1 Chapter 4 FINANCIAL INTERMEDIATION ©Thomson/South-Western 2006

2 The Economic Basis For Financial Intermediation Borrowers require money to get businesses started. Savers seek a place for their money to grow. Intermediators (either directly or indirectly) help both parties by getting the available money from savers to borrowers. Intermediaries Money B B B B B S S S S S

3 Risks and Costs in the Absence of Intermediation Asymmetric information: Borrowers have information about their activities and prospects that they do not disclose to lenders. Asymmetric information gives rise to two problems: adverse selection moral hazard

4 Risks and Costs in the Absence of Intermediation Adverse Selection Condition in which people who are most undesirable from the other party’s viewpoint are the ones most likely to seek to engage in a transaction. Moral Hazard R isk that one party to a transaction will undertake activities that are undesirable from the other’s party viewpoint.

5 How Intermediation Helps Financial intermediaries: have superior ability to deal with asymmetric information and the associated problems of adverse selection and moral hazard; specialize in assessing the credit risks of prospective borrowers; have access to such private information are better equipped to monitor borrowers’ activities after the loan is made.

6 Transactions Costs Transactions costs: money and time spent carrying out financial transactions Costs associated with asymmetric information By pooling funds, financial intermediaries can exploit economies of scale. By reducing transactions costs, financial intermediaries benefit both savers and deficit spenders.

7 Benefits of Intermediation Benefits to Savers From savers’ viewpoint, financial intermediaries pool thousands of individuals’ funds and can overcome certain obstacles that stop savers from purchasing primary claims directly. Allows individual savers to diversify

8 Benefits of Intermediation Benefits to Deficit Units From borrowers/spenders’ perspective, financial intermediaries broaden the range of instruments, denominations, and maturities that an institution is able to issue, borrowing costs  – borrowers can tailor instruments to best fit their needs.

9 Classification & Growth Of Financial Intermediaries Financial Intermediaries issue (secondary) claims against themselves to the public in order to obtain funds with which to purchase (primary) claims issued by deficit-spending units. Three categories: 1.depository institutions, 2.contractual savings institutions, 3.investment-type intermediaries.

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12 1. Depository Institutions Types 1.1 Commercial banks 1.2 Savings & loan associations 1.3 Mutual savings banks 1.4 Credit unions They: issue checking, savings, and time deposits; use the funds obtained to make various types of loans and to purchase securities. Deposits issued by these institutions have no market risk because the principal does not fluctuate in nominal value.

13 Figure 4-1

Commercial Banks. Commercial banks are the largest and most important of all financial intermediaries. Liabilities (sources of funds) demand deposits, savings accounts, time deposits. Assets (uses of funds) mortgages, government securities, business (commercial) loans, consumer loans

Savings & Loan Associations (S & Ls) S&Ls were first formed on the East Coast in the 1830s by groups of people seeking to foster home ownership. Individuals would pool their savings and make loans to a few members to finance the purchase of a few homes. The federal government established the Federal Housing Administration to insure mortgages, and to encourage the issue of amortized mortgages through S&Ls.

16 Other Institutions 1.3 Mutual Savings Banks (MSBs) encourage working class employees to save 1.4 Credit Unions (CUs) not-for-profits for members

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18 2. Contractual Savings Institutions 2.1 Insurance companies Life insurance Non-Life insurance 2.2 Private pension funds 2.3 State & local government retirement funds

Life Insurance Companies Life insurance companies: Issue policies to customers Collect premiums as a continuing source of funds Invest > two-thirds of the funds in corporate bonds and equities Typically regulated by the state insurance commissioner. Life insurance policies: have a specified cash surrender value--policyholders can obtain that cash on request.

Fire & Casualty Insurance Companies Fire and casualty insurance companies sell protection against loss resulting from fire, theft, accident, natural disaster, malpractice suits, and other events. They obtain funds from: premiums, retained earnings, and new stock share issues. Property losses are more difficult to predict, so fire and casualty companies’ assets must be more liquid than life insurance companies’ assets.

Private Pension Funds & Government Retirement Funds Pension funds manage portfolios more efficiently than individuals by providing: financial expertise, economies of scale, reduced transactions costs, and diversification.

Private Pension Funds & Government Retirement Funds The U.S. tax code encourages pension plans--income is nontaxable until retirement. Employers withhold the funds from workers' paychecks and send them to a pension fund. The retirement fund invests the contributions in corporate stocks, bonds and U.S. government bonds.

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24 3. Investment-Type Financial Intermediaries 3.1 Mutual funds 3.2 Finance companies 3.3 Money market mutual funds

25 3. Investment-Type Financial Intermediaries 3.1 Mutual funds Funds seek to maximize various goals (growth, income, etc.) Funds specialize in industries (tech, health, etc.) - Open-end: can sell shares back or buy more shares from to Mutual Fund NAV - No load fund: pay annual fee - Load fund: pay up-front fee - Close-end: sell shares in the market price

26 3. Investment-Type Financial Intermediaries 3.2 Finance companies sales finance companies consumer finance companies business finance companies 3.3 Money market mutual funds same as mutual funds but short-term invest in highly liquid assets

27 3. Investment-Type Financial Intermediaries These intermediaries provide: low transactions costs, the financial expertise & experience supplied by mutual fund management, increased diversification relative to that feasible for a typical individual.