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

2. 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

3. 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?

4. 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?

5. 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

6. 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?

7. 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?

8. 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?

9. 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?

10. 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)

11. 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