Chapter 2. Financial Intermediaries & Financial Innovation financial institutions role of financial intermediaries asset/liability management financial innovation

I. Financial Institutions provide financial services transforming financial assets (own one type, issue another type) trade financial assets create & sell assets on behalf of others investment advice & management

depository institutions acquire funds mostly from deposits nondepository institutions acquire funds from other sources

II. Role of Financial Intermediaries raise funds FOR direct investment their assets stock, bonds, loans raise funds BY indirect investment issue their own liabilities accept deposits, sell insurance policies sell mutual funds shares

indirect investments allow investors choice of desired maturity maturity intermediation diversification w/ small amount of capital lower transactions costs alternative payment mechanisms

III. Asset/liability Managment liabilties = claims on financial institution liabilities differ in the certainty about their amount and timing

Type I Liabilities timing and amount is certain fixed rate bank CD GIC (guaranteed investment contract) (principal and fixed interest payment due on specified date)

Type II Liabilities amount is certain, timing is not term life insurance policy (amount of policy is known, but timing of death is not)

Type III Liabilities amount not certain, but timing is variable rate bank CD (know the maturity date, but not size of interest payment)

Type IV Liabilities amount and timing uncertain auto insurance policy property insurance policy (how much is the damage? when will damage occur?)

type of liabilities issued determines the types of assets bought & held long-term or short-term? risk?

IV. Financial Innovation creation of new financial assets new ways to use financial assets dramatic in past 30 years

why does it happen? changing times/ new risks increased volatility in -- interest rates -- stock prices -- exchange rates led to development of derivatives

advances in technology rapid flow of information rapid calculation of risks and prices rapid trading competition among institutions for products for strategies

circumvent regulations, tax laws NOW accounts in 1970s “selling short against the box” sophistication of market professionals devise & use complex securities price complex securities

Asset securitization take individual loans pool them together issue & sell securities w/ cash flow back by the loan pool payments

old way: bank originates mortgage bank holds mortgage & collects payments until loan is paid new way: bank sells mortgage to Fannie Mae bank gets fee for servicing mortgage Fannie Mae issues securities

advantages bank capital not tied up in loans institutions specialize in part of process pool of loans is diversified (less risk) loans are more liquid easier to get cheaper to get