2 Financial Intermediation At any point in time there are individuals in the economy with both a surplus and shortage of funds.For the economy to function efficiently it should be possible for those with a surplus to lend to those with a deficit.
3 Bringing Together Borrowers and Lenders Direct Financings vs. Indirect FinancingFunds are either exchanged between the borrower and lender directly or via a financial institution.
4 Direct FinancingThe direct exchange of money and financial claims between individuals with excess funds and individuals with a shortage of funds.The participant with a deficit issues a financial claim (a bond for example) purchased by the participant with a surplus of funds.
5 Direct FinancingPrivate Placement The entire claim is sold to an individual investor or a small group of investorsBrokers and DealersBrokers – Serve as a matchmaker, bringing together the two sidesDealers and Market Makers – Serve to both buy and sell (at different prices) a given security.
6 Direct Financing Investment Bankers Main role is helping those seeking funds market new claims.May purchase a claim directly then sell it off in pieces for a profit (close to intermediation).
8 Problems w/o Financial Institutions Monitoring is costlyLack of LiquidityPrice Risks
9 Indirect Financing (Intermediation) An intermediary transforms assets acquired through the market into a more widely preferred asset (which becomes their liability).The intermediary is then holding a direct claim in terms of their assets The participants holding the claims issued by the intermediary are said to have an indirect claim.
10 Direct FinancingPrivate PlacementBrokers & DealersInvestment BankersSurplus FundsHouseholdsBusinessGovernmentDeficit FundsHouseholdsBusinessGovernment
11 The roles of Financial Intermediation Maturity and Denomination IntermediationMaturity - The intermediary can produce assets of varying maturities.Denomination - Similarly the intermediaries can produce a wide variety of denominations in the new assets
12 Intermediation Examples Commercial Bank: Accept Deposits and uses the cash to make loans to other participants (both households and businesses)Mutual Fund Firm: Pooling Funds of individuals and uses them to buy a portfolio of securities – (Form of Denomination Intermediation)
13 The Roles of Intermediation DiversificationThe firm is able to change the risk characteristics of the claims.For example a mutual fundThe size of the firm allows it to be more cost effective at producing this risk reduction .
14 The Roles of Intermediation Information Cost ReductionSpecialization allows the intermediary to focus on investment analysis. This is a costly process for the individual. Another example is allowing a reduction in loan contracting costs.Providing a payment mechanismThe firms provide a means of non cash payment (checks, debit card etc…). The intermediaries also provide many claims that are highly liquid, allowing individuals to invest in less liquid assets indirectly.
15 Special Roles played by FI’s Brokerage FunctionResearch and information provider (reduces information costs such as agency costs)Economies of Scale (decreases transaction costs and information costs)Asset – Transformation FunctionPurchase primary claims and issue secondary claims backed by the primary claims (reducing contracting costs)Allows for risk sharing via diversification (reduces price and liquidity risk)
16 Special Roles played by FI’s Transmission of Monetary PolicyCredit AllocationIntergenerational Transfer of Wealth
17 Special Roles played by FI’s Economy - Wide ServicesInformation, Liquidity, Price risk reduction, Transaction cost and Maturity intermediation servicesInstitution Specific ServicesMonetary policy transmission (Depository Institutions)Credit allocation (Thrifts, Farm Banks)Intergenerational Transfers (Insurance and pensions)Payments services (Depository Institutions)Denomination Intermediation (Mutual Funds)
18 Approximate Share of total financial assets Trends over time.Intermediaries have traditionally played a key role in the financial markets –Can you think of any trends that may have been occurring in terms of the importance of different types of intermediaries?Approximate Share of total financial assetsCommercial Banks 45%Mutual Funds 2%Private Pension Funds 5%
19 RegulationGiven their vital role in the economy FI’s are highly regulated. The goal of this regulation is to protect against a disruption in the services they offer.Some segments of the population could be discriminated against without regulation (race, gender etc)The difference the private benefits and private costs of regulation is the net regulatory burden.
20 Justification of Regulation of FI’s Safety and Soundness RegulationMonetary Policy RegulationPromotion of “Fair” CompetitionCredit Allocation RegulationConsumer Protection RegulationInvestor Protection RegulationEntry RegulationWe will refer to these throughout the semester – Know them!
21 Forms of Regulation Disclosure Regulation Requires FI to make public financial information (decreases asymmetric information, and relies on efficient markets)Securities Act of 1933 and Securities Exchange Act of 1934 – Establishment of SECAgencies responsible for Trading (NASD, CFTC etc)Federal Reserve SystemInternational Agencies (BIS and IBA)
22 Regulatory DialecticRegulation proceeds as a progression over time, basically a dialogue between the regulators and the institutions being regulated.
23 Fixed Income MarketsTo provide the intermediary role, most of the financial institutions become active participants in the fixed income market.The market provides a source of funds and risk managementNew products have been developed that broaden the market, manage risk, and provide profit opportunities.
24 Trends in the Market Types of Financial Innovation Market Broadening InstrumentsIncrease liquidity of the market attracts new investors and provides opportunities for borrowersRisk Management InstrumentsReallocate financial risks to those willing and able to borrow themArbitraging InstrumentsAllow investors and borrowers to take advantage of differences between markets
25 Reasons for Innovation Increased volatility of interest ratesAdvances in TechnologyGreater sophistication among participantsIncreased CompetitionGlobalizationAvoiding Regulation
26 Asset SecuritizationSecuritization is the pooling and repackaging of loans so they have the characteristics of security instruments which enable them to be more easily resold.Creates both Maturity Intermediation and Denomination Intermediation.
27 Securitization Benefits to Issuers Benefits to investors Diversification – Broadens funding sourceAbility to manage capital requirementsProvides Fee IncomeManage interest rate volatilityBenefits to investorsIncreased LiquidityReduced Credit RiskBenefits to BorrowersReduced spreads
28 Asset / Liability Management in FI’s Liabilities – Determine the amount and timing of cash outflows that are made by the institution. The outflows satisfy the obligations issued by the institution as an intermediary.Examples include, coupon payments on a bond issued by the institution and interest payments on deposits (banks)Assets – Provide cash inflows for the institution.Examples include: loans made by the institutions (banks), investments in other assets, fee income, etc
29 The Asset / Liability Management Problem The type of issues associated with managing the firms in flow and outflow depends on the institutionCommercial Banks – Manage Spread IncomeInsurance Firms – Mange Spread and timing of commitmentsPension Funds – cover futures obligations at the lowest possible costInvestment companies – fee income
30 Liability and Liquidity The ability to meet obligations creates liquidity risk for financial institutions. Institutions need to have the cash available to meet their cash outflows.Management of short term cash flows is therefore a very important issue.One of the main determinants of a firm’s ability to mange liquidity is the size and timing of the cash out flows.
31 Liabilities Amount of Cash Outlay Timing of Example Type I Fixed Rate DepositType IILife InsuranceType IIIFloating Rate CDType IVPensionObligations