CHAPTER 3

Financial intermediaries

Financial Institutions

Functions of Financial Institutions

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

cash S a v o rs F in a n c ia l

cash B o rro w e rs

In s titu tio n s se c o n d a ry p rim a r y s e c u r itie s s e c u r itie 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 Mutual Funds Insurance

Types of Intermediation
1. 2. 3. 4. Liquidity Maturity Denomination Risk

Types of Financial Institutions

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

By Business Operations:

Thrift type Contractual type Investment type Other type

Thrift-type Financial Institutions

Banks:
Commercial Banks Savings Banks Investment Banks (Merchant Banks) 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 Retirement Funds/Pension Funds

Investment-type Financial Institutions

Investment Companies:
Closed-end Investment Companies - Investment Brokers Open-end Investment Companies - Mutual Funds/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 Provide payment mechanism Supply credit allocation

Analysis of Financial Institutions

1. 2. 3. 4. Transaction Costs Information Asymmetry -- Moral Hazard Financial Risks Financial Innovation

Financial Innovations: Enhance Internal Control-Planning, Control, and Administration Tighten Asset Management and Quality 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. A bank is a company which carries on banking business with a valid banking license. (Banking Ordinance)

Banking Business
Banking 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 than three months; B Paying or collecting cheques drawn by or paid 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

Traditional Theory of the Role of Banks

Eight significant elements by Llewellyn (1998)
information advantages, imperfect information, delegated monitoring, control, insurance role of banks, commitment theories, regulatory subsidies and the special role of banks in the payment systems.

Banks solve problems associated with asymmetric information between lenders: ex ante (adverse selection) and ex post (moral hazard) behavior of borrowers. With large investments in information technology and expertise, banks are able to evaluate a borrowers credit worthiness and verify the borrowers 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 rates encouraging borrowers to undertake riskier activities), banks can reduce the size of loans and may refuse loans to some borrowers. Moral hazard arises as a result of changes in the two parties incentives after entering into a contract such that the riskiness of the contract is altered. With bank close monitoring, borrowers will 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 maximum probability that loaned funds will be repaid. Lending contracts are incomplete in that the value in large part is determined by the behavior of the borrower after the issuance of the loan.

Depositors delegate banks to monitor the behaviour of borrowers. Financial intermediaries act as delegated monitors of depositors to overcome problems of asymmetric information Diamond (1984)

Banks provide Liquidity

Borrowers and lenders have different liquidity preferences banks pool funds together banks rely on the law of averages to be able to offer liquidity to their customers. The existence of banks can be derived from the banks 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 important because due to small size and relative opacity, funding through public markets is virtual impossible. Banks build relationships with customers that give them valuable information about their operations. Enhanced bank-customer relationships help small businesses access funding because the bank has got special knowledge about the firm. In difficult times, e.g. economic recession, firms with strong relationships with a bank are better able to obtain financing to endure the recession.

Payment System and Monetary Policy

Payment and settlement systems are to economic activity what roads are to traffic, necessary but typically taken for granted unless they cause an accident or bottlenecks develop Bank for International Settlements (1994). Banks administer payment systems which are core to 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 riskpooling 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 projects; individuals might not want to take on much risk when their available funds are too small to effectively insure themselves. banks can offer this service at lower cost than savers can manage individually. savers have access to economies of scale not otherwise 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 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 Factors in Financial Institutions

1. 2. 3. 4. 5. Crossing Traditional Boundaries Global Competition New Opportunities Deregulation/Re-regulation Corporate Restructuring

The Development in Banking Industry

1. Institutionalization 2. Globalization 3. Securitization

Structural Change in Banking

1. Technological Change 2. Regulation Change 3. Economical Change - Interest Rate Fluctuation 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 individuals savings Two forms of financing: internal and external
Internal-retained cash and selling new shares External-loans and bonds

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

Financial Markets
Financial 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 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
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

Function of Financial Markets Function of Financial Markets

Segments of Financial Markets

Function of Financial Markets

1. Direct Finance
Borrowers borrow directly from lenders in financial markets by selling securities (financial instruments) which are claims on the borrowers future income or assets 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 borrowers future income or assets

Direct Investing:
Direct Finance Direct lending gives rise to direct claims against borrowers.
Flow of funds Borrowers
(loans of spending power for an agreed-upon period of time)

Lenders )

Primary Securities
(stocks, bonds, notes, etc., evidencing direct claims against borrowers)

Indirect Investing:
Indirect Finance Financial intermediation of funds.
Primary Securities
(direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes, etc.)

Secondary Securities
(indirect claims against ultimate borrowers issued by financial intermediaries in the form of deposits, insurance policies, retirement savings accounts, etc.)

Ultimate borrowers

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

Ultimate lenders

Flow of funds
(loans of spending power)

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 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) 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 Market

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 dont 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: Exchanges
Trades conducted in central locations (e.g., New York Stock Exchange, CBT)
2.

1.

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. 2.

Money Market: Short-Term (maturity < 1 year) 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 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.

World Stock Markets

U.S. stock markets are no longer always the largestat one point, Japan's was larger

Financial Intermediaries
Financial intermediaries- an organization that rises money from 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 (only stocks, only bonds, only dot.com.cos,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) 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 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 intermediary obtains funds from savers the intermediary then makes loans/investments with borrowers

Function of Financial Intermediaries : 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) Needed because of transactions costs, risk sharing, and asymmetric information

Function of Financial Intermediaries : Indirect Finance

Transaction Costs
Transactions Costs: the time and money spent in carrying out financial transactions
1. Financial intermediaries make profits by

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 Financial Intermediaries : Indirect Finance

Transaction Costs

A financial intermediarys 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. 2.

Banks provide depositors with checking accounts that enable them to pay their bills easily Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary

Function of Financial Intermediaries : Indirect Finance Risk Sharing

Another benefit made possible by the FIs low transaction costs is that they can help reduce the exposure of investors to risk, through a process 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 diversify their asset holdings. 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 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 Hazard
1. It is the problem created by asym. info. after

transaction occurs 2. In financial markets it is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lenders 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 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 cant distinguish good from bad credit risks, which discourages transactions from taking place. Solutions include
Government-required information disclosure Private collection of information The pledging of collateral to insure lenders against the borrowers default Requiring borrowers to invest substantial resources of their own

2. Moral Hazard: Lenders cant 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 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). 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 securities such as corporate bonds, stocks and mortgages.

Types of Financial Intermediaries

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