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Financial Intermediation and

Financial Intermediaries



Q.:

1. Intermediation and Financial

Intermediaries, its Functions

2. Types of Financial Institutions



1. Intermediation and Financial

Intermediaries, its Functions� Financial intermediaries channel funds between

borrowers and lenders.

Intermediation transforming assets

± the function of transforming assets or liabilities into

other assets or liabilities

� Liabilities ± deposits

� Assets ± loans

± this is the principal activity of most financial

institutions.

± intermediation improves social welfare by

channeling resources to their most effective use.



The Functions of Intermediation

� Facilitate the acquisition/payment of goods

&services via lower transactions costs

± Chequing services provided by banks improve economic

efficiency.

� Facilitate the creation of a ³portfolio´

± A portfolio is a collection of financial assets

± The financial system provides economies of scale & scope

� Economies of Scope: cost savings that stem from engaging incomplementary activities.

� Economies of Scale: obtained when the unit cost of an

operation decreases as more of it is done.



� Ease liquidity constraints

± Reallocate consumption/savings patterns

� Often the liquidity required to make certain purchases is not in line

with the immediate flow of income available to individuals.

± The ability to influence the allocation of consumption and

investment is probably the most important function of

intermediation.

� Provide security

± Intermediation provides a host of services that reduce or shift

risk.

± Financial institutions can also influence the riskiness of financial transactions [contracts and insurance].



� Reduce asymmetric information problem

Asymmetric information can take on many forms, and is quite

complicated. However, to begin to understand the implicationsof asymmetric information, we will focus on two specific forms:

Adverse selection and Moral hazard

± Moral hazard

� the chance that an individual may have an incentive to act in away such as to put that individual at greater risk; the individualperceives as beneficial actions that are deemed undesirable byanother .

± Adverse selection

� decision making that results from the incentive for some peopleto engage in a transaction that is undesirable to everyone else

± Banks have a comparative advantage in offering specializedservices that help to reduce this problem.

± Banks can also take advantage of this asymmetricinformation problem, with dire consequences.



Adverse Selection

1.Before transaction occurs

2.Potential borrowers most likely toproduce adverse outcomes are onesmost likely to seek loans and be selected

Moral Hazard

1.After transaction occurs

2.Hazard that borrower has incentives toengage in undesirable (immoral)activities making it more likely that won¶tpay loan back

Financial intermediaries reduce adverse

selection and moral hazard problems, enabling

them to make profits



The Function of Financial Institutions

� Brokerage an ³agency´

function

± Brokers are agents who bring would-bebuyers and sellers together so transactions

can be made.

Intermediation provides value-added

but there are potential³externalities´. One intermediary¶s

actions can have consequences for

the entire system.



� Banks are particularly adept at

intermediation because they can

perform the necessary functions

more cheaply than most institutions.� Technological change and

deregulation have narrowed the

comparative advantage of banks.



Function of Financial Markets1. Allows transfers of funds from

person or business withoutinvestment opportunities to onewho has them

2. Improves economic efficiency



Indirect finance, which involves the activities

of financial intermediaries, is many times

more important than direct finance, in

which businesses raise funds directly

from lenders in financial markets.

Financial intermediaries, particularly banks,are the most important source of external

funds used to finance businesses.



2. Types of Financial Institutions

� Deposit-taking (depository institutions) accept and

manage deposits and make loans. These institutions

are divided into banks and other deposit-takinginstitutions (near-banks). Other deposit-taking

institutions:

± Trust companies ± also provide administrative services for

estates and trusts (fiduciaries).

± Credit unions ± these are member owned so that depositorsare also shareholders.

± Mortgage loan companies ± also permit investors to invest

in a portfolio of assets primarily real estate.



� Insurance Companies and Pension Funds

± Insurance companies provide the means of

channeling savings to provide for unforeseen

expenses by pooling the risks of their

clientele.

± There are also institutions that specialize in

the management of pension plans and funds. Government legislation plays are large role in

dictating how these pensions are

administered.



� Investment Dealers and Investment Funds

± The plethora of investment funds (mutual funds) pool funds for

investment in a wide range of activities and instruments without

providing the other functions of a typical bank

± Investment dealers primarily underwrite corporate andgovernment securities.

� Government financial institutions

± Deposit-taking role

± Channeling funds from the public to private sector

± Protecting private funds by providing deposit insurance (KDIF).

� Other Intermediaries

± Sales, finance, and consumer loan companies.



The ³Four-Pillars´

� Chartered banks: personal, commercial loans and

deposits

� Trust companies and credit unions: fiduciary

responsibilities, personal loans and deposits

� Insurance companies: underwriting insurance

contracts.

± Further subdivided into Life Insurers and Property and Casualty

Insurers

� Investment dealers: underwriting and brokering

securities.



16

Primary Assets and Liabilities of Financial Intermediaries



Regulation

Two Main Reasons for Regulation

1.Increase information to investorsA. Decreases adverse selection and moral hazard

problemsB. Securities commissions force corporations to

disclose information

2.Ensuring the soundness of financial

intermediariesA. Prevents financial panics

B. Chartering, reporting requirements, restrictionson assets and activities, deposit insurance, andanti-competitive measures



Key Points

� Intermediation is a central concept

� Financial institutions can be classifiedby type, size, function

� Financial markets can be classified bysize, term, organization, type of assetsissued

� Banks are the most adept at theintermediation function

� Financial systems should strive for efficiency



Case: Financial Development

andE

conomic Growth� Financial repression leads to low growth

� Why?

1. Poor legal system2. Weak accounting standards

3. Government directs credit (state-owned banks)

4. Financial institutions nationalized

5. Inadequate government regulation

� Financial Crises



Financial Crises and Aggregate

Economic Activity

Analysis of the affects of adverse selection

and moral hazard can also assist us in

understanding financial crises, major

disruptions in financial markets. Then end

result of most financial crises in the

inability of markets to channel funds from

savers to productive investmentopportunities.




Economic Activity

� Factors Causing Financial Crises

1. Increases in Interest Rates

2. Increases in Uncertainty

3. Asset Market Effects on Balance Sheets

� Stock market effects on net worth

� Unanticipated deflation� Cash flow effects




Economic Activity

� Factors Causing Financial Crises

4. Problems in the Banking Sector

5. Government Fiscal Imbalances

U.S. Financial Crisis

� The U.S. has a long history of banking

and financial crises, dating back to 1819. � The next figure outlines the events

leading to a financial crisis.



Case: The Great Depression

� In 1928 and 1929, stock prices doubled in

the U.S. The Fed tried to curb this period

of excessive speculation with a tight

monetary policy. But this lead to a

collapse of more than 60% in October of

1929.

� Further, between 1930 and 1933, one-third of U.S. banks went out of business.



Case: The Great Depression

� Adverse selection and moral hazard in

credit markets became severe. Firms with

productive uses of funds were unable to

get financing. The prolonged economic

contraction lead to an unemployment rate

around 25%.



Home task

1. Per capital income in the RK and the

developed countries (3-5 countries).

2.

Financial crises:description and factorsgenerated last crisis.

3. How financial crisis was reflected in

efficiency of financial intermediaries

activity?

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