TYPES OF FINANCIAL INTERMEDIARIES

In a modern economy we may distinguish four main types of units that participate in the economic process, always
remembering that the units as we find them in life are only approximations of the ideal types set up in a scheme of
classification: (1) households (as consumers and as suppliers of labor services); (2) business enterprises; (3) nonprofit
organizations; and (4) government.

Business enterprises as well as nonprofit and government organizations may be further subdivided according to the
nature of their predominant economic activity. For this study we need to consider only one of the many possible
subdivisions, that into financial and nonfinancial enterprises or organizations. This subdivision classes as financial
enterprises all economic units—business enterprises as well as nonprofit and government organizations—that are
primarily engaged in the holding of and trading in intangible assets (claims and equities).

Nonfinancial enterprises, of course, also hold intangible assets, e.g. cash and receivables, and have liabilities and equity
which of necessity always are classified as intangible. Conversely, financial enterprises own some tangible assets, at
least office equipment and often the buildings in which they operate and the land on which the buildings stand. The
differences between financial and nonfinancial enterprises are, nevertheless, fairly clear-cut in practice. The tangible
assets of financial enterprises almost always constitute only a very small proportion of their total assets. Although for
nonfinancial enterprises the share of intangibles in total assets is usually not negligible, and in many cases quite
substantial, the nature of operations usually permits the allocation of a specific enterprise to either the financial or the
nonfinancial category without unduly stretching the definition used here and without doing violence to current practices of
classification.

Financial intermediaries include most of the units falling within the classification of financial enterprises, but are not
identical with them. Financial intermediaries are taken to include all financial enterprises with the exception of two types:
(1) units whose assets consist predominantly of the securities of, or of claims against, wholly owned or majority-owned
subsidiaries and affiliates (holding companies); and (2) units owned by one or a small group of individuals, or by
corporations or nonprofit organizations, if they make no substantial use of outside funds; i.e. enterprises identical with or
similar to what are usually called personal holding companies.

A further distinction is sometimes helpful in analysis: that between primary and secondary financial intermediaries.
Primary financial intermediaries are those which draw their funds from households, business enterprises, or government
and make them available in turn to the same groups. Secondary financial intermediaries rely for most of their funds on
primary financial intermediaries, or use their own funds chiefly to acquire the securities of or claims against primary
financial intermediaries. Unçler this definition most financial intermediaries operating in the United States are primary. At
the present time the only important secondary financial intermediaries are sales finance, personal finance, factoring, and
mortgage companies, all of which obtain most of their funds from commercial banks. This group also includes some
governmental organizations financed by other government-owned financial intermediaries (e.g. Banks for Cooperatives
and Federal Intermediate Credit Banks) or which make most of their funds available to financial intermediaries (e.g.
Federal Home Loan Banks, whose assets consist mostly of loans to savings and loan associations). In the case of some
financial intermediaries, for example certain investment companies, a substantial proportion of assets consists of the
securities of other financial intermediaries. However, as long as these constitute the minority of total assets, the holders
may still be classified as primary financial intermediaries.

Further classification of the individual economic units that fall within the definition of financial intermediaries varies from
country to country, changes over time, and depends on the nature of financial intermediaries operating at a given time and
place, which in turn is greatly influenced by prevailing legal arrangements and financial customs. In the United States the
definition of financial intermediaries includes for the period with which this study deals the types of institutions listed
below, each of which is made up of individual units reasonably similar in the nature of their operations and in the character
of assets and liabilities. In presenting the statistical material in the rest of this study, several of these groups are further
subdivided, and a few are omitted from most parts of the study for lack of adequate data.

A. The Banking System

1. Federal Reserve Banks
2. Commercial banks
3. Savings banks
4. Postal savings system
B. Other depository organizations
1. Savings and loan associations
2. Credit unions
C. Insurance organizations
1. Private life insurance organizations (including fraternal and savings bank life insurance)
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 2. Private noninsured pension funds
3. Government insurance and pension funds
4. Property insurance companies
D. Other financial intermediaries
1. Investment companies (including investment-holding and installment investment companies)
2. Land banks
3. Mortgage companies
4. Finance companies (including sales finance, personal finance and factoring companies)
5. Security brokers and dealers
6. Government lending institutions
E. Personal trust departments (including common trust funds)

The above grouping of financial intermediaries into one to two dozen distinct types is a functional classification which has
become established by time. No such grouping, of course, is entirely satisfactory, and several other principles of
classification exist that are defensible from various points of view and are possibly preferable for purposes differing from
those of this study.

The first two groups of financial intermediaries bring together all those organizations which function primarily as
depositories of short-term funds of nonfinancial economic units (plus the Federal Reserve Banks). The right-hand side of
their balance sheet consists, apart from intra-group entries, primarily of short-term liabilities to households, nonfinancial
business enterprises and government and nonprofit organizations, liabilities which are regarded by the owners as being
ordinarily realizable at any time without delay and at a definitely known and unchanging face value. The separation of
intermediaries belonging to the banking system from other depositories is made more in deference to custom than as a
reflection of a genuine difference. One very important difference among the financial intermediaries in the two groups
exists, but it does not separate the banking system in a broad sense from other depositories. It rather distinguishes
between (1) those depositories which are able to create money (Federal Reserve Banks and checking departments of
commercial banks) and which thus in their lending and investment activities are to some extent freed (not individually but
as a group) from the limitations imposed by previous receipt of deposits; and (2) all other depositories, which are not able
to create money and thus are limited in their lending and investment activities to the receipt of deposits and the increase
in net worth.

The common feature of the financial intermediaries combined under the heading of insurance organizations is their
primary purpose, the provision of a specialized service—protection against specified risks in consideration for definite
payments by or for the account of the insured. Most of these organizations accumulate a considerable amount of funds in
performing their basic function, and the size of the funds is essentially determined by the nature of their insurance
contracts. In principle, and for the most part also in practice, the liabilities of insurance organizations are of a longterm
nature, falling due only in accordance with the terms of contract. Although part of the claims of the insured may be
liquidated before the originally stipulated time, the exercise of this right remains the exception rather than the rule and is
precluded for a large part of the total liabilities of this type, specifically those of government and private pension and
retirement funds. Thus, while the liabilities of insurance organizations to their policyholders may at some times acquire a
character close to that of short-term deposits, the actual nature of most of them remains quite different as is evidenced by
their much slower rate of turnover.

No similar unifying principle can be claimed for the financial intermediaries in group D. This indeed is a catch-all category.
It includes intermediaries, which finance themselves primarily by the issuance of their own securities (investment
companies and land banks), those which draw their funds for the most part from other financial intermediaries (mortgage
companies, finance companies, security brokers and dealers), and those which are financed directly by the government
and thus indirectly by the buyers of government securities.

Personal trust departments, finally, have been treated as a separate group because they administer assets on the basis of
a trustee relationship rather than, as do the other financial intermediaries, as debtors (or issuers of equity securities) who
invest what in law are their own funds.

Grouping of financial intermediaries is not a matter of great importance for the interpretation of the data. A word, however,
is necessary on the reasons for excluding from the study a few specific types of enterprises that might be regarded as
falling within the definition of financial intermediaries that was adopted.

1. Investment counsel organizations have been excluded, notwithstanding their similarity in some respects to the
personal trust departments of banks, because they generally do not have the power of independent action with
respect to the funds they administer but are limited to advising the beneficial owners. This factor alone might not
have been regarded as decisive—some of the trust funds administered by personal trust departments are subject
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 to similar limitations—but the absence of reliable data both on the total amount of funds administered by
investment counsel organizations and on their distribution (except for one rough estimate for the middle 1930's)'
made exclusion unavoidable.
2. Trustees other than banks and trust companies have been omitted for two reasons. First, many of them are
individuals who do not make a continuing and primary occupation of the activity, an argument perhaps not
decisive in the case of a limited number of law firms which specialize in this type of business and are reputedly of
substantial importance in some financial centers. Second, complete lack of data again forces exclusion,
irrespective of whether or not the basic definition used is interpreted as including nonbank trustees.
3. Also excluded were a few groups of financial organizations which are known or believed to be of relatively small
size or for which no satisfactory information was available. Commercial paper and discount houses, acceptance
dealers, and title guaranty companies belong to this category, although most of their assets consist of intangibles,
and their operations are not too different from those of some banks.
4. Pawnbrokers were omitted not only because of their relatively small importance and the limited information
available, but also because their operations combine trading in tangible assets with the holding of intangibles.
5. In excluding labor unions and foundations we are following usual practice. Notwithstanding that most of their
assets consist of intangibles; the exclusion can be justified by the subsidiary character of their financial operations
as compared with their activities in their main field of operation.
6. It is debatable whether the U.S. Treasury should be treated as a financial intermediary to the extent that it issues
metallic or paper currency. This has not been done here, primarily because the issuance of Treasury currency
has been regarded as an attribute of basic governmental power.

While accurate data about the size of the omitted organizations are generally lacking, it is safe to say that those that
should or could be included within the basic definition of financial intermediaries have throughout the period covered
by this study held assets amounting to only a small fraction of the assets of those included. The types of omitted
organizations that would fall under the basic definition adopted are known to be negligible in size and importance as
compared with the financial intermediaries covered by the study.

Goldsmith, R. W. (1958). Financial Intermediaries in the American Economy Since 1900. Cambridge,
Massachussetts: Princeton University Press.

DEFINITION OF FINANCIAL INTERMEDIARIES

A financial intermediary is a financial institution such as bank, building society, insurance company, and investment bank
or pension fund.

A financial intermediary offers a service to help an individual/ firm to save or borrow money. A financial intermediary helps
to facilitate the different needs of lenders and borrowers.

EXAMPLES OF FINANCIAL INTERMEDIARIES

1. Insurance Companies
If you have a risky investment, you might wish to insure, against the risk of default. Rather than trying to find a
particular individual to insure you, it is easier to go to an insurance company who can offer insurance and help
spread the risk of default.
2. Financial Advisers
A financial adviser doesn’t directly lend or borrow for you. They can offer specialist advice on your behalf. It saves
you understanding all the intricacies of the financial markets and spending time looking for best investment.
3. Credit Union
Credit unions are informal types of banks which provide facilities for lending and depositing within a particular
community.
4. Mutual funds/Investment trusts
These are mutual investment schemes. These pool the small savings of individual investors and enable a bigger
investment fund. Therefore, small investors can benefit from being part of a larger investment trust. This enables
small investors to benefit from smaller commission rates available to big purchases.

BENEFITS OF FINANCIAL INTERMEDIARIES

1. Lower search costs. You don’t have to find the right lenders; you leave that to a specialist.
2. Spreading risk. Rather than lending to just one individual, you can deposit money with a financial intermediary
who lends to a variety of borrowers – if one fails; you won’t lose all your funds.

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 3. Economies of scale. A bank can become efficient in collecting deposits, and lending. This enables economies of
scale – lower average costs. If you had to seek out your own saving, you might have to spend a lot of time and
effort to investigate best ways to save and borrow.
4. Convenience of Amounts. If you want to borrow £10,000 – it would be difficult to find someone who wanted to
lend exactly £10,000. But, a bank may have 1,000 people depositing £10 each. Therefore, the bank can lend you
the aggregate deposits from the bank and save you finding someone with the exact right sum.

POTENTIAL PROBLEMS OF FINANCIAL INTERMEDIARIES

1. No guarantee they will spread the risk. Due to poor management, they may risk depositors’ money on ill-
judged investment schemes.
2. Poor information. A financial intermediary may become complacent about spreading the risk and invest in
schemes which lose their depositors money (ex. banks buying US mortgage debt bundles, which proved to be
nearly worthless – precipitating the global credit crunch.)
3. Rely on liquidity and confidence. To be profitable, they may only keep reserves of 1% of their total deposits. If
people lose confidence in the banking system, there may be a run on the bank as depositors ask for their money
bank. But the bank won’t have sufficient liquidity because they can’t recall all their long-term loans. (This can be
overcome to some extent by a lender of last resort, such as the Central Bank and / or government)

Pettinger, T. (2016). Functions and Examples of Financial Intermediaries. Oxford, England: EconomicsHelp.org. Retrieved
18 January 2018, from https://www.economicshelp.org/blog/6318/economics/functions-and-examples-of-financial-
intermediaries/

EXAMPLES OF FINANCIAL INTERMEDIARIES

1. Commercial Banks
They act as intermediary between savers and users (investment) of funds.
2. Savings and Credit Associations
These are firms that take the funds of many savers and then give the money as a loan in form of mortgage and to
other types of borrowers. They provide credit analysis services.
3. Credit Unions
These are cooperative associations whose members have common bond e.g. employees of the same company. The
savings of the member are loaned only to the members at a very low interest rate e.g. SACCOS charge interest on
outstanding balance of loan.
4. Pension Funds
These are retirement schemes or plans funded by firms or government agencies for their workers. They are
administered mainly by the trust department of commercial banks or life insurance companies. Examples of pension
funds are NSSF, NHIF and other registered pension funds of individual firms.
5. Life Insurance Companies
These are firms that take savings in form of annual premium from individuals and them invest, these funds in
securities such as shares, bonds or in real assets. Savers will receive annuities in future.
6. Brokers
These are people who facilitate the exchange of securities by linking the buyer and the seller. They act on behalf of
members of public who are buying and selling shares of quoted companies.
7. Investment Bankers
These are institutions that buy new issue of securities for resale to other investors.
They perform the following functions:
1. Giving advice to the investors
2. Giving advice to firms which wants to
3. Valuation of firms which need to merge
4. Giving defensive tactics in case of forced takeover
5. Underwriting of securities.

https://www.businesswritingservices.org/business-finance/430-types-of-financial-intermediaries

TYPES OF FINANCIAL INTERMEDIARIES

1. Deposit-type institutions
Depository-type institutions are the most commonly used types of financial intermediaries because people use their
services on a daily basis. Depository institutions offer different types of checking or savings accounts and time
deposits. Depository Institutions use the deposits to make loans such as mortgages, consumer loans and business
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 loans. The deposits and interest paid on deposit accounts are insured by federally sponsored insurance agencies
and therefore are considered risk-free. These deposits are also highly liquid and can usually be withdrawn on
demand. Types of depository institutions are listed and briefly explained as follows.
a. Commercial Banks
Commercial Banks are the largest among all financial intermediaries and are also the most diversified due to
the large range of assets and liabilities they hold. Their liabilities are in the form of checking and savings
deposits, and various types of time deposits. Bank deposits are insured by the FDIC up to $100,000. The
assets that commercial banks hold are securities of various forms and denominations such as mortgage
loans, consumer loans, business loans and loans to state and local governments. Commercial banks are
among the most regulated forms of business due to their vital role in the well-being of the economy.
b. Thrift Institutions
Savings and loans associations and mutual savings banks are often called thrift institutions. Thrift institutions
offer checking and savings accounts and other various types of time-deposits and use these funds to
purchase long-term mortgages. Savings and loans are the largest residential mortgage lenders. Thrift
Institutions specialize in maturity intermediation since they take liquid deposits and lend the out in the form of
long-term collateralized loans. Thrift institution deposits are insured by the FDIC up to $100,000.
c. Credit Unions
Credit Unions are small non-profit depository institutions that are owned by their members who are also their
customers. Members of credit unions all have a common bond such as military service, occupation etc...
Credit union’s primary liabilities are checking deposits (share drafts) and savings accounts (share accounts)
and credit unions usually make their investments in the form of short-term installment consumer loans.
Deposits made to credit unions are insured by the FDIC up to $100,000. The most significant difference
between credit unions and commercial banks are the restrictions that most loans are made to consumers
only, the common bond requirement for members, the non-profit nature and the tax exemptions due to their
cooperative nature.

2. Contractual Savings Institutions

These are savings institutions that obtain their funds through long-term contractual arrangements and invest these
funds on the capital markets. Insurance companies and pension funds are contractual savings institutions. They
usually have a steady inflow of funds from their contractual arrangements therefore they usually don’t experience
difficulties with liquidity and can make long-term investments in securities such as bonds and sometimes common
stock.
a. Life Insurance Companies
Life insurance companies issues securities which are claims meant to protect individuals and families from
events such as premature death or early retirement. In the event of early death or retirement the
beneficiaries receive benefits that were promised in the contract. Many life insurance companies also offer
some savings to their policy holders. Since their cash-flows are predictable they are able to invest in long-
term securities that provide higher yields. Life Insurance companies are regulated by the states they operate
in unlike depository institution which are regulated by the federal government.
b. Casualty Insurance Companies
These types of insurance companies sell policies that protect individuals or businesses against loss of
property from fire, theft, accidents or other causes that can be predicted through statistical models. Casualty
insurance companies' primary source of funds comes from premiums charged to the policyholders. Unlike life
insurance companies, the cash outflows of casualty insurance companies are not as predictable; therefore
they invest their funds in short-term, highly marketable securities. Since short-term securities usually offer
lower returns, casualty insurance companies invest in higher risk securities such as stocks to earn higher
returns. To reduce taxes, casualty insurance companies often also invest in municipal bonds.
c. Pension Funds
Pension funds generally acquire funds from employer and employee contributions while the employee is still
working and provide the employee with payments during retirement. Pension funds usually invest funds in
corporate bonds and equities. Pension funds are beneficial to individuals because they help employees plan
and save for retirement. Because of the long-term investment nature, pension funds generally invest in long-
term, higher yield securities.

3. Investment Funds
a. Mutual Funds
Mutual funds pool together funds from investors and then build a portfolio consisting of equities and bonds.
The investors own shares which represent a portion of the mutual fund pie. The amount of shares an investor
owns is dependent on the amount of money he or she contributed. Mutual funds are beneficial to small
investors because they offer diversification, economies of scale for transaction costs, and professional

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 portfolio management. The value of a mutual fund’s share is not fixed; it fluctuates with the change in value
of the mutual fund's portfolio. Different mutual funds specialize in different sectors. Some mutual funds
specialize in high-risk growth stocks which are good for young and risk tolerant investors while others
specialize in income type securities which are better for older retired individuals who need income to pay for
their living expenses.
b. Money Market Mutual Funds
A money market mutual fund (MMMF) is simply a mutual fund that strictly invests its pool of funds in money
market securities which are short-term securities with low default-risk. These securities are usually sold in
denominations starting at $1-million therefore most investors don’t have enough money to purchase them
directly. MMMF’s offer small investors the opportunity to invest in these short-term securities without taking
on huge financial risks. MMMF’s generally allow investors to write checks and make withdraws making them
competitive with checking and savings accounts. However, there are usually limits on how many withdraws
can be made and the accounts are not insured.

4. Other Types of Financial Intermediaries

a. Finance Companies
Finance companies obtain most of their money by issuing commercial paper (short-term IOUs) to investors,
and the rest is obtained from the sale of equity capital and long-term debt obligations. Finance companies
then take this money and make loans to consumers and businesses. There are three basic types of finance
companies: (1) consumer finance companies which specialize in loans made to households, (2) business
finance companies which make loans and leases to businesses and (3) sales finance companies which
finance the items that are sold by retail stores. Finance companies are regulated by the states they operate
in but are also subject to regulation by the federal government.
b. Federal Agencies
The U.S. government acts as a financial intermediary through its agencies which take part in financial
intermediary type transactions. The goal of federal agencies is to reduce the costs of borrowing funds in
order to increase the flow of funds in certain sectors of the economy. Government agencies achieve this by
selling debt securities called agency securities and then lending the funds from the sale to the economic
sectors they serve. These agencies usually serve the housing sector and agriculture sector because many
argue that these sectors would not be able to obtain credit at a reasonable cost if the government did not
take direct intervention.

https://www.subjectmoney.com/definitiondisplay.php?word=A%20List%20and%20Explanation%20of%20Different%20Typ
es%20of%20Financial%20Intermediaries

THE NATURE OF FINANCIAL INTERMEDIATION

The Economics of Financial Intermediation
 In a world of perfect financial markets there would be no need for financial intermediaries (middlemen) in the
process of lending and/or borrowing
 Costless transactions
 Securities can be purchased in any denomination
 Perfect information about the quality of financial instruments
Reasons for Financial Intermediation
 Transaction costs
 Cost of bringing lender/borrower together
 Reduced when financial intermediation is used
 Relevant to smaller lenders/borrowers
 Portfolio Diversification
 Spread investments over larger number of securities and reduce risk exposure
 Option not available to small investors with limited funds
 Mutual Funds—pooling of funds from many investors and purchase a portfolio of many different
securities
 Gathering of Information
 Intermediaries are efficient at obtaining information, evaluating credit risks, and are specialists in
production of information
 Asymmetric Information
 Adverse Selection
 Moral Hazard
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Asymmetric Information
 Buyers/sellers not equally informed about product
 Can be difficult to determine credit worthiness, mainly for consumers and small businesses
 Borrower knows more than lender about borrower’s future performance
 Borrowers may understate risk
 Asymmetric information is much less of a problem for large businesses—more publicly available information
Adverse Selection
 Related to information about a business before a bank makes a loan
 Small businesses tend to represent themselves as high quality
 Banks know some are good and some are bad, how to decide
 Charge too high an interest, good credit companies look elsewhere—leaves just bad credit risk
companies
 Charge too low interest, have more losses to bad companies than profits on good companies
 Market failure—Banker may decide not to lend money to any small businesses
Moral Hazard
 Occurs after the loan is made
 Taking risks works to owners advantage, prompting owners to make riskier decisions than normal
 Owner may ―hit the jackpot‖, however, bank is not better off
 From owner’s perspective, a moderate loss is same as huge loss—limited liability
The Evolution of Financial Intermediaries in the US
 The institutions are very dynamic and have changed significantly over the years
 The relative importance of different types of institutions and has changed from 1952 to 2002
 Winners—Pension funds and mutual fund
 Losers—Depository institutions (except credit unions) and life insurance companies
 Changes in relative importance caused by
 Changes in regulations
 Key financial and technological innovations
1950s and Early 1960s
 Stable interest rates
 Fed imposed ceilings on deposit rates
 Little competition for short-term funds from small savers
 Many present day competitors had not been developed
 Therefore, large supply of cheap money
Mid 1960s
 Growing economy meant increased demand for loans
 Percentages of bank loans to total assets jumped from 45% in 1960 to nearly 60% in 1980
 Challenge for banks was to find enough deposits to satisfy loan demand
 Interest rates became increasingly unstable
 However, depository institutions still fell under protection of Regulation Q
Regulation Q
 Glass-Steagall Banking Act of 1933.
 Prohibited the payment of interest on demand deposits.
 Ceiling on the maximum rate commercial banks can pay on time deposits.
 Intent was to promote stability by removing competition.
Consequences of Regulation Q
 Rising short-term interest rates meant depository institutions could not match rates earned in money market
instruments such as T-bills and commercial paper
 Financial disintermediation—Wealthy investors and corporations took money from depository institutions and
placed in money market instruments
 However, option was not opened to small investor—money market instruments were not sold in small
denominations
Bank Reaction to Regulation Q
 In 1961 banks were permitted to offer negotiable certificates of deposit (CDs) in denominations of $100,000 not
subject to Regulation Q
 In mid-1960s short-term rates became more volatile and wealthy investors switched from savings accounts to
large CD’s
Money Market Mutual Fund
 In 1971 Money Market mutual Funds were developed and were a main cause in the repeal of Regulation Q
 Small investors pooled their funds to buy a diversified portfolio of money market instruments
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  Some mutual funds offered limited checking withdrawals
 Small investors now had access to money market interest rates in excess permitted by Regulation Q
The Savings and Loan (S&L) Crisis
 As interest rates rose in late 1970s, small investors moved funds out of banks and thrifts
 Beginning of disaster for S&Ls since they were dependent on small savers for their funds
The S&L Crisis
 Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Depository
Institutions Act of 1982
 Dismantled Regulation Q
 Permitted S&Ls (as well as other depository institutions) to compete for funds as money market rates
soared
Change in the Financial Makeup of S&Ls
 Most of their assets (fixed-rate residential mortgages, 30 year) yielded very low returns
 Interest paid on short-term money (competing with mutual funds) was generally double the rate of return on
mortgages
 Market value of mortgages held by S&Ls fell as interest rates rose making the value of assets less than value of
liabilities
The S&L Crisis
 Since financial statements are based on historical costs, extent of asset value loss was not recognized unless
mortgage was sold
 Under the Garn-ST. Germain Act, S&Ls were permitted to invest in higher yielding areas in which they had little
expertise (specifically junk bonds and oil loans)
 Investors were not concerned because their deposits were insured by Federal Savings and Loan Insurance
Corporation (FSLIC)
 Result was an approximate $150 billion bail-out—paid for by taxpayers
The Rise of Commercial Paper
 Financial disintermediation created situation where corporations issued large amounts of commercial paper
(short-term bonds) to investors moving funds away from banks
 This growth paralleled the growth in the money market mutual funds
 Banks lost their largest and highest quality borrowers to commercial paper market
 To compensate for this loss of quality loans, banks started making loans to less creditworthy customers and
lesser developed countries (LDC’s)
 As a result, bank loan portfolios became riskier in the end of 1980s
The Evolution of Financial Intermediaries
 The increase in commercial paper was aided by technological innovations
 Computers and communication technology permitted transactions at very low costs
 Complicated modeling permitted financial institutions to more accurately evaluate borrowers—addressed
the asymmetric problem
 Permitted banks to more effectively monitor inventory and accounts receivable used as collateral for
loans
The Institutionalization of Financial Markets
 Institutionalization—more and more funds now flow indirectly into financial markets through financial
intermediaries rather than directly from savers
 These ―institutional investors‖ have become more important in financial markets relative to individual investors
 Easier for companies to distribute newly issued securities via their investment bankers
Reason for Growth of Institutionalization
 Growth of pension funds and mutual funds
 Tax laws encourage additional pensions and benefits rather than increased wages
 Legislation created a number of new alternatives to the traditional employer-sponsored defined benefits plan,
primarily the defined contribution plan
 IRAs
 403(b) and 401(k) plans
 Growth of mutual funds resulting from the alternative pension plans—Mutual fund families
 The Transformation of Traditional Banking
 During 1970s & 80s banks extended loans to riskier borrowers
 Especially vulnerable to international debt crisis during 1980s
 Increased competition from other financial institutions
 Rise in the number of bank failures

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The Transformation of Traditional Banking
 Although banks’ share of the market has declined, bank assets continue to increase
 New innovation activities of banks are not reflected on balance sheet
 Trading in interest rates and currency swaps
 Selling credit derivatives
 Issuing credit guarantees
 Banks still have a strong comparative advantage in lending to individuals and small businesses
 Banks offer wide menu of services
 Develop comprehensive relationships—easier to monitor borrowers and address problems
 In 1999 the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933 permitting the merging of banks
with many other types of financial institutions.
Financial Intermediaries: Assets, Liabilities, and Management
 Unlike a manufacturing company with real assets, banks have only financial assets
 Therefore, banks have financial claims on both sides of the balance sheet
 Credit Risks
 Interest Rate Risks
Credit Risks
 Banks tend to hold assets to maturity and expect a certain cash flow
 Do not want borrowers to default on loans
 Need to monitor borrowers continuously
 Charge quality customers lower interest rate on loans
 Detect possible default problems
Interest Rate Risks
 Banks are vulnerable to change in interest rates
 Want a positive spread between interest earned on assets and cost of money (liabilities)
 Attempt to maintain an equal balance between maturities of assets and liabilities
 Adjustable rate on loans, mortgages, etc. minimizes interest rate risks
Balance Sheets of Depository Institutions
 All have deposits on the right-hand side of balance sheet
 Investments in assets tend to be short term in maturity
 Do face credit risk because they invest heavily in nontraded private loans
Balance Sheets of Non-depository Financial Intermediaries
 Some experience credit risk associated with nontraded financial claims
 Asset maturities reflect the maturity of liabilities
 Insurance and pension funds have long-term policies and annuities—invest in long-term instruments
 Consumer and commercial finance companies have assets in short-term non-traded loans—raise funds
by issuing short-term debt

9|FIN 107 MOJICA