1. Financial Intermediation and Innovation

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 Financing
Funds are either exchanged between the borrower and lender directly or via a financial institution.

4. Direct Financing
The 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 Financing
Private Placement The entire claim is sold to an individual investor or a small group of investors
Brokers and Dealers
Brokers – Serve as a matchmaker, bringing together the two sides
Dealers 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).

7. Direct Financing
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8. Problems w/o Financial Institutions
Monitoring is costly
Lack of Liquidity
Price 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 Financing
Private Placement
Brokers & Dealers
Investment Bankers
Surplus Funds
Households
Business
Government
Deficit Funds
Households
Business
Government

11. The roles of Financial Intermediation
Maturity and Denomination Intermediation
Maturity - 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
Diversification
The firm is able to change the risk characteristics of the claims.
For example a mutual fund
The size of the firm allows it to be more cost effective at producing this risk reduction .

14. The Roles of Intermediation
Information Cost Reduction
Specialization 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 mechanism
The 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 Function
Research and information provider (reduces information costs such as agency costs)
Economies of Scale (decreases transaction costs and information costs)
Asset – Transformation Function
Purchase 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 Policy
Credit Allocation
Intergenerational Transfer of Wealth

17. Special Roles played by FI’s
Economy - Wide Services
Information, Liquidity, Price risk reduction, Transaction cost and Maturity intermediation services
Institution Specific Services
Monetary 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 assets
Commercial Banks 45%
Mutual Funds 2%
Private Pension Funds 5%

19. Regulation
Given 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 Regulation
Monetary Policy Regulation
Promotion of “Fair” Competition
Credit Allocation Regulation
Consumer Protection Regulation
Investor Protection Regulation
Entry Regulation
We 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 SEC
Agencies responsible for Trading (NASD, CFTC etc)
Federal Reserve System
International Agencies (BIS and IBA)

22. Regulatory Dialectic
Regulation proceeds as a progression over time, basically a dialogue between the regulators and the institutions being regulated.

23. Fixed Income Markets
To 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 management
New 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 Instruments
Increase liquidity of the market attracts new investors and provides opportunities for borrowers
Risk Management Instruments
Reallocate financial risks to those willing and able to borrow them
Arbitraging Instruments
Allow investors and borrowers to take advantage of differences between markets

25. Reasons for Innovation
Increased volatility of interest rates
Advances in Technology
Greater sophistication among participants
Increased Competition
Globalization
Avoiding Regulation

26. Asset Securitization
Securitization 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 source
Ability to manage capital requirements
Provides Fee Income
Manage interest rate volatility
Benefits to investors
Increased Liquidity
Reduced Credit Risk
Benefits to Borrowers
Reduced 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 institution
Commercial Banks – Manage Spread Income
Insurance Firms – Mange Spread and timing of commitments
Pension Funds – cover futures obligations at the lowest possible cost
Investment 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 Deposit
Type II
Life Insurance
Type III
Floating Rate CD
Type IV
Pension
Obligations