financial intermediaries

1. Chapter. 3
Why are financial intermediaries
special ?
• INTRODUCTION
– Why is there a need for financial markets
and institutions?
05/20/17 By Umair Rafique 1

2. By Umair Rafique 2
“It is the ability to foretell what is going to
happen tomorrow, next week, next month, and
next year. And to have the ability afterwards to
explain why it didn’t happen.”
Sir Winston Churchill
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3. By Umair Rafique 3
What are Financial
Intermediaries (FIs)?
• Financial Securities: contingent claims on future
cash flows – debt, equity, derivatives, hybrids.
• All firms’ liabilities & net worth are
predominately comprised of financial securities.
• But most firms hold real assets such as inventory,
plant & equipment, buildings.
• FIs’ assets are predominately comprised of
financial securities.
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4. By Umair Rafique 4
Transparent, Transluscent and Opaque FIsF in a n c ia l I n t e r m e d ia t io n : T h e F lo w o f F u n d s a n d P r im a r y S e c u r it ie s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s In s u r a n c e C o m p a n ie s F u n d s D e f ic it U n it s
B a n k s F u n d s D e f ic it U n it s
M u t u a l F u n d s F u n d s D e f ic it U n it s
U n d e r w r it e r s
In v e s t m e n t B a n k s
F u n d s D e f ic it U n it s
D e a l e r s F u n d s D e f ic it U n it s
B r o k e r s F u n d s D e f ic it U n it s
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5. By Umair Rafique 5
What Services Do FIs Provide?
• Information
• Liquidity
• Reduced Transaction Costs
• Transmission of Monetary Policy
• Credit Allocation
• Payment Services
• Intergenerational Wealth Transfer
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6. By Umair Rafique 6
FIs are the most regulated of all
firms.
• Safety and Soundness Regulation
– Deposit Insurance
• Monetary Policy Regulation
– Reserve Requirements
• Credit Allocation Regulation (eg., mortgages)
• Consumer Protection Regulation
– Community Reinvestment Act, Home Mortgage
Disclosure Act, Truth in Lending Protection
• Investor Protection Regulation
• Entry Regulation
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7. By Umair Rafique 7
Types of FIs
• Depository Institutions
• Insurance Companies
• Securities Firms and Investment Banks
• Mutual Funds
• Finance Companies
• Distinctions blurred by the Gramm-Leach-
Bliley Act of 1999 that created Financial
Holding Companies (FHCs).
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8. By Umair Rafique 8
Features Common to Most FIs
• High Amount of Financial Leverage
– Low equity/assets ratios. Capital requirements.
• Off-balance sheet items
– Contingent claims that under certain
circumstances may eventually become balance
sheet items (ex. Derivatives, commitments)
• Revenue: Interest Income & Fees
• Costs: Interest Expenses and Personnel
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9. By Umair Rafique 9
Depository Institutions
• Commercial Banks: accept deposits and make
loans to consumers and businesses.
– Money Center Banks: Citigroup, Bank of NY, Bank
One, Bankers Trust (Deutschebank), JP Morgan Chase
and HSBC Bank USA.
• Savings Associations (S&Ls)
– Qualified Thrift Lender (QTL) mortgages must exceed
65% of thrift’s assets.
• Savings Banks
– Use deposits to fund mortgages & other assets.
• Credit Unions
– Nonprofit mutually owned institutions (owned by
depositors).
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10. Chapt. 3 - Why are FI’s Special
• INTRODUCTION (Cont’d)
– A financial system that operates efficiently is
beneficial to the economy – such a system
will promote adequate capital formation for
economic growth, so that firms with the most
promising investment opportunities will
receive funds, and those with poor
opportunities will not.
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11. Chapt. 3- Why are FI’s Special
• INTRODUCTION (Cont’d)
– Imagine a world in which there are no
financial intermediaries. Businesses need
financing and individuals have savings to
hold either as cash or investments. The only
way an individual can invest in a business is
to place his funds directly with the business,
by buying stock, buying bonds, or making
some other type of loan.
05/20/17 By Umair Rafique 11

12. Chapt. 3- Why are FI’s Special
• INTRODUCTION (Cont’d)
– In our economy, there are two ways in which
funds can be transferred among savers and
borrowers:
• Direct financing
• Indirect financing
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13. By Umair Rafique 13
What are Financial
Intermediaries (FIs)?
• Financial Securities: contingent claims on future
cash flows – debt, equity, derivatives, hybrids.
• All firms’ liabilities & net worth are
predominately comprised of financial securities.
• But most firms hold real assets such as inventory,
plant & equipment, buildings.
• FIs’ assets are predominately comprised of
financial securities.
05/20/17

14. By Umair Rafique 14
Transparent, Transluscent and Opaque FIsF in a n c ia l I n t e r m e d ia t io n : T h e F lo w o f F u n d s a n d P r im a r y S e c u r it ie s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s
F u n d s S u r p l u s U n it s In s u r a n c e C o m p a n ie s F u n d s D e f ic it U n it s
B a n k s F u n d s D e f ic it U n it s
M u t u a l F u n d s F u n d s D e f ic it U n it s
U n d e r w r it e r s
In v e s t m e n t B a n k s
F u n d s D e f ic it U n it s
D e a l e r s F u n d s D e f ic it U n it s
B r o k e r s F u n d s D e f ic it U n it s
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15. By Umair Rafique 15
What Services Do FIs Provide?
• Information
• Liquidity
• Reduced Transaction Costs
• Transmission of Monetary Policy
• Credit Allocation
• Payment Services
• Intergenerational Wealth Transfer
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16. By Umair Rafique 16
FIs are the most regulated of all
firms.
• Safety and Soundness Regulation
– Deposit Insurance
• Monetary Policy Regulation
– Reserve Requirements
• Credit Allocation Regulation (eg., mortgages)
• Consumer Protection Regulation
– Community Reinvestment Act, Home Mortgage
Disclosure Act, Truth in Lending Protection
• Investor Protection Regulation
• Entry Regulatio
05/20/17

17. By Umair Rafique 17
Types of FIs
• Depository Institutions
• Insurance Companies
• Securities Firms and Investment Banks
• Mutual Funds
• Finance Companies
• Distinctions blurred by the Gramm-Leach-
Bliley Act of 1999 that created Financial
Holding Companies (FHCs).
05/20/17

18. By Umair Rafique 18
Features Common to Most FIs
• High Amount of Financial Leverage
– Low equity/assets ratios. Capital requirements.
• Off-balance sheet items
– Contingent claims that under certain
circumstances may eventually become balance
sheet items (ex. Derivatives, commitments)
• Revenue: Interest Income & Fees
• Costs: Interest Expenses and Personnel
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19. By Umair Rafique 19
Depository Institutions
• Commercial Banks: accept deposits and make
loans to consumers and businesses.
• Money Center Banks: Citigroup, Bank of NY,
BankOne, Bankers Trust (Deutschebank), JP
Morgan Chase and HSBC Bank USA.
• Savings Associations (S&Ls)
• Qualified Thrift Lender (QTL) mortgages must
exceed 65% of thrift’s assets.
• Savings Banks
• Use deposits to fund mortgages & other assets.
• Credit Unions
• Nonprofit mutually owned institutions (owned by
depositors).
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20. Chapt. 3- Why are FI’s Special
• INTRODUCTION (Cont’d)
• Indirect financing – a financial intermediary
helps transfer claims and funds between
savers and borrowers
• the main route for transferring funds
among savers and borrowers
• the financial institution borrows funds
from savers and then invests/lends to
borrowers
05/20/17 By Umair Rafique 20

21. Chapt. 3- Why are FI’s Special
• Broker Function/Direct Financing
• Brokers do not actually buy or sell
securities; they conduct transactions at
their clients’ requests. Brokers charge a
fee for their service.
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22. Chapt. 3 - Why are FI’s Special
• Broker Function/Direct Financing
• Dealers “make a market” in a particular
security by holding an inventory of the
security and standing ready to buy or sell
at stated “bid” and “ask” prices. Dealers
profit from the bid-ask spread, which is
the difference between the bid (the highest
price at which the dealer will buy) and the
ask (the lowest price at which the dealer
will sell).
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23. Chapt. 3 - Why are FI’s Special
• Broker Function/Direct Financing
• Investment bankers help those who need
funds to market newly created financial
claims.
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24. Chapt. 3- Why are FI’s Special
• Asset Transform /Indirect Financing
• Financial intermediaries transform financial
claims in ways that make them more
attractive to some investors. Financial
intermediaries purchase direct claims with
one set of characteristics from borrowers,
then transform these claims to ones with
different characteristics which they then sell
to savers.
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25. Chapt. 3 - Why are FI’s Special
• Benefits of Financial Intermediation
• reduction of asymmetric information
problem
• adverse selection problem
• agency costs
• monitoring costs
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26. Chapt. 3 - Why are FI’s Special
• Benefits of Fin Inter. (Cont’d)
• liquidity – consumers can hold liquid assets (such as
checking accounts), allowing consumers the benefit
of being able to make payments without incurring
large transaction costs associated with liquidating
an asset
• credit risk diversification – investment in a wide
variety of securities reduces risk; many individuals
cannot afford to diversify their portfolios
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27. Chapt. 3 - Why are FI’s Special
• Benefits of Fin Inter. (Cont’d)
• economies of scale and lowered transaction
costs
• maturity flexibility – convert the maturity of
a security to a maturity acceptable to
individual investors
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28. Chapt. 3 - Why are FI’s Special
• Other Benefits of Fin Inter.
• transmission of monetary policy
• credit allocation
• transfers across time/generations
• efficient payment services
• denomination divisibility – break down large
investments into affordable securities
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29. Chapt. 3 - Why are FI’s Special
• Government and Regulation
• Government is another party that affects
financial markets and institutions in three
ways:
• (1) as a borrower
• (2) as controller of the money supply;
and
• (3) as regulator of financial institutions
and markets.
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30. Chapt. 3 - Why are FI’s Special
• Regulation
• If the benefits described on the previous
page were lost, the impact on the economy
could be devastating.
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31. Chapt. 3 - Why are FI’s Special
• Regulation
• There are six types of regulation to enhance
the benefits of financial intermediaries.
• 1) Safety and soundness regulation, to
protect against the failure of financial
intermediaries.
• 2) Monetary policy regulation, to provide
stability to the economy.
• 3) Credit allocation regulation, to provide
credit to certain sectors of the economy.
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32. Chapt. 3 - Why are FI’s Special
• Regulation
• Six types of regulation (Cont’d).
• 4) Consumer protection regulation.
• 5) Investor protection regulation.
• 6) Entry and chartering regulation.
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33. Chapt. 3- Why are FI’s Special
• Brief History of Trends in Banking
• Late 1700s, early 1800s - attempts to
form a central bank
• 1830s to 1860s - unregulated "Wildcat
banking" era
• 1860s - formation of a national
banking system, but problems with
depressions and panics continue
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34. Chapt. 3 - Why are FI’s Special
• Brief History of Trends in Banking
• 1913 - Creation of the Federal Reserve
System for banks
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35. Chapt. 3 - Why are FI’s Special
• Brief History of Trends in Banking
• 1930s - The Great Depression - many
banks fail. Regulation of the banking
industry is increased with limits on
banking activities, monitoring of banking
institutions, and the institution of deposit
insurance to build confidence in the
banking industry. Investment and
commercial banking activities are
separated.
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36. Chapt. 3 - Why are FI’s Special
• Brief History of Trends in Banking
• 1950s through 1990s - growth in the
pension funds industry and then in the
investment (mutual funds) industry
means increased competition for
savers' funds.
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37. Chapt. 3 - Why are FI’s Special
• Brief History of Trends in Banking
• 1970s and 1980s - Thrift institutions (S&Ls
and mutual savings banks), hampered by
existing regulations, have trouble competing
with banks, especially under the pressure of
high inflation. Deregulation permits
financial institutions to compete for deposits
and make a wider range of investments.
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38. Chapt. 3 - Why are FI’s Special
• Brief History of Trends in Banking
• 1980s - Deregulation allows imprudent managers to
exploit the system and take risks, causing the
failure of many more savings and loans.
• Late 1980s and early 90s - Increased regulation to
limit risk-taking. Deposit insurance for the thrift
and banking industries is reorganized, and powers
of federal regulators to intervene when institutions
are failing are increased.
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39. Chapt. 3 - Why are FI’s Special
• Brief History of Trends in Banking
• 1994 and on - Deregulation permitting
increased branching as well as
broadening the scope of activities
carried on by financial institutions.
• As transactions costs fall, direct
transactions markets are evolving.
• Technological Innovation changes the
traditional structure of FI’s
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