1. The Nature of Financial
Intermediation
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2. The Economics of Financial
Intermediation
īŽ In a world of perfect financial markets
there would be no need for financial
intermediaries (middlemen) in the
process of lending and/or borrowing
īŽ Costless transactions
īŽ Securities can be purchased in any
denomination
īŽ Perfect information about the quality of
financial instruments
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3. Reasons for Financial
Intermediation
īŽ Transaction costs
īŽ Cost of bringing lender/borrower together
īŽ Reduced when financial intermediation is used
īŽ Relevant to smaller lenders/borrowers
īŽ Portfolio Diversification
īŽ Spread investments over larger number of securities and
reduce risk exposure
īŽ Option not available to small investors with limited funds
īŽ Mutual Fundsâpooling of funds from many investors and
purchase a portfolio of many different securities
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4. Reasons for Financial
Intermediation
īŽ Gathering of Information
īŽ Intermediaries are efficient at obtaining
information, evaluating credit risks, and are
specialists in production of information
īŽ Asymmetric Information
īŽ Adverse Selection
īŽ Moral Hazard
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5. Asymmetric Information
īŽ Buyers/sellers not equally informed about
product
īŽ Can be difficult to determine credit worthiness,
mainly for consumers and small businesses
īŽ Borrower knows more than lender about
borrowerâs future performance
īŽ Borrowers may understate risk
īŽ Asymmetric information is much less of a
problem for large businessesâmore publicly
available information
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6. Adverse Selection
īŽ Related to information about a business before a
bank makes a loan
īŽ Small businesses tend to represent themselves as
high quality
īŽ Banks know some are good and some are
bad, how to decide
īŽ Charge too high an interest, good credit companies look
elsewhereâleaves just bad credit risk companies
īŽ Charge too low interest, have more losses to bad companies
than profits on good companies
īŽ Market failureâBanker may decide not to lend money to
any small businesses
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7. Moral Hazard
īŽ Occurs after the loan is made
īŽ Taking risks works to owners
advantage, prompting owners to make
riskier decisions than normal
īŽ Owner may âhit the jackpotâ, however,
bank is not better off
īŽ From ownerâs perspective, a moderate loss
is same as huge lossâlimited liability
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8. The Evolution of Financial
Intermediaries in the US
īŽ The institutions are very dynamic and
have changed significantly over the
years
īŽ The relative importance of different types of
institutions and has changed from 1952 to
2002
īŽ WinnersâPension funds and mutual fund
īŽ LosersâDepository institutions (except credit
unions) and life insurance companies
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9. The Evolution of Financial
Intermediaries in the U.S.
īŽ Changes in relative importance caused by
īŽ Changes in regulations
īŽ Key financial and technological innovations
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10. 1950s and Early 1960s
īŽ Stable interest rates
īŽ Fed imposed ceilings on deposit rates
īŽ Little competition for short-term funds from
small savers
īŽ Many present day competitors had not
been developed
īŽ Therefore, large supply of cheap
money
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11. Mid 1960s
īŽ Growing economy meant increased demand
for loans
īŽ Percentages of bank loans to total assets
jumped from 45% in 1960 to nearly 60% in
1980
īŽ Challenge for banks was to find enough
deposits to satisfy loan demand
īŽ Interest rates became increasingly unstable
īŽ However, depository institutions still fell under
protection of Regulation Q
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12. Regulation Q
īŽ Glass-Steagall Banking Act of 1933.
īŽ Prohibited the payment of interest on
demand deposits.
īŽ Ceiling on the maximum rate
commercial banks can pay on time
deposits.
īŽ Intent was to promote stability by
removing competition.
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13. Consequences of Regulation
Q
īŽ Rising short-term interest rates meant depository
institutions could not match rates earned in money
market instruments such as T-bills and commercial
paper
īŽ Financial disintermediationâWealthy investors
and corporations took money from depository
institutions and placed in money market instruments
īŽ However, option was not opened to small investorâ
money market instruments were not sold in small
denominations
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14. Bank Reaction to Regulation
Q
īŽ In 1961 banks were permitted to offer
negotiable certificates of deposit (CDs)
in denominations of $100,000 not
subject to Regulation Q
īŽ In mid-1960s short-term rates became
more volatile and wealthy investors
switched from savings accounts to large
CDâs
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15. Money Market Mutual Fund
īŽ In 1971 Money Market mutual Funds were
developed and were a main cause in the
repeal of Regulation Q
īŽ Small investors pooled their funds to buy a
diversified portfolio of money market instruments
īŽ Some mutual funds offered limited checking
withdrawals
īŽ Small investors now had access to money market
interest rates in excess permitted by Regulation Q
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16. The Savings and Loan (S&L) Crisis
īŽ As interest rates rose in late 1970s,
small investors moved funds out of
banks and thrifts
īŽ Beginning of disaster for S&Ls since
they were dependent on small savers
for their funds
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17. The S&L Crisis
īŽ Depository Institutions Deregulation and
Monetary Control Act of 1980 and the
Garn-St. Germain Depository
Institutions Act of 1982
īŽ Dismantled Regulation Q
īŽ Permitted S&Ls (as well as other
depository institutions) to compete for
funds as money market rates soared
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18. Change in the Financial
Makeup of S&Ls
īŽ Most of their assets (fixed-rate residential
mortgages, 30 year) yielded very low returns
īŽ Interest paid on short-term money (competing
with mutual funds) was generally double the
rate of return on mortgages
īŽ Market value of mortgages held by S&Ls fell
as interest rates rose making the value of
assets less than value of liabilities
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19. The S&L Crisis
īŽ Since financial statements are based on historical costs, extent
of asset value loss was not recognized unless mortgage was
sold
īŽ Under the Garn-ST. Germain Act, S&Ls were permitted to invest
in higher yielding areas in which they had little expertise
(specifically junk bonds and oil loans)
īŽ Investors were not concerned because their deposits were
insured by Federal Savings and Loan Insurance Corporation
(FSLIC)
īŽ Result was an approximate $150 billion bail-outâpaid for by
taxpayers
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20. The Rise of Commercial
Paper
īŽ Financial disintermediation created
situation where corporations issued
large amounts of commercial paper
(short-term bonds) to investors moving
funds away from banks
īŽ This growth paralleled the growth in the
money market mutual funds
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21. The Rise of Commercial
Paper
īŽ Banks lost their largest and highest
quality borrowers to commercial paper
market
īŽ To compensate for this loss of quality
loans, banks started making loans to
less creditworthy customers and lesser
developed countries (LDCâs)
īŽ As a result, bank loan portfolios
became riskier in the end of 1980s
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22. The Evolution of Financial
Intermediaries
īŽ The increase in commercial paper was aided
by technological innovations
īŽ Computers and communication technology
permitted transactions at very low costs
īŽ Complicated modeling permitted financial
institutions to more accurately evaluate borrowers
âaddressed the asymmetric problem
īŽ Permitted banks to more effectively monitor
inventory and accounts receivable used as
collateral for loans
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23. The Institutionalization of
Financial Markets
īŽ Institutionalizationâmore and more funds
now flow indirectly into financial markets
through financial intermediaries rather than
directly from savers
īŽ These âinstitutional investorsâ have become
more important in financial markets relative to
individual investors
īŽ Easier for companies to distribute newly
issued securities via their investment bankers
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24. Reason for Growth of
Institutionalization
īŽ Growth of pension funds and mutual funds
īŽ Tax laws encourage additional pensions and
benefits rather than increased wages
īŽ Legislation created a number of new
alternatives to the traditional employer-
sponsored defined benefits plan, primarily the
defined contribution plan
īŽ IRAs
īŽ 403(b) and 401(k) plans
īŽ Growth of mutual funds resulting from the
alternative pension plansâMutual fund families
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25. The Transformation of
Traditional Banking
īŽ During 1970s & 80s banks extended
loans to riskier borrowers
īŽ Especially vulnerable to international
debt crisis during 1980s
īŽ Increased competition from other
financial institutions
īŽ Rise in the number of bank failures
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26. The Transformation of
Traditional Banking
īŽ Although banksâ share of the market has
declined, bank assets continue to increase
īŽ New innovation activities of banks are not
reflected on balance sheet
īŽ Trading in interest rates and currency swaps
īŽ Selling credit derivatives
īŽ Issuing credit guarantees
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27. The Transformation of
Traditional Banking
īŽ Banks still have a strong comparative
advantage in lending to individuals and small
businesses
īŽ Banks offer wide menu of services
īŽ Develop comprehensive relationshipsâeasier to
monitor borrowers and address problems
īŽ In 1999 the Gramm-Leach-Bliley Act
repealed the Glass-Steagall Act of 1933
permitting the merging of banks with many
other types of financial institutions.
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28. Financial Intermediaries: Assets,
Liabilities, and Management
īŽ Unlike a manufacturing company with real
assets, banks have only financial assets
īŽ Therefore, banks have financial claims on
both sides of the balance sheet
īŽ Credit Risks
īŽ Interest Rate Risks
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29. Credit Risks
īŽ Banks tend to hold assets to maturity
and expect a certain cash flow
īŽ Do not want borrowers to default on
loans
īŽ Need to monitor borrowers continuously
īŽ Charge quality customers lower interest
rate on loans
īŽ Detect possible default problems
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30. Interest Rate Risks
īŽ Banks are vulnerable to change in
interest rates
īŽ Want a positive spread between interest
earned on assets and cost of money
(liabilities)
īŽ Attempt to maintain an equal balance
between maturities of assets and liabilities
īŽ Adjustable rate on loans, mortgages,
etc. minimizes interest rate risks
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31. Balance Sheets of Depository
Institutions
īŽ All have deposits on the right-hand side
of balance sheet
īŽ Investments in assets tend to be short
term in maturity
īŽ Do face credit risk because they invest
heavily in nontraded private loans
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32. Balance Sheets of Non-
depository Financial
Intermediaries
īŽ Some experience credit risk associated with
nontraded financial claims
īŽ Asset maturities reflect the maturity of liabilities
īŽ Insurance and pension funds have long-term policies
and annuitiesâinvest in long-term instruments
īŽ Consumer and commercial finance companies have
assets in short-term nontraded loansâraise funds by
issuing short-term debt
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