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  1. 1. Chapter 2. Financial Intermediaries & Financial Innovation <ul><li>financial institutions </li></ul><ul><li>role of financial intermediaries </li></ul><ul><li>asset/liability management </li></ul><ul><li>financial innovation </li></ul>
  2. 2. I. Financial Institutions <ul><li>provide financial services </li></ul><ul><ul><li>transforming financial assets </li></ul></ul><ul><ul><li>(own one type, issue another type) </li></ul></ul><ul><ul><li>trade financial assets </li></ul></ul><ul><ul><li>create & sell assets on behalf of others </li></ul></ul><ul><ul><li>investment advice & management </li></ul></ul>
  3. 3. <ul><li>depository institutions </li></ul><ul><ul><li>acquire funds mostly from deposits </li></ul></ul><ul><li>nondepository institutions </li></ul><ul><ul><li>acquire funds from other sources </li></ul></ul>
  4. 4. II. Role of Financial Intermediaries <ul><li>raise funds FOR direct investment </li></ul><ul><ul><li>their assets </li></ul></ul><ul><ul><li>stock, bonds, loans </li></ul></ul><ul><li>raise funds BY indirect investment </li></ul><ul><ul><li>issue their own liabilities </li></ul></ul><ul><ul><li>accept deposits, </li></ul></ul><ul><ul><li>sell insurance policies </li></ul></ul><ul><ul><li>sell mutual funds shares </li></ul></ul>
  5. 5. indirect investments allow investors <ul><li>choice of desired maturity </li></ul><ul><ul><li>maturity intermediation </li></ul></ul><ul><li>diversification w/ small amount of capital </li></ul><ul><li>lower transactions costs </li></ul><ul><li>alternative payment mechanisms </li></ul>
  6. 6. III. Asset/liability Managment <ul><li>liabilties = claims on financial institution </li></ul><ul><li>liabilities differ in the certainty about their amount and timing </li></ul>
  7. 7. Type I Liabilities <ul><li>timing and amount is certain </li></ul><ul><ul><li>fixed rate bank CD </li></ul></ul><ul><ul><li>GIC (guaranteed investment contract) </li></ul></ul><ul><ul><li>(principal and fixed interest payment due on specified date) </li></ul></ul>
  8. 8. Type II Liabilities <ul><li>amount is certain, timing is not </li></ul><ul><ul><li>term life insurance policy </li></ul></ul><ul><ul><li>(amount of policy is known, </li></ul></ul><ul><ul><li>but timing of death is not) </li></ul></ul>
  9. 9. Type III Liabilities <ul><li>amount not certain, but timing is </li></ul><ul><ul><li>variable rate bank CD </li></ul></ul><ul><ul><li>(know the maturity date, but not size of interest payment) </li></ul></ul>
  10. 10. Type IV Liabilities <ul><li>amount and timing uncertain </li></ul><ul><ul><li>auto insurance policy </li></ul></ul><ul><ul><li>property insurance policy </li></ul></ul><ul><ul><li>(how much is the damage? </li></ul></ul><ul><ul><li>when will damage occur?) </li></ul></ul>
  11. 11. <ul><li>type of liabilities issued determines the types of assets bought & held </li></ul><ul><ul><li>long-term or short-term? </li></ul></ul><ul><ul><li>risk? </li></ul></ul>
  12. 12. IV. Financial Innovation <ul><li>creation of new financial assets </li></ul><ul><li>new ways to use financial assets </li></ul><ul><li>dramatic in past 30 years </li></ul>
  13. 13. why does it happen? <ul><li>changing times/ new risks </li></ul><ul><ul><li>increased volatility in </li></ul></ul><ul><ul><li>-- interest rates </li></ul></ul><ul><ul><li>-- stock prices </li></ul></ul><ul><ul><li>-- exchange rates </li></ul></ul><ul><ul><li>led to development of derivatives </li></ul></ul>
  14. 14. <ul><li>advances in technology </li></ul><ul><ul><li>rapid flow of information </li></ul></ul><ul><ul><li>rapid calculation of risks and prices </li></ul></ul><ul><ul><li>rapid trading </li></ul></ul><ul><li>competition among institutions </li></ul><ul><ul><li>for products </li></ul></ul><ul><ul><li>for strategies </li></ul></ul>
  15. 15. <ul><li>circumvent regulations, tax laws </li></ul><ul><ul><li>NOW accounts in 1970s </li></ul></ul><ul><ul><li>“ selling short against the box” </li></ul></ul><ul><li>sophistication of market professionals </li></ul><ul><ul><li>devise & use complex securities </li></ul></ul><ul><ul><li>price complex securities </li></ul></ul>
  16. 16. Asset securitization <ul><li>take individual loans </li></ul><ul><li>pool them together </li></ul><ul><li>issue & sell securities w/ cash flow back by the loan pool payments </li></ul>
  17. 17. <ul><li>old way: </li></ul><ul><ul><li>bank originates mortgage </li></ul></ul><ul><ul><li>bank holds mortgage & collects payments until loan is paid </li></ul></ul><ul><li>new way: </li></ul><ul><ul><li>bank originates mortgage </li></ul></ul><ul><ul><li>bank sells mortgage to Fannie Mae </li></ul></ul><ul><ul><li>bank gets fee for servicing mortgage </li></ul></ul><ul><ul><li>Fannie Mae issues securities </li></ul></ul>
  18. 18. advantages <ul><li>bank capital not tied up in loans </li></ul><ul><li>institutions specialize in part of process </li></ul><ul><li>pool of loans is diversified (less risk) </li></ul><ul><li>loans are more liquid </li></ul><ul><ul><li>easier to get </li></ul></ul><ul><ul><li>cheaper to get </li></ul></ul>