AK/ECON 3430 3.0 Money, Banking and Finance A Fall 2016 Topic 7B: Financial Intermediation Prof. Brenda Spotton Visano

Designing a Financial System Financial needs: payments system; short-term consumer and business credit; long-term consumer credit (mortgages) and business credit (capital investment); financial advice; portfolio diversification; retirement planning Financial System Structural Principles: Individual financial self-sufficiency? Specialization with Financial Brokers? Specialization with Financial Intermediaries? Economic benefits of an Intermediary: asset transformation may stimulate saving/investment enhanced information quality

Information Problems: Adverse Selection = Suppliers of funds (lenders, e.g.) have difficulty distinguishing the quality of the users of funds (borrowers, e.g.) Solutions? Pure competition? Collect your own information; lend at your own risk Lender requires collateral from the borrower? Lend only if borrower has own investment in the enterprise? Collectively require information disclosure, with standardized reporting?

Information Problems: Moral Hazard = Suppliers of funds (e.g., lenders) have difficulty monitoring borrowers risk-taking with borrowed funds in insurance = increase in the likelihood of the insured event happening Solutions? Pure competition? Collect your own information; lend at your own risk; charge higher insurance premia? Lend only if borrower has own investment in the enterprise? Collectively require information disclosure, with standardized reporting? Restrict what borrowers can do with funds?

Economic Contributions of FIs as Information Providers Offer bookkeeping services to clients Collect and assess information on potential investment or lender risks Create standardized ways of reporting information Offer specialized monitoring and credit rating services

Building a Financial Intermediary Financial Intermediary manages a portfolio of funds comprised of liabilities (sources of funds) and assets (uses of funds) for meeting (some of) financial needs How would/should the FI operate as the manager of that portfolio? What are its primary financial goals?

Creating a Financial Intermediary to meet the Need for a Payments and Credit System Suppose we create a specialist firm that takes deposits of circulating medium of exchange (gold, currency, e.g.) and lends out excess “money” The process of lending is the process of acquiring interest earning assets and “paying” for them by creating more chequable deposits – which act as additional medium of exchange Problem: which assets to acquire/which loans to make as a prudent portfolio manager? What are the risks? How much to loan out?

Managing the Firm’s Portfolio of Assets and Liabilities Portfolio Objectives: maximize return, minimize risk (liquidity or bankers’ risk, market risk, credit or default risk, and interest rate risk) Given that liabilities are highly liquid (convertible on demand into currency), how would you operate as the manager of this portfolio? What restrictions would you impose on yourself? Equity (Bank capital) restrictions? Asset restrictions?

Our “3430 Bank of Deposit” Are there any restrictions we might self-impose on our bank portfolio? What risks do we face? Which assets would we acquire? Which assets would we prohibit? What would be our loan to deposit ratio? (i.e., reserve ratio?) What equity (= bank capital = Assets - Liabilities) would we hold as a minimum? How does our bank portfolio compare with the bank portfolios of Canadian chartered banks?

Canada’s Solution to Household Financing Needs Financial Market/ Instruments Financial Intermediaries/ Financial Contracts Payments system   None Depository Institutions: Chartered Banks, Credit Unions / Currency, Deposit account balances Savings or borrowing opportunities short term for consumption smoothing Depository Institutions, Credit Card companies Savings Accounts, Lines of Credit, Credit Card balances Portfolio diversification opportunities longer term for retirement and asset growth  Stock Market / Exchange traded funds Pension Funds / Pension Fund Mutual Funds / Mutual Fund / RRSPs Financial advice and quality information about investments  Stock Exchange Financial Advisors, Securities Firms Mortgage financing house purchase Chartered Banks / Mortgages (Note: financial institutions may package and resell mortgages on secondary market)

Canada’s Solution to Non-financial Businesses Financing Needs Financial Market/ Instruments Financial Intermediaries/ Financial Contracts Payments system   None Depository Institutions: Chartered Banks, Credit Unions Currency, Deposit account balances Access to working/operating capital (short term funds for buying inputs to produce output for profit)  Money Market / Commercial Paper Depository Institutions / Lines of Credit Small business access to start-up financial capital Venture Capital Market /Venture Capital Funds Medium and large business access to (1) loans for physical capital investment in expanding business and (2) market for selling equity in company  Bond Market /Corporate Bonds Stock Market / Stocks Chartered Banks / Corporate Loans