.S. dollars deposited, in foreign

banks outside the U.S. (such as London) or in foreign branches of U.S. Banks.foreign branches of U.S. Banks.

� World Stock Markets� U.S. stock markets are no longer always the

largest—at one point, Japan's was larger

Financial Intermediaries

�Financial intermediaries- an organization that rises money from investors and provide financing for investors and provide financing for individuals, companies e t.c.�mutual funds,�pension funds,�insurance co.,� banks

Mutual Funds� Mutual funds- pools the savings of many investors

and invests in a portfolio of securities; � mutual funds offer investors low-cost diversification

and professional management;� Two types: Open-end funds and Close-end funds

funds pursue a wide variety of investment strategies � funds pursue a wide variety of investment strategies (only stocks, only bonds, only dot.com.co’s,high-tech growth stocks, mixture of stock and bonds “balanced” funds, funds of funds)

Pension Funds� Pension funds- investment plan set up by

employer (companies) for providing employees retirement� Defined contribution pension plan (a % of monthly

pay is contributed to a pension fund-partly by employer, partly by employee)employer, partly by employee)

� Defined benefit pension plan (the employer invest to the pension fund)

� Tax advantages� Macedonian experience

Other financial institutions� Insurance companies- sells insurance policies

and with cash finance companies

� Banks- collect deposits and lend money to individuals and companies (short term and long individuals and companies (short term and long term loans)

Function of Financial Intermediaries : Indirect Finance

Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman:the middleman:

• the intermediary obtains funds from savers

• the intermediary then makes loans/investments with borrowers

Function of FinancialIntermediaries : Indirect Finance

� This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers.

� More important source of finance than securities markets (such as stocks)securities markets (such as stocks)

� Needed because of transactions costs, risk sharing, and asymmetric information

Function of FinancialIntermediaries : Indirect FinanceTransaction Costs

� Transactions Costs: the time and money spent in carrying out financial transactions

1. Financial intermediaries make profits by reducing transactions costs reducing transactions costs

2. Reduce transactions costs by developing expertise and taking advantage of economies of scale

� Economies of scale: the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases.

Function of FinancialIntermediaries : Indirect FinanceTransaction Costs

• A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions

• For example:

1. Banks provide depositors with checking accounts that enable them to pay their bills easily

2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary

Function of FinancialIntermediaries : Indirect Finance Risk Sharing

� Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharingprocess known as risk sharing� FIs create and sell assets with lesser risk to one

party in order to buy assets with greater risk from another party

� This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors

Function of Financial Intermediaries : Indirect Finance

Risk Sharing

� Financial intermediaries also help by providing the means for individuals and businesses to diversifytheir asset holdings.

� Diversification: investing in a collection (portfolio) of � Diversification: investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets.

� Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.

Function of Financial Intermediaries : Indirect Finance

Asymmetric Information: Adverse Selection and Moral Hazard

� Another reason FIs exist is to reduce the impact of asymmetric information.

� One party lacks crucial information about another party, impacting decision-making.

� Lack of information creates problems in the financial system before the transaction is entered into (adverse selection) and after (moral hazard).

Function of Financial Intermediaries : Indirect Finance

Asymmetric Information: Adverse Selection and Moral Hazard� Adverse Selection

1. It is the problem created by asym. info. before transaction occurstransaction occurs

2. Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome- the bad credit risks- are the ones who most actively seek out a loan and are thus most likely to be selected.

Function of Financial Intermediaries : Indirect Finance

Asymmetric Information: Adverse Selection and Moral Hazard

� Moral Hazard1. It is the problem created by asym. info. after

transaction occurs2. In financial markets it is the risk (hazard) that the

borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, becuase they make it less likely that the loan will be paid back.

3. Moral hazard also leads to conflict of interest, in which one party in a financial contract has incentives to act in its own interest rather than in the interests of other party.

Function of Financial Intermediaries : Indirect Finance

Asymmetric Information: Adverse Selection and Moral Hazard

� Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits.

� Small savers provide their funds to the financial � Small savers provide their funds to the financial markets by lending these funds to a trustworthy intermediary, a bank.

� The bank then lends the funds out either by making loans or by buying securities.

� The financial intermediaries are better at screening out bad credit risk from good ones, and reduce losses due to adverse selection.

The Negative Consequences of Information Costs

The Negative Consequences of Information Costs 1. Adverse Selection: Lenders can’t distinguish good from bad

credit risks, which discourages transactions from taking place.Solutions include

Government-required information disclosurePrivate collection of information

The pledging of collateral to insure lenders against the borrower’s default Requiring borrowers to invest substantial resources of their ownRequiring borrowers to invest substantial resources of their own

2. Moral Hazard: Lenders can’t tell whether borrowers will do what they claim they will do with the borrowed resources; borrowers may take too many risks.Solutions include Forced reporting of managers to owners

Requiring managers to invest substantial resources of their own Covenants that restrict what borrowers can do with borrowed funds

Financial Intermediaries and Information Costs� The problems of adverse selection and moral

hazard make direct finance expensive and difficult to get.

� These drawbacks lead us immediately to indirect finance and the role of financial institutions.Much of the information that financial � Much of the information that financial intermediaries collect is used to reduce information costs and minimize the effects of adverse selection and moral hazard

Financial Intermediaries and Information Costs

� Screening and Certifying to Reduce Adverse Selection

� Monitoring to Reduce Moral Hazard

Types of Financial Intermediaries

Types of Financial Intermediaries

Depository Institutions

� Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts (savings and loan associations, mutual savings banks, and credit unions).savings banks, and credit unions).

� Commercial banks� Raise funds primarily by issuing checkable, savings, and

time deposits which are used to make commercial, consumer and mortgage loans

� Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios

Types of Financial Intermediaries

Contractual Savings Institutions (CSIs)

� All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.

� They tend to invest their funds in long-term � They tend to invest their funds in long-term securities such as corporate bonds, stocks and mortgages.

Types of Financial IntermediariesInvestment Intermediaries

� Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operationsoperations

� Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds

Types of Financial Intermediaries

� Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instrumentsmoney market instruments

� Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.